CHAPTER EIGHTEEN

1. CHAPTER EIGHTEEN ACCOUNTING FOR NOTES AND INTEREST

2. PROMISSORY NOTE • Def. - a written promise to pay a specific sum at a definite future date. • Also called a “note.” • Often used when credit is extended for 60 days or more, or when large amounts of money are involved.

3. PROMISSORY NOTE PRINCIPAL $ 1,500.00

4. PROMISSORY NOTE Date of the note $ 1,500.00 June 9, 20 - -

5. PROMISSORY NOTE Term of the note $ 1,500.00 June 9, 20 - - Ninety Days AFTER DATE I PROMISE TO PAY TO

6. TERM OF THE NOTE • Def. - months or days • from date of issue to date of maturity • Used to calculate TIME • the term of the note stated as a fraction of a year • Note: It is common to use 360 days as a year. When the term of note is expressed as months, TIME is calculated in months.

7. TERM OF THE NOTE • Def. - months or days • from date of issue to date of maturity • Used to calculate TIME • the term of the note stated as a fraction of a year • Note: It is common to use 360 days as a year. When the term of the note is expressed as days, the TIME is calculated using the exact number of days.

8. COMPUTING DUE DATE Example: Note is dated June 9, 20-- and is due in 90 days. Days in June 30 STEP #1 Start with the month the note was issued.

9. COMPUTING DUE DATE Example: Note is dated June 9, 20-- and is due in 90 days. Days in June 30 9 Deduct date of note (June 9) Days remaining in June 21 Subtract the date the note was issued (we do not count the date of issuance).

10. COMPUTING DUE DATE Example: Note is dated June 9, 20-- and is due in 90 days. Days in June 30 9 Deduct date of note (June 9) Days remaining in June 21 Add: Days in July 31 31 Days in August STEP #2 Add to the result of step #1 the no. of days in as many months as possible without exceeding the time of the note.

11. COMPUTING DUE DATE Example: Note is dated June 9, 20-- and is due in 90 days. Days in June 30 9 Deduct date of note (June 9) Days remaining in June 21 Add: Days in July 31 31 Days in August By the end of August, 83 days of the note have past.

12. COMPUTING DUE DATE Example: Note is dated June 9, 20-- and is due in 90 days. Days in June 30 9 Deduct date of note (June 9) Days remaining in June 21 Add: Days in July 31 31 Days in August STEP #3 Subtract the result of step #2 from the time of the note. (90 - 83)

13. COMPUTING DUE DATE Example: Note is dated June 9, 20-- and is due in 90 days. Days in June 30 9 Deduct date of note (June 9) Days remaining in June 21 Add: Days in July 31 31 Days in August The result is the date of the month the note is due.

14. COMPUTING DUE DATE Example: Note is dated June 9, 20-- and is due in 90 days. Days in June 30 9 Deduct date of note (June 9) Days remaining in June 21 Add: Days in July 31 31 Days in August Maturity date, September 7 7 The 90th day (Sept. 7th) is called the Maturity Date.

15. COMPUTING DUE DATE Example: Note is dated June 9, 20-- and is due in 90 days. Days in June 30 9 Deduct date of note (June 9) Days remaining in June 21 Add: Days in July 31 31 Days in August Maturity date, September 7 7 Total time in days 90

16. PROMISSORY NOTE $ 1,500.00 June 9, 20 - - Ninety Days AFTER DATE I PROMISE TO PAY TO PAYEE Sarah Morney THE ORDER OF

17. PROMISSORY NOTE $ 1,500.00 June 9, 20 - - Ninety Days AFTER DATE I PROMISE TO PAY TO Sarah Morney THE ORDER OF One Thousand Five Hundred and 00/100 Brentwood Bank PAYABLE AT WITH INTEREST AT 9% per Annum from Date INTEREST RATE Notes may be Interest bearing or non Interest bearing.

