| Problem | ||
| 1 | Business transactions
often
involve the exchange of cash, property, goods, or service for a note or
similar instrument. 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.
This opinion sets forth the Board's views regarding the appropriate accounting when the face amount of a note does not reasonably represent the present value of the consideration given or received in the exchange. Such a situation may arise if the note is noninterest bearing or has a stated interest rate which is different from the rate of interest appropriate for the debt at the date of the transaction. Unless the note is recorded at its present value, the sales price and profit to the seller in the year of the transaction and the purchase price and cost to the buyer are misstated, and interest income and interest expense in subsequent periods are also misstated. Objective: to refine the manner of applying existing accounting principles in this circumstance. Thus, it is not intended to create a new accounting principle. |
|
| 2 | Applicability. This Opinion is applicable to receivables and payables which represent contractual rights to receive money or contractual obligations to pay money, whether or not there is any stated provisions for interest. Such receivables and payables are collectively referred to as "notes." Examples: secured and unsecured notes, debentures, bonds, mortgage notes, equipment obligations, and some accounts receivable and payable. | |
| Discussion | ||
| 6 | Note received or issued for cash | |
| total interest = difference between the actual amount of cash received by the borrower and the total amount agreed to be repaid to the lender. | ||
| The difference between the face amount and the proceeds upon issuance is shown as either discount or premium, which is amortized over the life of the note. | ||
| 7 | Note issued or received for cash plus some stated or unstated right or obligation. | |
| The rights or
privileges are
given accounting recognition by establishing a note discount or premium
account.
In such instances, the effective interest rate differs from the stated rate. |
||
| 8 | Note received or issued in a noncash transaction: | |
| A note exchanged for property, goods, or service represents two elements, which may or may not be stipulated in the note: | ||
| 1. | The principal amount, equivalent to the bargained exchange price of the property, goods, or service as established between the supplier and the purchaser | |
| 2 | an interest factor to compensate the supplier over the life of the note for the use of his funds. | |
| Notes so exchanged are
accordingly
valued and accounted for at the present value of the consideration
exchanged
between the contracting parties in a manner similar to that followed
for
a cash transaction.
The difference between the face amount and the present value upon issuance is shown as either discount or premium, which is amortized over the life of the note. |
||
| 9 | Determination of Present Value: | |
| 1. | Established exchange price [same as the price would be for a cash sale] of property, goods, or service acquired or sold in consideration for a note may be used to establish present value. | |
| 2. | When notes are traded in an open market, the market rate of interest and market value of the notes provide the evidence of present value. | |
| 3. | In absence of (1) or (2) above, the present value of a note that stipulates either no interest or a rate of interest that is clearly unreasonable should be determined by discounting all future payments on the notes using an imputed rate of interest. This determination should be made at the time the note is issued, assumed, or acquired, any subsequent changes in prevailing interest rates should be ignored. | |
| Note: The Board expressed the view that (1) and (2) above are preferable to (3) | ||
| Opinion | ||
| 11 | Note exchanged for cash | |
| a. | Note exchanged solely
for cash
The note is assumed to have a present value equal to the cash proceeds exchanged. |
|
| b. | Note exchanged for cash
plus some other rights or privileges
The value of the rights or privileges should be given accounting recognition. |
|
| 12 | Note exchanged for property,
goods, or service.
General assumption: 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: |
|
| 1. | The interest rate is not stated, or | |
| 2. | The stated interest rate is unreasonable, or | |
| 3. | The stated face amount of the note is materially different from the current sales price for the same or similar items or from the market value of the note at the date of the transaction. | |
| 13 | Determining an appropriate interest rate: | |
| No specific interest rate applicable in all circumstances | ||
| Some general guides in selecting a rate. | ||
| Credit standing of the issuer | ||
| Restrictive covenants. | ||
| The Collateral | ||
| Payment and other terms pertaining to the debt | ||
| Tax consequences to the buyer and seller | ||
| Additional considerations. | ||
| Prevailing rates for similar instruments of issuers with similar credit ratings will normally help determine the appropriate interest rate. | ||
| Rate will normally be at least equal to the rate at which the debtor can obtain financing of a similar nature from other sources at the date of the transaction | ||
| Objective in selecting a rate: to approximate the rate which would have resulted if an independent borrower and an independent lender had negotiated a similar transaction under comparable terms and conditions with the option to pay the cash price upon purchase or to give a note for the amount of the purchase which bears the prevailing rate of interest to maturity. | ||
| 14 | The selection of a rate may also be influenced by: | |
| An approximation of the prevailing market rates for the source of credit that would provide a market for sale or assignment of the note. | ||
| The prime or higher rate for notes which are discounted with banks, giving due might to the credit standing of the maker. | ||
| Published market rates for similar quality bonds | ||
| Current rates for debentures with substantially identical terms and risks that are traded in open markets. | ||
| The current rate charged by investors for first or second mortgage loans on similar property. | ||
| 15 | Amortization of discount and premium. | |
| Difference between present value and the face amount should be treated as discount or premium and amortized as interest expense over the life of the note. | ||
| Should use the "interest" method - amortize in such a way as to result in a constant rate of interest when applied to the amount outstanding at the beginning of any given period. | ||
| Other amortization methods not completely ruled out if results obtained are not materially different. | ||
| 16 | Statement Presentation of Discount and Premium: The discount or premium is not an asset or liability separable from the note giving rise to it. | |
| Should be reported in the balance sheet as a direct deduction from or addition to the face amount of the note. | ||
| Should not be classified as a deferred charge or deferred credit. | ||
| Description of note should
include:
effective interest rate face amount should be disclosed in the financial statements or in the notes to the statements |
||
| Amortization of discount or premium should be reported as interest in the statement of income | ||
| Issue costs should be reported [separately] in the balance sheet as deferred charges | ||