Discounting the Notes

Receivable:
Many business concerns which obtain notes receiable from their
customers prefer to sell the notes to a bank for cash rather than to
hold them until maturity. selling a note recieable to abank or finance
company is often called discounting a note receivable.
The holder of the note endorses the back of the note (as in
endorsing a check) and delievers the note to the bank.The bank
expects to collect the maturity value (principal plus interest) from
the maker of the note at the maturity date, but if the maker fails to
pay, the bank can demand payment from the endorser.
When a business endorses a note and turns it over to a bank for
cash, it is promising to pay the note if the maker fails to do so. The is
therefore contigently liable to the bank.
To illustrate, assume that on May 28 Symplex Company received a
1,200, 60 days, 12% note dated May 27 from John Owen. It held the
note until June 2 and then discounted it at its bank at 14%. Since the
maturity date of this note is July 26, the bank must wait 54 days after
discounting the note to collect from Owen.These 54 days are called
discount period and are calculated as follows:

Time of the note in

days .................................................................................... 60
Less time held by Symplex Company :
Number of days in May ................................................... 31
Less the date of the note .................................................. 27
Days held in May ............................................................. 4
Days held in June ................................. .......................... 2
Total days held ..............................................................
6
Discount period in
days ............................................................................... 54

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At the end of discount period, the bank expect to collect the maturity
value of this note from Owen, for remaining days upto the maturity days,
which is calculated as follows:

Principal of the
note .................................................................................. 1,200
Interest on 1,200 for 60 days at
12% .......................................................... 24
Maturity
value .......................................................................................... 1,224
======

The bank's discount rate, is 14% . Consequently, in discounting the note,

it will deduct 54 days' interest at 14% from the note's maturity value & will
give Symplex Company the reminder.The reminder is called the proceeds
of the note.The amount of interest deducted is known as bank
discount.calculated as follows:

Maturity value of the

note .............................................................................. 1,224.00
Less interest on 1,200 for 54 days at
14% ...................................................... 25.70
Proceeds .............................................................................................
1,198.30

========

* If the proceeds amount is more than principal amount the difference

shall be recorded as interest earned, contrary, if the proceeds amount is
less than principal amount the difference shall be recorded as interest
expense.

June 2 Cash ............................................................ 1, 198.30

Interest Expense .......................................... 1.70
Notes receivable ....................................
1, 200.00
Discounted the John Owen note for 54 days
at 14%

In the situation just described, the principal of the discounted note

exceeded the proceeds. However, in many cases, the proceeds exceeds the
principal . When this happens, the difference is credited to Interest Earned.
For example, suppose that instead of discounting the John Owen note on
June 2, Symplex held the note and discounted it on June 26. If the note is
discounted on June 26 at 14% , the discount period is 30 days, the discount
is 14.28, and the proceeds of the note are 1,209.72, calculated as follows:

Maturity value of the

note .............................................................................. 1,224.00
Less interest on 1,224 for 30 days at
14% ................................................... 14.28
Proceeds .............................................................................................
1,209.72

==========

And since the proceeds exceeds the principal, the

transaction is recorded as follows:

June 26 Cash ............................................................ 1,209.72

Interest Earned ......................................
9.72
Notes receivable ....................................
1, 200.00
Discounted the John Owen note for 30 days
at 14%

Discounted note receiveable paid by its maker : Before the

maturity date of the discounted note, the bank will notify the maker, John
Owen , that it now holds the note. John Owen therefore make payment
directly to the bank. John's payment of the note will require no entries in the
accounting records of Symplex Company.

Discounted note receiveable defaulted by its maker : Now let

us assume that when note matures, John is unable to pay the bank.
Symplex Company would then be obligated to "make the note good"-
---that is, to immediately pay the bank the full 1,224 maturity value
of the note. Thus, the Company's contigent liability becomes a real
liability. The entry to record payment of this note in the event of
John's default is shown below :

Account Receiveable, John

Owen ............................................. 1,224
Cash ..........................................................................
...... 1,224
To record payment to bank of maturity value of discounted John
Owen note,
defaulted by maker.

Disclosure of contingent liabilities : Since contingent liabilities

are potential liabilities rather than full-fledged liabilities, they are not
included in the liability section of the balance sheet. However, these
potential liabilities may affect the financial position of the business if
future events cause them to become real liabilities. Therefore,
contingent liabilities should be disclosed in footnotes to the
financial statements. The contingent liability arising from the
discounting of notes receiveable could be disclosed by the following
footnote:

Note 6: Contingencies and commitments

At December 31, 19---,the Company was contingently
liable for notes receivable discounted with maturity values in
the amount of 250,000.