5) On December 31, 20x1 Allan Richards, a general building contractor, completed

Question

5) On December 31, 20x1 Allan Richards, a general building contractor, completed renovation work on office space for the Astor Company. Mr. Richards was offered three different forms of payment (on December 31, 20x1), as follows: a) A non-interest bearing note due on December 31, 20x4 (3-year note) b) A promissory note due on December 31, 20x4: for: $235,000 Face Value: 210,000 4% Stated Interest Rate: Interest payment dates: December 31, 20x2, 20x3 and 20x4. c) A series of three cash payments to Mr. Richards: Each payment amount: $70,000 Payment dates: December 31, 20x1, December 31, 20x2 and December 31, 20x3. The fair value of the services is not known and the notes are not readily marketable. Under the current circumstances, the recent interest rate incurred by Mr. Richards was: The recent interest rate incurred by the Astor Company was: IThe effective interest method of amortization is used by both parties to this transaction. 8% 6% REQUIRED: (Reminder: Round to the nearest dollar.) 1) Determine which form of payment Mr. Richards should select (from choices A, B or C above) and indicate WHY that form of payment was chosen. Based on your answer to (1) above (for the choice you selected): [a] 2) Prepare the appropriate journal entry (ies) that Mr. Richards should make on December 31, 20x1. Prepare the appropriate journal entry (ies) on December 31, 20x2. Indicate the proper balance sheet presentation for the outstanding note receivable [b] [c] as of December 31, 20x2.

Explanation / Answer

1. To choose the form of payment, we first need to calculate the Present value of payments to be made under all the alternatives. Since, we are calculating it from the point of view of Mr. Richards, interest rate of 8% will be used for calculating discounting factors.

Present value under Alternative A = 235,000 / (1.08)^3 = 235,000 / 1.25971 = $186,551
Present value under Alternative B = 8,400 / 1.08 + 8,400 / (1.08)^2 + 218400 / (1.08)^3  
                                                      = 7,778 + 7,202 + 173,373 = $188,353
Present value under Alternative C = 70,000 + 70,000 / 1.08 + 70,000 / (1.08)^2  
                                                      = 70,000 + 64,815 + 60,014 = $194,429

Since, the present value of payment under Alternative C is least, Mr. Richards should choose the Alternative C as form of payment.

2. Journal entries

c. Mr. Richards would show Outstanding Note Receivable at 186,551 + 14,924 = $201,475 under Non-current assets in the balance sheet as of December 31, 2002.

Date Description Debit Credit a. Dec 31, 2001 Note Receivable 186,551      Service Revenue 186,551 b. Dec 31, 2002 Note Receivable (186,551 x 8%) 14,924      Interest Revenue 14,924

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