Specific Types of Notes Payable

What is the amount of the periodic payment for an installment note issued at discount?

Face value divided by the annuity factor for the term of the note and the stated rate on the note.

Note in Exchange for Rights or Other Privileges

A firm may borrow from a customer and ask for an interest rate less than the prevailing rate in exchange for a reduced price on goods or services to be sold to the customer. Part of the consideration received on the borrowing is a prepayment by the customer for the reduced price. The note is recorded as always using the prevailing rate. The difference between the amount borrowed and the present value of the note is unearned revenue.

Example: Non-interest-Bearing Notes Payable

A firm purchases a used plant asset by issuing a one-year, $10,165 face value note. The note pays no cash interest. The purchase occurred on July 1, Year 1 for this calendar-year firm. The plant asset has a market value of $9,500. The implied market rate of interest is 7% as shown below. A non-interest-bearing note is another example for which the stated rate (0% here) is less than the yield rate.

Example: Non-interest-Bearing Notes Payable (Solution)

A firm purchases a used plant asset by issuing a one-year, $10,165 face value note. The note pays no cash interest. The purchase occurred on July 1, Year 1 for this calendar-year firm. The plant asset has a market value of $9,500. The implied market rate of interest is 7% as shown below. A non-interest-bearing note is another example for which the stated rate (0% here) is less than the yield rate. $10,165(PV of $1, I=?, N=1) = $9,500 (PV of $1, I=?, N=1) = $9,500/$10,165 = .93458 This present value factor corresponds to I = 7%. The purchaser included the 7% interest in the face value of the note. (Net method is shown.) July 1, Year 1 Equipment 9,500 Note Payable 9,500 December 31, Year 1 Interest Expense $9,500(.07/2) 332.50 Note Payable 332.50 Interest expense is based on the beginning net liability balance June 30, Year 2 Interest Expense 332.50 Note Payable 332.50 Note Payable 10,165 Cash 10,165 Total interest on the note = $665 = $332.50(2) = $10,165 - $9,500. This solution illustrates the net method. There is no separate accounting for the discount. The gross method could also have been used. The straight-line method is inappropriate in this example given the magnitude of the difference between the stated and yield rates.

Non-interest-Bearing Notes Payable

A non-interest-bearing note payable is one in which the interest element is not explicitly stated but rather is included in the face amount of the note. These notes are recorded at the present value of future cash flows, using the market rate of interest as the discount rate. In this instance, a discount related to the note will be recorded and amortized using the effective interest method.

Note in Exchange for Rights or Other Privileges Example

At the beginning of 20x4, Duke Inc. borrowed $40,000 by issuing a three-year noninterest-bearing note with face value of $40,000. The prevailing rate on similar notes is 10%. In exchange, Duke agrees to provide the creditor (customer of Duke) with goods at a reduced price over four years. The present value of the note is $40,000(PV1, i=.10, n=3) = $40,000(.75131) = $30,052. Journal entries (gross method): 1/1/x4 Cash 40,000 Discount on note 9,948 40,000 - 30,052 Note payable 40,000 Unearned revenue 9,948 Duke receives an interest-free loan in exchange for reducing the prices on its goods to the creditor firm which is also Duke's customer. The loan is in substance only for $30,052 and is the basis for interest expense recognition. The remaining $9,948 received by Duke is a prepayment by the customer for reduced prices on the goods it will buy from Duke. 12/31/x4 Interest expense 3,005 .10(30,052) Unearned revenue 2,487 9,948/4 Discount on note 3,005 Sales revenue 2,487 The remaining journal entries for interest proceed as illustrated in other examples. The ending net balance of the note immediately before payment will be $40,000 because the discount will be fully amortized. The recognition of sales revenue proceeds as above over four years assuming the customer purchases equivalent amounts of goods each year.

Seco Corp. was forced into bankruptcy and is in the process of liquidating assets and paying claims. Unsecured claims will be paid at the rate of forty cents on the dollar. Hale holds a $30,000 noninterest-bearing note receivable from Seco collateralized by an asset with a book value of $35,000, and a liquidation value of $5,000. The amount to be realized by Hale on this note is

Bankruptcy law specifies that secured creditors are to be satisfied before any assets are paid to unsecured creditors. Hale is a secured creditor for the $5,000 liquidation value. A liquidation value is paid at the liquidation of the firm and thus acts as a secured debt. The remaining claim of $25,000 ($30,000 - $5,000) is unsecured and at the 40% rate yields an additional claim of $10,000, for a total amount to be realized of $15,000.

Is a noninterest-bearing note issued at a premium or discount?

