Intermediate Accounting 1

1
Notes Receivable

Module 006: Notes Receivable

Course Learning Outcomes:

1. State the initial and subsequent measurement of note receivables.
2. Learn how to compute for present value factors and how to properly
apply them.
3. Learn how to prepare amortization tables.
4. Know how to compute for the effective interest rate.

Note Receivable
A note receivable is a claim supported by a formal promise to pay a certain sum of money
at a specific future date usually in the form of a promissory note. A note can be negotiable
instrument that a maker signs in favor of a designated payee who may legally and readily
sell or otherwise transfer the note to others. Note receivables are considered fairly liquid,
even if long-term, because entities may easily convert them to cash, although a fee might be
paid to do so.
Although all notes contain an interest element because of the time value of money, entities
classify notes as either interest-bearing or non-interest bearing.
Interest bearing notes have a stated interest rate, i.e., the contracted interest rate stated on
the promissory note. Other terms for stated interest rate include nominal rate, coupon rate,
and face rate.
Non-interest bearing notes do not have a stated interest rate because they include the
interest element as part of the face amount. The face amount of a non-interest bearing note
represents an unspecified principal and an unspecified interest. Present value computation
is needed to separate the interest element from the principal element.
Trade and Non-Trade Notes Receivables
Entities frequently accept notes receivable from customers who need to extend the
payment period of an outstanding account receivable. Notes may also be required from
high-risk or new customers. In some industries (e.g., pleasure and sport boat industry and
hospitals), notes support all credit sales. Note receivables obtained from the sale of goods
or services in the ordinary course of business are classified as trade notes receivable.
Note receivables from other sources are non-trade notes receivable. Examples are note
receivables from loans to employees and affiliates and disposal of property, plant, and
equipment on credit.

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Initial Measurement
Receivables are initially recognized at fair value plus transaction costs that are directly
attributable to the acquisition.
For measurement purposes, receivables are classified into the following:
a. Short-term receivable
b. Long-term receivable that bears a reasonable interest rate
c. Long-term receivable that bears no interest (noninterest bearing)
d. Long-term receivable that bears an unreasonable interest rate (below-market interest
rate)

Short-Term Receivable
The fair value of a short-term receivable may be equal to its face amount. However, if the
transaction contains a significant financing component, the fair value of the short-term
receivable is equal to its present value.

PFRS 15: Exceptions on trade receivables

 Trade receivables that do not have a significant financing component shall be measured
at their transaction price.
 As a practical expedient, a trade receivable may not be discounted if it is due within 1
year.

Long-Term Receivables
 The fair value of a long-term receivable that bears a reasonable interest rate is equal to
the face amount. An interest rate is deemed reasonable if it approximates the market
rate at transaction date.
 The fair value of a long-term receivable that bears no interest (long-term noninterest
bearing receivable) is equal to the present value of the future cash flows from the
receivable discounted using an imputed interest rate.
 The fair value of a long-term receivable that bears an unreasonable interest rate is also
equal to the present value of the future cash flows from the receivable discounted using
an imputed interest rate.
The imputed rate of interest is the more clearly determinable of either:
a. The prevailing rate for a similar instrument of an issuer with a similar credit rating or
b. A rate of interest that discounts the face (nominal) amount of the receivable to the
current cash sales price of the goods or services.
Other terms for imputed rate of interest are effective interest rate, market rate and yield
rate.
The difference between the present value and the face amount of the receivable is initially
recognized as unearned interest and subsequently recognized as interest revenue under
the effective interest method.
The effective interest rate is the rate that exactly discounts estimated future cash payments
or receipts through the expected life of the financial instrument or, when appropriate, a
shorter period to the net carrying amount of the financial asset or financial liability.
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Notes Receivable

When calculating the effective interest rate, an entity shall estimate cash flows considering
all contractual terms of the financial instrument (for example, prepayment, call and similar
options) but shall not consider future credit losses. The calculation includes all fees and
points paid or received between parties to the contract that are an integral part of the
effective interest rate, transaction costs, and all other premiums or discounts. There is a
presumption that the cash flows and the expected life of a group of similar financial
instruments can be estimated reliably. However, in those rare cases when it is not possible
to estimate reliably the cash flows or the expected life of a financial instrument (or group of
financial instruments), the entity shall use the contractual cash flows over the full
contractual term of the financial instrument (or group of financial instruments).

