Ch. 13 Accounting for Notes and Interest - … Sheet Presentation of Notes Payable Current...

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Ch. 13 Accounting for Notes and Interest

1. Promissory note

2. Notes Payable and Interest Expense

3. Notes Receivable and Interest Income

4. Discounting a Note

Promissory Notes

A promissory note is a written promise to pay a sum of

money at a definite time in the future.

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Payee

Time

Pay to the order of

Principal

Interest Rate

Due date Payable at

Maker

Date

Parts of a Promissory Notes

• The date of the note

• The time or term of the note

• The words pay to the order of make the note negotiable.

Negotiable means that the note, like a check, can be transferred by

endorsement to another party

• The payee of the note is the person who will be paid when the note

reaches its payment date

• The principal is the amount borrowed or the amount of credit

extended

• Interest is the charge for credit

• The due date is the date the note is due for payment

• The maker of the note is the person who has signed the note and

promises to pay

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Determining the Due Date of Note

A 60-day note is issued on March 15

The note would mature 60 days from March 15:

The due date of the note is May 14

Number of days remaining in March (31-15) 16

Number of Days in April 30

Total days at end of April 46

Days in May to reach 60 14

Term of note 60

Calculating Interest The following formula is used to calculate interest:

Interest = Principal x Rate x Time

Assume a $4,000, 60-day note has an interest rate of 10%

The total interest would be:

$66.67 = $4,000 x .10 x 60/360

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Notes Payable and Interest Expense

Notes payable may be issued in various situations. The most

common include the following:

Note issued to a supplier for an extension of time to pay an

existing account payable

Note issued directly for the purchase of merchandise or other

property

Note issued for a loan of cash

Balance Sheet Presentation of Notes Payable

Current Liability: A note is to be paid within a year

Long-Term Liability: A note not due for payment within the year

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Note Payable Issued for an Extension of Time

Assume on June 17 Julie Kearney purchased $700 worth of

merchandise from Kevin Walsh

Terms of the purchase were n/30

General Journal

Date Account Title P.R. Debit Credit

Jun. 17 Purchases 700

Accounts Payable – Kevin

Walsh 700

Note Payable Issued for an Extension of Time

On July 17, Julie contacted Kevin for an extension of

time to make payment. Kevin requests a promissory

note at 9% and allows Julie 30 days to make

payment.

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General Journal


Jul. 17 Accounts Payable - Kevin

Walsh 700

Notes Payable 700

Payment of a Note at Maturity

Assume on August 16 Julie pays the principal and

interest due on the July 17 note.

Julie made the following entry to record the payment of

the note and interest:

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General Journal


Aug. 16 Notes Payable 700.00

Interest Expense 5.25

Cash 705.25

Note Issued for Merchandise

On March 23, Robert Griffin purchased $2,000 of

merchandise from Southland Foods and issued a 30-day,

12% note.

Robert made the following entry to record the purchase:

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General Journal


Mar. 23 Purchases 2,000

Notes Payable 2,000

Note Issued for Merchandise

On April 22, Robert pays the principal and interest due on

the note and records the following entry:

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General Journal


Apr. 22 Notes Payable 2,000

Interest Expense 20

Cash 2,020

Note Issued for a Loan of Cash

On August 8, Wilcox Company borrowed $5,000 for 90

days at 10% from the Columbus National Bank.

Wilcox made the following entry to record the loan:

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General Journal


Aug. 8 Cash 5,000

Notes Payable 5,000

Note Issued for a Loan of Cash

On Nov. 6, Wilcox Company pays the principal and

interest due on the note and records the following entry:

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General Journal


Nov. 6 Notes Payable 5,000

Interest Expense 125

Cash 5,125

Discounting a Note Payable

The practice of a lending institution to deduct the interest from the

principal at the time of borrowing.

On August 8, Wilcox Company issues a $5,000, 90-day, note which

the bank discounts at 10%.

The bank deducts the interest immediately and Wilcox Company

receives the face amount of the note, less the interest.

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The amount received is known as the proceeds.

