Question

1. On January 1, 2013, VHF Industries acquired a machine and financed the purchase price of this acquisition by issuing a 4-year loan to the vendor. The face value of the loan is $8,000,000. The loan requires VHF to make 4 annual installment payments of $2,100,990; each payment is due December 31 starting on December 31, 2013. VHF chose to finance this purchase using the non-cash loan, but VHF could have purchased the machine for a cash price of $6,074,700. VHF must use the effective interest method to account for this loan in accordance with GAAP.

Requirement 1: Based on the contract (form) information for this non-cash loan, what is the stated interest rate (show your calculation details)?

Requirement 2: State whether substance equals form or substance differs from form. Then provide an explanation to support your answer.

Requirement 3: Prepare VHF’s journal entry to record the acquisition of this machine on 1/1/13. VHF does not use any discount or premium accounts in its chart of accounts.

Requirement 4: Determine the implicit market rate that VHF must use to recognize interest expense for this non-cash loan.

Answer 1

1. The stated rate is 0%

2. Substance differs from form. The loan is non-interest bearing in the sense that no explicit payment of interest is made. However, the loan effectively has interest since the annual payments contain both principal and interest payments. Moreover, it can be observed that the total payments are greater than the cash price equivalent of the asset, suggesting the presence of imputed interest. Any difference between the cash price equivalent and the total payments made shall be treated as interest cost. Therefore, while the loan does not have an interest payment in form, it does have an interest payment in substance.

3. The journal entry is:

Particulars	Debit	Credit
Equipment	6,074,700
Notes Payable		6,074,700

4. The formula for computing the implicit market rate is:

6,074,700 = 2,100,990*(1-(1+r)^-4)/r

solving the above equation we get r = 14.3768%