6.3.2: Notes Receivable
- Page ID
- 100441
\( \newcommand{\vecs}[1]{\overset { \scriptstyle \rightharpoonup} {\mathbf{#1}} } \)
\( \newcommand{\vecd}[1]{\overset{-\!-\!\rightharpoonup}{\vphantom{a}\smash {#1}}} \)
\( \newcommand{\dsum}{\displaystyle\sum\limits} \)
\( \newcommand{\dint}{\displaystyle\int\limits} \)
\( \newcommand{\dlim}{\displaystyle\lim\limits} \)
\( \newcommand{\id}{\mathrm{id}}\) \( \newcommand{\Span}{\mathrm{span}}\)
( \newcommand{\kernel}{\mathrm{null}\,}\) \( \newcommand{\range}{\mathrm{range}\,}\)
\( \newcommand{\RealPart}{\mathrm{Re}}\) \( \newcommand{\ImaginaryPart}{\mathrm{Im}}\)
\( \newcommand{\Argument}{\mathrm{Arg}}\) \( \newcommand{\norm}[1]{\| #1 \|}\)
\( \newcommand{\inner}[2]{\langle #1, #2 \rangle}\)
\( \newcommand{\Span}{\mathrm{span}}\)
\( \newcommand{\id}{\mathrm{id}}\)
\( \newcommand{\Span}{\mathrm{span}}\)
\( \newcommand{\kernel}{\mathrm{null}\,}\)
\( \newcommand{\range}{\mathrm{range}\,}\)
\( \newcommand{\RealPart}{\mathrm{Re}}\)
\( \newcommand{\ImaginaryPart}{\mathrm{Im}}\)
\( \newcommand{\Argument}{\mathrm{Arg}}\)
\( \newcommand{\norm}[1]{\| #1 \|}\)
\( \newcommand{\inner}[2]{\langle #1, #2 \rangle}\)
\( \newcommand{\Span}{\mathrm{span}}\) \( \newcommand{\AA}{\unicode[.8,0]{x212B}}\)
\( \newcommand{\vectorA}[1]{\vec{#1}} % arrow\)
\( \newcommand{\vectorAt}[1]{\vec{\text{#1}}} % arrow\)
\( \newcommand{\vectorB}[1]{\overset { \scriptstyle \rightharpoonup} {\mathbf{#1}} } \)
\( \newcommand{\vectorC}[1]{\textbf{#1}} \)
\( \newcommand{\vectorD}[1]{\overrightarrow{#1}} \)
\( \newcommand{\vectorDt}[1]{\overrightarrow{\text{#1}}} \)
\( \newcommand{\vectE}[1]{\overset{-\!-\!\rightharpoonup}{\vphantom{a}\smash{\mathbf {#1}}}} \)
\( \newcommand{\vecs}[1]{\overset { \scriptstyle \rightharpoonup} {\mathbf{#1}} } \)
\(\newcommand{\longvect}{\overrightarrow}\)
\( \newcommand{\vecd}[1]{\overset{-\!-\!\rightharpoonup}{\vphantom{a}\smash {#1}}} \)
\(\newcommand{\avec}{\mathbf a}\) \(\newcommand{\bvec}{\mathbf b}\) \(\newcommand{\cvec}{\mathbf c}\) \(\newcommand{\dvec}{\mathbf d}\) \(\newcommand{\dtil}{\widetilde{\mathbf d}}\) \(\newcommand{\evec}{\mathbf e}\) \(\newcommand{\fvec}{\mathbf f}\) \(\newcommand{\nvec}{\mathbf n}\) \(\newcommand{\pvec}{\mathbf p}\) \(\newcommand{\qvec}{\mathbf q}\) \(\newcommand{\svec}{\mathbf s}\) \(\newcommand{\tvec}{\mathbf t}\) \(\newcommand{\uvec}{\mathbf u}\) \(\newcommand{\vvec}{\mathbf v}\) \(\newcommand{\wvec}{\mathbf w}\) \(\newcommand{\xvec}{\mathbf