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Crown Company Sold Property to Leary: Balance of Discount on Notes Payable

On January 1, 2010, Crown Company sold property to Leary Company. There was no established exchange price for the property, and Leary gave Crown a $2,000,000 zero-interest-bearing note payable in five equal annual installments of $400,000, with the first payment due December 31, 2010. The prevailing rate of interest for a note of this type is 9%. The present value of the note at 9% was $1,442,000 at January 1, 2010.

What should be the balance of the Discount on Notes Payable account on the books of Leary at December 31, 2010 after adjusting entries are made, assuming that the effective-interest method is used?

Solution Summary

The implicit interest rate is the one that equates the cash received with the amounts to be paid in the future. So, the interest must be $558,000 over the time of the note, not 9%. The rule is explained to you and the work in Excel shows you why 9% isn't right and what the correct rate to use is. A full amortization schedule at 9% and the correct rate is given along with the balance in NP.