Problem 6 - Accounting

Question

On June 30, Mystic Mountain Game Company purchased land for \(\$ 250,000\) and a building for \(\$ 690,000\), paying \(\$ 240,000\) cash and issuing an \(8 \%\) note for the balance, secured by a mortgage on the property. The terms of the note provide for 20 semiannual payments of \(\$ 35,000\) on the principal plus the interest accrued from the date of the preceding payment. Journalize the entry to record (a) the transaction on June 30 , (b) the payment of the first installment on December 31 , and (c) the payment of the second installment the following June 30 .

Step-by-Step Solution

Answer

Record the purchase using Land: $250,000 Building: $690,000 Cash: -$240,000 Notes Payable: -$700,000. Payments split: interest $28,000 (first) and $26,600 (second).

Step 1: Determine Total Purchase Cost

The total cost of the land and building is the sum of both, which is \(\(250,000 + \)690,000 = $940,000\).

Step 2: Calculate Cash and Note Payable

Mystic Mountain Game Company paid \(\(240,000\) in cash and issued an \(8\%\) mortgage note for the balance. The balance is \(\)940,000 - \(240,000 = \)700,000\).

Step 3: Journalize June 30 Transaction

The journal entry on June 30 to record the purchase is as follows: 1. Debit Land for \(\(250,000\) 2. Debit Building for \(\)690,000\) 3. Credit Cash for \(\(240,000\) 4. Credit Notes Payable for \(\)700,000\).

Step 4: Calculate Interest for First Payment

The interest for the first payment on December 31 is calculated on the full note balance of \(\(700,000\). The interest is \(\frac{8}{100} \times \frac{6}{12} \times 700,000 = \)28,000\).

Step 5: Journalize First Installment Payment

For December 31 payment: 1. Debit Interest Expense for \(\(28,000\)2. Debit Notes Payable for \(\)35,000\) (principal portion)3. Credit Cash for \($63,000\) (sum of interest and principal).

Step 6: Calculate Interest for Second Payment

The balance after the first payment is \(\(700,000 - \)35,000 = \(665,000\). Calculate interest for the second installment: \(\frac{8}{100} \times \frac{6}{12} \times 665,000 = \)26,600\).

Step 7: Journalize Second Installment Payment

For the payment made on June 30: 1. Debit Interest Expense for \(\(26,600\)2. Debit Notes Payable for \(\)35,000\) (principal portion)3. Credit Cash for \($61,600\) (sum of interest and principal).

Key Concepts

Mortgage Note

A mortgage note is an agreement in which a borrower pledges a property as security for a loan. In this case, Mystic Mountain Game Company purchased land and a building by making a down payment of $240,000 and issued a mortgage note for the remaining balance. This note specifies that the remaining amount of $700,000 is secured against the property, and the borrower is required to make periodic payments, including both principal and interest.

A mortgage note typically includes the loan amount, interest rate, payment schedule, and terms of default. The interest rate applied here is 8%, signifying that the company is liable to pay not just the borrowed principal but also the interest calculated over the life of the loan. It is essential for companies to carefully read and understand all the terms laid out in a mortgage note, as it binds the borrower legally to meet these obligations.

Interest Calculation

Interest calculation plays a crucial role in determining the total cost of borrowing under a mortgage note. In this exercise, interest is calculated on the outstanding balance of the note. The company taps into an 8% annual interest rate, but since the payments are semiannual, the interest is calculated for 6 months at a time.

Let's break down the process:

• Calculate the interest for the first six-month period: \( ext{Interest} = rac{8}{100} imes rac{6}{12} imes 700,000 = 28,000\)
• For the next period, after a principal payment of $35,000: \( ext{New Principal} = 700,000 - 35,000 = 665,000\)
• Calculate the new interest: \( ext{Interest} = rac{8}{100} imes rac{6}{12} imes 665,000 = 26,600\)

Each period's interest is calculated based on the reduced principal amount. This method ensures that over time, as the debt principal decreases, the interest expense also reduces, leading to a more manageable debt load.

Installment Payments

Installment payments comprise two components: the principal repayment and the interest. It is a common way to repay debts as it breaks down the payment into manageable chunks.

In this context:

• Each semiannual installment includes a principal repayment of $35,000.
• The interest amount is calculated based on the remaining balance before the payment.

For example, for the payment on December 31:

• Interest = $28,000
• Principal = $35,000
• Total Payment = $63,000 (Sum of principal and interest)

Similarly, the payment on June 30 consists of:

• Interest = $26,600
• Principal = $35,000
• Total Payment = $61,600

These installment payments help the company to systematically reduce the debt at each interval while also managing cash flow effectively.

Asset Purchase Accounting

Assets like land and buildings are significant investments for a business. Recording their purchase correctly in the books is essential for accurate financial reporting.

When Mystic Mountain Game Company purchased these assets, the transaction involved:

• Debiting the "Land" account by $250,000
• Debiting the "Building" account by $690,000
• Crediting the "Cash" account by $240,000 to reflect the cash paid
• Crediting "Notes Payable" by $700,000 for the mortgage note

This journal entry ensures that the financial statements accurately depict the company's assets and liabilities. Accurate asset purchase accounting not only helps in preparation of true financial statements but also aids in future depreciation calculations and investment analyses.