ACCOUNTING FOR NOTES AND INTEREST CHAPTER EIGHTEEN ACCOUNTING FOR NOTES AND INTEREST

PROMISSORY NOTE Def. - a written promise to pay a specific sum at a definite future date. Also called a “note.” Often used when credit is extended for 60 days or more, or when large amounts of money are involved.

PROMISSORY NOTE PRINCIPAL $ 1,500.00

PROMISSORY NOTE Date of the note $ 1,500.00 June 9, 20 - -

PROMISSORY NOTE Term of the note $ 1,500.00 June 9, 20 - - Ninety Days AFTER DATE I PROMISE TO PAY TO

TIME is calculated in months. TERM OF THE NOTE Def. - months or days from date of issue to date of maturity Used to calculate TIME the term of the note stated as a fraction of a year Note: It is common to use 360 days as a year. When the term of note is expressed as months, TIME is calculated in months.

TERM OF THE NOTE Def. - months or days Used to calculate TIME from date of issue to date of maturity Used to calculate TIME the term of the note stated as a fraction of a year Note: It is common to use 360 days as a year. When the term of the note is expressed as days, the TIME is calculated using the exact number of days.

month the note was issued. COMPUTING DUE DATE Example: Note is dated June 9, 20-- and is due in 90 days. Days in June 30 STEP #1 Start with the month the note was issued.

COMPUTING DUE DATE Example: Note is dated June 9, 20-- and is due in 90 days. Days in June 30 Deduct date of note (June 9) 9 Days remaining in June 21 Subtract the date the note was issued (we do not count the date of issuance).

COMPUTING DUE DATE Example: Note is dated June 9, 20-- and is due in 90 days. Days in June 30 Deduct date of note (June 9) 9 Days remaining in June 21 Add: Days in July 31 Days in August 31 STEP #2 Add to the result of step #1 the no. of days in as many months as possible without exceeding the time of the note.

83 days of the note have past. COMPUTING DUE DATE Example: Note is dated June 9, 20-- and is due in 90 days. Days in June 30 Deduct date of note (June 9) 9 Days remaining in June 21 Add: Days in July 31 Days in August 31 By the end of August, 83 days of the note have past.

COMPUTING DUE DATE Example: Note is dated June 9, 20-- and is due in 90 days. Days in June 30 Deduct date of note (June 9) 9 Days remaining in June 21 Add: Days in July 31 Days in August 31 STEP #3 Subtract the result of step #2 from the time of the note. (90 - 83)

The result is the date of the month the note is due. COMPUTING DUE DATE Example: Note is dated June 9, 20-- and is due in 90 days. Days in June 30 Deduct date of note (June 9) 9 Days remaining in June 21 Add: Days in July 31 Days in August 31 The result is the date of the month the note is due.

called the Maturity Date. COMPUTING DUE DATE Example: Note is dated June 9, 20-- and is due in 90 days. Days in June 30 Deduct date of note (June 9) 9 Days remaining in June 21 Add: Days in July 31 Days in August 31 Maturity date, September 7 7 The 90th day (Sept. 7th) is called the Maturity Date.

COMPUTING DUE DATE Example: Note is dated June 9, 20-- and is due in 90 days. Days in June 30 Deduct date of note (June 9) 9 Days remaining in June 21 Add: Days in July 31 Days in August 31 Maturity date, September 7 7 Total time in days 90

PROMISSORY NOTE PAYEE $ 1,500.00 June 9, 20 - - Ninety Days AFTER DATE PROMISE TO PAY TO THE ORDER OF Sarah Morney

PROMISSORY NOTE INTEREST RATE $ 1,500.00 June 9, 20 - - Ninety Days AFTER DATE I PROMISE TO PAY TO THE ORDER OF Sarah Morney One Thousand Five Hundred and 00/100 PAYABLE AT Brentwood Bank WITH INTEREST AT 9% per Annum from Date INTEREST RATE Notes may be Interest bearing or non Interest bearing.