It is issued at a discount.

Example: Installment Note

On 1/1/x5, a firm purchased a building by paying $100,000 down and signing a $400,000, 6%, 10-year secured mortgage note. The note calls for annual payments beginning 12/31/x5. The prevailing interest rate for a note of this type is 10%. Each payment includes principal and interest, and the note is fully paid with the last payment. The gross or net method can be used as always but the straight-line method is not appropriate because each payment reduces principal. Using SL would associate equal amounts of discount to each period when the amount of principal outstanding is declining each period.

Example: Installment Note (solution)

On 1/1/x5, a firm purchased a building by paying $100,000 down and signing a $400,000, 6%, 10-year secured mortgage note. The note calls for annual payments beginning 12/31/x5. The prevailing interest rate for a note of this type is 10%. Each payment includes principal and interest, and the note is fully paid with the last payment. The gross or net method can be used as always but the straight-line method is not appropriate because each payment reduces principal. Using SL would associate equal amounts of discount to each period when the amount of principal outstanding is declining each period. The annual payment (pmt) is computed using the stated rate and total note amount as indicated in the note: 400,000 = pmt(PV annuity, i=.06, n=10) = pmt(7.36009) 400,000/7.36009 = pmt = $54,347 The amount borrowed is the present value of all payments required on the note using the prevailing or yield rate of 10%. The problem is silent on the fair value of the building. Therefore, the present value of the note (at the yield rate) is used for recording both the note and building. Amount borrowed = $54,347(PV annuity, i=.10, n=10) = $54,347(6.14457) =$333,939 Journal entries (net method): 1/1/x5 Building 433,939 Cash 100,000 Mortgage note payable 333,939 12/31/x5 Interest expense 33,394 333,939(.10) Mortgage note payable 20,953 Cash 54,347 12/31/x6 Interest expense 31,299 (333,939 - 20,953)(.10) Mortgage note payable 23,048 Cash 54,347 The ending 20x5 balance of the note payable is $312,986 = $333,939 - $20,953, the principal portion of the first payment. The total balance is reported as follows: (1) $23,048 current liability (CL), and $289,938 noncurrent (NCL) = $312,986 - $23,048. The portion of the liability to be paid in 20x6 is the amount classified as current for 20x5 ($23,048). The ending 20x6 balance of the note payable is $289,938 = $333,939 - $20,953 - $23,048. This balance also can be computed as $54,347(PV annuity, i=.10, n=8) because there are eight payments remaining at this point. Total interest over the 10 year note term equals the difference between the total payments on the note less the amount borrowed = (10 x $54,347) - $333,939 = $209,531.

What is the principal amount of a noninterest-bearing note?

Present value of the face amount discounted at the yield rate on the note.

What is the amount borrowed on an installment note issued at discount?

Product of the periodic payment and the annuity factor for the term of the note and the yield rate on the note.

A company issued a short-term note payable to a bank with a stated 12 percent rate of interest . The bank charged a .5% loan origination fee and remitted the balance to the company. The effective interest rate paid by the company in this transaction would be

The .5% loan origination fee reduces the proceeds to the borrower AND increases the total interest to be paid by the same amount. The effect is to raise the interest rate above 12.5%. Assume the loan amount is $1,000 before the loan origination fee. Therefore, the net amount loaned is $995 [1 - .005($1,000)]. However, the full $1,000 must be paid at maturity. The total interest to be paid is thus increased by the $5 origination fee ($1,000 - $995). For simplicity, assume the loan is for a full year. Then total interest paid is: .12($1,000) + $5 = $125. The effective rate of interest for the year then is: $125/$995 = .1256. This exceeds 12.5%.

Define "discount on note".

The amount of revenue recognized over the term of a note exchanged for cash and other privileges.

House Publishers offered a contest in which the winner would receive $1,000,000, payable over 20 years. On December 31, 2005, House announced the winner of the contest and signed a note payable to the winner for $1,000,000, payable in $50,000 installments every January 2. Also on December 31, 2005, House purchased an annuity for $418,250 to provide the $950,000 prize monies remaining after the first $50,000 installment, which was paid on January 2, 2006. In its 2005 income statement, what should House report as contest prize expense?

The contest prize expense is the present value of the total cost incurred. That present value amount is the current sacrifice (cost) to the firm to meet its future obligation as of the balance sheet date. The present value, which is also the expense amount is $468,250, which is the sum of the present value of the last 19 payments ($418,250) and the present value of the first payment ($50,000) due just after the balance sheet date.

How is the total interest expense recognized on a noninterest-bearing note?

Total payments less amount borrowed.