x}\) \(\newcommand{\yvec}{\mathbf y}\) \(\newcommand{\zvec}{\mathbf z}\) \(\newcommand{\rvec}{\mathbf r}\) \(\newcommand{\mvec}{\mathbf m}\) \(\newcommand{\zerovec}{\mathbf 0}\) \(\newcommand{\onevec}{\mathbf 1}\) \(\newcommand{\real}{\mathbb R}\) \(\newcommand{\twovec}[2]{\left[\begin{array}{r}#1 \\ #2 \end{array}\right]}\) \(\newcommand{\ctwovec}[2]{\left[\begin{array}{c}#1 \\ #2 \end{array}\right]}\) \(\newcommand{\threevec}[3]{\left[\begin{array}{r}#1 \\ #2 \\ #3 \end{array}\right]}\) \(\newcommand{\cthreevec}[3]{\left[\begin{array}{c}#1 \\ #2 \\ #3 \end{array}\right]}\) \(\newcommand{\fourvec}[4]{\left[\begin{array}{r}#1 \\ #2 \\ #3 \\ #4 \end{array}\right]}\) \(\newcommand{\cfourvec}[4]{\left[\begin{array}{c}#1 \\ #2 \\ #3 \\ #4 \end{array}\right]}\) \(\newcommand{\fivevec}[5]{\left[\begin{array}{r}#1 \\ #2 \\ #3 \\ #4 \\ #5 \\ \end{array}\right]}\) \(\newcommand{\cfivevec}[5]{\left[\begin{array}{c}#1 \\ #2 \\ #3 \\ #4 \\ #5 \\ \end{array}\right]}\) \(\newcommand{\mattwo}[4]{\left[\begin{array}{rr}#1 \amp #2 \\ #3 \amp #4 \\ \end{array}\right]}\) \(\newcommand{\laspan}[1]{\text{Span}\{#1\}}\) \(\newcommand{\bcal}{\cal B}\) \(\newcommand{\ccal}{\cal C}\) \(\newcommand{\scal}{\cal S}\) \(\newcommand{\wcal}{\cal W}\) \(\newcommand{\ecal}{\cal E}\) \(\newcommand{\coords}[2]{\left\{#1\right\}_{#2}}\) \(\newcommand{\gray}[1]{\color{gray}{#1}}\) \(\newcommand{\lgray}[1]{\color{lightgray}{#1}}\) \(\newcommand{\rank}{\operatorname{rank}}\) \(\newcommand{\row}{\text{Row}}\) \(\newcommand{\col}{\text{Col}}\) \(\renewcommand{\row}{\text{Row}}\) \(\newcommand{\nul}{\text{Nul}}\) \(\newcommand{\var}{\text{Var}}\) \(\newcommand{\corr}{\text{corr}}\) \(\newcommand{\len}[1]{\left|#1\right|}\) \(\newcommand{\bbar}{\overline{\bvec}}\) \(\newcommand{\bhat}{\widehat{\bvec}}\) \(\newcommand{\bperp}{\bvec^\perp}\) \(\newcommand{\xhat}{\widehat{\xvec}}\) \(\newcommand{\vhat}{\widehat{\vvec}}\) \(\newcommand{\uhat}{\widehat{\uvec}}\) \(\newcommand{\what}{\widehat{\wvec}}\) \(\newcommand{\Sighat}{\widehat{\Sigma}}\) \(\newcommand{\lt}{<}\) \(\newcommand{\gt}{>}\) \(\newcommand{\amp}{&}\) \(\definecolor{fillinmathshade}{gray}{0.9}\)Recognition and Measurement of Notes Receivable
A note receivable is an unconditional written promise to pay a specific sum of money on demand or on a defined future date and is supported by a formal written promissory note. For this reason, notes are negotiable instruments the same as cheques and bank drafts.
