The Montana Company paid for legal services received by giving the law firm a $10,000 three-year, 6% note payable (interest payable at the end of the year) on January 1 of Year One. The market rate of interest for a note of this type is 10%. The value of the legal services is not specified. Therefore the present value of the note is used as the amount to record both sides of the transaction. In some cases, the stated rate is intentionally lowered to ease the cash flow requirements of the debtor firm during the note term.
Present Value of Future Cash Flows:
$10,000 X .75131 (PV of $1, N = 3, I = 10%) = $7,513
$600 X 2.48685 (PV of an Annuity, N = 3, I = 10%) = 1,492
Total Present Value of Future Cash Flows $9,005
In this example, we illustrate the gross method. The note payable is listed at face value, with separate accounting of the discount. The net method is also acceptable and would record the note payable initially at $9,005 with no discount recorded. Interest expense for Year 1 is .10 x $9,005 (balance at beginning of Year 1). Interest expense is based on the net note at the beginning of each period, regardless of whether the gross or net method is used. The yield rate (10%) is used to compute interest.
The legal expenses are recorded at the present value of the future payments. The value of the services is defined by the present value of $9,005 because the law firm accepted the note. The worth of the note is its present value using the market rate of interest (10%). That present value includes the present value of both the face amount and the interest payments. The stated rate of 6% is used only to compute the interest payments. Interest expense is based on the market rate of 10%.
The total interest expense over the note term ($2,795) is the difference between the principal of $9,005 and the sum of the future payments of $11,800 (3 x $600 + $10,000) . It also equals the sum of the $1,800 cash interest over the term (3 x $600) and the $995 discount. The discount represents additional interest because the firm received only $9,005 worth of services but must pay $10,000 at the note's maturity.
If the straight-line (SL) method of amortization had been chosen, the journal entry for the three interest payments would be the same, as follows:
Interest expense 932
Discount on note payable 332 (995/3)