18. CALCULATING INTEREST FORMULA: PRINCIPAL x RATE x TIME $1,500.00 9% 90/360 x x $33.75 Interest

19. CALCULATING INTEREST Example: A $2,000, 8% note due in 3 months FORMULA: x x PRINCIPAL RATE TIME x 3/12 $2,000.00 x 8% $40 Interest

20. PROMISSORY NOTE $ 1,500.00 June 9, 20 - - Ninety Days AFTER DATE I PROMISE TO PAY TO Sarah Morney THE ORDER OF One Thousand Five Hundred and 00/100 Brentwood Bank PAYABLE AT MATURITY DATE WITH INTEREST AT 9% per Annum from Date 6 Sept. 7, 20-- No. Due

21. PROMISSORY NOTE $ 1,500.00 June 9, 20 - - Ninety Days AFTER DATE I PROMISE TO PAY TO Sarah Morney THE ORDER OF One Thousand Five Hundred and 00/100 Brentwood Bank PAYABLE AT WITH INTEREST AT 9% per Annum from Date Maker of Note Paul DeBruke 6 Sept. 7, 20-- No. Due

22. NOTES RECEIVABLE TRANSACTIONS • Six types • Note received from a customer to extend time for payment of an account • Note collected at maturity • Note renewed at maturity • Note discounted before maturity • Note dishonored • Collection of dishonored note

23. NOTE RECEIVED TO EXTEND TIME FOR PAYMENT Example: Accounts Receivable customer, Michael Putter owes $2,000. To settle this account, Putter signs a 90-day, 10% note dated June 8. Why would we want to accept this note?

24. NOTE RECEIVED TO EXTEND TIME FOR PAYMENT Example: Accounts Receivable customer, Michael Putter owes $2,000. To settle this account, Putter signs a 90-day, 10% note dated June 8. Two reasons to accept this note: • Note is a formal, written promise to pay. • Can be converted to cash at a bank if necessary • Note is likely to bear interest.

25. GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT 1 June 8 Notes Receivable 2,000 2 Accounts Receivable 2,000 3 Received note to settle 4 account 5 Mr. Putter’s balance is removed from Accounts Receivable and placed into Notes Receivable. 6 7 8 9 10 11

26. NOTE RECEIVED TO EXTEND TIME FOR PAYMENT Example: What if Accounts Receivable customer Michael Putter gives a check for $250 and a note for $1,750 instead? Let’s look at the Journal Entry!

27. GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT 1 June 8 Cash 250 2 Notes Receivable 1,750 3 Accounts Receivable 2,000 4 Received cash and note 5 to settle account 6 7 8 9 10 11

28. NOTE COLLECTED AT MATURITY When a note receivable matures, it may be collected: • By the payee • By the bank named in the note, or • By a bank where it was left for collection.

29. NOTE COLLECTED AT MATURITY Example: On September 6 (the due date), Putter pays the principal and interest on the note. Principal of note $2,000 Interest 50 $2,000 x 10% x 90/360

30. NOTE COLLECTED AT MATURITY Example: On September 6 (the due date), Putter pays the principal and interest on the note. Principal of note $2,000 Interest 50 Maturity Value $2,050

31. GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT 1 Sept 6 Cash 2,050 2 Notes Receivable 2,000 3 Interest Revenue 50 4 Received payment of note 5 with interest 6 7 8 9 10 11

32. NOTE COLLECTED AT MATURITY Example: What if the note had been left at Planet Bank for collection instead? Planet Bank would collect the maturity value from Putter, subtract out a service charge and deposit the remainder in our account.

33. GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT 1 Sept 6 Cash 2,040 2 Collection Expense 10 3 Notes Receivable 2,000 4 Interest Revenue 50 5 Received payment of note 6 with interest less collection 7 fee 8 9 10 11

34. NOTE RENEWED AT MATURITY Example: At maturity Putter is unable to pay the maturity value. Instead, he pays only the $50 interest and signs a new 60-day, 10% note. Let’s look at the Journal Entry!

35. GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT 1 Sept 6 Cash 50 2 Notes Receivable (new note) 2,000 3 Notes Receivable (old note) 2,000 4 Interest Revenue 50 5 Received new note plus 6 interest on old note 7 8 9 10 11

36. NOTE RENEWED AT MATURITY Example: What if Putter pays the $50 interest and $500 toward the principal? Let’s look at the Journal Entry!

37. GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT 1 Sept 6 Cash 550 2 Notes Receivable (new note) 1,500 3 Notes Receivable (old note) 2,000 4 Interest Revenue 50 5 Received new note plus 6 partial payment and interest 7 on old note 8 9 10 11

38. NOTE DISCOUNTED BEFORE MATURITY • If a business needs cash before the due date of a note, it can endorse the note and transfer it to a bank. • Bank charges an interest fee “Bank Discount” • for the time between the date of discounting and the due date of the note. • The difference between the maturity value and the bank discount is called the “Proceeds.”

39. NOTE RENEWED AT MATURITY Example: Assume the $2,000, 10%, 90-day note from Putter dated June 8 is discounted at the bank on July 8 at a rate of 12%. Calculating the discount and proceeds is a four step process.

40. NOTE RENEWED AT MATURITY Example: Assume the $2,000, 10%, 90-day note from Putter dated June 8 is discounted at the bank on July 8 at a rate of 12%. Step #1 Compute the maturity value of the note. Face Interest Maturity Value = + $2,000 $50 $2,050 + =

41. NOTE RENEWED AT MATURITY Example: Assume the $2,000, 10%, 90-day note from Putter dated June 8 is discounted at the bank on July 8 at a rate of 12%. Step #2 Compute the number of days in the discount period - from the discount date to the due date. Days in July 31 Less: Discount date 8 The discount date is not counted in the Discount Period.

42. NOTE RENEWED AT MATURITY Example: Assume the $2,000, 10%, 90-day note from Putter dated June 8 is discounted at the bank on July 8 at a rate of 12%. Step #2 Compute the number of days in the discount period - from the discount date to the due date. Days in July 31 Less: Discount date 8 Remaining days in July 23 Plus days in August 31 Plus due date (Sept) 6 Days in Discount Period 60

43. NOTE RENEWED AT MATURITY Example: Assume the $2,000, 10%, 90-day note from Putter dated June 8 is discounted at the bank on July 8 at a rate of 12%. Step #3 Compute the discount amount. Maturity Value Discount Period Discount Amount Discount Rate = X X $41 $2,050 12% 60/360 = X X

44. NOTE RENEWED AT MATURITY Example: Assume the $2,000, 10%, 90-day note from Putter dated June 8 is discounted at the bank on July 8 at a rate of 12%. Step #4 Compute the proceeds. Maturity Value Discount Amount Proceeds - = $2,009 - $2,050 = $41 Let’s journalize the discounting of this note.

45. GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT 1 July 8 Cash 2,009 2 Notes Receivable 2,000 3 Interest Revenue 9 4 Discounted note receivable 5 What if the proceeds are less than the face value of the note? 6 7 8 9 10 11

46. GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT 1 July 8 Cash 1,992 2 Interest Expense 8 3 Notes Receivable 2,000 4 Discounted note receivable 5 The difference represents interest expense. 6 7 8 9 10 11

47. NOTE DISHONORED • Maker of the note does not pay or renew it at maturity • Maker is still liable • But note loses its legal status • Payee transfers the amount due from Notes Receivable to Accounts Receivable

48. NOTE DISHONORED Example: Putter dishonors the $2,000, 10% 90-day note. Interest, although it has not been paid by the maker, is recognized as earned by the payee.

49. GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT 1 Sept 6 Accounts Receivable/Putter 2,050 2 Notes Receivable 2,000 3 Interest Revenue 50 4 Note receivable dishonored 5 The entire maturity value is debited to Accounts Receivable. 6 7 8 9 10 11

50. NOTE DISHONORED Example: If Putter’s note had been discounted at the bank and then was dishonored by the maker, the bank will require the PAYEE to pay the principal, interest and bank fees. The payee then attempts to recover the maturity value PLUS the bank fee from the maker.