Accounting for Promissory Note.pdf

Unit VI Accounting for Promissory Note Overview Background

A promissory note is a written promise made by a maker, i.e., the person or business that signs the note, promising to pay the payee, i.e., the creditor, a certain amount of money at a fixed determinable future time which may or may not include interest.

Purpose

The purpose of Unit VIII “Accounting for Promissory Note” is to illustrate how an issued promissory note would be recorded in the books of both the maker and the payee. A lengthy discussion of discounting customers’ promissory note is also included in this unit.

In this unit

This unit contains the following topics: Topics Promissory Note Typical Transactions Interest on Notes Discounting a Note Receivable Endorsement or Discounting with Recourse Notes Receivable Discounted in the Balance Sheet Discounting Own Note Issued Review Questions Exercises

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Promissory Note Overview

A promissory note is an unconditional promise to pay a definite sum of money on demand or at a future date (Needles, Belverd, et al, 1999). This written promise made by a maker promising to pay a payee a sum certain in money at a fixed or determinable future time may or may not include interest.

Illustration

The payee regards all promissory notes it holds that are due in less than a year as Notes Receivable in the current assets section of the balance sheet. The maker regards them as Notes Payable in the current liabilities section of the balance sheet (Needles, Belverd, et al, 1999). The following is an example of a simple promissory note. Quezon City, Philippines P10,000.00 July 1, 20X1 PROMISSORY NOTE FOR VALUE RECEIVED, I promise to pay Joseph Labrador the amount of Ten Thousand Pesos (P10,000.00) on August 30, 20X1 plus interest at the annual rate of 12 percent. (Signed) Mary de Jesus Continued on next page

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Promissory Note, Continued Components

The components of a promissory note are as follows:  Maker. The person or business that signs the note and promises to pay the amount required by the agreement. The maker is the debtor. In the illustration – Mary de Jesus.  Payee. The person or business to whom the maker promises future payment. The payee is the creditor. In the illustration – Joseph Labrador.  Principal amount or principal. The amount loaned out by the payee and borrowed by the maker of the note. In the illustration – P10,000.00.  Interest. The revenue to the payee for loaning out principal and the expense to the maker for borrowing the principal.  Interest period or term of the note. The period of time during which interest is to be computed. It extends from the date of the note to maturity date.  Interest rate. The percentage rate that is multiplied to the principal amount and the term of the note in computing for the interest.  Maturity date or due date. The date on which final payment of the note is due.  Maturity value. The sum of principal and interest due at the maturity date of note.  Place of issue. The locality where the maker executed the note. In the illustration – Quezon City.

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Typical Transactions Overview

A promissory note may arise from any of the following transactions: 1. A client receives services on goods for which he issues a promissory note in favor of the company. The client is a debtor and is the maker of the note. The company to whom the note was issued is a creditor and is the payee of the note. 2. The client has an outstanding account with the company, which will become due. If the client is not in a position to pay, he could offer a promissory note to extend time for the payment of his account. 3. A loan is extended to a borrower who issues a promissory note. The borrower is a maker-debtor and the lender is a payee-creditor.

Illustration No.1

Note arising from services rendered or goods sold. When a company renders services or sells merchandise to a customer and receives a promissory note in consideration for such goods or services, the transaction is recorded as: Notes Receivable Service Income or Sales Received note for services rendered or goods sold.

Illustration No. 2

xxx

Note arising to extend an account. If the sample promissory note illustrated is given to extend payment of an account, the transaction will be recorded as: Notes Receivable Account Receivable Received note to extend payment of an account.

Illustration No. 3

xxx

xxx xxx

Note arising from a loan transaction. If the note was received in consideration of a loan, the transaction will be recorded as: Notes Receivable Cash Received note for a loan granted.

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xxx xxx

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Interest on Notes Overview

A promissory note may either be a non-interest or an interest-bearing note. A non-interest bearing note is a promissory note, which does not provide any payment for interest so that the amount to be paid at maturity is equal to the face value of the note. An interest-bearing note, on the other hand, is a note which provides for payment of the interest so that the amount to be paid at maturity is equal to the maturity value, i.e., sum of the principal and interest

Illustration

The sample promissory note illustrated above issued by Mary de Jesus in favor of Joseph Labrador for P10,000 is an interest-bearing note. The note will become due on August 30, 20X1. On this date Labrador will receive full payment on the note. Interest is computed using the formula: Principal x Rate x Time. Therefore: Interest (P10,000 x 12% x 60/360)

P

Principal Maturity Value

200 10,000

P 10,200 =======

The entry to record collection of the note at maturity is: Cash Notes Receivable Interest Income Collected note on the date of maturity

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10,200 10,000 200

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Discounting a Note Receivable Overview

A promissory note is a negotiable instrument. This means that a note is readily transferable from one business or person to another and may be sold for cash. To obtain quick cash, payees sometimes sell or endorse a note received from another party before it matures. The payee normally endorses the note to a bank, which in turn collects the maturity value from the maker at maturity date.

