Notes Receivable

• A written promise to pay• Usually longer-term and more formal• Usually for a stated amount and a specified period • Either formally stated or implicit interest rate

Notes Receivable

• A written promise to pay• Usually longer-term and more formal• Usually for a stated amount and a specified period • Either formally stated or implicit interest rate

Implicit interest is when there is no formally stated interest rate, but the note is priced at a discount.

Notes Receivable

• A written promise to pay• Usually longer-term and more formal• Usually for a stated amount and a specified period • Either formally stated or implicit interest rate

Implicit interest is when there is no formally stated interest rate, but the note is priced at a discount.

For example, a $1,000, 1-year note (with no stated interest rate) that sells for $900 has an implied interest rate of 11.1%.

Notes Receivable

Since notes tend to be longer-term, inflation whittles away the amount we can expect to recover from the note’s proceeds.

Notes Receivable

Since notes tend to be longer-term, inflation whittles away the amount we can expect to recover from the note’s proceeds.

To handle this, we generally carry long-term notes receivable on the balance sheet at their net present value.

Notes Receivable

Since notes tend to be longer-term, inflation whittles away the amount we can expect to recover from the note’s proceeds.

To handle this, we generally carry long-term notes receivable on the balance sheet at their net present value.

Short-term notes can be carried at face value, since they will likely not suffer from inflation.

Valuing Notes Receivable

To properly value long-term notes, we need the following information:

Valuing Notes Receivable

To properly value long-term notes, we need the following information:

• Stated interest rate• Date of issue• Interest payment schedule• Principal payment schedule (usually end of note term)• Market interest rate for similar risk note (discount rate)

Valuing Notes Receivable

Using this information, do the following:

Valuing Notes Receivable

Using this information, do the following:

1. Set up repayment timeline.

Valuing Notes Receivable

Using this information, do the following:

1. Set up repayment timeline.2. Plot actual cash inflows on timeline, using

stated interest rate and face value of the note.

Valuing Notes Receivable

Using this information, do the following:

1. Set up repayment timeline.2. Plot actual cash inflows on timeline, using

stated interest rate and face value of the note.3. Discount plotted cash inflows using market

equivalent-risk rate of interest (discount rate).

Valuing Notes Receivable

Example: 4 year note; no stated interest; $10,000 face value

Valuing Notes Receivable

Example: 4 year note; no stated interest; $10,000 face value

1. Set up repayment timeline.

Year0

Year2

Year1

Year3

Year4

Valuing Notes Receivable

Example: 4 year note; no stated interest; $10,000 face value

2. Plot actual cash inflows on timeline, using stated interest rate and face value of the note.

Year0

Year2

Year1

Year3

Year4

$0

Valuing Notes Receivable

Example: 4 year note; no stated interest; $10,000 face value

2. Plot actual cash inflows on timeline, using stated interest rate and face value of the note.

Year0

Year2

Year1

Year3

Year4

$0 $0

Valuing Notes Receivable

Example: 4 year note; no stated interest; $10,000 face value

2. Plot actual cash inflows on timeline, using stated interest rate and face value of the note.

Year0

Year2

Year1

Year3

Year4

$0 $0 $0

Valuing Notes Receivable

Example: 4 year note; no stated interest; $10,000 face value

2. Plot actual cash inflows on timeline, using stated interest rate and face value of the note.

Year0

Year2

Year1

Year3

Year4

$0 $0 $0 $0

Valuing Notes Receivable

Example: 4 year note; no stated interest; $10,000 face value

2. Plot actual cash inflows on timeline, using stated interest rate and face value of the note.

Year0

Year2

Year1

Year3

Year4

$0 $0 $0 $0 $10,000

Valuing Notes Receivable

Example: 4 year note; no stated interest; $10,000 face value

3. Discount plotted cash inflows using market equivalent-risk rate of interest (discount rate).

Year0

Year2

Year1

Year3

Year4

$0 $0 $0 $0 $10,000

Assume discount rate = 7%.

