PROMISSORY NOTES

Businesses operating on a larger scale grant credit through the acceptance of

promissory note rather than open account credit. The use of promissory note serves the
purpose of security and negotiability because it evidences acknowledgement of one’s
liability. In the event the debtor or maker fails to pay, the there is a strong claim against
the debtor. A written promise to pay is more certain of collection compared to an oral
promise.

Definition of Terms

* Notes receivable – claims supported by formal promises to pay usually in the form of
notes
* Negotiable promissory notes – an unconditional promise in writing made by one
person to another, signed by the maker, engaging to pay on demand or at a fixed
determinable future time a sum certain in money or to bearer.
* Dishonored notes – when promissory note matures and is not paid. This should be
removed from the notes receivable account and transferred to accounts receivable at an
amount including, if any, interest and other charges.
* Discounting of Notes – the payee may obtain cash before maturity date at a bank or
other financing company. The payee then becomes the endorser; the bank or other
financing company becomes the endorsee.

Sample Promissory Note

Dasmariñas, Cavite
P100,000 May 1, 2020

For value received, I promise to pay Raphael Regudo the sum of One
Hundred Thousand (P100,000) ninety days from date with simple
interest at 12% per annum.

SGD Kimberly Coloma

Elements of the Note

* Maker – Kimberly Coloma

* Payee – Rapahel Regudo
* Principal (Face) – P100,000. It is the amount appearing on the face of the note. It
represents the amount borrowed
* Interest Rate – 12%. Annual interest rate of interest appearing on the face of the note
which will be the basis of interest charges to the maker. It is usually stated at an
annual rate
* Interest - amount of interest for the full term of the note

Interest (I) = Principal x Rate x Time (P x R x T)

Interest (I) = P100,000 x 12% x 90/360
= P3,000

* Term – 90 days. It is the period of time during which interest should be computed. It
extends from the issue date to the maturity date of the note
* Issue Date – May 1, 2020. It is the date when the note was signed and issued

* Maturity Date – July 30, 2020. It is the date when maturity value should be paid and
is computed as follows:

Days remaining in May (31 – 1) 30

Days in June 30
Days for July 30 (maturity date)
Term of Note 90

* Maturity Value – amount due on the note at the date of maturity

Maturity Value (MV) = Principal plus Interest (P + I)

Maturity Value (MV) = P100,000 + P3,000
= P103,000
Journal Entries

May 1 Notes Receivable P100,000

Cash P100,000
To record receipt of 90-day note.

31 Interest Receivable 1,000

Interest Income (100,000 x 12% x 30/360) 1,000
To record accrued interest.

June 30 Interest Receivable 1,000

Interest Income (100,000 x 12% x 30/360) 1,000
To record accrued interest.

July 30 Interest Receivable 1,000

Interest Income (100,000 x 12% x 30/360) 1,000
To record accrued interest.

Cash 103,000
Notes Receivable 100,000
Interest Receivable 3,000
To record collection of Notes plus interest

 If no accrual of interest was made, the

entry upon collection is:
Cash 103,000
Notes Receivable 100,000
Interest Income 3,000

Assume that the maker dishonored the note on July 30. The maker is still liable to pay
the maturity value including protest fees and charges that may accrue after maturity
date.
July 30 Accounts Receivable P103,000
Notes Receivable P100,000
Interest Receivable/Interest Income 3,000
To record Notes receivable dishonored

DISCOUNTING OF NOTE RECEIVABLE

When a note is negotiable, the payee may obtain cash before maturity date at a bank or
other financing company. This is called discounting of notes receivable. It is a
convenient way for a business or individual to cash in on a note at any time before
maturity. To discount the note, the payee must endorse it. The payee then becomes the
endorser; the bank or other financing company becomes the endorsee.

When a note is discounted, the original payee receives the proceeds of the discounted
note. The bank – new payee – will receive the maturity value of the note at maturity. To
receive cash on the note before maturity, the seller is willing to accept a significantly
discounted price.
Notes are generally discounted with recourse. This means that the entity discounting
the note guarantees payment if the maker of the note defaults or dishonors payment.

Entry for Notes Discounted with recourse (if the problem is silent):

Cash xxx
Notes Receivable Discounted xxx

Entry for Notes Discounted without recourse:

Cash xxx
Notes Receivable xxx

Terms Related to Discounting

* Net Proceeds – refer to the discounted value of the note received by the endorser from
the endorsee. It is computed as follows:

Net proceeds (NP) = Maturity Value minus Discount (MV – D)

* Discount – amount of interest deducted by the bank in advance

Discount (D) = Maturity Value x Discount Rate x Discount Period

(MV x DR x DP)

* Discount Rate – rate used by the bank in computing the discount. If no discount rate
is given, it is safe to assume that it is equal to the interest rate

* Discount Period- period of time from date of discounting to maturity date. Simply
computed, discount period equals term of note minus expired portion up to the date of
discounting. It is the unexpired term of the note

