CHAPTER 2: NOTES PAYABLE

NOTES PAYABLE
Notes payable are liabilities evidenced by a written document known as “promissory note”. 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 determined future time a sum certain in money to order or to bearer.

CLASSIFICATION AND MEASUREMENT

Classification Initial Subsequent Amortized? Fair value Interest
measurement measurement changes expense is
based on
Financial Financial Fair value Fair value No Yes Nominal rate
liabilities liabilities at (presented in
fair value P/L)
through profit
or loss
Financial Fair value Amortized cost Yes No Effective rate
liabilities at minus
amortized transaction cost
cost

Initial measurement
Interest bearing Face value
SHORT TERM Non-interest bearing Face value, unless discounting is
material should be measured at
present value
Interest bearing With reasonable interest Face value
rate
LONG TERM With unreasonable Present value
interest rate
Non-interest bearing Present value

FREQUENTLY ASKED QUESTIONS:

1. The initial and subsequent measurement of notes payable.
2. For financial liabilities at amortized cost, the subsequent measurement can be determine trough the use of
amortization table.
3. Interest expense for the year:
 For FVPL liabilities –nominal rate
 For FAC liabilities - effective rate
4. Current and non-current portion of notes payable
 For notes payable at face value - the payment within 12 months is classified as the current portion.
 For notes payable at present value - the payment within 12 months less effective interest is classified as the
current portion.

Notes bearing a realistic interest rate

Suppose an enterprise issued a note in settlement of an overdue trade account. In that case, the entry is:

Accounts payable xx
Notes payable xx

On maturity date, the maker shall pay the principal plus the interest and make the following entry:
Notes payable xx
Interest expense xx
Cash xx

An entity shall accrue interest from the date of the note to the end of the reporting period when the maturity falls on a date
in the next reporting period and the entity has not yet settled the note. The maker shall prepare the following entry:
 CHAPTER 2: NOTES PAYABLE
Interest expense xx
Interest payable xx

Long-term Notes – Principal and Interest are payable periodically

PROBLEM 1
On March 31, 20x6, ABC Inc, issued P3,000,000, 12% promissory note for the machinery it purchased. An equal principal
amount of P1,000,000 and interest on the unpaid balance of the principal are payable annually every March 31 starting
March 31, 20x7. Thus, the following are the amounts to be paid during 20x7 through 20x9.
Due date Principal Interest due Total amount due
3/31/20x7 1,000,000 3M x 12% = 360,000 1,360,000
3/31/20x8 1,000,000 2M x 12% = 240,000 1,240,000
3/31/20x9 1,000,000 1M x 12% = 120,000 1,120,000
Assume the entity reports on a calendar-year basis. Provide the following are the entries for 20x6 through 20x9. Assume
further that no reversing entries are made:
Determine the amounts that shall be presented in its statement of financial position on December 31, 20x6, 20x7 and 20x8
as current and non-current liabilities.

Long-term Notes – Principal matures in lump sum, interest is payable periodically:

PROBLEM 2
Assume that on March 31, 2026, MNO Co. issued a three-year, P4,000,000, 12% promissory note for purchase of
machinery. Interest on this note is payable annually on its anniversary date.
Assume the entity reports on a calendar-year basis. Provide the following are the entries for 20x6 through 20x9. Assume
further that no reversing entries are made:
Determine the amounts that shall be presented in its statement of financial position on December 31, 20x6, 20x7 and 20x8
as current and non-current liabilities:

Note bearing an unreliable interest rate

A note bears an unrealistic interest rate when any one or both two situations exist:
a. the interest rate appearing on the face of the note is significantly different from the market rate of similar notes; and
b. the consideration received on account of the note issued has a fair value that is significantly different from the face
value of the note.
In such cases, the note and the interest to be paid based on the stated rate are discounted at the market rate of interest on
the date of the issuance.
If the rate stated on the face of the note is higher than the market rate of interest, the discounted amount is higher than the
face value of the note, resulting in a premium on notes payable. If the rate stated on the face of the note is lower than the
market rate of interest, the discounted amount is lower than the face value of the note, resulting in a discount on notes
payable.

Short-term Note: Stated rate > Market rate:

PROBLEM 3
On May 1, 20x6, Dino Inc. purchased from Sims Co. a piece of special equipment by issuing a 14%, one-year note for
P320,000. There is no equivalent cash price for this equipment, but the market rate of interest on similar notes is 8%. The
present value of the future cash outflow to settle the obligation is:
Assuming the entity reports on a calendar year basis, prepare the entries in 20x6 and the amortized cost on December 31,
20x6.
Assuming no reversing entries were made on January 1, 20x7, prepare the necessary entries relating to the note.