Valuing Notes Receivable

Example: 4 year note; no stated interest; $10,000 face value

3. Discount plotted cash inflows using market equivalent-risk rate of interest (discount rate).

Year0

Year2

Year1

Year3

Year4

$0 $0 $0 $0 $10,000

Assume discount rate = 7%.

Therefore, discount multiplier =1

1.07year

Valuing Notes Receivable

Example: 4 year note; no stated interest; $10,000 face value

3. Discount plotted cash inflows using market equivalent-risk rate of interest (discount rate).

Year0

Year2

Year1

Year3

Year4

$0 $0 $0 $0 $10,000

0 x 1/1.070

Valuing Notes Receivable

Example: 4 year note; no stated interest; $10,000 face value

3. Discount plotted cash inflows using market equivalent-risk rate of interest (discount rate).

Year0

Year2

Year1

Year3

Year4

$0 $0 $0 $0 $10,000

$0

Valuing Notes Receivable

Example: 4 year note; no stated interest; $10,000 face value

3. Discount plotted cash inflows using market equivalent-risk rate of interest (discount rate).

Year0

Year2

Year1

Year3

Year4

$0 $0 $0 $0 $10,000

$0 $0

Valuing Notes Receivable

Example: 4 year note; no stated interest; $10,000 face value

3. Discount plotted cash inflows using market equivalent-risk rate of interest (discount rate).

Year0

Year2

Year1

Year3

Year4

$0 $0 $0 $0 $10,000

$0 $0 $0 $0 10,000 x 1/1.074

Valuing Notes Receivable

Example: 4 year note; no stated interest; $10,000 face value

3. Discount plotted cash inflows using market equivalent-risk rate of interest (discount rate).

Year0

Year2

Year1

Year3

Year4

$0 $0 $0 $0 $10,000

$0 $0 $0 $0 $7,629

Valuing Notes Receivable

Example: 4 year note; no stated interest; $10,000 face value

The journal entry to record this note is:

Valuing Notes Receivable

Example: 4 year note; no stated interest; $10,000 face value

The journal entry to record a purchase of this note for cash is:

Notes Receivable $10,000Discount, Notes Rec. $2,371Cash $7,629

Valuing Notes Receivable

Example: 4 year note; 9% stated interest; $10,000 face value

1. Set up repayment timeline.

Year0

Year2

Year1

Year3

Year4

Valuing Notes Receivable

Example: 4 year note; 9% stated interest; $10,000 face value

Valuing Notes Receivable

Example: 4 year note; 9% stated interest; $10,000 face value

2. Plot actual cash inflows on timeline, using stated interest rate and face value of the note.

Year0

Year2

Year1

Year3

Year4

$0 $900 $900 $900 $900$10,000

Valuing Notes Receivable

Example: 4 year note; 9% stated interest; $10,000 face value

2. Plot actual cash inflows on timeline, using stated interest rate and face value of the note.

Year0

Year2

Year1

Year3

Year4

$0 $900 $900 $900

9% x $10,000of interest paid annually

$900$10,000

Valuing Notes Receivable

Example: 4 year note; 9% stated interest; $10,000 face value

2. Plot actual cash inflows on timeline, using stated interest rate and face value of the note.

Year0

Year2

Year1

Year3

Year4

$0 $900 $900 $900

Repayment of principal (stated amount) at the maturity of note

$900$10,000

Valuing Notes Receivable

Example: 4 year note; 9% stated interest; $10,000 face value

Year0

Year2

Year1

Year3

Year4

$0 $900 $900 $900

3. Discount plotted cash inflows using market equivalent-risk rate of interest (discount rate).

Assume discount rate = 13%.

