College
Accounting,
by Heintz and Parry
Chapter 17:
Accounting for
Notes and Interest
In late February, Eddie called a local disc jockey
named C. D. Player (real name Cal Plotnick) to let him know
that he was 5 days late paying his $440 bill (they instituted
this procedure after the “Diss Jockey” Dan Miller debacle).
Mr. Player asked if he could send the store a promissory
note (a written promise to pay a specific amount on a
specific date). He wanted an extra 90 days to pay and he
was willing to pay the store 12% interest to get the
extension. Before he agreed, Nick wanted to know how
much interest he would be receiving.
Question: How much interest would the store
receive on this note?
Answer:
Interest would be calculated using the
following formula:
or
Principal X Rate X Time = Interest
$440 X 12% X 90/360 = $13.20
Time is expressed as a fraction of a year because the interest
rate is expressed as an annual rate. Most banks and
businesses use 360 days as the denominator because they’re
allowed to (and it increases the interest collected).
Based on this information, Nick decided to accept the note.
Question: What accounts would be debited and
credited (and for what amount) when the store
receives this note?
Answer:
The entry is shown below.
Date
Description
P. R.
2001
Feb. 22 Notes Receivable
Accounts Receivable-C. D. Player
Debit
440.00
Credit
440.00
The due date would be calculated as follows:
Days in February:
28
Minus date of note:
- 22
Days remaining in Feb.
6
Add: Days in March
31
Days in April
30
Total days before May
67
90 total days - 67 before May = May 23 is the due date.
Question: What accounts would be debited and
credited (and for what amount) when the note is paid on
May 23?
Answer:
The entry is shown below.
Date
Description
2001
May 23 Cash
Notes Receivable
Interest Revenue
P. R.
Debit
Credit
453.20
440.00
13.20
The $453.20 payment received is called the maturity value
(calculated as principal + interest).
“What if he doesn’t have the money by May 23?” Nick asked.
Eddie thought about that for a second. “One option is that he
could make a partial payment and issue a new note for the rest.”
Question: What accounts would be debited and
credited (and for what amount) if C. D. Player paid the
interest plus $100 and issued a new note on May 23?
Answer:
The entry is shown below.
Date
Description
2001
May 23 Cash
Notes Receivable (new note)
Notes Receivable (old note)
Interest Revenue
P. R.
Debit
Credit
113.20
340.00
440.00
13.20
“Okay, Eddie, that could work, but what if we really need the
money? A new note isn’t going to do us much good then.”
“Actually, Nick, you can turn the note into cash at any time. You
just take the note to the bank and discount it. Let’s say that 30
days from now you want the money. The bank would pay you
the maturity value, less a discount based on a discount rate of
15% (for our example) that allows them a fair profit on the deal.”
Questions: What formula is used to calculate a
discount? What would the discount be in this example?
Answer:
”The discount would be calculated using the
following formula:
Maturity Value
X Bank Discount Rate
X Time Until Maturity
= Discount
$453.20
X
15%
X 60/360
$11.33
The relevant time is 60 days because the note is for 90 days and
you’ve held it for 30, so the bank will have to wait 90 - 30 = 60
days to get the money.
The amount of money you receive, also called the proceeds, is
based on the formula: Maturity value - Discount = Proceeds,
which in this case would be $453.20 - 11.33 = $441.87.”
Question: What accounts would be debited and
credited (and for what amount) when the bank discounts
this note?
Answer:
The entry is shown below.
Date
Description
2001
Mar. 24 Cash
Notes Receivable
Interest Revenue
P. R.
Debit
441.87
Credit
440.00
1.87
“Of course, if you discount the note too soon, you might
actually lose money, and the difference would need to be
debited to interest expense.”
“All of that makes sense, Eddie, but what happens if C. D. Player
doesn’t pay the bank when the note is due?”
“Good question. According to most bank discounting
agreements, we would have to pay off the dishonored note,
along with a small added bank fee, maybe $10.”
Question: What accounts would be debited and
credited (and for what amounts) when the store pays the
bank for the dishonored note?
Answer:
The entry is shown below.
Date
Description
2001
May 23 Accounts Receivable-C. D. Player
Cash
P. R.
Debit
463.20
Credit
463.20
”We would debit accounts receivable because we would attempt
to collect the money (including the late fee) from C.D.Player. In
fact, we would accumulate 12% interest on this amount until the
day he finally paid us.”
Question: If C.D. Player paid on the dishonored note
30 days later, what accounts would be debited and
credited (and for what amount) when the note is paid on
June 22?
Answer:
The entry would look like this.
Date
Description
P. R.
2001
June 22 Cash
Accounts Receivable-C. D. Player
Interest Revenue
Debit
467.83
Credit
463.20
4.63
The interest calculation is:
Amount owed X interest rate X time = interest
or $463.20
X
12%
X 30/360 = $4.63
”Now, if we want to be as accurate as possible, at the end of
each month we should accrue the interest revenue that we’ve
earned on the note that month.”
Question: On February 28, 2001, what accounts
would be debited and credited (and for what amount) to
accrue the interest?
Answer:
The entry would look like this.
Date
Description
2001
Feb. 28 Interest Receivable (an asset)
Interest Revenue
P. R.
Debit
Credit
.88
.88
The interest calculation is:
Amount owed X interest rate X time = interest
or $440.00
X
12%
X 6/360 = $.88
”Now, it’s not worth making an entry for $.88, but if we start
accepting notes from others, the amounts could get significant.”
“Hey, I had a thought, Eddie. Suppose I sent a promissory note
to Hospital Records so we can put off paying that $2000 we owe
them. Do you think they’d let me do that?”
Question: What accounts would be debited and
credited (and for what amount) if Hospital Records
accepts our note?
Answer:
The entry is shown below.
Date
Description
P. R. Debit
2001
Feb. 22 Accounts Payable-Hospital Records
2000.00
Notes Payable
Credit
2000.00
“By the way, Nick, if Hospital Records doesn’t like the idea, you
could give a note to the bank for cash and use the proceeds to
pay Hospital Records. Only the debit part of the entry would
change.”
Date
Description
2001
Feb. 22 Cash
Notes Payable
P. R.
Debit
2000.00
Credit
2000.00
“In either case, the entry on the due date would be the same.”
Question: What accounts would be debited and
credited (and for what amounts) if the note were paid off
after 60 days at 14% interest?
Answer:
The entry is shown below.
Date
Description
2001
Apr. 23 Notes Payable
Interest Expense
Cash
P. R.
Debit
2000.00
46.67
Credit
2046.67
”With a note payable, we should normally make an adjusting
entry to accrue interest expense in order to get a more accurate
picture of our net income.”
Question: If we made an adjusting entry on
February 28, 2001, what accounts would be debited and
credited (and for what amount) to accrue the interest?
Answer:
The entry would look like this.
Date
Description
2001
Feb. 28 Interest Expense
Interest Payable
P. R.
Debit
4.67
Credit
4.67
The interest calculation is:
Amount owed X interest rate X time = interest
or $2000.00 X
14%
X 6/360 = $4.67
”By the way, both this adjusting entry and the one for interest
receivable could have a reversing entry so that you don’t have
to zero out the interest receivable or payable accounts when
payment occurs on the due date.“
“Great. It sounds like I have a new tool for dealing with slowpaying customers and cash flow problems. How did you get to
be so smart about this stuff, anyway?”
“It’s my accounting teacher, Professor Gene Yuss. He explains
things so that anybody can understand them.”