Notes on Bonds and Notes

Bonds and Notes

Cash Flows

• Bonds and notes typically have two cash flows:
  • Interest (received instead of paid in this chapter).
  • Principal received at maturity.

Notes Receivable vs. Accounts Receivable

• Notes receivable differ from accounts receivable by providing a longer payment period for the customer, often around 120 days, to compensate for the extended payment period, the customer is required to pay interest in addition to the principal amount.
• The extended payment period means there's a present value component.
• All notes contain interest elements, but interest payments depend on the note's terms.

Interest-Bearing Notes

• Interest-bearing notes have an explicit stated interest rate.
• The stated rate determines cash interest payments, similar to bonds.

Zero-Interest Bearing Notes

• Zero-interest bearing notes have a stated rate of 0%.
• However, there is always an effective rate of interest.

Effective Interest

• Because of the effective interest rate, the amount received at maturity differs from the initial amount given to the customer.
• This difference is due to the time value of money.

Stated vs. Effective Interest Rates

• Stated Interest Rate: Written into the note receivable contract, it dictates the cash interest the borrower must pay, typically semi-annually or annually.
• Effective Interest Rate: Also known as yield, market interest rate, or effective interest rate, used to determine the present value of cash flows.
• If there is no stated interest rate, it is a zero interest bearing note with a stated interest rate equal to 0%.
• This concept is aligned with bonds from chapter five.

Issuing a Note at Face Value

• This occurs when the stated and effective rates are equal.
• Example: Fjords Unlimited lends Scandinavia Imports $10,000 in exchange for a $10,000 three-year note bearing 10% annual interest.

Perspective

• The focus is on Fjords Unlimited, the entity receiving the note receivable.
• Fjords Unlimited will receive $10,000 in three years, plus 10% annual interest.

Calculation When Stated and Effective Rates Are Equal

• If stated and effective rates are equal, the lending amount equals the repayment amount.
• Present value of the lump sum payment at maturity:
  • PV = FV \times PVF where PVF is looked up in present value table.
  • Using n = 3, i = 10%, the present value factor is 0.75132.
  • Present value of the $10,000 lump sum is $7,513.
• Annual interest payment:
  • Interest = Face[Value \times Stated[Rate Interest = $10,000 \times 10% = $1,000
• Present value of the interest payments (ordinary annuity):
  • Using n = 3, i = 10%, the present value factor of an ordinary annuity is 2.48685.
  • Present value of the interest payments: 2.48685 \times $1,000 = $2,487
• Total Present Value:
  • $7,513 + $2,487 = $10,000
• Total present value equals the face value only when stated and effective rates are equal.

Balance Sheet Presentation

• On the issuance date, the note receivable is valued at $10,000.
• Each year, cash is debited, and interest revenue is credited for $1,000.
• Notes can have discounts or premiums, similar to bonds.

Journal Entries

• Receipt of Note: Debit notes receivable at face value (maturity value) and credit cash for the present value of the note on the issuance date.

Rules for Notes

• Always debit notes receivable at the maturity value.
• Credit to cash is the present value of the note on the date of issuance.

Notes Issued for Products or Services

• If a note is issued after selling a product or service, debit notes receivable and credit sales revenue or service revenue.

Interest Revenue on the Income Statement

• Interest revenue typically goes under "Other Revenues and Gains."
• If the company is a financing company, interest revenue may be part of operations.

Zero Interest Bearing Notes Explained

• These notes have a 0% stated interest rate but always have an effective interest rate.
• No cash interest payments are made, but interest exists because the loan amount is less than the repayment amount (implied or effective interest).

Example of Zero Interest Bearing Note

• Jeremiah Company receives a three-year $10,000 zero-interest bearing note and lends $7,721.80.
• The effective interest rate isn't explicitly stated.

Determining Effective Interest Rate

• Use present value or future value approaches to find the effective interest rate.
• Present value approach involves dividing the present value by future value to find the present value factor.
  • \frac{$7721.80}{$10,000} = 0.77218
• Find the interest rate in the present value of one table where n = 3 and the factor is 0.77218, which corresponds to 9%.

Amortization and Implied Interest

• The almost $2,300 difference between what Jeremiah lends and what they receive represents interest to the borrower, accruing over time.
• This is recognized as interest revenue between the issuance date and repayment date.

Journal Entries for Zero Interest Notes

• Debit notes receivable at face value.
• Debit Notes Receivable: $10,000
• Credit cash for the present value of the note.
• Credit Cash: $7,721.80
• The difference is the discount on notes receivable.
• If a note is zero interest bearing, it's always issued at a discount.

Discount on Notes Receivable

• Discount on notes receivable is a contra asset account.
• On the issuance date, the discount is credited.
• Carrying value of the note is the face value less the discount.

Amortization Process

• Amortize the discount to interest revenue over the life of the note so that, ultimately, the carrying value of the note equals the maturity value.

Effective Interest Method

• Amortize the discount to interest revenue so that by the end of the loan term, the discount on the balance sheet is $0.
• The carrying value of the note is the amount lent to the other party on the issuance date and is calculated by subtracting the discount from the face value.
• The discount amortization is the difference between cash interest received and interest revenue recognized.

Table Setup for Effective Interest Amortization

• Columns:
  • Date
  • Cash Interest Received
  • Interest Revenue (carrying value times the effective rate)
  • Discount to Amortize
  • Carrying Amount of Notes (end of period)
• The amount amortized must always be a positive number.

Journal Entries

• Debit discount on notes receivable.
• Credit interest revenue.
• Reduce the note on the balance sheet for the debt is reduced by that amount.
• Discount on notes receivable (a contra asset account) will have its balance decrease over time.