Cash Price Equivalent

The fair value of receivables may be measured in relation to the fair value of the asset given
up in exchange for the receivable. Such fair value is the cash price equivalent of the noncash
asset given up.
Cash price equivalent is the amount that would have been paid if the transaction was
settled outright on cash basis, as opposed to installment basis or other deferred
settlements.
Example 1:
JKL Co. sells household appliances either on cash basis or on 6-month installment basis. On
January 1, 2018, a TV set with a cash price of P100,000 was sold at an installment price of
P120,000.
The receivable will be initially recognized at P100,000, the cash price equivalent of the TV
set. The P20,000 difference (P120,000 installment price less P100,000 cash price) will be
amortized over the credit term as interest revenue using the effective interest method.
Example 2:
JKL Co. sells goods for P250,000 to a customer who was granted a special credit period of 1
year. JKL Co. normally sells the goods for P220,000 with a credit period of 1 month or with
a P5,000 discount for cash basis (i.e., outright payment in cash).
The initial measurement of the receivable is computed as follows:
Normal selling price with credit period of 1 month 220,000
Discount for cash on delivery (5,000
Cash price equivalent of the goods sold 215,000

Both the selling prices of P250,000 (special credit) and P220,000 (normal credit) constitute
a financing transaction, i.e., they include consideration for the credit period granted. To
compute for the cash price equivalent of the goods sold, which is the fair value of the
consideration, the P5,000 discount given for outright payment in cash is deducted from the
normal selling price of P220,000 with credit period of 1 month.

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 However, if the entity opts to use the practical expedient allowed by PFRS 15, the
receivables are measured at the undiscounted transaction prices of P120,000 (Example 1)
and P250,000 (Example 2).

Illustration: Initial Measurement at Face Amount

JKL Co. received the following note receivables on January 1, 2018:
9-month, 10% note from A Company 5,000
6-month noninterest bearing note from B, Inc. (the effect
of discounting is deemed immaterial) 10,000
14%, 3-year note from C Corp. 20,000
Market rate of interest on January 1, 2018 10%
Requirement: At what amount will the notes be initially recognized?
Answer: 5,000 +10,000 + 20,000 = 35,000
All of the notes are permitted to be measured at face amount.
 The P5,000 note is a short-term note and bears interest rate that is consistent with the
market rate of interest.
 The P10,000 note, although noninterest bearing, is a short-term note and the problem
states that the effect of discounting this note is deemed immaterial.
 The P20,000 note, although long-term, bears an interest rate that is reasonable in
relation to the current market rate on January 1, 2018, i.e., 14% nominal rate is above
10% market rate.

Subsequent Measurement
Receivables initially measured at face amount are subsequently measured at recoverable
historical cost (or net realizable value).
Recoverable historical cost (net realizable value) represents the amount of cash expected
to be recovered from the contractual cash flows of the receivable. Recoverable historical
cost is computed as the face amount of the receivable minus subsequent repayments of
principal and minus any reduction (directly or through the use of an allowance account) for
impairment or uncollectibility.
Receivables initially measured at present value are subsequently measured at amortized
cost.
Amortized cost is the amount at which a financial asset or financial liability is measured at
initial recognition minus principal repayments, plus or minus the cumulative amortization
using the effective interest method of any difference between the initial amount and the
maturity amount, and minus any reduction (directly or through the use of an allowance
account) for impairment or uncollectibility.
The amortized cost of a receivable is determined using the effective interest method.
Effective interest method is a method of calculating the amortized cost of a financial asset
or a financial liability (or a group of financial assets or financial liabilities) and or allocating
the interest income or interest expense over the relevant period.
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Notes Receivable

