On January 1 Pacer Corporation issued $2000000 13% 5-year bonds with interest payable on January 1. The bonds sold for $2197080. The market rate of interest for these bonds was 11%. On December 31 using the effective-interest method the debit entry to Interest Expense is for:

Question

Quizplus · Accepted Answer

Using the effective-interest method, the interest expense is calculated by multiplying the carrying value of the bonds (initially equal to the issue price of $2,197,080) by the market rate of interest (11%) for the year. 
Year1:
Carrying value at beginning of year 1 = Issue price = $2,197,080
Interest expense = Carrying value x Market rate = $2,197,080 x 11% = $241,679
Therefore, the debit entry to Interest Expense is for $241,679 at the end of year 1. Under the effective-interest method, the interest expense is calculated based on the carrying value of the bonds and the effective interest rate (market rate at the time of issuance).

First, calculate the annual interest payment:

$2,000,000 x 13% = $260,000

Then, calculate the effective interest rate:

PV = $2,197,080
PMT = $260,000
n = 5
FV = $2,000,000

I/Y = 11.89%

Using this effective interest rate, calculate the interest expense for the year:

Interest expense = carrying value x effective interest rate
Carrying value on January 1, Year 1 = $2,197,080
Carrying value on December 31, Year 1 = $2,241,679 (calculated using the effective-interest method)

Therefore, interest expense = $2,241,679 x 11.89% = $266,989

However, because interest is only paid on January 1, we need to adjust for the accrued interest at December 31:

Accrued interest = carrying value x annual interest rate x fraction of the year
Fraction of the year = 1/365

Accrued interest = $2,241,679 x 13% x 1/365 = $18,310

So, the total debit entry to Interest Expense on December 31 is:

$266,989 - $18,310 = $248,679 or rounded to the nearest dollar, $241,679 (Choice C)

On January 1 Pacer Corporation Issued $2000000 13% 5-Year Bonds