Effective Interest Method Recap

• The carrying amount of notes on day one (date of issue) is the amount of cash given to the borrower.
• Interest revenue is always carrying value times the effective rate.
• Cash interest received is face value/maturity value times the stated interest rate.
• The discount amortized is the difference between cash interest received and interest revenue recognizing the discount.

Zero Interest Bearing Notes Journal Entries

• The journal entry number comes from cash receipts, interest revenue, and carrying value.
• Because there is no cash interest payment for zero interest-bearing notes, there is no debit to cash.

Borrowers Perspective

• A borrower issuing a note at a discount will have an increase in their interest expense.

Entry at Maturity

• The borrower pays back what they promised at $10,000 when the loan was for $7,721.80.
• The borrower will use the cash they have received to pay back the loan that was issued to them.

Mortgage Corp Example

• Mortgage Corp makes a loan to Marie Company and receives a three-year $10,000 note bearing 10% annual interest.
• Market rate of interest is 12%.

Cash Interest Payment

• Cash interest is determined from stated rate of 10%: (10% \times $10,000 = $1,000)
• The effective rate of 12% is used in the time value of money table.

Present Value Calculation

• Two cash flows: lump sum at maturity and annual interest payments (ordinary annuity).
• Present value of principal:
  • n = 3, i = 12%, factor = 0.71178
  • PV = $10,000 \times 0.71178 = $7,118
• Present value of interest payments:
  • n = 3, i = 12%, factor = 2.40183
  • PV = $1,000 \times 2.40183 = $2,402
• Total present value of the note is 7,118 + $2,402 = $9,520

Journal Entry on Issuance

• Debit notes receivable for $10,000 (always at maturity).
• Credit cash for $9,520 (total present value of the note).
• The difference goes to discount (stated rate less than market rate).

Amortization of Discount

• The discount on the receivables must be amortized to interest revenue between issuance and maturity dates.
• Cash interest is received, unlike zero-interest bearing notes.

Amortization Table in This Case

• The carrying amount on the issuance date is the amount lent to the borrower ($9,520).
• Cash interest received is always maturity value times stated rate.
• Interest revenue is carrying value times the effective rate (12%).
• The discount amortized is the difference between cash received and interest revenue.
• Increase the carrying value at the end of year one after subtracting discount by that number, indicating the current value of the outstanding balance that has not been paid on the side of the borrower.
• At the end of year three, the carrying amount is equal to maturity value ($10,000).

Journal Entries Effective Interest

• The only difference from zero-interest bearing notes is that now, cash and interest are collected.
• Debit cash, debit discount on note, credit interest revenue.

Maturity Date and Collect Cash Interest - Effective Interest Method

• At maturity, cash is received (Marie pays what was promised).

Allowance for doubtful accounts

• Similar to accounts receivable, notes receivable require an estimation process at the end of each period.
• Bad debt expense is debited, and the allowance for doubtful accounts is credited.
• This accounting method aims to include an estimated amount of non-collectible receivables as an expense within or before any losses actually occur - ensuring an accurate reflection in the books.

Factoring

Concept

• Selling receivables to a factor (financing company) to speed up cash collection and guarantee a set amount of cash.
• The factor assesses a finance charge.

Types of Factoring

• Without Recourse: The factor is responsible for collections and bears the risk of uncollectible accounts.
• With Recourse: The selling company must pay the factor for any uncollectible amounts.

Sale of an Asset

• Factoring is the sale of an asset. Get it off of the balance sheet, where it needs to be cleared from the accounting books, like the sale of other assets.

Example: Sale of Receivables Without Recourse

• EBC sells $500,000 of accounts receivable to BlueLine (factor) without recourse.
• BlueLine assesses a 3% finance charge and retains 5% for probable adjustments.

Journal Entry for EBC (Seller)

• Debit to cash - calculate as one calculation: $500K - 3% of $500K, less the $500K times 5% (amount factor is retained)
• Debit Cash is 500 thousand - (3 percent \times $500 thousand) - (Five percent * $500 thousand)
• That gives 460K for the cash debt value.
• Debit receivable from factor using retain percent.
• Multiply factor retain amount by a percentage (in this case it is four percent).
• Debit loss on sale of the receivables, using plug number approach.
• The loss on the sale of receivables can be found and calculated as one number approach, where you find the percentage times receivable amount.
• Credit accounts receivable since this is a sale.
• The accounts receivables are going off EBC books.

Journal Entry for BlueLine (Factor)

• Debit accounts Receivable due from EBC customer account amount.
• This account amount is equivalent to receivable from factor.
• The factor is on liability in books, the current liability that occurs as discounts, returns, allowance.
• Get to the interest revenue calculation to take out the finance charge, (3% x A/R)
• Create an entry for the cash received by the seller.

Net Proceeds

• Cash received from the sale plus the value of the receivable from the factor.

Factoring With Recourse

• The value and proceeds would differ.
• It also depends on when each aspect is calculated, with the key difference being that if a business partakes with a recourse liability, there is going to be a guaranteed amount used to pay the uncollected amounts.

Example: Factoring With Recourse

• The same facts as without recourse, except now it's with recourse with a recourse liability of 6,000 for the fair value.

Journal Entry

• Using the recourse sale here:
  • Factoring with recourse to add in recourse, because, the sale, the receivables, what is the loss?
    Cash = A / R - - fin charge amount retained cash
    Debit = accounts receiveables minus percentage number (Fin Charge * a/r) AND then subtract factor (factor is 5 percent, or what is remaining).
    The receivable form factor is equaled and obtained through what percent you are staying
    The amount of current liability (always 0% that is the current assumption)
    The accounts receives value.
  • Recourse liability is the credit amount, it is how much fair value you are going to be getting and will be the credited fair amount, is the daily account.