NOTE PAYABLE

TECHNICAL KNOWLEDGE

✓To define a promissory note.

✓To know the initial measurement of note payable.
✓To understand the subsequent measurement of note payable
at amortized cost.
✓To understand the fair value option of measuring note
payable.
✓To know the accounting for note payable issued solely for
cash, interest-bearing note payable and noninterest-
bearing note payable issued for property.
 NOTE PAYABLE

A 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 or determinable future time a sum
certain in money to order or to bearer.
 INITIAL MEASUREMENT OF NOTE PAYABLE

PFRS 9, paragraph 5.1.1, provides that a note payable not designated at fair value
through profit or loss shall be measured initially at fair value minus transaction costs
that are directly attributable to the issue of the note payable.

In other words, transaction costs are included in the measurement of note payable.

However, if the note payable is irrevocably designated at fair value through profit
or loss, the transaction costs are expensed immediately.

The "fair value” of the note payable is equal to the present value of the future cash
payment to settle the note payable using market rate of interest.
 SUBSEQUENT MEASUREMENT OF NOTE PAYABLE

PFRS 9, paragraph 5.3.1, provides that after initial recognition, a note payable shall be
measured:

a.At amortized cost using the effective interest method.

b. At fair value through profit or loss if the note payable is designated irrevocably
as measured at fair value through profit or loss.
 AMORTIZED COST OF NOTE PAYABLE

The amortized cost of note payable is the amount at which the note payable is
measured initially:

a. Minus principal repayment

b. Plus or minus the cumulative amortization using the effective interest method of
any difference between the face amount and present value of the note payable.

Actually, the difference between the face amount and present value is either discount
or premium on the issue of note payable.
 NOTE ISSUED SOLELY FOR CASH

When a note is issued solely for cash, the present value is equal to the cash
proceeds.
Illustration
On November 1, 2020, an entity discounted its own note of P1,000,000 at
12% for one year.

Note payable 1,000,000

Less: Discount (12% x 1,000,000) 120,000
Net proceeds 880,000
Journal Entry

Cash 880,000
Discount on note payable 120,000
Note payable 1,000,000

Actually, the discount on note payable of P120,000 is the total interest expense for one
year.

Thus, on December 31, 2020, after 2 months, the discount on note payable is amortized
as interest expense.

Interest expense 20,000

Discount on note payable 20,000
(120,000 x 2/12)
The straight line method is used in amortizing the discount on note payable for
simplicity. Besides, the note payable has only a term of one year.

If a statement of financial position is prepared on December 31, 2020, the note payable
is classified and reported as current liability.
Note payable 1,000,000
Discount on note payable (100,000)
Carrying amount 900,000

Observe that the discount on note payable is a direct deduction from the face amount
of the note payable.

The carrying amount of P900,000 is actually the "amortized cost" of the note payable.
 INTEREST BEARING NOTE ISSUED FOR PROPERTY

When a property or noncash asset is acquired by issuing a promissory note which is

interest bearing, the property or asset is recorded at the purchase price.
The purchase price is reasonably assumed to be the present value of the note and
therefore, the fair value of the property because the note issued is interest bearing.

Illustration
On January 1, 2020, an entity acquired an equipment for P1,000,000 payable in 5 annual
equal installments every December 31 of each year. Interest is 10% on the unpaid
balance.
Journal Entries

2020
Jan 1 Equipment 1,000,000
Note payable 1,000,000

Dec 31 Interest expense (10% x 1,000,000) 100,000

Note payable 200,000
Cash 300,000
Payment of the first installment and the interest for 2020

2021
Dec 31 Interest expense (10% x 800,000) 80,000
Note payable 200,000
Cash 280,000
Payment of the second installment and the interest for 2021
NONINTEREST BEARING NOTE ISSUED FOR PROPERTY
When a noninterest bearing note is issued for property, the property is recorded at
the cash price of the property.

The cash price is assumed to be the present value of the note issued.

The difference between the cash price and the face of the note issued represents the
imputed interest.

The imputed interest is based on the sound philosophy that no lender would part
away with his money or property interest-free.

Illustration
On January 1, 2020, an entity acquired an equipment with a cash price of P350,000
for P500,000, P100,000 down and the balance payable in 4 equal annual installments.
Journal entries for 2020
Jan 1 Equipment 350,000
Discount on note payable 150,000
Cash 100,000
Note payable 400,000

Dec 31 Note payable 100,000

Cash 100,000
Payment of annual installment

31 Interest expense 60,000

Discount on note payable 60,000
Amortization of the discount for 2020
 TABLE OF AMORTIZATION

YEAR NOTE PAYABLE FRACTION AMORTIZATION

2020 400,000 4/10 60,000
2021 300,000 3/10 45,000
2022 200,000 2/10 30,000
2023 100,000 1/10 15,000
1,000,000 150,000
Note payable represents the amount outstanding every year.

The note was issued on January 1, 2020 and the first payment was made on
December 31, 2020.

Thus, for 2019, the note payable outstanding is P400,000.

Fraction is developed from the note payable outstanding every year.

Amortization is the amount of discount multiplied by the fraction developed.

Thus, for 2020, P150,000 times 4/10 equals P60,000.

 ANOTHER ILLUSTRATION – NO CASH PRICE

On January 1, 2020, an entity acquired an equipment for P1,000,000 payable in 5 equal

annual installments on every December 31 of each year.

Observe that there is no agreed interest and no cash price is available for the equipment.

In such a case, the cost of the equipment is equal to the present value of the P200,000
annual installments in 5 years at an appropriate rate of 10%.

The rate of 10% is assumed to be the prevailing market rate of interest.

The present value of an ordinary annuity of 1 for 5 years at 10% is 3.7908.

