On January 1, year 2, Southern Corporation received $107,720 for a $100,000 face amount, 12% bond, a price that yields 10%. The bonds pay interest semiannually. Southern elects the fair value option for valuing its financial liabilities. On December 31, year 2, the fair value of the bond is determined to be $106,460. Southern recognized interest expense of $12,000 in its year 2 income statement. What was the gain or loss recognized on the year 2 income statement to report this bond at fair value?
A) $12,000 lossB) $1,260 gainC) $13,260 lossD) $6,460 gain

We have to separate interest expense which was recorded as $12,000, and the gains resulting from the difference in the fair market values of the bonds. To calculate the gain or loss we have to:

Bond price year 1 - bond price year 2 = $107,720 - $106,460 = $1,260

Since it's positive, it is a gain (because the bond is a liability, a lower price results in a gain).

Answer Link