Unit VI

Accounting for Promissory Note

Overview

Background A promissory note is a written promise made by a maker, i.e., the person or
business that signs the note, promising to pay the payee, i.e., the creditor, a
certain amount of money at a fixed determinable future time which may or may
not include interest.

Purpose The purpose of Unit VIII Accounting for romissory !ote" is to illustrate
how an issued promissory note would be recorded in the books of both the
maker and the payee. A lengthy discussion of discounting customers#
promissory note is also included in this unit.
In this unit This unit contains the following topics$
Topics See Page
romissory !ote % of &
Typical Transactions ' of &
Interest on !otes ( of &
)iscounting a !ote *ecei+able , of &
-ndorsement or )iscounting with *ecourse . of &
!otes *ecei+able )iscounted in the /alance
0heet
1% of &
)iscounting 2wn !ote Issued 13 of &
*e+iew 4uestions 1' of &
-xercises 1( of &

Marivic D. Valenzuela-Manalo age 1of &
Promissory Note

Overview A promissory note is an unconditional promise to pay a definite sum of money
on demand or at a future date 5!eedles, /el+erd, et al, 16667. This written
promise made by a maker promising to pay a payee a sum certain in money at
a fixed or determinable future time may or may not include interest.

Illustration The payee regards all promissory notes it holds that are due in less than a year
as Notes Receivable in the current assets section of the balance sheet. The
maker regards them as Notes Payable in the current liabilities section of the
balance sheet 5!eedles, /el+erd, et al, 16667. The following is an example of
a simple promissory note.
4ue8on 9ity, hilippines
1:,:::.::
;uly 1,
%:<1
*2=I002*> !2T-
?2* VA@U- *-9-IV-), I promise to pay ;oseph @abrador the
amount of Ten Thousand esos 51:,:::.::7 on August 3:, %:<1 plus
interest at the annual rate of 1% percent.
50igned7 =ary de ;esus

Continued on next page
Marivic D. Valenzuela-Manalo age %of &
Continued
Components The components of a promissory note are as follows$
Maker. The person or business that signs the note and promises to
pay the amount reAuired by the agreement. The maker is the debtor.
In the illustration B =ary de ;esus.
Payee. The person or business to whom the maker promises future
payment. The payee is the creditor. In the illustration B ;oseph
@abrador.
Principal amount or principal. The amount loaned out by the payee
and borrowed by the maker of the note. In the illustration B
1:,:::.::.
Interest. The re+enue to the payee for loaning out principal and the
expense to the maker for borrowing the principal.
Interest period or term of the note. The period of time during which
interest is to be computed. It extends from the date of the note to
maturity date.
Interest rate. The percentage rate that is multiplied to the principal
amount and the term of the note in computing for the interest.
Maturity date or due date. The date on which final payment of the
note is due.
Maturity value. The sum of principal and interest due at the maturity
date of note.
Place of issue. The locality where the maker executed the note. In the
illustration B 4ue8on 9ity.

Marivic D. Valenzuela-Manalo age 3of &
Typical Transactions
Overview A promissory note may arise from any of the following transactions$
1. A client recei+es ser+ices on goods for which he issues a promissory note
in fa+or of the company. The client is a debtor and is the maker of the
note. The company to whom the note was issued is a creditor and is the
payee of the note.
%. The client has an outstanding account with the company, which will
become due. If the client is not in a position to pay, he could offer a
promissory note to extend time for the payment of his account.
3. A loan is extended to a borrower who issues a promissory note. The
borrower is a makerCdebtor and the lender is a payeeCcreditor.

Illustration
o.!
!ote arising from ser+ices rendered or goods sold. Dhen a company renders
ser+ices or sells merchandise to a customer and recei+es a promissory note in
consideration for such goods or ser+ices, the transaction is recorded as$
!otes *ecei+able
0er+ice Income or 0ales
*ecei+ed note for ser+ices rendered or goods sold.
xxx
xxx

Illustration
o. "
!ote arising to extend an account. If the sample promissory note illustrated is
gi+en to extend payment of an account, the transaction will be recorded as$
!otes *ecei+able
Account *ecei+able
*ecei+ed note to extend payment of an account.
xxx
xxx

Illustration
o. #
!ote arising from a loan transaction. If the note was recei+ed in consideration
of a loan, the transaction will be recorded as$
!otes *ecei+able
9ash
*ecei+ed note for a loan granted.
xxx
xxx