Therefore, discount multiplier =1

1.13year

$900$10,000

Valuing Notes Receivable

Example: 4 year note; 9% stated interest; $10,000 face value

Year0

Year2

Year1

Year3

Year4

$0 $900 $900 $900

3. Discount plotted cash inflows using market equivalent-risk rate of interest (discount rate).

$0 900 x 1/1.131

$900$10,000

Valuing Notes Receivable

Example: 4 year note; 9% stated interest; $10,000 face value

Year0

Year2

Year1

Year3

Year4

$0 $900 $900 $900

3. Discount plotted cash inflows using market equivalent-risk rate of interest (discount rate).

$0 $796

$900$10,000

Valuing Notes Receivable

Example: 4 year note; 9% stated interest; $10,000 face value

Year0

Year2

Year1

Year3

Year4

$0 $900 $900 $900

3. Discount plotted cash inflows using market equivalent-risk rate of interest (discount rate).

$0 $796 $705 $624 $6,685

$900$10,000

Valuing Notes Receivable

Example: 4 year note; 9% stated interest; $10,000 face value

Year0

Year2

Year1

Year3

Year4

3. Discount plotted cash inflows using market equivalent-risk rate of interest (discount rate).

NPV = 796 + 705 + 624 + 6,685 = $8,810

$0 $900 $900 $900

$0 $796 $705 $624 $6,685

$900$10,000

Valuing Notes Receivable

The journal entry to record a purchase of this note for cash is:

Notes Receivable $10,000Discount, Notes Rec. $1,190Cash $8,810

Example: 4 year note; 9% stated interest; $10,000 face value

Valuing Notes Receivable

Example: 4 year note; 9% stated interest; $10,000 face value

Year0

Year2

Year1

Year3

Year4

$0 $900 $900 $900

Now assume that inflation is low, so discount rate is only 6%.

Assume discount rate = 6%.

Therefore, discount multiplier =1

1.06year

$900$10,000

Valuing Notes Receivable

Example: 4 year note; 9% stated interest; $10,000 face value

Year0

Year2

Year1

Year3

Year4

$0 $900 $900 $900

$0 $849 $801 $756 $8,634

$900$10,000

Valuing Notes Receivable

Example: 4 year note; 9% stated interest; $10,000 face value

Year0

Year2

Year1

Year3

Year4

$0 $900 $900 $900

$0 $849 $801 $756 $8,634

$900$10,000

NPV = 849 + 801 + 756 + 8,634 = $11,040

Valuing Notes Receivable

The journal entry to record a purchase of this note for cash is:

Notes Receivable $10,000Premium, Notes Rec. $1,040

Cash $11,040

Example: 4 year note; 9% stated interest; $10,000 face value

Valuing Notes Receivable

The journal entry to record a purchase of this note for cash is:

Notes Receivable $10,000Premium, Notes Rec. $1,040

Cash $11,040

Example: 4 year note; 9% stated interest; $10,000 face value

The premium reflects the amount we overpay in order to get a note with an interest rate that pays more than the inflation rate.

Notes ReceivableAmortization of Discount

Notes ReceivableAmortization of Discount

Go back to our 13% interest rate example:

The journal entry to record a purchase of this note for cash is:

Notes Receivable $10,000Discount, Notes Rec. $1,190Cash $8,810

Example: 4 year note; 9% stated interest; $10,000 face value

Notes ReceivableAmortization of Discount

Go back to our 13% interest rate example:

Notes ReceivableAmortization of Discount

At date of purchase, the balance sheet carries the note:

Notes ReceivableAmortization of Discount

At date of purchase, the balance sheet carries the note:

Note Receivable $10,000Less: Discount $1,190Carrying Value $8,810

Notes ReceivableAmortization of Discount

At date of purchase, the balance sheet carries the note:

Note Receivable $10,000Less: Discount $1,190Carrying Value $8,810

Amortization amount each year =

Carrying value x interest rate (discount rate) – interest actually paid

Notes ReceivableAmortization of Discount

At date of purchase, the balance sheet carries the note:

Note Receivable $10,000Less: Discount $1,190Carrying Value $8,810

Amortization amount each year =

Carrying value x interest rate (discount rate) – interest actually paid

Notes ReceivableAmortization of Discount

At date of purchase, the balance sheet carries the note:

Note Receivable $10,000Less: Discount $1,190Carrying Value $8,810

Amortization amount each year =

Year 1 amortization =

Carrying value x interest rate (discount rate) – interest actually paid

Notes ReceivableAmortization of Discount

At date of purchase, the balance sheet carries the note:

