Chapter 7, Problem 7.6P

Notes receivable; solving for unknowns

• LO7–7

Cypress Oil Company’s December 31, 2018, balance sheet listed $645,000 of notes receivable and $16,000 of interest receivable included in current assets. The following notes make up the notes receivable balance:

Note 1 Dated 8/31/2018, principal of $300,000 and interest at 10% due on 2/28/2019.

Note 2 Dated 6/30/2018, principal of $150,000 and interest due 3/31/2019.

Note 3 $200,000 face value noninterest-bearing note dated 9/30/2018, due 3/31/2019. Note was issued in exchange for merchandise.

The company records adjusting entries only at year-end. There were no other notes receivable outstanding during 2018.

Required:

1. Determine the rate used to discount the noninterest-bearing note.

2. Determine the explicit interest rate on Note 2.

3. What is the amount of interest revenue that appears in the company’s 2018 income statement related to these notes?

To determine

Note receivable:

Note receivable refers to a written promise for the amounts to be received within a stipulated period of time. This written promise is issued by a debtor or borrower to lender or creditor. Notes receivable is an asset of a business.

To determine: The rate of interest of the noninterest-bearing note.

Explanation of Solution

The rate of interest of the noninterest-bearing note is determined as follows:

Compute the amount of remaining discount of note 3:

Face Value of Note 1	$300,000
Face Value of Note 2	150,000
Face Value of Note 3	200,000
Total Face value of Notes	$650,000
Less: Carrying Value of Notes as Per Balance Sheet	(645,000)
Remaining Discount on note 3	$5,000

Table (1)

Compute the discount rate for 6 months:

$\begin{array}{c}\text{Discount Rate for 6 Months = }\frac{\text{Discount Amount for 6 Months}}{\text{Face Value}}\\ =\frac{\$10,000}{\$200,000}\\ =5\%\end{array}$ (1)

Note 3 is a 6-month noninterest bearing note, with three months remaining. Hence, $5,000 represents the discount for three months. Therefore, the total amount of discount for 6 months is $10,000.

Annualize the discount rate:

$\begin{array}{c}\text{Annual Discount Rate = Rate for 6 Months (1) }\times \frac{12}{6}\\ =5\%\times \frac{12}{6}\\ =10\%\end{array}$

Conclusion

Therefore, the discount rate is 10%.

To determine

The accrued interest on note 2.

Explanation of Solution

The accrued interest on note 2 is determined as follows:

Total Accrued interest Receivable	$16,000
Less: Interest Accrued on Note 1	(10,000) (2)
Accrued Interest on Note 2	$6,000

Table (2)

Working note:

$\begin{array}{l}\text{Interest = Principal }\times \text{ Rate }\times \text{ Period}\\ \text{=}\text{\$300,000 }\times \frac{10}{100}\times \frac{4\left(\text{August 31 to December 31}\right)}{12}\end{array}$ (2)

Compute the explicit interest rate of note 2:

$\begin{array}{c}\begin{array}{l}\text{Interest Rate for 4 Months }\\ \left(\text{August 31 to December 31}\right)\end{array}]\text{ = }\frac{\text{Interest Amount for 4 Months}}{\text{Face Value}}\\ =\frac{\$6,000}{\$150,000}\\ =4\%\end{array}$ (3)

Annualize the discount rate:

$\begin{array}{c}\text{Annual Interest Rate = Rate for 6 Months }\times \frac{12}{6}\\ =4\%\times \frac{12}{6}\\ =8\%\end{array}$

Conclusion

Therefore, the Interest rate is 8%.

To determine

The amount of interest revenue to be reported on the income statement of 2018:

Explanation of Solution

Interest on Notes Receivable:

The amount of interest on notes receivables is calculated as follows:

$\text{Interest = Principal }\times \text{ Rate of interest }\times \text{ Interest period}$

Compute the amount of interest for the following notes receivable.

Computation of Interest on Notes receivable
Note Number	Principal ($)	Interest Rate (%)	Period (Days/Months	Interest ($)
1	300,000	10	4 Months (August 31 to December 31)	10,000 (1)
2	150,000	8	6 Months (June 30 to December 31)	6,000 (2)
3	200,000	10	3 Months (September 30 to December 31)	5,000 (3)
Total Interest to be Reported in the Income Statement of 2016				21,000

Table (3)

Working Notes:

Note 1:

$\begin{array}{c}\text{Interest = Principal }\times \text{ Rate of interest }\times \text{ Interest period}\\ \text{ = \$300,000 }\times \frac{10}{100}\times \frac{4}{12}\\ =\$10,000\end{array}$ (4)

Note 2:

$\begin{array}{c}\text{Interest = Principal }\times \text{ Rate of interest }\times \text{ Interest period}\\ \text{ = \$150,000 }\times \frac{8}{100}\times \frac{6}{360}\\ =\$6,000\end{array}$ (5)

Note 3:

$\begin{array}{c}\text{Interest = Principal }\times \text{ Rate of interest }\times \text{ Interest period}\\ \text{ = \$200,000 }\times \frac{10}{100}\times \frac{3}{12}\\ =\$5,000\end{array}$ (6)

Conclusion

Therefore, the amount of interest revenue to be reported on the income statement of 2018 is $21,000.