To provide additional information, the debit could be recorded to an account entitled “Notes Receivable—Dishonored.” That is to say, if the original holder is without further liability, then the asset is effectively transferred and its amount should be removed from the books. For tax purposes, any gain made from the sale or redemption of the discount bond is treated as ordinary income up to the amount of the ratable share of the bond.
Accounting for Discounted Note Receivable
The bank accepts the note and gives the holder cash equal to its maturity value less a discount to the maturity value computed using what are direct costs a discount rate. One of the differences between notes receivable and accounts receivable is the greater negotiability of notes. By discounting a note with recourse, the endorser has a contingent liability. A contingent liability is a possible liability that may or may not occur depending on some future event. In summary, both cases represent different ways in which notes can be written.
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The holder will recognize Interest income in the income statements. Note receivable usually made when a business loan the money to another business. Sometimes its maturity date can be extended to over a year base on both parties’ negotiation. While both notes receivable and accounts receivable are similar as both represent assets, the accounting treatment for both is different. Due to its better liquidity, companies can dispose of their notes receivable to other parties. At that moment, the company will need to calculate various amounts to determine the accounting treatment of the discounted notes receivable.
Since the proceeding is lower than the face value of the bond, ABC Co. will suffer an interest expense of $336 ($25,000 – $24,644). One of the advantages of discount notes is that they are not as volatile as other debt instruments. They are, therefore, perceived to be a safe investment for investors looking to preserve their capital in a low-risk investable security. Discount notes are fixed-income securities that do not make interest payments for the duration of the note. Since investors don’t get the added advantage of periodic interest income, the notes are offered at a discount to par.
- Given that most discounted notes are reviewed for their creditworthiness by both the bank and the endorser, contingent liability rarely turns into a real liability.
- In the first case, the firm receives a total face value of $5,000 and ultimately repays principal and interest of $5,200.
- Since the proceeding is lower than the face value of the bond, ABC Co. will suffer an interest expense of $336 ($25,000 – $24,644).
If the note is not paid at maturity, the bank can collect from the original how much can you claim for funeral expense deductions holder of the note was discounted with recourse. If the arrangement is without recourse, the bank must find another solution. Given that most discounted notes are reviewed for their creditworthiness by both the bank and the endorser, contingent liability rarely turns into a real liability. Rather, they are usually referred to in the footnotes of the financial statements. If the maker pays the bank, the contingent liability will end; if the maker defaults, the contingent liability will become a real liability.
Journal entry
A discount on notes receivable arises when the present value of the payments to be received from a note are less than its face amount. The difference between the two values is the amount of the discount. A discount on notes payable arises when the amount paid for a note by investors is less than its face value. The size of this discount is especially large when the stated interest rate on a note is well below the market rate of interest.
Discount on Note Receivable
First of all, the company must calculate the maturity value of the note. Since the note has a face value of 25,000 and an interest rate of 10%, its maturity value will be as follows. In the second case, the firm receives the same $5,000, but the note is written for $5,200. The entry is for $150 because the amortization entry is for a 3-month period. After the entry on 31 December, the discount account has a balance of only $50. The adjusting journal entry in Case 1 is similar to the entries to accrue interest.
Thus, the company will have contingent liabilities that may arise due to the default of the note receivable. A contingent liability is the obligation that may or may not happen as it depends on the other future event. This liability is not required to record in the balance sheet, but they must be properly disclosed in the financial statements. Because they are perceived as safer investments, the amount an investor can earn with them is less compared to other investments.
To account for the difference between the present value of the payments to be received from a note and its face amount, amortize it over the remaining life of the note. For the party discounting the note, the discount is incrementally recognized as interest expense over the remaining term of the note. After the negotiation, the bank agrees to offer 15% discount rate. One problem with issuing notes payable is that it gives the company more debt than they can handle, and this typically leads to bankruptcy. Issuing too many notes payable will also harm the organization’s credit rating.
Therefore, it decides to discount the notes receivable to a local bank, which agrees on a 15% discount rate. Discount on notes receivable happens when a company discounts its notes receivables before their maturity date. For example, if a company needs cash, it may discount its notes receivables to another party, usually a financial institution.
The interest of $200 (12% of $5,000 for 120 days) is included in the face of the note at the time it is issued but is deducted from the proceeds at the time the note is issued. The note in Case 2 is drawn for $5,200, but the interest element is not stated separately. The principal is just the total payment less the amount allocated to interest. The interest portion is 12% of the note’s carrying value at the beginning of each year. The agreement calls for Ng to make 3 equal annual payments of $6,245 at the end of the next 3 years, for a total payment of $18,935. The $200 difference is debited to the account Discount on Notes Payable.
Notes receivable is a type of debt that companies provide in exchange for a promissory note. Sometimes, companies may sell the note before its maturity date, known as discounting. The biggest issuers of discount notes are government-sponsored agencies, such as the Federal Home Loan Mortgage Corporation (Freddie Mac) and the Federal Home Loan Bank (FHLB). These agencies issue notes to investors as a way to raise short-term capital for different projects.