Note Receivable Discounting

Endorsing a note receivable before maturity is called discounting a note receivable because the payee of the note receives less than its maturity value. This lower amount decreases the amount of interest income the payee earns on the note. Giving up some of this interest is the price the payee is willing to pay for the convenience of receiving cash early.

Endorsement

When a note is discounted at the bank before maturity, the bank advances the money equal to its value on the date of discounting computed on the bank rate of discount. The endorsement to the bank may either be •

with recourse or

•

without recourse.

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Endorsement or Discounting with Recourse Overview

The holder of the note (usually the payee) endorses the note and delivers it to the bank. The bank in turn pays the amount equal to the net cash proceeds (i.e., maturity value less the discount charged by the bank) to the endorser (usually the payee of the note). The bank expects to collect the maturity value of the note on the maturity date but also has recourse against the endorser or seller of the note. If the maker fails to pay on maturity date, the endorser is liable to the bank for payment (Needles, Belverd, et al, 1999). The endorser has a contingent liability in the amount equal to the maturity value of the note plus any protest fee that may be charged by the bank for the dishonoring of the note by the maker.

Illustration

Endorsement or discounting with recourse, therefore, has the effect of guaranteeing the payment of the note at maturity by the maker. If the maker does not pay, the endorser is liable to pay the bank. To illustrate, Joseph de Jesus, the maker, gives a 60-day, 12%, P10,000 note to Maria de la Cruz, the payee, on July 1, 20X1. On July 27, 20X1, de la Cruz endorses the note to Cocobank for discounting. On Aug. 30, 20X1, the maker de Jesus, should pay the bank. If he fails to do so, Cocobank can collect from the endorser, de la Cruz. The endorser, i.e., Maria de la Cruz, discounting the note with recourse, by such endorsement, incurs a liability depending upon a contingent event. This event is the failure of the maker, i.e., Joseph de Jesus, to pay the note at maturity. Not until after this event may the endorser be held liable for payment by the bank. This is known in accounting as a contingent liability. Continued on next page

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Endorsement or Discounting with Recourse, Continued Without Recourse

Endorsement or discounting without recourse is done by writing the words without recourse in the endorsement. Example of such endorsement is: Without recourse

The effect of an endorsement without recourse is to exempt the endorser from any liability, if the maker does not pay at maturity with certain exceptions. Generally, therefore, the endorser in this case does not incur any liability, even if only a contingent one. This type of discounting (without recourse) has the effect of collecting the note from a party (the bank), which assumes the role of the creditor. As such the credit entry is to Notes Receivable (Pasion, D., Pasion, W., Pasion, E., 1990).

Illustration of discounting with recourse

The following discussions will pertain only to discounting of notes with recourse. There are three dates encountered in the computation of the amount to be received from the bank for a note receivable discounted. To Illustrate, assume the following transactions: July 1, 20X1 - For merchandise sold, Mary de la Cruz received from Joseph de Jesus a P10,000 note, dated today, due in 60 days at 12%. July 27, 20X1 - Mary de la Cruz discounted the note of Joseph de Jesus at BPI. Bank discount rate is 14%.

The above may be diagrammed as follows: 60 days Date of 26 days Date of 34 days of note ____________________Discounting ______________ Maturity July 1 July 27 30

Date Aug.

The diagram illustrates that the entire term of the note is for 60 days. The start of the line diagram, i.e., July 1 represents the date Joseph issued the note (i.e., to Mary). There are 26 days considered the note was expired From July 1 to July 27, which is the date the note was discounted. The term of the note of 60 days less the expired days of 26 is equal to 34 days, which in turn represent the discount period (i.e., the period from the date the note was discounted up to maturity date). Continued on next page

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Endorsement or Discounting with Recourse, Continued Computing for the Net Proceeds

Steps in computing for the net proceeds, i.e., the amount to be paid by the bank to the endorser of the note. I. Determine the maturity value. Principal Add: Interest (10,000 x 12% x 60/360) Maturity Value

10,000 200 10,200 =====

II. Count the number of days from the date of discounting to the date of maturity. This is the discount period. Discount period = July 27 to August 30 July (31-27) exclude 27 = August = Discount period =

4 30 34 days =======

III. Compute the discount. In computing for the discount, the bank normally gives a higher discount rate but if no rate was given, use the interest rate of the note. Discount = Maturity Value x Discount Rate x Discount Period 10,200 x 14% x 34/360 = 134.87 IV. Compute for the net cash proceeds Net Proceeds = Maturity Value - Discount Maturity Value 10,200.00 Less: Discount 134.87 Net Proceeds 10,065.13 - The amount to be paid by ======= BPI to de la Cruz on July 27. Continued on next page

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Endorsement or Discounting with Recourse, Continued Journal Entries Date July 1

The following are the journal entries:

Joseph de Jesus’ Book Purchases 10,000 Notes Payable 10,000 Purchased Merchandise

Mary de la Cruz’s Book Notes Receivable 10,000 Sales 10,000 Sold - Merchandise

Discounted Joseph's note at 14%.

