[SchruteBeet]

I realize this question has been asked on the forum before however, what I don’t understand here is: if the note payable is outstanding for less than a year why are we still calculating the PV instead of just recording it at face?

On October 1 of the prior year, Fleur Retailers signed a 4-month, 16% note payable to finance the pur­chase of holiday merchandise. At that date, there was no direct method of pricing the merchandise, and the note’s market rate of interest was 11%. Fleur recorded the purchase at the note’s face amount. All of the merchandise was sold by December 1 of the prior year. Fleur’s prior-year financial statements reported interest payable and interest expense on the note for three months at 16%. All amounts due on the note were paid February 1 of the current year. As a result of Fleur’s accounting treatment of the note, interest, and merchandise, which of the following items was reported correctly?

A.Prior-year 12/31 retained earnings, yes; Prior-year 12/31 interest payable, yes

B.Prior-year 12/31 retained earnings, no; Prior-year 12/31 interest payable, no

C.Prior-year 12/31 retained earnings, yes; Prior-year 12/31 interest payable, no

D. Prior-year 12/31 retained earnings, no; Prior-year 12/31 interest payable, yes

The cost of the merchandise purchased (and sold by the end of the year) should have been based on the present value of the note used to pay for them, not the face amount. Since the note paid a higher rate of interest than what was required as a yield, the note would have a premium, a higher value than face.

Thus, the note’s present value was higher than its face amount, and the higher value should have been added to purchase cost and moved to cost of goods sold. The lower value that was used for purchase cost understated the cost of goods sold. If cost of goods sold was understated, then net income was wrong and retained earnings was not correct.

Interest payable, however, is based on the face amount of the note and the stated payment rate, so it is correct.

[Jott]

the note is being recorded at face, however, the question is asking about how to value the inventory not how to record the note. here the PV of the note is being used as a proxy for the value of the inventory purchased, which otherwise has “no direct method of pricing”. the PV of the note is higher than the face amount and therefore inventory is understated at the face amount of the note.

[SONA]

https://www.principlesofaccounting.com/illustrative%20entries/entrieslist.htm

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