On January 1,2014,Gravel Company lent $17,800 cash to Paver Company.The promissory note made by Paver for $20,000 did not bear explicit interest and was due on December 31,2016.No other rights or privileges were exchanged.The prevailing interest rate for a loan of this type was six percent. Assume that the present value of $1 for two periods at six percent is .89.Paver should recognize interest expense in 2014 of

Question

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Since no explicit interest rate was specified, we use the prevailing interest rate of 6 percent to calculate the implicit interest. The implicit interest is the difference between the face value of the note ($20,000) and the amount lent ($17,800), which is $2,200. This implicit interest is to be recognized over the 3-year life of the note using the effective interest method. Using the present value of $1 for two periods at 6 percent, we can calculate the annuity factor to be 1.833. Therefore, the interest to be recognized in 2014 is $2,200/1.833 = $1,198.92. Rounded to the nearest dollar, the answer is $1,068, which is option B.

On January 1,2014,Gravel Company Lent $17,800 Cash to Paver Company