230 fe | = ne Chapter 5 Notes Receivable Related standards: PFRS 9 Financial Instruments PFRS 15 Revenue from Contracts with Customers Learning Objectives 1. State the initial and subsequent measurements of note receivable. 2. Compute for present value factors and apply them properly. Prepare amortization tables. 4. Compute for the effective interest rate. | » Notes receivable A note receivable is a claim supported by a formal promise to pay2 certain sum of money at a specific future date usually in the form of a promissory note. A note can be a negotiable instrument that a maker signs in favor of a designated payee who may legally and readily sell or otherwise transfer the note to others. Note receivables are considered fairly liquid, even if long-term, becaus entities may easily convert them to cash, although a fee might bv paid to do so. Although all notes contain an interest element because ! the time value of money, entities classify notes as either interest bearing or noninterest-bearing. > Interest bearing notes have a stated interest rate, ie» the contracted interest rate stated on the promissory note. other terms for stated interest rate include nominal rate, coupon ™ and face rate. Noninterest-bearing notes do not have a stated interest because they include the interest element as part of the . amount. The face amount of a noninterest-bearing no Tepresents an unspecified principal and an unspecified inte att v Scanned with CamScannerNotes Receivable Present value computation is needed to separate the interest element from the principal element. Trade and non-trade notes receivables Entities frequently accept notes receivable from customers who need to extend the payment period of an outstanding account receivable. Notes may also be required from high-risk or new customers. In some industries (e.g., hospitals and colleges), notes support all credit sales. Notes receivable obtained from the sale of goods or services in the ordinary course of business are classified as trade notes receivable. Notes receivable from other sources are non-trade notes receivable, Examples include notes receivable from loans to employees and affiliates and sales of property, plant, and equipment on credit. Initial measurement Receivables are initially recognized at fair value plus transaction costs. For measurement purposes, receivables are classified into the following: a. Short-term receivable b. Long-term receivable that bears a reasonable interest rate Long-term receivable that bears no interest (noninterest bearing) d. Long term receivable that bears an unreasonable interest rate (below-market interest rate) c - A “short-term” receivable matures in 1 year or less while a “long-term” receivable matures beyond 1 year. Short-term receivable The fair value of a short-term receivable may be equal to its face amount. However, if the transaction contains a significant financing component, the fair value of the short-term receivable is equal to its Present value. Scanned with CamScanner7’ 232 _ Chapters, oss PFRS 15: Exceptions on trade receivables > Trade receivables that do not have a significant financin, component shall be measured at their transaction price, > As a practical expedient, a trade receivable may not be discounted if it is due within 1 year. Long-term receivables * The fair value of a long-term receivable that bears a reasonably interest rate is equal to the face amount. An interest rate is deemed ‘reasonable’ if it approximates the market rate a transaction date. % The fair value of a long-term receivable that bears no interest (long-term noninterest bearing receivable) is equal to the present value of the future cash flows from the receivable discounted using an imputed interest rate. * The fair value of a long-term receivable that bears an unreasonable interest rate is also equal to the present value of the future cash flows from the receivable discounted using an imputed interest rate. The imputed rate of interest is the more clearly determinable of either: a, the prevailing rate for a similar instrument of an issuer witha similar credit rating; or b. a rate of interest that discounts the face (nominal) amount of the receivable to the current cash sales price of the goods o* services. Other terms for imputed rate of interest include effecti”? interest rate, market rate and yield rate. The difference between the present value and the fa amount of the receivable is initially recognized as unearned interest and subsequently amortized as interest revenue under the effecti”” interest method. ; The effective interest rate is the rate that exactly discounts estimated future cash payments or receipts through the expec! Scanned with CamScannerNotes Receivable 233 Jife of the financial instrument or, when appropriate, a shorter period to the net carrying amount of the financial asset or financial liability. Cash price equivalent The fair value of receivables may be measured in relation to the fair value of the asset given up in exchange for the receivable. Such fair value is the cash price equivalent of the noncash asset given up. Cash price equivalent is the amount that would have been paid if the transaction was settled outright on cash basis, as opposed to installment basis or other deferred settlements. Example 1: An entity sells household appliances either on cash basis or on 6- month installment basis. On January 1, 20x1, a TV set with a cash price P100,000 was sold at an installment price of P120,000. > The receivable will be initially recognized at P100,000, the cash price equivalent of the TV set. The P20,000 difference (P120,000 installment price less P100,000 cash price) will be amortized over the credit term as interest revenue using the effective . interest method. Example 2: An entity sells goods for P250,000 to a customer who was granted a special credit period of 1 year: The entity normally sells the 800ds for P220,000 with a credit period of one month or with a P5,000 discount for cash basis (i.e., outright payment in cash). > The initial measurement of the receivable is computed as follows: Normal selling price with credit period of one month 220,000 Discount for cash basis — Em) Cash price equivalent of the goods sold ee Scanned with CamScanner234 Chae ER Both the selling prices of P250,000 (special credit P220,000 (normal credit) constitute a financing transaction, ; they include consideration for the credit period granted 3 compute for the cash price equivalent of the goods sold, which ig 4’ | fair value of the consideration, the P5,000 discount Biven fy | outright payment in cash is deducted from the normal sel price of P220,000 with credit