Question

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’s 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’s 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

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

(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

(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.

(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.