Illustration 1: Simple Interest

On April 1, 2018, JKL Co. received a P1,500,000, 10%, 3-year note receivable in exchange
for a vacant lot carried in the books at P850,000. Principal, in three equal installments, plus
interest are due annually starting April 1, 2019. Current market rates as of April 1, 2018,
December 31, 2018, and December 31, 2019 are 10%, 12% and 13%, respectively.
The entries relating to the note receivable are as follows:
April 1, Notes receivable 1,500,000
2018 Land 850,000
Gain on sale 650,000
to record the sale of land
Dec. 31, Interest receivable (1.5M x 10% x 9/12) 112,500
2018 Interest income 112,500
to record the accrued interest for 2018
April 1, Cash on hand (principal plus interest) 650,000
2019 Notes receivable 500,000
Interest income (1.5M x 10% x 3/12) 37,500
Interest receivable 112,500
to record the receipt of 1st installment on note receivable
Dec. 31, Interest receivable [(1.5M - .5M) x 10% x 9/12)] 75,000
2019 Interest income 75,000
to record the accrued interest for 2019
April 1, Cash on hand (principal plus interest) 600,000
2020 Notes receivable 500,000
Interest income (1M x 10% x 3/12) 25,000
Interest receivable 75,000
to record the receipt of 2nd installment on note receivable
Dec. 31, Interest receivable [(1.5M - .5M - .5 M) x 10% x 9/12)] 37,500
2020 Interest income 37,500
to record the accrued interest for 2020
April 1, Cash on hand (principal plus interest) 550,000
2021 Notes receivable 500,000
Interest income (.5M x 10% x 3/12) 12,500
Interest receivable 37,500
to record the receipt of the last installment on note
receivable

Observe the following:

 The note receivable is not discounted to its present value because it bears reasonable
interest rate, i.e., the stated rate of 10% is equal to the April 1, 2018 current rate of
10%.
 Under simple interest, interest is computed only on the outstanding principal balance.
 Changes in current market rates after April 1, 2018 are ignored.
 Initially and subsequently, the note receivable has been measured at face amount.
However, if the recoverable amount falls below face amount, impairment loss should be

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 recognized. This is needed to bring the carrying amount of the note equal to its
recoverable historical cost.

Illustration 2: Compounded Interest

On January 1, 2018, JKL Co. extended a P1,000,000 loan to one of its officers as part of JKL
Co.’s car and housing assistance program. The note received is due on January 1, 2021 and
bears 10% interest compounded annually.
The entries relating to the note receivable are as follows:
Jan. 1, Notes receivable 1,000,000
2018 Cash in bank 1,000,000
to record the loan
Dec. 31, Interest receivable (1M x 10%) 100,000
2018 Interest income 100,000
to record the accrued interest income for 2018
Dec. 31, Interest receivable (1M + 100K) x 10% 110,000
2019 Interest income 110,000
to record the accrued interest income for 2019
Dec. 31, Interest receivable (1M + 100K + 110K) x 10% 121,000
2020 Interest income 121,000
to record the accrued interest income for 2020
Jan. 1, Cash on hand (1M + 100K + 110K + 121K) 1,331,000
2021 Note receivable 1,000,000
Interest receivable 331,000
to record the collection of the loan together with accrued
interests

Observe the following:

 Under compound interest, interest is computed on the principal and any existing
interest receivable.
 All throughout the life of the note, the interest element is recognized separately as
interest receivable.

Illustration 3: Noninterest-bearing note – lump sum

On January 1, 2018, JKL Co. sold a transportation equipment with a historical cost of
P2,000,000 and accumulated depreciation of P700,000 in exchange for cash of P100,000
and a non-interest bearing note receivable of P1,000,000 due on January 1, 2021. The
prevailing rate of interest for this type of note is 12%.
The present value of the note on January 1, 2018 is computed as follows:
Future cash flow (face amount) 1,000,000
Multiply by: PV of P1 @ 12%, n=3 0.711780
Present value of note receivable 711,780
The rate used in the present value factor is the effective interest rate on initial recognition.
The “n” (period) of 3 cover the period Jan. 1, 2018 to Jan. 1, 2021.
The difference between the face amount and the present value of the note represents the
unearned interest income. The unamortized balance of the unearned interest income is a
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Notes Receivable

