The correct journal entry acknowledges the higher effective interest expense due to the bond being issued at a discount and properly accounts for the semi-annual interest payment.
Interest Expense Recognition:
- The effective interest method of amortization is used to allocate bond discount or premium over the life of the bond in a way that reflects the actual cost of borrowing. In this case, the effective interest rate is 9%, and the bonds were issued at a discount, which means the stated rate of 7% is lower than the market rate of 9%. As a result, the effective interest expense is higher than the stated interest payment.
- For the semi-annual interest payment on January 1, 2022, the interest expense is calculated as 9% of the carrying amount of the bonds on January 1, 2021.
Journal Entry:
- Debit Bond Interest Expense: $500,000 * 9% = $45,000 (annual interest expense)
- Credit Cash: $45,000 * 1/2 = $22,500 (semi-annual interest payment)
- Credit Discount on Bonds Payable: $45,000 - $22,500 = $22,500 (to amortize the discount)
Therefore, the correct journal entry is to debit Bond Interest Expense for $17,500 (half of the annual interest expense) and credit Cash for $17,500, reflecting the semi-annual interest payment. Option D accurately captures this entry, recognizing the higher effective interest expense and the cash payment made.