Notes Payable and Notes Receivable Chapter 16 Notes Payable and Notes Receivable Section 1: Accounting for Notes Payable Section Objectives Chapter 15 discussed the applications for accounts receivable and treatment of uncollectible debts. In Chapter 16, students will learn how to account for notes receivable and notes payable, emphasizing the treatment of interest. Determine whether an instrument meets all the requirements of negotiability. Calculate the interest on a note. Determine the maturity date of a note. Record routine notes payable transactions. 5. Record discounted notes payable transactions. McGraw-Hill © 2009 The McGraw-Hill Companies, Inc. All rights reserved.

Negotiable Instruments QUESTION: What is a negotiable instrument? A negotiable instrument is a financial document containing a promise or order to pay, that meets all the UCC requirements to be transferable to another party. ANSWER: What is a negotiable instrument? A negotiable instrument is a financial document containing a promise or order to pay, that meets all the uniform commercial code requirements to be transferable to another party.

UCC Requirements for Negotiability Objective 1 Determine whether an instrument meets all the requirements for negotiability UCC Requirements for Negotiability Must be in writing and signed by the maker. Must contain an unconditional promise to pay a definite amount of money. Must be payable either on demand or at a future time that is fixed or that can be determined. Must be payable to the order of a specific person or to the bearer. Must clearly name or identify the drawee if addressed to a drawee. The first objective of this chapter is to determine whether an instrument meets all the requirements for negotiability. The UCC requirements for negotiability include five elements. They are: 1) The financial instrument must be in writing and signed by the maker; 2) The financial instrument must contain an unconditional promise to pay a definite amount of money; 3) The financial instrument must be payable either on demand or at a future time that is fixed or that can be determined; 4) The financial instrument must be payable to the order of a specific person or to the bearer; and finally 5) The financial instrument must clearly name or identify the drawee if addressed to a drawee.

Notes Payable What is a note payable? QUESTION: What is a note payable? A note payable is a liability that represents a written promise by the debtor to pay the creditor a specified amount at a specified future date. ANSWER: What is a note payable? A note payable is a liability that represents a written promise made by a debtor to pay the creditor a specified amount at a specified future date.

Calculate the interest on a note Objective 2 Calculate the interest on a note QUESTION: What is interest? Interest is the fee charged for the use of money. ANSWER: The second objective of this chapter is to calculate the interest on a note. What is interest? Interest is the fee charged for the borrowing of money.

Calculating Interest on a note Interest = Principal x Rate x Time Amount being borrowed (also called face value) Indicated in fractions of a year The formula for calculating interest is to multiply the principal times the interest rate times the time. Notice that the principal is the amount being borrowed, or sometimes call the face value. The time element of the formula in expressed in months of a year. We will use a “banker’s year.” A banker’s year is a three-hundred sixty day time period used to calculate interest on a note. Notice in this example the time element of the equation uses three-hundred sixty days for the denominator Principal x Rate x Time = Interest $2,500 x 0.12 x (90/360) = $75

Determine the maturity date of a note Objective 3 Determine the maturity date of a note QUESTION: What is maturity value? Maturity value is the total amount that must be paid when a note becomes due. ANSWER: The third objective of this chapter is to determine the maturity date of a note. What is maturity value? Maturity value is the total amount of a note that must be paid when due. It includes both the principal and the interest.

Calculating the Maturity Date of a Note Principal + Interest = Maturity Value $2,500 + $75 = $2,575 Determine the number of days remaining in the month of issue. Determine the number of days in each full month of the note. Determine the number of days in the last month of the note. Add the days together to confirm that they equal the period of the note. The maturity value of the note in this example includes the principal amount of two-thousand five-hundred dollars plus the seventy-five dollars of interest. Calculating the maturity date of a note includes four steps. First, determine the number of days remaining in the month of issue. Second, determine the number of days in each full month of the note. Third, determine the number of days in the last month of the note, and finally, add the days together in the first three steps to confirm that they equal the period of the note.

A 90-day note is issued May 18. Number of days remaining in month of issue = Month of May 31 days Issue Date May 18 – 18 days May 13 days Number of days in each full month of the note = Term of note 90 days Days in May – 13 days In this example, a 90-day note was issued on May 18. First, the number of days remain in May is calculated to be thirteen. That leaves seventy-seven days before maturity. Next, thirty days in June and thirty-one days in July, which represent full months, are subtracted leaving the maturity date of August sixteenth. 77 days June – 30 days July – 31 days August 16 days Maturity date is August 16.

