Question

Use the following to answer questions 11 - 12 On September 1" the company borrows $100,000 from a local bank for nine months. A note is signed with principal and 4.5% interest to be paid when the note matures next year. A note payable was recognized on September 1" and no other entries regarding this transaction were made until December 31st. 11. $ In the adjusting entry recorded on December 31" determine the amount of interest expense that should be reported. 100,000 x .045 x 4 12. What effect would failure to record the adjusting entry for this note payable have on the financial statement items? A. would cause it to be overstated B. would cause it to be understated C. would have no effect Stockholders' Equity Assets С Liabilities 2 Revenue C Expenses Net income B A

Answer 1

11) Amount of interest expense for year-end adjustment = Amount borrowed x Interest rate x (# of months for which interest accrued / # of months in a year) Amount borrowed Interest rate Number of months for which interest accrued Number of months in a year Amount of interest expense for year-end adjustment $100,000 4.5% 4 (Time gap between Sept. 1 thru Dec. 31] 12 $1,500 ($100000 x 4.5% x (4/12)] 12) Interest expense is an expense item reported on income statement. So, if this adjusting entry is not recorded, expense will be under-stated which in turn will lead to over-statement of income for the reporting period concerned. On the other hand, adjusting entry will require a liability to be created for the interest expense accrued till the year end. If this adjusting entry is not recorded, liabilities will be understated. Assets с Liabilities SHs equity Revenue Expense Net Income в А C B A A - would cause it to be overstated; B - would cause it to be understated; C - would have no effect. NOTE: Net income will be finally closed to retained earnings at the year-end. As the retained earnings account is reported in stockholders' equity block on firm's balance sheet, when net income is overstated, it will obviously overstate the stockholders' equity balance also.