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ACCOUNTING FOR PROMISSORY NOTES

Promissory Note- a formal written document which contains an unconditional promise


to pay a sum certain in money at a determinable future time, made by a maker to a
payee.
- a promissory note is a negotiable instrument
- may either be interest bearing or non-interest bearing

Parties in a Promissory Note

a. Maker
- the party who made the promissory note and eventually signs on it.
- the party who makes or issues a promise to pay the agreed amount at a specified
future date.
- the debtor in the transaction.
- from the point of view of the maker, the promissory note is a LIABILITY (NOTES
PAYABLE)

b. Payee
- the person or business to whom the promise of future payment was made.
- the party who receives the promissory note.
- the creditor in the transaction
- from the point of view of the payee, the promissory note is an ASSET (NOTES
RECEIVABLE)

Elements of a Promissory Note

a. Principal- the amount of money owed or borrowed by the maker.


b. Interest Rate- percentage rate that is multiplied to the principal and the term of the
note to arrive at the interest for the period.
c. Interest Period or Term of the Note- the period of time during which interest is to be
computed (from date of issuance to maturity date of promissory note)
d. Interest- represents an opportunity cost. An income of the payee and an expense of
the maker.
e. Maturity Date- the date on which final payment of the promissory note is due.
f. Maturity Value- the amount that the payee expects to receive and the amount that the
maker expects to pay on maturity date.
- maturity value is the sum of the PRINCIPAL and INTEREST (if promissory note is
interest-bearing)

Common Transactions Involving Promissory Notes

a. Promissory note received for services rendered.


Notes Receivable xxxxxx
Service Income xxxxxx
Received note for services rendered
b. Promissory note received for money lent.
Notes Receivable xxxxxx
Cash xxxxxx
Received note for money lent

c. Promissory note received to extend a customer’s account.


Notes Receivable xxxxxx
Accounts Receivable xxxxxx
Received note to extend payment of
customer’s account

d. Collection of non-interest bearing note on maturity date


Cash xxxxxx
Notes Receivable xxxxxx
Collected promissory note on maturity
date.

e. Collection of an interest bearing note on maturity date


Cash xxxxxx
Notes Receivable xxxxxx
Interest Income xxxx
Collected promissory note on maturity
date.

Notes:
1. In the above transactions, promissory notes were RECEIVED by the entity. Thus, the
entity is the PAYEE of the note and records a NOTES RECEIVABLE (ASSET).
2. Notes Receivable is always recorded at the PRINCIPAL amount of the promissory
note.
3. Interest, on the part of the payee is an INCOME or REVENUE.
4. At Maturity Date, Cash is debited for the Maturity Value of the note.

f. Promissory note issued for supplies acquired.


Office Supplies xxxxxx
Notes Payable xxxxxx
Issued note for supplies purchased

g. Promissory note issued for money borrowed.


Cash xxxxxx
Notes Payable xxxxxx
Issued note for money borrowed

h. Promissory note issued to extend an account of the entity.


Accounts Payable xxxxxx
Notes Payable xxxxxx
Issued note to extend an account of the
entity
i. Payment of non-interest bearing note on maturity date
Notes Payable xxxxxx
Cash xxxxxx
Paid promissory note on maturity date.

j. Payment of an interest bearing note on maturity date


Notes Payable xxxxxx
Interest Expense xxxxxx
Cash xxxxxx
Paid promissory note on maturity date.

Notes:
1. In the above transactions, promissory notes were ISSUED by the entity. Thus, the
entity is the MAKER of the note and records a NOTES PAYABLE (LIABILITY).
2. Notes Payable is always recorded at the PRINCIPAL amount of the promissory note.
3. Interest, on the part of the maker is an EXPENSE.
4. At Maturity Date, Cash is credited for the Maturity Value of the note.

INTEREST ON PROMISSORY NOTES


Promissory Notes may either be Interest-bearing or Non-Interest Bearing
a. Interest-Bearing- promissory note provides for separate payment of interest aside
from the principal amount at maturity date.
b. Non-Interest Bearing- there is no separate payment for interest. At maturity date, the
amount to be received or paid is the principal.