CALCULATING INTEREST $1,500.00 9% 90/360 $33.75 Interest FORMULA: PRINCIPAL x RATE x TIME $1,500.00 x 9% x 90/360 $33.75 Interest

CALCULATING INTEREST $2,000.00 8% 3/12 $40 Interest FORMULA: PRINCIPAL Example: A $2,000, 8% note due in 3 months FORMULA: PRINCIPAL x RATE x TIME $2,000.00 x 8% x 3/12 $40 Interest

PROMISSORY NOTE MATURITY DATE $ 1,500.00 June 9, 20 - - Ninety Days AFTER DATE I PROMISE TO PAY TO THE ORDER OF Sarah Morney One Thousand Five Hundred and 00/100 PAYABLE AT Brentwood Bank MATURITY DATE WITH INTEREST AT 9% per Annum from Date No. 6 Due Sept. 7, 20--

PROMISSORY NOTE $ 1,500.00 June 9, 20 - - Ninety Days AFTER DATE I PROMISE TO PAY TO THE ORDER OF Sarah Morney One Thousand Five Hundred and 00/100 PAYABLE AT Brentwood Bank WITH INTEREST AT 9% per Annum from Date Maker of Note No. 6 Due Sept. 7, 20-- Paul DeBruke

NOTES RECEIVABLE TRANSACTIONS Six types Note received from a customer to extend time for payment of an account Note collected at maturity Note renewed at maturity Note discounted before maturity Note dishonored Collection of dishonored note

NOTE RECEIVED TO EXTEND TIME FOR PAYMENT Example: Accounts Receivable customer, Michael Putter owes $2,000. To settle this account, Putter signs a 90-day, 10% note dated June 8. Why would we want to accept this note?

NOTE RECEIVED TO EXTEND TIME FOR PAYMENT Example: Accounts Receivable customer, Michael Putter owes $2,000. To settle this account, Putter signs a 90-day, 10% note dated June 8. Two reasons to accept this note: Note is a formal, written promise to pay. Can be converted to cash at a bank if necessary Note is likely to bear interest.

GENERAL JOURNAL Mr. Putter’s balance is removed DATE DESCRIPTION DEBIT PR CREDIT 1 June 8 Notes Receivable 2,000 2 Accounts Receivable 2,000 3 Received note to settle 4 account 5 Mr. Putter’s balance is removed from Accounts Receivable and placed into Notes Receivable. 6 7 8 9 10 11

NOTE RECEIVED TO EXTEND TIME FOR PAYMENT Example: What if Accounts Receivable customer Michael Putter gives a check for $250 and a note for $1,750 instead? Let’s look at the Journal Entry!

GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT 1 June 8 Cash 250 2 Notes Receivable 1,750 3 Accounts Receivable 2,000 4 Received cash and note 5 to settle account 6 7 8 9 10 11

NOTE COLLECTED AT MATURITY When a note receivable matures, it may be collected: By the payee By the bank named in the note, or By a bank where it was left for collection.

NOTE COLLECTED AT MATURITY Example: On September 6 (the due date), Putter pays the principal and interest on the note. Principal of note $2,000 Interest 50 $2,000 x 10% x 90/360

NOTE COLLECTED AT MATURITY Example: On September 6 (the due date), Putter pays the principal and interest on the note. Principal of note $2,000 Interest 50 Maturity Value $2,050

GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT 1 Sept 6 Cash 2,050 2 Notes Receivable 2,000 3 Interest Revenue 50 4 Received payment of note 5 with interest 6 7 8 9 10 11

NOTE COLLECTED AT MATURITY Example: What if the note had been left at Planet Bank for collection instead? Planet Bank would collect the maturity value from Putter, subtract out a service charge and deposit the remainder in our account.

GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT 1 Sept 6 Cash 2,040 2 Collection Expense 10 3 Notes Receivable 2,000 4 Interest Revenue 50 5 Received payment of note 6 with interest less collection 7 fee 8 9 10 11

NOTE RENEWED AT MATURITY Example: At maturity Putter is unable to pay the maturity value. Instead, he pays only the $50 interest and signs a new 60-day, 10% note. Let’s look at the Journal Entry!

GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT 1 Sept 6 Cash 50 2 Notes Receivable (new note) 2,000 3 Notes Receivable (old note) 2,000 4 Interest Revenue 50 5 Received new note plus 6 interest on old note 7 8 9 10 11

NOTE RENEWED AT MATURITY Example: What if Putter pays the $50 interest and $500 toward the principal? Let’s look at the Journal Entry!

GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT 1 Sept 6 Cash 550 2 Notes Receivable (new note) 1,500 3 Notes Receivable (old note) 2,000 4 Interest Revenue 50 5 Received new note plus 6 partial payment and interest 7 on old note 8 9 10 11

NOTE DISCOUNTED BEFORE MATURITY If a business needs cash before the due date of a note, it can endorse the note and transfer it to a bank. Bank charges an interest fee “Bank Discount” for the time between the date of discounting and the due date of the note. The difference between the maturity value and the bank discount is called the “Proceeds.”

