Question

Epsilon Ltd. accepted a $600,000 two year note receivable from a customer in connection with a major inventory sale transaction on 1 January 20X5. The note required annual end of year interest payments of 2%, and the principal was due at the end of 20X6.

 

Required:

1. Assume that the market interest rate is 7%. Calculate the present value of the note, and prepare a schedule that shows the annual interest using the straight line method of amortization.

2. Prepare journal entries to record the initial sale transaction and each payment on the books of Epsilon, consistent with requirement 1. Use the gross method to record the note.

3. Prepare a schedule that shows the annual interest using the effective interest method of amortization.

4. Compare interest revenue as calculated in requirements 1 and 3. Which is more accurate? Explain. What method(s) are permitted under ASPE? IFRS?

Answer 1

Requirement 1

 

Present value:

       Maturity value $600,000 (P/F, 7%, 2)                    $524,064

       Interest $12,000 (P/A, 7%,2)                                       21,696

                                                                                           $545,760

 Discount ($600,000 - $545,760)                                     $54,240

 

(1) Opening Net Liability/ Receivable	(2) Interest Expense/Revenue  (3)  + (4)	(3) Interest Paid/ Received	(4) Discount Amortization Disc/2	(5) Closing Net Liability/ Receivable (1) + (4)
$545,760	$39,120	$12,000	$27,120	$572,880
$572,880	39,120	12,000	27,120	600,000

 

Requirement 2

 

1 January 20x5

       Note receivable............................................................................. 600,000

               Discount on note receivable...............................................................        54,240

               Sales revenue.....................................................................................         545,760

       

31 December 20x5

       Cash................................................................................................    12,000

       Discount on note receivable........................................................... 27,120

               Interest revenue ................................................................................          39,120

 

31 December 20x7

       Cash..............................................................................................   612,000

       Discount on note receivable.......................................................... 27,120

               Interest revenue ................................................................................         39,120

               Note receivable..................................................................................       600,000

Requirement 3

 

(1) Opening Net Liability/ Receivable	(2) Interest Expense/Revenue (1) X 7%	(3) Interest Paid/ Received	(4) Discount Amortization (2) – (3)	(5) Closing Net Liability/ Receivable (1) + (4)
$545,760	$38,204	$12,000	$26,204	$571,964
$571,964	40,036	12,000	28,036	600,000

 

The differences between requirements 1 and 3:

1.      In straight-line, interest revenue is $39,120 each period. This is higher than the first year under effective interest and lower than the second year.

2.      Notes receivable is higher under straight-line after the first year because more discount amortization has been recorded.

Effective interest is more accurate, because interest is a constant 7% of the opening balance. Under straight-line, interest is 7.2% ($39,120/$545,600) and 6.8% ($39,120/$572,880). This is less accurate. Either method is allowed under ASPE, but only effective interest is permitted under IFRS.