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Chapter 14: Question 16Q (page 752)

When is the stated interest rate of a debt instrument presumed to be fair?

Short Answer

Expert verified

The stated interest rate of a debt instrument is presumed to be fair except if:

  • The rate of interest is not stated.
  • The interest rate that is stated is not reasonable.
  • The face amount of the debt instrument is considerably different from the note鈥檚 current value.

Step by step solution

01

Meaning of Debt Instrument

A debt instrument refers to the financial instrument used by firms for obtaining capital. The users of the debt instrument can provide a loan to a firm with the agreement to repay it after the expiry of a certain period.

02

Conditions necessary for the stated interest rate of a debt instrument for presuming to be fair

If a bond is issued at par value and the risk is identical to the market risk, in this case, the stated interest rate on the bond should be similar to those being offered by the market. If it is identical, then the stated interest rate can be called as fair. However, in case the bond value is less than the par value and the risk involved is also high, then the bond should also provide a higher rate of interest and vice-versa.

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Most popular questions from this chapter

What are some forms of off-balance-sheet financing?

E14-2 (L01) (Classification) The following items are found in the financial statements.

(a) Discount on bonds payable.

(b) Interest expense (credit balance).

(c) Unamortized bond issue costs.

(d) Gain on repurchase of debt.

(e) Mortgage payable (payable in equal amounts over next 3 years).

(f) Debenture bonds payable (maturing in 5 years).

(g) Notes payable (due in 4 years).

(h) Premium on bonds payable.

(i) Bonds payable (due in 3 years).

Instructions

Indicate how each of these items should be classified in the financial statements.

Question: Zopf Company sells its bonds at a premium and applies the effective-interest method in amortizing the premium. Will the annual interest expense increase or decrease over the life of the bonds? Explain.

On April 1, 2017, Seminole Company sold 15,000 of its 11%, 15-year, \(1,000 face value bonds at 97. Interest payment dates are April 1 and October 1, and the company uses the straight-line method of bond discount amortization. On March 1, 2018, Seminole took advantage of favorable prices of its stock to extinguish 6,000 of the bonds by issuing 200,000 shares of its \)10 par value common stock. At this time, the accrued interest was paid in cash. The company鈥檚 stock was selling for $31 per share on March 1, 2018.

Instructions

Prepare the journal entries needed on the books of Seminole Company to record the following.

(a) April 1, 2017: issuance of the bonds.

(b) October 1, 2017: payment of semi-annual interest.

(c) December 31, 2017: accrual of interest expense.

(d) March 1, 2018: extinguishment of 6,000 bonds. (No reversing entries made.)

On January 1, 2017, Margaret Avery Co. borrowed and received $400,000 from a major customer evidenced by a zero-interest-bearing note due in 3 years. As consideration for the zero-interest-bearing feature, Avery agrees to supply the customer鈥檚 inventory needs for the loan period at lower than the market price. The appropriate rate at which to impute interest is 8%.

Instructions


(a) Prepare the journal entry to record the initial transaction on January 1, 2017. (Round all computations to the nearest dollar.)

(b) Prepare the journal entry to record any adjusting entries needed at December 31, 2017. Assume that the sales of Avery鈥檚 product to this customer occur evenly over the 3-year period.
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