If money doesn’t change hands when a company purchases property, plant, and equipment (PP&E), special issues can arise when valuing PP&E on the balance sheet. If a company signs a note for the asset purchase that extends 12 months past the balance sheet date, the company has to account for the assets using present value.
Imagine that Joe’s Cookie Cutter purchases the machine instead of self-constructing it, for a cost of $324,700. Joe’s doesn’t just have $324,700 lying around, so the company issues a two-year note to the manufacturer for the purchase.
The note is zero interest bearing and the prevailing market rate for the same type of note is 10 percent. Joe’s will make two annual payments for $162,350 at year-end.
On the date of purchase, Joe’s records the note payable for $324,700 and has to divvy up the $324,700 between equipment and discount on note payable using the present value of the note. Going to the appropriate present value of an ordinary annuity table, the factor at the intersection of 2 years and 10 percent is 1.7355.
Equipment books for $281,758 ($162,350 x 1.7335) and discount on note payable is $42,942 ($324,700 – $281,758). At the end of the year, Joe’s records interest expense and reduces the discount on note payable by $28,176 ($281,758 x the market rate of 10%). The following shows how the journal entries look for the purchase and payment at the end of first year.