valuation account (deduction) to the note receivable when determining its carrying
amount.
Note receivable 1,000,000
Unearned interest income (1,000,000 – 711, 780) (288,220)
Carrying amount of note receivable – Jan. 1, 2018 711,780
The note receivable is initially recorded as follows:
Jan. 1, Cash on hand 100,000
2018 Notes receivable 1,000,000
Accumulated depreciation 700,000
Loss on sale of equipment 488,220
Transportation equipment 2,000,000
Unearned interest income 288,220
An amortization table is prepared to serve as basis for subsequent journal entries.
Amortization – lump sum:
Interest income Unearned Present
Date (a) interest (b) value (c)
a = c x effective c = prev. bal.
interest rate b = prev. bal. - a +a
Jan. 1, 2018 288,220 711,780
Dec. 31, 2018 85,414 202,806 797,194
Dec. 31, 2019 95,663 107,143 892,857
Dec. 31, 2020 107,143 - 1,000,000
Observe the following:
 Under the effective interest method, interest income is computed by multiplying the
present value of the note by the effective interest rate.
 Periodic interests are added (amortized) to the present value of the note in order to
make the present value of the note equal to the face amount at maturity date.
 At any given point of time, the sum of unearned interest income and present value
equals the face amount, e.g., (288,220 + 711,780 = 1M) and (202,806 + 797,194 = 1M).
 Unearned interest income is decreased as interests are earned. At maturity date, its
balance is zero because, as of this point, all interests have already been earned.
 For a non-interest bearing note, the initial amount of unearned interest income
represents the total interest income to be recognized over the life of the note, e.g.,
[(total interest income: 85,414 + 95,663 + 107,143) = 288,220 initial balance of
unearned interest income].
The other entries relating to the note receivable are as follows:
Dec. 31, Unearned interest income 85,414
2018 Interest income 85,414
Dec. 31, Unearned interest income 95,663
2019 Interest income 95,663

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 Dec. 31, Unearned interest income 107,143
2020 Interest income 107,143
Jan. 1, Cash on hand 1,000,000
2021 Note receivable 1,000,000
to record the settlement of the note

The carrying amount of the note receivable is determined as follows:

Jan. 1, 2018 Dec. 31, 2018 Dec. 31, 2019
Note receivable 1,000,000 1,000,000 1,000,000
Unearned interest income (288,220) (202,806) (107,143)
Carrying amount 711,780 797,194 892,857

Notice that the carrying amounts are equal to the present value s on the amortization table
above.

Illustration 4: Noninterest-bearing note - installments

On January 1, 2018, JKL Co. sold transportation equipment with a historical cost of
P2,000,000 and accumulated depreciation of P700,000 in exchange for cash of P100,000
and a noninterest-bearing note receivable of P1,000,000 due in 4 equal annual installments
starting on December 31, 2018 and every December 31 thereafter. The prevailing rate of
interest for this type of note is 12%.
The present value of the notes as of January 1, 2018 is computed as follows:
Future cash flows – annual installments (1M ÷ 4) 250,000
Multiply by: PV of an ordinary annuity of P1 @ 12%, n=4 3.037349
Present value of note receivable 759,337
The rate used in the present value factor is the effective interest rate on initial recognition.
The “n” (period) of 4 is the number of installment collections.
The difference between the face amount and the present value of the note represents the
unearned interest income. The unamortized balance of the unearned interest income is a
valuation account (deduction) to the note receivable when determining its carrying
amount.
Note receivable 1,000,000
Unearned interest income (1,000,000 – 759,337) (240,663)
Carrying amount of note receivable – Jan. 1, 2018 759,337
The note receivable is initially recorded as follows:
Jan. 1, Cash on hand 100,000
2018 Notes receivable 1,000,000
Accumulated depreciation 700,000
Loss on sale of equipment 440,663
Transportation equipment 2,000,000
Unearned interest income 240,663
An amortization table is prepared to serve as basis for subsequent journal entries:
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Notes Receivable

