Rikki Company received proceeds of $188000 on 10-year 6% bonds issued on January 1 2017. The bonds had a face value of $200000 pay interest annually on December 31 and have a call price of 101. Rikki uses the straight-line method of amortization. What is the amount of interest Rikki must pay the bondholders in 2017?

Question

Quizplus · Accepted Answer

The annual interest payment is calculated by multiplying the face value of the bond ($200,000) by the coupon rate (6%). Therefore, the annual interest payment is $12,000.

Since the bonds were issued at a discount (proceeds of $188,000 vs. face value of $200,000), Rikki must amortize the discount over the life of the bonds using the straight-line method. The total discount is $12,000 ($200,000 - $188,000) and since the bonds have a 10-year life, the annual amortization is $1,200 ($12,000 / 10 years).

Therefore, the total interest expense for 2017 is the sum of the annual interest payment ($12,000) and the annual amortization of the discount ($1,200), which equals $13,200. However, since the call price is 101, Rikki will likely call the bonds before they mature, so the actual interest expense for 2017 will be less than $13,200.

The closest option is B, $12,000. The annual interest on the bonds is calculated as the face value of the bonds multiplied by the stated interest rate, which is $200,000 x 6% = $12,000. 
Since the bonds were issued on January 1, 2017, Rikki must pay interest for the portion of the year that the bonds were outstanding, which is from January 1, 2017, to December 31, 2017, or 12/12 of the year. 
Using the straight-line method, the amount of bond discount that must be amortized each year is calculated by subtracting the bond's face value from the proceeds received and dividing by the term of the bonds. In this case, the bond discount is $12,000 ($200,000 face value - $188,000 proceeds received) divided by 10 years, or $1,200 per year. 
Therefore, the amount of interest expense that Rikki must recognize in 2017 is the sum of the annual interest payment of $12,000 plus the amortization of bond discount of $1,200, or $13,200. However, since the bond's call price is 101, Rikki must reduce the interest expense by the amount of the call premium that would be paid if the bonds were called. The call premium is equal to 101% of the face value, or $202,000 ($200,000 face value x 101%). Since the bonds are not yet callable, this adjustment is not necessary. 
Thus, the amount of interest Rikki must pay the bondholders in 2017 is $12,000.

Rikki Company Received Proceeds of $188000 on 10-Year 6% Bonds