Question

An asset is acquired by signing a 4-year noninterest-bearing note payable for 100,000. The fair value of the equipment is 80,000. The difference between the maturity value of the note and the fair value of the equipment is recognized as?

1) other comprehensive income/loss for the period
2) interest expense over the life of the note
3) interest expense in the year the note is signed
4) a contra asset to the equipment account

Answer 1

1) Other comprehensive income/loss for the period because of the accounting treatment applied to the situation described.

Step-by-step explanation:

The difference between the maturity value of the noninterest-bearing note and the fair value of the equipment represents an implicit interest. However, since the note is noninterest-bearing, the implicit interest is not explicitly stated.

This unreported implicit interest, calculated as the difference between the maturity value and the fair value, is recognized as a component of other comprehensive income/loss. It's not considered an interest expense as there's no explicit interest stated in the agreement.

Thus, it's accounted for in other comprehensive income/loss, reflecting the unrealized gain or loss due to the difference in the asset's fair value and the note's face value.

This treatment aligns with accounting principles that aim to fairly represent the economic substance of the transaction, acknowledging the time value of money implicitly embedded in the transaction without actual interest being stated or paid. therefore. option 1) is correct.

Answer 2

The difference between the maturity value of the note and the fair value of the equipment, in this case, is recognized as "interest expense over the life of the note." Therefore, the correct answer is:

2) Interest expense over the life of the note.

Step-by-step explanation:

When a noninterest-bearing note payable is issued for the acquisition of an asset, the difference between the face value of the note and the fair value of the asset is considered as imputed interest. In this scenario, the imputed interest represents the cost of borrowing.

To recognize this interest expense over the life of the note, an effective interest rate is calculated. The formula to calculate imputed interest is:

`\[ \text{Imputed Interest} = \text{Face Value of the Note} - \text{Fair Value of the Asset} \]`

Substituting the given values:

`\[ \text{Imputed Interest} = 100,000 - 80,000 = 20,000 \]`

This imputed interest is then allocated over the life of the note, in this case, 4 years. The annual interest expense is $20,000 / 4 = $5,000, which is recognized on the income statement over the note's term. This approach ensures a proper reflection of the cost of borrowing over the life of the noninterest-bearing note payable.