FASB ASC: effective interest rate for valuing note, patent

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FASB ASC
1. You acquire the outstanding loan (note) of Shepard Company, who is having financial difficulty. Because of the financial difficulty, Shepard Company's credit rating has been downgraded and you acquire the note at a discount. To determine the purchase price of the note you discount it at the effective rate of interest rather than the rate of interest stated on the note. According to the FASB ASC, is it correct to discount the loan at the effective interest rate? (This is not troubled debt restructuring.) Please include the appropriate FASB ASC citation in your answer.

Yes, this is correct. FASB ASC 835-30-05-2 indicates that when a note is exchanged between parties, the note should be evaluated to see if the stated rate (face rate) varies from the prevailing (market) rate which yields the market value of the note. If there is a difference, as there is in the example given above, the discount is used to find the effective interest rate (FASB ASC 835-30-25-6).

Why is the market rate used instead of the face rate? Because you want to record the note at the fair value and the market rate of interest would give you an amount close to fair value.

835-30-05-2 Business transactions often involve the exchange of cash or property, goods, or service for a note or similar instrument. When a note is exchanged for property, goods, or service in a bargained transaction entered into at arm's length, there should be a general presumption that the rate of interest stipulated by the parties to the transaction represents fair and adequate compensation to the supplier for the use of the related funds. That presumption, however, must not permit the form of the transaction to prevail over its economic substance and thus would not apply if interest is not stated, the stated interest rate is unreasonable, or the stated face amount of the note is materially different from the current cash sales price for the same or similar items or from the market value of the note at the date of the transaction. The use of an interest rate that varies from prevailing interest rates warrants evaluation of whether the face amount and the stated interest rate of a note or obligation provide reliable evidence for properly recording the exchange and subsequent related interest.
835-30-25-6 A note issued solely for cash equal to its face amount is presumed to earn the stated rate of interest. However, in some cases the parties may also exchange unstated (or stated) rights or privileges, which are given accounting recognition by establishing a note discount or premium account. In such instances, the effective interest rate differs from the stated rate. For example, an entity may lend a supplier cash that is to be repaid five years hence with no stated interest. Such a non-interest-bearing loan may be partial consideration under a purchase contract for supplier products at lower than the prevailing market prices. In this circumstance, the difference between the present value of the receivable and the cash loaned to the supplier is appropriately regarded as an addition to the cost of products purchased during the contract term. The note discount shall be amortized as interest income over the five-year life of the note, as required by Section 835-30-35.
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2. Your company began operations on March 1, 2011, and incurred $60,000 of organization costs for starting-up the new business. These costs were the fees you paid to the State that you incorporated in. You ...