Kid Karate issued $100,000 of 6%, 10 year bonds when the market rate of interest was 5%. The proceeds from this bond issue were $107,000. Using the effective interest method of amortization, which of the following statements is true? Assume interest is paid annually.

Question

Quizplus · Accepted Answer

To answer this question, we need to understand the concepts of bond issuance, coupon rate, market rate, and the effective interest method of amortization.
Kid Karate issued $100,000 of 6%, 10-year bonds when the market rate of interest was 5%. The bonds were issued at a premium because the coupon rate (6%) is higher than the market rate (5%). The proceeds from this bond issue were $107,000, which means the premium is $7,000 ($107,000 - $100,000).
Now, let's address each statement:
a. Interest payments to bondholders each period will be $5,000.
This statement is incorrect. The interest payment is based on the face value of the bonds and the coupon rate. The annual interest payment is 6% of $100,000, which equals $6,000.
b. Interest payments to bondholders each period will be $5,350.
This statement is also incorrect. As calculated above, the annual interest payment is $6,000, not $5,350.
c. Amortization of the premium for the first interest period will be $5,000.
This statement is incorrect. The amortization of the premium is the process of gradually reducing the premium over the life of the bond. It is not equal to the entire premium or the interest payment.
d. Amortization of the premium for the first interest period will be $650.
To determine if this statement is correct, we need to calculate the amortization for the first period using the effective interest method. The effective interest expense for the first period is the market rate (5%) multiplied by the carrying amount of the bond at the beginning of the period. The carrying amount initially is the proceeds from the bond issue, which is $107,000.
Effective interest expense for the first period = Market rate × Carrying amount
Effective interest expense for the first period = 5% × $107,000
Effective interest expense for the first period = $5,350
The cash paid for interest is based on the coupon rate, which is $6,000. The difference between the cash paid and the effective interest expense is the amount of premium amortized in the first period.
Amortization of the premium for the first period = Cash paid for interest - Effective interest expense
Amortization of the premium for the first period = $6,000 - $5,350
Amortization of the premium for the first period = $650
Therefore, statement d is correct. The amortization of the premium for the first interest period will be $650.

Kid Karate Issued $100,000 of 6%, 10 Year Bonds When