Auditing Standards

Note exchanged for property, goods, or service. When a note is exchanged for property, goods, or
service in a bargained transaction entered into at arm’s length, there should be a general presumption that
the rate of interest stipulated by the parties to the transaction represents fair and adequate compensation
to the supplier for the use of the related funds. That presumption, however, must not permit the form of the
transaction to prevail over its economic substance and thus would not apply if (1) interest is not stated, or
(2) the stated interest rate is unreasonable (paragraphs 13 and 14) or (3) the stated face amount of the
note is materially different from the current cash sales price for the same or similar items or from the market
value of the note at the date of the transaction. In these circumstances, the note, the sales price, and the
cost of the property, goods, or service exchanged for the note should be recorded at the fair value of the
property, goods, or services or at an amount that reasonably approximates the market value of the note,
whichever is the more clearly determinable. That amount may or may not be the same as its face amount,
and any resulting discount or premium should be accounted for as an element of interest over the life of the
note (paragraph 15). In the absence of established exchange prices for the related property, goods,
or service or evidence of the market value of the note (paragraph 9), the present value of a note that
stipulates either no interest or a rate of interest that is clearly unreasonable should be determined
by discounting all future payments on the notes using an imputed rate of interest as described in
paragraphs 13 and 14. This determination should be made at the time the note is issued, assumed, or
acquired; any subsequent changes in prevailing interest rates should be ignored.
13. Determining an appropriate interest rate. The variety of transactions encountered precludes any
specific interest rate from being applicable in all circumstances. However, some general guides may be
stated. The choice of a rate may be affected by the credit standing of the issuer, restrictive covenants, the
collateral, payment and other terms pertaining to the debt, and, if appropriate, the tax consequences to the
buyer and seller. The prevailing rates for similar instruments of issuers with similar credit ratings
will normally help determine the appropriate interest rate for determining the present value of a
specific note at its date of issuance. In any event, the rate used for valuation purposes will normally be
at least equal to the rate at which the debtor can obtain financing of a similar nature from other sources at
the date of the transaction. The objective is to approximate the rate which would have resulted if an
independent borrower and an independent lender had negotiated a similar transaction under comparable
terms and conditions with the option to pay the cash price upon purchase or to give a note for the amount
of the purchase which bears the prevailing rate of interest to maturity.
14. The selection of a rate may be affected by many considerations. For instance, where applicable, the
choice of a rate may be influenced by (a) an approximation of the prevailing market rates for the source of
credit that would provide a market for sale or assignment of the note; (b) the prime or higher rate for notes
which are discounted with banks, giving due weight to the credit standing of the maker; (c) published market
rates for similar quality bonds; (d) current rates for debentures with substantially identical terms and risks
that are traded in open markets; and (e) the current rate charged by investors for first or second mortgage
loans on similar property.i