Discounting Notes Receivable

Just as accounts receivable can be factored, notes can be converted into cash by
selling them to a financial institution at a discount. Notes are usually sold
(discounted) with recourse, which means the company discounting the note agrees
to pay the financial institution if the maker dishonors the note. When notes
receivable are sold with recourse, the company has a contingent liability that must
be disclosed ni the notes accompanying the financial statements. A contingent
liability is an obligation to pay an amount in the future, if and when an uncertain
event occurs.
The discount rate is the annual percentage rate that the financial institution charges
for buying a note and collecting the debt. The discount periodis the length of time
between a note's sale and its due date. Thediscount, which is the fee that the
financial institution charges, is found by multiplying the note's maturity value by
the discount rate and the discount period.

Suppose a company accepts a 90day, 9%, $5,000 note, which has a maturity value
(principal + interest) of $5,110.96. In this example, precise calculations are made
by using a 365day year and by rounding results to the nearest penny.

If the company immediately discounts with recourse the note to a bank that offers a
15% discount rate, the bank's discount is $189.04

The bank subtracts the discount from the note's maturity value and pays the
company $4,921.92 for the note.

Maturity Value

$5,110.96

Discount

(189.04)

Discounted Value of Note

$4,921.92

The company determines the interest expense associated with this transaction by
subtracting the discounted value of the note from the note's face value plus any
interest revenue the company has earned from the note. Since the company
discounts the note before earning any interest revenue, interest expense is $78.08
($5000.00 $4,921.92). The company records this transaction by debiting cash for
$4,921.92, debiting interest expense for $78.08, and crediting notes receivable for
$5,000.00.

Suppose the company holds the note for 60 days before discounting it. After 60
days, the company has earned interest revenue of $73.97.

Since the note's due date is 30 days away, the bank's discount is $63.01. The bank
subtracts the discount from the note's maturity value and pays the company
$5,047.95 for the note.

Maturity Value

$5,110.96

Discount

(63.01)

Discounted Value of Note

$5,047.95

The company subtracts the discounted value of the note from the note's face value
plus the interest revenue the company has earned from the note to determine the
interest expense, if any, associated with discounting the note. In this example, the
interest expense equals $26.02.

Note's Face Value + Interest Revenue Earned

$5,073.97

Discounted Value of Note

(5,047.95)

Interest Expense

$ 26.02

The company records this transaction by debiting cash for $5,047.95, debiting
interest expense for $26.02, crediting notes receivable for $5,000.00, and crediting
interest revenue for $73.97.

Derecognition
Definition: Derecognition is the removal of a previously recognized financial asset
or liability from an entity's balance sheet. A financial asset should be derecognized
if either the entity's contractual rights to the asset's cash flows have expired or the
asset has been transferred to a third party (along with the risks and rewards of
ownership). If the risks and rewards of ownership have not passed to the buyer,
then the selling entity must still recognize the entire financial asset and treat any
consideration received as a liability.

Part of the year-end closing procedure may include a step to review all fixed assets
currently on the books to see if any should be derecognized. Otherwise, an
excessive amount of accumulated depreciation may clutter the balance sheet.