Accounting for Zero-Interest-Bearing Note Soon after beginning the year-end audit work on March 10 at Engone Company, the auditor has the following conversation with the controller. CONTROLLER: The year ended March 31st should be our most profitable in history and, as a consequence, the board of directors has just awarded the officers generous bonuses.
AUDITOR: I thought profits were down this year in the industry, according to your latest interim report.
CONTROLLER: Well, they were down, but 10 days ago we closed a deal that will give us a substantial increase for the year.
AUDITOR: Oh, what was it?
CONTROLLER: Well, you remember a few years ago our former president bought stock in Henderson Enterprises because he had those grandiose ideas about becoming a conglomerate. For 6 years we have not been able to sell this stock, which cost us $3,000,000 and has not paid a nickel in dividends. Thursday we sold this stock to Bimini Inc. for $4,000,000. So, we will have a gain of $700,000 ($1,000,000 pretax) which will increase our net income for the year to $4,000,000, compared with last year's $3,800,000. As far as I know, we'll be the only company in the industry to register an increase in net income this year. That should help the market value of the stock!
AUDITOR: Do you expect to receive the $4,000,000 in cash by March 31st, your fiscal year-end?
CONTROLLER: No. Although Bimini Inc. is an excellent company, they are a little tight for cash because of their rapid growth. Consequently, they are going to give us a $4,000,000 zero-interest-bearing note with payments of $400,000 per year for the next 10 years. The first payment is due on March 31 of next year.
AUDITOR: Why is the note zero-interest-bearing?
CONTROLLER: Because that's what everybody agreed to. Since we don't have any interest-bearing debt, the funds invested in the note do not cost us anything and besides, we were not getting any dividends on the Henderson Enterprises stock. Do you agree with the way the controller has accounted for the transaction? If not, how should the transaction be accounted for?