period of one month, 8 However, if the entity opts to use the practical expedien, allowed by PFRS 15, the receivables are measured at the undiscounted transaction prices of P120,000 (Example 1) ang 250,000 (Example 2). | Q Summary of Initial measurement of receivables Type of receivable Initial measurement 1. Short-term receivables (trade | Fair value plus transaction costs, receivables and non-trade receivables | > Fair value is equal to: collectible within one year) a. face amount; ot b. present value (when the transaction contains a signifi | financing component); OF c. transaction price w/ allowed practical expedient (for trade receivables). : 2. Long-term receivables Fair value plus transaction cos: | bearing reasonable interest | > Fair value is equal to face \ rate amount. | i 3. Long-term noninterest- Fair value plus transaction costs | bearing receivables > Fair value is equal tothe || present value of future os flows from the receivable 4. Long-term receivables Fair value plus transaction bearing unreasonable >_ Fair value is equal oe L Scanned with CamScannerNotes Receivable oss interest rate (below-market present value of future cash interest rate) flows from the receivable. ¢ When the cash price equivalent of the non-cash asset given up in exchange for the receivable is determinable, the fair value of the receivable is equal to the cash price equivalent, except when the practical expedient allowed by PFRS 15 is applicable. Illustration: Initial measurement at face amount ABC Co. received the following notes receivable on Jan. 1, 20x1: 9-month, 10% note from Alpha Company. 5,000 6-month, noninterest bearing note from Beta, Inc. (the effect of discounting is deemed immaterial) 10,000 _ 14%, 3-year note from Charlie Corp. 20,000 10% Market rate of interest on Jan. 1, 20x1 Requirement: At what amount will the notes be initially recognized? Answer: (5,000 + 10,000 + 20,000) = 35,000 All of the notes are permitted to be measured at face amount. * The P5,000 note is a short-term note and bears interest rate that is consistent with the market rate of interest. © The P10,000 note, although noninterest bearing, is a short-term note and the problem states that the effect of discounting this note is deemed immaterial. = The P20,000 note, although long-term, bears an interest rate that is reasonable in relation to the current market rate on. January 1, 20x1, i.e, the 14% nominal rate is above the 10% ~ market rate. Concept of time value of money An understanding of the concept of time value of money is €ssential in the study of accounting as well as in the application of Scanned with CamScanner236 Chi 236g the PFRSs. It plays a very important role in accountin, measurements and most of the topics in financial repo require its use. 8 Time value of money involves interest calculations, connotes a relationship between the value of money and time, The concept of time value of money provides that contractual agreements to receive cash (or to pay cash) in the future will earn (or incur) interests due to passage of time regardless of whether interests have been agreed upon or not, This is because of the opportunity to invest today’s peso and receive interest on that investment. There are two types of interest: (a) simple interest and () compound interest. Under simple interest, interest is earned only on the principal. Under compound interest, interest is ‘earned on both the principal and the interest. Two terms often used in conjunction with time value of money are (a) future value and (b) present value. 1. Future Value of an Amount (FV of P1) The future value of P1 answers the question: If I deposit 1 peso (P1) today in the bank (or in some other investment), how much will it be worth in the future?” Naturally, it will be worth more than Pl because of the interest. factor; but exactly how much will it be worth? To find out, we will use the future value factor. The future value of P1 factor may be determined by referring to a future value table, by using a financial calculator, by using other tools, or simply by using the formula below on # scientific calculator. FV of P1=(1+/)" Where: i=interest rate n= number of periods 0% Example: You deposited P10,000 today: The deposit eams 1 it interest compounded annually. How much will your dep0* worth after 3 years? Scanned with CamScannerNotes Receivable 237 By performing future value computation, we can determine the value of your deposit after 3 years as follows: pV of P1 = (1 + 10%)° FV of P1 = 1.331 Future value of deposit = (10,000 x 1.331) = 13,310 The future value of the deposit can also be computed manually as follows: Principal : 10,000 Interest in 1* year (10,000 x10%) 1,000 Compounded interest in 24 year [(10K + 1K) x 10%] 1,100 Compounded interest in 3" year [(10K + 1K + 1.1K) x 10%] 1,210 Value of deposit in 3 years 13,310 The problem with this approach is that it is tedious especially when the period (‘1’) is relatively long. 2. Present value of a future amount (PV of P1) The Present value of P1 answers the question: “How much do I have to deposit today to receive 1 peso (P1) in the future?” This is the exact opposite of the Future value of P1. The previous question was “what will be the amount of the future withdrawal?” Here, the question is “what is the amount of the present deposit?” Naturally, the present deposit will be worth less than P1 because of the interest factor; but exactly how much is it? To find out, we will use the present value factor. The present value of P1 factor may be determined by Teferring to a present value table, by using a financial calculator, by using other tools, or simply by using the formula below on a Scientific calculator. PV of P1=(1+/)" Scanned with CamScannerBB Chater Stoners Note that “n” is a negative value, This is the gq difference from the FV of P1 factor formula. l Example: You wish to withdraw P13,310 three years from now, The interest rate is 10% compounded annually. How much deposi should you make today? | By performing present value computation, we cay determine the amount of present deposit as follows: PV of Pl = (1+ 10%)? PV of P1 = 0.751315 Present value of future withdrawal = (13,310 x 0.751315) 10,000 This means that in order to receive P13,310 three years from now, you need to deposit P10,000 today. Notice that present value is the exact opposite of future value. The application of present value in relation to the accounting for receivables is based on the concept that all notes receivable contain an unspecified principal and an_ unspecified interest. These two elements are segregated using present value computations and accounted for as follows: 1. Principal element - represents the measurement of the note receivable. 