On January 1, 2014, Crown Company sold property to Leary Company. There was no established exchange price for the property, and Leary gave Crown a $4,000,000 zero-interest-bearing note payable in 5 equal annual installments of $800,000, with the first payment due December 31, 2014. The prevailing rate of interest for a note of this type is 9%. The present value of the note at 9% was $2,884,000 at January 1, 2014. What should be the balance of the Discount on Notes Payable account on the books of Leary at December 31, 2014 after adjusting entries are made, assuming that the effective-interest method is used?

Question

Quizplus · Accepted Answer

The balance of the Discount on Notes Payable account after adjusting entries at December 31, 2014, can be calculated using the effective-interest method. Initially, the note's present value is $2,884,000, which is less than its face value of $4,000,000, creating a discount of $1,116,000 ($4,000,000 - $2,884,000). Over the first year, interest expense is recognized on the carrying amount of the note. The interest expense for the first year is 9% of $2,884,000, which equals $259,560. Since the annual payment is $800,000, and part of this payment reduces the principal, the rest is applied to reduce the discount. The first payment does not occur until the end of the year, so the entire interest expense of $259,560 for the year increases the carrying amount of the note. The discount is reduced by the difference between the cash payment ($800,000) and the interest expense ($259,560), which is $540,440. Therefore, the new discount on the note is $1,116,000 (initial discount) - $540,440 (reduction in discount) = $575,560. However, since the question asks for the balance after adjusting entries are made but before the payment (which is due on December 31, 2014), we consider only the accumulation of interest expense for the year, which increases the carrying amount of the note but does not directly reduce the discount until the payment is made. The correct calculation for the discount balance immediately before the payment should consider the interest accrual over the year without subtracting the payment. Therefore, the correct answer reflects the balance of the discount before the payment is applied, which was a misunderstanding in the explanation provided. The correct balance of the discount, considering the effective interest method and recognizing the interest expense without considering the payment reduction yet, would still reflect the initial discount adjusted for the interest accrued over the year, which was not correctly addressed in the initial explanation.

On January 1, 2014, Crown Company Sold Property to Leary