6.4 Notes receivable
8 min read•august 20, 2024
Notes receivable are formal promises to pay a specific amount on a set date. They're a key financial instrument for companies extending credit or lending money, typically involving fixed payment schedules and interest rates.
Accounting for notes receivable involves initial recognition, valuation, and derecognition. Companies must track interest accrual, assess collectibility, and handle . Understanding notes receivable is crucial for managing a company's financial assets and cash flow.
Definition of notes receivable
- Notes receivable are written promises from a customer or borrower to pay a specific amount of money to the company on a specified future date
- Represent a formal agreement between the company and the customer or borrower, typically with a fixed payment schedule and interest rate
- Notes receivable are a type of financial instrument that arises when a company extends credit to a customer or lends money to another entity
Accounting for notes receivable
Initial recognition of notes receivable
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- When a company issues a note receivable, it records the transaction by debiting the Notes Receivable account and crediting the appropriate account (e.g., Cash, Sales, or Accounts Receivable)
- The initial recognition of notes receivable is recorded at the face value of the note, which is the amount that the borrower promises to pay at maturity
- Any associated costs, such as legal fees or origination fees, are typically expensed as incurred or amortized over the life of the note
Valuation of notes receivable
- After initial recognition, notes receivable are typically carried at their amortized cost, which is the face value of the note adjusted for any premium or discount and any allowance for uncollectible amounts
- If the note bears interest, the company must accrue interest revenue over the life of the note using the
- The company should assess the collectibility of notes receivable periodically and establish an if necessary
Derecognition of notes receivable
- A company derecognizes a note receivable when it has been paid in full by the borrower or when it has been sold or transferred to another party
- If the note is paid in full, the company debits Cash and credits Notes Receivable for the face value of the note, and recognizes any remaining interest revenue
- If the note is sold or transferred, the company debits Cash or the appropriate asset account for the proceeds received, credits Notes Receivable for the carrying value of the note, and recognizes any gain or loss on the transaction
Types of notes receivable
Interest-bearing vs non-interest-bearing notes
- Interest-bearing notes require the borrower to pay interest to the company in addition to the principal amount of the note (typically at a stated interest rate and on a specified schedule)
- Non-interest-bearing notes, also known as zero-interest notes, do not require the borrower to pay interest (the time value of money is incorporated into the face value of the note)
Secured vs unsecured notes
- Secured notes are backed by collateral, such as property or equipment, which the company can seize if the borrower defaults on the note
- Unsecured notes are not backed by collateral and represent a higher risk to the company (the company may have limited recourse if the borrower fails to pay)
Short-term vs long-term notes
- Short-term notes are those with a of one year or less from the date of issuance (presented as a current asset on the balance sheet)
- Long-term notes are those with a maturity date of more than one year from the date of issuance (presented as a non-current asset on the balance sheet)
Calculating interest on notes receivable
Simple interest method
- Under the simple interest method, interest is calculated based on the principal amount of the note and the stated interest rate, without considering compounding effects
- The formula for calculating simple interest is:
- Simple interest is rarely used in practice, as most notes receivable involve compound interest
Effective interest method
- The effective interest method is the preferred method for calculating interest on notes receivable under both and US
- This method calculates interest based on the carrying value of the note (which includes any unamortized discount or premium) and the effective interest rate (which equates the of the note's cash flows to its carrying value)
- The effective interest rate is determined at the inception of the note and remains constant over the life of the note
- Interest revenue is recognized each period based on the carrying value of the note multiplied by the effective interest rate, and the carrying value is adjusted for any cash payments received and interest revenue recognized
Accounting for dishonored notes
Recognition of dishonored notes
- A note is considered dishonored when the borrower fails to make a required payment on the note by the due date
- When a company determines that a note receivable has been dishonored, it should reclassify the note as past due or delinquent
- The company should also assess the collectibility of the dishonored note and consider establishing an allowance for doubtful accounts
Accounting for dishonored notes receivable
- If a dishonored note is subsequently collected, the company reverses any allowance for doubtful accounts related to the note and recognizes interest revenue for the period
- If a dishonored note is determined to be uncollectible, the company writes off the note by debiting the Allowance for Doubtful Accounts and crediting Notes Receivable
- Any collateral associated with the dishonored note should be seized and recorded at its fair value, with any deficiency recognized as a loss
Discounting of notes receivable
Concept of discounting notes receivable
- of notes receivable refers to the sale of a note to a third party (such as a bank) before its maturity date in exchange for cash
- The third party purchases the note at a discount to its face value, reflecting the time value of money and the risk associated with the note
- Discounting allows the company to receive cash immediately rather than waiting until the maturity date of the note
Accounting for discounted notes receivable
- When a company discounts a note receivable, it derecognizes the note and recognizes the cash proceeds received from the third party
- The difference between the cash proceeds and the carrying value of the note is recognized as a gain or loss on the sale of the note
