INTERMEDIATE

ACCOUNTING
PART 2

Arlyn C. Pasion prelim BSA 2

 Course Code InterAct 2
Course Title Intermediate Accounting 2
Course & Year BSA 2
Instructor Arlyn C. Pasion, CPA, MBA, REB

MODULE- PRELIM

TOPIC OUTLINE

1. CURRENT LIABILITIES
a. Recognition of Financial Liabilities
b. Classification of Financial Liabilities
c. Measurement of Financial Liabilities
d. Financial Statement Presentation
e. Trade Account Payable
f. Unearned Income
g. Accrued Expenses
h. Dividends payable
i. Exercises

2. NOTES PAYABLE
a. Initial Measurement
b. Short term payable
c. Long term payables
d. Cash price equivalent
e. Current and Non-Current Portions of a Note Payable

3. LOANS PAYABLE
a. Origination Fees
b. Subsequent measurement
c. Amount of Loan Amortization
d. Secured Loans
e. Credit lines
f. Summary
g. exercises

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INTERMEDIATE ACCOUNTING
PART 2
CHAPTER 1. CURRENT LIABILITIES

Liability- is a present obligation of the entity to transfer an economic resource as a result of past
events.

Obligation- is a duty or responsibility that an entity has no practical ability to avoid.

An obligation is either:
a. legal obligation- an obligation that results from a contract, legislation, or other
operation of law; or
b. constructive obligation- an obligation that results from an entity’s actions (e.g., past
practice or published policies) that create a valid expectation on others that the entity will accept
and discharge certain responsibilities.

Transfer of an economic resource- an obligation to transfer an economic resource may be an

obligation to:
a. pay cash, deliver goods, or render services;
b. exchange assets with another party on unfavorable terms;
c. transfer of assets if a specified uncertain future event occurs; or
d. issue a financial instrument that obliges the entity to transfer an economic resource.

Present obligation as a result of past events

A present obligation arises when
1. The entity has already purchased and received goods.
2. The entity has a present constructive obligation to provide free repair services
for the goods it has already sold.
3. The entity has received a loan proceeds from a loan.
4. The entity employed an employee and the latter already rendered services from
the entity.

RECOGNITION OF FINANCIAL LIABILITIES

A financial liability is recognized only when the entity becomes a party to the contractual
provisions of the instrument.

Recognition Criteria:
An item is recognized if:
1. It meets the definition of a liability; and
2. recognizing it would provide useful information, i.e. relevant and faithfully represented
information.
Classification of Financial Liabilities
All financial liabilities are classified as subsequent measured at amortized cost, except of
the following:
a) Financial liabilities at fair value through profit or loss (FVPL) and derivative liabilities-
subsequently measured at fair value
b) Financial liabilities that arise when a transfer of a financial asset does not qualify for
derecognition- subsequently measured on a basis that reflects the rights and obligations
that the entity has retained.
c) Financial guarantee contracts and commitments to provide a loan at a below-market
interest rate- subsequently measured at the higher of:
i. The amount of the loss allowance (12 month expected credit losses); and
ii. The amount initially recognized less, when appropriate, the cumulative amount
of income recognized in accordance with the principles of PFRS 15.

d) Contingent consideration recognized by an acquirer in a business combination-

subsequently measured at fair value through profit or loss.

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Note: reclassification of financial liabilities after initial recognition is prohibited.
Measurement of Financial Liabilities

Initial measurement
Financial liabilities are initially measured at fair value minus transaction costs, except financial
liabilities at FVPL whose transaction costs are expensed immediately.
Subsequent measurement
 Financial liabilities classified as amortized cost are subsequently measured at amortized cost.
 Financial liabilities classified as held for trading are subsequently measured at fair value with
changes in fair values recognized in profit or loss.
 Financial liabilities designated at FVPL are subsequently measured at fair value with changes
in fair values recognized as follows:
a. The amount of change in the fair value of the financial liability that is attributable to
changes in the credit risk of that liability is presented in other comprehensive income,
and
b. The remaining amount of change in the fair value of the liability is presented in profit
or loss.

FINANCIAL STATEMENT PRESENTATION

Liabilities are presented as either (a) current or (b) noncurrent on the face of a classified
statement of financial position. A classified statement of financial position is one that shows
current and noncurrent distinctions.
Current liabilities
Current liabilities are liabilities that are:
a. Expected to be settled in the entity’s normal operating cycle;
b. Held primarily for trading
c. Due to be settled within 12 months after the reporting period; or
d. The entity does not have an unconditional right to defer settlement of the liability for at
least twelve months after the reporting period.

Example of current liabilities

a. Financial assets measured at FVPL
b. Current portion of long-term notes, bonds, loans, and lease
c. Trade accounts and notes payable
d. Other non-trade payables due within 12 months after end of reporting period.
e. Unearned income expected to be earned within 12 months after the end of the reporting
period.
f. Bank overdraft.

