INTERMEDIATE ACCOUNTING 1

Brief Discussion on Notes Receivable and Other Receivable Concepts

CHAPTER 5: NOTES RECEIVABLE

Definition
Notes receivable are claims supported by formal promises to pay usually in the form of notes. A negotiable
promissory note is an unconditional promise in writing made by one person to another, signed by the maker,
engaging to pay on demand or at a fixed determinable future time a sum certain in money to order or to bearer.
Simply stated, a promissory note is a written contract in which one person, known as the maker, promises to
pay another person, known as the payee, a definite sum of money. The note may be payable on demand or at
a definite future date.
Standing alone, the term notes receivable only represents claims arising from sale of merchandise or service in
the ordinary course of business. Thus, notes received from officers, employees, shareholders, and affiliates shall
be designated separately.
Dishonored notes
When a note matures and is not paid, it is said to be dishonored. Theoretically, dishonored notes receivable
should be removed from the notes receivable account and transferred to accounts receivable. The amount
debited to accounts receivable should include the face amount, interest and other charges. Such approach is
defended on the ground that the overdue note has lost part of its status as a negotiable instrument and really
represents only an ordinary claim against the maker.
Initial measurement of notes receivable
Conceptually, notes receivable shall be measured initially at present value. The present value is the sum of all
future cash flows discounted using the prevailing market rate of interest for similar notes. The prevailing
market rate of interest is actually the effective interest rate. However, short-term notes receivable shall be
measured at face value. Cash flows relating to short-term notes receivable are not discounted because the effect
of discounting is usually immaterial.
Illustration
Assume the following transactions have been completed by ABC Corporation during a certain year:

Aug-05 Received a 60-day, 9%, P12,000 promissory note from X Company for merchandise sold.

Oct-04 Collected from X Company in settlement of its note dated August 05.

Oct-10 Received a 30-day, 12%, P16,000 promissory note from Y Company in settlement of an overdue
account.
Nov-06 Received a 120-day, 12%, P24,000 promissory note from Z Company in settlement of an account.

Nov-10 Y Company dishonored its note on maturity date.

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 Nov-30 Collected the amount due from Y Company on account of its overdue note. An additional charge
for interest at 12% on maturity value from maturity date is also collected.
Dec-31 Year-end adjustments are made.

The following are the entries for these transactions:

Aug-05 Notes Receivable 12,000
Sales 12,000

Oct-04 Cash 12,180

Notes Receivable 12,000
Interest Revenue 180
P12,000 x 9% x 60/360

Oct-10 Notes Receivable 16,000

Accounts Receivable 16,000

Nov-06 Notes Receivable 24,000

Accounts Receivable 24,000

Nov-10 Accounts Receivable 16,160

Notes Receivable 16,000
Interest Revenue 160
P16,000 x 12% x 30/360

Nov-30 Cash 16,273.12

Accounts Receivable 16,160
Interest Revenue 113.12
P16,160 x 12% x 21/360

Dec-31 Interest Receivable 440

Interest Revenue 440
P24,000 x 12% x 55/360

Interest-bearing notes receivable

The initial measurement of long-term notes will depend on whether the notes are interest-bearing or
noninterest-bearing.
Interest-bearing long-term notes are measured at face value which is actually the present value upon issuance.
Noninterest-bearing notes receivable
Noninterest-bearing long-term notes are measured at present value which is the discounted value of the future
cash flows using the effective interest rate. However, a noninterest bearing note does not necessarily mean that
there is no interest accruing on the receivable. The note is simply written in a form where the face value already
includes an imputed interest for the term of the note.

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When a noninterest bearing note is exchanged solely for cash and no other rights or privileges are exchanged,
the present value, or amortized cost of the note on the date it is received, is equal to the cash proceeds
exchanged. If a noninterest bearing note is exchanged for property, goods, or services, the present value of
the note on the date it is received is the fair market value of the property, goods, or services, or the fair market
value of the note, whichever is more clearly determinable. Otherwise, an imputed rate is used to determine its
present value.
Subsequent measurement
Subsequent to initial recognition, long-term notes receivable shall be measured at amortized cost using the
effective interest method. The amortized cost is the amount at which the note receivable is measured initially:
a. Minus principal repayment
b. Plus or minus cumulative amortization of any difference between the initial carrying amount and the
principal maturity amount
c. Minus reduction for impairment or uncollectability
For long-term noninterest-bearing notes receivable, the amortized cost is the present value plus
amortization of the discount, or the face value minus the unamortized unearned interest income.
Accordingly, only long-term notes receivable, both interest bearing and noninterest bearing, will be
discussed in conjunction with the concept of present value.
Present value concept
Present value is the concept that states an amount of money today is worth more than the same amount in the
future. In other words, money received in the future is not worth as much as an equal amount received today.
Receiving P1,000 today is worth more than P1,000 five years from now. The reason is that two factors impact
whether an amount today is worth more than the same amount in the future.
a. Interest Rate (or Rate of Return). An investor can put up his P1,000 today and presumably earn a rate
of return over the next five years. Present value considers any interest rate an investment might earn. If
this investment earns 5% rate of return per year, the P1,000 today is certainly worth more than receiving
P1,000 five years from now.
b. Inflation and Purchasing Power. Inflation is the process in which prices of goods and services rise over
time. If you receive money today, you can buy goods at today’s prices. Presumably, inflation will cause
the price of goods to rise in the future, which would lower the purchasing power of your money.
Types of present value factors

• Present value of 1. This is used when the note receivable is collectible at once (or lump sum). When
using the basic calculator, assume a note collectible at the end of 5 periods and an effective rate of 10%,
the PV of 1 is 0.6209 (i.e., 1 + 10% = 1.10; press the division sign twice then press the equal sign twice as
well. Your calculator should be showing 0.9091; this is the PV of 1 at 10% for 1 period or for the first
year. Thus, you need to press the equal sign four more times to get the PV of 1 at 10% for five periods).
• Present value of an ordinary annuity of 1. This is used when the note receivable is collectible in
installments until it is fully recovered. The first installment is collectible at the end of the first period; the
second installment is collectible at the end of the second period; and so on. Assuming the same case

