The financial accounting term deferred payment contract refers to an agreement to purchase an asset using a long-term credit arrangement. Accountants need to understand the terms of a deferred payment contract since they can be used to value an asset appearing on the company's balance sheet.
Explanation
Accounting rules state that an asset should be recorded at its fair market value, or the fair market value of what the company gave up to acquire the asset. The clarity of fair market value can be obscured by the payment terms when the asset is procured. For example, companies may enter into purchase agreements with sellers that provide them with long-term credit arrangements.
Assets purchased under long-term payment contracts need to be booked at the present value of the future payments. If the contract does not specify an interest rate, or the interest rate is deemed unreasonable, then one must be assigned. The assigned rate should consider the purchaser's credit rating, the length of the contract, and the rate of interest charged on similar arrangements.
Example
Company A has entered into an agreement to purchase a widget maker from Company XYZ. Company A's procurement group has negotiated a contract whereby Company A receives the widget maker in exchange for a non-interest bearing note payable of $50,000 due in three years. Unfortunately, the widget maker will be custom-built for Company A, so it's not possible to determine a fair market value.
Since the note does not indicate a rate of interest, Company A's accounting team has assigned the note payable an interest rate of 6%, which is the rate charged on similar purchases. The present value of the note would be calculated as:
Also known as a statement of financial position, the balance sheet is used to show the financial health of a company at a particular point in time. The balance sheet consists of assets, liabilities, and owner's equity in the company. It is one of the four key financial statements issued by public companies.
The financial accounting term property, plant, and equipment is used to describe assets of a long lasting nature, which are used in the normal operation of the company. The most common types of property, plant, and equipment are land, buildings, and machinery.
The financial accounting term cost of equipment refers to the asset valuation method that applies to equipment appearing on a company's balance sheet. The cost of equipment would include all expenses associated with the acquisition of the equipment as well as those needed to ready it for use by the company.
The financial accounting term cost of buildings refers to the asset valuation method that applies to buildings appearing on a company's balance sheet. The cost of buildings would include all expenses associated with the acquisition or construction of the building to ready it for use by the company.
The financial accounting term cost of land refers to the asset valuation method that applies to land appearing on a company's balance sheet. The cost of land would include all expenses associated with the acquisition of the property, as well as those needed to ready it for use by the company.
The financial accounting term self-constructed assets refer to those built by the company and appearing on its balance sheet. The cost of self-constructed assets would include direct costs such as materials and labor associated with its construction. Companies can optionally allocate a portion of indirect costs to the asset too.
The financial accounting term interest costs during construction refers to the financing charges incurred during the creation or acquisition of assets such as property, plant, and equipment. Companies can capitalize interest costs if they are material, otherwise they should be expensed.
The term lump sum purchase refers to an agreement that involves a single price paid for a bundle, or group, of assets. Since the lump sum purchase can involve several asset classes, it's necessary to allocate the price paid to each asset so the purchase can be accurately reflected on the company's balance sheet.