Illustration 1: Current liabilities

ABC Co. has the following liabilities as of Dec. 31, 20x1.
a. Trade accounts payable, net of debit balance in supplier’s account of P300,000
P5,000, net of unreleased checks of P4,000, and net of postdated
checks of P2,000.
b. Credit balance in customer’s accounts 2,000
c. Financial liability designated a FVPL 50,000
d. Bonds payable (maturing in 10 equal annual installments of P100,000) 1,000,000
e. 12%, 5-year note payable issued on October 1, 20x1 100,000
f. Deferred tax liability 5,000
g. Unearned rent 4,000
h. Contingent liability 10,000
i. Reserve for contingencies 25,000

Requirements: how much is the total current liabilities?

Solution:
a. Trade accounts payable, gross of debit balance, unreleased checks, and P311,000
postdated check (300k + 5k + 4k + 2k)
b. advances from customers (Credit balance in customer’s accounts 2,000
c. Financial liability designated a FVPL 50,000
d. current portion of Bonds payable 100,000

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 e. interest payable on the note in e. (P100,000 x 12% x 3/12) 3,000
g. Unearned rent 4,000
Notes:
 Deferred tax liabilities are always presented as noncurrent when an entity presents a
classified statement of financial position
 Contingent liability is not recognized but rather disclosed only in the notes.
 Reserve for contingencies is an appropriation of retained earnings and thus, presented in
equity.

Illustration 2: Current liabilities

ABC Co. has the following liabilities as of December 31, 20x1.

a. Trade accounts payable, including cost of goods received on P300,000
consignment of P10,000
b. Held for trading financial liabilities 50,000
c. Deferred revenue 20,000
d. Bank overdraft 10,000
e. Income tax payable 50,000
f. Accrued expenses 5,000
g. Share dividend payable 12,000
h. Advances from affiliates payable in 15 months after year end 23,000
i. Loan of XYZ Inc. guaranteed by ABC- it is possible that ABC will be 45,000
held liable for the guarantee

Requirement: how much is the current liabilities?

Solution.
a. Trade accounts payable, net of cost of goods received on consignment P290,000
(300,000- P10,000)
b. Held for trading financial liabilities 50,000
d. Bank overdraft 10,000
e. Income tax payable 50,000
f. Accrued expenses 5,000
Notes:
 Deferred revenue is similar to unearned revenue except that deferred revenue is long term.
For example, on December 31, 20x0, Entity A receives P300,000 for a 3-year supply
contract, whereby Entity A shall deliver goods worth P100,000 each year to the customer.
The entry is as follows

Dec 31, Cash 300,000

20x0 Unearned Revenue 100,000
Deferred Revenue 200,000

The portion of the advance collection applicable to 20x1 is credited to unearned revenue,
which is current liability; the portions applicable to 20x2 an 20x3 are credited to deferred
revenue, which is a noncurrent liability.

 Share dividends payable (stock dividends payable) is not a liability but rather an adjunct
equity account (i.e., presented as addition to share capital).
 The guarantee on the loan is not recognized as liability because it is not probable (i.e., it is
possible only) that ABC will be held liable for the guarantee.

TRADE ACCOUNT PAYABLE

Accounts payable from purchases of inventory are recognized when ownership over the goods is
transferred to the buyer. The amount recognized excludes trade discounts. Cash discounts are
included if the entity uses the gross method of recording purchases; they are excluded if the entity
uses the net method.

Illustration 1: Accounts payable

On December 31, 20x1, ABC Co. has accounts payable of P1,000,000 before possible adjustment
for the following:

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a. Goods in transit from a vendor to ABC on December 31, 20x1 with an invoice cost of
P50,000 purchased FOB shipping point was not yet recorded.
b. Goods shipped FOB shipping point from a vendor to ABC was lost in transit. The invoice
cost of P20,000 was not yet recorded.
c. Goods shipped FOB shipping point from a vendor to ABC on December 31, 20x1 amounting
to P8,000 was recorded and included in the year-end physical count as “goods in transit”.
d. Goods in transit from a vendor to ABC on December 31, 20x1 with an invoice cost of
P10,000 purchased FOB destination was not yet recorded. The goods were received in
January 20x2.
e. Goods with invoice cost of P15,000 was recorded and included in the year end physical count
as “goods in transit”. It was found out that the goods were shipped from a vendor under FOB
destination.

Requirement: compute for the adjusted accounts payable on December 31, 20x1
Solution:
Unadjusted accounts payable 1,000,000
a. FOB shipping point not yet recorded 50,000
b. FOB shipping point lost in transit, not yet recorded 20,000
e. FOB destination inappropriately recorded ( 15,000)
adjusted accounts payable P1,055,000

Notes:
 The goods in transit in “B” are properly included in accounts payable because the goods are
purchases FOB shipping point. Title to the goods is transferred to ABC upon shipment.
Therefore, ABC is liable to pay for the goods even if they are lost in transit.
 The goods in transit in “D” are properly excluded from accounts payable because the goods
are purchases FOB destination. Accounts payable will be recorded only when the goods are
received.

