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Module 5-NOTE Payable AND DEBT Restructure

accountancy (Mindanao State University General Santos)

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NOTE PAYABLE
A promissory note is an unconditional promise in writing made by one person to another,
signed by the maker, engaging to pay on demand or at a fixed or determinable future time a
sum certain in money to order or to bearer.

Initial measurement of note payable

Under PFRS 9, paragraph 5.1.1, a note payable not designated at fair value through profit or
loss shall be measured initially at fair value minus transaction costs that are directly
attributable to the issue of the note payable.

In other words, transaction costs are included in the measurement of note payable. However, if
the note payable is irrevocably designated at fair value through profit or loss, the
transaction costs re expensed immediately.

The “fair value” of the note payable is equal to the present value of the future cash payment
to settle the note payable.

The term “present value” is the discounted amount of the future cash outflow in settling the
note payable using the market rate of interest.

Subsequent measurement of note payable

Under PFRS 9, paragraph 5.3.1, after initial recognition, a note payable shall be measured:
a. At amortized cost using the effective interest method.
b. At fair value through profit or loss if the note payable is designated irrevocably as
measured at fair value through profit or loss.

Amortized cost of note payable

The amortized cost of note payable is the amount at which the note payable is measured
initially:
a. Minus principal repayment
b. Plus or minus the cumulative amortization using the effective interest method of any
difference between the face amount and present value of the note payable.

The difference between the face amount and present value is either discount or premium on
the issue of note payable.

Note issued solely for cash

When a note is issued solely for cash, the present value is equal to the cash proceeds.

Illustration
On November 1, 2020, an entity discounted its own note of P1,000,000 at 12% for one year.

Note payable 1,000,000

Less: Discount (12% x 1,000,000) 120,000
Net proceeds 880,000

Journal entry

Cash 880,000
Discount on note payable 120,000
Note payable 1,000,000

Actually, the discount on note payable of P120,000 is the total interest expense for one year.
Thus, on December 31, 2020, after 2 months, the discount on note payable is amortized as
interest expense.

Interest expense 20,000

Discount on note payable (120,000 x 2/12) 20,000

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The straight line method is used in amortizing the discount on note payable for simplicity.
Besides, the note payable has only a term of one year. If a statement of financial position is
prepared on December 31, 2020, the note payable is classified and reported as current liability.

Note payable 1,000,000

Discount on note payable ( 100,000)
Carrying amount 900,000

Observe that the discount on note payable is direct deduction from the face amount of the
note payable. The carrying amount of P900,000 is actually the “amortized cost” of the note
payable.

Interest bearing note issued for property

When a property or noncash asset is acquired by issuing a promissory note which is interest
bearing, the property or asset is recorded at the purchase price.

The purchase price is reasonably assumed to be the present value of the note and therefore,
the fair value of the property because the note issued is interest bearing.

Illustration

On January 1, 2020, an entity acquired an equipment for P1,000,000 payable in 5 annual equal
installment every December 31 of each year. Interest is 10% on the unpaid balance.

Journal entries

2020
Jan. 1 Equipment 1,000,000
Note payable 1,000,000

Dec. 31 Interest expense (10% x 1,000,000) 100,000

Note payable 200,000
Cash 300,000
Payment of the first installment and the interest for 2020.

2021
Dec. 31 Interest expense 80,000
Note payable 200,000
Cash 280,000
Payment for second installment and interest for 2021.

Noninterest bearing note issued for property

When a noninterest bearing note is issued for property, the property is recorded at the cash
price of the property.

The cash price is assumed to be the present value of the note issued. The difference between
the cash price and the face of the note issued represents the imputed interest.

The imputed interest is based on the sound philosophy that no lender would part away with his
money or property interest-free.

Illustration
On January 1, 2020, an entity acquired an equipment with a cash price of P350,000 for
P500,000, P100,000 down and the balance payable in 4 equal annual instalment.

