Notes Receivable – Definition
Notes receivable are a written, unconditional promise by an individual or business to pay a definite amount at a definite date or on demand.
The individual or business that signs the note is referred to as the maker of the note, and the person to whom the payment is to be made is called the payee.
Format of Notes Receivable
Below is a common format of notes receivable, in which J. Hart is the maker and C. Brecker is the payee.
In this illustration, C. Brecker records the note as an asset, and J. Hart records the note as a payable. The journal entries to record the note for each individual on April 5, 2019, the date of the note, are:
Although in this article we are primarily concerned with accounting for notes receivable, the concepts that we shall consider apply equally well to notes payable.
Types of Notes Receivable
There are several types of notes receivable that arise from different economic transactions. For example, trade notes receivable result from written obligations by a firm’s customers. In some industries, it is common for a seller to insist on a note rather than an open account for certain types of sales, for example, the sale of equipment of other personal or real property in which payment terms are normally longer than is customary for an open account.
In other cases, a particular customer’s credit rating may cause the seller to insist on a written note rather than relying on an open account. Further, if a particular customer is delinquent in paying his or her account, the seller may insist that the customer sign a note for the balance. Other notes receivable result from cash loans to employees, stockholders, customers, or others. For the purposes of our discussion, we will refer to all notes as promissory notes.
Elements of Promissory Notes
There are several elements of promissory notes that are important to the full understanding of accounting for these notes. These are the note’s principal, maturity date, duration, interest rate, and maturity value.
1. The Principal
The principal of the note is the amount that is lent or borrowed. It does not include the interest portion. Together the principal and the interest portions represent the note’s maturity value. The principal portion often referred to as the face value.
2. Maturity Date
The maturity date is the date that the note becomes due and payable. This date either is stated on the note or can be determined from the facts stated on the note. For example, a note may have a stated maturity date, such as December 31, or be due in a specific number of days or months, such as three months after the note’s date. The note shown above is due in 90 days from its date (April 5), or on July 4. This July 4 maturity date is computed as follows:
The duration of the notes receivable is the length of the time that the note is outstanding or the number of days called for by the notes. This period of time is important in figuring the interest charges related to the notes. In order to determine the duration of the notes, both the dates of the notes and their maturity dates must be known. For example, a note dated July 15 with a maturity date of September 15 has a duration of 62 days,
In this example, interest is based on the note’s being outstanding for 62 days.
Interest Rate. Interest is the income or expense from lending or borrowing money. To the lender or Payee, interest is income, and to the maker or borrower, it is an expense. The total interest related to a particular note is based in the note’s principal, rate of interest, and duration and can be calculated by using the following formula:
Interest = Principal x interest rate x Time
I = P x R x T
In applying this formula, interest rates are assumed to be stated in annual terms. For example, the total interest related to a $10,000, 12% note that is due in one year is $1,200, or
$1,200 = $10,000 x .12 x 1
If the same note had a term of only 5 months, the interest would be $500, calculated as follows:
$500 = $10,000 x .12 x 5/12
In some cases, the term of the note is expressed in days, and the exact number of days should be used in the interest computation. However, for simplicity, we will assume a 360-day year. For example, the interest related to a $10,000, 12% note with a 90-day term is $300, computed as follows:
$300 = $10,000 x .12 x 90/360
Accounting for Note Receivable
When a note is received from a customer, the account Notes Receivable is debited. The credit can be to Cash, Sales, or Accounts Receivable, depending on the transaction that gives rise to the note. In any event, the Notes Receivable account is at the face, or principal, of the note. No interest income is recorded at the date of the issue because no interest has yet been earned. Interest is recorded at the maturity date or at the end of the accounting period through an adjusting entry if the note extends beyond one period.
Receipt of the Note
To show the initial recording of a note receivable, assume that on July 1 the Fenton Company accepts a $2,000, 12%, 4-month note receivable from the Zoe Company in settlement of an open account receivable. The following entry is made to record this transaction:
In some situations, the receipt of the note results from a sale of merchandise. For example, assume that a $5,000 sale is made to a customer for a trade note receivable. In this case, the following two entries are made:
The previous two entries can be combined by debiting Notes Receivable and crediting Sales. However, to do so will result in a loss of information because not all the sales made to a particular customer are recorded in the customer’s subsidiary accounts receivable ledger.
Payment of the Note
When the payment on the note is received, Cash is debited, Note Receivables is credited, and Interest Revenue is credited. For example, assume that the $2,000 note from the Zoe Company recorded on July 1 is paid in full on October 31. The entry is:
In some cases, the note is received in one accounting period and collected in another. In these situations, interest must be accrued at year-end. For example, assume that the Bullock Company received a 3-month, 18% note for $5,000 on November 1, 2019 in exchange for cash. The firms’s year-end is December 31, and the note matured on January 31, 2020. The entries that the Bullock Company made on November 1, 2019, December 31, 2019, and January 31, 2020, are:
Defaulted Notes Receivable
When the borrower, or make of the note, fails to make the required payment at maturity, the note is considered to be defaulted. At that point, the note should be transferred to an open account receivable. Accounts Receivable is debited for the full maturity value, including the principal and unpaid interest. For example, if the Zoe Company defaults on its $2,000, 12% note, the Fenton Company will make the following entry on October 31:
Although it may seem strange to record interest revenue on defualted notes receivable, the Zoe Company is still obligated to pay both the interest and the principal. the account receivable is just as valid a claim as are the note receivable and the interest. Furthermore, bu transferring the note to Accounts Receivable, the remaining balance in the note receivable general ledger contains only the amounts of notes that have not yet matured. The Fenton Company should also indicate the default on the Zoe Company’s subsidiary accounts receivable ledger. Subsequently, if the account receivable proves uncollectible, it should be written off against the Allowance account.
Using Notes Receivable to Generate Cash
Both accounts and notes receivable can be used to generate immediate cash. Accounts receivable can be assigned, pledged, or factored. Essentially, in all these situations, the company that owns the receivable either sells it to bank or other lender or borrows against it to obtain immediate cash. The ability to raise cash in this manner is important to small and medium-sized businesses, which are often strapped for cash. Accounting for the assigning, or factoring of accounts receivable are topics covered in an intermediate accounting text.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True contributes to his own finance dictionary, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.