Calculating Maturity Date Month Days May 13 June 30 July 31 Aug 16 Total 90 days The days of the months are added together to verify they equal the ninety-day time period of the note. Period of Note 90 days

Notes Payable Transactions Objective 4 Record routine notes payable transactions Notes Payable Transactions Record the issuance of a note payable. 2010 May. 18 Store Equipment 4,000.00 Notes Payable—Trade 4,000.00 Issued note payable to Unpainted Furniture Inc. for purchase of store equipment. The fourth objective of the chapter is to record routine notes payable transactions. If four-thousand dollars worth of store equipment is purchased by issuing a note payable, the company would debit store equipment for four-thousand dollars and credit notes payable for the same.

Notes Payable Transactions Record payment of the note payable and interest: Interest rate is 8%, term of note is 90 days. 2010 Aug 16 Notes Payable—Trade 4,000.00 Interest Expense 80.00 Cash 4,080.00 Payment of May 18 note to Unpainted Furniture Inc. When the notes matures, the company must pay the maturity value of the note. This includes a debit to notes payable of four-thousand dollars – the face value of the note. Interest expense is debited for eighty dollars and cash is credited for the total of four-thousand eighty dollars. Interest is calculated by multiplying the four-thousand dollar face amount of the note by eight percent interest, then multiplying that amount by ninety over three-hundred sixty days.

Discounted Notes Payable Objective 5 Record discounted notes payable transactions Discounted Notes Payable Example: If a $12,000, 7% 60-day note is discounted with the bank, then the borrower would receive only $11,860. Face Amount – Discount = Proceeds $12,000 – $140 = $11,860 The fifth objective of this chapter is to record discounted notes payable transactions. What is discounting? Discounting is deducting the interest from the principal of a note in advance. In this example, a twelve-thousand dollar, seven percent interest, sixty day note is discounted with a bank. Notice how the calculated interest of one-hundred forty-dollars is deducted from the face amount of the note leaving net proceeds of eleven-thousand eight-hundred sixty dollars. $12,000 x 7% x 60/360 = $140 interest

Recording a Discounted Note Payable Record issuance of discounted note: 2010 June 1 Cash 11,860.00 Interest Expense 140.00 Notes Payable—Bank 12,000.00 To record note payable issued at a discount When recording the discounted note payable, the interest expense is debited for the interest paid in advance. Notice that Interest Expense is debited for the $140 interest paid in advance.

Recording the payment of a Discounted Note Record payment at maturity of a discounted note: 2010 July 31 Note Payable 12,000.00 Cash 12,000.00 To record the payment of note payable issued at a discount When the note matures, the notes payable account is debited for the face amount of the note, and a credit to cash is made for the same amount. No further interest expense is recorded at that time.

Reporting Notes Payable and Interest Expense Current liabilities if due within one year. Long-term liabilities if due in more than one year. Interest Expense Classified as a nonoperating expense. Listed in the Other Income and Expenses section of the income statement. On the balance sheet, notes payable are considered current liabilities if they are due within one year. Notes payable would be considered long-term liabilities if they were due in more than one year. On the income statement, interest expense is classified as a nonoperating expense and is listed in the other income and expenses section of the income statement.

Notes Payable and Notes Receivable Chapter 16 Notes Payable and Notes Receivable Section 2: Accounting for Notes Receivable Section Objectives 6. Record routine notes receivable transactions. 7. Compute the proceeds from a discounted note receivable, and record transactions related to discounting of notes receivable. 8. Understand how to use bank drafts and trade acceptances and how to record transactions related to those instruments. McGraw-Hill © 2009 The McGraw-Hill Companies, Inc. All rights reserved.

Record routine notes receivable transactions Objective 6 Record routine notes receivable transactions QUESTION: What is a note receivable? A note receivable is an asset representing a written promise by the debtor to pay the creditor a specified amount at a specified future date. ANSWER: The sixth objective of this chapter is to learn how to record routine notes receivable transactions. What is a note receivable? A note receivable is written promise made by the debtor to pay the creditor a specified amount of money at a specified future date.

Notes Receivable Transactions Record the receipt of a non-interest bearing note receivable. 2010 Sept. 18 Notes Receivable 1,600.00 Accounts Receivable/Li Jiunn 1,600.00 To record 30-day note receivable to replace overdue accounts receivable. The entry to record receipt of a non-interest bearing note receivable to replace an overdue account receivable is to debit notes receivable and credit accounts receivable.