Notes receivable can arise due to loans, advances to employees, or from higher-risk customers who need to extend the payment period of an outstanding account receivable. Notes can also be used for sales of property, plant, and equipment or for exchanges of long-term assets. Notes arising from loans usually identify collateral security in the form of assets of the borrower that the lender can seize if the note is not paid at the maturity date.
Notes may be referred to as interest-bearing or non-interest-bearing:
-
Interest-bearing notes have a stated rate of interest that is payable in addition to the face value of the note.
-
Notes with stated rates below the market rates or zero- or non-interest-bearing notes may or may not have a stated rate of interest. This is usually done to encourage sales. However, there is always an interest component embedded in the note, and that amount will be equal to the difference between the amount that was borrowed and the amount that will be repaid.
Notes may also be classified as short-term (current) assets or long-term assets on the balance sheet:
-
Current assets: short-term notes that become due within the next twelve months (or within the business's operating cycle if greater than twelve months);
-
Long-term assets: notes are notes with due dates greater than one year.
Cash payments can be interest-only with the principal portion payable at the end or a mix of interest and principal throughout the term of the note.
Notes receivable are initially recognized at the fair value on the date that the note is legally executed (usually upon signing). Subsequent valuation is measured at amortized cost.
Transaction Costs
It is common for notes to incur transactions costs, especially if the note receivable is acquired using a broker, who will charge a commission for their services. For a company using either ASPE or IFRS, the transaction costs associated with financial assets such as notes receivable that are carried at amortized cost are to be capitalized which means that the costs are to be added to the asset's fair value of the note at acquisition and subsequently included with any discount or premium and amortized over the term of the note.
Short-Term Notes Receivable
When notes receivable have terms of less than one year, accounting for short-term notes is relatively straight forward as discussed below.
Calculating the Maturity Date
Knowing the correct maturity date will have an impact on when to record the entry for the note and how to calculate the correct interest amount throughout the note's life. For example, to calculate the maturity date of a ninety-day note dated March 14, 2020:
For example, assume that on March 14, 2020, Ripple Stream Co. accepted a ninety-day, 8% note of $5,000 in exchange for extending the payment period of an outstanding account receivable of the same value. Ripple's entry to record the acceptance of the note that will replace the accounts receivable is:
The entry for payment of the note ninety days at maturity on June 12 would be:
In the example above, if financial statements are prepared during the time that the note receivable is outstanding, interest will be accrued to the reporting date of the balance sheet. For example, if Ripple's year-end were April 30, the entry to accrue interest from March 14 to April 30 would be:
When the cash payment occurs at maturity on June 12, the entry would be:
The interest calculation will differ slightly had the note been stated in months instead of days. For example, assume that on January 1, Ripple Stream accepted a three-month (instead of a ninety-day), 8%, note in exchange for the outstanding accounts receivable. If Ripple's year-end was March 31, the interest accrual would be:
Note the difference in the interest calculation between the ninety-day and the three-month notes recorded above. The interest amounts differ slightly between the two calculations because the ninety-day note uses a 90/365 ratio (or 24.6575% for a total amount of $98.63) while the three-month note uses a 3/12 ratio (or 25% for a total of $100.00).
Receivables, Interest, and the Time Value of Money
All financial assets are to be measured initially at their fair value which is calculated as the present value amount of future cash receipts. But what is present value? It is a discounted cash flow concept, which is explained next.
It is common knowledge that money deposited in a savings account will earn interest, or money borrowed from a bank will accrue interest payable to the bank. The present value of a note receivable is therefore the amount that you would need to deposit today, at a given rate of interest, which will result in a specified future amount at maturity. The cash flow is discounted to a lesser sum that eliminates the interest component—hence the term discounted cash flow. The future amount can be a single payment at the date of maturity or a series of payments over future time periods or some combination of both. Put into context for receivables, if a company must wait until a future date to receive the payment for its receivable, the receivable's face value at maturity will not be an exact measure of its fair value on the date the note is legally executed because of the embedded interest component.
