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Chapter 14: Q1CRC (page 768)

Question: Wie Company has been operating for just 2 years, producing specialty golf equipment for women golfers. To date, the company has been able to finance its successful operations with investments from its principal owner, Michelle Wie, and cash flows from operations. However, current expansion plans will require some borrowing to expand the company鈥檚 production line

As part of the expansion plan, Wie will acquire some used equipment by signing a zero-interest-bearing note. The note has a maturity value of $50,000 and matures in 5 years. A reliable fair value measure for the equipment is not available, given the age and specialty nature of the equipment. As a result, Wie鈥檚 accounting staff is unable to determine an established exchange price for recording the equipment (nor the interest rate to be used to record interest expense on the long-term note). They have asked you to conduct some accounting research on this topic.

Instructions

If your school has a subscription to the FASB Codification, go to http://aaahq.org/ascLogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses.

  1. Identify the authoritative literature that provides guidance on the zero-interest-bearing note. Use some of the examples to explain how the standard applies in this setting.
  2. How is present value determined when an established exchange price is not determinable and a note has no ready market? What is the resulting interest rate often called?
  3. Where should a discount or premium appear in the financial statements?

Short Answer

Expert verified

Answer

  1. Detailed in FASB 05-2,05-3.
  2. To estimate the present value of a note under such circumstances, an applicable interest rate may differ from the stated coupon rate.
  3. The financial statements or the notes to the statements must indicate the face amount.

Step by step solution

01

(a) Identifying the authoritative literature and examples

According to FASB ASC 835-30-051:

05-2: A note or comparable instrument is frequently exchanged for money, property, goods, or services in business transactions. There should generally be a presumption that the rate of interest agreed upon by the parties to the transaction represents fair and adequate compensation to the supplier for the use of the related funds when a note is exchanged for property, goods, or services in a bargained transaction entered into at arm's length. This presumption, however, must not allow the transaction's formalities to take precedence over its economic substance. As a result, it would not be applicable in cases where interest is not disclosed, the stated interest rate is unreasonable, or the stated face amount of the note differs materially from the current cash sales price for the same or similar goods or from the note's market value on the transaction date. Using an interest rate that differs from market rates necessitates reviewing whether the face value and claimed interest rate of a note or obligation serve as trustworthy proof for the exchange of property and the subsequent related interest.

05-3:When the face amount of a note does not fairly represent the current value of the consideration paid or received in the exchange, this Subtopic offers guidance for the appropriate accounting. The situation might occur if the note isn't interest-bearing or if its stated interest rate isn't the rate that's right for the debt at the time of the transaction. In this situation, if the note is not recorded at its present value, the sales price and profit to a seller in the transaction year and the purchase price and cost to the buyer are misstatements. Additionally, interest income and interest expense in later periods are misstatements.

According to FASB ASC 835-30-15

15-2: Except for a few situations mentioned below, the guidance in the Subtopic applies to receivables and payables that represent contractual rights to receive money or contractual obligations to pay money on fixed or determinable dates. In this Subtopic, notes collectively refer to such receivables and payables. Here are a few instances:

  1. Notes with and without security.
  2. Debentures.
  3. Bonds.
  4. Notes on mortgages
  5. Equipment requirements.
  6. a few receivables and payables
02

(b) Explaining how the present value is determined

According to FASB ASC 835-30-25

25-3: The difficulty of determining present value is more challenging if an established exchange price is not determinable and the note lacks a ready market. In certain situations, an approximate interest rate that may not match the stated coupon rate is used to calculate the present value of a note. Imputation is the term for this approximation process, and the resulting rate is an imputed interest rate.If the note's face value is significant and its term is lengthy, failing to recognize a seemingly slight discrepancy between the stated interest rate and the applicable current rate could materially affect the financial statements.

03

(c) Explaining where a discount or premium appears in the financial statements

According to FASB ASC 835-30-45

45-1A: The discount or premium that results from determining present value in cash or other forms of payment is not a separate asset or obligation from the note that gave rise to it. Therefore, the discount or premium must be shown on the balance sheet as a direct addition to or subtraction from the note's face value. It cannot be categorized as a deferred credit or charge.

45-2: The effective interest rate must be included in the note's description. The financial statements or notes must provide information about the face amount.