Wilcox Company records the following entry on August 8:

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General Journal


Aug. 8 Cash 4,875

Interest Expense 125

Notes Payable 5,000


On Nov. 6, Wilcox Company pays the principal and records

the following entry:

Interest on a discounted note is recorded at the time of

discounting, not at the time of payment.

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General Journal


Nov. 6 Notes Payable 5,000

Cash 5,000

Notes Receivable and Interest Income

Note Receivable

An asset to the person or business receiving the note

An asset because it represents a definite dollar amount that

will be collected at some point in the future

Interest Income

Interest earned on the note

Classified as a non-operating revenue account

Non-operating Revenue: revenue earned from a source

other than the normal operations of the business

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Advantages of a Note Receivable Over an Accounts Receivable

A note is a formal written promise, serving as proof

of a transaction

A note can bear interest, which is additional

revenue

A note is negotiable; it can be transferred by

endorsement to obtain cash or other assets

A note can be pledged (used) as security for a loan

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Reasons to Accept a Note

Allow extension of time for customer to pay an

account receivable

In exchange for sale of merchandise or other assets

For a loan of cash to

Employees

Customers

Other Businesses

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On July 17, Julie requests an extension of time to pay the amount due.

Kevin agrees to accept a 30-day, 9% note for $700 to settle the account.

Kevin prepares the following journal entry:

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General Journal


Jul. 17 Notes Receivable 700

Accounts Receivable – Julie

Kerney 700

Example

Example

Collection of a Note at Maturity

Assume on August 16 Kevin receives the principal

and interest due on the July 17 note.

Kevin makes the following entry to record the receipt

of the note and interest:

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General Journal


Aug. 16 Cash 705.25

Notes Receivable 700.00

Interest Income 5.25

Example

Note Received for Merchandise

On March 23, Southland Foods sells merchandise to

Robert Griffin and accepts a $2,000, 30-day, 12% note.

Southland Foods makes the following entry to record

the sale:

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General Journal


Mar. 23 Notes Receivable 2,000

Sales 2,000

Example

On April 22, Southland receives the principal and interest due on the note and records the following entry:

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General Journal


Apr. 22 Cash 2,020

Notes Receivable 2,000

Interest Income 20

Example

Note Received for a Loan of Cash

On April 1, Wynn Hanks, an employee of Southland

Foods, requested and was granted a $500 loan

from the company.

Wynn was required to sign a 90-day, 12% note in

return for the loan.

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General Journal


Apr. 1 Notes Receivable 500

Cash 500

Example

On June 30, Southland Foods receives the principal and interest due on the note and records the following entry:

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General Journal


Jun. 30 Cash 515

Notes Receivable 500

Interest Income 15

Discounting a Note Receivable

If money is needed before a note receivable matures,

the note can be discounted to a bank or finance

company.

In discounting a note, the bank deducts an interest

charge — the bank discount — from the maturity value

of the note to determine the amount of proceeds to be

received by the original payee of the note.

The maker of the note is then directed to pay the bank

the maturity value of the note on its due date.

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Steps in Discounting a Note Receivable

1. Calculate the maturity value of the note

2. Calculate the due date of the note

3. Calculate the discount period

4. Calculate the amount of the bank discount

5. Calculate the proceeds

6. Journalize the transaction

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Example

Discounting a Note Receivable

Assume Peter Rosenberg received a $9,000, 60-day, 6%

note on account from a customer on July 14.

Peter discounted the note at the First Savings Bank on

August 3.

First Savings Bank charges a discount rate of 12%.

Step 1: The interest on the note

= $9,000 x .06 x 60/360 = $90.

The maturity value = $9,000 + $90 = $9,090

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Example

Step 2: The due date of the note is 60 days after July 14,

or September 12

Step 3: The discount period = the number of days the

bank holds the note from July 14. From July 14

until August 3 = 20 days. Therefore the bank holds

the note for 40 days

Step 4: The amount of the bank discount

= $9,090 x .12 x 40/360 = $121.20

Step 5: The cash proceeds equals the maturity value of

the note less the bank discount, or $9,090 -

$121.20 = $8,968.80 28

Journal Entry to Record Discounting a Notes Receivable

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General Journal


Aug. 3 Cash 8,968.80

Interest Expense 31.20

Notes Receivable 9,000.00

Since the cash proceeds are less than the face value of the note,

interest expense is debited for the difference.