2. Interest element — initially recognized as unearned interest and amortized over the life of the note as interest income. In the example above, the P13,310 future withdrawal includes a principal element of P10,000 and an interest element P3,310. Assuming that the P13,310 future cash flow is represent? by a noninterest bearing note, the note will be initially measu only at P10,000. The P3,310 interest component is initi recognized as unearned interest. Scanned with CamScanner| Notes Receivable 39 | 10,000 present value represents the principal, i.e., the needed deposit today to receive the 13,310 after 3 years. 13,310 amount to be received after 3 years Present value computation 3,310 difference represents the interest income to be eared over the 3-year period. Example: In exchange for services, you received a noninterest- bearing note of P10,000, due in 3 years’ time. The P10,000 face amount represents the future value of the note receivable — a value that includes both principal and interest elements. Logically, you cannot recognize the note receivable now at P10,000 because that amount includes both interest and principal elements and the interest is not yet earned because there is no passage of time yet. Only the principal element should be recognized for the note. But how much is the principal element? At what amount will the note be recorded today? To find out, we need to discount the P10,000. The present value represents the principal element; the excess is unearned interest. Assuming the current market rate today is 12%, the present value is computed as follows: PV of Pl = (1+12%)3 PV of Pl = 0.71178 Present value of note = (10,000 x 0.71178) = Z118 The note receivable is recorded as follows: Toy T Note receivable 10,000 Revenue 7,118 Unearned interest income (10,000 - 7,118) 2,882 Scanned with CamScanner240 Chapter 5 iad The unearned interest income is a deduction to the Rote receivable when computing for the note’s carrying amount. Note receivable 10,009 Less: Unearned interest income (2,882) Not ivable - net 71 lote receivable — nei : 18 Notice that the initial carrying amount of the note receivable is equal to the present value. A receivable that bears a reasonable interest rate need not be discounted to present value because its face amount is deemed its principal amount. No segregation is needed because the principal is already specified. The interest element is recognized separately in profit or loss over the term of the receivable. €© Notice to examinees: Present value factors may or may not be provided during the CPA board exams so examinees are advised to memorize the formulas for present value factors. Of course, bringing of present value tables in the examination room is strictly prohibited! ® For examinees using non-scientific calculators, the PV of PI factor can be computed as follows: (assume PV of P1 @12%, n=3) Press 1.12, now press the division sign [=] twice, then press equal sign [3 three times (equal to the ‘n'). You should have 0.7117802478. Ee ee [For some calculators, you need to press the equal sign [=] once bets pressing it again for the “n” times. To check whether you need to press oe equal sign additionally or not, press 1.12 then press [+ | twice, now press ,if you come up with “1,” you need to press [= again for the “n’ times (ve 3x). If you come up with *.89285714285,” you don't need the additional you just have to press the [=] for the “n" times after pressing [+] twice. The Future value of P1 as discussed earlier may also computed using a non-scientific calculator as follows: (assu™ of P1 @5%, n=3) Scanned with CamScannerNotes Receivable oa press 1.05, now press the multiplication sign [x] twice then press the equal sign [2] twice (equal to 'n’ of 3 minus 1). You should have 1.157625. The Present Value of P1 and the Future Value of P1 are applicable only when the cash flow is on a Iump sum basis, meaning, on a “one-time” basis. If there are series of cash flows, the annuity factors shall be used. 3. Future value of an annuity of P1 The future value of an annuity of P1 answers the question “if [make a series of equal deposits over several periods, how much will they accumulate to in the future?” Notice the key difference between this situation and the previous situation. In the previous situation, I made just one deposit, here I am making series of deposits. There are two types of annuities: (1) ordinary annuities and (2) annuities due. " In the case of an ordinary annuity, deposits are made at the end of each interest period. 7 In the case of an annuity due, deposits are made at the beginning of each interest period, ie., the first deposit is made immediately or in advance. Example: If today is January 1, 20x1 and I plan to make a series of three deposits over the next 3 years with each deposit being made at the end of each year (December 31, 20x1, December 31, 20x2, and December 31, 20x3), this would be a case, of an ordinary annuity. Notice that the first deposit does not begin immediately. However,.if each deposit is to be made at the beginning of each year (January 1, 20x1, January 1, 20x2, January 1, 20x3), then We are dealing with an annuity due. Notice that the first deposit begins immediately or in advance. The future value of an ordinary annuity of P1 factor may be determined using the formula below: Scanned with CamScannerChapters " FV ofan ordinary annuity of P1 = [ (ati) =a | - i The future value of an annuity of P1 factor ay be determined by referring to a future value table for one additiong, period and subtracting 1 from it, or by using the formula below: net FV of an annuity due of P= [ as “al ] ad t Note that for annuity due, the “n” is increased by 1 period and the resulting factor is reduced by 1. Illustration: Future value of an annuity On January 1, 20x1, ABC Co. issued bonds due in ten years. The bond indenture requires ABC Co. to set up a sinking fund to be used to settle the bonds at maturity. ABC Co. decided to make 10 annual contributions of P10,000 to a sinking fund that earns 12% compounded interest. Relevant future value factors are shown below: , FV of P1 @ 12%, n=10...... FV of an ordinary annuity of P1 @ 12%, FV of an annuity due of P1 @ 12%, n=10. a._If ABC Co. makes the first contribution on December 31, 20x), how much is the value of the sinking fund after 10 years? Answer: 175,487.40 (10,000 x 17.54874). The FV of an ordinary annuity factor is used because the first contribution is not made immediately. b. If ABC Co. makes the first contribution on January 1, 20%! how much is the value of the sinking fund after 