On October 1, 2011, Master's Co. borrows $500,000 from its bank for five years at an annual interest rate of 10%. According to the terms of the loan, the principal amount will not be due for five years. Interest is to be paid monthly on the first day of each month, beginning November 1, 2011. With respect to this borrowing, Master's December 31, 2011, balance sheet included only a long-term note payable of $500,000. As a result:
A) The December 31, 2011, financial statements are accurate.
B) Liabilities are understated by $12,500 accrued interest payable.
C) Liabilities are understated by $4,167 accrued interest payable.
D) Liabilities are understated by the amount of interest for the five-year term of the note that has not yet been paid.

Question

Quizplus · Accepted Answer

Since interest is to be paid monthly and the first interest payment is due on November 1, 2011, only two months' worth of interest accrue in 2011 (November and December). Therefore, the accrued interest payable on December 31, 2011, would be $4,167 ($250,000 x 10% x 2/12). This means that the liabilities on the balance sheet are understated by $4,167, so the correct answer is C.