If the cash proceeds had exceeded the face value of the note,

interest income would be credited for the difference.

Contingent Liability on Discounted Notes When a note receivable is discounted, the payee must endorse

the note, thereby transferring ownership to the bank.

The endorsement also means that the payee agrees to pay the

bank the full maturity value of the note should the maker fail to

make payment when the note falls due.

A contingent liability is a possible liability, such as on a

discounted note of a customer, that may become a real liability if

certain events occur.

If a balance sheet is prepared during a time when notes have

been discounted, the balance sheet should show the amount of

the contingent liability in a footnote.

This is required under the adequate disclosure principle, which

states that financial statements must disclose all relevant data

about the financial position of the company.

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Reasons Notes Are Not Paid at Maturity

The maker is unable to pay the note on its due date and requests

an extension of time

The note is dishonored, maker simply doesn’t pay

Notes Renewed at Maturity

If the maker of a note is unable to pay the note at maturity, the

payee may be willing to renew all or part of the note.

When a note is renewed, the old note is canceled and a new note

is created.

The maker will usually pay the interest for the period of the

original note.

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Example Note Renewed at Maturity

Assume Julie Kearney owes Kevin Walsh a $700 note plus

interest of $5.25.

On August 16, the maturity date, Julie asks Kevin if she can

renew the note for another 30 days and pay the interest.

Kevin Walsh records the following entry to receive the interest

income and renew the note:

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General Journal


Aug. 16 Cash 5.25

Notes Receivable (new) 700.00

Notes Receivable (old) 700.00


Dishonored Note

A note not paid for or renewed

A worthless asset, but the payee of the note still has a

claim against the maker for the full maturity value of

the note

Since a dishonored note loses its legal status as a note

receivable, the payee transfers the amount due from

the Note Receivable account to the Accounts

Receivable account

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Example

Dishonored Note

Assume on August 16, Julie dishonors her note to

Kevin Walsh.

Kevin would prepare the following entry:

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General Journal


Aug. 16 Accounts Receivable - Julie

Kearney 705.25

Notes Receivable 700.00


Collection of a Dishonored Note

The payee has a legal right to continue to charge the

payor interest after the note was dishonored.

The interest is figured on the maturity value of the

note.

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Example Collection of a Dishonored Note

Assume in the previous slide Julie pays Kevin the amount due on

the note 30 days after the maturity date.

Kevin charges Julie 9% interest for the additional 30 days.

The additional interest is computed as

$705.25 x .09 x 30/360 = $5.29.

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On September 15, Kevin would prepare the following entry to

record the dishonored note:

General Journal


Sep. 15 Cash 710.54

Accounts Receivable – Julie

Kearney 705.25


Dishonored Discounted Note

When a note is discounted, the maker is directed to

pay the bank the full maturity value of the note on its

due date.

If the payor fails to make payment to the bank, the

bank will notify the endorser and ask for the full

maturity value and, usually, a protest fee.

A protest fee is a fee a bank charges the payee when

the note is dishonored by the maker.

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Example

Dishonored Discounted Note

Assume on Sept. 12, a discounted note with a principal

amount of $9,000 and a maturity value of $9,090 is

dishonored by the payor.

The bank notifies the payee that the note was dishonored

and charges the payee a protest fee of $100.

The payee will record the following journal entry:

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General Journal


Sep. 12 Accounts Receivable - Payor 9,190

Cash 9,190

Example

Collection of a Dishonored Discounted Note

Assume in the previous slide, that the payor pays the

amount due on the account on October 12.

The payee charges 6% interest for 30 days of extra

time.

The payee would record the following journal entry:

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General Journal


Oct. 12 Cash 9,235.95

Account Receivable – Payor 9,190.00


Ch. 13 Accounting for Notes and Interest - … Sheet Presentation of Notes Payable Current...

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