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Module 5-NOTE PAYABLE AND DEBT RESTRUCTURE
Module 5-NOTE PAYABLE AND DEBT RESTRUCTURE
Module 5-NOTE PAYABLE AND DEBT RESTRUCTURE
Module No. 5
Subject: Intermediate Accounting 2 Date of Submission: ____________
Name of Student: __________________________________________________
Course and Year: __________________________________________________
Semester and School Year: __________________________________________
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.
Under PFRS 9, paragraph 5.1.1, 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 re 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.
The term “present value” is the discounted amount of the future cash outflow in settling the note payable using the
market rate of interest.
Under PFRS 9, paragraph 5.3.1, 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.
The difference between the face amount and present value is either discount or premium on the issue of note payable.
Illustration
On November 1, 2020, an entity discounted its own note of P1,000,000 at 12% for one year.
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.
Observe that the discount on note payable is 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.
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 installment 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
2021
Dec. 31 Interest expense 80,000
Note payable 200,000
Cash 280,000
Payment for second installment and interest for 2021.
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 instalment.
Table of amortization
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
multiplies by the fraction developed.
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 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
Interest is equal to the preceding present value multiplied by the implied interest rate. Thus, for 2020, P758,160 times
10% equal 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 equal 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.
The noncurrent portion of the note payable would be reported as noncurrent liability.
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
Down payment 100,000
Present value of note (900,000 x .7513) 676,170
Cost of equipment 776,170
Imputed interest
Face value 900,000
Present value of note 676,170
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
The discount on note payable is amortized as interest expense using the “effective interest” method.
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.
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 of retained earnings.
Under the fair value option, any transaction cost is recognized as outright expense.
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.
DEBT RESTRUCTURING
Debt restructuring is a situation where the creditor, for economic or legal reasons related to the debtor’s financial
difficulties, grants to the debtor concession that would not be granted in a normal business relationship.
The concession either stems from an agreement between the creditor and debtor, or as imposed by law or court.
The objective of the creditor in a debt restructuring is to make the best of a bad situation or maximize recovery of
investment.
Thus, the creditor usually sustains an accounting loss on debt restructuring and the debtor usually realizes an
accounting gain.
1. Asset swap
2. Equity swap
3. Modification of terms
Asset swap
An asset swap is the transfer by the debtor to the creditor of any asset, such as real estate, inventory, receivables and
investment, in full payment of an obligation.
Under PFRS 9, paragraph 3.3.1, asset swap is treated as a derecognition of a financial liability or extinguishment of an
obligation.
Paragraph 3.3.3 provides that the difference between the carrying amount of the financial liability and the consideration
given shall be recognized in profit or loss.
At year-end, the entity transferred to the creditor land with carrying land with carrying amount of P1,500,000 and fair
value of P2,200,000.
Computation
USA GAAP
Under USA GAAP, asset swap is recorded as if two transactions have taken place, namely, the sale of the asset and the
extinguishment of the liability. Accordingly, two gains or losses are recognized.
The difference between the fair value of the asset and the carrying amount is gain or loss on exchange.
The difference between the carrying amount of the liability and the fair value of the asset is gain or loss on
restructuring.
Journal entry
Note that the gain on extinguishment under PFRS 9 includes both the gain on exchange and gain on debt restructuring
under USA GAAP.
Dacion en pago arises when a mortgaged property is offered by te debtor in full settlement of the debt.
The transaction shall be accounted for as an “asset swap” form of debt restructuring. This requires recognition of gain
or loss based on the balance of the obligation including accrued interest and other charges.
If the balance of the obligation including accrued interest and other charges is more than the carrying amount of the
property mortgaged, there is a loss on extinguishment.
Illustration
Land costing P500,000 and building costing P4,000,000 with accumulated depreciation of P800,000, were mortgaged
to secure a bank loan of P3,000,000.
Subsequently, the land and building were given to the bank in full payment of the liability.
Journal entry
Simply stated, an equity swap is the issuance of share capital by the debtor to the creditor in full or partial payment of
an obligation.
