Please see the answer explanation, as Im confused why the explanation would ADD amortization back into the discounted amount to find Carrying amount. Such as 850,000 + 25,000 = 875,000. I thought it would be subtraction, not addition.
On January 2, 20X1, Nast Co. issued 8% bonds with a face amount of $1,000,000 that mature on January 2, 20X7. 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?
A.
December 31, 20X1: Overstated; January 2, 20X7: Understated
B. correct**
December 31, 20X1: Overstated; January 2, 20X7: No effect
C.
December 31, 20X1: Understated; January 2, 20X7: Overstated
D.
December 31, 20X1: Understated; January 2, 20X7: No effect
Explanation
When the bond’s yield requires a discount, the bond’s interest expense is based (early on) on a lower principal, and thus the expense applying straight-line would be higher (it is an average expense for the term). The discount amortization would be too high for the first year (overstating bond carrying value), but under both methods at the end of the term, the carrying amounts will be the bond face amount.
Carrying amount on 1/2/X1 = $1,000,000 – $150,000 = $850,000
Amortization of discount:
Using straight-line = $150,000 / 6 yrs
= $25,000 / yr.
Using effective interest = (0.12 x $850,000) – (.08 x $1,000,000)
= $22,000
Carrying amount on 12/31/X1:
Using straight-line = $850,000 + $25,000
= $875,000
Using effective interest = $850,000 + $22,000
= $872,000
Overstatement of carrying
value when using straight-line = $875,000 – $872,000
= $3,000
Over the 6-year life of the bonds, the same total discount amortization will occur under each method. The bond carrying amount on January 2, 20X7, will be the maturity value regardless of the amortization method.
Thus, on December 31, 20X1, the bond carrying value will be overstated if straight-line amortization of discount is used but on January 2, 20X7, there will be no effect from its use.
.