Short-term Note: Stated rate < Market rate:

PROBLEM 4
On May 1, 20x6, Dino Inc. purchased from Sims Co. a piece of special equipment by issuing a 5%, one-year note for
P320,000. There is no equivalent cash price for this equipment, but the market rate of interest on similar notes is 10%. The
present value of the future cash outflow to settle the obligation is:
Assuming the entity reports on a calendar year basis, prepare the entries in 20x6 and the amortized cost on December 31,
20x6.
Assuming no reversing entries were made on January 1, 20x7, prepare the necessary entries relating to the note.
 CHAPTER 2: NOTES PAYABLE

Long-Term Notes with Unrealistic Interest Rate

Noninterest bearing note – lump sum
PROBLEM 5
On January 1, 20x1, an entity issues a noninterest-bearing note payable P1,600,000 in exchange for land. The
note is due on December 31, 20x3. The effective interest rate is 17%. Provide all the entries during the term of
the note payable.

Noninterest bearing note – installments

PROBLEM 6
On January 1, 20x1, an entity issues a noninterest-bearing note of P1,200,000 in exchange for land. The note is
due in three equal annual instalments every December 31. The effective interest rate is 17%.
Required:
a. Provide all the entries during the term of the note.
b. Compute for the current and noncurrent portions of the note on December 31, 20x1 and the amount of
“Discount on notes payable” allocated to each portion.

Noninterest-bearing note – installment in advance

PROBLEM 7
On January 1, 20x1, Otters Co. issued a 3-year, noninterest bearing note of P1,200,000 in exchange for
equipment. The note is due in three equal annual installments beginning on January 1, 20x1 and every January 1
thereafter. The effective interest rate is 10%.
Requirements:
a. Prepare amortization table.
b. How much is the interest expense in 20x1?
c. How much is the carrying amount of the note on December 31, 20x1?

DEBT RESTRUCTURING
This is a situation where the creditor, for economic legal reasons to the debtor’s financial difficulties, grants the debtor
concession that would not otherwise be granted in a normal business relationship. 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 realizes an accounting gain.

FORMS OF DEBT RESTRUCTURING

1. Asset swap – this is the transfer of any asset such as real estate, inventory or investment by the debtor to the creditor
in full settlement of an obligation. Asset swap results to derecognition of financial liability. The difference between
carrying amount of the financial liability and the consideration given shall be recognized in profit or loss.
Total liability (includes accrued interest) xx
Carrying amount of asset given (xx)
Gain on extinguishment (P/L) xx
According to US GAAP, asset swap results to 2 economic events namely, transfer or exchange of assets and
restructuring of liability. Thus, US GAAP requirement is to divide gain on extinguishment into gain or loss on
exchange and gain or loss on restructuring which can be computed based on the below template:

Total liability (includes accrued interest) xx

Fair value of asset given (xx)
Gain or (loss) on restructuring xx

Fair value of asset given xx

Carrying amount of asset given (xx)
Gain or (loss) on exchange xx
 CHAPTER 2: NOTES PAYABLE
PROBLEM 8
A bank loaned P10,000,000 to ABC Realty, which was invested in real estate development. Due to the economic
downturn in the real estate business, the company had low sales and therefore could not meet its loan obligations. On
December 31, 20x6, the loan’s due date, the bank agrees to accept from ABC a piece of land with a fair value of
P9,000,000 as full settlement of the P10,000,000 principal and one year of accrued interest at 12% (or P1,200,000). The
land has a carrying value of P10,500,000 in ABC’s books, based on the cost model.

2. Equity swap – this is a transaction whereby a debtor and creditor may renegotiate the terms of a financial liability
with the result that the liability is fully or partially extinguished by the debtor issuing equity instruments to the
creditor. Simply, equity swap is the issuance of equity instruments resulting to extinguishment of liability.
Total liability (includes accrued interest) xx
Initial measurement of equity instruments* (xx)
Gain on extinguishment (P/L) xx
*Accordingly, the equity instruments issued to extinguish financial liability shall be measured at the following
amounts in the order of priority:
1) Fair value of equity instruments issued
2) Fair value of liability instruments
3) Carrying amount of liability extinguished

PROBLEM 9
A bank agreed to accept ABC Realty’s 180,000 ordinary shares. ABC ordinary share has a par value of P50 and a fair
value of P60. Prepare the necessary journal entries for ABC.