Journal entries for 2020

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Jan. 1 Equipment 350,000

Discount on note payable 150,000
Cash 100,000
Note payable 400,000

Dec. 31 Note payable 100,000

Cash 100,000
Payment of annual installment.

Dec. 31 Interest expense 60,000

Discount on note payable 60,000
Amortization of the discount for 2020.

Table of amortization

Year Note payable Fraction Amortization

2020 400,000 4/10 60,000
2021 300,000 3/10 45,000
2022 200,000 2/10 30,000
2023 100,000 1/10 15,000
1,000,000 150,000

Note payable represents the amount outstanding every year.

The note was issued on January 1, 2020 and the first payment was made on December 31,
2020. Thus, for 2019, the note payable outstanding is P400,000.

Fraction is developed from the note payable outstanding every year. Amortization is the
amount of discount multiplies by the fraction developed.

Thus, for 2020, P150,000 times 4/10 equals P60,000.

Another illustration – no cash price

On January 1, 2020, an entity acquired an equipment for P1,000,000 payable in 5 equal annual
installments on every December 31 of each year.

Observe that there is no agreed interest and no cash price is available for the equipment.

In such a case, the cost of equipment is equal to the present value of the P200,000 annual
installments in 5 years at an appropriate rate of 10%. The rate of 10% is assumed to be the
prevailing market rate of interest. The present value of an ordinary annuity of 1 for 5 years at
10% is 3.7908.

Therefore, the present value of five P200,000 installments is P758,160, computed by

multiplying P200,000 by the present value factor of 3.7908

Journal entries for 2020

Jan. 1 Equipment 758,160

Discount on note payable 241,840
Note payable 1,000,000

Dec. 31 Note payable 200,000

Cash 200,000
First installment payment.

Dec. 31 Interest expense 75,816

Discount on note payable 75,816
Amortization of the discount on note payable for 2020.

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The “effective interest” method is followed in the amortization of the discount.

Table of amortization

Date Payment Interest Principal Present

value
Jan. 1, 2020 758,160
Dec. 31, 2020 200,000 75,816 124,184 633,976
Dec. 31, 2021 200,000 63,398 136,602 497,374
Dec. 31, 2022 200,000 49,737 150,263 347,111
Dec. 31, 2023 200,000 34,711 165,289 181,822
Dec. 31, 2024 200,000 18,178 181,822 -

Payment represents the annual installment

Interest is equal to the preceding present value multiplied by the implied interest rate. Thus,
for 2020, P758,160 times 10% equal P75,816.

Principal is the portion of the payment after deducting interest representing principal. Thus,
on December 31, 2020, P200,000 minus the interest of P75,816 equal P124,184.

Present value is the balance of the preceding present value after deducting the principal
payment. Thus, on December 31, 2020, P758,160 minus the principal payment of P124,184
equals P633,976.

On December 31, 2020, the current portion of the note payable would be reported as current
liability.

Note payable 200,000

Discount on note payable ( 63,398)
Carrying amount – amortized cost 136,602

The noncurrent portion of the note payable would be reported as noncurrent liability.

Note payable 600,000

Discount on note payable (102,626)
Carrying amount 497,374

Noncurrent bearing note payable lump sum

On January 1, 2020, an entity acquired an equipment for P1,000,000. The entity paid P100,000
down and signed a noninterest bearing note for the balance which is due after three years on
January 1, 2023.

There was no established cash price for the equipment. The prevailing interest rate for this
type of note is 10%. The present value of 1 for 3 periods is .7513.

Computation
Down payment 100,000
Present value of note (900,000 x .7513) 676,170
Cost of equipment 776,170

Imputed interest
Face value 900,000
Present value of note 676,170
Imputed interest 223,830

Journal entries

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1. To record the purchase of equipment on January 1, 2020:

Equipment 776,170
Discount on note payable 223,830
Cash 100,000
Note payable 900,000

2. To record the interest expense for 2020:

Interest expense 67,617

Discount on note payable 67,617

The discount on note payable is amortized as interest expense using the “effective
interest” method.