- If the company retains some risk related to the discounted note (such as the risk of default by the borrower), it may need to recognize a contingent liability for the estimated amount of the potential loss
Calculating discount on notes receivable
- The discount on a note receivable is the difference between the face value of the note and the present value of the note's future cash flows, calculated using the market interest rate for similar notes
- The formula for calculating the discount on a note receivable is:
- The market interest rate used to calculate the present value should reflect the risk associated with the note and the time value of money over the remaining term of the note
Impairment of notes receivable
Identifying impaired notes receivable
- A note receivable is considered impaired when it is probable that the company will be unable to collect all amounts due according to the contractual terms of the note
- Indicators of impairment may include significant financial difficulty of the borrower, a breach of contract (such as a default or delinquency in payments), or a concession granted to the borrower due to economic or legal reasons
- The company should assess the collectibility of its notes receivable on a regular basis and identify any notes that may be impaired
Measuring impairment loss on notes receivable
- The impairment loss on a note receivable is the difference between the note's carrying value and the present value of its expected future cash flows, discounted at the note's original effective interest rate
- The formula for calculating the impairment loss is:
- The expected future cash flows should be based on the company's best estimate of the amount and timing of future collections, considering all available evidence
Accounting for impairment of notes receivable
- When a note receivable is determined to be impaired, the company should recognize an impairment loss by debiting Bad Debt Expense and crediting Allowance for Doubtful Accounts
- The carrying value of the note should be reduced by the amount of the impairment loss, and future interest revenue should be calculated based on the new carrying value and the original effective interest rate
- If the expected future cash flows from the impaired note subsequently increase, the company may reverse some or all of the previously recognized impairment loss
Presentation and disclosure of notes receivable
Balance sheet presentation of notes receivable
- Notes receivable should be presented as a separate line item on the balance sheet, typically under current assets for short-term notes and non-current assets for long-term notes
- If the company has a significant amount of notes receivable, it may choose to present them in a separate section of the balance sheet or in the notes to the financial statements
- The notes to the financial statements should disclose the total amount of notes receivable, the allowance for doubtful accounts, and the net carrying value of the notes
Disclosure requirements for notes receivable
- The notes to the financial statements should disclose the significant terms of the notes receivable, including the interest rates, maturity dates, and any collateral or guarantees
- The company should also disclose its accounting policies related to notes receivable, including the methods used to recognize interest revenue and assess impairment
- If the company has discounted any notes receivable, it should disclose the amount of the discount and the gain or loss recognized on the sale of the notes
Notes receivable vs accounts receivable
Similarities between notes and accounts receivable
- Both notes receivable and accounts receivable represent amounts owed to the company by its customers or other third parties
- Both are typically recorded at their face value and may be subject to an allowance for doubtful accounts if they are deemed uncollectible
- Both generate interest revenue for the company, although the interest on accounts receivable is often implicit rather than explicitly stated
Differences between notes and accounts receivable
- Notes receivable are formal written promises to pay a specific amount on a specific date, while accounts receivable arise from the normal course of business and may not have a fixed payment date
- Notes receivable typically have a stated interest rate and a fixed maturity date, while accounts receivable may be non-interest bearing and have a more flexible payment schedule
- Notes receivable are often used for larger, one-time transactions or for extending credit to higher-risk customers, while accounts receivable are generated from the ongoing sale of goods or services to a wider range of customers
- Notes receivable may be secured by collateral or guaranteed by a third party, while accounts receivable are typically unsecured
- The accounting for notes receivable is generally more complex than for accounts receivable, due to the need to calculate interest revenue and assess impairment based on the specific terms of each note
Key Terms to Review (18)
Accrual Accounting: Accrual accounting is a method of accounting that recognizes revenue when it is earned and expenses when they are incurred, regardless of when cash is actually received or paid. This approach provides a more accurate picture of a company's financial position by matching income and expenses to the period in which they occur, thus ensuring that financial statements reflect the true performance and obligations of the business.
Allowance for Doubtful Accounts: Allowance for doubtful accounts is a contra-asset account that represents the estimated amount of accounts receivable that may not be collectible. This estimate is important because it allows businesses to present a more accurate picture of their financial health by recognizing the potential risk of bad debts in their revenue. The allowance is typically determined based on historical data, aging schedules, or specific identification of uncollectible accounts, and it directly relates to installment sales, accounts receivable, and notes receivable by adjusting the expected cash inflows from these financial assets.
Commercial Paper: Commercial paper is an unsecured, short-term debt instrument issued by corporations to raise funds for working capital and other short-term liabilities. Typically with maturities ranging from a few days to up to 270 days, it provides a flexible financing option for companies looking to manage cash flow needs efficiently without having to secure collateral. Commercial paper is often sold at a discount and redeemed at face value upon maturity, making it an attractive alternative to bank loans for financially stable corporations.
