Notes Receivable Accounting
Notes Receivable Definition
A note receivable is a formal, written promise to receive a specific amount of cash from another party on one or more future dates. Overdue accounts receivable are sometimes converted into notes receivable, thereby giving the creditor more time to pay, while also sometimes including a personal guarantee by the owner of the creditor.
Notes Receivable Terms
The payee is the party who receives payment under the terms of the note, and the maker is the party obligated to send funds to the payee. The amount of payment to be made, as listed in the terms of the note, is the principal. The principal is to be paid on the maturity date of the note.
A note receivable usually includes a specific interest rate, or a rate which is tied to another interest rate, such as a bank’s prime rate. The calculation of the interest earned on a note receivable is:
Principal x Interest rate x Time period = Interest earned
If an entity has a large number of notes receivable outstanding, it should consider setting up an allowance for doubtful notes payable, in which it can accrue a bad debt balance that it can use to write off any notes payable that later become uncollectible. An uncollectible note receivable is said to be a dishonored note.
Notes Receivable Accounting Example
For example, Aruba Bungee Cords (ABC) sells a number of bungee cords to Arizona Highfliers for $15,000, with payment due in 30 days. After 60 days of nonpayment, the two parties agree that Arizona will issue a note payable to ABC for $15,000, at an interest rate of 10%, and with payment of $5,000 due at the end of each of the next three months. The initial entry to convert the account receivable to a note receivable is:
At the end of the month, Arizona pays $5,000 under the terms of the note, as well as interest, which is calculated as $15,000 x 10% x 30 days/365 days = $123. The entry is:
At the end of the second month, Arizona pays another $5,000 under the terms of the note, as well as interest, which is calculated as $10,000 x 10% x 30 days/365 days = $82. The amount of interest has declined, since it is based on the remaining amount of principal outstanding, which was only $10,000 during the month. The entry is:
At the end of the third and final month, Arizona pays the last $5,000 increment under the terms of the note, as well as interest, which is calculated as $5,000 x 10% x 30 days/365 days = $41. The entry is:
The note has now been completely paid off, and ABC has recorded a total of $246 in interest income over a three-month period.
What if Arizona had instead agreed to pay all of the interest income on the maturity date of the note, which in the example is in 90 days? Then ABC accrues the interest in each of the three months of the note. For example, it would have made this entry at the end of the first month:
By the maturity date of the note, ABC would have accrued a total of $246 in interest income. When Arizona pays the interest on the maturity date, ABC’s entry to record the transaction would be:
If Arizona had been unable to pay the final installment of $5,000 and the related interest payment of $41, and ABC had been accruing the interest income, then ABC would have to write off the remaining note balance, as well as the related interest income. It could do so with the following entry:
|Allowance for doubtful accounts||5,041|
Notes Receivable Classification
You should classify a note receivable in the balance sheet as a current asset if it is due within 12 months or as non-current (i.e., long-term) if it is due in more than 12 months. If a note has a duration of longer than one year, and the maker does not pay interest on the note during the first year, it is customary to add the unpaid interest to the beginning principal balance in the second year, and use that as the basis upon which to calculate interest in the second year.
For example, the maker owes $200,000 to the payee at a 10% interest rate, and pays no interest during the first year. The interest earned by the payee in the first year is $20,000, which is rolled into the $200,000 principal balance at the beginning of the second year; consequently, the interest earned in the second year of $22,000 is higher than in the first year, because the calculation is based on an increased principal balance of $220,000.
A company's auditors will examine the classification of notes receivable from the most conservative perspective, and so will insist on their classification as short-term if there are reasonable grounds for doing so.
Notes receivable are also known as promissory notes receivable.