Marivic D. Valenzuela-Manalo age 'of &
Interest on Notes

Overview A promissory note may either be a nonCinterest or an interestCbearing note. A
nonCinterest bearing note is a promissory note, which does not pro+ide any
payment for interest so that the amount to be paid at maturity is eAual to the
face +alue of the note. An interestCbearing note, on the other hand, is a note
which pro+ides for payment of the interest so that the amount to be paid at
maturity is eAual to the maturity +alue, i.e., sum of the principal and interest

Illustration The sample promissory note illustrated abo+e issued by =ary de ;esus in fa+or
of ;oseph @abrador for 1:,::: is an interestCbearing note. The note will
become due on August 3:, %:<1. 2n this date @abrador will recei+e full
payment on the note.
Interest is computed using the formula$ rincipal x *ate x Time.
Therefore$
Interest 51:,::: x 1%E x ,:F3,:7 %::
rincipal 1:,:::
=aturity Value 1:,%::
GGGGGGG
The entry to record collection of the note at maturity is$
9ash
!otes *ecei+able
Interest Income
9ollected note on the date of maturity
1:,%::
1:,:::
%::

Marivic D. Valenzuela-Manalo age (of &
Discounting a Note Receivable

Overview A promissory note is a negotiable instrument. This means that a note is readily
transferable from one business or person to another and may be sold for cash.
To obtain Auick cash, payees sometimes sell or endorse a note recei+ed from
another party before it matures. The payee normally endorses the note to a
bank, which in turn collects the maturity +alue from the maker at maturity
date.

ote $eceiva%le
&iscounting
-ndorsing a note recei+able before maturity is called discounting a note
receivable because the payee of the note recei+es less than its maturity +alue.
This lower amount decreases the amount of interest income the payee earns on
the note. Hi+ing up some of this interest is the price the payee is willing to pay
for the con+enience of recei+ing cash early.

'ndorsement Dhen a note is discounted at the bank before maturity, the bank ad+ances the
money eAual to its +alue on the date of discounting computed on the bank rate
of discount. The endorsement to the bank may either be
with recourse or
without recourse.

Marivic D. Valenzuela-Manalo age ,of &
Enorsement or Discounting wit! Recourse

Overview The holder of the note 5usually the payee7 endorses the note and deli+ers it to
the bank. The bank in turn pays the amount eAual to the net cash proceeds
5i.e., maturity +alue less the discount charged by the bank7 to the endorser
5usually the payee of the note7. The bank expects to collect the maturity +alue
of the note on the maturity date but also has recourse against the endorser or
seller of the note. If the maker fails to pay on maturity date, the endorser is
liable to the bank for payment 5!eedles, /el+erd, et al, 16667. The endorser
has a contingent liability in the amount eAual to the maturity +alue of the note
plus any protest fee that may be charged by the bank for the dishonoring of the
note by the maker.

Illustration -ndorsement or discounting with recourse, therefore, has the effect of
guaranteeing the payment of the note at maturity by the maker. If the maker
does not pay, the endorser is liable to pay the bank. To illustrate,
;oseph de ;esus, the maker, gi+es a ,:Cday, 1%E, 1:,::: note to =aria de la
9ru8, the payee, on ;uly 1, %:<1. 2n ;uly %., %:<1, de la 9ru8 endorses the
note to 9ocobank for discounting. 2n Aug. 3:, %:<1, the maker de ;esus,
should pay the bank. If he fails to do so, 9ocobank can collect from the
endorser, de la 9ru8.
The endorser, i.e., =aria de la 9ru8, discounting the note with recourse, by
such endorsement, incurs a liability depending upon a contingent e+ent. This
e+ent is the failure of the maker, i.e., ;oseph de ;esus, to pay the note at
maturity. !ot until after this e+ent may the endorser be held liable for payment
by the bank. This is known in accounting as a contingent liability.
Continued on next page
Marivic D. Valenzuela-Manalo age .of &
Continued

(ithout
$ecourse
Endorsement or discounting without recourse is done by writing the words
without recourse in the endorsement. -xample of such endorsement is$
The effect of an endorsement without recourse is to exempt the endorser from
any liability, if the maker does not pay at maturity with certain exceptions.
Henerally, therefore, the endorser in this case does not incur any liability, e+en if
only a contingent one. This type of discounting 5without recourse7 has the effect
of collecting the note from a party 5the bank7, which assumes the role of the
creditor. As such the credit entry is to !otes *ecei+able 5asion, )., asion, D.,
asion, -., 166:7.

