ACCOUNTING FOR THE DISCOUNTING OF PROMISSORY NOTES

DISCOUNTING OF NOTES RECEIVABLE

When a note is negotiable, the payee may obtain cash before maturity date at a bank or
other financing company. This is called discounting of notes receivable. It is a convenient
way for a business or individual to cash in on a note at any time before maturity. To
discount the note, the payee must endorse it. The payee then becomes the endorser; the
bank or other financing company becomes the endorsee.

When a note is discounted, the original payee receives the proceeds of the discounted
note. The bank – new payee – will receive the maturity value of the note at maturity. To
receive cash on the note before maturity, the seller is willing to accept a significantly
discounted price.

Notes are generally discounted with recourse. This means that the entity discounting
the note guarantees payment if the maker of the note defaults or dishonors payment.

Entry for Notes Discounted with recourse (if the problem is silent):

Cash xxx
Notes Receivable Discounted xxx

Entry for Notes Discounted without recourse:

Cash xxx
Notes Receivable xxx

Terms Related to Discounting

* Net Proceeds – refer to the discounted value of the note received by the endorser from
the endorsee. It is computed as follows:

Net proceeds (NP) = Maturity Value minus Discount (MV – D)

* Discount – amount of interest deducted by the bank in advance

Discount (D) = Maturity Value x Discount Rate x Discount Period

(MV x DR x DP)

* Discount Rate – rate used by the bank in computing the discount. If no discount rate
is given, it is safe to assume that it is equal to the interest rate

* Discount Period- period of time from date of discounting to maturity date. Simply
computed, discount period equals term of note minus expired portion up to the date of
discounting. It is the unexpired term of the note

Steps in Discounting Notes Receivable

1. Determine the Maturity Value (MV) of the note

2. Determine the Discount Period (DP)
3. Compute the Discount (D)
4. Determine for the Net Proceeds (NP)
5. Compute for the Carrying Amount of the note (Principal + Accrued Interest)
6. Determine whether there is Gain or Loss on Discounting
(gain if NP > CA, loss if NP < CA)
7. Record all the activities related to the notes
Proforma entries for Net Proceeds

If Net Proceeds are less than the face value plus accrued interest (interest earned from
date of note to date of discounting) or the carrying amount, there is a loss on discounting
of notes

Cash xxx
Loss on Note Receivable Discounting xxx
Notes Receivable Discounted xxx
Interest Income xxx

To simplify, the loss on discounting of note may be offset against the interest income.
Hence,

Cash xxx
Notes Receivable Discounted xxx
Interest Income xxx

If Net Proceeds are greater than the face value plus accrued interest (interest earned
from date of note to date of discounting), or the carrying amount, there is a gain on
discounting of notes

Cash xxx
Notes Receivable Discounted xxx
Interest Receivable Income xxx
Gain on Note Receivable Discounting xxx

Again, to simplify, the gain on discounting of note may be added to the interest income.
Hence,

Cash xxx
Notes Receivable Discounted xxx
Interest Income xxx

The Note Receivable Discounted account is deducted from the Total Notes Receivable
when preparing the Statement of Financial Position with disclosure of the contingent
liability.

Illustrative Example

On July 1, 2020, Gerard Garments Store received a P150,000 note for 5 months at 12%
simple interest from Rya Cross-Stitch to replace its accounts receivable. After 3 months,
Gerard needed cash so it discounted the note at Banco de Niña at a discount rate of 14%.

* Step 1 – Determine Maturity Value (MV)

MV = Principal plus Interest (P + I)
MV = P150,000 + (P150,000 x 12% x 5/12)
MV = P150000 + P7,500
MV = P157,500
* Step 2 – Determine the Discount Period (DP)
The unexpired term of the note is the discount period. The discount period in the
example is 2 months – 5 months less 3 months that had lapsed
* Step 3 – Compute the Discount (D)

D = Maturity Value x Discount Rate x Discount Period

D = P157,500 x 14% x 2/12
D = P3,675

* Step 4 –Determine the Net Proceeds (NP)

NP = Maturity Value minus Discount (MV – D)

NP = P157,500 – P3,675
NP = P153,825

* Step 5 –Determine the carrying amount (CA)

CA =Principal plus Accrued Interest (P + AI)

CA =P150,000 + (P150,000 x 12% x 3/12)
CA =P150,000 + P4,500
CA =P154,500

* Step 6 – Determine whether there is Gain or Loss on Discounting

Carrying Value of the Note = P154,500

Less: Net Proceeds 153,825)
Loss on Discounting P 675**

** There is loss on discounting because Net Proceeds is less than the Carrying Amount.

* Step 7 – Record all the activities related to the Note

Jul 1 Notes Receivable P150,000

Accounts Receivable P150,000

Oct 1 Cash 153,825

Loss on Note Receivable Discounting 675
Notes Receivable Discounted** 150,000
Interest Income 4,500
or
Cash 153,825
Notes Receivable Discounted 150,000
Interest Income*** 3,825

Dec 1 Notes Receivable Discounted 150,000

Notes Receivable 150,000

If note is dishonored by maker:

Accounts Receivable 157,500

Cash 157,500

Notes Receivable Discounted 150,000

Notes Receivable 150,000

** The credit to Notes Receivable Discounted account means that the note was discounted
with recourse.
***Interest Income is net of the Loss on Note Receivable Discounting (P4,500-P675.)
BORROWING FROM A BANK OR FINANCING COMPANY

To obtain more resources for business operations, a company may borrow money from
the bank or other financial institutions. An interest-bearing note is usually issued by the
borrower.

Entry to record issuance of note to borrow money:

Cash xxx
Notes Payable xxx

Entry to record payment of notes:

Notes Payable xxx

Interest Expense xxx
Cash xxx

DISCOUNTING OWN NOTE

In the previous discussion, the maker of the note discounted is a customer; the party
discounting is the payee and a mere endorser and therefore only a person secondarily
liable. Where the note discounted is made by the party discounting, a primary liability
exists. In effect, the party discounting is entering into a contract of loan with the endorsee.

In discounting of notes payable, a business makes its own note and discounts the same
to a financial institution.

Illustrative Example

ABC Company discounted at the bank its own note of P500,000 at 12% for one year on
September 1, 2020. The entry to record the discounting is as follows:

Cash P440,000
Prepaid Interest 60,000
Notes Payable – Bank P500,000

Computation:
Face Value of the Note P500,000
Less: Discount (500,000 x 12%) (60,000)
Net Proceeds P440,000

On December 31, 2020, the Prepaid Interest is amortized as interest expense for 4
months (September to December) as follows:

Interest Expense (60,000 x 4/12) P20,000

Prepaid Interest P20,000