Interest
Date Collections income Amortization Present value
b = d x effective
a interest rate c=a-b d = prev. bal. - c
01/01/2018 759,337
12/31/2018 250,000 91,120 158,880 600,458
12/31/2019 250,000 72,055 177,945 422,513
12/31/2020 250,000 50,702 199,298 223,214
12/31/2021 250,000 26,786 223,214 0
Observe the following:
 Under the effective interest method, interest income is computed by multiplying the
present value of the note by the effective interest rate.
 Collection minus interest income equals the amortization of the principal component
(i.e., portion of collection applicable to principal component). The amortization is
deducted from the present value because the note is collectible in installments.
 The present value is reduced to zero at maturity date because, as of this point, the note
receivable has already been collected in full.
 For a non-interest bearing note, the initial amount of unearned interest income
represents the total interest income to be recognized over the life of the note, e.g.,
[(total interest income: 91,120 + 72,055 + 50,702 + 26,786) = 240,663 initial balance of
unearned interest income].
The other entries relating to the note receivable are as follows:
Using simple entries:
Dec. 31, Cash on hand 250,000
2018 Note receivable 250,000
to record the collection on the note
Dec. 31, Unearned interest income 91,120
2018 Interest income 91,120
Using compound entries:
Dec. 31, Cash on hand 250,000
2019 Unearned interest income 72,055
Note receivable 250,000
Interest income 72,055
Dec. 31, Cash on hand 250,000
2020 Unearned interest income 50,702
Note receivable 250,000
Interest income 50,702
Dec. 31, Cash on hand 250,000
2021 Unearned interest income 26,786
Note receivable 250,000
Interest income 26,786

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Current and Non-Current Portion of a Note Receivable
From the amortization table above, the carrying amount of the note receivable on
December 31, 2018 is P600,458. Since collections on the principal are due periodically, this
carrying amount includes both current and noncurrent portions. These portions should be
determined and disclosed separately in the financial statements.
To determine the current and noncurrent portions, we simply refer to the amortization
table. The current portion is the amortization in the immediately following year. This is the
portion of the next year’s collection applied to the principal. The noncurrent portion is the
present value in the immediately following year.
The sum of the current and noncurrent portions is equal to the carrying amount as of
December 31, 2018.
Current portion of notes receivable 177,945
Noncurrent portion of notes receivable 422,513
Carrying amount of notes receivable - Dec. 31, 2018 600,458

The unamortized balance of unearned interest income is derived by deducting the present
value from the outstanding face amount. The balance of the unamortized unearned interest
income as of December 31, 2018 is computed as follows:
Outstanding face amount (1M – 250K first installment) 750,000
Carrying amount of notes receivable – Dec. 31, 2018 (600,458)
Unearned interest income – Dec. 31, 2018 149,542

When disclosing in the financial statements, the unearned interest income is allocated to
both the current and non-current portions of the notes receivable. This is done by
deducting the present value of the portion from the related future cash collections.
The breakdown of the notes receivable is disclosed in the December 31, 2018 notes to
financial statements as follows:
Current portion of notes receivable:
Notes receivable P 250,000
Unearned interest 72,055
Notes receivable, net (presented in current assets) 177,945
Noncurrent portion of notes recivable:
Notes receivable 500,000
Unearned interest 77,487
Notes receivable, net (presented in noncurrent assets) 422,513
Total notes receivable, net - Dec. 31, 2018 P 600,458

The notes receivable (P250,000) pertains to the annual cash flow to be collected in 2019.
The unearned interest (72,055) is the difference between 250,000 cash flow and 177,945
current portion. The notes receivable (500,000) pertains to the annual cash flows to be
collected in 2020 and 2021 (250,000 x 2 = 500,000).
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Notes Receivable

Illustration 5: Non-interest bearing note – installment in advance

On January 1, 2018, JKL Co. sold transportation equipment with a historical cost of
P2,000,000 and accumulated depreciation of P700,000 in exchange for cash of P100,000
and a non-interest bearing note receivable of P1,000,000 due in 4 equal annual
installments starting on January 1, 2018 and every January 1 thereafter. The prevailing rate
of interest for this type of note is 12%.
The present value of the note as of January 1, 2018 is computed as follows:
Future cash flows – annual installments (1M ÷ 4) 250,000
Multiply by: PV of an annuity due of P1 @ 12%, n=4 3.40183
Present value of note receivable 850,458
The entries on January 1, 2018 are as follows:
Jan. 1, Cash on hand 100,000
2018 Notes receivable 1,000,000
Accumulated depreciation 700,000
Loss on sale of equipment 349,542
Transportation equipment 2,000,000
Unearned interest income (1M – 850,458) 149,542
to record the sale of equipment
Jan. 1, Cash on hand 250,000
2018 Note receivable 250,000
to record the first installment in advance