10 years? Scanned with CamScanner243 “Answer: 196,545.80 (10,000 x 19.65458). The FV of an annuity due factor is used because the first contribution is made immediately or in advance. Note that FV of PJ is not used because the contributions are made in installments. The FV of P1 is used when contribution jsmade on a lump-sum or “one-time” basis. For simplicity, the factors are given above. However, to illustrate how the formulas for the annuity factors are applied, computations are provided below: FV of an ordinary annuity of P1=[(1 + i)" -1]+ FV of an ordinary annuity of P1 = [(1+12%) - 1] +12% FV of an ordinary annuity of P1 = 17.54874 i-1 12%}-1 FV of an annuity due of P1 ={ [(1 + i)"*" - 1] FV of an annuity due of P1 ={ [(1+ 12%)" - 1] FV of an annuity due of P1 = 19.65458 In a non-scientific calculator, the FV of an ordinary annuity of P1 may be computed as follows (assume FV of an ordinary annuity of P1 @12%, n=10): Press 1.12, now press the multiplication sign |x| twice then press the equal sign [=] nine times (equal to ‘n’ minus 1). Now press minus |-} 1 then press equal sign. Lastly, divide [+] the resulting amount by 12%. You should come up with 17.5487350693. For the FV of an annuity due of P1 (assume FV of an annuity of P1 @12%, n=10): : Press 1.12, now press the multiplication sign twice then press the equal sign ten times (equal to ‘n’). Now press minus 1 then press equal sign. Divide the resulting amount by 12%. Press minus 1. You should come up with 19.6545832775. : Scanned with CamScanner244 Chapter 5 4, Present value of an annuity of P1 The present value of an annuity of P1 answers the question “y, much do I have to deposit today to be able to make several equal withdrawals of P1 each over equal periods in the future?” Note carefully the difference between this and the future value of an annuity. Under future value of an annuity, there ate several deposits and one withdrawal. Under present value of an annuity, there is one deposit and several withdrawals. Again, we have two types of annuities: ordinary annuities and annuities due. In the former case, the first installment is Made one period after the deposit, while in the latter case it is made immediately (i.e., right after the deposit is made or in advance). The formulas for present value of annuity factors are shown below: . n PV of an ordinary annuity of P1. = [ 1-(1+i) | 7 Note that “n” is again negative, similar to the PV of P1. PV of an annuity due of P1 = [ 1-asi” ] of * Note that for annuity due, the negative “n” is decreased by 1 period and the resulting factor is increased by1. Illustration: Present value of an annuity As consideration for services performed, you received a 710,000 noninterest-bearing note today, due in 10 equal annual installments of P1,000 each. Of course, you.already know that te P10,000 face amount includes both principal and interest elemen® that should be segregated. Therefore, you will record the note ee its present value. You then determined that the current marl Tate as of today is 12%. Scanned with CamScannerNotes Receivable - Case #1: Present value of an ordinary annuity If the first installment is due one year from now, how much is the jnitial carrying amount of the noninterest-bearing note? The PV of an ordinary annuity should be used because the first installment is not due immediately. PV of an ordinary annuity of P1 = [1-(1+i)"] +i PV of an ordinary annuity of P1 = [1 - (1 + 12%)""] + 12% PV of an ordinary annuity of P1 = 5.650223 Present value of note = (P10,000 divide by 10 installments, or P1,000 annual cash flow multiply by the PV of ordinary annuity factor of 5.650223) = (1,000 x 5.650223) = 5,650.22 The entry to record the note is as follows: Date | Note receivable 10,000 Revenue 5,650.22 Unearned interest income (10,000 - 5,650.22) 4,349.78 Again, the unearned interest income is a deduction from the note receivable. The “Discount on note receivable” account may also be used in lieu of the “Unearned interest income” account. Revenue is recognized at the present value of the note. Using a non-scientific calculator, the PV of an ordinary annuity may be computed as follows: (assume PV of ordinary annuity of P1 @12%, n= 10) Press 1.12, now press the division sign [+] twice, next press the equal sign 10 times (equal to ‘n’ of 10), next press minus [=] 1, press equal sign [=]. Lastly, divide [+] the resulting amount by the interest rate of 12%. Press equal sign. Disregard the negative sign by pressing [+/-}. You should come Up with §.65022302858, : qo caleulator does not have a [+/-] key, you may disregard the negative sign only on your mind, o@ Case #2: Present value ofan annuity due It the first installment is due immediately today, how much is the Initial carrying amount of the noninterest-bearing note? Scanned with CamScanner| 246 Chapters The PV of an annuity due should be used because the fig installment is due immediately. : PV of an annuity due of P1 = {[1-(1+i)©?] +i) +1 PV of an annuity due of Pl = {{1 - (1 + 12%)°] + 12%} +1 PV of an annuity due of P1 = 6.32825 Present value of note = (1,000 x 6.32825) = 6,328.25 The entry to record the note is as follows: Date | Note receivable 10,000 Revenue 6,328.35, Unearned interest income (10,000 - 6,328.25) 3,671.75 The entry to record the first installment that is due immediately is as follows: Date | Cash 1,000 Note receivable 1,000 The carrying amount of the note immediately after the receipt of the first installment is P5,328.25 (10,000 - 3,671.5 unearned interest — 1,000 first installment). Alternatively, the present value of,a note with an installment due immediately may be computed by using the formula for the pve an ordinary annuity but by reducing the “n” by 1 period and adding the amount of the first installment to the PV of note. This illustrated below: PV of an ordinary annuity of P1 = PV of an ordinary annuity of P1 = [1 - (1+ 12%) 9}/ 12% 5.32825 PV of note after the first installment made in advance (1,000 x 5.32825) Add back: First installment PV of note before the advance installment Scanned with CamScannerNotes Receivable oar The first installment is not discounted because it is due immediately; therefore, its “n’ (period) is zero. The present value of 1 with an “n” of zero is equal to 1 (e.g, ‘PV of P1 @12%, n=0' is equal to 1). Therefore, P1,000 multiplied by 1 is still P1,000. Using a non-scientific calculator, the PV of an annuity due of Pl may be computed as follows: (assume PV of an annuity due of P1 @12%, n= 10) Press 1.12, now press the division sign [+] twice, next press the equal sign E] 9 times (equal to ‘n’ of 10 minus 1), next press minus [-] 1, press equal sign [=]. Divide [=] the resulting amount by the interest rate of 12%. Press equal sign. Disregard the negative sign by pressing [+/-]. Add [+] 1. You should come up with 6.328249792. *if your calculator does not have a [+/-] key, you just imagine that the amount is not negative. &@ Accordingly, you will deduct 1 instead of adding 1. £2 Remember the following: Time value of money factor Application > Present value of P1 v Future cash flow is in lump sum. > Present value of an ordinary |“ Future cash flows are in annuity of P1 installments; first installment is not made immediately. > Present value of an annuity |” Future cash flows are in due of P1 installments; first installment is made immediately or in advance. In practice, time value of money factors are frequently used by accountants, bankers, financial analysts and other business professionals. As discussed earlier, time value of money factors may be determined in various ways. However, for proper documentation and to facilitate the Teview of audit working papers, auditors are normally required to document how they arrive at certain value factors. These are Scanned with CamScannerdocumented in the audit working papers, normally in electronj, form or spreadsheets (e.g, Microsoft Office Excel®). Subsequent measurement Receivables initially measured at face amount are subsequently measured at recoverable historical cost (or net realizable value), Recoverable historical cost (net realizable value) represents the amount of cash expected to be recovered from the principal amount of the receivable. It is computed as the face amount of the receivable minus subsequent repayments of principal and minus any reduction (directly or through the use of an allowance account) for impairment or uncollectability. Receivables initially measured at present value are subsequently 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 |oss allowance.” (PFRS 9.Appendix A) ‘The amortized cost of a receivable is determined using the effective interest method. _ Effective interest method is a method ‘of calculating tt amortized cost of a financial asset or a financial liability and allocating the interest income or interest expense over the relevant period. {2 Summary: Initial & subsequent measurement of receivables Type of receivable | Initial measurement | . Subsequent measuremet i Shor lerm Fair value plus | If the initial eee oe transaction costs. measurement is: i trade receivables > Fair value is a. face amount, th _ equal to: Scanned with CamScannerNotes Receivable 249 ollectible within one year) a. face amount; or b. present value (if the transaction: contains a significant financing component); OF c. transaction price w/ allowed practical expedient (for trade receivables). subsequent measurement is recoverable historical cost. b. present value, the subsequent measurement is amortized cost. c. transaction price, the measurement is subsequently updated using the principles of PFRS 15. 2. Long-term Fair value plus > Recoverable |___interest rate) the receivable. receivables transaction costs. historical cost bearing > Fair value is reasonable equal to face interest rate amount. 3. Long-term Fair value plus > Amortized cost noninterest- transaction costs. bearing > Fair value is receivables equal to present value of future cash flows from the receivable. 4. Long-term Fair value plus > Amortized cost receivables transaction costs. bearing > Fair value is unreasonable equal to present interest rate value of future (below-market cash flows from Scanned with CamScanner ‘If the initial measurement is cash price equivalent of the non-cash asset given up, the subsequent measurement is amortized cost.250 Shap ters Illustration 1: Simple interest On April 1, 20x1, ABC Co. received a P1,500,000, 10%, 3-year ny, receivable in exchange for land with carrying amount of P 850,09 Principal, in three equal installments, plus interest are diy annually starting April 1, 20x2. Current market rates as of Aprily 20x1, December 31, 20x1, and December 31, 20x2 are 10%, 12% and 13%, respectively. ‘Analysis: v Type of receivable: Long-term receivable bearing reasonable interest | rate — nominal rate of 10% is equal to the current rate on initial recognition of 10%. v Initial measurement: Face amount Subsequent measurement: Recoverable historical cost | ¥ Type of interest: Simple interest — interest is computed based only | on the outstanding principal balance es The entries relating to the note receivable are as follows: April | Notes receivable 1,500,000 Pn Land 850,000 Gain on sale 650,000 to record the sale of land Dec. | Interest receivable (15M x 10% x 9/12) 112,500 ont Interest income 112,500 + to record the accrued interest for 20x1 April | Cash (principal plus interest) 650,000 aa Notes receivable (1,500,000 + 3) 500,000 Interest income (1.5Mx 10% x 3/12) 37,500 Interest receivable 112,500 to record the receipt of 1% installment on note receivable Pe. Interest receivable [(1.5M-5M)x10%x 9/12)] 75,000 a 20:2 | ' Interest income 5 to record the accrued interest for 20x2 oo Cash (principal plus interest) 600,000 oo) 2a Notes receivable a Interest income (1M x 10% x 3/12) B Scanned with CamScannerNotes Receivable 251 Interest receivable P00 to record the receipt of 2nd installment on note receivable Interest receivable 37,500 [(.5M - 5M - 5M) x 10% x 9/12] Interest income 37,500 to record the accrued interest for 20x3 Cash (principal plus interest) 550,000 Notes receivable 500,000 Interest income (5M x 10% x 3/12) 12,500 Interest receivable 37,500 to record the receipt of last installment on note receivable Observe the following: ; © The note receivable is not discounted to its present value because it bears a reasonable interest rate, ie., the stated rate of 10% is equal to the April 1, 20x1 current rate of 10%. © Under simple interest, interest is computed only on the outstanding principal balance. @ Changes in current market rates after April 1, 20x1 are ignored. © Initially and subsequently, the note réceivable is measured at face amount. However, if the recoverable amount falls below face amount, impairment loss should be recognized. This is needed to bring the carrying amount of the note equal to its recoverable historical cost. Impairment is discussed in the next chapter. llustration 2: Compounded interest On January 1, 20x1, ABC Co. extended a P1,000,000 loan to one of its officers. The note received is due on January 1, 20x4 and bears 10% interest compounded annually. Scanned with CamScanner252 Chapters Y ‘Type of receivable: Long-term receivable bearing reasonable int, rate ~ nominal rate of 10% is assumed equal to the current flee initial