Question

On December 5, Johnson Company borrowed $3,000 from Bulldog Bank and Trust by issuing a 30-day, noninterest-bearing note payable. The bank discounted the note at 15% deducting $37.50 in advance. The amount of interest expense for the current period is $32.50. On December 31, Johnson Company needs to record the adjusting entry for prepaid interest expense. Determine the correct adjusting entry.

Answer 1

The correct adjusting entry on December 31 for Johnson Company's prepaid interest expense is to debit Interest Expense for $32.50 and to credit Prepaid Interest for $32.50, which aligns the expense with the period funds were used.

Step-by-step explanation:

When Johnson Company borrowed $3,000 from Bulldog Bank and Trust with a 30-day, noninterest-bearing note with a discount of 15%, the bank deducted $37.50 as discount interest in advance. The effective interest for the period is calculated as $32.50. Johnson Company will need to adjust for prepaid interest expense on December 31. This involves recognizing the proportion of the prepaid interest that has expired as an expense.

The adjusting entry for prepaid interest expense at the end of the period would be:
Debit: Interest Expense $32.50
Credit: Prepaid Interest $32.50

This entry ensures that the prepaid interest is matched with the period in which the funds were in use, and thus conforms to the accrual basis of accounting, aligning with the company's revenue and expenses for the period.