Illustration 2: Accounts payable

On December 31, 20x1, ABC Co. has accounts payable of P1,000,000 before possible adjustment
for the following:
a. Checks drawn but not yet released to payees amounted to P12,000, while checks drawn and
released to payees but were postdated amounted to P5,000.
b. On December 28, 20x1, a vendor authorized ABC to return for full credit goods shipped and
billed at P25,000 on December 14, 20x1. ABC shipped the returned goods on December 31,
20x1 but the credit memo was received and recorded only on January 3, 20x2.
c. Goods shipped FOB shipping point, freight prepaid from a vendor on December 28, 20x1
was recorded at invoice cost at shipment date. The invoice cost is P14,000 while the freight
cost is P3,000.
d. Goods shipped FOB destination freight collect were received on December 29, 20x1. The
invoice cost of P40,000 was credited to accounts payable on date of receipt and the related
freight of P5,000 was debited to an expense account.

Requirement: compute for the adjusted accounts payable on December 31, 20x1.

Solution:
Unadjusted accounts payable P1,000,000
a. unreleased checks and postdated checks (12k +5K) 17,000
b. purchase return (25,000)
c. unrecorded freight on FOB -SP, freight prepared 3,000
d. freight shouldered on behalf of the seller ( 5,000)
adjusted accounts payable P990,000

Notes:
 the freight in “c” is included in accounts payable because the goods were purchased FOB
shipping point. Ownership is transferred to ABC upon shipment but the seller shouldered the
freight cost (i.e., freight prepaid) which are supposed to be paid by ABC.

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 The freight in “d” is excluded from accounts payable because the goods were purchased FOB
destination. Ownership is transferred to ABC only upon receipt of the shipment but ABC
shouldered the costs (i.e., freight collect) which are supposed to be paid by seller. The
accommodation for the freight is treated as a reduction from accounts payable.

UNEARNED INCOME
Unearned income represents advance collection of income that is not yet earned. Prior to earning,
unearned income is classified as liability.
Examples:
a. Advance received for future delivery of goods or rendering of services.
b. Proceeds from sale of gift certificates redeemable in goods or services.

Illustration 1: unearned revenue- sale of goods

ABC Co. require advance payments for custom built guitar effects, gadgets, and racks. The
records of ABC Co. show the following:

Unearned revenue, January1, 20x1 1,000,000

Advances received during 20x1 10,000,000
Advances applied to orders shipped in 20x1 8,000,000
Advances pertaining to orders cancelled in 20x1 300,000

Requirements:
Compute for the current liability assuming:
a. the advance payments received are non-refundable and
b. the advance payments received are refundable

Solutions:
Requirement (a) advances are non- refundable

Unearned income
1,000,000 Jan. 1, 20x1
Advances earned 8,000,000 10,000,000 Advances received
Orders cancelled 300,000
Dec. 31, 20x1 2,700,000

Answer to requirement (a): 2,700,000

Requirement (b): advances are refundable

Unearned income- Dec. 31, 20x1 (see previous solution) P2,700,000
Liability for refundable deposits (orders cancelled) 300,000
Total current liability for advance received P3,000,000

The advances pertaining to the cancelled orders remain as liability, not as unearned income but as
liability for refundable deposits.

Liability for deposits received

Liability for deposits received represents cash receipts that are held in trust for other parties.
Examples:
a. Deposits liabilities of banks and other entities performing similar function
b. Deposits received for returnable containers, such as bottles, cases, crates, trays, boxes, and
similar items that contain the goods sold but must be returned to the seller upon consumption
of the goods.
c. Security deposits received from lessees
d. Deposits received from escrow agreements
e. Deposits for future subscription of the entity’s own equity instrument to the extent that the
deposits are repayable in cash.

Illustration: security deposit from a lease:

On January 1, 20x1, ABC Co. received a P100,000 security deposit from a tenant in conjunction
with a 10-year lease. ABC will return the security deposit to the tenant at the end of the lease
term, net of costs of any damages to the leased property. The discount rate is 10%.

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Requirement: provide the entries in 20x1.

Jan.1, Cash 100,00

20x1 Security deposits (100K x PV of 1 @10%, n=10) 0 38,554
“Day 1” difference* 61,446
Dec. 31, Interest expenses (38,554x10%) 3,85
20x1 Security deposit 5 3,855

ACCRUED EXPENSES

Accrued Expenses are liabilities for expenses already incurred but not yet paid (e.g., salaries
payable, utilities payable, and the like).
Illustration:

ABC Co. is preparing its December 31, 20x1 year end financial statements. The following
information was gathered:
 The bill for December’s utility costs of P30,000 was received and paid on January 10,
20x2.
 A P20,000 advertising bill was received on January 2, 20x2. Of the total billing, P15,000
pertain to advertisements in December 20x1 and P5,000 pertains to advertisements in
January 20x2.
 A lease, effective December 16,20x0, calls a fixed rent of P100,000 per month, payable
one month thereafter. In addition, rent equal to 5% on net sales over P1,000,000 per year
is payable on January 31 of the following year.
 Total cash sales and collections on accounts amounted to P1,000,000. Accounts
receivable has a bet increase of P200,000. Commissions of 15% of sales are paid on the
same day cash is received from customers.