NOTE RENEWED AT MATURITY Example: Assume the $2,000, 10%, 90-day note from Putter dated June 8 is discounted at the bank on July 8 at a rate of 12%. Calculating the discount and proceeds is a four step process.

NOTE RENEWED AT MATURITY Example: Assume the $2,000, 10%, 90-day note from Putter dated June 8 is discounted at the bank on July 8 at a rate of 12%. Step #1 Compute the maturity value of the note. Face + Interest = Maturity Value $2,000 $50 $2,050 + =

NOTE RENEWED AT MATURITY Example: Assume the $2,000, 10%, 90-day note from Putter dated June 8 is discounted at the bank on July 8 at a rate of 12%. Step #2 Compute the number of days in the discount period - from the discount date to the due date. Days in July 31 Less: Discount date 8 The discount date is not counted in the Discount Period.

NOTE RENEWED AT MATURITY Example: Assume the $2,000, 10%, 90-day note from Putter dated June 8 is discounted at the bank on July 8 at a rate of 12%. Step #2 Compute the number of days in the discount period - from the discount date to the due date. Days in July 31 Less: Discount date 8 Remaining days in July 23 Plus days in August 31 Plus due date (Sept) 6 Days in Discount Period 60

NOTE RENEWED AT MATURITY Example: Assume the $2,000, 10%, 90-day note from Putter dated June 8 is discounted at the bank on July 8 at a rate of 12%. Step #3 Compute the discount amount. Maturity Value Discount Rate Discount Period Discount Amount = X X $41 $2,050 12% 60/360 = X X

NOTE RENEWED AT MATURITY Example: Assume the $2,000, 10%, 90-day note from Putter dated June 8 is discounted at the bank on July 8 at a rate of 12%. Step #4 Compute the proceeds. Maturity Value Discount Amount Proceeds - = $2,009 $2,050 - $41 = Let’s journalize the discounting of this note.

What if the proceeds are less than the face value of the note? GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT 1 July 8 Cash 2,009 2 Notes Receivable 2,000 3 Interest Revenue 9 4 Discounted note receivable 5 What if the proceeds are less than the face value of the note? 6 7 8 9 10 11

The difference represents GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT 1 July 8 Cash 1,992 2 Interest Expense 8 3 Notes Receivable 2,000 4 Discounted note receivable 5 The difference represents interest expense. 6 7 8 9 10 11

NOTE DISHONORED Maker of the note does not pay or renew it at maturity Maker is still liable But note loses its legal status Payee transfers the amount due from Notes Receivable to Accounts Receivable

Interest, although it has not is recognized as earned NOTE DISHONORED Example: Putter dishonors the $2,000, 10% 90-day note. Interest, although it has not been paid by the maker, is recognized as earned by the payee.

The entire maturity value is debited to Accounts Receivable. GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT 1 Sept 6 Accounts Receivable/Putter 2,050 2 Notes Receivable 2,000 3 Interest Revenue 50 4 Note receivable dishonored 5 The entire maturity value is debited to Accounts Receivable. 6 7 8 9 10 11

The payee then attempts to recover the maturity value NOTE DISHONORED Example: If Putter’s note had been discounted at the bank and then was dishonored by the maker, the bank will require the PAYEE to pay the principal, interest and bank fees. The payee then attempts to recover the maturity value PLUS the bank fee from the maker.

GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT 1 Sept 6 Accounts Receivable/Putter 2,060 2 Cash 2,060 3 Paid bank for dishonored 4 note 5 6 7 8 9 10 11

COLLECTION OF A DISHONORED NOTE Example: On October 16, the payee collects from Putter after the note had been discounted and dishonored. The maker pays the maturity value, bank fee and additional interest for the period since dishonoring the note.

GENERAL JOURNAL + + = = + $2,082.89 = + + DATE DESCRIPTION DEBIT PR CREDIT 1 Oct 16 Cash 2,082.89 2 3 4 Principal + Interest + Bank Fee + + = $2,000 $50 $10 $2,060 5 6 $2,060 x 10% x 40/360 = $22.89 7 + $2,082.89 $2,060 $22.89 = 8 9 10 11

GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT 1 Oct 16 Cash 2,082.89 2 Accounts Receivable 2,060.00 3 Interest Revenue 22.89 4 Collected dishonored note 5 with interest 6 7 8 9 10 11

When a business has many notes, it may keep a Notes Receivable NOTES RECEIVABLE REGISTER Date Received Interest Maker Time Due Date Amount Rate Amount 20-- Apr. 4 L. Peters 60-day June 3 400.00 8% 5.33 21 J. Slaw 60-day June 21 600.00 9% 9.00 May 2 S. Alpart 30-day June 1 700.00 9% 5.25 19 L. Shein 90-day Aug. 17 800.00 9% 18.00 June 20 J. Slaw 60-day Aug. 19 500.00 9% 7.50 When a business has many notes, it may keep a Notes Receivable Register.