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 above except that the note is collectible in 5 annual installments, with the first collection done at the
end of the first year, the PV of an ordinary annuity of 1 is 3.7908 (i.e., 1 + 10% = 1.10; press the division
sign twice then press the equal sign twice as well. Your calculator should be showing 0.9091; this is the
PV of 1 at 10% for 1 period or for the first year. Thus, you need to press the equal sign four more times
to get the PV of 1 at 10% for five periods just in the case above. Your calculator now should be showing
0.6209; press the minus button, hit 1, then press the equal button to show -0.3791, press the +/- button
to bring it to its positive form. Divide this by the rate which is 10% then press the equal button).
• Present value of annuity due of 1. This is used when the note receivable is collectible in installments
until it is fully recovered, but unlike the second case above, the first installment here is collected
immediately or at the beginning of the term; that is the date when the note receivable is recorded, and
not at the end of the first period. Assuming the case in the second illustration except that instead of
having the first installment collected by the period-end, the first installment is collected at the beginning
of the term, the PV of annuity due of 1 is 4.1699 (i.e., 1 + 10% = 1.10; press the division sign twice then
press the equal sign twice as well. Your calculator should be showing 0.9091; this is the PV of 1 at 10%
for 1 period or for the first year. Unlike the first and second cases where the equal button has to be
pressed four more times to bring the PV to 5 periods, the equal button here is pressed only three more
times. Hence, in calculating this type of PV, the number of periods should always be lessened by 1. When
you do this, your calculator should be showing 0.68301. Press the minus button, hit 1, then press the
equal button to show -0.3170; press the +/- button to bring it to its positive form. Divide this by the rate
which is 10% then press the equal button. The answer at this point is 3.1699; press addition button then
hit 1).
Illustrations
Interest bearing note
An entity owned a tract of land costing P800,000 and sold the land for P1,000,000. The entity received a 3-year
note for P1,000,000 plus interest of 12% compounded annually.
When interest is compounded, this means that any accrued interest receivable also earns interest.
The selling price of P1,000,000 is reasonably assumed to be the present value of the note because the note is
interest bearing.
Journal entries for the foregoing illustration are the following:
First Year Note Receivable 1,000,000
Land 800,000
Gain on Sale of Land 200,000

Accrued Interest Receivable 120,000

Interest Income 120,000
P1,000,000 X 12%

Second Year Accrued Interest Receivable 134,400

Interest Income 134,000

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 Face Value 1,000,000
Interest Accrued for First Year 120,000
Total 1,120,000
Interest for Second Year (12% X 1,120,000) 134,400

Third Year Cash 1,404,928

Notes Receivable 1,000,000
Accrued Interest Receivable 254,400
Interest Income 150,528

Face Value 1,000,000

Interest Accrued:
First Year 120,000
Second Year 134,400 254,400
Total 1,254,400
Interest for Third Year (12% X 1,254,400) 150,528
Cash Received 1,404,928

Noninterest bearing note with cash sale price

An entity manufactures and sells machinery. On January 01, 2019, the entity sold machinery costing P280,000
for P400,000. The buyer signed a noninterest bearing note for P400,000 in four equal installments every
December 31. The cash sale price of machinery is P350,000.
Face value of note 400,000
Present value - cash sales price 350,000
Unearned interest income 50,000

Jan-01 Notes Receivable 400,000

Sales 350,000
Unearned Interest Income 50,000

Cost of Sales 280,000

Inventory 280,000

Dec-31 Cash 100,000

Notes Receivable 100,000

To record the unearned interest as income over the term of the note:
Dec-31 Cash 20,000
Notes Receivable 200,000

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 Year Note Receivable Fraction Unearned Interest Allocable Interest Income
2019 400,000 4/10 50,000 20,000
2020 300,000 3/10 50,000 15,000
2021 200,000 2/10 50,000 10,000
2022 100,000 1/10 50,000 5,000
1,000,000 50,000

Observations:

• The first installment is received on December 31, 2019. Thus, the note payable outstanding for 2019 is
P400,000 and is decreased by P100,000 each year.
• The fractions are developed from the note receivable balance every year (i.e., 2019 – 400,000/1,000,000
or 4/10; 2020 – 300,000/1,000,000 or 3/10; and so on).
• The fractions developed are multiplied by the total unearned interest of P50,000 to get the yearly
interest income (i.e., 2019 – 4/10 x 50,000 = 20,000; 2020 – 3/10 x 50,000 = 15,000; and so on).
If a statement of financial position is prepared in December 31, 2019, the portion of the note receivable which
is due within 1 year is classified as current asset.

Note receivable-current portion 100,000

Unearned interest income (15,000)
Carrying amount or amortized cost 85,000

Noninterest bearing note present value (installment)

On January 01, 2019, an entity sold an equipment with a cost of P250,000 for P400,000. The buyer paid a down
payment of P100,000 and signed a noninterest bearing note for P300,000 payable in equal annual installment
of P100,000 every December 31. The prevailing rate for a note of this type is 10%.
Since no cash sale price is available to serve as the market value of the note, we need to make use of the effective
rate given to calculate its present value.
Using the PV of an ordinary annuity of 1 at 10% for 3 periods, since the note is payable in installment every
December 31 (end of each period), the PV factor is 2.4869; multiply this by the annual installment of P100,000
to get the note’s PV which is P248,690.
The unearned interest income and gain on sale of equipment are computed as follows:
Face value of note 300,000
Present value of note (100,000 x 2.4869) 248,690
Unearned interest income 51,310
Present value of note 248,690
Cash received-down payment 100,000
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 Sale price 348,690
Cost of equipment 250,000
Gain on sale of equipment 98,690

Journal entries for 2019 are as follows:

To record the sale of equipment:
Cash 100,000
Note Receivable 300,000
Equipment 250,000
Gain on Sale 98,690
Unearned Interest Income 51,310
To record the first installment collection:
Cash 100,000
Note Receivable 100,000
To record the interest income for 2019:
Unearned Interest Income 24,869
Interest Income 24,869

In this case, the computation of the interest income is made using the effective interest method.