Requirements: compute for the accrued liabilities on Dec. 31, 20x1.

Solution:
Utility expenses for December 20x1 30,000
Advertising costs incurred in December 20x1 15,000
Rent expenses form December 16 to 31, 20x1 (100k/2) 50,000
Contingent rent expenses (1.2M-1M)x 5% 10,000
Additional commission expenses 30,000
Total accrued liabilities 135,000

Addition commission expenses is computed as follows:

Total commission expenses (1.2M total sales x 15%) 180,000
Commission expenses paid (1M cash collections x 15%) (150,000)
Additional commission expenses 30,000

Dividends payable

The liability to pay dividend is recognized when the dividend is appropriately authorized and is
no longer at the discretion of the entity, which is:
a. The date when the declaration of the dividend (e.g., by the board of directors) is approved
by the relevant authority (e.g., by the shareholders) if such approval is required; or
b. The date when the dividend is declared (e.g., by the board of directors) if further approval
is not required.
Dividends declared by banks are subject to the approval of the BSP.
Only cash and property dividends are recognized as liabilities. Stock dividends
are not liabilities; ‘share dividends distributable’ (stock dividends payable’) is
presented in equity as an addition to share capital.

Liability for remittable collections

Liabilities may also arise from amounts collected on behalf of third parties. Examples:
a. Taxes withheld
b. SSS premiums, Philhealth, Pag-ibig and similar contributions

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 c. Output value added taxes (VAT)
d. Collections made by an agent or broker on behalf of a principal.

EXERCISES

PROBLEM 1- current liabilities

Entity B’s liabilities as of December 31, 20x1 include the following:

Accounts payable P500,000

Held for trading financial liabilities P1,000,000
Note payable (P1m due in 20x3) 2,800,000
Unearned revenue 300,000
Dividends payable 800,000
Deferred tax liability 200,000

Requirements: compute for the total current liabilities.

PROBLEM 2: ACCOUNTS PAYABLE

Kew Co.’s accounts payable balance at December 31, 20x1 was P2,200,000 before considering
the following data:

 Goods shipped to Kew F.O.B. shipping point on December 22, 20x1were lost in transit. The
invoice cost of P40,000 was not recorded by Kew. On January 7, 20x2, Kew filed a
P40,000clai against the common carrier.
 On December 27, 20x1, a vendor authorized Kew return, for full credit, goods shipped and
billed at P70,000 on December 3, 20x1. The returned goods were shipped by Kew on
December 28, 20x1. A P70,000credit memo was received and recorded by Kew on January 5,
20x2.
 Goods shipped to Kew F.O.B. destination on December 20, 20x1 were received and recorded
on January 6, 20x2. The invoice cost was P50,000.

Requirement: what amount should Kew report as accounts payable in its December 31, 20x1
statement of financial position?

PROBLEM 3- EXERCISES

VENERABLE RESPECTED CO. has the following liabilities as of December 31, 20x1.

a. Trade accounts payable, net of debit balance in supplier’s account of

P10,000, net of unreleased checks of P8,000, and net of postdated checks
of P4,000. P600,000
b. Credit balance in customer’s accounts 4,000
c. Financial liability designated at FVPL 100,000
d. Bonds payable maturing in 10 equal annual installments of P200,000 2,000,000
e. 12% 5-year note payable issued on October 1, 20x1 200,000
f. Deferred tax liability 10,000
g. Unearned rent 8,000
h. Contingent liability 20,000
i. Reserve for contingencies 50,000

Requirements: how much is the total current liabilities?

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NOTES PAYABLE

Notes payable are obligations supported by debtor promissory notes. The accounting for notes
payable is similar to the accounting for notes receivables.

Initial Measurement
Notes payable are initially recognized at fair value minus transaction costs.

Fair Value- is the price that would be received to sell and asset or paid to transfer a liability in an
orderly transaction between market participants at the measurement date.

For measurement purposes, notes payable are classified into the following:

a. Short term payable

b. Long term payable that bears a reasonable interest rate.
c. Long term payable that bears no interest (noninterest bearing)
d. Long term payable that bears an unreasonable interest rate (‘below-market’ interest rate)

A short-term payable matures in 1 year or less, while a long-term payable matures beyond one
year.

Short term payable

The fair value of the short-term payable may be equal to its face amount. However, if it is clear
that the arrangement effectively constitutes a financing transaction and the imputed rate of
interest can be determined without undue cost or effort, the fair value of the short-term payable is
equal to its present value.

Long term payables:

 The fair value of the long-term payable 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 the
transactions date.
 The fair value of the long-term payable that bears no interest (long-term noninterest bearing
payable) is equal to the present value of the future cash flows on the instrument discounted
using an imputed interest rate.
 The fair value of the long-term payable that bears an unreasonable interest rate is also equal
to the present value of the future cash flows on the instrument discounted using an imputed
interest rate.

Other terms for imputed rate of interest include effective interest rate, market rate and yield
rate. Effective interest rate is the rate that exactly discounts the future cash payments over the
life of the financial liability equal to it’s carrying amount.

