Notes Payable Principles

Accounting for noncurrent notes payable

1. Noncurrent notes payable are issued for the present value of all future cash flows, including principal, and interest payments computed using the stated rate. The computation of present value uses the yield rate at the date of issuance. When notes are used to acquire nonmonetary items such as plant assets, the fair value of the property acquired or fair value of the note, whichever is more reliable, is used to record both sides of the transaction. If the fair value of the note is more reliable, the interest rate implicit in the note is used for recording the note, and interest expense over the term.

Notes payable features

1. Notes payable derive from borrowing and purchase transactions. A promissory note details the rights and duties of each party. Important aspects such as the interest rate, principal, interest payment dates and note term are clearly identified.

Types of notes for accounting purposes -- Simple Interest

1. Simple interest notes have a face value that is also the maturity amount, the amount the debtor pays when the note matures (end of note term). The stated interest rate and face value determine the annual interest to be paid. A 5%, $10,000 (face value) note pays $500 interest per year, for example. Payments may be required at any specified interval including monthly, quarterly, semiannually, and annually. The $10,000 face value is paid at maturity.

What is the distinction between notes payable and accounts payable?

1. Time period is usually extended; 2. Notes have an interest element.

Accounting for noncurrent notes payable

2. At subsequent balance sheet dates, notes are reported at the present value of remaining payments, again using the yield rate at the date of issuance. 3. Periodic interest expense is computed as the product of the yield rate at the date of issuance, and the beginning net note liability (present value). This approach is called the effective interest method and is required by GAAP. The difference between cash interest paid and interest expense recognized at each payment date is the amortization of discount or premium.

Types of notes for accounting purposes -- Installment Notes

2. Installment notes - each payment includes principal and interest - have no maturity value because the last payment reduces the note payable balance to zero. These notes are often used to purchase plant assets and may be secured by those assets. A mortgage note is an example.

Notes payable features (Short-term Notes)

2. Short-term notes are classified as current liabilities if they meet that definition. Compared with accounts payable, short-term notes payable generally have a term of at least 30 days and bear interest. Short-term notes are typically reported at face value, rather than at present value.

Types of notes for accounting purposes

3. Interest rates and principal. Both types of notes above involve two interest rates although often the two rates are the same on a given note. 4. The stated rate is the rate stated in the note and determines the cash interest due on the note each period. 5. The yield rate for the note (also called effective or market rate) is the rate on notes of similar risk and term. If the note is to be reported at present value, the yield rate is used for that computation.

Notes payable features (Long-term Notes)

3. Long-term notes are a major source of significant debt financing, especially for smaller firms. Long-term borrowing with notes involves one or a small number of creditors. Larger firms are more likely to use bonds for long-term debt financing, enabling a larger number of potential creditors to participate. Bonds generally have longer terms than notes. Long-term notes are reported at present value and are noncurrent liabilities if they meet that definition. The portion of the note principal to be paid off next year is classified as current.

Accounting for noncurrent notes payable

4. Another approach, called the straight-line method, amortizes the discount or premium equally each period. This approach is allowed only if it results in interest expense amounts not materially different from the effective interest method. The net note liability for this approach is only an approximation of the present value of the note.

Accounting for noncurrent notes payable

5. The gross or net method of recording the note and interest expense are both acceptable. The gross method separates the face value (note payable) and discount or premium in different accounts. The net method uses one combined net account (note payable), which is the present value and net note liability under the effective interest method.

Accounting for noncurrent notes payable

6. The fair value of notes must be disclosed - the estimate of the amount required to pay off the note at the balance sheet date. Notes are not typically traded on an exchange so an estimate must be made of the note's fair value using the current yield rate on similar notes. Also disclosed are the details of noncurrent notes such as interest rates, assets pledged, call and conversion provisions and restrictions, and the aggregate maturity amounts for each of the five years following the balance sheet date. Firms also choose the fair value option. This reporting option is illustrated in a lesson on bond accounting and is applied to notes in the same way. 7. Loan origination fees and points are amortized under the effective interest method.

Types of notes for accounting purposes -- Issued at Discount

6. When the yield rate exceeds the stated rate at time of borrowing, the note is issued at a discount which is recorded in a contra account to the note. When the yield rate is less than the stated rate, the note is issued at a premium and recorded in an adjunct account to the note. If the two rates are equal, the note is issued at face value. Discounts and premiums are much more common for bonds but the accounting is the same for notes and bonds.

Types of notes for accounting purposes -- Stated and Fair Rate

7. The stated interest rate on a note is considered to be the fair rate (yield rate) unless (i) there is no stated rate, or (ii) the rate is clearly unreasonable, or (iii) the face value of the note is materially different from the fair value of consideration received for the note.

Types of notes for accounting purposes -- Discount / Premium

8. The discount or premium is amortized over the note term with the discount amortization increasing the net note liability and the premium amortization decreasing the net note liability.

