[Anonymous]

I got this question right by making an educated guess.

Since 10,000 note is non-interest bearing, I assumed that note was issued at a discount (face amount is maturity amount which includes PV interest + PV principal). so I checked YES for “discount on N/R”….

Next, I was like “hmm, since it’s a purchase commitment there has to be some kind of recording, so I checked YES for “deferred charge”…..

BUT, I honestly have no idea why we would record the deferred charge (prepaid expense, which is an asset)… Please someone explain… Is it because this deferred charge/asset will reduce our payment in the future? I can’t seem to understand this.

QUESTION is:

Jole Co. lent $10,000 to a major supplier in exchange for a non interest-bearing note due in three years and a contract to purchase a fixed amount of merchandise from the supplier at a 10% discount from prevailing market prices over the next three years. The market rate for a note of this type is 10%. On issuing the note, Jole should record:

Discount on

note receivable

Deferred charge

a.

Yes

No

b.

Yes

Yes

c.

No

Yes

d.

No

No

Explanation

Choice “b” is correct. In this transaction, $10,000 is exchanged for a non-interest bearing note receivable and a commitment to purchase merchandise at a 10% discount. In order to correctly account for the transaction, interest must be imputed on the non-interest bearing note, which will result in the recognition of a discount on the note receivable, and the purchase commitment must be recognized, which will result in the recognition of a deferred charge.

It is important to note that no calculations or journal entries are necessary to answer this question. Despite the fact that the question does present numeric facts, it is a conceptual question. However, to clarify the transaction, the following journal entry is presented for illustrative purposes, assuming that the face value of the note receivable is $10,000, the present value of the note receivable is $7,500 (calculated using a PV factor of 0.7513 based on 3 periods at 10%) and the fair value of the purchase commitment is $2,500.

Debit (Dr) Credit (Cr)

Notes receivable $ 10,000

Deferred charge 2,500

Cash $ 10,000

Discount on note receivablet 2,500

The note receivable will be reported on the balance sheet at its present value of $7,500 ($10,000 NR – 2,500 discount).

The discount on notes receivable will be amortized to interest revenue over the next three years using the effective interest method. The deferred charge will reduce the amount paid for future purchases.

Debit (Dr) Credit (Cr)

Merchandise Inventory $ 25,000 (fair value)

Cash $ 22,500

Deferred charge 2,500

[Jen]

The issuer will record a deferred charge (prepaid expense) because he issued a non-interest bearing note for $10,000 with proceeds of $10,000. Because the issuer must impute interest on a non-interest bearing note, he is basically issuing a discounted note. NORMALLY, when a note is issued at a discount, the proceeds of the note are LESS than the face-value of the note because the issuer of the note is going incorporate a profit into the terms of the loan (e.g., give proceeds of 7,500 and require repayment of 10,000 in three years).

Ex: Journal entry for the ISSUER

Dr Note receivable 10,000
Cr Discount on note 2,500
Cr Cash 7,500

In this problem, the discounted present value of the note is $7,500, which means there is a $2,500 discount on the note, and the proceeds are $10,000. If you prepare the issuer's journal entry, you'll notice the issuer paid $2,500 too much.

Dr Note receivable 10,000
Dr ?
Cr Discount on note 2,500
Cr Cash 10,000

The extra $2,500 the issuer paid is treated as a deferred charge (prepaid expense) for the purchase commitment. In the future, the issuer will record the inventory at FMV and use the deferred charge to offset the lower, discounted price he is actually paying.

[Jen]

Not sure if I made it clear in my response, but, in this problem the issuer paid the extra $2,500 in exchange for the discount he will receive under the purchase commitment. That was his way of profiting from the terms of the loan. Since that extra money was to secure that discount, that is why it is a deferred charge. He hasn't incurred any expense related to the merchandise yet.

[Author]

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