Let's assume that a company gives a promissory note for $10,000 to someone in exchange for a unique used machine for which the fair value is not known. The note will come due in three years and it does not specify any interest. Due to the company's weak financial position it will have to pay a high interest rate if it were to borrow money. In this example, there is no explicit interest cost. However, due to the issuer's financial difficulty and the seller having to wait three years to collect the money, there has to be some interest cost. In other words, there is some interest and it is implicit. To properly record the note and the machine, the accountant must determine the amount of the interest, which is known as imputing the interest. In effect the accountant must convert the implicit interest to explicit interest. This is done by discounting the $10,000 by using the interest rate that the issuer of the note would have to pay to another lender. If the rate is 12% per year, the interest that was implicit in the note is $2,880 and the principal portion of the note is the remaining $7,120.
If another company with the same financial condition purchased this unique machine by issuing a $7,120 note with a stated interest rate of 12% per year, the interest cost of $2,880 would be explicit. In this situation, there is no need to impute the interest.
Another example of an implicit cost is the opportunity cost of a sole proprietor working in her own business. For example, Gina works as a sole proprietor and her business reported a net income of $30,000 for the year. Since a sole proprietor does not receive a salary or wages, there is no explicit cost reported for Gina's work in her business. However, if Gina is foregoing a salary of $40,000 from another company, that is an implicit cost for her business. After considering this implicit cost, Gina is losing $10,000 by working in her proprietorship.
If Gina operates her business as a corporation, Gina will be an employee of the corporation. If her annual salary is $40,000 the corporation's income statement would report the $40,000 salary as an explicit cost for Gina's work.
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