Cash price equivalent

The fair value of a payable may be measured in relation to the cash price equivalent of the
noncash asset (noncash consideration) received in exchange for the payable.
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 settlement.

Example 1:
An entity purchases a TV set on a 6-month installment basis. The installment price is
P120,000. However, if the TV set is purchased outright in cash, the cash price would have
been P100,000.

 The payable is initially recognized at P100,000, the cash price equivalent of the TV set.
The P20,000 difference will be amortized over the credit term as interest expense using
the effective interest method.

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Example 2:
An entity purchases goods for P250,000 under a special credit period of 1 year. The seller
normally sells the goods for P220,000 with a credit period of 1 month or with a P5,000 discount
for cash basis

 The initial measurement of the payable is computed as follows:

Normal purchase price with credit period of 1-month P220,000

Discount for outright payment (P5,000)
Cash priced equivalent of the goods purchased P215,000

Subsequent measurement
Notes payable that are initially measured at face amount are subsequently measured at face
amount or expected settlement amount.
Notes payable that are initially measured at present value are subsequently measured at
amortized cost.

 Amortized cost is the “amount at which the 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, for financial assets adjusted for any loss
allowance.”

The amortized cost is determined using the effective interest method.

When a note payable is initially measured at present value or cash price equivalent, the
difference between that amount and the face amount is initially recognized as a discount (or
premium) in the case of bonds payable) and subsequently amortized as interest expensed using
the effective interest method.
Effective interest method- is a method of calculating the amortized cost of financial asset
or financial liability and of allocating the interest income or interest expenses over the relevant
period.

Illustration 1: Short term note

On July 1, 20x1, ABC Co. borrowed P1,000,000and issued a one year note payable. The lender
“discounted the note at 12%.

Case 1. Lump Sum

The note is due in lump sum on June 30, 20x2. The effect of discounting is immaterial.

Analysis:
The note is short-term and the effect of discounting is immaterial. Therefore, the note is initially
measured at face amount (net of the advanced interest).

The entries as follows:

July 1, Cash (1M x 88%) 880,000
20x1 Discount on notes payable (1M x 12%) 120,000
Notes Payable 1,000,000
To record the note payable)
Dec 31, Interest expense (1mx 12% x 6/12) 60,000
20x1 Discount on notes payable 60,000
To record interest expense
June 30, Interest expense (1mx 12% x 6/12) 60,000
20x2 Discount on notes payable 60,000
To record interest expense
June Notes payable 1,000,000
30,20x2 Cash 1,000,000
To record the settlement of notes payable

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The carrying amounts of the note are determined as follows:
July 1, 20x1 Dec. 31, 20x1
Notes payable 1,000,000 1,000,000
Discount on notes payable (120,000) (60,000)
Carrying amounts 880,000 940,000

Notes:
 ABC Co., the borrower, is referred to as the “maker” or “issuer” of the note. The lender is
the ‘payee.”
 “discount on notes payable” is a contra-liability account (i.e., a valuation account). It is
deducted when determining the carrying amount of the note.
 Theoretically, all liabilities should be measured at present value except when:
a. The effect of discounting is deemed immaterial;
b. Discounting is prohibited by a Standard (e.g., PAS 12 Income taxes prohibits the
discounting of tax liabilities); or
c. The transaction is made in the usual or customary terms.
 If the effect of discounting is not deemed immaterial, a short-term note is nonetheless
measured at present value. Judgment on materiality rests with the entity’s management.
 The standards do not require short-term notes to measure at face amount nor prohibit
their discounting.

Case 2: Installment
The note is due in equal quarterly installments starting September 30, 20x1. The effect of
discounting is immaterial.

Analysis:
The note is also measured at face amount. However, because the note is due in installments, the
P120,000 advance interest is allocated over the installment periods based on, for example, the
outstanding principal balance of the note or some other arbitrary apportionment.

The entries are as follows:

July 1, Cash (1M x 88%) 880,000
20x1 Discount on notes payable (1M x 12%) 120,000
Notes payable 1,000,000
Sept. Notes payable 250,000
30, Interest expense 48,000
20x1 Cash 250,000
Discount on notes payable 48,000
Dec. Notes payable 250,000
31, Interest expense 36,000
20x1 Cash 250,000
Discount on notes payable 36,000

Outstanding balance
Date of note Allocation interest expense
9/30/20x1 1,000,000 120k x 1/ 2.5 48,000
12/31/20x1 750,000 120k x .75/2.5 36,000
3/31/20x2 500,000 120k x .5 / 2.5 24,000
6/30/20x2 250,000 120k x .25 / 2.5 12,000
a 2,500,000 120,000
a
The fractions used in the allocation are derived from the outstanding balances of the note

The carrying amounts of the note are determined as follows:

July 1, 20x1 Sept. 20, 20x1 Dec.
31, 20x1
Notes payable 1,000,000 750,000
500,000
Discount on notes payable (120,000) (72,000)
(36,000)

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Carrying amounts 880,000 678,000
464,000

Illustration 2: Long-term note with reasonable interest- Simple interest

On October 1, 20x1, ABC Co. issued a two-year, 12% P1,000,000 note payable in exchange for a
piece of land. Principal is due on October 1, 20x3 but interest is due annually.

