Chapter 9, Problem 2P

Notes Payable and Effective Interest On November 1,2019, Edwin Inc. borrowed cash and signed a $60,000, 1-year note payable.

Required:

Compute the following items assuming (a) an interest-bearing note at 12%, (b) a non-interest-bearing note discounted at 12%:

cash received

effective interest rate

interest expense for 2019

Prepare the journal entries for Edwin under each case for 2019 and 2020.

Next Level Why is the effective rate higher for the non-interest-bearing note?

To determine

Compute the following items assuming (a) an interest-bearing note at 12%, (b) non-interest- bearing note discounted at 12%.

1. a) Cash received
2. b) Effective interest rate
3. c) Interest expense for 2019

Explanation of Solution

1. (a)   An interest bearing note at 12%

(a) Compute the cash received for interest-bearing note at 12%:

The cash received for interest-bearing note at 12% is $60,000. As the note includes an interest-bearing at 12% thus the face value of the note will be given by the creditor to the Incorporation E.

1. (b)  Compute the effective interest rate for interest bearing note at 12%:

The effective interest rate for interest bearing note is 12%.

1. (c)   Compute the interest expense for an interest bearing note at 12% for 2019.

$\begin{array}{c}\text{Interest}\text{expense}=\text{Face value of note}\times \text{Discount rate}\times \frac{\left[\begin{array}{l}\text{2months expired}\\ \text{out of 1 year}\end{array}\right]}{12\text{months in a year}}\\ =\$60,\text{000 }\times 12\text{\% }\times \frac{2}{12}\\ =\$1,200\end{array}$

Thus, the interest expense for 2019 is $1,200.

(b) non-interest- bearing note discounted at 12%.

1. (a) Compute the cash received for non-interest bearing note discounted at 12%:

$\begin{array}{c}\text{Cash received by Incorporation E = Face value of note }\times \text{ 88\%}\\ \text{=\$60,000}\times \text{0}\text{.88}\\ \text{=\$52,800}\end{array}$

Note: For the non-interest bearing note the creditor will not give the face value of the note. Instead, the creditor will deduct the interest rate 12% from the face value of the note and the balance amount will be given to Incorporation E.

Thus, the cash received by Incorporation E is $52,800.

1. (b) Compute the effective interest rate for non-interest bearing note discounted at 12%:

$\begin{array}{c}\text{Effective interest rate = }\frac{\text{Total interest paid}}{\text{Amount of cash borrowed}}\times 100\%\\ =\frac{\left(\text{Face value of note}-\text{Amount of cash received}\right)}{\$19,400}\times 100\%\\ =\frac{\left(\$60,000-\text{\$52,800}\right)}{\$52,800}\times 100\%\\ =13.64\%\left(\text{Rounded off}\right)\end{array}$

Thus, the effective interest rate on non-bearing interest note is$13.64\%$.

1. (c) Compute the interest expense for 2019 for non-interest bearing note discounted at 12%:

$\begin{array}{c}\text{Interest}\text{expense}=\text{Total discount on notes payable}\times \frac{\left[\begin{array}{l}\text{2months expired}\\ \text{out of 1 year}\end{array}\right]}{12\text{months in a year}}\\ =\$7,200\times \frac{2}{12}\\ =\$1,200\end{array}$

Thus, the amount of interest expense for 2019 is $1,200.

To determine

Prepare the journal entries for Incorporation E under each case for 2019 and 2020.

Explanation of Solution

Note payable: Note payable denotes a long-term liability that describes the amount borrowed, signed and issued note. The note carries all the details of payable amounts, interest amounts, and maturity dates.

Prepare journal entries for Incorporation E assuming interest bearing note at 12%.

1. a) To record the cash received:

Date	Account titles and explanation	Debit ($)	Credit($)
November 1, 2019	Cash	60,000
	Notes Payable		60,000
	(To record the amount borrowed on note)

Table (1)

1. b) To record the adjusting entry for interest expense on December 31, 2019:

Date	Account titles and explanation	Debit ($)	Credit($)
December 31, 2019	Interest expenses	1,200
	Interest payable		1,200
	(To record the amount of accrued interest during the year ended December 31, 2019)

Table (2)

1. c) To record the payment of interest at maturity date:

Date	Account titles and explanation	Debit ($)	Credit($)
October 31, 2020	Interest expenses (1)	6,000
	Interest payable	1,200
	Cash		7,200
	(To record the amount of interest paid at maturity)

Table (3)

Working note (1):

Calculate the amount of interest expense:

$\begin{array}{c}\text{Interest expense}=\text{Face value of note}\times \text{Discount rate}\times \\ \frac{\left[\text{Number of month from January to October}\right]}{12\text{months in a year}}\\ =\$60,\text{000 }\times 12\text{\% }\times \frac{10}{12}\\ =\$6,000\end{array}$

1. d) To record the payment of note at maturity:

Date	Account titles and explanation	Debit ($)	Credit($)
October 31, 2020	Notes payable	60,000
	Cash		60,000
	(To record the payment of note at maturity)

Table (4)

Prepare journal entries for Incorporation E assuming non-interest bearing note discounted at 12%.

1. a) To record the cash received:

Date	Account titles and explanation	Debit ($)	Credit($)
November 1, 2019	Cash	52,800
	Discount on notes payable	7,200
	Notes Payable		60,000
	(To record the amount borrowed at a discount rate of 12%)

Table (5)

1. b) To record the adjusting entry for interest expense on December 31, 2019.

Date	Account titles and explanation	Debit ($)	Credit($)
December 31, 2019	Interest expenses	1,200
	Discount on notes payable		1,200
	(To record the amount of accrued interest during the year ended December 31, 2019)

Table (6)

1. c) To record the interest expense incurred from January 1 to October 31.

Date	Account titles and explanation	Debit ($)	Credit($)
October 31, 2019	Interest expenses (2)	6,000
	Discount on notes payable		6,000
	(To record the amount of interest expenses on note incurred from January 1 to October 31)

Table (7)

Working note (2):

Calculate the amount of interest expense:

$\begin{array}{c}\text{Interest}\text{expense}=\left[\begin{array}{l}\text{Face value of note}\times \text{Discount rate}\times \\ \frac{10\text{months }\left(\text{from January 1 to October 31}\right)}{12\text{months in a year}}\end{array}\right]\\ =\$60,\text{000 }\times 12\text{\% }\times \frac{10}{12}\\ =\$6,000\end{array}$

1. d) To record the payment of note at maturity:

Date	Account titles and explanation	Debit ($)	Credit($)
October 31, 2020	Notes payable	60,000
	Cash		60,000
	(To record the payment of note at maturity)

Table (8)

To determine

Explain the reason for the higher effective rate for the non-interest bearing note.

Explanation of Solution

Effective interest rate: The fixed interest rate which is applied on the carrying value of note, to amortize the note discount is referred to as effective interest rate.

Reasons for the higher effective rate for the non-interest bearing note:

In the above situation, Incorporation E pays the same of amount of interest of $7,200. However, Incorporation E receives $60,000 under interest bearing note, $52,800 under non-interest bearing note. As, it receives less amount of cash for the non-interest bearing note, the effective rate of interest of the non-interest bearing note is higher than the effective rate of interest of an interest bearing note.