Question

Jacobs Company issued bonds with a $178,000 face value on January 1, Year 1. The bonds were issued at 105 and carried a 5-year term to maturity. They had a 7% stated rate of interest that was payable in cash on December 31st of each year. Jacobs uses the straight-line method to amortize bond discounts and premiums. Based on this information alone, how does the recognition of interest expense during Year 1 affect the company’s accounting equation?

Multiple Choice

• Increase liabilities by $1,780, decrease assets by $10,680, and decrease equity by $12,460

• Decrease both assets and stockholders’ equity by $12,460

• Decrease both assets and stockholders’ equity by $10,680

• Decrease equity by $10,680, decrease liabilities by $1,780, and decrease assets by $12,460

Answer 1

Ans:Decrease equity by $10,680, decrease liabilities by $1,780, and decrease assets by $12,460.

Explanation:

Issue price of bond = 178,000 x 105%

= $186900

Premium on bonds payable = Issue price of bond - Face value of bond

= 186900-178000

= $8,900

Bond life = 5 years

Premium on bond payable to be amortized annually = Premium on bonds payable / Bond life

= 8,900/5

= $1,780

Annual interest payable on bonds = 178,000 x 7%

= $12,460

Hence, annual bond interest expense to be debited = Annual interest payable on bonds - Premium on bond payable to be amortized annually

= 12,460-1,780

= $10,680

Interest expense of $10,680, will decrease equity

Interest payment of $12,460, will decrease assets

Bond premium amortization of $1,780 will decrease liabilities.

First option is the right option.

Decrease equity by $10,680, decrease liabilities by $1,780, and decrease assets by $12,460.

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