Analysis:
 Type of payable: Long term with reasonable interest rate- the 12% nominal rate is assumed
to be equal to the current rate on initial recognition because no additional information is
given.
 Initial measurement: face amount
 Subsequent measurement: face amount or expected settlement amount
 Type of interest: Simple interest- interest is computed only on the outstanding principal
balance.

Journal entries
Oct. 01, Land 1,000,000
20x1 Notes payable 1,000,000
To record the notes payable
Dec. 31, Interest expense (1M x 12% x 3/12) 30,000
20x1 Interest payable 30,000
To record the accrued interest
Oct. 01, Interest expense (1M x 12% x 3/12) 90,000
20x2 Interest payable 30,000
Cash 120,000
To record the payment of accrued interest.
Dec. 31, Interest expense (1M x 12% x 3/12) 30,000
20x2 Interest payable 30,000
To record the accrued interest
Oct. 01, Interest expense (1M x 12% x 3/12) 90,000
20x3 Interest payable 30,000
Cash 120,000
To record the payment of accrued interest.
Oct. 01, Notes payable 1,000,000
20x3 cash 1,000,000
to record the settlement of note payable

Illustration 3: Long term note with reasonable interest- Compound interest

On January 1, 20x1, ABC Co. issued a three year, 12% P1,000,000 note payable in exchange for
a piece of land. Principal and interest are due on Dec. 21, 20x3.
Analysis:
 Type of payable and measurement- same as illustration 2 above
 Type of interest: compound interest- interest is computed on both the outstanding balances
of principal and accrued interest.


Journal entries
Oct. 01, Land 1,000,000
20x1 Notes payable 1,000,000
To record the notes payable
Dec. 31, Interest expense (1M x 12%) 120,000
20x1 Interest payable 120,000
To record the accrued interest
Dec. 31, Interest expense (1M+120K x 12%) 134,400
20x2 Interest payable 134,400
To record the payment of accrued interest.
Oct. 01, Interest expense (1M+120k+134.4K)x 12% 150,528
20x3 Interest payable 254,400
Cash 404,928

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 To record the payment of accrued interest.
Oct. 01, Notes payable 1,000,000
20x3 cash 1,000,000
to record the settlement of note payable

Illustration 4: noninterest bearing note-Lump sum

On January 1, 20x1, ABC Co. acquired equipment in exchange for P100,000 cash and a 3-year,
noninterest-bearing, P1,000,000 note payable due on January 1, 20x4. The prevailing interest rate
is 12%.
Analysis:
 Type of payable: long term noninterest -bearing (lump sum)
 Initial measurement: present value (using PVof 1)
 Subsequent measurement: amortized cost.

 Initial measurement:
Future cash flow (face amount) P1,000,000
Multiply by: PV of 1 @12%, n=3 0.711780
Present value of note payable -Jan 1, 20x1 P711,700.00
Jan 1, 20x1 Equipment (100k + 711,780 811,780
Discount on notes payable (1M-711,780) 288,220
Cash 100,000
Notes Payable 1,000,000

Notes:
 The difference between the present value and face amount represents the discount on
notes payable. The unamortized balance of the discount is deducted from the face amount
when determining the carrying amount of the note.
 The discount of the note payable on initial recognition of a noninterest-bearing note
represents the total interest expense to be recognized over the term of the note.
 The equipment is measured at the amount of cash paid plus the present value of the note
issued.

 Subsequent measurement: amortization table (lump sum)

date Interest expense Discount on notes Present value

payable
Jan. 01, 20x1 288,200 711,780
Dec. 31, 20x1 85,414 202,806 797,194
Dec. 31, 20x2 95,663 107,143 892,857
Dec. 31, 20x3 107,143 - 1,000,000
TOTAL 288,200

Other pertinent entries

Dec. 31, Interest expense 85,414
20x1 Discount on notes payable 85,414
Dec. 31, Interest expense 95,663
20x2 Discount on notes payable 95,663
Oct. 01, Interest expense 107,143
20x3 Discount on notes payable 107,143
Jan. 01, Notes payable 1,000,000
20x4 cash 1,000,000

Illustration 4: noninterest bearing note-Installment

On January 1, 20x1, ABC Co. acquired equipment in exchange for P100,000 cash and a 4-year,
noninterest-bearing, P1,000,000 note payable in 4 equal annual installments starting December
31, 20x1. The prevailing interest rate is 12%.
Analysis:
 Type of payable: long term noninterest -bearing (Installment)
 Initial measurement: present value (using PVof ordinary annuity of P1)
 Subsequent measurement: amortized cost.