Date Annual collection Interest income (10%) Principal Present value

Jan. 01, 2019 - - - 248,690
Dec. 31, 2019 100,000 24,869 75,131 173,559
Dec. 31, 2020 100,000 17,356 82,644 90,915
Dec. 31, 2021 100,000 9,085 90,915 -

Observations:

• The interest income is computed by multiplying the present value by 10%. Thus, for 2019, 10% x
P248,690 equals P24,869.
• The principal payment is equal to annual collection minus interest income. Thus, for 2019, P100,000
minus P24,869 equals P75,131. This means that in every P100,000 installment each year, it is allocated
to interest income (reduction of unearned interest income) and repayment of the principal amount.
• The present value is equal to the preceding balance (balance last date) minus the payment allocable to
the principal amount. Hence, on December 31, 2019, P248,690 (preceding balance) minus P75,131
(payment allocable to principal for 2019 annual installment) equals P173,559.

Noninterest bearing note present value (lump sum)

On January 01, 2019, an entity sold an equipment costing P600,000 with accumulated depreciation of P250,000.
The entity received as consideration P100,000 cash and a P400,000 noninterest bearing note due on January
01, 2022. The prevailing rate of interest for a note of this type is 10%.

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The present value of 1 at 10% for 3 years (lump sum payment) is 0.7513. Thus, this transaction will cause the
following amounts:
Face value of note 400,000
Present value of note (400,000 x 0.7513) 300,520
Unearned interest income 99,480
Present value of note 300,520
Cash received-down payment 100,000
Sale price 400,520
Carrying amount of equipment (600,000 – 250,000) 350,000
Gain on sale of equipment 50,520

The unearned interest income is sometimes described as discount on note receivable.

To record the sale of equipment:
Cash 100,000
Note Receivable 400,000
Accumulated Depreciation 250,000
Equipment 600,000
Gain on Sale 50,520
Unearned Interest Income 99,480

To record the interest income for 2019:

Unearned Interest Income 30,052
Interest Income 30,052

Date Interest income (10%) Unearned interest Present value

Jan. 01, 2019 - 99,480 300,520
Dec. 31, 2019 30,052 69,428 330,572
Dec. 31, 2020 33,057 36,371 363,629
Dec. 31, 2021 36,371 - 400,000

Observations:

• The effective interest method is used.

• The interest income is computed by multiplying the present value by 10%.
• The unearned interest income is arrived at by deducting the interest income from the preceding
unearned interest income balance.
• The present value is arrived at by adding the interest income to the preceding present value balance.
This can also be computed by deducting the balance of unearned interest income from the face value
(i.e., for December 31, 2019, P400,00 minus P69,428 equals P330,572).

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 2020
Dec-31 Unearned Interest Income 33,057
Interest Income 33,057
2020
Dec-31 Unearned Interest Income 36,371
Interest Income 36,371
2022
Jan-01 Cash 400,000
Note Receivable 400,000

CHAPTER 6: RECEIVABLES – ADDITIONAL CONCEPTS

Loan Receivable defined
A loan receivable is a financial asset arising from a loan granted by a bank or other financial institution to a
borrower or client. The term of the loan may be short-term, but in most cases, the repayment periods cover
several years.
Measurement of loan receivable
At initial recognition, an entity shall measure a loan receivable at fair value plus transaction costs that are
directly attributable to the acquisition of financial asset. The fair value of the loan receivable at initial recognition
is normally the transaction price, meaning, the amount of the loan granted. Transaction costs that are directly
attributable to the loan receivable include direct origination costs which are included in the initial measurement
of the loan. However, indirect origination costs should be treated as outright expense.
The loan receivable is measured subsequently at amortized cost using the effective interest method. The
amortized cost is the amount at which the loan receivable is measured initially:
a. Minus principal repayment
b. Plus or minus cumulative amortization of any difference between the initial carrying amount and the
principal maturity amount
c. Minus reduction for impairment or uncollectability
Origination fees
Lending activities usually precede the actual disbursement of funds and generally include efforts to identify and
attract potential borrowers and to originate a loan. The fees charged by the bank against the borrower for the
creation of the loan are known as origination fees.

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Origination fees include compensation for the following activities:
a. Evaluating the borrower’s financial condition
b. Evaluating guarantees, collateral and other security
c. Negotiating the terms of the loan
d. Preparing and processing the documents related to the loan
e. Closing and approving the loan transaction
If the origination fees are received from the borrower, they are recognized as unearned interest income and
amortized over the term of the loan. If they are not chargeable against the borrower, the fees are known as
direct origination costs which are deferred and also amortized over the term of the loan. Preferably, the direct
origination costs are offset directly against any unearned origination fees received. If the origination fees
received exceed the direct origination costs, the difference is unearned interest income subject to amortization
and will increase interest income. If they are less than the direct origination costs, the difference is charged to
direct origination costs subject to amortization and will decrease interest income. Regardless of the scenario,
both the origination fees received and the direct origination costs are included in the measurement of the loan
receivable.
Illustration
Global Bank granted a loan to a borrower on January 01, 2019. The interest on the loan is 12% payable annually
starting December 31, 2019. The loan matures in three years in December 31, 2021.
Principal amount 5,000,000
Origination fees received from borrower 331,800
Direct origination costs incurred 100,000

To compute for the initial carrying amount of the loan:

Principal amount 5,000,000

Origination fees received (331,800)
Direct origination costs incurred 100,000
Initial carrying amount of loan 4,768,200

Journal entries on January 01, 2019:

To record the loan
Loans Receivable 5,000,000
Cash 5,000,000
To record the origination fees received from the borrower:
Cash 331,800
Unearned Interest Income 331,800
To record the direct origination costs incurred by the bank:
Unearned Interest Income 100,000
Cash 100,000

