Accounting: The Language of Business - Vol. 2 (Intermediate: Part 148)

• You cannot serve God and money (Matthew 6:24)

 Short-Term Operating Assets: Cash and Receivables (Part M)

by

Charles Lamson 

No Stated Interest Rate or Stated Interest Rate Less Than the Market Rate

When there is no interest rate stated or the stated interest rate is less than the market interest rate, the face value of a note receivable no longer provides a valid measure of its present value. In this case, a company records the note at its present value rather than its face value. There are two approaches to measure present value:

• If a company receives the note in exchange for goods or services, assume that the note's present value is the fair value of the goods or services provided. Fair value estimates can be based on the value of comparable goods and services or the market value of the note if it is traded.

• If the company cannot determine the fair value of the goods or services, compute present value as the value of the note discounted at the market rate of interest. Here the market rate of interest is known as the imputed rate of interest.

The difference between the face value of the note and the fair value of the goods and services provided or the present value of the note is a discount, which represents the deferred interest revenue to be earned over the note's life. The firm initially records deferred interest revenue as a discount on notes receivable (a contra-asset account) and then amortizes the amount to interest revenue over the loan term. Example 9.13 shows accounting for a note with no stated interest rate.

In this example, Fitzgerald collected the note before the end of its fiscal year. However, if the note is still outstanding when the company prepares financial statements, it must record interest on the loan as shown in Example 9.14.

Financing with Notes Receivable. In a manner similar to accounts receivable, companies can sell notes receivable to secure immediate cash. A company sells a note receivable by transferring it to another party before the maturity date. Selling a note receivable is typically referred to as discounting. The accounting approach for selling or discounting a note receivable is similar to factoring accounts receivable as illustrated in Example 9.15. If the conditions are met to consider the transaction a sale, the company removes the receivable from the books and reports a gain or loss. One difference in accounting for the sale of a note receivable versus an account receivable is that notes receivable earn interest. Therefore, the company must accrue any interest that has been earned but not received as of the time the note is sold.

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 465-467*

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