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  Initial measurement:
Future cash flow – annual installment (P1M/4) 250,000
Multiply by: PVof ordinary annuity of P1 @12%, n=4 3.037349
Present value of note payable -Jan 1, 20x1 P759,337.00
Jan 1, 20x1 Equipment (100k +759,337) 859,337
Discount on notes payable (1M-759,337) 240,663
Cash 100,000
Notes Payable 1,000,000

 Subsequent measurement: amortization table (Installment)

date payments Interest expense Amortization Present value
Jan. 01, 20x1 759,337
Dec. 31, 20x1 250,000 91,120 158,880 600,458
Dec. 31, 20x2 250,000 72,055 177,945 422,513
Dec. 31, 20x3 250,000 50,702 199,298 223,215
Dec. 31, 20x4 250,000 26,785 223,215 0

Other pertinent entries

Dec. 31, Notes Payable 250,000
20x1 Interest expense 91,120
Cash 250,000
Discount on notes payable 91,120
Dec. 31, Notes Payable 250,000
20x2 Interest expense 72,055
Cash 250,000
Discount on notes payable 72,055
Dec. 31, Notes Payable 250,000
20x3 Interest expense 50,702
Cash 250,000
Discount on notes payable 50,702
Dec. 31, Notes Payable 250,000
20x4 Interest expense 26,785
Cash 250,000
Discount on notes payable 26,785

CURRENT AND NON-CURRENT PORTIONS OF A NOTE PAYABLE

When the principal amount is due in installments, the carrying amount of the note includes both
current and non-current portions. These portions are presented or disclosed separately in the
financial statements.
To determine the current and non-current 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 payment applied to the principal. The nu-current portion is the present
value in the immediately following year.
For example, the carrying amount of the note on December 31, 20x1 is P600,458. The
current portion is P177,945 the amortization due on December 31, 20x2. And the non-current
portion is P422,513 the present value of the note as of December 31, 20x2

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LOANS PAYABLE

Loan payable is similar to note payable, it is also supported by a formal promise to pay a
certain sum of money at specific future date(s). however, the term “loans payable” can be used to
connote bank loans and similar types of financing.
Loans payable are accounted for similar to notes payable. However, loans transactions
normally involve transaction costs. Recall that financial liabilities are initially recognize at fair
value minus transaction costs.

 Transaction costs are “incremental costs that are directly attributable to the acquisition,
issue or disposal of a financial asset or liability. An incremental cost is one that would not
have been incurred if the entity had not acquired, issued or disposed of the financial
instrument.”
Transaction costs include fees and commissions paid to agents, advisers, brokers
and dealers; levies by regulatory agencies and securities exchanges; and transfer taxes
and duties.
Transaction costs do not include debt premiums or discounts, financing costs or internal
administrative or holding costs.

ORIGINATION FEES

Origination fee is an upfront fee charged by a lender to cover the costs of processing the loan
(e.g., evaluating the borrower’s financial condition, evaluating and recording guarantees,
collateral and other security arrangements, negotiating the terms of the instrument, preparing and
processing documents and closing the transaction. Origination fees normally come in the form of
a “service fee” which is a percentage of the principal amount and is directly deducted from loan
proceeds released to borrower.
Origination fees are deducted when measuring the carrying amount of the loan payable.
Origination fees are subsequently amortized using the effective interest method. The subsequent
amortization increases both the interest expense and carrying amount of the loan.
Origination fees are included in the calculation of the effective interest rate, meaning on
transaction date, the origination fees are treated as adjustment to the effective interest rate.

Illustration 1: origination fees.

On January 1, 20x1, ABC Co. borrowed P1,000,000 from a bank. The bank charged a 3% loan
origination fee. The principal is due on January 1, 20x4 but 10% interest is due annually starting
on January 1, 20x2.

 Initial measurement
Principal amount P1,000,000
Origination fee (1M x 3%) (30,000)
Carrying amount of loan on Jan. 1, 20x1 P970,000

Jan. 01, Cash 970,000

20x1 Discount on loan payable 30,000
Loan Payable 1,000,000

 Subsequent measurement:

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The effective interest rate on the loan is not equal to the 10% stated rate because the origination
fee. We will compute for the imputed interest rate using the “trial and error” approach.
To limit the number of “tries” we need to observe the following concepts:
 If a financial instrument’s carrying amount is less than its face amount, the difference is a
discount.
 If a financial instrument’s carrying amount is greater 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 discount, the effective interest 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.
Discount Effective interest rate is higher than nominal rate
Premium Effective interest rate is lower than nominal 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.

Illustration 2: Amount of Loan Amortization

You want to acquire a car with a cash price of P2,000,000 through a 12-month auto loan that
requires equal monthly-end payments. The effective interest rate is 12%.

Requirements: Compute for the following:

a. amount of monthly payment
b. total interest expense on the loan

requirement (a): amount of monthly payment

Future cash flows x PV factor = Present Value

 Future cash flows: this represents the monthly payment on the loan. This is what we are
computing.
 PV factor: the payments are due on a monthly basis. Accordingly, we will use an “n” (period)
of 12 and a discount rate of 1% (12% per annum /12 months)
 Present value: The present value is P2,000,000 i.e., cash price.