3. To record the full payment of the note on January 1, 2023:

Note payable 900,000

Cash 900,000

Table of amortization
Discount on
Date Interest expense note payable Present
value
1/1/2020 223,830 676,170
12/31/2020 67,617 156,213 743,787
12/31/2021 74,379 81,834 818,166
12/31/2022 81,834 - 900,000

Interest expense is equal to the preceding present value multiplied by the implied interest
rate. Thus, for 2020, P676,170 times 10% equals P67,617.

Discount on note payable is the balance minus the interest expense every year. Thus, on
December 31, 2020, P223,830 minus the interest of P67,617 equals P156,213.

Present value is the preceding balance plus the interest expense every year. Thus, on
December 31, 2020, P676,170 plus the interest of P67,617 equals P743,787.

Fair value option of measuring note payable

PFRS 9, paragraph 4.2.2, provides that at initial recognition, a note payable may be
irrevocably designated as at fair value through profit or loss.

PFRS 9, paragraph 5.7.7, provides that the gain or loss on financial liability designated at fair
value through profit or loss shall be accounted for as follows:

a. The change in fair value attributable to the credit risk is recognized in other
comprehensive income.

Credit risk is the risk that the issuer of the liability would cause a financial loss to the
other party by failing to discharge the obligation.

Credit risk does not include market risk such as interest risk, currency risk and price risk.

b. The remaining amount of the change in fair value is recognized in profit or loss.

Application Guidance B5.7.9 provides that amount recognized in other comprehensive income
resulting from change in fair value attributable to credit risk shall not be subsequently
transferred to profit or loss. However, the cumulative gain or loss recognized may be
transferred within equity of retained earnings.
Under the fair value option, any transaction cost is recognized as outright expense.

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There is no amortization of discount and premium on note payable.

As a matter of fact, interest expense is recognized using the nominal or stated interest rate.

Illustration

On January 1, 2020, an entity borrowed from a bank P4,000,000 on a 12% 5-year interest
bearing note.

The entity received P4,000,000 which is the fair value of the note on January 1, 2020.
Transaction cost of P100,000 was paid by the entity. The fair value of the note payable was
P3,500,000 on December 31, 2020.

The entity has elected irrevocably the fair value option for measuring the note payable.
The change in fair value comprised P50,000 attributable to credit risk and P450,000
attributable to interest risk.

Journal entries for 2020

Jan. 1 Cash 4,000,000
Note payable 4,000,000

Jan. 1 Transaction cost 100,000

Cash 100,000

Dec. 31 Interest expense 480,000

Cash 480,000

Dec. 31 Note payable 500,000

Gain from change in fair value 450,000
Gain from credit risk – OCI 50,000

Carrying amount 4,000,000

Fair value – December 31, 2020 3,500,000
Decrease in fair value of liability – gain 500,000

The gain from change in fair value is recognized in profit of loss

The gain from credit risk is recognized in other comprehensive income.

DEBT RESTRUCTURING

Debt restructuring is a situation where the creditor, for economic or legal reasons related to
the debtor’s financial difficulties, grants to the debtor concession that would not be granted in
a normal business relationship.

The concession either stems from an agreement between the creditor and debtor, or as
imposed by law or court.

The objective of the creditor in a debt restructuring is to make the best of a bad situation or
maximize recovery of investment.

Thus, the creditor usually sustains an accounting loss on debt restructuring and the debtor
usually realizes an accounting gain.

Types of debt restructuring

There are three types of debt restructuring, namely:

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1. Asset swap
2. Equity swap
3. Modification of terms

Asset swap
An asset swap is the transfer by the debtor to the creditor of any asset, such as real estate,
inventory, receivables and investment, in full payment of an obligation.

Under PFRS 9, paragraph 3.3.1, asset swap is treated as a derecognition of a financial liability
or extinguishment of an obligation.

Paragraph 3.3.3 provides that the difference between the carrying amount of the financial
liability and the consideration given shall be recognized in profit or loss.

