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, 2014. 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, 2015. 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 I, prepare the entries required on Big Corp.'s books on September 30, 2014, December 31, 2014, and September 30, 2015.
(b) Assuming Little Corp. chooses Option 2; prepare the entries required on Big Corp.'s books on September 30, 2014, December 31, 2014, and September 30, 2015.
(c) Compare the amount of interest income earned by Big Corp. in 2014 and 2015 under both options. Comment briefly.
(d) From management's perspective, does one option provide better liquidity for Big at December 31, 2014? Does one option provide better cash flows than the other?