Question

On January 1, 2017, Margaret Avery Co. borrowed and received $400,000 from a major customer evidenced by a zero-interest-bearing note due in 3 years. As consideration for the zero-interest-bearing feature, Avery agrees to supply the customer’s inventory needs for the loan period at lower than the market price. The appropriate rate at which to impute interest is 8%.

Instructions

(a) Prepare the journal entry to record the initial transaction on January 1, 2017. (Round all computations to the nearest dollar.)

(b) Prepare the journal entry to record any adjusting entries needed at December 31, 2017. Assume that the sales of Avery’s product to this customer occur evenly over the 3-year period.

Short answer

1. Unearned sales revenue is $82,468
2. Interest expense is $25,403

Step-by-step solution

Meaning of Zero-Interest-bearing Note

The borrower won't require paying any interest during the four-year term of the zero interest note. Notes without interest do not imply that there is no interest. The inferred-interest rate is the current market rate built into the system.

(a) Preparing journal entry

Date	Particulars	Debit ($)	Credit ($)
Jan 1, 2017	Cash	400,000
	Discount on notes payable	82,468
	Notes payable		400,000
	Unearned sales revenue $\left(\$400,000-\$317,532\right)$		82,468

Working notes:

Face value	$400,000
Present value of 1 at 8% for 3 years	0.79383
Present value	$317,532

(b) Preparing journal entry

Date	Particulars	Debit ($)	Credit ($)
Dec 31, 2017	Interest expense $\left(\$317,532\times 8\%\right)$	25,403
	Discount on notes payable		25,403
Dec 31, 2017	Unearned sales revenuedata-custom-editor="chemistry" $\left(\frac{\$82,468}{3}\right)$	27,489
	Sales		27,489