Accounting issue
How should an entity initially measure the equity instruments issued to extinguish a financial liability?
The accounting issue of “extinguishment of a financial liability by issuing equity instruments” is now well-settled
under IFRIC 19.
IFRIC 19 provides that when equity instruments issued to extinguish all or part of a financial liability are recognized
initially, an entity shall measure the equity instruments at the fair value of the equity instruments issued, unless that
fair value cannot be reliably measured. If the fair value of the equity instruments issued cannot be reliably measured,
the equity instruments shall be measured to reflect the fair value of the financial liability extinguished.
Simply stated, the equity instruments issued to extinguish a financial liability shall be measured at the following
amounts in the order of priority.
The gain or loss on extinguishment shall be reported as a separate line item in the income statement.
Illustration
The entity issued share capital with a total per value of P2,000,000 and fair value of P4,500,000 in full settlement of the
bonds payable and accrued interest. On the other hand, the fair value of the bonds payable is P4,700,000.
Modification of terms,
Interest concession may involve a reduction of interest rate, forgiveness of unpaid interest or a moratorium on interest.
Maturity value concession may involve an extension of the maturity date or a reduction of the principal amount.
PFRS 9, paragraph 3.3.2, provides that a substantial modification of terms of an existing financial liability shall be
accounted for as an extinguishment of the old financial liability and the recognition of a new financial liability.
Under Application Guidance B3.3.6 of PFRS 9, there is a substantial modification of terms if the gain or loss on
extinguishment is at least 10% of the old financial liability.
The difference between the carrying amount of the old liability and the present value of new or restructured liability
shall be accounted for as gain or loss on extinguishment of debt.
The old effective rate is used in computing the present value of the new liability.
Any costs or fees incurred as a result of the substantial modification of terms shall be recognized as part of gain or loss
n extinguishment.
The entity is granted by the creditor the following concessions on January 1, 2020:
This requires computation of the present value of the new note payable using the old rate of 14%.
The present value of the new note payable is equal to the present value of the new principal plus the present value of
the interest payments on the new principal liability.
Computation
The present value of 1 at 14% for 4 periods is 0.5921 and the present value of an ordinary annuity of 1 at 4 periods is
2.9137.
Journal Entries
1. To record the extinguishment of the old note payable:
2. To record the interest payment on the new note payable for 2020:
December 31,2020
December 31,2021
Books of creditor
No substantial modification
This requires the computation of the present value of the new note payable using the old rate 10%.
The present value of 1 at 10% for three periods of 0.7513 and the present value of an ordinary of 1 at 10% for the three
periods is 2.4869.
The gain is less than 10% of the carrying amount of old liability of P6,000,000.
In accordance with PFRS 9, paragraph B5.4.6, the IASB recently clarified that any gain or loss on modification should
be recognized in profit or loss even if there is no substantial modification on terms.
The interest expense is computed based on the original effective rate and any discount or premium on the new liability
is amortized using the effective interest method.
Journal entries
* 10% times P5, 181, 769 equals P518, 177. There is a difference of P54 due to rounding of present value factor.
Thus, for 2020, P5, 000, 000 x 14% equals P700, 000.
Thus, for 2020, P5, 497, 330 x 10% equals P549, 733 and so on.
Thus, for 2020, P700,000 minus P549,733 equals P150,267, and so on.
References
Valix, C. & Valix, C.A. (2018). Practical Accounting 1 vol 2. GIC Enterprises and Co., Inc. Manila, Philippines
Valix, C. & Valix, C.A. (2013). Theory of Accounts 2013 edition. GIC Enterprises and Co., Inc. Manila, Philippines
Valix, C. Valix, C.A. (2019). Financial Accounting and Reporting vol 2. GIC Enterprises and Co., Inc. Manila,
Philippines
Robles, N. & Empleo P. (2016). The Intermediate Accounting Series Vol 2. Millenium Books, Inc., Mandaluyong City
Uberita, C. (2012). Practical Accounting 1 2013 Edition. GIC Enterprises and Co, Inc. Manila, Philippines