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Thus, the unearned interest income has credit balance of P231,800 to be amortized over the term of the loan
using the effective interest method.
Conceptually, the origination fees received and the direct origination costs affect the effective interest rate. This
is because the unearned interest income should reflect the effective interest rate at the date of the loan. Since
the origination fees received and the direct origination costs adjusted the unearned interest income, the latter
does not reflect the current effective rate anymore. Thus, a new effective interest rate has to be computed.
For the record, the effective interest rate is different from the stated or nominal rate. The stated or nominal
rate is the interest rate reflected on the face of the loan or note. The effective interest rate or market rate, on
the other hand, is the prevailing interest rate for similar instruments in the market. Ideally, these two rates
should be the same at initial recognition. This would cause the carrying amount (or present value) of the loan
(based on the effective rate) to be equivalent with its face value (based on the stated rate). However, normal
situations would reveal that the interest used on loans and the market rates differ. This means that the carrying
amount (or present value) of the loan is not the same with its face value.

Taking these into consideration, the below concept can be drawn:

Carrying amount of the loan is less than the Face value SR < ER Discount

Carrying amount of the loan is greater than the Face value SR > ER Premium

Analysis:

• When the loan’s initial carrying amount is BELOW its face value, it is said to be issued at a DISCOUNT.
This means that the stated rate is LESS THAN the effective interest rate.
• When the loan’s initial carrying amount is ABOVE its face value, it is said to be issued at a PREMIUM.
This means that the stated rate is GREATER THAN the effective interest rate.
Going back to the previous problem, since the carrying amount of the loan, P4,768,200, is below the face
amount of P5,000,000, this means that it has been issued at a discount. Therefore, its stated rate of 12% must
be lower than the effective interest rate. The goal here is to get a present value based on an effective interest
rate (which should be greater than the stated rate) that is equivalent to P4,768,200 by means of trial and error.
Using 13% effective interest rate, the PV of the loan is as follows:

PV of the principal (P5,000,000 x 0.6931) 3,465,500

PV of the interest (P5,000,000 x 12% = P600,000 x 2.3612) 1,416,720
Present value of the loan 4,882,220

A lower effective interest rate results to a higher present value. Stated differently, a higher effective interest rate
results to a lower present value. Hence, the new effective interest rate should be higher than 13% to bring a
lower present value (i.e., P4,768,200 is lower than P4,882,220).

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For simplicity purposes, an interest rate of 14% is determined to be the new effective interest rate when using
a financial calculator and will bring the below amortization table:

Date Interest received (12%) Interest income (14%) Amortization Carrying amount
Jan. 01, 2019 - - - 4,768,200
Dec. 31, 2019 600,000 667,548 67,548 4,835,748
Dec. 31, 2020 600,000 677,005 77,005 4,912,753
Dec. 31, 2021 600,000 687,247* 87,247 5,000,000

Observations:

• Interest received = Principal x Stated rate; P5,000,000 x 12% = P600,000

• Interest income = Carrying amount x Effective rate; for Dec. 31, 2019, P4,768,200 x 14% = P667,548
• Amortization = Interest income – Interest received; for Dec. 31, 2019, P667,548 - P600,000 = P67,548
• Carrying amount = Previous carrying amount + Amortization; ; for Dec. 31, 2019, P4,768,200 + P67,548
= P4,835,748
• *P4,912,753 x 14% equals P687,785. The difference is due to rounding of present value factors.
Journal entries from December 31, 2019 to December 31, 2021 are as follows:
Dec. 31, 2019 Cash 600,000
Interest Income 600,000

Unearned Interest Income 67,548

Interest Income 67,548
Dec. 31, 2020 Cash 600,000
Interest Income 600,000

Unearned Interest Income 77,005

Interest Income 77,005
Dec. 31, 2021 Cash 600,000
Interest Income 600,000

Unearned Interest Income 87,247

Interest Income 87,247

Cash 5,000,000
Loan Receivable 5,000,000

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Impairment of loan
PFRS 9 provides that an entity shall recognize a loss allowance for expected credit losses on financial asset
measured at amortized cost. It further provides that an entity shall measure this loss allowance at an amount
equal to the lifetime expected credit losses if the credit risk on that financial instrument has increased
significantly since the initial recognition.
Credit losses are the present value of all cash shortfalls. Expected credit losses are an estimate of credit losses
over the life of the financial instrument.
When measuring expected credit losses, an entity should consider the following:
a. The probability-weighted outcome
b. The time value of money
c. Reasonable and supportable information that is available without undue cost or effort
The amount of impairment loss can be measured as the difference between the carrying amount and the
present value of estimated future cash flows discounted at the original effective rate. The carrying amount of
the loan receivable shall be reduced either directly or through the use of an allowance account.
Credit risk
Credit risk is the risk that one party to a financial instrument will cause a financial loss for the other party by
failing to discharge an obligation. The risk contemplated is the risk that the issuer will fail to perform a particular
obligation. It does not necessarily relate to the credit worthiness of the issuer.
Illustration
International Bank loaned P5,000,000 to Bankrupt Company on January 01, 2017. The terms of the loan require
principal payment of P1,000,000 each year for 5 years plus interest at 10%. The first principal payment is due
on December 31, 2017. Bankrupt Company made the required payments on December 31, 2017 and December
31, 2018. However, during 2019, Bankrupt Company began to experience financial difficulties and was unable
to make the required principal and interest payment on December 31, 2019. On this date, International Bank
assessed the collectability of the loan and had determined that the remaining principal payments will be
collected but the collection of the interest is unlikely. In connection with this, the loan receivable has carrying
amount of P3,300,000 including the accrued interest of P300,000 on December 31, 2019. International Bank
projected the cash flows from the loan on December 31, 2019 as follows:

