Question

E7.11 (LO 6) (Interest-Bearing and Non–Interest-Bearing Notes) Little Corp. was experiencing cash flow problems and was unable to pay its $105,000 account payable to Big Corp. when it fell due on September 30, 2020. Big agreed to substitute a one-year note for the open account. The following two options were presented to Little by Big Corp.:

Option 1: A one-year note for $105,000 due September 30, 2021. Interest at a rate of 8% would be payable at maturity.
Option 2: A one-year non–interest-bearing note for $113,400. The implied rate of interest is 8%.
Assume that Big Corp. has a December 31 year end.

Instructions
a. Assuming Little Corp. chooses Option 1, prepare the entries required on Big Corp.'s books on September 30, 2020, December 31, 2020, and September 30, 2021.

b. Assuming Little Corp. chooses Option 2, prepare the entries required on Big Corp.'s books on September 30, 2020, December 31, 2020, and September 30, 2021.

c. Compare the amount of interest income earned by Big Corp. in 2020 and 2021 under both options. Comment briefly.

d. From management's perspective, does one option provide better liquidity for Big at December 31, 2020? Does one option provide better cash flows than the other?

Answer 1

Answer.

a) When option 1 is selected, the required Journal Entries are as follows.
Date	Account Tittle	Debit	Credit
2020
Sept.30	Account Payable	$105,000
	Notes Payable		$105,000
	To record acceptance of note payable
Dec.31	Interest Expense	$2,100
	Interest Payable		$2,100
	To record outstanding interest payable
2021
Sept.30	Notes Payable	$105,000
	Interest Expense	$6,300
	Interest Payable	$2,100
	Cash		$113,400
	To make payment of note and interest
b) When option 2 is selected, the required Journal Entries are as follows
Date	Account Tittle	Debit	Credit
2020
Sept.30	Account Payable	$105,000
	Discount on Notes Payable	$8,400
	Notes Payable		$113,400
Dec.31	Interest Expense	$2,100
	Discount on Notes Payable		$2,100
	To record amortization of discount
2021	Notes Payable	$113,400
Sept.30	Interest Expense	$6,300
	Discount on Notes Payable		$6,300
	Cash		$113,400
	To record cash payment for Notes payable
c) The amount of interest earned by big corporation under both option one and two is
same i.e, $8,400. Under option 2, the interest is the difference of Principal amount
and face vale of note. That is $113,400 - $105,000= $8,400.
d) Yes, from management perspective, option one does provide better liquidity for Big
at December 31 as it is able to receive the interest payment of $700. Option one
does not provide better cash flow than other. Cash flow for both are same.But
Inflow of cash in option is quick as compared to option 2.