Discount on notes receivable

Definition of discount on notes receivable

Notes receivable can also be used to obtain immediate cash. This is done by giving a discount on notes receivable to a bank or other lender prior to their maturity date.

Explanation

Discounting means selling or pledging a customer’s note receivable to the bank at some point prior to the note’s maturity date. The term discount is used because the bank deducts the interest it charges from the note’s maturity value and thus discounts the note. The note is usually discounted with recourse. this means that the company discounting the note, called the endorser, guarantees the eventual full payment of its maturity value. If the maker fails to make the required payments, the bank will present the note to the endorser and demand full payment.
By discounting a note with recourse, the endorser has a contingent liability. A contingent liability is a possible liability that may or may not occur depending on some future event. In many cases, these liabilities are not included in the balance sheet with other liabilities. Rather, they are usually referred to in the footnotes to the financial statements. If the maker pays the bank, the contingent liability will end; if the maker defaults, the contingent liability will become a real liability. Because most discounted notes are reviewed for their creditworthiness by both the bank and the endorser, the contingent liability rarely into a real liability.

Accounting for a discount on notes receivable

One of the differences between notes and accounts receivable is the greater negotiability of notes. A holder of a note can readily convert it to cash by discounting it at a bank, either with or without recourse. The bank accepts the note and gives the holder cash equal to its maturity value less a discount computed by a discount rate to the maturity value. The bank gets its money back plus the discount when the note is paid by its maker at maturity. If the note is not paid at maturity, the bank can collect from the original holder if it was discounted with recourse. If the arrangement is without recourse, the bank must find another remedy.
For notes discounted with recourse, the original holder is contingently liable for paying the note. That is, it will have to pay the note if it is defaulted. This type of liability is not disclosed in the balance sheet but should be described in a footnote if it is material.
A five-step process is used in accounting for a discount on notes receivable:
1. Compute the maturity value.
2. Compute the discount (discount rate times maturity value).
3. Compute the proceeds (maturity value less discount).
4. Compute the net interest income or expense (proceeds less carrying value).
5. Prepare the journal entry.
The following illustrations apply this process to compute the discount on three notes receivable by the Sample Company.

Example 1

The Sample Company discounts a $100,000 note receivable on May 15, 20×2. These facts are known:

Step 1: Compute the maturity value:

Step 2: Compute the discount:

Step 3: Compute the proceeds:

Step 4: Compute the net interest income or expense:

Step 5: Prepare the journal entry:

Example 2

Suppose that the same note in Example 1 is discounted on April 1, 20×2, instead of May 15 and that all other facts are the same:
Step 1: Compute the maturity value: $102,000
Step 2: Compute the discount:

Step 3: Compute the proceeds:

Step 4 Compute the net interest income or expense:

Step 5: Prepare the journal entry:

Example 3

Now, assume the same facts as in Example 2, except that the note is assigned originally on June 30, 20×1. It is discounted on April 1, 20×2.
Step 1: Compute the maturity value:

Step 2: Compute the discount:

Step 3 Compute the proceeds:

Step 4: Compute the net interest income or expense:

Step 5: Prepare the journal entry:

Disclosures

The example entries show the credit being made directly to the Notes Receivable account just as if the note had been collected. This approach is always appropriate if the discounting is without recourse. That is if the original holder is without further liability, then the asset is effectively transferred and its amount should be removed from the books.
This approach may be appropriate if the discount on notes receivable is with recourse, as long as disclosure of the contingent liability is made either parenthetically or in a footnote that the note will be paid when it matures. However, since the holder is contingently liable for paying the maturity value to the bank, it may be appropriate to use a contra asset account, Notes Receivable—Discounted. For Example 1, this journal entry would be made:

This account balance can be shown in the balance sheet as a deduction from all notes receivable. This approach is not commonly found in practice.

Entry at maturity

If the original entry has a credit to the regular Notes Receivable account, no entry is needed when the note is paid in full by its maker. If the contra account is used, a journal entry like this one must be made:

If the note is not paid and was discounted without recourse, no further entry is needed; however, if it was discounted with recourse, the original holder must record its payment to the bank and the restoration of the receivable to its full balance plus interest and any protest fee for failure to pay at maturity. If the note in Example 1 is defaulted and the Sample Company pays the bank the maturity value and a $100 protest fee, this entry is needed:

To provide additional information, the debit could be recorded to an account entitled Notes Receivable—Dishonored.
Presented in the following examples are sample disclosures of receivables from actual financial statements. Footnotes are also widely used as a supplement to the balance sheet disclosure to inform readers of other facts about receivables.

Example

Balance sheet disclosures of receivables:

Example

Disclosure of receivables including footnote details — related-party receivable

NOTE 10
Jerome J. Goldstein, Chairman of the Board and President, assumed the company’s obligation to purchase a condominium in Florida (near the Aquafilter plant) and agreed to reimburse the company for its advances toward the construction costs. At December 31, 2018, the company had a note receivable from Mr. Goldstein representing such advances. The note, amounting to $64,349.44, bears interest at 18% and is due December 31, 2019.