SIMPLE INTEREST COMPUTATION:


I = PRT

Where:
P = Principal of the promissory note
R = Interest Rate
T = Time Period

Notes:
1. When computing for interest, if silent, the rate is to be assumed ANNUAL.
2. The maximum time period for computing interest is ONE YEAR.
3. Interest can be computed on a:
a. Monthly Basis (Use 12 months as denominator)
b. Daily Basis (Use 360 as denominator)
4. When counting for the number of days for interest computation, the rule is:
Exclude the First, Include the Last.
ILLUSTRATION:
On October 15, 2015 King Service Center received a 12% P150,000 promissory
note from Queen representing the sum of money lent by King to Queen. The promissory
note is due on December 14 of the same year

REQUIREMENT: Prepare the journal entries on the books of King and Queen
respectively, on October 15 and December 14, 2015

1. To record the transaction on October 15, the following entries are prepared:

BOOKS OF KING SERVICE CENTER


October 15 Notes Receivable 150,000
Cash 150,000
Received note for money lent

BOOKS OF QUEEN
October 15 Cash 150,000
Notes Payable 150,000
Issued a 12% promissory note
for money borrowed.

2. To record the transaction on December 14, maturity date of the note, the following
entries are prepared:

BOOKS OF KING SERVICE CENTER


December 14 Cash 153,000
Notes Receivable 150,000
Interest Income 3,000
Collected promissory note on
maturity date.

BOOKS OF QUEEN

December 14 Notes Payable 150,000


Interest Expense 3,000
Cash 153,000
Paid promissory note on
maturity date.

*Supporting computations:
Principal P 150,000
Interest (150,000 x 12% x 60/360) 3,000
Maturity Value P 153,000

Interest Period is computed as follows:


Number of Days in October 31
Date of Note (15)
Remaining days in October 16
Number of Days in November 30
Number of Days needed in December 14
Total Number of Days of the Note 60
 
QUERY: What if, on December 14, QUEEN failed to settle the promissory note?

If the maker does not settle the promissory note on maturity date, it is said to have been
DISHONORED.

BOOKS OF KING SERVICE CENTER


December 14 Accounts Receivable 153,000
Notes Receivable 150,000
Interest Income 3,000
Maker dishonored the
promissory note.

If the promissory note is dishonored, it loses the status of a negotiable instrument


and thus, is transferred to ACCOUNTS RECEIVABLE at maturity value.
DISCOUNTING OF CUSTOMER’S NOTE

MAKER PAYEE BANK

- discounting involves selling or endorsing the promissory note before the maturity date
- the purpose is to generate quick cash to support some of the entity’s finances
- when the payee discounts the promissory note, the payee receives lesser proceeds
compared to the amount to be received at maturity date.
- discounting may either be on a WITH RECOURSE or on a WITHOUT RECOURSE
basis.

DISCOUNTING OF CUSTOMER’S NOTE WITH RECOURSE


-the payee discounts the promissory note with a bank, and in turn the bank pays the
payee, an amount computed at the date of discounting
a. If the discounting is with recourse, the PAYEE guarantees to the bank that at maturity
date, the maker will pay the maturity value of the note.
b. In the event that the MAKER dishonors the promissory note at maturity date, the
payee will be liable to pay the BANK.

MAKER PAYEE BANK

c. The bank holds a recourse or a right against the payee or the seller of the note.
d. If the discounting is with recourse, a CONTINGENT LIABILITY is recorded, Liability
on Discounted Notes Receivable.
e. The MAKER is still PRIMARILY LIABLE to pay the promissory note. However, if the
discounting is with recourse, the payee becomes SECONDARILY liable to the bank, in
the event of non-payment by the maker.

