INTERMEDIATE ACCOUNTING 2

WEEK 2 LECTURE
AY 2020-2021
Chapter 2:Notes Payable

Learning objectives
1. State the initial and subsequent measurement of notes and loans payable.
2. Apply a present value factors properly.
3. Prepare amortization tables.
4. Explain the accounting for origination fees on loans payable.

Note Payable
Notes payable are obligations supported by debtor promissory notes. The accounting for notes payable is
similar to the accounting for notes receivable.
Initial measurement
Note payable are initially recognized at fair value minus transaction costs.
Fair value- is “the price that would be received to sell an asset or paid to transfer a liability in an orderly
transaction.
For measurement purposes, note payable are classified in into the following.
a. Short-term payable
b. Long-term payable that bears a reasonable interest rate
c. Long-term payable that bears no interest (noninterest bearing)
d. Long-term payable that bears an unreasonable interest rate (below-market interest rate)
A “short-term” payable matures in 1 year or less, while a “long-term” payable matures beyond 1 year.
Short-term payable
The term value of short-term payable may be equal to its face amount. However, if it is clear that the
arrangement effectively constitutes a financing transaction and the imputed rate of interest can be
determined without undue cost or effort, the fair value of short-term payable is equal to its present value.
Long-term payables
❖ The fair value of a long-term payable that bears a reasonable interest rate is equal to the face
amount.
❖ the fair value of long-term payable that bears no interest (long-term noninterest bearing payable)
is equal to the present value of the future cash flows on the instrument discounted using an imputed
interest rate.
❖ The fair value of a long-term payable that bears an unreasonable interest rate is also equal to the
present value of the future cash flows on the instrument discounted using an imputed interest rate.
 Other terms for imputed rate of interest include effective interest rate, market rate and yield rate.
Effective interest rate is the rate that exactly discounts the future cash payments over the life of the
financial liability equal to its carrying amount.

Cash Price equivalent

Cash price equivalent of the noncash asset (noncash consideration) received in exchange for the payable.
Cash price equivalent is the amount would have been paid if the transaction was settled outright on cash
basis, as opposed to installment basis or other deferred settlement.

Subsequent measurement
Notes payable that are liability measurement at face amount are subsequently measurement at face amount
or expected settlement amount. Notes payable that are initially measured at present value are subsequent
measured at amortized cost.
Amortized cost is the “amount at which the financial asset or financial liability is measured at initial
recognition minus principal repayments, plus or minus the cumulative amortization using the effective
interest method of any difference between that initial amount and the maturity amount and, for financial
assets adjusted for any loss allowance.
The amortized cost is determined using the effective interest method is a method of calculating the
amortized cost of a financial asset or financial liability and of allocating the interest income or interest
expense over the relevant period.
SUMMARY OF MEASUREMENT
Note payable are initially measured at fair value minus transaction costs, the fair value is determined as
follows:

Type of payable Initial measurement Subsequent measurement

• Short-term payable a. Face amount; or
b. Present Value (if the
transaction clearly
constitutes financing
and the imputed rate of
interest can be
determined without
undue cost or effort)
• Long-term payable with ➢ Face amount
reasonable interest rate
• Long-term noninterest ➢ Present Value
bearing payable
• Long-term payable with ➢ Present Value
unreasonable interest
rate
a. Face amount or expected
settlement amount if the
initial measurement is
face amount.
b. Amortized cost id the
initial measurement is
present value.
➢ Face amount or expected
settlement amount
➢ Amortized cost
➢ Amortized cost
A note payable may be issued for cash, purchased of good or other noncash consideration. Regardless of
the consideration received, the accounting depends on the note’s classification for measurement purposes.
To apply effective interest rate method, we need the effective interest rate, which the problem did not state.
However the effective interest rate is defined as the rate that exactly discounts the future cash flows to
carrying amount of the note. We can translate this definition in the following equation.

Future Cash flows x PV factor at x% = Present value

Where : x% the effective interest rate.
Example:
➢ The future cash flow is P1,404,928 (i.e the required payment on the note).
➢ The carrying amount of the note is P1,000,000 (i.e, the cash price equivalent or P1,404,928 face
amount less P404,928 discounts).
The amounts are substituted in the equation as follows:
➢ 1,404,928 x PV of 1 @x% = P1,000,000.00
Trial and error approach
we will “squeeze” for the effective interest rate (x%) in the equation above using a “trial and error”
approach. Thereafter, we will adjust the interest depending on the outcome of the trial using, as a guide ,
the inverse relationship between the effective interest rate and the amount of present value. This means
that if we need a higher amount of present value, we will use a lower interest rate and vice -versa. We will
continue adjusting the interest rate until we get the rate balances the equation.