Illustration

An entry provided the following balance at year-end:

Note payable 2,000,000

Accrued interest payable 400,000

At year-end, the entity transferred to the creditor land with carrying land with carrying amount
of P1,500,000 and fair value of P2,200,000.

Computation

Note payable 2,000,000

Accrued interest payable 400,000
Total liability 2,400,000
Less: Carrying amount of land
1,500,000
Gain on extinguishment of debt 900,000
Journal entry

Note payable 2,000,000

Accrued interest payable 400,000
Land 1,500,000
Gain on extinguishment of debt 900,000

USA GAAP

Under USA GAAP, asset swap is recorded as if two transactions have taken place, namely, the
sale of the asset and the extinguishment of the liability. Accordingly, two gains or losses are
recognized.

The difference between the fair value of the asset and the carrying amount is gain or loss on
exchange.

The difference between the carrying amount of the liability and the fair value of the asset is
gain or loss on restructuring.

Fair value of land 2,200,000

Carrying amount of land 1,500,000
Gain on exchange 700,000

Note payable 2,000,000

Accrued interest payable 400,000

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Total liability 2,400,000

Fai value of land 2,200,000
Gain on debt restructuring 200,000

Journal entry

Note payable 2,000,000

Accrued interest payable 400,000
Land 1,500,000
Gain on exchange 700,000
Gain on debt restructuring 200,000

Note that the gain on extinguishment under PFRS 9 includes both the gain on exchange and
gain on debt restructuring under USA GAAP.

PFRS 9 shall be followed as this is in conformity with international accounting standard.

Dacion en pago accounting

Dacion en pago arises when a mortgaged property is offered by te debtor in full settlement of
the debt.

The transaction shall be accounted for as an “asset swap” form of debt restructuring. This
requires recognition of gain or loss based on the balance of the obligation including accrued
interest and other charges.

If the balance of the obligation including accrued interest and other charges is more than the
carrying amount of the property mortgaged, there is a loss on extinguishment.

Illustration

Land costing P500,000 and building costing P4,000,000 with accumulated depreciation of
P800,000, were mortgaged to secure a bank loan of P3,000,000.

Face amount of the loan 3,000,000

Accrued interest payable 200,000
Legal fee and bank service charge 50,000

Subsequently, the land and building were given to the bank in full payment of the liability.

Journal entry

Mortgage payable 3,000,000

Accrued interest payable 200,000
Bank service charges 50,000
Loss on extinguishment of debt 450,000
Accumulated depreciation 800,000
Land 500,000
Building 4,000,000

Total liability 3,250,000

Less: Carrying amount of land and building (500,000 + 3,200,000)
3,700,000
Loss on extinguishment of debt ( 450,000 )
Equity swap

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An “equity swap” is a transaction whereby a debtor and creditor may renegotiate the terms of
a financial liability with the result that the liability is fully or partially extinguished by the
debtor issuing equity instruments to the creditor.

Simply stated, an equity swap is the issuance of share capital by the debtor to the creditor in
full or partial payment of an obligation.

Accounting issue
How should an entity initially measure the equity instruments issued to extinguish a financial
liability?

The accounting issue of “extinguishment of a financial liability by issuing equity instruments” is

now well-settled under IFRIC 19.

IFRIC 19 provides that when equity instruments issued to extinguish all or part of a financial
liability are recognized initially, an entity shall measure the equity instruments at the fair
value of the equity instruments issued, unless that fair value cannot be reliably
measured. If the fair value of the equity instruments issued cannot be reliably measured,
the equity instruments shall be measured to reflect the fair value of the financial liability
extinguished.

Simply stated, the equity instruments issued to extinguish a financial liability shall be
measured at the following amounts in the order of priority.

a. Fair value of equity instruments issued

b. Fair value of liability extinguished
c. Carrying amount of liability extinguished

The difference between the carrying amount of the financial liability and the initial
measurement of the equity instruments issued shall be recognized in profit or loss.

The gain or loss on extinguishment shall be reported as a separate line item in the income
statement.