Date of cash flow Amount projected

Dec. 31, 2020 500,000
Dec. 31, 2021 1,000,000
Dec. 31, 2022 1,500,000

Required: How much is the impairment loss to be recognized for the foregoing loan?
First thing to do is to get the present value of the cash projections using the original effective interest rate. The
present value of 1 at 10% is to be used each year for the independent annual cash flows such that for one period,
0.9091 is used; 0.8264 is used for the second period; and 0.7513 is used for the third period.
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 Date of cash flow Present value of amount projected
Dec. 31, 2020 (500,000 x 0.9091) 454,550
Dec. 31, 2021 (1,000,000 x 0.8264) 826,400
Dec. 31, 2022 (1,500,000 x 0.7513) 1,126,950
Total 2,407,900

Next step is to compare the present value with the loan’s carrying amount:
Carrying amount of loan 3,300,000
Present value of cash flows 2,407,900
Impairment loss 892,100

Journal entry on December 31, 2019 to account for the impairment of the loan:
Loan Impairment Loss 892,100
Accrued Interest Receivable 300,000
Allowance for Loan Impairment 592,100

The accrued interest receivable is credited directly because the collection of interest is unlikely.
When this loan receivable is presented on the Statement of Financial Position, it would appear like this:
Loan receivable (at face amount) 3,000,000
Allowance for loan impairment (592,100)
Impairment loss 2,407,900

Succeeding journal entries after December 31, 2019 are the following:
Dec. 31, 2020 Cash 500,000
Loan Receivable 500,000

Allowance for Loan Impairment 240,790

Interest Income 240,790
P2,407,900 x 10%

Dec. 31, 2021 Cash 1,000,000

Loan Receivable 1,000,000

Allowance for Loan Impairment 214,869

Interest Income 214,869

Loan receivable - December 31, 2020 2,500,000

Allowance for loan impairment (592,100 - 240,790) (351,310)
Carrying amount - December 31, 2020 2,148,690
Interest income for 2021 (2,148,690 x 10%) 214,869

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 Dec. 31, 2022 Cash 1,500,000
Loan Receivable 1,500,000

Allowance for Loan Impairment 136,441

Interest Income 136,441

Loan receivable - December 31, 2021 1,500,000

Allowance for loan impairment (351,310 - 214,869) (136,441)
Carrying amount - December 31, 2021 1,363,559
Interest income for 2022 (1,363,559 x 10%) 136,356

Notice that the recognition of interest income annually is charged against the allowance for loan impairment
account.
Three-stage impairment approach

• Stage 1 – This stage covers debt instruments that have not declined significantly in credit quality since
initial recognition or that have low credit risk. Under this scenario, a 12-month expected credit loss is
recognized.
• Stage 2 – This stage covers debt instruments that have declined significantly in credit quality since initial
recognition but do not have objective evidence of impairment. Under this scenario, a lifetime expected
credit loss is recognized. There is rebuttable presumption that there is a significant increase in credit risk
if the contractual payments are more than 30 days past due.
• Stage 3 – This stage covers debt instruments that have objective evidence of impairment at the reporting
date. Under this scenario, a lifetime expected credit loss is recognized.
A 12-month expected credit loss is defined as the portion of the lifetime expected credit loss from default events
that are possible within 12 months after the reporting period. A lifetime expected credit loss is defined as the
expected credit loss that results from all default events over the expected life of the instrument. It shall always
be recognized for trade receivables through aging, percentage of accounts receivable, and percentage of sales.
Interest income

• Under Stages 1 and 2, interest income is computed based on the gross carrying amount or face amount.
• Under Stage 3, interest income is computed based on the net carrying amount which is equal to the
gross carrying amount or face amount minus allowance for credit loss.
Illustrations
Stage 1 – Low credit risk
On January 01, 2019, a bank loaned P2,000,000 to a borrower. The contract specified an effective interest of
10%, a term of 8 years, and interest is payable annually every December 31. On December 31, 2019, based on
the most relevant information available, the bank determined that the loan had a 12-month probability of
default of 5% and expected to collect only 80% of the principal. The present value of 1 at 10% for 7 periods is
0.51 (for simplicity, the PV factors are rounded to the nearest hundredths for the purpose of these illustrations).

DCACPAMBA'20 P a g e 15 | 26
Journal entries for 2019:
Jan-01 Loan Receivable 2,000,000
Cash 2,000,000

Dec-31 Cash 200,000

Interest Income 200,000

Loan Impairment Loss 59,200

Allowance for Loan Impairment 59,200

Carrying amount - December 31, 2019 2,000,000

Probability of collection 80%
Expected cash flow 1,600,000
Multiply by PV of 1 at 10% for 7 periods 0.51
Present value of cash flow - December 31, 2019 816,000
Carrying amount - December 31, 2019 2,000,000
Present value of cash flow - December 31, 2019 816,000
Expected credit loss 1,184,000
Multiply by probability of default within 12 months 5%
12-month expected credit loss 59,200
Loan receivable 2,000,000
Allowance for loan impairment (59,200)
Carrying amount - December 31, 2019 1,940,800

Stage 2 – Significant increase in credit risk but no objective evidence of impairment

(Continuation) On December 31, 2020, the bank determined that there was a significant increase in the credit
risk of the loan receivable but no objective evidence of impairment. The bank concluded that there is a 40%
probability of default over the remaining life of the loan and the bank expected to collect only 70% of the
principal balance. The present value of 1 at 10% for 6 periods is 0.56.
Journal entries for 2020:
Dec-31 Cash 200,000
Interest Income 200,000

31 Loan Impairment Loss 427,200

Allowance for Loan Impairment 427,200

Carrying amount - December 31, 2020 2,000,000

Probability of collection 70%
Expected cash flow 1,400,000
Multiply by PV of 1 at 10% for 6 periods 0.56
Present value of cash flow - December 31, 2020 784,000
Carrying amount - December 31, 2020 2,000,000
Present value of cash flow - December 31, 2020 784,000
Expected credit loss 1,216,000
Multiply by probability of default within 6 years 40%
DCACPAMBA'20 P a g e 16 | 26
 Lifetime expected credit loss allowance 486,400
Unadjusted allowance - December 31, 2019 (59,200)
Impairment loss 427,200
Loan receivable 2,000,000
Allowance for loan impairment (486,400)
Carrying amount - December 31, 2020 1,513,600