Therefore, the present value of five P200,000 installments is P758,160, computed by

multiplying P200,000 by the present value factor of 3.7908.
Journal Entries for 2020

Jan 1 Equipment 758,160

Discount on note payable 241,840
Note payable 1,000,000

Dec 31 Note payable 200,000

Cash 200,000
First installment payment.

31 Interest expense (10% x 800,000) 75,816

Discount on note payable 75,816
Amortization of the discount on note payable for 2020.

The “effective interest” method is followed in the amortization of discount.

 TABLE OF AMORTIZATION

DATE PAYMENT INTEREST PRINCIPAL PRESENT VALUE

Jan. 1, 2020 758,160
Dec. 31, 2020 200,000 75,816 124,184 633,976
Dec. 31, 2021 200,000 63,398 136,602 497,374
Dec. 31, 2022 200,000 49,737 150,263 347,111
Dec. 31, 2023 200,000 34,711 165,289 181,822
Dec. 31, 2024 200,000 18,178 181,822 -
Payment represents the annual installment.

Interest is equal to the preceding present value multiplied by the implied interest rate.
Thus, for 2020, P758,160 times 10% equals P75,816.

Principal is the portion of the payment after deducting interest representing principal.

Thus, on December 31, 2020, P200,000 minus the interest of P75,816 equals P124,184.

Present value is the balance of the preceding present value after deducting the principal
payment.

Thus, on December 31, 2020, P758,160 minus the principal payment of P124,184 equals
P633,976.
On December 31, 2020, the current portion of the note payable would be reported as
current liability.

Note payable 200,000

Discount on note payable (63,398)
Carrying amount - amortized cost 136,602

The noncurrent portion of the note payable would be reported as noncurrent liability.

Note payable 600,000

Discount on note payable (102,626)
Carrying amount - amortized cost 497,374
 NONINTEREST BEARING NOTE PAYABLE LUMP SUM
On January 1, 2020, an entity acquired an equipment for P1,000,000. The entity paid
P100,000 down and signed a noninterest bearing note for the balance which is due after
three years on January 1, 2023.

There was no established cash price for the equipment. The prevailing interest rate for
this type of note is 10%. The present value of 1 for 3 periods is .7513.

Computation Imputed Interest

Down payment 100,000 Face value of note 900,000
Present value of note 676,170 Present value of note 676,170
Cost of equipment 776,170 Imputed Interest 223,830
Journal entries

1. To record the purchase of equipment on January 1, 2020:

Equipment 776,170
Discount on note payable 223,830
Cash 100,000
Note payable 900,000

2. To record the interest expense for 2020:

Interest expense 67,617
Discount on note payable 67,617
The discount on note payable is amortized as interest expense using “effective
interest” method.

3. To record the full payment of the note on January 1, 2023:

Note payable 900,000
Cash 900,000
 TABLE OF AMORTIZATION

DISCOUNT ON
DATE INTEREST EXPENSE NOTE PAYABLE PRESENT VALUE
1/1/2020 223,830 676,170
12/31/2020 67,617 156,213 743,787
12/31/2021 74,379 81,834 818,166
12/31/2022 81,834 - 900,000
Interest expense is equal to the preceding present value multiplied by the
implied interest rate.
Thus, for 2020, P676,170 times 10% equals P67,617.

Discount on note payable is the balance minus the interest expense every
year.
Thus, on December 31, 2020, P223,830 minus the interest of P67,617 equals
P156,213.

Present value is the preceding balance plus the interest expense every year.
Thus, on December 31, 2020, P676,170 plus the interest of P67,617 equals
P743,787.
 FAIR VALUE OPTION OF MEASURING NOTE PAYABLE

PFRS 9, paragraph 4.2.2, provides that at initial recognition, a note payable may be
irrevocably designated as at fair value through profit or loss.

PFRS 9, paragraph 5.7.7, provides that the gain or loss on financial liability designated at
fair value through profit or loss shall be accounted for as follows:

a. The change in fair value attributable to the credit risk is recognized in other
comprehensive income.
Credit risk is the risk that the issuer of the liability would cause a financial loss to
the other party by failing to discharge the obligation.
Credit risk does not include market risk such as interest risk, currency risk and
price risk.
b. The remaining amount of the change in fair value is recognized in profit or loss.

Application Guidance B5.7.9 provides that amount recognized in other comprehensive

income resulting from change in fair value attributable to credit risk shall not be
subsequently transferred to profit or loss.

However, the cumulative gain or loss recognized may be transferred within equity or
retained earnings.

Under the fair value option, any transaction cost is recognized as outright expense.

There is no amortization of discount and premium on note payable.

As a matter of fact, interest expense is recognized using the nominal or stated interest
rate.
Illustration

On January 1, 2020, an entity borrowed from a bank P4,000,000 on a 12% 5-year interest
bearing note.

The entity received P4,000,000 which is the fair value of the note on January 1, 2020.
Transaction cost of P100,000 was paid by the entity.

The fair value of the note payable was P3,500,000 on December 31, 2020.

The entity has elected irrevocably the fair value option for measuring the note
payable.

The change in fair value comprised P50,000 attributable to credit risk and P450,000
attributable to interest risk.
Journal entries for 2020
Jan 1 Cash 1,000,000
Note payable 1,000,000

1 Transaction cost 100,000

Cash 100,000

Dec 31 Interest expense (12%x4,000,000) 480,000

Cash 480,000

31 Note payable 500,000

Gain from change in fair value 450,000
Gain from credit risk – OCI 50,000
Carrying amount 4,000,000
Fair value - December 31,2020 3,500,000
Decrease in fair value of liability - gain 500,000

The gain from change in fair value is recognized in profit or loss.

The gain from credit risk is recognized in other comprehensive income