Illustration of
discounting
with recourse
The following discussions will pertain only to discounting of notes with recourse.
There are three dates encountered in the computation of the amount to be recei+ed
from the bank for a note recei+able discounted.
To Illustrate, assume the following transactions$
;uly 1, %:<1 C ?or merchandise sold, =ary de la 9ru8 recei+ed from ;oseph de ;esus
a 1:,::: note, dated today, due in ,: days at 1%E.
;uly %., %:<1 C =ary de la 9ru8 discounted the note of ;oseph de ;esus at /I. /ank
discount rate is 1'E.
The abo+e may be diagrammed as follows$
,: days
)ate of %, days )ate of 3' days )ate
of note IIIIIIIIIIIIIIIIIIII)iscounting IIIIIIIIIIIIII
=aturity
;uly 1 ;uly %. Aug.
3:
The diagram illustrates that the entire term of the note is for ,: days. The start
of the line diagram, i.e., ;uly 1 represents the date ;oseph issued the note 5i.e., to
=ary7. There are %, days considered the note was expired ?rom ;uly 1 to ;uly
%., which is the date the note was discounted. The term of the note of ,: days
less the expired days of %, is eAual to 3' days, which in turn represent the
discount period 5i.e., the period from the date the note was discounted up to
maturity date7.
Continued on next page
Marivic D. Valenzuela-Manalo age Jof &
Dithout recourse
Continued

Computing for
the et
Proceeds
0teps in computing for the net proceeds) i.e., the amount to be paid by the
bank to the endorser of the note.
I. )etermine the maturity +alue.
rincipal 1:,:::
Add$ Interest 51:,::: x 1%E x ,:F3,:7 %::
=aturity Value 1:,%::
GGGGG
II. 9ount the number of days from the date of discounting to the date of
maturity. This is the discount period.
)iscount period G ;uly %. to August 3:
;uly 531C%.7 exclude %. G '
August G 3:
)iscount period G 3' days
GGGGGGG
III. 9ompute the discount. In computing for the discount, the bank
normally gi+es a higher discount rate but if no rate was gi+en, use the
interest rate of the note.
&iscount * Maturity +alue , &iscount $ate , &iscount Period
1:,%:: x 1'E x 3'F3,: G 13'.J.
IV. 9ompute for the net cash proceeds
et Proceeds * Maturity +alue - &iscount
=aturity Value 1:,%::.::
@ess$ )iscount 13'.J.
!et roceeds 1:,:,(.13
GGGGGGG
C The amount to be paid by
/I to de la 9ru8 on ;uly %..
Continued on next page
Marivic D. Valenzuela-Manalo age 6of &
Continued

.ournal 'ntries The following are the Kournal entries$
)ate .oseph de .esus/ Book Mary de la Cru0/s Book
;uly 1 urchases 1:,::: !otes *ecei+able 1:,:::
!otes ayable 1:,::: 0ales 1:,:::
urchased =erchandise 0old C =erchandise
&iscounted .oseph1s note at !23.
I
%. 9ash 1:,:,(.13
Interest -xpense 13'.J.
Interest Income %::
!otes *ecei+able )iscounted 1:,:::
)iscounted note at 1'E to /I.
4ssuming .oseph paid the note at maturity.
II
Aug. 3: !otes ayable 1:,::: !otes *ecei+able )iscounted 1:,:::
Interest -xpense %:: )iscounted
9ash 1:,%:: !otes *ecei+able 1:,:::
aid !ote at maturity To close contingent liability
0ept. 1 4ssuming .oseph failed to honor the note at maturity and BPI charged a protest fee of P566.
III
777 !otes ayable 1:,::: Accounts *ecei+able 1:,.::
Interest -xpense .:: 9ash 1:,.::
Accounts ayable 1:,.:: aid dishonored note with protest fee.
)ishonored note at maturity.
!otes *ecei+able )iscounted 1:,:::
!otes *ecei+able 1:,:::
To close contingent liability
777 In theory, this entry must be effected, but actual experience shows
that a maker does not ordinarily prepare this entry but instead prepares
an entry only when the note is finally paid.
Continued on next page
Marivic D. Valenzuela-Manalo age 1:of &
Continued