First Trial : (at 10%)

Future cash flows x PV factor at x% = PV of note
➢ 1,404,928 x PV of P1 @10% = P1,000,000.00
➢ (1,404,928 x 0.7513148009) = 1,055,543 is not equal to 1,000,000
We need a lower amount of present value. Therefore, we need to increase the interest rate. Lets try
12%

Second Trial: (12%)

Future cash flows x PV factor at x% = PV of note
➢ 1,404,928 x PV of P1 @12%, N=3 = P1,000,000.00
➢ (1,404,928 x 0.7117802478) = 1,000,000 is equal to 1,000,000
the effective interest rate is 12%. This rate exactly discount the future cash flow to carrying amount
of the note.
  Notes:

 Interest payable is computed by multiplying the nominal rate of the face amount. Interest expense
is computes by multiplying the effective interest rate to the present value.
 The discount amortization increase the interest expense recognized each period. Total interest
expense over the life of the note is greater than the actual payments for interest.
 The total interest expense recognized over the life of a note with unreasonable interest rate is equal
to the sum of the discount on note payable on initial recognition and the subsequent payments for
interest.
The following other present value scenarios are discussed in intermediate Accounting

• Note with brlow-market interes (simple interest) -principal due at maturity, interest due in semi-
annual installments
• Note with below market interest (simple interest) – principal and interests due in installments
• Note with below market interest (compounded interest) – principal and interests due at maturity
• Non-interest bearing note with deferred payments.
Loan payable
Loan payable is similar to note payable ; it is also supported by formal promise to a certain sum of money
at specific future date(s). Loans payable are accounted for similar to notes payable. However , loan
transactions normally involve transaction cost.
Recall that financial liabilities are initially recognized at fair value minus transaction costs.

• Transaction Costs are “incremental cost that are directly attributable to the acquisition, issue or
disposal of financial asset of Financial liability. Transaction cost include fees and commissions paid
to agents, advisers, brokers and dealers: levies by regulatory agencies and securities exchanges; and
transfers taxes and duties.
Transaction costs do not include debt premiums or discounts, financing costs or internal
administrative or holding cost.
Origination fees
Origination fees is an upfront fee charged by lender to cover the costs of processing the loan (e.g evaluating
the borrower’s financial condition, evaluating and recording guarantees, collateral and other security
arrangements negotiating the terms of instrument, preparing and processing and closing the transactions.
Originations fees are deducted when measuring the carrying amount of a loan payable.
Cost of bank loan
The cost of banks loan may be determined in several ways.

• Simple interest rate for a 1-year loan = interest / borrowed amount.

• Discounted interest rate for a 1-year loan = Net interest expense / Net loan proceeds
• Add-on installments interest rate for a 1-year loan = Interest / Average borrowed amount.
Fixed and Variable interest loans
A fixed interest loan is one where the interest charges are based on a fixed rate. A variable interest
loan is one where the interest charges vary as market interest rate change. The loans (notes) in the previous
illustrations are examples of fixed interest loans. Variable rate loans are discussed in Advance Accounting.

Credit Lines
A credit line (line credit) is an arrangement between financial institution (e.g., a bank) and a borrower that
establishes the maximum amount (credit limit) that the borrower can obtain. A credit line assures the
borrower of an immediate source of financing when the need for cash arises, but subject to the credit limit.
Credit Card – a credit card uses a line of credit granted to the cardholder by a bank or a credit card
company. the cardholder can use the credit card to borrow cash or make credit purchases. When the credit
limit is reached, the card can no longer be used until the obligation is settled.
A credit card is different from debit card. a debit card is linked to the cardholder’s bank account. Therefore
the funds use to purchases are automatically withdrawn (debited) from the cardholder bank account. Debit
card allows the cardholder to use his own funds but in a cashless and convenient way, electronically.
Revolving credit agreement (committed line of credit) imposes a legal obligation on the bank, but the
borrower pays a commitment fee. A credit line which imposes no legal obligation on the bank is called non-
committed line of credit.
Commercial paper
Commercial paper consists of short-term (usually 270 days or less)., unsecured, notes payable issued by
large companies with high credit ratings to investors. Commercial paper is a lowest cost of source of fund
than bank loans. It is usually issued at below the prime rate.