Stage 3 – Objective evidence of impairment

(Continuation) On December 31, 2021, the borrower was in financial difficulty and the loan was considered
impaired. The bank concluded that only 50% of the principal balance will be collected on December 31, 2026.
Interest for 2021 was collected. The present value of 1 at 10% for 5 periods is 0.62.
Journal entries for 2021:
Dec-31 Cash 200,000
Interest Income 200,000

31 Loan Impairment Loss 893,600

Allowance for Loan Impairment 893,600

31 Allowance for Loan Impairment 1,000,000

Loan Receivable 1,000,000

Carrying amount - December 31, 2021 2,000,000

Probability of collection 50%
Expected cash flow 1,000,000
Multiply by PV of 1 at 10% for 5 periods 0.62
Present value of cash flow - December 31, 2021 620,000
Carrying amount - December 31, 2021 2,000,000
Present value of cash flow - December 31, 2021 620,000
Lifetime expected credit loss allowance 1,380,000
Unadjusted allowance - December 31, 2020 (486,400)
Impairment loss 893,600

The interest income for 2021 is still based on the gross carrying amount because the loan is still under Stage 2
for the entire year 2021. On 2022, the interest income would be based on the net carrying amount using the
effective method and would have the following journal entry:
Dec-31 Allowance for Loan Impairment 62,000
Interest Income 62,000

Loan receivable - December 31, 2021 1,000,000

Allowance for loan impairment 380,000
Carrying amount - December 31, 2021 620,000

DCACPAMBA'20 P a g e 17 | 26
 Interest income for 2022 (620,000 x 10%) 62,000
Carrying amount - December 31, 2022 682,000
Interest income for 2023 (682,000 x 10%) 68,200
Carrying amount - December 31, 2023 750,200
Interest income for 2024 (750,200 x 10%) 75,020
Carrying amount - December 31, 2024 825,220
Interest income for 2025 (825,220 x 10%) 82,522
Carrying amount - December 31, 2025 907,742
Interest income for 2026 92,258
Carrying amount - December 31, 2026 1,000,000

Receivable Financing
A receivable financing is the financial flexibility or capability of an entity to raise money out of its receivables.
When an entity experiences decline in business activities such that the sales decrease and customers are not
paying their accounts on time, and it is still obliged to pay its currently maturing obligations, the entity may be
forced to look for cash. One option is through financing its receivables.
Some of the most common forms of receivable financing are the following:
1. Pledge of accounts receivable
2. Assignment of accounts receivable
3. Factoring of accounts receivable
4. Discounting of notes receivable
Pledge of accounts receivable
Pledging refers to the use of receivables as collateral for a loan. This also known as general assignment of
receivables. Under a pledging arrangement, the entity still retains the title to the receivables and thus, collects
the balances from the customers. This does not involve special accounting problems. The only entry required in
the books would record the loan obtained from the finance company or bank by debiting Cash and crediting
Note Payable (with a corresponding debit to Discount on Note Payable if the proceeds are less than the face
amount of the note). With respect to pledged accounts, no entry is required. Disclosure by way of a note to
financial statements is sufficient to describe the pledging that took place.
Illustration
Assume that on December 01, 2019, ABC Manufacturing borrowed P500,000 from Manila Bank by issuing a one-
year note and was discounted by the bank at 12%. Accounts receivable totaling P1,200,000 are pledged to
secure the loan.
On the date of borrowing, the only entry needed on ABC’s books is as follows:
Dec-01 Cash 440,000
Discount on Note Payable 60,000
Note Payable - Bank 500,000

DCACPAMBA'20 P a g e 18 | 26
In the banking parlance, discounting the loan means that the interest for the term of the loan is deducted in
advance.
Face value of loan 500,000
Interest deducted in advance (500,000 x 12%) 60,000
Net proceeds 440,000

At year-end, the interest accruing from the loan has to be booked by a charge to the discount on note payable.
Dec-31 Interest Expense 5,000
Discount on Note Payable 5,000
Amortization of discount for one month (60,000 x 1/12)

Assignment of accounts receivable

Assignment of accounts receivable is a more formal borrowing arrangement in which specific receivables are
identified and used as security for loan. This is also known as specific assignment of accounts receivable. The
borrower, known as the assignor, pledges the specifically described receivables to a lender, called the assignee,
and signs a promissory note payable. The assignor retains the credit risks and continues collection efforts. In
most cases, customers are not notified of the assignment and they make payments directly to the assignor (non-
notification basis) and the assignor remits the collection to the assignee. If the assignment is on notification
basis, the customers are notified to make their payments directly to the assignee.
The assignee usually lends only a certain percentage of the face value of the accounts assigned because the
assigned accounts may not be fully realized by reason of such factors as sales discount, sales return and
allowances, and uncollectible accounts. Such a percentage maybe 70%, 80%, or 90% depending on the quality
of the accounts. The assignee usually charges interest for the loan that it makes and requires service or financing
charge or commission for the assignment agreement.
Illustrations
Non-notification basis

An entity assigned P700,000 of accounts receivable to a bank under a non-notification

Apr-01 arrangement. The bank advances 80% less a service charge of P5,000. The entity assigned a
promissory note that provides for interest of 1% per month on the unpaid loan balance.

Accounts Receivable-Assigned 700,000

Accounts Receivable 700,000

Cash 555,000
Service Charge (560,000 - 5,000) 5,000
Note Payable-Bank 560,000

DCACPAMBA'20 P a g e 19 | 26
Apr-05 Issued a credit memo for sales return to a customer whose account was assigned, P20,000.
Sales Return 20,000
Accounts Receivable-Assigned 20,000
Apr-10 Collected P300,000 of the assigned accounts less 2% discount.
Cash 294,000
Sales Discount (2% X 300,000) 6,000
Accounts Receivable-Assigned 300,000
Apr-30 Remitted the total collections to the bank plus interest for one month.
Note Payable-Bank 294,000
Interest Expense (1% X 560,000) 5,600
Cash 299,600

May-07 Assigned accounts of P15,000 proved worthless.

