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Book Values Using Effective Interest Rate

BC, Inc. plans to acquire an additional machine on January 1, 2004 to meet the growing demand for its product. Carlton Company offers to provide the machine to BC using the option listed below (each option gives BC exactly the same machine and gives Carlton Company approximately the same net present value cash equivalent at 10%)
Option 2 - Installment purchase requiring 15 annual payments of $118,326 due December 31 each year.

The expected economic life of this machine to BC is 15 years. Salvage value at that time is estimated to be $60,000. Straight-line depreciation was used. Interest expense under Option 2 is computed using the effective interest method.

Based upon current GAAP, state how, if at all, the book value of the machine and the obligation should appear on the December 31, 2004 balance sheet of BC.

Solution Preview

The present value of the annual payment is $899,996.96 by using the annuity formula with interest rate 10%, annual payment $118,326, and 15 years.

(1) To record the machine, its cost is the present value of all annual payments = $899,996.96
The annual depreciation is (cost $899,996.96 - salvage ...

Solution Summary

This response determines the book values of BC, Inc using the effective interest method.