Amortization table – installment in advance

Interest
Date Collections income Amortization Present value
b = d x effective
a interest rate c=a-b d = prev. bal. - c
01/01/2018 850,458
01/01/2018 250,000 - 250,000 600,458
01/01/2019 250,000 72,055 177,945 422,513
01/01/2020 250,000 50,702 199,298 223,214
01/01/2021 250,000 26,786 223,214 0
No interest income is recognized on the first installment because there is no passage of
time yet. Interest is earned only when there is a passage of time.
The entries on December 31, 2018 and January 1, 2019 are as follows:
Dec. 31, Unearned interest 72,055
2018 Interest income 72,055
Dec. 31, Cash on hand 250,000
2018 Note receivable 250,000
To record the 2nd installment collection

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The amortization table above shows carrying amounts as of January 1 of each of the
subsequent years. These carrying amounts are net of the January 1 collections. To compute
for the carrying amount of the notes receivable as of December 31, the amount of collection
on the following day (i.e., January 1 of next year) is simply added back to the January 1
present value.
The carrying amount of the notes receivable as of December 31, 2018 is determined as
follows:
Carrying amount of notes receivable - Jan. 1, 2019 422,513
Add back: Collection on Jan. 1, 2019 250,000
Carrying amount of notes receivable - Dec. 31, 2018 672,513

Illustration 6: Non-interest bearing note – semiannual cash flows

On January 1, 2018, JKL Co. sold machinery with historical cost of P2,000,000 and
accumulated depreciation of P1,100,000 in exchange for a 3-year, P1,200,000 noninterest-
bearing note receivable due in equal semi-annual payments every July 1 and December 31
starting on July 1, 2018. The prevailing rate of interest for this type of note is 10%.
Discounting semiannual cash flows
When discounting cash flows that are due in semiannual installments, the “n” (period) used
in the present value factor is multiplied by 2 because there are two semiannual
installments per year. Furthermore, the effective interest rate is divided by 2 because
interest rates are normally expressed on a per annum basis.
When cash flows are due quarterly, “n” is multiplied by 4 and the interest rate is divided by
4 because there are 4 quarters in a year. When cash flows are due monthly, “n” is multiplied
by 12 and the rate is divided by 12 because there are 12 months in a year. When cash flows
are due weekly, “n” is multiplied by 52 and the rate is divided by 52. When cash flows are
due daily, “n” is multiplied by 365 and the rate is divided by 365.
Therefore, the “n” to be used in the illustration above is 6 years (i.e., 3 years x 2) and the
discount rate is 5% (i.e., 10% ÷ 2).
The PV of an ordinary annuity of P1 @ 5%, n=6 is computed at 5.075692067.
The present value of the note as of January 1, 2018 is computed as follows:
Future cash flows – semiannual installments (1.2M ÷ 6) 200,000
Multiply by: PV of an ordinary annuity of P1 @ 5%, n=6 5.075692
Present value of note receivable 1,015,138
The note receivable is initially recognized as follows:
Jan. 1, Note receivable 1,200,000
2018 Accumulated depreciation 1,100,000
Machinery 2,000,000
Unearned interest income (1.2M – 1,015,138) 184,862
Gain on sale of machinery 115,138
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Amortization table – semi-annual installments

Interest
Date Collections income Amortization Present value
01/01/2018 1,015,138
07/01/2018 200,000 50,757 149,243 865,895
12/31/2018 200,000 43,295 156,705 709,190
07/01/2019 200,000 35,460 164,540 544,650
12/31/2019 200,000 27,232 172,768 371,882
07/01/2020 200,000 18,594 181,406 190,476
12/31/2020 200,000 9,524 190,476
The other entries in 2018 are as follows:
July 1, Cash on hand 200,000
2018 Unearned interest income 50,757
Note receivable 200,000
Interest income 50,757
Dec. 31, Cash on hand 200,000
2018 Unearned interest income 43,295
Note receivable 200,000
Interest income 43,295

Illustration 7: Noninterest-bearing note – non-uniform cash flows

On January 1, 2018, JKL Co. sold machinery costing P2,000,000 with accumulated
depreciation of P1,100,000 in exchange for a 3-year, P1,200,000 noninterest-bearing note
receivable due as follows:
Date Amount of installment
Dec. 31, 2018 600,000
Dec. 31, 2019 400,000
Dec. 31, 2020 200,000
Total 1,200,000

The prevailing rate of interest for this type of note is 10%.

