Question

E14-17B (L03) (Imputation of Interest) Presented below are two independent situations: (a) On January 1, 2017, Excess Inc. purchased undeveloped land that had an assessed value of $261,000 at the time of purchase. A $500,000, zero-interest-bearing note due January 1, 2022, was given in exchange. There was no established exchange price for the land, nor a ready market value for the note. The interest rate charged on a note of this type is 15%. Determine at what amount the land should be recorded at January 1, 2017, and the interest expense to be reported in 2017 related to this transaction. (b) On January 1, 2017, DonnAll Diamond borrowed $1,000,000 (face value) from Allstar Co., a major customer, through a zero-interest-bearing note due in 3 years. Because the note was zero-interest-bearing, DonnAll agreed to sell dia- monds to this customer at lower than market price. A 12% rate of interest is normally charged on this type of loan. Prepare the journal entry to record this transaction and determine the amount of interest expense to report for 2017.

Answer 1

The student's question involves calculating the present value of zero-interest-bearing notes, associated investment recognitions, and interest expenses using imputed interest rates. In each case, the present value and interest expense are calculated using the formula for present value and recognizing the expense over the life of the note.

Step-by-step explanation:

The student is asking about how to calculate and record the present value of investments and interest expense in two different scenarios involving zero-interest-bearing notes. We are provided with two separate cases, one concerning the purchase of land using a zero-interest-bearing note and another dealing with a zero-interest-bearing loan used for a business transaction. Both situations require the imputation of interest to recognize both the present value of the note at issuance and the interest expense over time.

Scenario (a)

Excess Inc. purchased land for a zero-interest-bearing note of $500,000 due in five years. Given the interest rate of 15%, the present value is calculated using the formula PV = FV / (1 + i)^n, which results in the land being recorded at its present value on January 1, 2017. The interest expense for 2017 is also calculated based on the imputed interest rate.

Scenario (b)

Donnell Diamond borrowed $1,000,000 through a zero-interest-bearing note payable in three years, with market diamonds sold at a discount. A journal entry records this transaction at the present value of the note, using a 12% interest rate. The correct interest expense for 2017 would be based on the same imputed rate.