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I Cash 10,065.13 Interest Expense 134.87 Interest Income 200 Notes Receivable Discounted 10,000 Discounted note at 14% to BPI. Assuming Joseph paid the note at maturity. II 10,000 Notes Receivable Discounted 10,000 200 Discounted 10,200 Notes Receivable 10,000 To close contingent liability

Aug. 30

Notes Payable Interest Expense Cash Paid Note at maturity

Sept. 1

Assuming Joseph failed to honor the note at maturity and BPI charged a protest fee of P500. III Notes Payable 10,000 Accounts Receivable 10,700 Interest Expense 700 Cash 10,700 Accounts Payable 10,700 Paid dishonored note with protest fee. Dishonored note at maturity. Notes Receivable Discounted 10,000 Notes Receivable 10,000 To close contingent liability

***

*** In theory, this entry must be effected, but actual experience shows that a maker does not ordinarily prepare this entry but instead prepares an entry only when the note is finally paid. Continued on next page

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Endorsement or Discounting with Recourse, Continued Discussion

The following are the explanations for the different parts of the discounting process: I

-

As per computations, the net proceeds of the note is P10,065.13. The interest for 26 days (July 1 to July 27) amounting to P86.67 is considered earned by de la Cruz. As a contingent liability is incurred, Mary de Jesus should credit a contingent liability account, Notes Receivable Discounted. It would not be proper to credit Notes Receivable, as this procedure would not show the contingent liability in the accounts.

II

- The payment made by Joseph to the bank has two effects: (1) it discharges Mary from the guarantee Joseph has made to the bank and (b) Mary has no more claim from Joseph. These two effects are shown in the entry above.

III

- Non-payment by Joseph to the bank has two effects: (1) it makes Mary a guarantor/endorser liable to the bank and thus, making her pay the maturity value of the note plus any protest fee that may be charged by the bank. (2) Payment by Mary to the bank does not release Joseph from his liability. Although the note is no longer binding, he is still liable to Mary to an amount equal to maturity value plus protest fee.

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Notes Receivable Discounted in the Balance Sheet Overview

We have learned that in a discounting with recourse, we are creating a new account title called “Notes Receivable Discounted” to indicate the presence of a contingent liability in the books of the endorser. How do we present this in the balance sheet would be the focus of the following discussions.

Four Methods

There are four methods of presenting the contingent liability on notes discounted in the balance sheet. They are the following:

1. As a contingent liability on the liability side BALANCE SHEET Current Assets: Notes Receivable Plant, Property & Equipment:

P50,000

Current Liabilities: Long Term Liabilities: Contingent Liabilities: Notes Receivable Discounted P10,000

2. As a deduction form Notes Receivable on the asset side: BALANCE SHEET Current Assets: Notes Receivable P50,000 Less: Notes Receivable Discounted 10,000

P40,000

3. As a footnote to the Balance Sheet with the Notes Receivable being shown as net. BALANCE SHEET Current Assets: Notes Receivable P40,000 FOOTNOTE: There is a P10,000 note discounted at BPI. 4. As a parenthetical note in the Balance Sheet BALANCE SHEET Current Assets: Notes Receivable (Discounted, P10,000)

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P40,000

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Discounting Own Note Issued Overview

It will be noted in the illustrations on Joseph de Jesus’ book that interest is not recorded at the time the note is issued. Payment of interest is usually made on maturity date of the note. There is another method of issuing promissory note where the creditor would collect the interest on the note being issued by the maker on the same day the loan was granted. This scheme in paying interest in advance for the note issued is called discounting one’s own note. In this case, there are two alternative methods of recording such transactions, either the expense, Interest Expense account or the asset, Prepaid Interest account may be debited. Notes Payable account is credited at face value of the note and Cash account is debited for the net amount, i.e., face value of the note minus the interest.

Illustration

On July 1, for money borrowed, Joseph de Jesus discounted its own 30-day, 12% P10,000 note with Mary de la Cruz. The following will be the possible entries to record the July 1 transaction: de Jesus’ Book July 1

Cash Interest Expense Notes Payable Discounted own note. or Cash Prepaid Interest Notes Payable Discounted own note.

9,900 100 10,000 9,900 100 10,000

When the maker pays the discounted note on the date of maturity, he will pay only an amount equal to the face value of the note issued. Since the payee deducted already from the amount loaned to the maker the interest that the former will be earning from the note on maturity date, the maker will no longer pay the interest. Thus, if de Jesus pays the note on July 31, he would be paying only P10,000, the principal amount of the note. de Jesus’ Book July 31 Notes Payable Cash Settled discounted note.

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10,000 10,000

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