Discounting non-uniform (unequal) cash flows
Annuity factors are applicable only when the series of cash flows are uniform or equal.
When the series of cash flows vary, the PV of P1 should be used.
A cash flow that is due one period from initial recognition is discounted using PV of P1 for a
period (n) of 1. A cash flow that is due two periods from initial recognition is discounted
using PV of P1 for a period (n) of 2, and so on.

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The present value of the note is computed as follows:
Date Collections PV of P1 @ 10%, n=1 to 3* Present value
Dec. 31, 2018 600,000 0.90909 545,455
Dec. 31, 2019 400,000 0.82645 330,579
Dec. 31, 2020 200,000 0.75131 150,263
Totals 1,200,000 1,026,296

* PV of P1 @ 10%: n=1 is 0.90909; n=2 is 0.82645; n=3 is 0.75131

Amortization table – non-uniform installments:

Interest
Date Collections income Amortization Present value
01/01/2018 1,026,296
12/31/2018 600,000 102,630 497,370 528,926
12/31/2019 400,000 52,893 347,107 181,818
12/31/2020 200,000 18,182 181,818 0

The entries in 2018 are as follows:

Jan. 1, Note receivable 1,200,000
2018 Accumulated depreciation 1,100,000
Machinery 2,000,000
Unearned interest income 173,704
Gain on sale of machinery 126,296
Dec. 31, Cash on hand 600,000
2018 Unearned interest 102,630
Note receivable 600,000
Interest income 102,630

Illustration 8: Receivable with Cash Price Equivalent

On January 1, 2018, JKL Co. sold inventory costing P800,000 with a list price of P1,100,000
and a cash price of P1,200,000 noninterest-bearing note due on December 31, 2020.
The note receivable is initially recognized as follows:
Jan. 1, Note receivable 1,200,000
2018 Sales 1,000,000
Unearned interest (1.2 M – 1M) 200,000
Notice that the list price is ignored. The difference between the face amount of the note and
the cash price equivalent represents the unearned interest income which shall be
amortized as interest income using the effective interest method.
The application of the effective interest method requires the use of an effective interest
rate. But what is the effective interest rate? At what amounts will interest income be
recognized? To answer, let us go back to the definitions of effective interest rate and
imputed rate of interest.
 Intermediate Accounting 1
15
Notes Receivable

The effective interest rate or imputed interest rate is the rate that exactly discounts
estimated future cash receipts to the net carrying amount of the receivable as of initial
recognition.
The net carrying amount of the note receivable as of January 1, 2018 is the present value of
P1,000,000 (i.e., cash price equivalent) and the future cash receipt is P1,200,000.
To illustrate the definition of effective interest rate, we will make a variation of our
previous formula for computing the present value of future cash flows:
Previous formula: (used in the previous illustrations)
Future cash flows xx
Multiply by: PV factor at x% xx
Present value of note receivable xx

Variation: (presented as an equation)

Future cash flows x PV factor at x% = Present value

Where: x% = the effective interest rate

The effective interest rate (x%) can be computed using various methods and tools. We will
use manual computation using a “trial and error” approach combined with interpolation.

Trial and Error Approach

Under the trial and error approach, we will initially use a random interest rate on the
variation formula above. Thereafter, we will adjust the interest rate depending on the
outcome of the trial using the inverse relationship between the effective interest rate and
the amount of present value as a guide. This means that if we need a higher amount of
present value, we should use a lower effective interest rate, and vice-versa. We will
continue adjusting the interest rate until we get the rate that exactly discounts the
estimated future cash receipts to the initial carrying amount of the receivable. In other
words, we will squeeze for the effective interest rate in the equation.
Let us apply the trial and error approach. Let us try a random interest rate, say 10%. Using
the formula above, we will determine if the future cash flows of P1,200,000 discounted at
10% using “n” of 3 (or PV of P1 @ 10%, n=3) is equal to the present value of the note of
P1,000,000. The note is collectible in lump sum, so we will use the PV of P1 factor:

First trial: (at 10%)

Future cash flows x PV factor at x% = PV of note
 1,200,000 x PV of P1 @ 10%, n=3 = 1,000,000
 1,200,000 x 0.751315 = 901,578 is not equal to 1,000,000

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We need a substantially higher amount of present value. Therefore, we need to decrease
substantially the interest rate. Let us try 6%.