3. Modification of terms - modification of terms of a financial liability may involve either the interest or maturity value
or both. Modification of terms can be done either through:
1) Reduction of the interest rate or forgiveness of unpaid interest or a moratorium on interest payment.
2) Extension of the maturity date or reduction of the amount to be paid at maturity.
Total liability (includes accrued interest) xx
Present value of modified liability (using the original effective rate) (xx)
Gain on extinguishment (P/L) xx
IFRS 9 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.
1) There is a substantial modification of terms if the gain or loss on extinguishment is at least 10% of the carrying
amount of the old liability.
2) If there is a direct cost involved in modification of terms, such is deducted from the carrying amount of the old
liability.

PROBLEM 10
On December 31, 20x1, an entity enters into a restructuring agreement to modify terms of its existing loan as follows:
 The principal is reduced from P2,800,000 to P2,500,000.
 The lender waived the accrued interest of P400,000.
 The nominal rate is decreased from 14% to 9%.
 The maturity date is extended from December 31, 20x1 to January 1, 20x6.
The principal is due lump sum at maturity date but interest is payable annually at each year-end. The original effective rate
is 14%. The prevailing rate on December 31, 20x1 is 12%. Provide the entry to record the modification of the loan.

LOANS PAYABLE
A loan payable is a financial liability arising from a loan granted by a bank or other financial institution to a borrower or
client. The term of the loan may be short-term but, in most cases, the repayment periods cover several years.

Measurement:
Face value xx
Origination fees (xx)
Initial measurement xx
 CHAPTER 2: NOTES PAYABLE
The origination fees received from borrower are recognized as unearned interest income and amortized over the term of
the loan. A loan payable is subsequently measured at amortized cost using the effective interest method.

PROBLEM 11
On January 1, 2021, ABC borrowed P1,000,000 from a bank. The bank charged a 3% loan origination fee. The principal is
due on January 1, 2024 but 10% interest is due annually starting on January 1, 2022. Compute the initial measurement.

Subsequent measurement:
The effective interest rate on the loan is not equal to the 10% stated rate because of the origination fee. We will compute
for the imputed interest rate using “trial and error” approach.
Observe the following:
 If the financial instrument’s carrying amount is less than its face amount, the difference is a discount.
 If the financial instrument’s carrying amount is grater than its face amount, the difference is a premium.

Discount Carrying amount is less than face amount

Premium Carrying amount is greater than face amount

 When there is a discount, the effective interest rate is higher than the nominal rate (stated rate or coupon rate)
 When there is a premium, the effective interest rate is less than the nominal rate (stated rate or coupon rate)

There is no discount or premium if the carrying amount is equal to the face amount. Consequently, the effective interest
rate is also equal to the nominal rate.

Continuing the illustration, we know that the loan is issued at a discount because the initial carrying amount of P970,000
is less than the face amount of P1,000,000. Therefore, the effective interest rate must be higher than the nominal rate of
10%.

First trial using 11%:

 (Principal of P1,000,000 x PV of 1 @ 11%, n = 3) + (Interest of P100,000 x PVOA @11%, n = 3) = P970,000
 (1,000,000 x 0.731191381) + (100,000 x 2.443714716) = 970,000
 (731,191 + 244,371 = 975,562 is not equal to P970,000.

We need a lower amount, therefore, we need to increase the rate.

Second trial at 12%:

 (Principal of P1,000,000 x PV of 1 @ 11%, n = 3) + (Interest of P100,000 x PVOA @11%, n = 3) = P970,000
 (1,000,000 x 0.731191381) + (100,000 x 2.443714716) = 970,000
 (731,191 + 244,371 = 975,562 is not equal to P970,000.

In here, we need to perform interpolation. We can infer from the values derived above that the effective interest rate is
between 11% and 12%. To perform the interpolation, we will use the following formula:
x% - 11%
12% - 11%

970,000 – 975,562
951,963 - 975,562

= 0.2357
The computed value is added to the lower rate to derive the effective interest rate. The effective interest rate is 11.2357%.
Date Interest payments Interest expense Amortization Present value
1/1/20x1 970,000
1/1/20x2 100,000 108,986 8,986 978,986
1/1/20x3 100,000 109,996 9,996 988,982
1/1/20x4 100,000 111,018 11,018 1,000,000
 CHAPTER 2: NOTES PAYABLE
PROBLEM 12 Cost of bank loan
On July 1, 2021, Cody Co. obtained a P2,000,000, 180-day bank loan at an annual rate of 12%. The loan agreement
requires Cody to maintain a P400,000 compensating balance in its checking account at the lending bank. Cody would
have otherwise maintained a balance of only P200,000 in this checking account, The checking account earns an annual
rate of 6%. Based on a 360-day year, what is the effective interest rate on the borrowing?