&iscussion The following are the explanations for the different parts of the discounting
process$
I - As per computations, the net proceeds of the note is 1:,:,(.13.
The interest for %, days 5;uly 1 to ;uly %.7 amounting to J,.,. is
considered earned by de la 9ru8. As a contingent liability is incurred,
=ary de ;esus should credit a contingent liability account, Notes
Receivable Discounted. It would not be proper to credit !otes
*ecei+able, as this procedure would not show the contingent liability
in the accounts.
II - The payment made by ;oseph to the bank has two effects$ 517 it
discharges =ary from the guarantee ;oseph has made to the bank and
5b7 =ary has no more claim from ;oseph. These two effects are
shown in the entry abo+e.
III - !onCpayment by ;oseph to the bank has two effects$ 517 it makes
=ary a guarantorFendorser liable to the bank and thus, making her
pay the maturity +alue of the note plus any protest fee that may be
charged by the bank. 5%7 ayment by =ary to the bank does not
release ;oseph from his liability. Although the note is no longer
binding, he is still liable to =ary to an amount eAual to maturity +alue
plus protest fee.

Marivic D. Valenzuela-Manalo age 11of &
Notes Receivable Discounte in t!e "alance #!eet

Overview De ha+e learned that in a discounting with recourse, we are creating a new
account title called !otes *ecei+able )iscounted" to indicate the presence of
a contingent liability in the books of the endorser. &ow do we present this in
the balance sheet would be the focus of the following discussions.

8our Methods There are four methods of presenting the contingent liability on notes
discounted in the balance sheet. They are the following$
1. As a contingent liability on the liability side
B494C' S:''T
9urrent Assets$ 9urrent @iabilities$
!otes *ecei+able (:,::: @ong Term @iabilities$
lant, roperty L -Auipment$ 9ontingent @iabilities$
!otes *ecei+able )iscounted 1:,:::
%. As a deduction form !otes *ecei+able on the asset side$
B494C' S:''T
9urrent Assets$
!otes *ecei+able (:,:::
@ess$ !otes *ecei+able )iscounted 1:,::: ':,:::
3. As a footnote to the /alance 0heet with the !otes *ecei+able being shown as net.
B494C' S:''T
9urrent Assets$
!otes *ecei+able ':,:::
8OOTOT'$ There is a 1:,::: note discounted at /I.
'. As a parenthetical note in the /alance 0heet
B494C' S:''T
9urrent Assets$
!otes *ecei+able 5)iscounted, 1:,:::7 ':,:::

Marivic D. Valenzuela-Manalo age 1%of &
Discounting Own Note Issue

Overview It will be noted in the illustrations on ;oseph de ;esus# book that interest is not
recorded at the time the note is issued. ayment of interest is usually made on
maturity date of the note.
There is another method of issuing promissory note where the creditor would
collect the interest on the note being issued by the maker on the same day the
loan was granted. This scheme in paying interest in ad+ance for the note
issued is called discounting ones own note. In this case, there are two
alternati+e methods of recording such transactions, either the expense, Interest
Expense account or the asset, Prepaid Interest account may be debited. Notes
Payable account is credited at face +alue of the note and Cash account is
debited for the net amount, i.e., face +alue of the note minus the interest.

Illustration 2n ;uly 1, for money borrowed, ;oseph de ;esus discounted its own 3:Cday,
1%E 1:,::: note with =ary de la 9ru8.
The following will be the possible entries to record the ;uly 1 transaction$
de .esus/ Book
;uly 1 9ash 6,6::
Interest -xpense 1::
!otes ayable 1:,:::
)iscounted own note.
or
9ash 6,6::
repaid Interest 1::
!otes ayable 1:,:::
)iscounted own note.
Dhen the maker pays the discounted note on the date of maturity, he will
pay only an amount eAual to the face +alue of the note issued. 0ince the
payee deducted already from the amount loaned to the maker the interest
that the former will be earning from the note on maturity date, the maker
will no longer pay the interest. Thus, if de ;esus pays the note on ;uly
31, he would be paying only 1:,:::, the principal amount of the note.
de .esus/ Book
;uly 31 !otes ayable 1:,:::
9ash 1:,:::
0ettled discounted note.

Marivic D. Valenzuela-Manalo age 13of &
Marivic D. Valenzuela-Manalo age 1'of &