NOTES RECEIVABLE REGISTER Interest Discounted Date Collected Remarks Rate Amount Bank Date 8% 5.33 June 3 9% 9.00 June 20 Renewal for $500 9% 5.25 June 1 Sent for collection 5/30 9% 18.00 9% 7.50 Renewal of 4/21 note

ACCRUED INTEREST RECEIVABLE Revenue should be recognized when it is earned. Not always practical Interest is earned day by day Common for interest to be recognized when note is due If note is received and due within a single accounting period If note is received in one period and due in the next, accrued interest must be recorded at the end of the period.

ACCRUED INTEREST RECEIVABLE Example: The fiscal year ends on June 30. Two notes from the Notes Receivable Register remain outstanding. Accrued interest on these notes must be calculated and recognized. Days from Issue Date to June 30 Accrued Interest June 30 Date of Issue Rate of Interest Principal $800.00 May 19 9% 42 $8.40 $800.00 x 9% x 42/360

ACCRUED INTEREST RECEIVABLE Example: The fiscal year ends on June 30. Two notes from the Notes Receivable Register remain outstanding. Accrued interest on these notes must be calculated and recognized. Days from Issue Date to June 30 Accrued Interest June 30 Date of Issue Rate of Interest Principal $800.00 May 19 9% 42 $8.40 $500.00 June 20 9% 10 1.25 $9.65

GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT 1 June 30 Accrued Interest Receivable 9.65 2 Interest Revenue 9.65 3 Interest accrued on notes 4 receivable 5 6 7 8 9 10 11

NOTES PAYABLE TRANSACTIONS Four types Note issued to a supplier to extend time for payment of an account. Note issued as security for cash loan. Note paid at maturity. Note renewed at maturity.

NOTE ISSUED TO EXTEND TIME FOR PAYMENT Example: $700 is owed to Bella & Co. on June 11. Bella & Co. agrees to accept a $700, 90-day, 10% note dated June 11. The maker would record this as a Note Payable.

The balance owed to Bella & Co. placed into Notes Payable. GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT 1 June 11 Accounts Payable/Bella & Co. 700 2 Notes Payable 700 3 Issued note to settle account 4 5 The balance owed to Bella & Co. is removed from Accounts Payable and placed into Notes Payable. 6 7 8 9 10 11

NOTE ISSUED TO EXTEND TIME FOR PAYMENT Example: A partial payment of $200 is made to Bella & Co. on June 11. A note is issued to Bella & Co. for the remaining $500. Let’s look at the Journal Entry!

GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT 1 June 11 Accounts Payable/Bella & Co. 700 2 Cash 200 3 Notes Payable 500 4 Made partial payment and 5 issued note to settle account 6 7 8 9 10 11

NOTE ISSUED AS SECURITY FOR CASH LOAN TWO TYPES: Interest-bearing notes Face value of note is received in cash, maker pays face value plus interest at maturity. Non-interest-bearing notes Interest is deducted in advance, called “discounting”. Face value minus interest is received in cash, maker pays face value at maturity.

INTEREST-BEARING NOTES EXAMPLE: Borrowed $6,000 on June 16 from Planet Bank on a 60-day, 10.5% note. Let’s look at the Journal Entry!

GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT 1 June 16 Cash 6,000 2 Notes Payable 6,000 3 Issued note for bank loan 4 5 6 7 8 9 10 11

NON-INTEREST-BEARING NOTES EXAMPLE: A non-interest-bearing 60-day note was issued for $6,000 on June 16. The bank discounts at the rate of 10.5%. The maker will not receive the whole $6,000. 10.5% x $6,000 x 60/360 = $105 discount $6,000 - $105 = $5,895

Maker receives the proceeds GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT 1 June 16 Cash 5,895 2 3 Maker receives the proceeds but promised to pay the maturity value ($6,000). 4 5 6 7 8 9 10 11

GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT 1 June 16 Cash 5,895 2 Discount on Notes Payable 105 3 Notes Payable 6,000 4 Issued note for bank loan 5 6 7 8 9 10 11

Maker of the note’s Balance Sheet June 30, 20-- Assets Current Assets Liabilities Current Liabilities Notes Payable $6,000 Less: Discount on Notes Payable 105 $5,895 Balance Sheet shows the Discount on Notes Payable as a reduction from the Notes Payable account.

