NOTES PAYABLE

ACTG15 TOPIC2 - NOTES PAYABLE

I. Key Concepts of Notes Payable

  1. Definition:

    • A note payable is a written promissory note in which the maker (borrower) unconditionally promises to pay a definite sum of money on demand or on a specific future date to the payee (lender).

    • It is a formal, legally binding credit instrument.

  2. Characteristics:

    • Principal (Face Value):

      • The amount borrowed and stated on the note.

    • Interest Rate:

      • The stated percentage applied to the principal to calculate interest expense. May be explicit (stated) or implicit (not stated, but implied by the difference between face value and present value of consideration received).

    • Term:

      • The period from issuance date to maturity date.

    • Maker/Payee:

      • The issuer is the debtor (maker); the recipient is the creditor (payee).

    • Unconditional Promise:

      • The obligation to pay is not subject to any contingencies.

  3. Distinction from Accounts Payable:

    • Notes Payable:

      • Formal credit instruments with explicit interest terms (even if non-interest bearing) and a specific maturity date.

    • Accounts Payable:

      • Informal obligations arising from credit purchases of goods/services, usually without a written promise or explicit interest.

II. Classifications of Notes Payable

Notes Payable are classified based on their duration:

  1. Short-term (Current) Notes Payable:

    • Payable within one year from the end of the reporting period or within the normal operating cycle, whichever is longer.

    • Presented under "Current Liabilities" on the Statement of Financial Position (SFP).

  2. Long-term (Non-current) Notes Payable:

    • Payable beyond one year from the end of the reporting period.

    • Presented under "Non-current Liabilities" on the SFP.

    • NOTE: The current portion of a long-term note payable (i.e., the amount due within the next 12 months) is reclassified to Current Liabilities.

III. Initial and Subsequent Measurement

The core principle from Millan is that a note payable is initially measured at its fair value, which is generally the present value of future cash flows discounted using the market interest rate at issuance.

A. Initial Measurement

The initial carrying amount (recorded value) depends on the relationship between the stated interest rate and the market (effective) interest rate.

  1. Interest-Bearing Note with a Realistic (Market) Rate:

    • Condition: The stated interest rate is reasonable (approximately equal to the market rate for similar notes).

    • Initial Measurement: The note is recorded at its FACE VALUE.

    • Journal Entry:

      • Cash xxx

      • Notes Payable xxx

  2. Non-Interest-Bearing Note (Stated Rate = 0%) or Note with Unrealistic Rate:

    • Condition: The note bears no interest or has an unrealistically low (or high) stated rate. The face value does not represent fair value.

    • Initial Measurement: The note is recorded at the PRESENT VALUE of its future cash flows, discounted at the market (effective) interest rate.

    • Journal Entry (for a non-interest-bearing note):

      • Cash (amt. actually received) xxx

      • Discount on Notes Payable xxx

      • Notes Payable (face value) xxx

  3. Note Issued in Exchange for Property, Goods, or Services:

    • The note is measured at the fair value of the consideration received (property, goods, services) OR the fair value of the note itself, whichever is more clearly determinable.

    • If neither is reliably determinable, the note is measured at its present value using an imputed market interest rate.

B. Subsequent Measurement: Amortization of Discount or Premium

After initial recognition, notes payable not measured at face value (i.e., those with a discount or premium) are subsequently measured at amortized cost using the effective interest method.

Summary Table: Measurement of Notes Payable

Type of Note

Initial Measurement

Subsequent Measurement

Realistic Interest Rate

Face Value

Face Value (no discount/premium to amortize)

Non-Interest-Bearing / Unrealistic Rate

Present Value (PV) of future cash flows, creating a Discount or Premium.

Amortized Cost using the Effective Interest Method.

Issued for Property/Goods/Services

Fair Value of what was received or fair value of the note (PV if neither is clear).

Amortized Cost using the Effective Interest Method.

Key Takeaway:

  • The central theme is present value.

  • A note payable is a liability to pay money in the future, and its economic value upon issuance is the present worth of those future payments, determined by the prevailing market interest rate. This principle governs both initial recognition and subsequent amortization.

IV. Examples and Illustrations

Illustration 1: Short-term Note

  • On July 1, 20x1, ABC Co. borrowed ₱1,000,000 and issued a one-year, note payable. The lender discounted the note at 12%.

  • Case 1: Lump Sum

    • The note is due in lump sum on June 30, 20x2. 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).

Journal Entries:

  • July 1, 20x1:

    • Cash (₱1M × 88%) - 880,000

    • Discount on notes payable (₱1M × 12%) - 120,000

    • Notes payable - ₱1,000,000

  • Dec. 31, 20x1:

    • Interest expense (₱1M × 12% × 6/12) - 60,000

    • Discount on notes payable - 60,000

  • June 30, 20x2:

    • Interest expense (₱1M × 12% × 6/12) - 60,000

    • Discount on notes payable - 60,000

    • Notes payable - 1,000,000

    • Cash - 1,000,000

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 ₱120,000 advanced interest is allocated over the installment periods based on, for example, the outstanding principal balance of the note or some other arbitrary appointment.

Journal Entries:

  • July 1, 20x1:

    • Cash (₱1M × 88%) - 880,000

    • Discount on notes payable (₱1M × 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

Illustration 2: Long-term note with reasonable interest - Simple interest

  • On October 1, 20x1, ABC Co. issued a two-year, 12%, ₱1,000,000 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 × 12% × 3/12) - 30,000

    • Interest payable - 30,000

  • Oct. 1, 20x2:

    • Interest expense (₱1M × 12% × 9/12) - 90,000

    • Interest payable - 30,000

    • Cash - 120,000

  • Dec. 31, 20x2:

    • Interest expense (₱1M × 12% × 3/12) - 30,000

    • Interest payable - 30,000

Further Illustrations

  • A variety of cases illustrating different note payable types, such as compounded interest, non-interest bearing notes in lump sum and installments, and cash price equivalents for inventory purchases are included in the subsequent pages.

  • Each instance follows a similar format of analysis, noting the type of payment structure, measurement, journal entries, and the overall impairment in relation to the notes payable and corresponding financial obligations.