Discount on Note Receivable
Discount on Note Receivable incurs when the face value on note receivable is bigger than the present value of the payment to be received. The discounted amount is the difference between the face value and present value. It should be amortized over the lifetime of a note receivable and net off with interest revenue.
Note Receivable is the balance sheet items which fall under current assets with a maturity date less than a year. It is the promissory note to receive the money in the future which includes both principal and interest. The holder will recognize Interest income in the income statements. Note receivable usually made when a business loan the money to another business. Sometimes its maturity date can be extended to over a year base on both parties’ negotiation.
Discounted on Note Receivable happens when the holder (lender) needs cash before the maturity date and decides to sell them to other financial institutes (bank) at a lower price. The bank will charge a discount as they have to pay immediately while waiting to receive a whole amount at the maturity date. In addition to discounted, the note also requires guarantee from the lender. It means that if the borrower fails to make full payment on the maturity date, the company (lender) will take full responsibility and pay back to the bank.
Thus, the company will have contingent liabilities that may arise due to the default of the note receivable. A contingent liability is the obligation that may or may not happen as it depends on the other future event. This liability is not required to record in the balance sheet, but they must be properly disclosed in the financial statements.
Discounted on Note Receivable Formula
Accounting for Discounted Note Receivable
- Step 1: Calculate the maturity value: it is the amount which the company expects to collect from the borrower. It includes both principal and interest. This is the amount that the bank expects to receive on the maturity date.
- Step 2: calculate discount: we can calculate by using the above formula.
- Step 3: Calculate Process: it is the value which the bank pay to us which equals maturity value less discount.
- Step 4: Calculate interest income or expense: if the bank pays more than the carrying value, the difference is recorded as interest income. If banks pay less than carrying value, it will generate interest expense.
- Step 5: Prepare Journal Entries: The holder needs to reverse the note receivable from the balance sheet and recognize cash plus interest income or expense.
Discounted on Note Receivable Example
Company A holds a note receivable with the following detail.
After the negotiation, the bank agrees to offer 15% discount rate. Please calculate the discount and prepare journal entry. Assume the offer made at the beginning of note receivable.
- Step 1: calculate the maturity value
|Interest (10,000 * 8% * 3/12)||200|
- Step 2: Compute the discount
Discount = 10,200 * 15% * 3/12 = $ 382.50
- Step 3: Compute the proceed
- Step 4: Compute the interest income or interest expense
As the proceed is bigger than carry amount, so we need to record the interest expense.
- Step 5: Journal Entry: Company need to record cash receive by debit cash $ 9,817.5 and debit interest expense $ 182.5 and credit note receivable to reverse it from the balance sheet.