45-3:Discount or premium amortization must be reported as an interest expense. Issue costs must be recorded as deferred charges on the balance sheet.

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Most popular questions from this chapter

(Issuance and Redemption of Bonds; Income Statement Presentation) Holiday Company issued its 9%, 25-year mortgage bonds in the principal amount of \(3,000,000 on January 2, 2003, at a discount of \)150,000, which it proceeded to amortize by charges to expense over the life of the issue on a straight-line basis. The indenture securing the issue provided that the bonds could be called for redemption in total but not in part at any time before maturity at 104% of the principal amount, but it did not provide for any sinking fund.

On December 18, 2017, the company issued its 11%, 20-year debenture bonds in the principal amount of $4,000,000 at 102, and the proceeds were used to redeem the 9%, 25-year mortgage bonds on January 2, 2018. The indenture securing the new issue did not provide for any sinking fund or for redemption before maturity.

Instructions

(a) Prepare journal entries to record the issuance of the 11% bonds and the redemption of the 9% bonds.

(b) Indicate the income statement treatment of the gain or loss from redemption and the note disclosure required.

Matt Ryan Corporation is interested in building its own soda can manufacturing plant adjacent to its existing plant in Partyville, Kansas. The objective would be to ensure a steady supply of cans at a stable price and to minimize transportation costs. However, the company has been experiencing some financial problems and has been reluctant to borrow any additional cash to fund the project. The company is not concerned with the cash flow problems of making payments, but rather with the impact of adding additional long-term debt to its balance sheet.

The president of Ryan, Andy Newlin, approached the president of the Aluminum Can Company (ACC), its major supplier, to see if some agreement could be reached. ACC was anxious to work out an arrangement, since it seemed inevitable that Ryan would begin its own can production. The Aluminum Can Company could not afford to lose the account.

After some discussion, a two-part plan was worked out. First, ACC was to construct the plant on Ryan鈥檚 land adjacent to the existing plant. Second, Ryan would sign a 20-year purchase agreement. Under the purchase agreement, Ryan would express its intention to buy all of its cans from ACC, paying a unit price which at normal capacity would cover labor and material, an operating management fee, and the debt service requirements on the plant. The expected unit price, if transportation costs are taken into consideration, is lower than current market. If Ryan did not take enough production in any one year and if the excess cans could not be sold at a high enough price on the open market, Ryan agrees to make up any cash shortfall so that ACC could make the payments on its debt. The bank will be willing to make a 20-year loan for the plant, taking the plant and the purchase agreement as collateral. At the end of 20 years, the plant is to become the property of Ryan.

Instructions

  1. What are project financing arrangements using special-purpose entities?
  2. What are take-or-pay contracts?
  3. Should Ryan record the plant as an asset together with the related obligation?
  4. If not, should Ryan record an asset relating to the future commitment?
  5. What is meant by off-balance-sheet financing?

(Effective-Interest Method) Samantha Cordelia, an intermediate accounting student, is having difficulty amortizing bond premiums and discounts using the effective-interest method. Furthermore, she cannot understand why GAAP requires that this method be used instead of the straight-line method. She has come to you with the following problem, looking for help.

On June 30, 2017, Hobart Company issued \(2,000,000 face value of 11%, 20-year bonds at \)2,171,600, a yield of 10%. Hobart Company uses the effective-interest method to amortize bond premiums or discounts. The bonds pay semiannual interest on June 30 and December 31. Prepare an amortization schedule for four periods.

Differentiate between a fixed-rate mortgage and a variable-rate mortgage.

On January 2, 2012, Banno Corporation issued \(1,500,000 of 10% bonds at 97 due December 31, 2021. Interest on the bonds is payable annually each December 31. The discount on the bonds is also being amortized on a straight-line basis over the 10 years. (Straight-line is not materially different in effect from the preferable 鈥渋nterest method.鈥�)

The bonds are callable at 101 (i.e., at 101% of face amount), and on January 2, 2017, Banno called \)900,000 face amount of the bonds and redeemed them.

Instructions

Ignoring income taxes, compute the amount of loss, if any, to be recognized by Banno as a result of retiring the $900,000 of bonds in 2017 and prepare the journal entry to record the redemption.
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