Notes Receivable Transactions Record the receipt of an interest bearing note receivable. 2010 June 11 Notes Receivable 1,200.00 Accounts Receivable/Trey Leone 1,200.00 To record 60-day note receivable to replace an overdue account receivable. The entry to record receipt of an interest bearing note receivable to replace an over due account receivable is the same. Debit notes receivable and credit accounts receivable.

Notes Receivable Transactions Record the receipt of cash from a customer in payment of their note. 2010 Aug 11 Cash 1,220.00 Note Receivable 1,200.00 Interest Income 20.00 Collection of Trey Leone’s note plus (interest= 1,200 x 10% x 60/360 days) The entry to record the receipt of cash from a customer for payment of their note includes a debit to cash for the total money received; a credit to notes receivable for the face amount of the note; and a credit to interest income. Interest income is calculated by taking the face amount of the note and multiplying that amount by the interest rate times the numbers of days the note was written for divided by three-hundred sixty days.

Partial Collection of a Note Partial payments are applied first to interest and then to principal. When total cash payment of $620 is paid by the borrower. . . 2010 Aug 11 Cash 620.00 Notes Receivable 600.00 Interest Income 20.00 Collection of interest and one-half of Trey Leone’s note; balance renewed for 30 days Next we will examine special situations involving notes receivable including partial collection of a note; notes not collected at maturity; and notes received at the time of a sale. When a note is partially paid, the partial payment is first applied to interest and then to principal. In this example, the six-hundred twenty dollar cash payment applies twenty dollars to interest income, and six-hundred dollars to the principal of the note. Interest = $600 x 10% x 60/360 = $20 100% of interest

Not Collected at Maturity Note Receivable Not Collected at Maturity If a note is not paid and not renewed, it is dishonored. 2010 Aug 11 Accounts Rec./Trey Leone 1,220.00 Notes Receivable 1,200.00 Interest Income 20.00 To charge back Leone dishonored note plus interest to maturity If a note is note paid and not renewed, the note is dishonored. When the note is dishonored, a credit entry is made to notes receivable for the face amount of the note. Interest income is recognized and added to the account receivable debit balance. Interest income is recognized and added to the account receivable.

Note Receivable at the Time of Sale 2010 Aug 15 Notes Receivable 1200.00 Sales 1200.00 Received 60-day, 9% note from Sylvia Madeo on sale of goods A note receivable recognized at the time of sale requires a debit entry to notes receivable, and a credit entry to sales.

Discounting a Note Receivable Compute the proceeds from a discounted note receivable, and record transactions related to discounting of notes receivable Objective 7 Discounting a Note Receivable If the noteholder wants cash before the maturity date, the note can be discounted (sold) at the bank. The seventh objective of this chapter is to compute the proceeds from a discounted notes receivable, and record transactions related to discounting of notes receivable. If the holder of a note receivable wants to receive cash before the maturity date, they may sell the note to a bank. This process is called discounting of a note receivable.

Discounting a Note Receivable The bank pays the proceeds to the noteholder. Principal + Interest – Discount (Maturity Value) Cash proceeds paid to the note holder begins by calculating the maturity value of the note. Remember that the maturity value of a note receivable is the face amount of the note plus the interest income. From this maturity value the note discount is subtracted yielding the net cash proceeds paid. = Proceeds

Calculating the Discount and Discount Period The discount period is the period from the date the note is taken to the bank to be discounted (or sold) and continues on to the maturity date. Calculating the Discount and the Proceeds Step 1: Determine the maturity value of the note. Step 2: Calculate the number of days in the discount period. Step 3: Compute the discount charged by the bank. Step 4: Calculate the proceeds. The discount period used to calculate the note discount is the period of time from the date the note is taken to the bank to be sold, and continues on to the maturity date. There are four steps required to calculate the net cash proceeds received from a discounted note. The first steps involves determining the maturity value of the note. The second step requires calculation of the number of days in the discount period. The third step requires computation of the discount dollar amount charged by the bank. The fourth step then involves calculating the net cash proceeds to be paid by the bank.

Recording a Discounted Note Receivable 2010 Sept. 18 Cash 1,980.00 Interest Expense 20.00 Notes Receivable–Discounted 2,000.00 To record discounting of Jack Miller note In this example, a two-thousand dollar note is discounted. The amount of the discount is calculated to be twenty dollars. The discount amount is charged to interest expense, and subtracted from the note receivable balance to yield net cash proceeds of one-thousand nine-hundred eighty dollars.

Contingent Liability for a Discounted Note QUESTION: What is a contingent liability? A contingent liability is an item that can become a liability if certain future events happen. ANSWER: What is a contingent liability? A contingent liability is an item that can become a liability if certain future events happen.