recognition because no additional information is given, a ¥ Initial measurement: Face amount ¥ Subsequent measurement: Recoverable historical cost V_ Type of interest: Compounded interest ~ interest is computed basey on both principal and accrued interest balances. The entries relating to the note receivable are as follows: Jan. | Note receivable 1,000,000 y Cash 1,000,009 a to record the loan Dec. | Interest receivable (1M x 10%) 100,000 eu Interest income 100,000 ood to record the accrued interest income for 20x1 Dec. | Interest receivable (1M + 100K) x 10% 110,00 a Interest income “| 110,000 to record the accrued interest income for 20x2 Dec. | Interest receivable (1M+100K+110K)x10% 121,000 july | __ Interest income 121,00 S to record the accrued interest income for 20x3 Jan. | Cash (1M + 100K + 110K + 121K) 1,331,000 aig | Note receivable 1,000.00 Interest receivable(100K+110K+121K) 331,000 to record the collection of the loan together with accrued interests Observe the following: ® Under compound interest, interest is computed on both ue principal and any existing interest receivable. P @ All throughout the life of the note, the interest element * recognized separately as interest receivable. Illustration 3: Noninterest-bearing note — Jump sum et On January 1, 20x1, ABC Co. sold a transportation equiP™ with a historical cost of P2,000,000 and accumulated depred*™ of P700,000 in exchange for cash of P100,000 and a nonin! i Scanned with CamScannerNotes Receivable 253 bearing note receivable of P1,000,000 due on January 1, 20x4. The prevailing rate of interest for this type of note is 12%. “Analysis: Y_ Type of receivable: Long-term noninterest-bearing receivable Y Initial measurement: Present value Y Present value factor: “PV of P1” because the note is collectible on alump sum basis. ~ ¥ Subsequent measurement: Amortized cost using the effective interest method. The present value of the note on January 1, 20x1 is computed as follows: Future cash flow (face amount) 1,000,000 Multiply by: PV of P1@12%,n=3 0.711780 Present value of note receivable 711,780 The rate used in the present value factor is the effective interest rate on initial recognition. The “n” of 3 covers the period Jan. 1, 20x1 to Jan. 1, 20x4. + u 3 times. ‘Altemative solution on a non-scientific calculator: 1.12 Multiply by lump sum cash flow of 1,000,000 [=] 711,780 The difference between the face amount and the present value of the note represents the unearned interest income. The unamortized balance of the unearned interest income is a valuation accourit (deduction) to the note receivable when determining its carrying amount. Note receivable 1,000,000 Unearned interest income (1M - 711,780) (288,220) Carrying amount of note receivable - Jan. 1, 20x1 711,780 The note receivable is initially recorded as follows: Scanned with CamScanner254 100,000 | Cash 1, | Notes receivable 1,000,000 20x1 | Accumulated depreciation 700,000 Loss on sale of equipment (squeeze) 488,220 Transportation equipment 2,000.09 Unearned interest income 288,299 ‘An amortization table is prepared to serve as basis fo subsequent journal entries. Amortization table — lump sum: Date _| Interest income | Uncarned interest a=cx effective _|__interest rate Jan. 1, 20x1_| Dec. Dec. 31, 20x2 Dec. 31, 20x3 Present value b= prev. bal. - a c= prev. bal.+a _711,780 107,143 1,000,000 ev Observe the following: @ Under the effective interest method, interest income is computed by multiplying the present value of the note by the effective interest rate. & Periodic interests are added (amortized) to the present value of the note in order to make the present value of the note equal to the face amount at maturity date. = At any given point of time, the sum of unearned interest income and present value equals the face amount, eg. (28520" 711,780 = 1M), (202,806 + 797,194 = IM), etc. © Unearned interest income is decreased as interests are earned: At maturity date, its balance is zero becatise, as of this point all interests have already been earned. @ For a non-interest bearing note, the initial amount of # interest income represents the total interest income ' recognized over the life of the note, e.g,, [(total interest income: 854 95,663 + 107,143) = 288,220 initial balance of unearned interest income]. near ae Scanned with CamScannerNotes Receivable a 5 _ Notes Receloatte _ he other entries relating to the note receivable are as follows: ‘ec. 31, | Unearned interest income 85,414 20x1 Interest income 85,414 to record the accrued interest income for the period De. 31, | Unearned interest income 95,663 nas? Interest income 95,663 Dec. 31, | Unearned interest income 107,143 2083 Interest income 107,143 J.1, | Cash 1,000,000 ad Note receivable . 1,000,000 to record the settlement of the note The carrying amount of the note receivable is disclosed in the notes to financial statements as follows: Jan. 1, 20x1__Dec. 31, 20x1_Dec. 31, 20x2 Note receivable 7,000,000 1,000,000 —1,000,000 Unearned interest income (288,220) __(202,806) (107,143) Carrying amount 711,780 797,194 892,857 Notice that the carrying amounts are equal to the present values on the amortization table above. Alternative solution: Determine the carrying amount of the note on December 31, 20x1 and on December 31, 20x2. > Press 711,780, the PV of note on Jan. 1, 20x1 . Multiply the amount by 1.12 (100% + 12%). You should get 797,194, the carrying amount on December 31, 20x1. . . > Multiply again by 1.12. You should get 892,857, the carrying amount on December 31, 20x2. (Amounts are rounded-off) Mlustration 4; Noninterest-bearing note — installments On January 1, 20x1, ABC Co. sold transportation equipment with a historical cost of 2,000,000 and accumulated depreciation of °700,000 in exchange for cash of P100,000 and a noninterest- bearing note receivable of P1,000,000 due in 4 equal annual stems starting on December 31, 20x1 and every December seater, The prevailing rate of interest for this type of note is Scanned with CamScanner256 Chapters Analysis: Y Type of receivable: Long-term: noninterest-bearing receivable Y Initial measurement: Present value Y Present value factor: “PV of ordinary annuity of P1” because the note is collectible in installments and the first installment is dye after one period from initial recognition. Y Subsequent measurement: Amortized cost using the effective intereg method. The present value of the note as of January 1, 20x1 is computed as follows: Future cash flows — annual installments (1M + 4) 250,000 Multiply by: PV of an ordinary annuity of P1 @12%, n=-4 3.037349 Present value of note receivable 759,337 The rate used in the present value