Steps in Discounting Notes Receivable

1. Determine the Maturity Value (MV) of the note

2. Determine the Discount Period (DP)
3. Compute the Discount (D)
4. Determine for the Net Proceeds (NP)
5. Compute for the Carrying Amount of the note (Principal + Accrued Interest)
6. Determine whether there is Gain or Loss on Discounting
(gain if NP > CA, loss if NP < CA)
7. Record all the activities related to the notes

Proforma entries for Net Proceeds

If Net Proceeds are less than the face value plus accrued interest (interest earned from
date of note to date of discounting) or the carrying amount, there is a loss on
discounting of notes

Cash xxx
Loss on Note Receivable Discounting xxx
Notes Receivable Discounted xxx
Interest Income xxx
To simplify, the loss on discounting of note may be offset against the interest income.
Hence,

Cash xxx
Notes Receivable Discounted xxx
Interest Income xxx

If Net Proceeds are greater than the face value plus accrued interest (interest earned
from date of note to date of discounting), or the carrying amount, there is a gain on
discounting of notes

Cash xxx
Notes Receivable Discounted xxx
Interest Receivable Income xxx
Gain on Note Receivable Discounting xxx

Again, to simplify, the gain on discounting of note may be added to the interest income.
Hence,

Cash xxx
Notes Receivable Discounted xxx
Interest Income xxx

The Note Receivable Discounted account is deducted from the Total Notes Receivable
when preparing the Statement of Financial Position with disclosure of the contingent
liability.

Illustrative Example

On July 1, 2020, Gerard Garments Store received a P150,000 note for 5 months at 12%
simple interest from Rya Cross-Stitch to replace its accounts receivable. After 3 months,
Gerard needed cash so it discounted the note at Banco de Niña at a discount rate of
14%.

* Step 1 – Determine Maturity Value (MV)

MV = Principal plus Interest (P + I)
MV = P150,000 + (P150,000 x 12% x 5/12)
MV = P150000 + P7,500
MV = P157,500
* Step 2 – Determine the Discount Period (DP)
The unexpired term of the note is the discount period. The discount period in the
example is 2 months – 5 months less 3 months that had lapsed

* Step 3 – Compute the Discount (D)

D = Maturity Value x Discount Rate x Discount Period

D = P157,500 x 14% x 2/12
D = P3,675

* Step 4 –Determine the Net Proceeds (NP)

NP = Maturity Value minus Discount (MV – D)

 NP = P157,500 – P3,675
NP = P153,825

* Step 5 –Determine the carrying amount (CA)

CA =Principal plus Accrued Interest (P + AI)

CA =P150,000 + (P150,000 x 12% x 3/12)
CA =P150,000 + P4,500
CA =P154,500

* Step 6 – Determine whether there is Gain or Loss on Discounting

Carrying Value of the Note = P154,500

Less: Net Proceeds 153,825)
Loss on Discounting P 675**

** There is loss on discounting because Net Proceeds is less than the Carrying Amount.

* Step 7 – Record all the activities related to the Note

Jul 1 Notes Receivable P150,000

Accounts Receivable P150,000

Oct 1 Cash 153,825

Loss on Note Receivable Discounting 675
Notes Receivable Discounted** 150,000
Interest Income 4,500
or
Cash 153,825
Notes Receivable Discounted 150,000
Interest Income*** 3,825

Dec 1 Notes Receivable Discounted 150,000

Notes Receivable 150,000

If note is dishonored by maker:

Accounts Receivable 157,500

Cash 157,500

Notes Receivable Discounted 150,000

Notes Receivable 150,000

** The credit to Notes Receivable Discounted account means that the note was
discounted with recourse.
***Interest Income is net of the Loss on Note Receivable Discounting (P4,500-P675.)

BORROWING FROM A BANK OR FINANCING COMPANY

To obtain more resources for business operations, a company may borrow money from
the bank or other financial institutions. An interest-bearing note is usually issued by
the borrower.

Entry to record issuance of note to borrow money:

 Cash xxx
Notes Payable xxx

Entry to record payment of notes:

Notes Payable xxx

Interest Expense xxx
Cash xxx

DISCOUNTING OWN NOTE

In the previous discussion, the maker of the note discounted is a customer; the party
discounting is the payee and a mere endorser and therefore only a person secondarily
liable. Where the note discounted is made by the party discounting, a primary liability
exists. In effect, the party discounting is entering into a contract of loan with the
endorsee.

In discounting of notes payable, a business makes its own note and discounts the same
to a financial institution.

Illustrative Example

ABC Company discounted at the bank its own note of P500,000 at 12% for one year on
September 1, 2020. The entry to record the discounting is as follows:

Cash P440,000
Prepaid Interest 60,000
Notes Payable – Bank P500,000

Computation:
Face Value of the Note P500,000
Less: Discount (500,000 x 12%) (60,000)
Net Proceeds P440,000

On December 31, 2020, the Prepaid Interest is amortized as interest expense for 4
months (September to December) as follows:

Interest Expense (60,000 x 4/12) P20,000

Prepaid Interest P20,000