Question

(Accounting for Zero-Interest-Bearing Note) Soon after beginning the year-end audit work on March 10 at Engone Company, the auditor has the following conversation with the controller.

Controller: The year ended March 31st should be our most profitable in history and, as a consequence, the board of directors has just awarded the officers generous bonuses.

Auditor: I thought profits were down this year in the industry, according to your latest interim report.

Controller: Well, they were down, but 10 days ago we closed a deal that will give us a substantial increase for the year.

Auditor: Oh, what was it?

Controller: Well, you remember a few years ago our former president bought stock in Henderson Enterprises because he had those grandiose ideas about becoming a conglomerate. For 6 years we have not been able to sell this stock, which cost us \(3,000,000 and has not paid a nickel in dividends. Thursday we sold this stock to Bimini Inc. for \)4,000,000. So, we will have a gain of \(700,000 (\)1,000,000 pretax) which will increase our net income for the year to \(4,000,000, compared with last year’s \)3,800,000. As far as I know, we’ll be the only company in the industry to register an increase in net income this year. That should help the market value of the stock!

Auditor: Do you expect to receive the \(4,000,000 in cash by March 31st, your fiscal year-end?

Controller: No. Although Bimini Inc. is an excellent company, they are a little tight for cash because of their rapid growth. Consequently, they are going to give us a \)4,000,000 zero-interest-bearing note with payments of $400,000 per year for the next 10 years. The first payment is due on March 31 of next year.

Auditor: Why is the note zero-interest-bearing?

Controller: Because that’s what everybody agreed to. Since we don’t have any interest-bearing debt, the funds invested in the note do not cost us anything and besides, we were not getting any dividends on the Henderson Enterprises stock.

Instructions

Do you agree with the way the controller has accounted for the transaction? If not, how should the transaction be accounted for?

Short answer

There are various issues in the accounting of the controller because he states that this year is most profitable based on the transaction for which cash is not received yet, andit is also not probable because the investing company is facing issues related to liquidity.

Step-by-step solution

Definition of Auditor

An auditor can be defined as the individual responsible for providing the authentication to the financial statement issued by the business entity. It analyses the financial statement based on accuracy and then issues reports.

Issued with the accounting

1. The first issue is whether the transaction is fair or not without any force. It is stated by the controller that the stock of the business entity is not marketed for six months; therefore, the generation of the revenue is questionable.

2. The second issue is related to collecting cash against the note from Bimini. The company is facing liquidity issues due to development that raises questions regarding collectability.

3. Another issue is in respect of imputed interest rates. Even if the transaction is fair, then a zero-interest-bearing note will raise the question regarding the gain or loss that occurred during the transaction

4. For recognizing again, the imputed interest rate must be 5%:

Particular	Amount $
Payment of $400,000 per year @5% for 10 years (PVAF:7.72)	$3,088,000
Less: Cost of investment	(3,000,000)
Gain	$88,000

Step 3: Accounting Needed to be Done

The business entity must select the more realistic rate of 8%

Particular	Amount $
Payment of $400,000 per year @8% for 10 years (PVAF:6.71)	$2,684,000
Less: Cost of investment	(3,000,000)
Loss	($316,000)

Journal entry for same:

Date	Accounts and Explanation	Debit $	Credit $
	Note receivables	$4,000,000
	Loss on Disposal of Investment	$316,000
	Equity Investment		$3,000,000
	Discount on notes receivables		$1,316,000