Chapter 4 Notes Receivable

Objectives Explain why a business uses negotiable instruments Determine the maturity date of a promissory note Calculate the interest and a maturity value of a promissory note Determine the bank discount on a discounted note Record journal entries for notes receivable Define the accounting terms introduced in this chapter

Negotiable Instruments Chapter 4 Section 1 Negotiable Instruments

Negotiable Instrument A financial document that transfers ownership from one person to another. Example: a check

Promissory Note Referred to as a ‘note’ A promise to pay a certain amount of money on demand and/or at a specific time. Formal legal document Proof of a debt Must contain certain information to be enforceable Textbook page 116 Figure 4-1

Promissory Note (continued) Principal – amount of money borrowed Face Value – amount written on the note Issue Date – Date the note is signed Maturity Date – Date payment is due (due date) Term – The amount of time between the issue date and the maturity date. Payee – person or company to whom the note is payable. Maker – Person or firm who promises to repay the principal and interest, signs the note.

Determining the Maturity Date of a Note Expressed in Months – maturity date falls on the same day of the month as the issue date, plus the specified number of months. Ex: Issued on May 1 (term of three months), maturity date is August 1 Textbook page 117

Calculating Interest on a Note Interest – fee charged for the use of money Interest Rate – the amount of interest expressed as a percentage of the principal. Formula Interest = Principal x Interest Rate x Time (I = P x I x T)

Interest Rates Stated on an annual basis If the term of the note is less than one year, the time calculation is expressed as a fraction of one year. Common Time Fractions: 3 months = 3/12 60 days = 60/365 6 months = 6/12 90 days = 90/365

Example Suppose that a principal in a note is $1,800, the interest rate is 12%, and the term is 90 days (90/365). Calculate the interest on the note. $1,800 x .12 x (90/365) = Interest $53.26

Maturity Value The principal plus the interest. Using the previous example, what is the maturity value? Principal + Interest = Maturity Value $1,800 + $55.26 = $1,853.26

Interest – Bearing Note A note that requires the principal plus interest to be repaid at maturity. Businesses may also use an interest table Textbook page 119 Figure 4-3 Use the terms from the previous example.

Complete the following: Ch. 4 Demonstration Packet: Problems 4-1 and 4-2

Chapter 4 Section 2 Notes Receivable

Notes Receivable A promissory note accepted by a person or business. A business may ask for a note if it makes a loan to an employee, a preferred customer, or supplier. Normal credit period, 30 days. Textbook pages 121-123

Dishonored Note When the maker of the note fails to pay or renew the note at maturity. The maker still owes the payee the maturity value of the note. Legal steps might be needed Notes Receivable Past Due – A note that has been dishonored is recorded in a current asset account. Textbook pages 123-124

Discounting Notes Receivable Chapter 4 Section 3 Discounting Notes Receivable

Discounted Notes Receivable Instead of holding them to maturity, a business can sell notes receivable to a bank. Receive cash immediately To discount, the business endorses the note and delivers to the bank Bank discounts the note by deducting its share of the interest in advance. Interest deducted is called bank discount Amount the business actually receives is called proceeds

Proceeds The maturity value minus the bank discount. Bank holds the note until the note becomes due and collects the maturity value directly from the maker of the note.

Contingent Liability Agreement to pay the note if the maker does not. The liability of the endorser (business) is contingent on (depends on) whether or not the maker dishonors the note. When a business discounts a note, the business has a contingent liability. If the maker dishonors the note, the business is liable to the bank for the note’s maturity value.

Conservatism Principle Practice of reporting contingent liabilities. To be conservative when reporting the financial position of a business, it is best to present amounts that are least likely to overstate income or assets. When a note is discounted, It’s recorded in Notes Receivable Discounted Contra Asset Account Used to report face value of all discounted notes receivable. By showing Notes Receivable Discounted as a deduction from Notes Receivable, the balance sheet reflects the book value of notes receivable and contingent liability.

Recording Discounted Notes Receivable On July 15 Spectrum accepted a 10%, 60-day note for $1,500 from Mallary Palmer. On July 30 Spectrum discounted the note to obtain cash to buy additional merchandise. The discount rate was 10.5%. To record this transaction, you need to calculate the maturity value, discount period, and bank discount. On September 13th: Interest = 1500 x .10 x (60/365) Maturity Value = $1524.66 Discount Period – number of days in the term of the note less the number of days the business held the note.

Spectrum Example Issue Date – July 15th Discount Date – July 30th Maturity Date – September 15th Discount Period is 45 days Equation to calculate the bank discount: Maturity Value x Discount Rate x Discount Period = Bank Discount $1,524.66 x .105 x 45/365 = $19.74 The proceeds are the maturity value less the bank discount: $1,524.66 - $19.74 = $1,504.92 Textbook page 128 (general journal)

Complete the following: Demonstration Problems 4-6 and 4-7