Allowance for Doubtful Accounts 15,000
Accounts Receivable-Assigned 15,000
May-20 Collected P300,000 of the assigned accounts.
Cash 300,000
Accounts Receivable-Assigned 300,000
Remitted the total amount due to the bank to pay off the loan balance plus interest for one
May-30
month.
Note Payable-Bank (560,000 - 294,000) 266,000
Interest Expense (1% X 266,000) 2,660
Cash 268,660
To transfer the remaining balance of assigned accounts to account receivable:
Accounts Receivable 65,000
Accounts Receivable-Assigned 65,000
Total accounts receivable-assigned 794,000
Less:
Collections (294,000 + 300,000) 594,000
Sales discount 6,000
Sales return 20,000
Worthless accounts 15,000 (635,000)
Balance
65,000

DCACPAMBA'20 P a g e 20 | 26
Notification basis
An entity assigned P1,000,000 of accounts receivable to a bank under a notification
arrangement. The bank loans 80% less 4% service charge on the gross amount assigned. The
Jul-01
entity signed a promissory note that provides for 1% interest per month on the unpaid loan
balance.

Accounts Receivable-Assigned 1,000,000

Accounts Receivable 1,000,000

Cash (800,000 - 40,000) 760,000

Service Charge (4% X 1,000,000) 40,000
Note Payable-Bank 800,000

Received notice from bank that P600,000 of the assigned accounts were collected less 2%
Jul-31
discount. A check was sent to the bank for the interest due.

Note Payable-Bank 588,000

Sales Discount (2% X 600,000) 12,000
Accounts Receivable-Assigned 600,000

Interest Expense (1% X 800,000) 8,000

Cash 8,000

Received notice from bank that P300,000 of the assigned accounts were collected. Final
Aug-31 settlement was made by the bank for the excess collections together with the uncollected
assigned accounts of P100,000.

Cash 85,880
Interest Expense 2,120
Note Payable-Bank 212,000
Accounts Receivable-Assigned 300,000

Accounts Receivable 100,000

Accounts Receivable-Assigned 100,000

Loan from bank 800,000

Less: July collection by bank (588,000)
Balance due the bank 212,000
August collection by bank 300,000
Less: Loan balance (212,000)
Excess collection 88,000
Less: Interest (1% x 212,000) (2,120)
Remittance from bank 85,880

An entity should present the following accounts at year-end:

Accounts receivable-unassigned 4,000,000

Accounts receivable-assigned 1,000,000
DCACPAMBA'20 P a g e 21 | 26
 Allowance for doubtful accounts 100,000
Note payable-bank (related to assignment) 400,000

Accounts receivable-unassigned 4,000,000

Accounts receivable-assigned 1,000,000
Total 5,000,000
Allowance for doubtful accounts (100,000)
Net realizable value 4,900,000

The entity, moreover, shall disclose its equity in the assigned accounts determined as follows:

Accounts receivable-assigned 1,000,000

Note payable-bank (400,000)
Equity in assigned accounts 600,000

Factoring accounts receivable

Factoring is a sale of accounts receivable on a without recourse notification basis. It is an outright sale of
receivables where the factor (the finance company) assumes the risk of collection and generally handles the
billing and collection function. Factoring differs from an assignment in that an entity actually transfers
ownership of the accounts receivable to the factor. The customers, whose accounts are factored, are notified
and required to pay directly to the factor. As in any sale of assets, a gain or loss is recognized for the difference
between the proceeds received and the net carrying amount of the receivables factored.
Factoring may take the form of the following:
1. Casual factoring
2. Factoring as a continuing agreement
In a casual factoring, an entity finds itself in a critical position; it may be forced to factor some or all of its
accounts receivable at a substantial discount to a bank or a finance entity to obtain the much needed cash.
For example, an entity factored P100,000 of accounts receivable with an allowance for doubtful accounts of
P5,000 for P80,000.
The entry for this is as follows:

Cash 80,000
Allowance for Doubtful Accounts 5,000
Loss on Factoring 15,000
Accounts Receivable 100,000

Factoring may also involve a continuing arrangement where a finance entity purchases all of the accounts
receivable of a certain entity. In this setup, before a merchandise is shipped to a customer, the selling entity
requests the factor’s credit approval. If it is approved, the account is sold immediately to the factor after
shipment of the goods. The factor then assumes the credit function as well as the collection function. For
compensation, typically the factor charges a commission or factoring fee of 5% to 20% for its services of credit
approval, billing, collecting, and assuming uncollectible factored accounts. Moreover, the factor may withhold
DCACPAMBA'20 P a g e 22 | 26
a predetermined amount as a protection against customer returns and allowances and other special
adjustments. This amount withheld is known as the factor’s holdback. It is actually called receivable from factor
and classified as current asset. Final settlement of the factor’s holdback is made after the factored receivables
have been fully collected.
Illustration
An entity factored accounts receivable of P500,000 with credit terms of 2/10, n/30 immediately after shipment
of the goods to the customer. The factor charged a 5% commission based on the gross amount of the receivables
factored. In addition, the factor withheld 20% of the amount of the receivables factored to cover sales return
and allowances.

The journal entries for the foregoing illustration are as follows:

Cash 365,000
Sales Discount 10,000
Commission 25,000
Receivable from Factor 100,000
Accounts Receivable 500,000

Gross amount 500,000

Less:
Sales discount (2% x 500,000) 10,000
Commission (5% x 500,000) 25,000
Factor's holdback (20% x 500,000) 100,000 135,000
Cash received from factoring 365,000

If the customer is subsequently allowed a credit of P50,000 for damaged merchandise:

Sales Return and Allowances 50,000

Sales Discount (2% X 50,000) 1,000
Receivable from Factor 49,000

When all the receivables factored are collected by the factor with no further returns and allowances,
the final settlement with the factor is recorded as follows:

Cash (100,000 - 49,000) 51,000

Receivable from Factor 51,000

Credit card
A credit card is a plastic card which enables the holder to obtain credit up to a predetermined limit from the
issuer for the purchase of goods and services. The credit card has enabled retailers and other businesses to
continue to sell goods and services where the customers obtain possession of the goods immediately but do
not have to pay for the goods for about one month. Generally, credit card entities are responsible for approving
the credit of customers and collecting the receivables for a service fee from 1% to 5% of the credit card sales.