Illustration

An entity showed the following data at year-end:

Bonds payable 5,000,000

Accrued interest payable 500,000

The entity issued share capital with a total per value of P2,000,000 and fair value of
P4,500,000 in full settlement of the bonds payable and accrued interest. On the other hand,
the fair value of the bonds payable is P4,700,000.

Fair value of shares issued is used

Bonds payable 5,000,000

Accrued interest payable 500,000
Share capital 2,000,000
Share premium 2,500,000
Gain on extinguishment of debt 1,000,000

Fair value of shares issued 4,500,000

Par value of shares issued 2,000,000
Share premium 2,500,000

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Bonds payable 5,000,000

Accrued interest payable 500,000
Carrying amount of bonds payable 5,500,000
Fair value of shares issued 4,500,000
Gain on extinguishment of debt 1,000,000

Fair value of bonds payable is used

Bonds payable 5,000,000

Accrued interest payable 500,000
Share capital 2,000,000
Share premium 2,700,000
Gain on extinguishment of debt 800,000

Fair value of shares issued 4,700,000

Par value of shares issued 2,000,000
Share premium 2,700,000

Carrying amount of bonds payable 5,500,000

Fair value bonds payable 4,700,000
Gain on extinguishment of debt 800,000

Carrying amount of bonds payable is used

Bonds payable 5,000,000

Accrued interest payable 500,000
Share capital 2,000,000
Share premium 3,500,000

Carrying amount of bonds payable 5,500,000

Par value of shares issued 2,000,000
Share premium 3,500,000

If the carrying amount of liability is used, there is no gain or loss on extinguishment.

Modification of terms,

Modification may involve either the interest, maturity value or both.

Interest concession may involve a reduction of interest rate, forgiveness of unpaid interest or a
moratorium on interest.

Maturity value concession may involve an extension of the maturity date or a reduction of the
principal amount.

PFRS 9, paragraph 3.3.2, provides that a substantial modification of terms of an existing

financial liability shall be accounted for as an extinguishment of the old financial liability and
the recognition of a new financial liability.

Under Application Guidance B3.3.6 of PFRS 9, there is a substantial modification of terms if the
gain or loss on extinguishment is at least 10% of the old financial liability.

The difference between the carrying amount of the old liability and the present value of new
or restructured liability shall be accounted for as gain or loss on extinguishment of debt.

The old effective rate is used in computing the present value of the new liability.

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Any costs or fees incurred as a result of the substantial modification of terms shall be
recognized as part of gain or loss n extinguishment.

Illustration – Modification of terms

On, January 1, 2020, an entity showed the following:
Note payable – due January 1, 2020 – 14% 5,000,000
Accrued interest payable 1,000,000

The entity is granted by the creditor the following concessions on January 1, 2020:

a. The accrued interest of P1,000,000 is forgiven.

b. The principal obligation is reduced to 4,000,00.
c. The new interest rate is 10% payable every December 31.
d. The new date of maturity is December 31, 2023.

This requires computation of the present value of the new note payable using the old rate of
14%.

The present value of the new note payable is equal to the present value of the new principal
plus the present value of the interest payments on the new principal liability.

Computation

The present value of 1 at 14% for 4 periods is 0.5921 and the present value of an ordinary
annuity of 1 at 4 periods is 2.9137.

PV of principal (4,000,000 x .5921) 2,368.400

PV of interest payments (400,000 x 2.9137)
1,165,480
Present value of new note payable 3,533,880
Face value of new note payable 4,000,000
Discount on note payable 466,120

Note payable-old 5,000,000

Accrued interest payable 1,000,000
Carrying amount of old liability 6,000,000
Present value of new note payable 3,533,880
Gain on extinguishment of debt 2,466,120

Journal Entries
1. To record the extinguishment of the old note payable:

Note payable-old 5,000,000

Accrued interest payable 1,000,000
Discount on note payable 466,120
Note payable –new 4,000,000
Gain on extinguishment of debt 2,466,120