Types of notes for accounting purposes -- Principal / Interest

9. The principal amount of the note is the amount borrowed and is the present value at the date of issuance. The total interest over the note term equals the difference between the total payments required under the note (principal and interest at the stated rate), and the principal amount. 10. Total interest also equals total cash interest over the term plus the discount or minus the premium at issuance.

Define "interest-bearing note payable".

A note in which the interest element is explicitly stated.

Debt Amortization Schedule

Date Cash Interest Interest Exp. Discount Amt. Unamortized Ciscount Carrying Value 1/1/Y1 $995 $9,005 12/31/Y1 $600 $900 $300 $695 $9,305 12/31/Y2 $600 $931 $331 $364 $9,636 12/31/Y3 $600 $964 $364 $0 $10,000 Totals $1,800 $2,795 $995

Example: Interest-Bearing Long-Term Notes Payable where Stated and Market Rates Unequal. Continued.

Entries: Year 1: Legal Expenses $9,005 1/1/1 Discount on Note Payable $995 Note Payable $10,000 The discount account is contra to Note Payable 12/31/1 Interest Expense $900 Discount on Note Payable $300 Cash $600 Year 2: Interest Expense $931 12/31/2 Discount on Note Payable $331 Cash $600 Year 3: Interest Expense $964 12/31/3 Discount on Note Payable $364 Cash $600 Note Payable $10,000 Cash $10,000

What is the net note balance for a note issued at a discount?

Face value less unamortized discount.

Noncurrent Interest-Bearing Note Payable

Noncurrent Interest-Bearing Note Payable -- An interest-bearing note payable is one in which the interest element is explicitly stated. These notes are recorded at the present value of future cash flows, using the market rate of interest as the discount rate. If the stated interest rate and the market interest rate are the same, the present value of the future cash flows is equal to the face amount of the note. If the stated interest rate and the market rate of interest are not equal, the present value of the future cash flows is not equal to the face amount of the note. In this instance, a discount or premium will be recorded, and the amortization of the related premium or discount will be completed using the effective interest method.

What is the reported amount of a note calling for a face amount due at maturity, issued with an effective interest rate not equal to the stated rate?

Present value of remaining cash flows discounted at the effective rate.

What is the amount of interest recognized for a period on a note calling for a face amount due at maturity, issued with an effective interest rate not equal to the stated rate?

Product of effective rate at date of issuing the note and the principal balance at the beginning of the period.

What is the amount of interest recognized for a period on an installment note (one requiring equal periodic payments that include both principal and interest)?

Product of effective rate at date of issuing the note and the principal balance at the beginning of the period.

Example: Interest-Bearing Long-Term Notes Payable where Stated and Market Rates Unequal.

The Montana Company paid for legal services received by giving the law firm a $10,000 three-year, 6% note payable (interest payable at the end of the year) on January 1 of Year One. The market rate of interest for a note of this type is 10%. The value of the legal services is not specified. Therefore the present value of the note is used as the amount to record both sides of the transaction. In some cases, the stated rate is intentionally lowered to ease the cash flow requirements of the debtor firm during the note term. Present Value of Future Cash Flows: $10,000 X .75131 (PV of $1, N = 3, I = 10%) = $7,513 $600 X 2.48685 (PV of an Annuity, N = 3, I = 10%) = 1,492 Total Present Value of Future Cash Flows $9,005

What causes a discount on a note?

This occurs when a note is issued with a yield rate greater than the stated rate.

What causes a premium on a note?

This occurs when a note is issued with a yield rate less than the stated rate.

List the two different methods of amortizing a discount or premium on a note.

1. Effective interest method; 2. Straight-line method.

List the two different methods of recording a note for which a discount or premium is recorded?

1. Gross method; 2. Net method.

Example: Interest-Bearing Long-Term Notes Payable where Stated and Market Rates Unequal. Concluded.

In this example, we illustrate the gross method. The note payable is listed at face value, with separate accounting of the discount. The net method is also acceptable and would record the note payable initially at $9,005 with no discount recorded. Interest expense for Year 1 is .10 x $9,005 (balance at beginning of Year 1). Interest expense is based on the net note at the beginning of each period, regardless of whether the gross or net method is used. The yield rate (10%) is used to compute interest. The legal expenses are recorded at the present value of the future payments. The value of the services is defined by the present value of $9,005 because the law firm accepted the note. The worth of the note is its present value using the market rate of interest (10%). That present value includes the present value of both the face amount and the interest payments. The stated rate of 6% is used only to compute the interest payments. Interest expense is based on the market rate of 10%. The total interest expense over the note term ($2,795) is the difference between the principal of $9,005 and the sum of the future payments of $11,800 (3 x $600 + $10,000) . It also equals the sum of the $1,800 cash interest over the term (3 x $600) and the $995 discount. The discount represents additional interest because the firm received only $9,005 worth of services but must pay $10,000 at the note's maturity. If the straight-line (SL) method of amortization had been chosen, the journal entry for the three interest payments would be the same, as follows: Interest expense 932 Discount on note payable 332 (995/3) Cash 600

When is the straight-line method not allowed for notes payable accounting?

Installment notes, and when the yield and stated rates are materially different.