Sec 2 - Notes Receivable

Question 1

Notes Receivable

Answer 1

Notes Receivable

• Notes receivable (NR) are more formal and over a longer period of time than AR
• Key issue is valuation of the NR
• There is an interest element
• Explicit interest is stated (e.g., 5%)
• Implicit interest is computed using the _present value of the future cash flows_- this is also referred to as discounting a note

Question 2

Interest Bearing Notes

Answer 2

Interest-bearing notes receivable

• The interest element is *explicitly stated*.
• For example, the note might be identified as a three-year, 9% note receivable.
• The amount of cash to be collected from an interest-bearing note is the face amount of the note (principal) plus interest.

Question 3

Non-interest-bearing note receivable

Answer 3

Non-interest-bearing note receivable

• The interest element is not explicitly stated, it is Implicit.
• For example, the note might be identified as a two-year, $13,000 non-interest-bearing note.
• The amount of cash to be collected** from a non-interest-bearing note is the **face amount of the note.
• That is, the face amount of the note includes principal and interest that will be collected at maturity date.

Question 4

Recording a Note Receivable

Answer 4

Recording a Note Receivable

• Present value – In accordance with U.S. GAAP, all notes are recorded at the present value of future cash flows (notes of less than one-year term _need not be recorded at present value_).
• The discount rate used in this calculation is the market rate of interest on the date of note creation (this rate may be different from the note’s stated rate—the rate that appears on the note).
• Furthermore, any discounts related to notes will be amortized by applying the effective interest method.
• Market value – If the stated interest rate is equal to the market rate of interest, the present value of future cash flows will be equal to the face amount of the note. In this situation, no discounts will exist.
• Interest/market rate – If the stated interest rate is not equal to the market rate of interest, the present value of future cash flows will not be equal to the face amount of the note. In this situation, a discount related to the note will exist.
• For a non-interest-bearing note, the present value of future cash flows will not be equal to the face amount of the note. In this situation, a discount related to the note will exist.

Question 5

Determination of Present Value of Future Cash Flows

Answer 5

• Cash transaction – If the transaction is a cash transaction, such as a lending transaction, the present value of future cash flows will equal the amount of cash that exchanged hands on the date of note creation.
• Noncash transaction – If the transaction is a non-cash transaction, such as the sale of a non-cash asset and the receipt of a note receivable, the transaction will be recorded at the fair market value of the non-cash asset or the fair market value of the note receivable (present value of future cash flows), whichever one can be more clearly determined.

Question 6

Example: 1

Simple interest note, stated rate equals market rate.

Answer 6

Example:

• Simple interest note, stated rate equals market rate. A calendar-year fiscal-year firm receives a three-year, 6%, $10,000 note on March 1 of the current year from a sale. The note pays interest each September 1 and March 1.

The first four entries are shown:

March 1
Note Receivable 10,000
Sales 10,000
September 1
Cash (.06(1/2)$10,000) 300
Interest Revenue 300
December 31
Interest Receivable (.06(4/12)$10,000) 200
Interest Revenue 200
March 1 (following year)
Cash 300
Interest Receivable 200
Interest Revenue (.06(2/12)$10,000) 100

Question 7

Example: 2
Simple interest note, principal and interest are due in annual installments.

Answer 7

Example:

• Simple interest note, principal and interest are due in annual installments. A calendar-year fiscal-year firm receives a 12%, $300,000 note on May 1, 20x7. Beginning 20x8, the note calls for $100,000 of principal, along with interest on the outstanding note balance at the beginning of the period, to be paid each April 30.

Interest revenue recognized:
In 20x7: $300,000(.12)(8/12) = $24,000
In 20x8: $300,000(.12)(4/12) + $200,000(.12)(8/12) = 28,000
In 20x9: $200,000(.12)(4/12) + $100,000(.12)(8/12) = 16,000
In 20x0: $100,000(.12)(4/12) = 4,000

Question 8

Example: 3
Each note payment includes principal and interest.