ILLUSTRATION:
On July 1 2013, Allen Molina received a 60-day 12% P150,000 promissory note from
Hannah Marie Sy. On July 27, 2013 Allen discounted the promissory note with PNB. At
that time the discount rate was 14%

There are THREE dates to be encountered when computing for the amount received
when a promissory note is discounted
a. Date of the Note
b. Date of Discounting
c. Maturity Date
60 DAYS

26 DAYS 34 DAYS AUGUST


JULY 1 JULY 27
30
DATE OF DATE OF DISCOUNT PERIOD MATURITY
NOTE DISCOUNTING DATE

*the discount period runs from the date the note was discounted until the maturity date.
In this illustration, it runs from July 27 to August 30.

In computing for the net proceeds from discounting, the following steps are to be
followed:

1. Compute for the MATURITY VALUE of the promissory note.


Principal P 150,000
Interest (150,000 x 12% x 60/360) 3,000
Maturity Value P 153,000

2. Compute for the number of days in the discount period.


No. of days in July (31-27) 4
No. of Days in August until Maturity Date 30
Discount Period 34

3. Compute for the DISCOUNT.

DISCOUNT = Maturity Value x Discount Rate x Discount Period


= P153,000 x 14% x (34/360)
= P 2,023

4. Compute for the amount of Net Proceeds.


Net Proceeds = Maturity Value – Discount

Maturity Value P 153,000


Discount ( 2,023)
Net Proceeds P 150,977

On July 27, PNB pays Allen Molina P150,977.


PRO- FORMA JOURNAL ENTRIES:

On the date of discounting the journal entry prepared involves:

Cash xxxxxx
Liability on Discounted Notes Receivable xxxxxx
Interest Income xxxxxx
To record discounting of customer’s note

OR

Cash xxxxxx
Interest Expense xxxxxx
Liability on Discounted Notes Receivable xxxxxx
To record discounting of customer’s note

Notes:
1. Cash is debited for the Net Proceeds received from discounting the
customer’s note.
2. Liability on Discounted Notes Receivable is the contingent liability account,
credited for the principal of the promissory note.
3.Liability on Discounted Notes Receivable is credited because the payee incurs a
liability to the bank that is contingent upon the non-payment of the maker.
4. Interest Expense is debited when, Net Proceeds is less than the principal.
5. Interest Income is credited when, Net Proceeds is greater than the
principal.

Continuing the illustration:

BOOKS OF ALLEN MOLINA (PAYEE)

July 27 Cash 150,977


Liability on Discounted Notes Receivable 150,000
Interest Income 977
To record discounting of customer’s note

TWO POSSIBLE SCENARIOS CAN HAPPEN ON AUGUST30, MATURITY


DATE OF THE NOTE:
a. Hannah honors the promissory note.
b. Hannah dishonors the promissory note and the bank charges protest
fees.
A. HANNAH HONORED THE PORMISSORY NOTE

BOOKS OF ALLEN MOLINA (PAYEE)

Aug 30 Liability on Discounted Notes Receivable 150,000


Notes Receivable 150,000
Maker honored the promissory note.

If the maker honors the promissory note, the payee has to remove from its books, the
contingent liability (Liability on Discounted Notes Receivable) and Notes Receivable.

B. HANNAH DISHONORED THE PORMISSORY NOTE AND THE BANK


CHARGED P1,000 PROTEST FEES

BOOKS OF ALLEN MOLINA (PAYEE)

Aug 30 Liability on Discounted Notes Receivable 150,000


Accounts Receivable-Hannah Sy 154,000
Notes Receivable 150,000
Cash 154,000
Maker dishonored the promissory note.

Maturity Value P153,000


Protest Fees 1,000
Amount to be paid on Maturity Date P154,000
since maker dishonored the note

If the maker dishonors the promissory note:


1. The payee has to record an entry involving a debit to Accounts Receivable (equal to
the maturity value of the note plus protest fees) and a credit to Cash for the same
amount.
2. The payee has to remove from its books, the contingent liability (Liability on
Discounted Notes Receivable) and Notes Receivable.
3. If the maker dishonors the note, the payee pays the bank and the payee eventually
goes after the maker for the unpaid amount.

FINANCIAL STATEMENT PRESENTATION:


Liability on Discounted Notes Receivable is presented as a Current Liability under
Trade and Other Payables.