GAAP for zero-interest-bearing note Essay

Custom Student Mr. Teacher ENG 1001-04 31 May 2016

GAAP for zero-interest-bearing note

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 account research on this topic. (a) 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.
(b) 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?
(c) Where should a discount or premium appear in the financial statements? What about issue costs?

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This work requires that you consider the fair value of the note on the seller’s books (note receivable). Portion of the codification are cut and pasted into the document for you. There are two pieces of purchasing an asset with a note. The asset value and the value of the note. Here, the asset value is not known. Below it discusses that if you don’t know the value of the asset, you use the value of what was exchanged for it. Quotes from Codification
360 Assets
845 Nonmonetary Transactions
10 Overall
30 Initial Measurement 30-8 Fair value should be regarded as not determinable within reasonable limits if major uncertainties exist about the realizability of the value that would be assigned to an asset received in a nonmonetary transaction accounted for at fair value. An exchange involving parties with essentially opposing interests is not considered a prerequisite to determining a fair value of a nonmonetary asset transferred; nor does an exchange ensure that a fair value for accounting purposes can be ascertained within reasonable limits. If neither the fair value of a nonmonetary asset transferred nor the fair value of a nonmonetary asset received in exchange is determinable within reasonable limits, the recorded amount of the nonmonetary asset transferred from the entity may be the only available measure of the transaction.
310 Receivables
10 Overall
30 Initial Measurement
Certain Receivables 30-1

The following provides initial measurement guidance for certain notes receivable, specifically those exchanged for cash and those exchanged for property, goods, or services. Such notes may be originated by an entity or purchased from a third party. 30-3 As indicated in paragraph 835-30-25-8, notes exchanged for property, goods, or services are valued and accounted for at the present value of the consideration exchanged between the contracting parties at the date of the transaction in a manner similar to that followed for a cash transaction. 30-5 As indicated in paragraph 835-30-25-10, in circumstances where interest is not stated, the stated amount is unreasonable, or the stated face amount of the note is materially different from the current cash sales price for the same or similar items or from the market value of the note at the date of the transaction, the note, the sales price, and the cost of the property, goods, or services exchanged for the note shall be recorded at the fair value of the property, goods, or services or at an amount that reasonably approximates the market value of the note, whichever is the more clearly determinable.

30-6 Paragraph 835-30-25-11 explains that, in the absence of established exchange prices for the related property, goods, or services or evidence of the market value of the note (as described in paragraph 835-30-25-2), the present value of a note that stipulates either no interest or a rate of interest that is clearly unreasonable shall be determined by discounting all future payments on the notes using an imputed rate of interest as described in Subtopic 835-30. Paragraph 835-30-25-11 explains that this determination shall be made at the time the note is acquired; any subsequent changes in prevailing interest rates shall be ignored.
————————— Now, to your questions…

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 account research on this topic. (a) 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.

The literature says that you value assets acquired by the value of that asset. If you don’t know it, you are supposed to figure it out, if possible, by looking at the cash price you could have paid (but didn’t). Or, if there is just no way to figure it out reasonably, then you look at the fair value of the item traded, in this case the note. So, you see if there is a market value for the note. Is it traded? Does it bear an interest rate so you can get the present value of it? No! The value of this note isn’t immediately apparent because you don’t have an interest rate to use to discount it back to the present value. So, you have to impute an interest rate (whole other section in the codification!). Another example of difficulty valuing an asset exchange would be when a firm leases, rather than sells, their inventory. What is the selling price? The present value of the minimum future rentals are used to establish a likely selling price for the purpose of recording the sale and the gross profit from the sale.

Another example of difficulty valuing an asset exchange is when assets are traded and there is no cash price or cash exchange. You would use the value of whichever asset is more readily determined, such as the price of the stock on actively traded exchanges. (b) 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? You have to discern an interest rate by looking at the prevailing interest rates for similar instruments with firms of similar credit status to this one. This is called the imputed interest rate. (c) Where should a discount or premium appear in the financial statements? What about issue costs? The discount or premium is a contra account to the note receivable on the issuer’s books (reduces assets in the balance sheet). Cost to issue should be spread over the life of the note (capitalized as asset in the balance sheet and amortized over life of note).

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  • Date: 31 May 2016

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