College Accounting, by Heintz and Parry Chapter 17: Accounting for Notes and Interest

In late February, Eddie called a local disc jockey named C. D. Player (real name Cal Plotnick) to let him know that he was 5 days late paying his $440 bill (they instituted this procedure after the “Diss Jockey” Dan Miller debacle). Mr. Player asked if he could send the store a promissory note (a written promise to pay a specific amount on a specific date). He wanted an extra 90 days to pay and he was willing to pay the store 12% interest to get the extension. Before he agreed, Nick wanted to know how much interest he would be receiving. Question: How much interest would the store receive on this note?

Answer: Interest would be calculated using the following formula: Principal X Rate X Time = Interest or $440 X 12% X 90/360 = $13.20 Time is expressed as a fraction of a year because the interest rate is expressed as an annual rate. Most banks and businesses use 360 days as the denominator because they’re allowed to (and it increases the interest collected). Based on this information, Nick decided to accept the note. Question: What accounts would be debited and credited (and for what amount) when the store receives this note?

Answer: The entry is shown below. Date Description P. R. Debit Credit 2001 Feb. 22 Notes Receivable Accounts Receivable-C. D. Player The due date would be calculated as follows: Days in February: 28 Minus date of note: - 22 Days remaining in Feb. 6 Add: Days in March 31 Days in April 30 Total days before May total days - 67 before May = May 23 is the due date. Question: What accounts would be debited and credited (and for what amount) when the note is paid on May 23?

Answer: The entry is shown below. Date Description P. R. Debit Credit 2001 May 23 Cash Notes Receivable Interest Revenue The $ payment received is called the maturity value (calculated as principal + interest). “What if he doesn’t have the money by May 23?” Nick asked. Eddie thought about that for a second. “One option is that he could make a partial payment and issue a new note for the rest.” Question: What accounts would be debited and credited (and for what amount) if C. D. Player paid the interest plus $100 and issued a new note on May 23?

Answer: The entry is shown below. Date Description P. R. Debit Credit 2001 May 23 Cash Notes Receivable (new note) Notes Receivable (old note) Interest Revenue “Okay, Eddie, that could work, but what if we really need the money? A new note isn’t going to do us much good then.” “Actually, Nick, you can turn the note into cash at any time. You just take the note to the bank and discount it. Let’s say that 30 days from now you want the money. The bank would pay you the maturity value, less a discount based on a discount rate of 15% (for our example) that allows them a fair profit on the deal.” Questions: What formula is used to calculate a discount? What would the discount be in this example?

Answer: ”The discount would be calculated using the following formula: Maturity Value $ X Bank Discount Rate X 15% X Time Until Maturity X 60/360 = Discount $11.33 The relevant time is 60 days because the note is for 90 days and you’ve held it for 30, so the bank will have to wait = 60 days to get the money. The amount of money you receive, also called the proceeds, is based on the formula: Maturity value - Discount = Proceeds, which in this case would be $ = $ ” Question: What accounts would be debited and credited (and for what amount) when the bank discounts this note?

Answer: The entry is shown below. Date Description P. R. Debit Credit 2001 Mar. 24 Cash Notes Receivable Interest Revenue 1.87 “Of course, if you discount the note too soon, you might actually lose money, and the difference would need to be debited to interest expense.” “All of that makes sense, Eddie, but what happens if C. D. Player doesn’t pay the bank when the note is due?” “Good question. According to most bank discounting agreements, we would have to pay off the dishonored note, along with a small added bank fee, maybe $10.” Question: What accounts would be debited and credited (and for what amounts) when the store pays the bank for the dishonored note?

Answer: The entry is shown below. Date Description P. R. Debit Credit 2001 May 23 Accounts Receivable-C. D. Player Cash ”We would debit accounts receivable because we would attempt to collect the money (including the late fee) from C.D.Player. In fact, we would accumulate 12% interest on this amount until the day he finally paid us.” Question: If C.D. Player paid on the dishonored note 30 days later, what accounts would be debited and credited (and for what amount) when the note is paid on June 22?

Answer: The entry would look like this. Date Description P. R. Debit Credit 2001 June 22 Cash Accounts Receivable-C. D. Player Interest Revenue 4.63 The interest calculation is: Amount owed X interest rate X time = interest or $ X 12% X 30/360 = $4.63 ”Now, if we want to be as accurate as possible, at the end of each month we should accrue the interest revenue that we’ve earned on the note that month.” Question: On February 28, 2001, what accounts would be debited and credited (and for what amount) to accrue the interest?

Answer: The entry would look like this. Date Description P. R. Debit Credit 2001 Feb. 28 Interest Receivable (an asset).88 Interest Revenue.88 The interest calculation is: Amount owed X interest rate X time = interest or $ X 12% X 6/360 = $.88 ”Now, it’s not worth making an entry for $.88, but if we start accepting notes from others, the amounts could get significant.” “Hey, I had a thought, Eddie. Suppose I sent a promissory note to Hospital Records so we can put off paying that $2000 we owe them. Do you think they’d let me do that?” Question: What accounts would be debited and credited (and for what amount) if Hospital Records accepts our note?

Answer: The entry is shown below. Date Description P. R. Debit Credit 2001 Feb. 22 Accounts Payable-Hospital Records Notes Payable “By the way, Nick, if Hospital Records doesn’t like the idea, you could give a note to the bank for cash and use the proceeds to pay Hospital Records. Only the debit part of the entry would change.” Date Description P. R. Debit Credit 2001 Feb. 22 Cash Notes Payable “In either case, the entry on the due date would be the same.” Question: What accounts would be debited and credited (and for what amounts) if the note were paid off after 60 days at 14% interest?

Answer: The entry is shown below. Date Description P. R. Debit Credit 2001 Apr. 23 Notes Payable Interest Expense Cash ”With a note payable, we should normally make an adjusting entry to accrue interest expense in order to get a more accurate picture of our net income.” Question: If we made an adjusting entry on February 28, 2001, what accounts would be debited and credited (and for what amount) to accrue the interest?

Answer: The entry would look like this. Date Description P. R. Debit Credit 2001 Feb. 28 Interest Expense 4.67 Interest Payable 4.67 The interest calculation is: Amount owed X interest rate X time = interest or $ X 14% X 6/360 = $4.67 ”By the way, both this adjusting entry and the one for interest receivable could have a reversing entry so that you don’t have to zero out the interest receivable or payable accounts when payment occurs on the due date.“ “Great. It sounds like I have a new tool for dealing with slow- paying customers and cash flow problems. How did you get to be so smart about this stuff, anyway?” “It’s my accounting teacher, Professor Gene Yuss. He explains things so that anybody can understand them.”