Second trial: (at 6%)

Future cash flows x PV factor at x% = PV of note
 1,200,000 x PV factor @ 6%, n=3 = 1,000,000
 1,200,000 x 0.839619 = 1,007,543 is not equal to 1,000,000
We need a slightly lower amount of present value. Therefore, we need to increase slightly
the interest rate. Let us try 7%.

Third trial: (at 7%)

Future cash flows x PV factor at x% = PV of note
 1,200,000 x PV of P1 @ 7%, n=3 = 1,000,000
 1,200,000 x 0.816298 = 979,558 is not equal to 1,000,000

In here, we need to perform interpolation. Looking at the values derived above, we can
reasonably expect that the effective interest rate is a rate between 6% and 7%.
To perform the interpolation, we will use the following formula:
x% - 6%
7% - 6%
Where: x% again is the effective interest rate.
The formula is derived based on our expectation that the effective interest rate is
somewhere between 6% and 7%. Notice that the lower rate appears in both the numerator
and denominator of the formula while x% appears in the numerator.
Let us substitute the amounts of present values computed earlier on the formula.
1,000,000 - 1,007,543 (7,543)
= = 0.2695
979,558 - 1,007,543 (27,985)
The amount computed is added to 6% to derive the effective interest rate. The effective
interest rate is 6.2695% (6% + .2695).
Notes:
 The present value of the x% in the interpolation formula is equal to P1,000,000, the
initial carrying amount of the note.
 We have estimated earlier that x% is somewhere between 6% and 7%. Thus, in the
formula above, 6% is deducted in both the numerator and denominator.
 The computed amount is added to 6% because the estimate of x% is higher than 6%,
but lower than 7%.
The amortization table using 6.2695% as the effective interest rate is presented below.
 Intermediate Accounting 1
17
Notes Receivable

Interest Unearned
Date income interest Present value
01/01/2018 200,000 1,000,000
12/31/2018 62,695 137,305 1,062,695
12/31/2019 66,626 70,679 1,129,321
12/31/2020 70,803 (124) 1,200,124

Notice that there is still a slight difference of P124. However, if this is deemed immaterial,
we can regard the computed rate as the effective interest rate.
The entry on December 31, 2018 is as follows:
Dec. 31, Unearned interest 62,695
2018 Interest income 62,695
The carrying amounts of the notes receivable on January 1 and December 31, 2018 are as
follows:
Jan. 1, 2018 Dec. 31, 2018
Note receivable 1,200,000 1,200,000
Unearned interest income (200,000) (137,305)
Carrying amount 1,000,000 1,062,695

References and Supplementary Materials

Books and Journals
1. Valix, C.T., Peralta, J.F, & Valix, C.M. (2019), Intermediate Financial Accounting (2019
edition, Volume 1). Manila, Philippines: GIC Enterprises & Co., Inc.
2. Robles, N.S., & Empleo, P.M., The Intermediate Accounting Series Volume 1 (2016
edition). Manila, Philippines: GIC Enterprises & Co., Inc.
3. Milan, Z.V.B., Intermediate Financial Accounting 1A (2016 edition). Baguio City,
Philippines: Bandolin Enterprise

Online Supplementary Reading Materials

1. https://www.harpercollege.edu/academics/academic_support/tutoring/subjects/pdf
/Notes%20Receivable%20-%20CR.pdf
2. https://dictionary.cambridge.org/dictionary/english/note-receivable
3. https://www.accountingformanagement.org/notes-receivable/
4. http://oer2go.org/mods/en-
boundless/www.boundless.com/accounting/definition/notes-receivable/index.html
5. https://ebrary.net/336/accounting/notes_receivable

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