factor is the effective interest rate on initial recognition. The “n” of 4 is the number of installment collections. Altemative solution on a non-scientific calculator: 1.12 [+][=] [=] 4 times, then] 1 ][-}12% [E], then disregard negative sign. Multiply by 250,000 annual cash flow | =| 759,337. The difference between the face amount and the present value of the note represents ‘the unearned interest income. The unamortized balance of the unearned interest income is a valuatiot account (deduction) to the note receivable when determining i carrying amount. Note receivable 1,000,000 Unearned interest income (1M -759,337) 240,663) Carrying amount of note receivable - Jan, 1, 20x1 75935 L The note receivable is initially recorded as follows: Scanned with CamScannerNotes Receivable as Jan, | Cash 100,000 20x1_| Note receivable 1,000,000 Accumulated depreciation 700,000 Loss on sale of equipment (squeeze) 440,663 Transportation equipment 2,000,000 Unearned interest income 240,663 An amortization table is prepared to serve as basis for subsequent journal entries: Amortization table — installment: | Interest Collections | income | Amortization | Present value b= dx effective interest rate a 11/20x1_| 12/31/20x1 | _ 250,000 /A58 12/31/20x2 | 250,000 | 72,055 | 177,985 | 422,513 12/31/20x3 | _ 250,000 199,298 | __223,214 12/31/20x4 | 250,000 223,214 ev Observe the following: ® Under the effective interest method, interest income is computed by multiplying the present value of the note by the effective interest rate. © Collection minus interest income equals the amortization of the principal component (i.e., portion of collection applicable to principal component). The amortization is deducted from the present value because the note is collectible in installments. + The present value is reduced to zero at maturity date because, as of this point, the note receivable has already been collected in full. ® Fora non-interest bearing note, the initial amount of unearned interest income represents the total interest income to be recognized over the life of the note, e,, {(total interest income: 91,120 + 72,055 + 50,702 + 26,786) = 240,663 initial balance of unearned interest income]. Scanned with CamScanner258 a The other entries relating to the note receivable are as follows. Using simple entries: (Dec. 31, 20x1) Dec. | Cash 250,000 31, Note receivable 250m 20x1 to record the collection on the note | Dec. | Unearned interest income 91,120 : 31, Interest income 91,1 20x1 to record the accrued interest income {for the period Using compound entries: (Dec. 31, 20x2 to 20x4) Dec. 31, | Cash 250,000 202) Unearned interest income 72,055 Note receivable 250,000 Interest income 72,055 to record the collection on the note ____| and the accrued interest income for the period Dec.31, | Cash 250,000 75 | Unearned interest income 50,702 Note receivable 250,000 Interest income 50,702 Dec.31, | Cash 250,000 704" | Unearned interest income 26,786 Note receivable 250,000 Interest income 26,786, Current:and noncurrent portions of a note receivable From the amortization table above, the carrying amount of the note receivable on December 31, 20x1 is P600,458. Since collections on the principal are due periodically, this carrying amou™ includes both current and noncurrent portions. These portions should be determined and disclosed separately in the finan“ statements. ; ie To determine the: current and noncurrent: portions “ simply refer to the amortization table. The current portion is amortization in the immediately following year. This 1 Scanned with CamScanner_—_ Notes. Receivable asp ortion of the next year’s collection applied to the principal. The noncurrent portion is the present value in the immediately following yeat. The amortization table is re-provided below: | Interest Amortization | Present value Date | Collections | income | | bedx interest rate 1/1/20x1 | a | effective | c=a-b d= prev. bal.—c | | 91,120 | 055 | 50,702__| “12/31/20x1 250,000 | 158,880 | 600,458 _| | | 199,298 | 7 223,214 223,214 250,000 250,000 This is the current portion of the note on Dec. 31, 20x1. 12/31/20x3 12/31/20x4 | | This is the noncurrent portion of the note on Dec. 31, 20x1 The sum of the current and noncurrent portions is equal to the carrying amount as of December 31, 20x1. Current portion of notes receivable 177,945 Noncurrent portion of notes receivable 422,513 Carrying amount of notes receivable - Dec. 31, 20x1 600,458 Unamortized balance of unearned interest income The unamortized balance of unearned interest income is derived by deducting the present value from the outstanding face amount. The balance of the unamortized unearned interest income as of December 31, 20x1 is computed as follows: Outstanding face amount (IM - 250K first installment) 750,000 Carrying amount of notes receivable - Det. 31, 20x1 600,458 Unearned interest income - Dec. 31, 20x1 149,542 Scanned with CamScanner260 Chapters When disclosing in the financial statements, the unearneg interest income is allocated to both the current and noncurren; portions of the notes receivable. This is done by deducting the present value of the portion from the related future cash collections. The breakdown of the notes receivable is disclosed in the December 31, 20x1 notes to financial statements as follows: Current portion of notes receivable: Notes receivable * P 250,000 Unearned interest » (72,055) Notes receivable, net (presented in current assets) 17,945 Noncurrent portion of notes receivable: Notes receivable « 500,000 Unearned interest 4 (77,487) Notes receivable - net (presented in noncurrent assets) 422,513 Total notes receivable, net - Dec. 31, 20x1 P 600,458 *This pertains to the annual cash flow to be collected in 20x2. » (250,000 cash flow — 177,945 current portion). ©This pertains to the annual cash flows to be collected in 20x3 and 20x4 (250,000 x2= 500,000). 4 (500,000 cash flow - 422,513 noncurrent portion). Altermative solution: Determine the carrying amount of the note on December 31, 20x1 and on December 31, 20x2. Press 759,337, the PV of the note on Jan. 1, 20x1. Save to “memory” (¢9 wa] ,'M-in', or equivalent). Multiply by 12%. The resulting. amount 91,120.44 represents the interest income for 20x1. Deduct this amount from the collection of 250,000 (e.g., press [+/- ] then + 250,000). The resuting amount of 158,879.56 represents the amortization of the principal compen in 20x1. Deduct this amount from the amount saved in the memory (¢.9» 1 ). Press ‘memory recall” (e.g., MRC] .M, or equivalent). You should 600,458, the carrying amount of the note on December 31, 20x1. Now multiply that amount by 12%. The resulting amount of 72,054.88 represents the interest income for 20x2. Repeat the rest of the PreV",, steps. You should get 422,512, the carrying amount of the note December 31, 20x2. (Amounts are rounded-off) Scanned with CamScannerNotes Receivable oe ote: yOu are not getting any of the illustrated shortcuts, don’t despair. The shortcuts are tot important. 