 Future cash flows x (PV of ordinary annuity of 1 @1%, n=12) = P2,000,000

 Future cash flows x 11.2550775 = P2,000,000
 Future cash flows = 2,000,000/ 11.2550775
 Future cash flows (monthly payment) = P177,697.58

Requirement (b): Total interest expense over the term of the loan
Monthly payment 177,697.58
Multiply by: No. of payments on the loan 12
Total cash payments 2,132,370.96
Present value of loan on initial recognition (2,000,000)
Total interest expense 132,371

Amortization Table
date monthly interest amortization present
  payments expense   value
2,000,000
1st month 177,697.58 20,000 157,697.58 1,842,302.42
2nd month 177,697.58 18,423 159,274.58 1,683,027.84
3rd month 177,697.58 16,830 160,867.58 1,522,160.26
4thmonth 177,697.58 15,222 162,475.58 1,359,684.68
5th month 177,697.58 13,595 164,102.58 1,195,582.10
6th month 177,697.58 11,956 165,741.58 1,029,840.52
7th month 177,697.58 10,298 167,399.58 862,440.94

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 8th month 177,697.58 8,624 169,073.58 693,367.36
9th month 177,697.58 6,934 170,763.58 522,603.78
10thmonth 177,697.58 5,226 172,471.58 350,132.20
11th month 177,697.58 3,501 174,196.58 175,935.62
12thmonth 177,697.58 1,762 175,935.62 0.00
2,132,370.96 132,371 2,000,000.00
Secured Loans
A secured loan is one that has a collateral security which the lender can take if the borrower
defaults.

a. Mortgage loan- loan secured by a real property (e.g., lot or building.) the borrower signs
a mortgage note evidencing the loan and the encumbrance over the property.
b. Chattel mortgage- loan secured by movable personal property (e.g., car, equipment,
jewelry, or livestock).

Assets such as inventories, cash surrender value, receivables, cash in bank (e.g., compensating
balance), and investments in securities can also be used as collateral security for loans.

Credit lines
Some loans are obtained through pre-arranged credit lines. A credit line is an arrangement
between a financial institution and a borrower that establishes the maximum amount of loan
(credit limit) that the borrower can obtain. A credit line assures the borrower of an immediate
source of financing when the need of cash arises, but subject to the credit limit. This provides
convenience and saves the borrower cost and time in processing numerous individual loans.
Furthermore, interest accrues only on amounts actually borrowed; thus, unnecessary interest
expenses can be avoided.

Credit card- a credit card uses a line of credit granted to the cardholder by a bank or a credit card
company. The cardholder can use the credit card to borrow cash or make credit purchases. When
the credit card is used, the cardholder becomes a debtor to the card provider. When the credit
limit is reached, the card can no longer be used until the obligation is settled.

Debit card- a debit card is linked to the cardholder’s bank account. Therefore, the funds used for
purchases are automatically withdrawn (debited) from the bank holder’s bank account. When the
funds linked to the debit card are consumed, the card can no longer be used until additional funds
are deposited to the account. A debit card is not a credit line because the cardholder actually owns
the cash being used.

Summary
 Notes payable are initially recognized at fair value minus transaction costs.
 Short term notes are initially measured either at face amount or present value
 Long term notes with reasonable interest rate are initially recognized at face amount
 Long term non-interest-bearing notes and long-term notes with unreasonable interest rate
are initially measured at present value
 Notes are initially measured at the cash price equivalent of the noncash consideration
received if this amount is determinable.
 Stated interest rate (nominal rate, coupon rate, or face rate) is the rate appearing on the face
of an interest-bearing note.
 Effective interest rate (imputed rate of interest, current market rate or yield rate) is the rate
used in present value computations.
 A noninterest-bearing note has an unspecified principal and an unspecified interest. These
elements are separated through present value computations.
 Future cash flows x PV factor at x% = present value
 PV of P1 is used when the future cash flow is in lump sum.
 PV of an ordinary annuity of P1 is used when future cash flows are in installments and the
first installment does not begin immediately
 PV of n annuity due of P1 is used when the future cash flows are in installments and the
first installment begins immediately
 Total interest expense recognized over the life of a non interest bearing note is equal to the
discount on note payable on initial recognition

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  Interest payable= face amount nominal rate
 Interest expense= present value x effective interest rate
 Origination fees are deducted from the carrying amount of the loan and subsequently
amortized using the effective interest method.

References:

Intermediate Accounting 2, Millan, 2019 edition

Practical Accounting vol. 2, Valix, 2016

EXERCISES:

PROBLEM 1

On January 1, 20x1, an entity issues a 3-year, noninterest-bearing, note payable amounting to

P2,000,000 in exchange for equipment. The principal on the note is due on December 31, 20x3.
The effective interest rate on January 1, 20x1 is 16%.

Requirement:

a. Provide all the entries during the term of the note payable.

PROBLEM 2

On January 1, 20x1, an entity issues a 3-year, non-interest-bearing, note payable amounting to

P3,000,000 in exchanged for equipment. The principal on the note is due in three equal annual
installments payable every Dec. 31. The effective interest rate on January 1, 20x1 is 18%.

Requirements:
a. Compute for the current and non-current portions of the note payable on December 31,
20x1.

b. Provide all the entries during the term of the note payable.

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