Question

On January 2, Year 4, Nast Co. issued 8% bonds with a face amount of $1 million that mature on January 2, Year 10. The bonds were issued to yield 12%, resulting in a discount of $150,000. Nast incorrectly used the straight-line method instead of the effective-interest method to amortize the discount. How is the carrying amount of the bonds affected by the error?
At Dec. 31, Year 4At Jan. 2, Year 10
A. Overstated
No effect
B. Understated
No effect
C. Understated
Overstated
D. Overstated
Understated

Answer 1

Answer:

Option A: [Overstated , No effect]

Explanation:

December 31, 20X1: Overstated; January 2, 20X7: No effect

Our term period is from January 2, Year 4 to January 2, Year 10.

$\therefore$  Total Term = 6 years.

The straight-line method uses a constant expense for the whole term, whereas, the effective-interest method uses a gradually increasing expense.

Let, us calculate the carrying amount with both approaches

After 1st Year:

Carrying amount on 2-Jan-Year1 = $1,000,000 - $150,000

Carrying amount on Year 1 = $850,000

Discount Amortization will be:

By Straight-Line Method = $150,000 / 6 yrs  

By Straight-Line Method = $25,000 / yr

By Effective-Interest Method = ($850,000 * 12%) - ($1,000,000 * 8%)

By Effective-Interest Method = $22,000

Carrying amount on 31-Jan-Year1:

By Straight-Line Method = $850,000 + $25,000

By Straight-Line Method = $875,000

By Effective-Interest Method = $850,000 + $22,000

By Effective-Interest Method = $872,000

Difference of carrying  value (Straight-line vs Effective Interest) will be obtained by subtracting.

$\therefore$  Difference in Carrying Value = $875,000 - $872,000

   Difference in Carrying Value = $3,000

Hence, for 1 Year period, straight-line method gives an overstatement as compared to effective-interest method.

After 6 Years:

For both approaches, the total carrying amounts at the term's end must be equal. As the same total discount amortization will occur under each method.

Hence, for 6 years period, use of any method will have no effect on the carrying amount.