Unit 2: accounting for receivables introduction

2.4.3 Discounting Note Receivable

Notes Receivable can be converted to cash before they mature. This can be done by discounting notes receivable at a financial institution or bank. To illustrate, assume that ABC co hold a Birr 3,000, 90 days 12% note, dated May 15 .On July 4, the note is discounted at DASHEN BANK at the rate of 12% ABC’s co proceeds from the bank are computed as follows:

Principal of the note - - - - - - - - - - - - - - - - - - - Br. 3,000
(+) Interest from the note (3000 x 12% x 90/360) - - - - 75
= Maturity value - - - - - - - - - - - - - - - - - - - - -- - - - 3075
(-) Bank discount (3075 x 12% x 40/360)* - - - - - - - 41
= Proceeds - - - - - - - - - - - - - - - - - - - - - - - - - - - - - 3,034

*ABC Company held the note for 50 of the 90 days before discounting.

The entry to record discounting of the note is

August 14 Cash 3034

Interest Revenue 34
Notes Receivable 3000

It should be observed that the proceeds from discounting a note receivable might be less than the face value. When this situation occurs, the excess of the face value over he proceeds is recorded as interest expense. The amount and direction of the difference between the interest rate and the discount rate will affect the result, as will the relationship between the full term of the note and the length of the discount period.

Notes receivable are discounted with recourse or without recourse. When a note is discounted without recourse, the bank assumes the risk of a bad debt loss and the original payee doesn’t have a contingent liability. A contingent liability is an obligation to make a future payment if, and only if an uncertain future event occurs. If a note is discounted with recourse and the original maker of the note fails to pay the bank when it matures, the original payee of the note must pay for it. This means a company discounting a note with recourse has a contingent liability until the bank is paid. A company should disclose contingent liabilities in notes to its financial statements.

Review Exercises 1. XYZ Company has accepted a Br. 12, 000, 60 day, non – interest bearing not dated Oct. 18 in settlement of open account. Assuming that the cash is collected in the due date. Record the acceptance of Notes receivable and collection of cash. 2. ABC Company has accepted a Br. 11, 000, 60 – day, 12% note dated September 28 in settlement of open account. Fiscal period ends on December 31. Show the entry to record: (a) If the cash is collected at maturity (honored) (b) If the note is dishonored 3. EFG co. holds a 120-day, 10% not for a Br. 20,000, dated September 5, is discounted at WEGAGEN BANK on October 8 at the rate of 15%. Determine the proceeds and record discounting of the note.