On January 1, 2020, Queen Ltd. sold property to King Company. There was no established exchange price for the property, and King gave Queen a $ 3,000,000, zero-interest-bearing note payable in five equal annual instalments of $ 600,000, with the first payment due December 31, 2020. The market rate of interest for a note of this type is 9%. The present value of the note at 9% was $ 2,333,791 at January 1, 2020. What should be the balance of the Note Payable to Queen Ltd. account on King's December 31, 2020 adjusted trial balance, assuming that the note is recorded at net and the effective-interest method is used? (Round to the nearest dollar, if necessary.)

Question

Quizplus · Accepted Answer

The effective interest rate can be calculated as follows:

Effective interest rate = (1 + 9%/5)^(5/1) -1 = 7.16%

The first interest expense can be calculated as: 
Interest expense = 7.16% x $2,333,791 = $167,255

Therefore, the first payment of $600,000 should be allocated as follows: 
Interest expense: $167,255 
Reduction in note payable: $432,745

The balance of the note payable after the first payment can be calculated as follows: 
Note payable balance = $2,333,791 - $432,745 = $1,901,046

The balance of the Note Payable to Queen Ltd. account on King's December 31, 2020 adjusted trial balance should be $1,943,832, which is the sum of the remaining four equal annual instalments of $ 600,000 discounted at 7.16%: 
$600,000 / (1 + 7.16%) + $600,000 / (1 + 7.16%)^2 + $600,000 / (1 + 7.16%)^3 + $600,000 / (1 + 7.16%)^4 = $1,943,832 (rounded).