BACKGROUND: Chapter 10 discusses acquisition of property, plant and equipment and related issues, including the capitalization of Interest. To successfully calculate actual interest and record the journal entry necessary in Step D of the interest capitalization process outlined in your course packet. you first have to be comfortable with the recognition of interest expense in various scenarios There are two issues to think about when recognizing interest expense: 1. How much total interest expense should be recognized on the income Statement during the current period? This determines the debit side of the entry 2. How much of that interest expense will be paid in the current period and how much will be accrued at year end? This determines whether the credit side of entry is to Cash or Interest Payable. For example, assume that ABC Inc. borrowed $100,000 at 6% on June 1, 2011. Interest is payabile annually on May 31, To determine how much interest expense should be recognized on the income Statement, it can be helpful to use a timeline to determine the proper entries. The loan is outstanding beginning June 1, 2011, so that is the first month we begin to accrue Interest. The interest rate given is always an annual rate, so we need to count out 12 months to make sure we have accounted for interest related to the entire first year of the loan Finally, interest is paid at the end of May, so we can indicate that cash will be paid during May 2012 YEAR JAN FEB MAR APR MAY JUN JUL OCT Y1 1 2 5 Y2 8 10 11 12.5 1 2 5 From the timeline, we can easily see that we need to accrue 7 months of interest in Y1 (the debit side) and that none of that amount will be paid in Y1 (the credit side). Interest expense in Y1 equals $3.500 (5100,000 X 6% = $6,000 x 7/12). This entry would most likely be made as an adjusting entry at the end of Y1, as there is no triggering cash payment. Interest Expense Cash Interest Payable 3,500 12/31/41 12/31/41 3,500 AUG 3 3 SEP 4 4 NOV 6 6 DEC 7 7 9 There are a number of ways to account for the Y2 activity Chronologically, there is a triggering event on May 31, 2072 when ABC makes a cash interest payment for interest owed on the first 12 months that the loan was outstanding ($6,000). Of this amount, we accrued for 7 months of interest in Y1 and the remaining 5 months need to be accrued and recognized as interest expense in Y2 ($100,000 x 6% 5/12). The interest Paya" created at the end of Y1 has now been paid off. By the end of the year, the loan has been outstanding for another 7 months for which no cash payments have been made. Interest Expense Interest Payable 5/31/42 2,500 6,000 5/31/42 5/31/2 3,500 12/31/42 3,500 3,500 12/31/2 Cash CHAPTER 10 HANDOUT - INTEREST EXPEN Luted below are three soenarios related to KACPs outstanding borrowings. Prepare all oumal entries necessary to record interest dhe recognized during ROY1 and 2012. Und the timelines to help you an hustrated in the example. Round to the nearest gale on March 1, 2012 KAC Inc, issued $500,000 of 9% bonds. They mature in 10 years, with interest payable seniannusly MAY SEP OCT NOV AUG JUL MAR DEC FEB APR JUN YEAR JAN Y1 Y2 How much of the cash paid in 20Y2 relates to 20Y2 interest expense? Liabilities + Assets Equity What is the total 20Y2 impact on the accounting equation? Indicate the impact by entering for Increaso, "D" for Decrease and "NE" for No Effect B. On August 120Y1 KAC Inc. purchased equipment by issuing a 2-year, 540,000,5% note. Interest is payable annually YEAR JAN FEB MAR APR MAY JUL JUN AUG DEC SEP OCT NOV YI Y2 How much of the cash paid in 20Y2 relates to 20Y2 Interest expense? What is the total 2072 impact on the accounting equation? Indicate the impact by entering for increase, "D" for Decrease and "NE" for No Effect Assets Liabilities Equity CHAPTER 10 HANDOUT - INTEREST EXPENSE PAGE 2 C. On May 31, 2011 KAC Inc. borrowed $300.000 by losing a 4 year, 5% promissory note Interest is payable annually YEAR JAN FEB MAR APR MAY JUN Y1 Y2 DEC AUG JUL OCT NOV SEP Equity How much of the cash paid in 20Y2 relates to 2072 interest expense? What is the total 2022 impact on the accounting equation? Indicate the impact by entering for increase, *D* for Decrease and "NE" for No Effect Assets Llabilities