[Anonymous]

Can some one please help me understand this question in a simple language ?? I could not figure it out at all 🙁

On October 1, 2010, 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, 2010. Fleur’s 2010 financial statements reported interest payable and interest expense on the note for 3 months at 16%. All amounts due on the note were paid February 1, 2011. Fleur’s 2010 cost of goods sold for the holiday merchandise was

A. Overstated by the difference between the note’s face amount and the note’s October 1, 2010 present value.

This answer is incorrect. Refer to the correct answer explanation.

B. Overstated by the difference between the note’s face amount and the note’s October 1, 2010 present value plus 11% interest for 2 months.

This answer is incorrect. Refer to the correct answer explanation.

C. Understated by the difference between the note’s face amount and the note’s October 1, 2010 present value.

D. Understated by the difference between the note’s face amount and the note’s October 1, 2010 present value plus 16% interest for 2 months.

Answer C is correct. Per ASC Topic 835, when a note is exchanged for property, goods, or services, the stated interest rate is presumed to be fair unless (1) interest is not stated, (2) the stated rate is unreasonable, or (3) the current cash price of the property, goods, or services is materially different from the market value of the note. In these circumstances, the note and the cost of the property, goods, or services should be recorded at the fair value of the property, goods, or services or the market value of the note, whichever is more clearly determinable. The note signed by Fleur bears an unreasonable interest rate of 16% as compared to the market rate of 11%.

If the note payable had been for more than 1 year, the correct entry would have recorded the inventory at the market value of the note, since at the time of the transaction there was no direct method of pricing the merchandise. A premium on the note payable would have been recorded (since the stated rate was greater than the market rate) and the premium would have been subsequently amortized over the term of the note payable.

However, since the term of the note is less than 1 year (4 months), Fleur’s recording of the inventory purchase and the note payable at the face amount of the note is appropriate accounting treatment per ASC Topic 835.

Because the entry records inventory at the face amount of the note rather than at its present value, and the inventory was all sold prior to December 31, 2010, cost of goods sold would be understated. (If 11% had been used the purchases would have been recorded at a higher amount.)

[Anonymous]

@Ali Alabdullatif…the easier way to figure it out is to plug some numbers to the question. Let's assume the face amount of the note is $100,000. The stated rate 16% is higher than market rate 11%, so the note is sold for a premium, let's say $125,000. On the day the note is sold, Fleur will receive $125,000 instead of $100,000. The difference ($125,000 – $100,000) is to “compensate” the higher interest rate, 5% (16%-11%). The question said “Fluer records the purchase at face amount of the note”, which mean, in our case, $100,000. That $100,000 should have been $125,000 (the present value of the note) because that is true cost of the note of $100,000 in 16%. Therefore, purchase is under-valued for $25,000 (in our case), which is the difference between the face value of the note ($100,000) & the present value of the note ($125,000). Since, COGS=Beginning Bal + purchase – Ending Bal, COGS will absorb the undervalued difference.

[mds86]

The part that trips me up about this question is:

However, since the term of the note is less than 1 year (4 months), Fleur's recording of the inventory purchase and the note payable at the face amount of the note is appropriate accounting treatment per ASC Topic 835.

I get how the question can be C, but is the answer not saying that it was right to record it at face, thus the COGs at face would be OK?

AUD - 64, 75
BEC - 67, 75
REG - 33, 58, 76
FAR - 41, 73, 84
DONE.

Tip: If you don't feel like you're studying hard, you'll probably fail. Study harder.

[Anonymous]

@mds86…you are right. That paragraph doesn't make sense to me either. The explaination makes sense, then the second one (you just mentioned) was sorta contracdicting…anyone?

[mds86]

You know, in terms of the test, I have never seen a question like this from Becker or elsewhere. It could be flawed. The point is that – yes, if a note is due in less than 12 months, then face value is OK. Otherwise, you gotta PV that shi*t.

AUD - 64, 75
BEC - 67, 75
REG - 33, 58, 76
FAR - 41, 73, 84
DONE.

Tip: If you don't feel like you're studying hard, you'll probably fail. Study harder.

[gregbou1]

[Author]

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