Credit risk: Credit risk refers to the possibility that a borrower will fail to meet their financial obligations as agreed, potentially leading to losses for the lender. It is an important consideration in financial transactions, especially when assessing the quality and reliability of cash equivalents, accounts receivable, and notes receivable. Understanding credit risk helps in evaluating the potential for defaults and ensuring adequate measures are in place to mitigate such risks.
Discounting: Discounting is the process of determining the present value of a future cash flow or series of cash flows by applying a discount rate. This concept is essential for understanding how the value of money changes over time, as it reflects the idea that money available today is worth more than the same amount in the future due to its potential earning capacity.
Effective Interest Method: The effective interest method is a way of calculating interest on financial instruments such as loans or bonds based on the actual amount of interest earned or incurred over time. This method reflects the time value of money and recognizes that the interest expense or revenue changes as the carrying amount of the asset or liability fluctuates. By applying this method, financial statements provide a more accurate representation of the financial health and performance related to interest-bearing instruments.
GAAP: GAAP, or Generally Accepted Accounting Principles, is a collection of commonly followed accounting rules and standards for financial reporting. It establishes a framework for consistent financial reporting, ensuring that companies present their financial statements in a way that is understandable and comparable across different organizations. This standardization is crucial for investors, regulators, and other stakeholders who rely on accurate financial information to make informed decisions.
IFRS: International Financial Reporting Standards (IFRS) are accounting standards developed by the International Accounting Standards Board (IASB) that aim to bring transparency, accountability, and efficiency to financial markets around the world. These standards provide a common global language for business affairs so that financial statements are comparable across international boundaries, promoting cross-border investment and economic growth.
Impairment: Impairment refers to a permanent reduction in the value of an asset, indicating that its carrying amount exceeds its recoverable amount. This concept is crucial for recognizing losses on assets, ensuring that financial statements present an accurate view of a company's financial health. Impairment can affect various asset types, including notes receivable, acquisition costs, intangible assets, and available-for-sale securities, impacting both balance sheets and income statements.
Interest income: Interest income is the revenue earned by an entity from interest-bearing assets, such as cash equivalents, loans, or investments. This income is crucial for understanding the financial health of an organization, as it contributes to overall profitability and cash flow. It plays a significant role in financial reporting and impacts various accounting practices.
Maturity Date: The maturity date is the specific date on which a financial instrument, such as a note receivable or bond, is due for payment in full. This date is crucial for determining when the borrower must repay the principal amount and any interest accrued, which helps both lenders and borrowers plan their cash flows and investment strategies. Understanding the maturity date is essential for assessing the risk and return associated with different financial instruments.
Present Value: Present value (PV) is the current worth of a sum of money that will be received or paid in the future, discounted back to the present using a specific interest rate. It is essential in finance as it helps determine how much future cash flows are worth today, considering factors such as interest rates and the time value of money. Understanding present value is crucial for making informed decisions about investments, loans, and other financial instruments.
Promissory note: A promissory note is a written, unconditional promise to pay a specified amount of money to a designated party at a future date or on demand. This financial instrument serves as evidence of a loan and includes terms such as the principal amount, interest rate, and maturity date, making it essential in the context of notes receivable.
Recoveries: Recoveries refer to the amount of money collected after previously written-off accounts or losses. In the context of notes receivable, recoveries are particularly important as they represent the successful collection of amounts that were once deemed uncollectible, thus improving the financial position of a company. This process can enhance cash flow and positively impact financial statements when a business is able to reclaim funds that were previously thought to be lost.
Related Party Transactions: Related party transactions are financial interactions between parties that have a pre-existing relationship, such as family members, business partners, or entities under common control. These transactions can significantly affect financial reporting and disclosures due to the potential for conflicts of interest or non-market pricing. Transparency is essential when reporting these transactions to provide users of financial statements with a clear understanding of any risks involved.
Straight-line method: The straight-line method is a commonly used accounting technique for allocating the cost of an asset evenly over its useful life. This approach provides a simple and consistent way to recognize expense, making it easier for businesses to predict their financial performance. It is particularly important in various aspects of financial accounting, such as asset acquisition, depreciation, and amortization, as well as in assessing long-term liabilities and bond payable calculations.
Uncollectible Accounts: Uncollectible accounts refer to receivables that a company has deemed unlikely to be collected due to the debtor's inability to pay. This concept is crucial for accurately reflecting the financial health of a business, as it impacts both the income statement and balance sheet by recognizing potential losses associated with accounts receivable. Understanding uncollectible accounts helps in managing credit risk and making informed decisions regarding credit policies.
Write-off procedure: The write-off procedure refers to the process of removing an uncollectible receivable from a company's books, recognizing that it is unlikely to be collected. This procedure is essential for maintaining accurate financial records, as it reflects the reality of the company's financial position and ensures that accounts receivable do not overstate potential income. The write-off typically involves debiting bad debt expense and crediting accounts receivable, which helps businesses better manage their financial health.