For example, assume that a company makes a sale on account for $5,000 and receives a $5,000, six-month note receivable in exchange. The face value of the note is therefore $5,000. If the market rate of interest is 9%, or its value without the interest component, is $4,780.79 and not $5,000. The $4,780.79 is the amount that if deposited today at an interest rate of 9% would equal $5,000 at the end of six months. Using an equation, the note can be expressed as:
(0 PMT, .75% I/Y, 6 N, 5000 FV)
Where I/Y is interest of .75% each month (9%/12 months) for six months.
N is for interest compounded each month for six months.
FV is the payment at the end of six months' time (future value) of $5,000.
To summarize, the discounted amount of $4,780.79 is the fair value of the $5,000 note at the time of the sale, and the additional amount received after the sale of $219.21 (
) is interest income earned over the term of the note (six months). However, for any receivables due in less than one year, this interest income component is usually insignificant. For this reason, both IFRS and ASPE allow net realizable value (the net amount expected to be received in cash) to approximate the fair value for short-term notes receivables that mature within one year. So, in the example above, the $5,000 face value of the six-month note will be equivalent to the fair value and will be the amount reported, net of any estimated uncollectability (i.e. net realizable value), on the balance sheet until payment is received. However, for notes with maturity dates greater than one year, fair values are to be determined at their discounted cash flow or present value, which will be discussed next.
Long-Term Notes Receivable
The difference between a short-term note and a long-term note is the length of time to maturity. As the length of time to maturity of the note increases, the interest component becomes increasingly more significant. As a result, any notes receivable that are greater than one year to maturity are classified as long-term notes and require the use of present values to estimate their fair value at the time of issuance. After issuance, long-term notes receivable are measured at amortized cost. Determining present values requires an analysis of cash flows using interest rates and time lines, as illustrated next.
Present Values and Time Lines
The following timelines will illustrate how present value using discounted cash flows works. Below are three different scenarios:
-
Assume that on January 1, Maxwell lends some money in exchange for a $5,000, five-year note, payable as a lump-sum at the end of five years. The market rate of interest is 5%. Maxwell's year-end is December 31. The first step is to identify the amount(s) and timing of all the cash flows as illustrated below on the timeline. The amount of money that Maxwell would be willing to lend the borrower using the present value calculation of the cash flows would be $3,917.63 as follows:
In this case, Maxwell will be willing to lend $3,917.63 today in exchange for a payment of $5,000 at the end of five years at an interest rate of 5% per annum. The entry for the note receivable at the date of issuance would be:
-
Now assume that on January 1, Maxwell lends an amount of money in exchange for a $5,000, five-year note. The market rate of interest is 5%. The repayment of the note is payments of $1,000 at the end of each year for the next five years (present value of an ordinary annuity). The amount of money that Maxwell would be willing to lend the borrower using the present value calculation of the cash flows would be $4,329.48 as follows:
The entry for the note receivable would be:
Note that Maxwell is willing to lend more money ($4,329.48 compared to $3,917.63) to the borrower in this example. Another way of looking at it is that the interest component embedded in the note is less for this example. This makes sense because the principal amount of the note is being reduced over its five-year life because of the yearly payments of $1,000.
-
How would the amount of the loan and the entries above differ if Maxwell received five equal payments of $1,000 at the beginning of each year (present value of an annuity due) instead of at the end of each year as shown in scenario 2 above? The amount of money that Maxwell would be willing to lend using the present value calculation of the cash flows would be $4,545.95 as follows:
The entry for the note receivable would be:
Again, the interest component will be less because a payment is paid immediately upon execution of the note, which causes the principal amount to be reduced sooner than a payment made at the end of each year.
Below is a comparison of the three scenarios:
| Scenario 1 | Scenario 2 | Scenario 3 | |
|---|---|---|---|
| Single payment | Five payments of | Five payments of | |
| at maturity | $1,000 at the end | $1,000 at the beginning | |
| of each month | of each month | ||
| Face value of the note |
$5,000 |
$5,000 |
$5,000 |
| Less: present value of the note | 3,918 | 4,329 | 4,546 |
| Interest component | $1,082 | $671 | $454 |
Note that the interest component decreases for each of the scenarios even though the total cash repaid is $5,000 in each case. This is due to the timing of the cash flows as discussed earlier. In scenario 1, the principal is not reduced until maturity and interest would accrue over the full five years of the note. For scenario 2, the principal is being reduced on an annual basis, but the payment is not made until the end of each year. For scenario 3, there is an immediate reduction of principal due to the first payment of $1,000 upon issuance of the note. The remaining four payments are made at the beginning instead of at the end of each year. This results in a reduction in the principal amount owing upon which the interest is calculated.
This is the same concept as a mortgage owing for a house, where it is commonly stated by financial advisors that a mortgage payment split and paid every half-month instead of a single payment once per month will result in a significant reduction in interest costs over the term of the mortgage. The bottom line is: If there is less principal amount owing at any time over the life of a note, there will be less interest charged.
Present Values with Unknown Variables
As is the case with any algebraic equation, if all variables except one are known, the final unknown variable can be determined. For present value calculations, if any four of the five variables in the following equation
PV = (PMT, I/Y, N, FV)
are known, the fifth "unknown" variable amount can be determined using a business calculator or an Excel net present value function. For example, if the interest rate (I/Y) is not known, it can be derived if all the other variables in the equation are known. This will be illustrated when non-interest-bearing long-term notes receivable are discussed later in this chapter.
Present Values when Stated Interest Rates are Different than Effective (Market) Interest Rates
Differences between the stated interest rate (or face rate) and the effective (or market) rate at the time a note is issued can have accounting consequences as follows:
-
If the stated interest rate of the note (which is the interest rate that the note pays) is 10% at a time when the effective interest rate (also called the market rate, or yield) is 10% for notes with similar characteristics and risk, the note is initially recognized as:
face value = fair value = present value of the note
This makes intuitive sense since the stated rate of 10% is equal to the market rate of 10%.
-
If the stated interest rate is 10% and the market rate is 11%, the stated rate is lower than the market rate and the note is trading at a discount.
-
If the stated interest rate is 10% and the market rate is 9%, the stated rate is higher than the market rate and the note is trading at a premium.
The premium or discount amount is to be amortized over the term of the note. Below are the acceptable methods to amortize discounts or premiums:
-
If a company follows IFRS, the effective interest method of amortization is required (discussed in the next section).
-
If a company follows ASPE, the amortization method is not specified, so either straight-line amortization or the effective interest method is appropriate as an accounting policy choice.
Long-Term Notes, Subsequent Measurement
Under IFRS and ASPE, long-term notes receivable that are held for their cash flows of principal and interest are subsequently accounted for at amortized cost, which is calculated as:
-
Amount recognized when initially acquired (present value) including any transaction costs such as commissions or fees
-
Plus interest and minus any principal collections/receipts. Payments can also be blended interest and principal.
-
Plus amortization of discount or minus amortization of premium
-
Minus write-downs for impairment, if applicable
Below are some examples with journal entries involving various stated rates compared to market rates.
1. Notes Issued at Face Value
Assume that on January 1, Carpe Diem Ltd. lends $10,000 to Fascination Co. in exchange for a $10,000, three-year note bearing interest at 10% payable annually at the end of each year (ordinary annuity). The market rate of interest for a note of similar risk is also 10%. The note's present value is calculated as:
| Face value of the note | $ | 10,000 |
| Present value of the note principal and interest: | ||
 |
||
| PV = (1000 PMT, 10 I/Y, 3 N, 10000 FV) | 10,000 | |
| Difference | $ | 0 |
In this case, the note's face value and present value (fair value) are the same ($10,000) because the effective (market) and stated interest rates are the same. Carpe Diem's entry on the date of issuance is:
If Carpe Diem's year-end was December 31, the interest income recognized each year would be:
2. Stated Rate Lower than Market Rate: A Discount
Assume that Anchor Ltd. makes a loan to Sizzle Corp. in exchange for a $10,000, three-year note bearing interest at 10% payable annually. The market rate of interest for a note of similar risk is 12%. Recall that the stated rate of 10% determines the amount of the cash received for interest; however, the present value uses the effective (market) rate to discount all cash flows to determine the amount to record as the note's value at the time of issuance. The note's present value is calculated as:
| Face value of the note | $10,000 |
|---|---|
| Present value of the note principal and interest: | |
|
|
| PV = (1000 PMT, 12 I/Y, 3 N, 10000 FV) | $9,520 |
| Difference | $480 |
As shown above, the note's market rate (12%) is higher than the stated rate (10%), so the note is issued at a discount.
Anchor's entry to record the issuance of the note receivable:
Even though the face value of the note is $10,000, the amount of money lent to Sizzle would only be $9,520, which is net of the discount amount and is the difference between the stated and market interest rates discussed earlier. In return, Anchor will receive an annual cash payment of $1,000 for three years plus a lump sum payment of $10,000 at the end of the third year, when the note matures. The total cash payments received will be $13,000 over the term of the note, and the interest component of the note would be:
| Cash received | $13,000 | |
|---|---|---|
| Present value (fair value) | 9,520 | |
| Interest income component | 3,480 | (over the three-year life) |
As mentioned earlier, if Anchor used IFRS the $480 discount amount would be amortized using the effective interest method. If Anchor used ASPE, there would be a choice between the effective interest method and the straight-line method.
Below is a schedule that calculates the cash received, interest income, discount amortization, and the carrying amount (book value) of the note at the end of each year using the effective interest method:
| $10,000 Note Receivable Payment and Amortization Schedule | ||||
|---|---|---|---|---|
| Effective Interest Method | ||||
| Stated rate of 10% and market rate of 12% | ||||
| Cash | Interest | Amortized | Carrying | |
| Received | Income @12% | Discount | Amount | |
| Date of issue | $9,520 | |||
| End of year 1 |
$1,000 |
$1,142* |
$142 |
9,662 |
| End of year 2 | 1,000 | 1,159 | 159 | 9,821 |
| End of year 3 | 1,000 | 1,179 | 179 | 10,000 |
| End of year 3 final payment | 10,000 | - | - | 0 |
| $13,000 | $3,480 | $480 | ||
* 
The total discount $480 amortized in the schedule is equal to the difference between the face value of the note of $10,000 and the present value of the note principal and interest of $9,250. The amortized discount is added to the note's carrying value each year, thereby increasing its carrying amount until it reaches its maturity value of $10,000. As a result, the carrying amount at the end of each period is always equal to the present value of the note's remaining cash flows discounted at the 12% market rate. This is consistent with the accounting standards for the subsequent measurement of long-term notes receivable at amortized cost.
If Anchor's year-end was the same date as the note's interest collected, at the end of year 1 using the schedule above, Anchor's entry would be:
Alternatively, if Anchor used ASPE the straight-line method of amortizing the discount is simple to apply. The total discount of $480 is amortized over the three-year term of the note in equal amounts. The annual amortization of the discount is $160 ($480 
3 years) for each of the three years as shown in the following entry:
Comparing the three years' entries for both the effective interest and straight-line methods shows the following pattern for the discount amortization of the note receivable:
| Effective Interest | Straight-Line | |
| End of year 1 | $142 | $160 |
| End of year 2 | 159 | 160 |
| End of year 3 | 179 | 160 |
| $480 | $480 |
The amortization of the discount using the effective interest method results in increasing amounts of interest income that will be recorded in the adjusting entry (decreasing amounts of interest income for amortizing a premium) compared to the equal amounts of interest income using the straight-line method. The straight-line method is easier to apply but its shortcoming is that the interest rate (yield) for the note is not held constant at the 12% market rate as is the case when the effective interest method is used. This is because the amortization of the discount is in equal amounts and does not take into consideration what the carrying amount of the note was at any given period of time. At the end of year 3, the notes receivable balance is $10,000 for both methods, so the same entry is recorded for the receipt of the cash.
3. Stated Rate More than Market Rate: A Premium
Had the note's stated rate of 10% been greater than a market rate of 9%, the present value would be greater than the face value of the note due to the premium. The same types of calculations and entries as shown in the previous illustration regarding a discount would be used. Note that the premium amortized each year would decrease the carrying amount of the note at the end of each year until it reaches its face value amount of $10,000.
| $10,000 Note Receivable Payment and Amortization Schedule | ||||
|---|---|---|---|---|
| Effective Interest Method | ||||
| Stated rate of 10% and market rate of 9% | ||||
| Cash | Interest | Amortized | Carrying | |
| Received | Income @9% | Premium | Amount | |
| Date of issue | $10,253 | |||
| End of year 1 |
$1,000 |
$923* |
$77 |
10,176 |
| End of year 2 | 1,000 | 916 | 84 | 10,091 |
| End of year 3 | 1,000 | 908 | 92 | 10,000 |
| End of year 3 final payment | 10,000 | - | - | 0 |
| $13,000 | $2,747 | $253 | ||
* 
Anchor's entry on the note's issuance date is for the present value amount (fair value):
If the company's year-end was the same date as the note's interest collected, at the end of year 1 using the schedule above, the entry would be:
The entry when paid at maturity would be:
A video is available on the Lyryx web site. Click Here to view the video.
4. Zero-Interest Bearing Notes
Some companies will issue zero-interest-bearing notes as a sales incentive. The notes do not state an interest rate but the term "zero-interest" is inaccurate because financial instruments always include an interest component that is equal to the difference between the cash lent and the higher amount of cash repaid at maturity. Even though the interest rate is not stated, the implied interest rate can be derived because the cash values lent and received are both known. In most cases, the transaction between the issuer and acquirer of the note is at arm's length, so the implicit interest rate would be a reasonable estimate of the market rate.
Assume that on January 1, Eclipse Corp. received a five-year, $10,000 zero-interest bearing note. The amount of cash lent to the issuer (which is equal to the present value) is $7,835 (rounded). Eclipse's year-end is December 31. Looking at the cash flows and the time line:
Notice that the sign for the $7,835 PV is preceded by the +/- symbol, meaning that the PV amount is to have the opposite symbol to the $10,000 FV amount, shown as a positive value. This is because the FV is the cash received at maturity or cash inflow (positive value), while the PV is the cash lent or a cash outflow (opposite or negative value). Many business calculators require the use of a +/- sign for one value and no sign (or a positive value) for the other to calculate imputed interest rates correctly. Consult your calculator manual for further instructions regarding zero-interest note calculations.
The implied interest rate is calculated to be 5% and the note's interest component (rounded) is $2,165 (
), which is the difference between the cash lent and the higher amount of cash repaid at maturity. Below is the schedule for the interest and amortization calculations using the effective interest method.
| Non-Interest-Bearing Note Receivable Payment and Amortization Schedule | ||||
|---|---|---|---|---|
| Effective Interest Method | ||||
| Cash | Interest | Amortized | Carrying | |
| Received | Income @5% | Discount | Amount | |
| Date of issue | $7,835.26 | |||
| End of year 1 |
$0 |
$391.76* |
$391.76 |
8,227.02 |
| End of year 2 | 0 | 411.35 | 411.35 | 8,638.37 |
| End of year 3 | 0 | 431.92 | 431.92 | 9,070.29 |
| End of year 4 | 0 | 453.51 | 453.51 | 9,523.81 |
| End of year 5 | 0 | 476.19 | 476.19 | 10,000.00 |
| End of year 5 payment | 10,000 | 0 | ||
| $2,164.74 | $2,164.74 | |||
* 
The entry for the note receivable when issued would be:
At Eclipse's year-end of December 31, the interest income at the end of the first year using the effective interest method would be:
At maturity when the cash interest is received, the entry would be:
If Eclipse used ASPE instead of IFRS, the entry using straight-line method for amortizing the discount is calculated as the total discount of $2,164.74, amortized over the five-year term of the note resulting in equal amounts each year. Therefore, the annual amortization is $432.95 (
) each year is recorded as:
5. Notes Receivable in Exchange for Property, Goods, or Services
When property, goods, or services are exchanged for a note, and the market rate and the timing and amounts of cash received are all known, the present value of the note can be determined. For example, assume that on May 1, Hudson Inc. receives a $200,000, five-year note in exchange for land originally costing $120,000. The market rate for a note with similar characteristics and risks is 8%. The present value is calculated as follows:
PV = (0 PMT, 8 I/Y, 5 N, 200000 FV)
PV = $136,117
The entry upon issuance of the note and sale of the land would be:
However, if the market rate is not known, either of following two approaches can be used to determine the fair value of the note:
-
Determine the fair value of the property, goods, or services given up. As was discussed for zero-interest bearing notes where the interest rate was not known, the implicit interest rate can still be derived because the cash amount lent, and the timing and amount of the cash flows received from the issuer are both known. In this case the amount lent is the fair value of the property, goods, or services given up. Once the interest is calculated, the effective interest method can be applied.1
For example, on June 1, Mayflower Consulting Ltd. receives a $40,000, three-year note in exchange for some land. The market rate cannot be accurately determined due to credit risks regarding the issuer. The land cost and fair value is $31,750. The interest rate is calculated as follows:
I/Y = (+/-31750 PV, 0 PMT, 3 N, 40000 FV)
I/Y = 8%; the interest income component is $8,250 over three years (
)The entry upon issuance of the note would be:
-
Determine an imputed interest rate. An imputed interest rate is an estimated interest rate used for a note with comparable terms, conditions, and risks between an independent borrower and lender.
On June 1, Edmunds Co. receives a $30,000, three-year note in exchange for some swampland. The land has a historic cost of $5,000 but neither the market rate nor the fair value of the land can be determined. In this case, a market rate must be imputed and used to determine the note's present value. The rate will be estimated based on interest rates currently in effect for companies with similar characteristics and credit risk as the company issuing the note. For IFRS companies, the "evaluation hierarchy" identified in IFRS 13 Fair Value Measurement would be used to determine the fair value of the land and the imputed interest rate. In this case, the imputed rate is determined to be 7%. The present value is calculated as follows:
PV = (7 I/Y, 3 N, 30000 FV)
PV = $24,489
The entry upon issuance of the note would be:
Loans to employees
In cases where there are non-interest-bearing long-term loans to company employees, the fair value is determined by using the market rate for loans with similar characteristics, and the present value is calculated on that basis. The amount loaned to the employee invariably will be higher than the present value using the market rate because the loan is intended as a reward or incentive. This difference would be deemed as additional compensation and recorded as Compensation expense.
Impairment of notes receivable
Just as was the case with accounts receivable, there is a possibility that the holder of the note receivable will not be able to collect some or all of the amounts owing. If this happens, the receivable is considered impaired. When the investment in a note receivable becomes impaired for any reason, the receivable is re-measured at the present value of the currently expected cash flows at the loan's original effective interest rate.
The impairment amount is recorded as a debit to bad debt expense and as a credit either to an allowance for uncollectible notes account (a contra account to notes receivable) or directly as a reduction to the asset account.