Zero Interest Bearing Note

Question

On January 1, 2022 Hideki Matsuyama provides services in exchange for a $10,000 zero-interest bearing note due in 4 years. The effective interest rate for a note of this type is 15 percent. What journal entry to interest revenue does Hideki make on December 31, 2023? Use a positive for a debit, negative for a credit, and zero if there is no journal entry.

Answer 1

Lets understand the concept behind this problem and then lets work on the Journal entry.

Hideki performed some service to a Buyer. Buyer has to pay for the service.

Buyer has agreed to Pay $10,000 after 4 years, in the form of Zero Interest bearing note.

+++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++

Lets understand certain concepts here

Zero Interest bearing note means the Buyer dont have to pay during the 4 years any interest.

Zero Interest bearing note DOES NOT mean there is NO Interest. Interest is Built in, it is implied at the Current Market Rate. Basically Interest is there (whenever time is involved interest is certainly there), but it is not paid during the tenure.

As Interest is implied, Hideki has to recognize Interest Income (in addition to the revenue towards providing the service) and the Buyer has to recognize Interest Expense (in addition to the cost of the service).

As the Interest never paid or received during the tenure, Interest amount needs to be shown as Receivable for Hideki and Payable for the Buyer during the 4 years. At the end of the 4 years it will be paid.

Interest is always Compounded (Need to calculate Interest on Interest amount due) and not simple interest.

+++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++

Lets do the Calculation

Hideki will receive $10,000 after 4 years. $10,000 includes Interest amount as well. Interest is Compounded as well.

Basically Lets assume the Charge for the Service is "X".

Then $10,000 = X [ (1.15) * (1.15)*(1.15)*(1.15)]

X = $10,000 / 1.15 power 4

X = $5717.53

You can apply the PV factor for 15% for 4 years = .5717

So the cost to the buyer / income to Hideki from service to be recognized immediately = $5717.53

Interest component for 4 years in total = $10,000 - $5717.53 = $4282.47

The buyer will not pay Interest periodically and also he is not going to pay for the Cost of Service Now. He is going to pay Cost of Service and Interest together at the end of 4 years = $5717.53 + $4282.47 = $10,000

+++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++

Lets do Interest calculation

We know that the Total interest due will be $4282.47. What we dont know is every year how much is the Interest portion to be recognized as Income for Hideki / Expense for the Buyer.

Interest as of End of 1st year = $5717.53 (Cost of Service) * 15% = $857.63. Total due at the end of 1st year = $5717.53 + $857.63 = $6575.16

Interest as of End End of 2nd year = $5717.53*15% + $857.63 *15% = $986.27. Total due at the end of 2nd year = $6575.16 (opening bal) + $986.27 (int) = $7561.44

Interest as of End of 3rd year = $5717.53*15% + $986.27*15% = $1134.22. Total due at the end of 3rd year = $7561.44+ $1134.22= $8695.65

Interest as of End of 4th year = $5717.53*15% + $1134.22*15% = $1304.35. Total due at the end of 4th year = $8965.65+ $1304.35= $10,000

++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++

Journal Entry for Hideki (he is the seller. For him it is Revenue and Receivable)

1-1-2022

Accounts Receivable from Buyer (Dr.) = $5717.53

Service Revenue (Cr.) = $5717.53

(Sale of service. Recognize Service revenue)

+++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++

12-31-2022

Accounts Receivable from Buyer (Dr.) = $857.63

Interest Revenue (Cr.) = $857.63

(1st Year Interest revenue recognition)

+++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++

12-31-2023

Accounts Receivable from Buyer (Dr.) = $986.27

Interest Revenue (Cr.) = $986.27

(2nd Year Interest revenue recognition)

+++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++

12-31-2024

Accounts Receivable from Buyer (Dr.) = $1134.22

Interest Revenue (Cr.) = $1134.22

(3rd Year Interest revenue recognition)

+++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++

12-31-2025

Accounts Receivable from Buyer (Dr.) = $1304.35

Interest Revenue (Cr.) = $1304.35

(4th Year Interest revenue recognition)

Cash (Dr.) = $10,000

Accounts Receivable from Buyer (Cr.) = $10,000

(Final payment of $10,000 and making AR becoming Zero)

+++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++

In the Books of Buyer of the Service (for him it is Cost and Payable)

1-1-2022

Cost of Service (Dr.)= $5717.53 (P&L account)

Discount on Notes payable (Dr.) = $4282.47 (Balance Sheet)

Notes Payable (Cr.) = $10,000 (Balance Sheet to be displayed after Netting off with Discount)

(Recognize Cost of service and create liability for the Notes payable with recognition of Discount)

+++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++

12-31-2022

Interest Expense (Dr.) = $857.63 (P&L)

Discount on Notes Payable (Cr.) = $857.63 (BS)

(Amortize 1st year interest and recognize it as expense)

+++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++

12-31-2023

Interest Expense (Dr.) = $986.27 (P&L)

Discount on Notes Payable (Cr.) = $986.27 (BS)

(Amortize 2nd year interest and recognize it as expense)

+++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++

12-31-2024

Interest Expense (Dr.) = $1134.22 (P&L)

Discount on Notes Payable (Cr.) = $1134.22 (BS)

(Amortize 3rd year interest and recognize it as expense)

+++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++

12-31-2025

Interest Expense (Dr.) = $1304.35(P&L)

Discount on Notes Payable (Cr.) = $1304.35 (BS)

(Amortize 4th year interest and recognize it as expense. Discount on Notes Payable balance is Zero)

Notes Payable (Dr.) = $10,000

Cash (Cr.) = $10,000

(Final payment of Notes payable)