DCACPAMBA'20 P a g e 23 | 26
Two entries are necessary when involving credit card transactions: first is at the time of sale, and second is when
payment is received from the card issuer. Assume for example credit card sales from customers who are using
Diners Club credit cards that amount to P200,000 for a certain period. The credit card receipts are forwarded to
Diners Club and payment is subsequently received from Diners Club minus a 3% service charge.
To record the credit card sales:
Accounts Receivable-Diners Club 200,000
Sales 200,000

To record the payment from Diners Club:

Cash 194,000
Credit Card Service Charge (200,000 X 3%) 6,000
Accounts Receivable-Diners Club 200,000

Discounting of notes receivable

Discounting a note receivable is endorsing a promissory note to a bank or a financing company, the latter
advancing the maturity value of the note less a charge called discount. A company that discounts a customer’s
note receivable at the bank is in essence selling the note to the bank with recourse obligation. Since the
endorsing company still has a continuing involvement on the discounted note, the transaction does not qualify
for derecognition of receivable.
The following terms and computations are necessary relating to discounting of notes receivable:
1. Principal is the amount stated on the face of the note (also called the face value).
2. Interest is the amount of interest for the entire term of note, computed as: Principal X Interest Rate X
Term.
3. Maturity date is the date when the note is due and payable.
4. Maturity value is the total amount due on the note at maturity date, computed as: Principal + Interest.
If the note is noninterest bearing, then its maturity value is equal to its principal or face value alone.
5. Discount rate is the rate of interest used by bank in computing discount.
6. Discount period is the period of time remaining on the term of the note, meaning, the period from the
date of discounting to maturity date.
7. Discount is the amount of interest earned by the bank, computed as: Maturity Value X Bank Discount
Rate X Discount Period.
8. Proceeds is the discounted value of the note received by the endorser of the note from the bank,
computed as: Maturity Value – Discount.
Illustration
On December 21, 2012, ABC Manufacturing discounted the 60-day, 15%, P800,000 note from Customer F at
National Bank. The note is dated December 1 and the bank’s discounted rate is 18%. Computations and entries
pertaining to the note discounted are as follows (assume a 360-day year):
Principal 800,000
Add:
Interest (800,000 x 15% x 60/360) 20,000
DCACPAMBA'20 P a g e 24 | 26
 Maturity value 820,000
Less:
Discount (820,000 x 18% x 40/360) 16,400
Proceeds 803,600

Dec-21 Interest Receivable 6,667

Interest Revenue 6,667
800,000 x 15% x 20/360

21 Cash 803,600
Liability on Discounted Notes 803,600

In the first entry, the accrued interest up to the date of discounting is recognized as interest revenue. In the
second entry, the credit to the liability account indicates that the note is discounted with recourse, and ABC
Company is still liable to the financing company for the note in case the maker fails to pay it on maturity
date. Hence, the transfer is not treated as derecognition, as the company guarantees to compensate the
financial institution for the credit losses that are likely to occur.
Assuming that the note matures without notice of protest, ABC Manufacturing will cancel both the assets
(Notes Receivable and Interest Receivable) and the liability (Liability on Discounted Notes) in its books with
the following entry:
Jan-30 Liability on Discounted Notes 803,600
Interest Expense 3,067
Interest Receivable 6,667
Notes Receivable 800,000

When Customer F fails to pay on maturity date, ABC Manufacturing will be obliged to pay the maturity value
of the note plus protest fees and other bank charges. The total amount paid by ABC on account of the
discounted note is to be charged to the account of the maker of the note.
Assuming that in the foregoing example, the bank charged protest fees and other charges of P5,000, ABC
will prepare the following entries:
Jan-30 Liability on Discounted Notes 803,600
Interest Expense 3,067
Interest Receivable 6,667
Notes Receivable 800,000

30 Accounts Receivable (820,000 + 5,000) 825,000

Cash 825,000

If discounting of a note is on a without recourse basis, the endorser is, therefore, relieved of the
responsibility for the note that is dishonored on maturity. The discounting is, therefore, treated as a sale

DCACPAMBA'20 P a g e 25 | 26
 and the note would qualify for derecognition. In such a case, no liability on discounted note is recorded by
the seller, and the entries in the previous example would be modified as follows:
Dec-21 Interest Receivable 6,667
Interest Revenue 6,667
800,000 x 15% x 20/360

21 Cash 803,600
Loss on Sale of Notes Receivable 3,067
Notes Receivable 800,000
Interest Receivable 6,667

PREPARED BY:

DJEHAN C. ASTILLA, CPA, MBA (units)

Instructor, Department of Accountancy
College of Economics, Management and Development Studies
Cavite State University – Indang, Cavite

THE ABOVE DISCUSSIONS ARE LIFTED FROM THE FOLLOWING SOURCES:

▪ Valix, C.N., Peralta, J.F., Valix, C.A.M. (2019) Intermediate Accounting Volume 1. Sampaloc, Manila
▪ Robles, N.S., Empleo, P.M. (2012) Intermediate Accounting Volume 1. Mandaluyong City
▪ (2020) Investopedia, New York City

“Don’t turn your back on wisdom, for she will protect you. Love her, and she will guard you. Getting wisdom is the wisest thing you
can do! And whatever else you do, develop good judgment. If you value wisdom, she will make you great. Embrace her, and she
will honor you. She will place a lovely wreath on your head; she will present you with a beautiful crown.” -Proverbs 4:6-9 NLT
DCACPAMBA'20 P a g e 26 | 26