Note Receivable $10,000Less: Discount $1,190Carrying Value $8,810

Amortization amount each year =

Year 1 amortization = (8,810 x 0.13)

Carrying value x interest rate (discount rate) – interest actually paid

Notes ReceivableAmortization of Discount

At date of purchase, the balance sheet carries the note:

Note Receivable $10,000Less: Discount $1,190Carrying Value $8,810

Amortization amount each year =

Year 1 amortization = (8,810 x 0.13) - 900

Carrying value x interest rate (discount rate) – interest actually paid

Notes ReceivableAmortization of Discount

At date of purchase, the balance sheet carries the note:

Note Receivable $10,000Less: Discount $1,190Carrying Value $8,810

Amortization amount each year =

Year 1 amortization = (8,810 x 0.13) – 900 = $245

Notes ReceivableAmortization of Discount

So, we can set up an annual amortization table:

Notes ReceivableAmortization of Discount

So, we can set up an annual amortization table:

Year (a)

Beg. Carrying

Value

(b)

Interest Rate

(c)

Interest Actually

Paid

(d)

Amortization

Amount

[(a) x (b)] – (c)

Ending Carrying

Value

(a) + (d)

0

1

2

3

4

Notes ReceivableAmortization of Discount

So, we can set up an annual amortization table:

Year (a)

Beg. Carrying

Value

(b)

Interest Rate

(c)

Interest Actually

Paid

(d)

Amortization

Amount

[(a) x (b)] – (c)

Ending Carrying

Value

(a) + (d)

0 --- --- --- --- 8,810

1 8,810 0.13 900 245

2

3

4

Notes ReceivableAmortization of Discount

So, we can set up an annual amortization table:

Year (a)

Beg. Carrying

Value

(b)

Interest Rate

(c)

Interest Actually

Paid

(d)

Amortization

Amount

[(a) x (b)] – (c)

Ending Carrying

Value

(a) + (d)

0 --- --- --- --- 8,810

1 8,810 0.13 900 245 9,055

2 9,055

3

4

Notes ReceivableAmortization of Discount

So, we can set up an annual amortization table:

Year (a)

Beg. Carrying

Value

(b)

Interest Rate

(c)

Interest Actually

Paid

(d)

Amortization

Amount

[(a) x (b)] – (c)

Ending Carrying

Value

(a) + (d)

0 --- --- --- --- 8,810

1 8,810 0.13 900 245 9,055

2 9,055 0.13 900 277

3

4

Notes ReceivableAmortization of Discount

So, we can set up an annual amortization table:

Year (a)

Beg. Carrying

Value

(b)

Interest Rate

(c)

Interest Actually

Paid

(d)

Amortization

Amount

[(a) x (b)] – (c)

Ending Carrying

Value

(a) + (d)

0 --- --- --- --- 8,810

1 8,810 0.13 900 245 9,055

2 9,055 0.13 900 277 9,332

3 9,332 0.13 900 313 9,645

4 9,645

Notes ReceivableAmortization of Discount

So, we can set up an annual amortization table:

Year (a)

Beg. Carrying

Value

(b)

Interest Rate

(c)

Interest Actually

Paid

(d)

Amortization

Amount

[(a) x (b)] – (c)

Ending Carrying

Value

(a) + (d)

0 --- --- --- --- 8,810

1 8,810 0.13 900 245 9,055

2 9,055 0.13 900 277 9,332

3 9,332 0.13 900 313 9,645

4 9,645 0.13 900 354 10,000

Notes ReceivableAmortization of Discount

Actual interest revenue reported each year is equal to actual interest paid + the amount of discount

amortized (or – the amount of premium amortized)

Notes ReceivableAmortization of Discount

Actual interest revenue reported each year is equal to actual interest paid + the amount of discount

amortized (or – the amount of premium amortized)

Journal entry to record receipt of year 1 interest:

Notes ReceivableAmortization of Discount

Actual interest revenue reported each year is equal to actual interest paid + the amount of discount

amortized (or – the amount of premium amortized)

Journal entry to record receipt of year 1 interest:

Cash $900Disc, Notes Rec $245

Interest Revenue, Notes Rec $1,145