4@ Before we move on, I strongly urge you to recall and memorize the preparation of the two amortization tables that we have discussed. We will be using these tables repeatedly in the succeeding sections of this book and in the other books of Intermediate Accounting and Advanced Accounting. 4, Amortization table for a lump sum cash flow Interest income | Unearned interest | Present value | a=cx effective : interest rate | B= prev. bal. -a c= prev. bal. + a Interest Date Collections | income | Amortization Present value b=d xefective | interest rate cra-b- | d=prev.bal.-c Sn Illustration 5: Noninterest-bearing note - installment in advance : On January 1, 20x1, ABC Co. sold transportation equipment with a historical cost of P2,000,000 and accumulated depreciation of P700,000 in exchange for cash of P100,000 and a noninterest- bearing note receivable of P1,000,000 due in 4 equal annual installments starting on January 1, 20x1 and every January 1 thereafter. The prevailing rate of interest for this type of note is 12%, Analysis: Y Type of receivable: Long-term rioninterest-bearing receivable ¥” Initial measurement: Present value Y Present value factor: “PV of an annuity due of P1” because the note is collectible in installments and the first installment is due immediately. Subsequent measurement: Amortiz method. ed cost using the effective interest Scanned with CamScanneri oxy The present value of the note on January 1, 20x1 is computed a. | follows: | Future cash flows - annual installments (1M +4) 250,000 Multiply by: PV of an annuity due of P1 @12%, n=-4 —— 3.40183 | Present value of note receivable —_——sst Alternative solution on a nor scientific calculator: 1.12|*}|+} |=] 3 times (i.e., n minus 1), then |- =][+]12% [=], disregard the negative sign then increase the value by 1. Mai by 250,000 annual cash flow [=] 850,458, The entries on January 1, 20x1 are as follows: Jan. 1, | Cash 100,000 201 | Note receivable 1,000,000 Accumulated depreciation 700,000 Loss on sale of equipment (squeeze) 349,542 Transportation equipment 2,000,000 Unearned interest income * 149,542 to record the sale of equipment Jan, i Cash 250,000 am Note receivable 250,000 to record the first installment due in advance 4 (1,000,000 face amount less 850,458 present value) Amortization table — installment in advance Interest Date Collections | income | Amortization | Present valvt bedx a effective cea-b d= prev. bal.-f interest rate 850,458. eS 250,000 600,458 72,055 177,945 422,513 |_Jan. 1, 20x3 Jan. 1, 20x4 50,702 199,298 26,786 223,214 Scanned with CamScannerNotes Receivable 263 _ No interest income is recognized on the first installment pecause there is no passage of time yet. Interest is earned only when there is a passage of time. The entries on December 31, 20x1 and January 1, 20x2 are as follows: Dec. | Unearned interest 72,055 31, Interest income 72,055 20x1 to record the accrued interest income for 20x1 yan, | Cash 250,000 202 | Note receivable 250,000 to record the 2"4 installment collection. The interest income of ®72,055 shown on the ‘Jan. 1, 20x2’ row in the amortization table above is the interest income for 20x1 because it is during this period that the interest has been earned. The amortization table above shows carrying amounts as of January 1 of each of the subsequent years. These carrying amounts are net of the January 1 collections. To compute for the carrying amount of the notes receivable as of December 31, the * amount of collection on the following day (i.e., January 1 of next year) is simply added back to the January 1 present value. The carrying amount of the notes receivable as of December 31, 20x1 is determined as follows: Carrying amount of notes receivable - Jan. 1, 20x2 422,513 Add back: Collection on Jan. 1, 20x2 250,000 Carrying amount of notes receivable - Dec. 31, 20x1 672,513 Stematve ‘solution: Determine the carrying amount of the note on Dec. 31, x1, Press 850,458, the PV of the note on Jan. 1, 20x1. Save to ‘memory’ (e.g., ‘Mil Min, or equivalent). Deduct from memory the 250,000 advance Nstallment (e.g., [M-] )- Press “memory recall” (e.9., [MRC], M, or equivalent). i e Tesulting amount of 600,458 is the carrying amount of the note immediately after the receipt of the first installment. . Scanned with CamScanner264 Shape g 26h Si [Next, multiply by 12%. The resulting amount of 72,054.96 represen interest income for 20x1. Deduct this amount from the second coli 250,000 (e.g., press [+/-] then + 250,000) Deduct the resulting ay 177,945.04 from memory (e.g., M-] ). Press “memory recall” (e.g, | or equivalent). You should get 422,512.96, the carrying amount of the Tote gg January 1, 20x2. Add back the Jan. 1, 20x2 collection of 250,000, Yo, should get 672,512.96, the carrying amount of the note of on December a, 20x1. ’ lection | punto | | Ilustration 6: Noninterest-bearing note - semiannual cag, flows On January 1, 20x1, ABC Co. sold machinery with historical cos, of P2,000,000 and accumulated depreciation of P1,100,000 in exchange for a 3-year, P1,200,000 noninterest-bearing note receivable due in equal semi-annual payments every July 1 and December 31 starting on July 1, 20x1. The prevailing rate of interest for this type of note is 10%. | Discounting semiannual cash flows When discounting cash flows that are due in semiannual installments, the “n" (period) used in the present value factor is multiplied by 2 because there are two semiannual installments pet year. Furthermore, the effective interest rate is divided by 2) because interest rates are normally expressed on a per annum) basis. J When cash flows are due quarterly, “n” is multiplied by 4 and the interest rate is divided by 4 because there are 4 quarters in a year. When cSt flows are due monthly, “n” is multiplied by 12 and the rate is divided by because there are 12 months in a year. When cash flows are due weekly, “# is multiplied by 52 and the rate is divided by 52. When cash flows are daily, “n” is multiplied by 365 and the rate is divided by 365. When flows are due per minute....oh well, you get what I mean....whew! (panti® Therefore, the “n” to be used in the illustration above is6 years (i.e., 3 years x 2) and the discount rate is 5% (i.e., 10% * oF y The present value of the note as of January 1, 20 computed as follows: ‘ Scanned with CamScanner