2. To record the interest payment on the new note payable for 2020:

Interest expense (10% x 4,000,000) 400,000

Cash 400,000

3. The amortize the discount on note payable for 2020:

Interest expense 94,743

Discount on note payable 94,743

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Date Interest Interest Discount

Carrying
paid expense amortization amount
1/1/2020 3,533.880
12/31/2020 400,000 494,743 94,743 3,628,623
12/31/2021 400,000 508,007 108,007 3,736,630
12/31/2022 400,000 523,128 123,128 3.859,758
12/31/2023 400,000 540,242 140,242 4,000,000

December 31,2020

Interest paid (10% x 4,000,000) 400,000

Interest expense (14% x 3,533,880) 494,743
Discount amortization
94,743
Carrying amount-January 1, 2020 3,533,880
Carrying amount – December 31, 2020 3,628,623

December 31,2021

Interest paid 400,000

Interest expense (14% x 3,628,623)
508,007

Discount amortization
108,007
Carrying amount – December 31, 2020 3,628,623
Carrying amount – December 31, 2021 3,736,630

Books of creditor

Journal entries for 2020 on the books of creditor

Jan. 1 Note receivable – new 4,000,000

Loss on debt restructure 2,466,120
Note receivable – old 5,000,000
Accrued interest receivable 1,000,000
Unearned interest income 466,120

Dec. 31 Cash 400,000

Interest income 400,000

31 Unearned interest income 94,743

Interest income 94,743

No substantial modification

Note payable- due January 1, 2020 – 10% 5,000,000

Accrued interest payable 1,000.000
a. The accrued interest of P1,000,000 is forgiven.
b. The interest rate is 14% payable every December 31.
c. The date of maturity is December 31, 2022.

Note payable 5,000,000

Accrued interest payable 1,000,000
Carrying amount if old liability 6,000,000

This requires the computation of the present value of the new note payable using the old rate
10%.

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The present value of 1 at 10% for three periods of 0.7513 and the present value of an ordinary
of 1 at 10% for the three periods is 2.4869.

PV of principal (5,000,000 x .7513) 3,756,500

PV of interest payments (5,000,000 x 14% x 2.4869) 1,740,830
Total present value of new liability 5,497,330
Carrying amount of old liability 6,000,000
Present value of new note payable 5,497,330
Gain on modification 502,670

Present value of new note payable 5,497,330

Face amount of new note payable 5,000,000
Premium on the new note payable 497,330

The gain is less than 10% of the carrying amount of old liability of P6,000,000.

Under Application Guidance B3.3.6 of PFRS 9, there is no substantial modification of terms.

In accordance with PFRS 9, paragraph B5.4.6, the IASB recently clarified that any gain or loss
on modification should be recognized in profit or loss even if there is no substantial
modification on terms.

The interest expense is computed based on the original effective rate and any discount or
premium on the new liability is amortized using the effective interest method.

Journal entries

1. To record the modified liability on January 1, 2020:

Accrued interest payable 1,000,000

Premium on note payable 497,330
Gain on modification of terms 502,670

2. To record the annual interest payment foe 2020.

Interest expense (5,000,000 x 14%) 700,000

Cash 700,000

3. To amortize the premium on note payable:

Premium on note payable 150,267

Interest expense 150,267

Date Interest Interest Premium

Carrying
paid expense amortization amount
1/1/2020
5,497,330
12/31/2020 700,000 549,733 150,267
5,347,063
12/31/2021 700,000 534,706 165,294
5,181,769
12/31/2022 700,000 518,231* 181,769
5,000,000

* 10% times P5, 181, 769 equals P518, 177. There is a difference of P54 due to rounding of
present value factor.

Interest paid equals face value times modified stated rate.

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Thus, for 2020, P5, 000, 000 x 14% equals P700, 000.

Interest expense equals carrying amount times original effective rate,

Thus, for 2020, P5, 497, 330 x 10% equals P549, 733 and so on.

Premium amortization equals interest paid minus interest expense.

Thus, for 2020, P700,000 minus P549,733 equals P150,267, and so on.

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