Contingent Liability for a Discounted Note The note holder endorses the discounted note receivable. If the maker of the note dishonors the note, the bank can obtain payment from the endorser. The endorser has a contingent liability. If the note holder endorses a discounted note and the maker of the note dishonors it, the bank may obtain payment from the endorser. If this situation occurs, the endorser is said to have a contingent liability. There liability will only arise if the maker of the note dishonors it.

Reporting Contingent Liabilities The contingent liability can appear as a separate item on the balance sheet: Notes Receivable $ 7,400 Notes Receivable – Discounted (2,000) Net Notes Receivable $ 5,400 Another common way to report contingent liabilities is to present net notes receivable on the balance sheet and to include a footnote with information about the discounted notes receivable. The most common way to report a contingent liability for a discounted note receivable is to present the net notes receivable on the balance sheet and to include a footnote in the financial statements regarding the discounted note receivable information.

Discounted Non-interest Bearing Note Receivable at Maturity 2010 Oct. 18 Note Receivable--Discounted 2,000.00 Notes Receivable 2,000.00 To record payment of discounted note by Jack Miller If a discounted non-interest bearing is paid at maturity, the contingent liability is removed from the books. If the note is paid at maturity, then the contingent liability is removed from the books.

Interest-Bearing Note Receivable Discounted An $1,800 90-day, 6% note was received from Kim Myers. It was discounted at 10% when there was still 30 days left until maturity. 2010 Nov. 28 Cash 1,811.77 Notes Receivable--Discounted 1,800.00 Interest Income 11.77 To record discounting of Kim Myers note In this example, a one-thousand eight-hundred dollar ninety-day six per cent discounted note receivable was received when there was still thirty days left until maturity. The maturity value of the note is one-thousand eight-hundred twenty seven dollars. The discount is fifteen dollars and twenty-three cents. Therefore, the proceeds received are one-thousand eight-hundred eleven dollars and seventy-seven cents. The discount is calculated by taking the maturity amount of the note, $1,827 and multiplying that figure by the discount rate of ten percent, then multiplying that amount by thirty days divided by three-hundred sixty. The discount is then subtracted from the maturity value of the note to yield the net cash proceeds received. Proceeds received: $1,800 x 6% x 90/360 = $27 interest. $1,800 + $27 = $1,827 maturity value. $1,827 x 10% x 30/360 = $15.23 discount. $1827 – 15.23 = $1811.77 net cash proceeds received.

Maturity of Discounted Interest-Bearing Note Receivable The $1,800 90-day, 6% note which was received from Kim Myers and was later discounted is paid at maturity by Myers. 2010 Dec. 28 Notes Receivable--Discounted 1,800.00 Notes Receivable 1,800.00 To record payment by Myers of discounted note When the discounted note is paid at maturity, the contingent liability is removed from the books. Contingent liability is removed from books.

Reporting Notes Receivable and Interest Income Notes Receivable Current asset if due within one year. Long-term asset if due in more than one year. Interest Income Classified as non-operating income. Listed in the Other Income and Expenses section of the income statement. A note receivable is reported on the balance sheet as a short-term asset if it is due within one year. Notes receivable are reported as a long-term asset if it is due in more than one year. Interest income received from the note receivable is classified as non-operating income and reported in the other income and expense section of the income statement.

Objective 8 Understand how to use bank drafts and trade acceptances and how to record transactions related to those instruments. The eighth objective of this chapter is to understand how to use bank drafts and trade acceptances, and to record transactions related to those instruments.

Drafts and Acceptances Draft: a written order that requires one party to pay a stated sum of money to another party Check Bank Draft A bank orders another bank to pay the stated amount to a specific party. It is more readily accepted than a business or personal check. Commercial Draft One party orders another party to pay a specified amount on a specified date. It is used for special shipment and collection situations. A draft is a written order that requires one party to pay a stated sum of money to another party. The three most common types of drafts are a check, a bank draft, and a commercial draft. A bank draft orders one bank to pay the stated amount of the draft to a specific party. Bank drafts are more readily accepted than a business or personal check. With a commercial draft, one party orders another party to pay a specified amount on a specified date. Commercial drafts are used for special shipment and collection situations.

Trade Acceptance: a draft used in recording transactions involving the sale of goods Recorded as a sale on credit Original transaction Accounted for as a promissory note Trade acceptance A trade acceptance is a draft used in recording transactions involving the sale of goods. The original transaction is recorded as a sale on credit, and the trade acceptance is accounted for as a promissory note.

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