STATED vs. EFFECTIVE INTEREST RATE INTEREST-BEARING NOTE NON-INTEREST-BEARING NOTE $105/$6,000 = 1.75% Interest rate for 60 days

STATED vs. EFFECTIVE INTEREST RATE INTEREST-BEARING NOTE NON-INTEREST-BEARING NOTE $105/$6,000 = 1.75% x 6 10.5% Effective rate

STATED vs. EFFECTIVE INTEREST RATE INTEREST-BEARING NOTE NON-INTEREST-BEARING NOTE $105/$6,000 = 1.75% x 6 10.5% Interest-bearing notes…. Effective rate = Stated rate

STATED vs. EFFECTIVE INTEREST RATE INTEREST-BEARING NOTE NON-INTEREST-BEARING NOTE $105/$6,000 = 1.75% $105/$5,895 = 1.781% x 6 x 6 10.5% 10.686% Non-Interest-bearing notes…. Effective rate  Stated rate

NOTE PAID AT MATURITY EXAMPLE: The interest-bearing note is paid at maturity. $6,000 x 10.5% x 60/360 = $105 interest $6,000 + $105 = $6,105 paid

GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT 1 Aug 15 Notes Payable 6,000 2 Interest Expense 105 3 Cash 6,105 4 Paid note with interest at 5 maturity 6 7 8 9 10 11

NOTE PAID AT MATURITY Now let’s look at the non-interest-bearing note at maturity. $6,000 maturity value is paid to Payee. Discount on Notes Payable becomes Interest Expense.

GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT 1 Aug 15 Notes Payable 6,000 2 Interest Expense 105 3 Cash 6,000 4 Discount on Notes Payable 105 5 Paid note at maturity 6 7 8 9 10 11

NOTE RENEWED AT MATURITY EXAMPLE: The maker pays only $1,000 plus the $105 interest on the $6,000 note and signs a new $5,000, 60-day, 10.5% note. Old note is removed, Interest expense of $105 is recognized, Cash is reduced and new note is recorded.

GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT 1 Aug 15 Notes Payable (old note) 6,000 2 Interest Expense 105 3 Cash 1,105 4 Notes Payable 5,000 5 Paid interest and part of old 6 note and issued new note 7 8 9 10 11

Multiple notes are recorded on a Notes Payable Register. Date Issued Interest Maker Time Due Date Amount Rate Amount 20-- Apr. 14 L. Knoop 60-day June 13 2,000.00 9% 30.00 May 13 Apex Bank 90-day Aug 11 8,000.00 10% 200.00 June 2 S. Bront 30-day July 2 1,500.00 11% 13.75 Multiple notes are recorded on a Notes Payable Register.

NOTES PAYABLE REGISTER Interest Date Paid Amount Remarks Rate Amount 2,000.00 9% 30.00 June 13 Settled 2/14 invoice 8,000.00 10% 200.00 1,500.00 11% 13.75 Settled 4/2 invoice

ACCRUED INTEREST PAYABLE EXAMPLE: Issued a $900, 60-day 10% note on May 31. June 30 is the company’s fiscal year end. An adjusting entry is needed on June 30 to record the interest accrued on the note from May 31 to June 30.

GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT 1 June 30 Interest Expense 7.50 2 Accrued Interest Payable 7.50 3 Interest accrued on note 4 payable 5 6 7 8 9 10 11

ACCRUED INTEREST PAYABLE EXAMPLE: If instead it was a $900, 60-day non-interest-bearing note that was discounted at the bank at 10%. An adjusting entry is needed on June 30 to move the interest for the period (May 31 to June 30) from Discount on Notes Payable to the Interest Expense account.

Journal entry to record GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT 1 May 31 Cash 885 2 Discount on Notes Payable 15 3 Notes Payable 900 4 Issued note for bank loan 5 6 Journal entry to record note’s issuance 7 8 9 10 11

GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT 1 May 31 Cash 885 2 Discount on Notes Payable 15 3 Notes Payable 900 4 Issued note for bank loan 5 6 June 30 Interest Expense 7.50 7 Discount on Notes Payable 7.50 8 Interest accrued on note 9 payable 10 11