Answer 8

Example:

• Each note payment includes principal and interest. A firm receives a 7%, two-year, $20,000 note from a sale, on January 1, 20x7. The note calls for two equal annual payments to be made beginning December 31, 20x7. The present value of an annuity of $1 for two periods at 7% is 1.80802. Let P = annual payment.
• *$20,000 = P(1.80802)**
• *P = $11,062**

January 1, 20x7 Note Receivable 20,000
Sales 20,000

December 31, 20x7 Cash 11,062
Interest Revenue 1,400*
Note Receivable 9,662
*$20,000(.07)
This is the interest portion of the first payment.
The $9,662 is return of principal.

December 31, 20x8 Cash 11,062
Interest Revenue 724**
Note Receivable 10,338

**($20,000 - $9,662)(.07)

This entry closes the note receivable account ($20,000 - $9,662 - $10,338 = $0).

1. Must determine the total annual payment, through the annuity calculation.
2. Then determine the interest payment for the period payment, and subtract from the annual payment to determine the principle payment.
3. Both interest and principle will be included in each payment.

Question 9

Example: 4
Simple interest note, stated rate and market rates are unequal

Answer 9

Example:

• Simple interest note, stated rate and market rates are unequal. A firm, which is not an equipment dealer, sells used equipment (cost, $40,000; accumulated depreciation, $16,000) and receives a two-year, 4%, $25,000 note on January 1, 20x8. The note calls for annual interest to be paid each December 31 beginning 20x8 with the principal due December 31, 20x9. The equipment has no known market value but the prevailing (market) interest rate at the date of sale is 8%. Relevant present values of $1 at 8% for two years: single payment, .85734; annuity, 1.78326.
• The note is recorded at present value: $25,000(.85734) + .04($25,000)(1.78326) = $23,217. Thus, the note is recorded at a discount of $1,783 ($25,000 - $23,217). The true value of the note on receipt is $23,217 because this amount reflects the current market interest rate. This amount is also used as the fair value of the equipment in computing the gain or loss on disposal.

January 1, 20x8 Note Receivable 23,217
Accumulated Depreciation 16,000
Loss on Disposal 783
Equipment 40,000

• (This entry records the note using the net method. The gross method would record the note at $25,000 and credit Discount on Notes for $1,783. Either approach is acceptable and both report the net notes receivable balance at present value.)

December 31, 20x8 Cash .04($25,000) 1,000

Note Receivable 857
Interest Revenue 1,857*
* .08($23,217)

The $857 amount is the increase in the value of the note for 20x8 because the cash
interest was less than the growth in the note’s present value over time. Had the gross method been used, the discount account would have been debited for $857 rather than the note receivable account. Under either reporting approach, the net note balance is now $24,074 ($23,217 + $857). This amount is the present value of
the remaining payments at December 31, 20x8, which can also be computed as ($25,000 + $1,000)/1.08.

December 31, 20x9 Cash .04($25,000) 1,000
Note Receivable 926
Interest Revenue 1,926*
Cash 25,000
Note Receivable 25,000
* .08($23,217 + $857)

Question 10

Example: 5
Non-interest-bearing note

Answer 10

Example:

• Non-interest-bearing note. A non-interest-bearing note has a zero stated rate. The term non-interest-bearing is a misnomer, however, because the interest is included in the note’s face value. Assume the same information as in the previous example except that there is no stated rate. Now the present value of the note is $21,434 [$25,000(.85734)]. The note is recorded at this amount. The entries are similar except that no cash interest is received. The first interest entry is shown:

December 31, 20x8 Note Receivable 1,715
Interest Revenue 1,715*
* .08($21,434)

Question 11

Interest Rates:

Answer 11

• The stated interest rate, also referred to as the face rate or the coupon rate, is the rate contracted as part of the note.
• The effective-interest rate, also referred to as the market rate or the effective yield, is the rate used in the market to determine the value of the note—that is, the discount rate used to determine present value.

Question 12

Present Value:

Answer 12

• PVF = Present Value of Future Cash Flows
• PV-OA = Present Value of an Ordinary Annuity
  
  • An annuity is a series of identical payments occurring at equal time intervals.
  • When the payments appear at the end of each time period, the annuity is said to be an ordinary annuity or an annuity in arrears
• PV of Principle:
• PV of Interest: