CHAPTER 2: NOTES PAYABLE

Illustrations

1. Short-term note
Illustration:
On July 1, 20x1, ABC Co. borrowed P1,000,000 and issued a one-year note payable. The lender
discounted the note at 12%.

The term “discounted” used in this context means the lender deducted the 12% interest in advance. ABC Co.’s proceeds
from the note are net of the advanced interest.

Case 1: Lump sum

The note is due in lump sum on June 30, 30x2. The effect of discounting (i.e. time value of money) is
immaterial.

Analysis:
The note is short-term and the effect of discounting is immaterial. Therefore, the note is initially
measured at face amount (net of the advanced interest).

The entries are as follows:

July 1, 20x1 Cash (1M x 88%) 880,000
Discount on notes payable (1M x 12%) 120,000
Notes payable 1,000,000
Dec 31, 20x1 Interest expense (1M x 12% x 6/12) 60,000
Discount on notes payable 60,000
June 30, 20x2 Interest expense (1M x 12% x 6/12) 60,000
Discount on notes payable 60,000
June 30, 20x2 Notes payable 1,000,000
Cash 1,000,000

The carrying amounts of the note are determined as follows:

July 1, 20x1 Dec 31, 20x1
Notes payable 1,000,000 1,000,000
Discount on notes payable (120,000) (60,000)
Carrying amounts 880,000 940,000

Notes:
1. ABC Co., the borrower, is referred to as the “maker” or “issuer” of the note. The lender is the “payee.”
2. “Discount on notes payable” is a contra-liability account (i.e. a valuation account). It is deducted
when determining the carrying amount of the note.
3. Theoretically, all liabilities should be measured at present value except when:
a. The effect of discounting is deemed immaterial;
b. Discounting is prohibited by a Standard (e.g. PAS 12 Income Taxes prohibits the discounting
of tax liabilities); or
c. The transaction is made in the usual or customary terms.
4. If the effect of discounting is not deemed immaterial, a short-term note is nonetheless measured at
present value. Judgment on materiality rests with the entity’s management.
5. The Standards do not require short-term notes to be measured at face amount nor prohibit their
discounting.
Case 2: Installment
The note is due in equal quarterly installments starting September 30, 20x1. The effect of discounting
is immaterial.

Analysis:
The note is also measured at face amount. However, because the note is due in installments, the
P120,000 advanced interest is allocated over the installment periods based on, for example, the
outstanding principal balance of the note or some other arbitrary apportionment.

The entries are as follows:

July 1, 20x1 Cash (1M x 88%) 880,000
Discount on notes payable (1M x 12%) 120,000
Notes payable 1,000,000
Sept 30, 20x1 Notes payable 250,000
Interest expense 48,000
Cash 250,000
Discount on notes payable 48,000
Dec 31, 20x1 Notes payable 250,000
Interest expense 36,000
Cash 250,000
Discount on notes payable 36,000
The entries in 20x2 follow the same pattern.

Date Outstanding balance of note Allocation Interest expense

9/30/20x1 1,000,000 120,000 x 1M/2.5M 48,000
12/31/20X1 750,000 120,000 x 750K/2.5M 36,000
3/31/20X2 500,000 120,000 x 500K/2.5M 24,000
6/30/20X2 250,000 120,000 x 250K/2.5M 12,000
Totals 2,500,000 120,000
The fractions used in the allocation are derived from the outstanding balances of the note.

The carrying amounts of the note are determined as follows:

July 1, 20x1 Sept 30, 20x1 Dec 31,20x1
Notes payable 1,000,000 750,000 500,000
Discount on notes payable (120,000) (72,000)* (36,000)*
Carrying amounts 880,000 678,000 464,000

Notes:
1. 72,000 = 36,000 + 24,000 + 12,000
2. 36,000 = 24,000 + 12,000
2. Long-term note with reasonable interest – simple interest
Illustration:
On October 1, 20x1, ABC Co. issued a two-year, 12%, P1,000,000 note payable in exchange for a piece
of land. Principal is due on October 1, 20x3 but interest is due annually.

Analysis:
 Type of payable: Long-term with reasonable interest rate – the 12% nominal rate is assumed to be
equal to the current rate on initial recognition because no additional information is given.
 Initial measurement: Face amount
 Subsequent measurement: Face amount or expected settlement amount
 Type of interest: Simple interest – interest is computed only on the outstanding principal balance

Journal entries:
Oct 1, 20x1 Land 1,000,000
Notes payable 1,000,000
Dec 31, 20x1 Interest expense (1M x 12% x 6/12) 30,000
Interest payable 30,000
Oct 1, 20x1 Interest expense (1M x 12% x 9/12) 90,000
Interest payable 30,000
Cash 120,000
Dec 31, 20x2 Interest expense (1M x 12% x 6/12) 30,000
Interest payable 30,000
Oct 1, 20x3 Interest expense (1M x 12% x 9/12) 90,000 120,000
Interest payable 30,000
Cash
Oct 1, 20x1 Notes payable 1,000,000
Cash 1,000,000

3. Long-term note with reasonable interest – compounded interest

Illustration:
On October 1, 20x1, ABC Co. issued a three-year, 12%, P1,000,000 note payable in exchange for a piece
of land. Principal and interest are due on December 31, 20x3.

Analysis:
 Type of payable: Long-term with reasonable interest rate
 Type of interest: Compounded interest – interest is computed on both the outstanding balances of
principal and accrued interest

Journal entries:
Jan 1, 20x1 Land 1,000,000
Notes payable 1,000,000
Dec 31, 20x1 Interest expense (1M x 12%) 120,000
Interest payable 120,000
Dec 31, 20x2 Interest expense [(1M + 120K) x 12%] 134,400
Interest payable 134,400
Dec 31, 20x3 Interest expense [(1M + 134.4K) x 12%] 150,528
Interest payable 254,400
Cash 404,928
Dec 31, 20x3 Notes payable 1,000,000
Cash 1,000,000
4. Noninterest-bearing note – lump sum
Illustration:
On January 1, 20x1, ABC Co. acquired equipment in exchange for P100,000 cash and a 3-year,
noninterest-bearing, P1,000,000 note payable due on January 1, 20x4. The prevailing interest rate is
12%.

Analysis:
 Type of payable: Long-term noninterest-bearing (lump sum)
 Initial measurement: Present value (using PV of P1)
 Subsequent measurement: Amortized cost

Initial measurement:
Future cash flow (face amount) 1,000,000
Multiply by: PV of P1 @ 12%, n=3 0.711780
Present value of note payable – Jan 1, 20x1 711,780

Journal entries:
Jan 1, 20x1 Equipment (100K + 711,780) 811,780
Discount on notes payable (1M – 711,780) 288,220
Cash 100,000
Notes payable 1,000,000

Notes:
1. The difference between the present value and face amount represent the discount on note payable.
The unamortized balance of the discount is deducted from the face amount when determining the
carrying amount of the note.
2. The discount on note payable on initial recognition of a noninterest-bearing note represents the
total interest expense to be recognized over the term of the note.
3. The equipment is measured at the amount of cash paid plus the present value of the note issued.

Subsequent measurement: Amortization table

Date Interest expense Discount on notes payable Present value
Jan 1, 20x1 - 288,220 711,780
Dec 31,20x1 85,414 202,806 797,194
Dec 31, 20x2 95,663 107,143 892,857
Dec 31, 20x3 107, 143 - 1,000,000
Total 288,220

Other pertinent entries:

Dec 31, 20x1 Interest expense 85,414
Discount on notes payable 85,414
Dec 31, 20x2 Interest expense 95,663
Discount on notes payable 95,663
Dec 31, 20x3 Interest expense 107,143 107,143
Discount on notes payable
Jan 1, 20x4 Notes payable 1,000,000
Cash 1,000,000
5. Noninterest-bearing note – installment
Illustration:
On January 1, 20x1, ABC Co. acquired equipment in exchange for P100,000 cash and a 4-year,
noninterest-bearing, P1,000,000 note payable due in 4 equal annual installments starting December 31,
20x1. The prevailing interest rate is 12%

Analysis:
 Type of payable: Long-term noninterest-bearing (installment)
 Initial measurement: Present value (using PV of ordinary annuity of P1)
 Subsequent measurement: Amortized cost

Initial measurement:
Future cash flow – annual installments (1M/4) 250,000
Multiply by: PV of an ordinary annuity of P1 @ 12%, n=4 3.037349
Present value of note payable – Jan 1, 20x1 759,337

Journal entries:
Jan 1, 20x1 Equipment (100K + 759,337) 859,337
Discount on notes payable (1M – 759,337) 240,663
Cash 100,000
Notes payable 1,000,000

Subsequent measurement: Amortization table

Date Payments Interest expense Amortization Present value
Jan 1, 20x1 - - - 759,337
Dec 31,20x1 250,000 91,120 158,880 600,458
Dec 31, 20x2 250,000 72,055 177,945* 422,513**
Dec 31, 20x3 250,000 50,702 199,298 223,215
Dec 31, 20x4 250,000 26,785 223,215 0

*Current portion of the notes payable on Dec 31, 20x1: Amortization on Dec 31, 20x2
**Noncurrent portion of the notes payable on Dec 31, 20x1: Present value on Dec 31, 20x2

Other pertinent entries:

Dec 31, 20x1 Notes payable 250,000
Interest expense 91,120
Cash 250,000
Discount on notes payable 91,120
Dec 31, 20x2 Notes payable 250,000
Interest expense 72,055
Cash 250,000
Discount on notes payable 72,055
Dec 31, 20x3 Notes payable 250,000
Interest expense 50,702
Cash 250,000
Discount on notes payable 50,702
Dec 31, 20x4 Notes payable 250,000
Interest expense 26,785
Cash 250,000
Discount on notes payable 26,785
6. Noninterest-bearing note – installment in advance
Illustration:
On January 1, 20x1, ABC Co. acquired equipment in exchange for P100,000 cash and a 4-year,
noninterest-bearing, P1,000,000 note payable due in 4 equal annual installments. The first installment
is due on January 1, 20x1. The succeeding installment payments are due every December 31. The
prevailing interest rate is 12%.

Analysis:
 Type of payable: Long-term noninterest-bearing (installment in advance)
 Initial measurement: Present value (using PV of annuity due of P1)
 Subsequent measurement: Amortized cost

Initial measurement:
Future cash flow – annual installments (1M/4) 250,000
Multiply by: PV of an annuity due of P1 @ 12%, n=4 3.401830
Present value of note payable – Jan 1, 20x1 850,458

Journal entries:
Jan 1, 20x1 Equipment (100K + 850,458) 950,458
Discount on notes payable (1M – 850,458) 149,542
Cash 100,000
Notes payable 1,000,000
Jan 1, 20x1 Notes payable 250,000
Cash 250,000

Subsequent measurement: Amortization table

Date Payments Interest expense Amortization Present value
Jan 1, 20x1 - - - 850,458
Jan 1, 20x1 250,000 - 250,000 600,458
Dec 31,20x1 250,000 72,055 177,945 422,513
Dec 31, 20x2 250,000 50,702 199,298 223,215
Dec 31, 20x3 250,000 26,785 223,215 0
No interest is recognized on the first installment because interest is incurred only after passage of time.

The entry on Dec 31, 20x1 is as follows:

Dec 31, 20x1 Notes payable 250,000
Interest expense 72,055
Cash 250,000
Discount on notes payable 72,055
The entries in the subsequent years follow the same pattern.

Query: What is the balance of the ‘Discount on notes payable’ on December 31, 20x1

Answer:
Outstanding face amount (1M less payments of 250K & 250K) 500,000
Present value on Dec 31, 20x1 (422,513)
Discount on note payable – Dec 31, 20x1 77,487
6.1 Noninterest-bearing note – installments due at the start of each year
Illustration:
Use the same information in Illustration 6 but assume that the succeeding installment payments are
due every Jan 1.

Requirement: Computer for the carrying amount of the note on December 31, 20x1.

Solution:
Date Payments Interest expense Amortization Present value
Jan 1, 20x1 - - - 850,458
Jan 1, 20x1 250,000 - 250,000 600,458
Jan 1, 20x2 250,000 72,055 177,945 422,513
Jan 1, 20x3 250,000 50,702 199,298 223,215
Jan 1, 20x4 250,000 26,785 223,215 0
The amortization table above shows carrying amounts on January 1 of each of the subsequent years.
These carrying amounts are net of the January 1 payments. To compute for the carrying amount of the
note on December 31, the amount of payment on the following day (i.e. January 1 of next year) is simply
added back to the January 1 present value.

The carrying amount of the note on December 31, 20x1 is determined as follows:
Carrying amount of note payable – Jan 1, 20x2 422,513
Add back: Payment on Jan 1, 20x2 250,000
Carrying amount of note payable – Dec 31, 20x1 672,513

7. Noninterest-bearing note – semiannual installments

Illustration:
On January 1, 20x1, ABC Co. issued a 3-year, P1,200,000 noninterest-bearing note payable due in equal
semiannual payments starting July 1, 20x1. The prevailing interest rate is 10%.

Initial measurement:
Future cash flows – semiannual installments (1.2M/6) 200,000
Multiply by: PV of an annuity due of P1 @ 5%, n=6 5.075692
Present value of note payable – Jan 1, 20x1 1,015,138

Notes:
1. When discounting cash flows that are due in semiannual payments, the “n” (period) is multiplied by
2 because there are two semiannual installments per year.
2. The effective interest rate is divided by 2 because interest rates are normally expressed on a per
annum basis.

Subsequent measurement: Amortization table

Date Payments Interest expense Amortization Present value
Jan 1, 20x1 - - - 1,015,138
July 1, 20x1 200,000 50,757 149,243 865,895
Dec 31,20x1 200,000 43,295 156,705 709,190
July 1, 20x2 200,000 35,460 164,540 544,650
Dec 31,20x2 200,000 27,233 172,767 371,883
July 1, 20x3 200,000 18,594 181,406 190,477
Dec 31, 20x4 200,000 9,523 190,477 0
The interest expense in 20x1 is P94,052 (50,757 + 43,295) and so on with the subsequent years.
8. Noninterest-bearing note – non-uniform installments
Illustration:
On January 1, 20x1, ABC Co. issued a 3-year, P1,200,000 noninterest-bearing note payable due as
follows:
Date Amount of installment
December 31, 20x1 600,000
December 31, 20x2 400,000
December 31, 20x3 200,000
Total 1,200,000

The prevailing interest rate is 10%

Notes:
1. Annuity factors are applicable only when the series of cash flows are uniform or equal. When cash
flows vary, the PV of P1 should be used.
2. A cash flow that is due one period from initial recognition is discounted using an ‘n’ of 1, and so on.

Initial measurement:
Date Cash flows PV of P1 @ 10%, n=1 to 3* Present value
Dec 31, 20x1 600,000 0.90909 545,455
Dec 31, 20x2 400,000 0.82645 330,579
Dec 31,20x3 200,000 0.75131 150,263
Totals 1,200,000 1,026,296

Subsequent measurement:
Date Payments Interest expense Amortization Present value
Jan 1, 20x1 - - - 1,026,296
Dec 31, 20x1 600,000 102,630 497,370 528,926
Dec 31, 20x2 400,000 52,893 347,107 181,819
Dec 31,20x3 200,000 18,181 181,819 0

Variation: First installment payment due in advance

Date Amount of installment
December 31, 20x1 600,000
December 31, 20x2 400,000
December 31, 20x3 200,000
Total 1,200,000

Initial measurement:
Date Cash flows PV of P1 @ 10%, n=0 to 2* Present value
Jan 1, 20x1 600,000 1 600,000
Jan 1, 20x2 400,000 0.90909 363,636
Jan 1,20x3 200,000 0.82645 165,290
Totals 1,200,000 1,128,926
9. Noninterest-bearing note – cash price equivalent
Illustration:
On January 1, 20x1, ABC Co. issued a 3-year, P1,404,928 noninterest-bearing note in exchange for
inventory with a list price of P1,299,999 and a cash price of P1,000,000.

Analysis:
 Initial measurement: The fair value of the note on initial recognition is the cash price equivalent of
the inventory purchased
 Subsequent measurement: Amortized cost

The note payable is recorded as follows:

Jan 1, 20x1 Inventory 1,000,000
Discount on notes payable (1,404,928 – 1M) 404,928
Notes payable 1,404,928
The list price is ignored because it is irrelevant. The difference between the P1,404,928 face amount
and the P1,000,000 cash price equivalent represents the discount on note payable, which will be
amortized as interest expense using the effective interest method.

10. Long-term note issued solely for cash

Illustration:
On January 1, 20x1, ABC Co. issued a 3-year, P1,000,000 noninterest-bearing note payable to XYZ, Inc.,
a related party, in exchange for cash. The prevailing interest rate is 12%.

Case 1: Proceeds equal to present value of note

The proceeds received from the note are P711,780.

The note is long-term and noninterest-bearing. Therefore, it is measured at present value (1M x PV of
P1 @ 12%, n=3 = P711,780).
The entry to record the note payable is as follows:
Jan 1, 20x1 Cash 711,780
Discount on note payable (1M – 711,780) 288,220
Note payable 1,000,000

Case 2: Proceeds equal to face amount of note

The proceeds received from the note are P1,000,000, equal to the face amount.

The note is also measured at the present value of P711,780. However, because the proceeds are equal
to face amount, rather than the present value (which is usually the case in real-life transactions), a “Day-
1 difference” arises.
The entry to record the note payable is as follows:
Jan 1, 20x1 Cash 1,000,000
Discount on note payable (1M – 711,780) 288,220
Note payable 1,000,000
Unrealized gain – “Day 1 difference” 288,220
The “Day-1 difference” is recognized immediately in profit or loss on initial recognition. The “Discount
on note payable: is amortized using the effective interest method.
11. Note with ‘below-market’ rate of interest
Illustration:
On January 1, 20x1, ABC Co. issued a 3-year, P1,000,000 note payable in exchange for a machine.
Principal is due on January 1, 20x4 but interest is due annually every January 1. The prevailing interest
rate for this type of note is 12%.

Analysis:
 Type of payable: Long-term payable with unreasonable interest rate – the nominal rate of 3% is
below the current rate of 12%
 Initial measurement: Present value
 Present value factors: “PV of P1” for the principal because it is due in lump sum at maturity date.
“PV of ordinary annuity of P1” for the interests because they are due periodically.
 Subsequent measurement: Amortized cost

Initial measurement:
To compute for the present value of the note, the future cash flows are first identified then multiplied
by the present value factors
Future cash flows PV of P1 @ 12%, n=3 Present value
Principal 1,000,000 0.71178* 711,780
Interest 30,000 2.40183** 72,055
Totals 783,835
*PV of P1 @ 12%, n=3
**PV of ordinary annuity of P1 @ 12%, n=3
Subsequent measurement:
Date Payments Interest expense Amortization Present value
Jan 1, 20x1 - - - 783,835
Jan 1, 20x2 30,000 94,060 64,060 847,895
Jan 1,20x3 30,000 101,747 71,747 919,642
Jan 1, 20x4 30,000 110,358 80,358 1,000,000

The note payable is recorded as follows:

Jan 1, 20x1 Equipment 783,835
Discount on notes payable 216,165
Note payable 1,000,000
Dec 31, 20x1 Interest expense 94,060
Interest payable (1M x 3%) 30,000
Discount on note payable 64,060
Jan 1, 20x2 Interest payable 30,000
Cash 30,000
Dec 31, 20x2 Interest expense 101,747
Interest payable (1M x 3%) 30,000
Discount on note payable 71,747
Notes:
1. Interest payable is computed by multiplying the nominal rate to the face amount. Interest expense
is computed multiplying the effective interest rate to the present value.
2. The discount amortization increases the interest expense recognized each period. Total interest
expense over the life of the note is greater than the actual payments for interest.
3. The total interest expense recognized over the life of a note with unreasonable interest rate is equal
to the sum of the discount on note payable on initial recognition and the subsequent payments for
interest.