6.4 Notes receivable

Notes receivable are formal written promises to pay a specific amount on a set date, usually with a stated interest rate. They differ from accounts receivable in that they're documented legal instruments, often used for larger transactions or higher-risk credit situations. This section covers how to recognize, value, and derecognize notes receivable, along with key topics like interest calculation, dishonored notes, discounting, and impairment.

Definition of Notes Receivable

A note receivable is a written promise from a borrower or customer to pay the company a specific amount of money on a specified future date. Unlike an informal accounts receivable, a note represents a formal legal agreement that typically includes a fixed payment schedule and an interest rate.

Notes receivable arise when a company extends credit to a customer, lends money to another entity, or converts an existing account receivable into a more formal arrangement (often because the customer needs more time to pay).

Accounting for Notes Receivable

Initial Recognition of Notes Receivable

When a company receives a note, it records the note at its face value (the amount the borrower promises to pay at maturity). The entry debits Notes Receivable and credits the appropriate account depending on the transaction:

• Cash if the company is lending money directly
• Sales Revenue if the note arises from a sale
• Accounts Receivable if an existing receivable is being converted to a note

Any associated costs like 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 carried at amortized cost. This is the face value adjusted for any unamortized premium or discount and reduced by any allowance for uncollectible amounts.

If the note bears interest, the company accrues interest revenue over the note's life using the effective interest method (more on this below). The company should also periodically assess collectibility and establish an allowance for doubtful accounts when needed.

Derecognition of Notes Receivable

A company removes a note receivable from its books when:

• The borrower pays in full. Debit Cash for the total amount received (principal plus any remaining interest), and credit Notes Receivable for the face value. Recognize any remaining interest revenue.
• The note is sold or transferred. Debit Cash (or the appropriate asset) for the proceeds, credit Notes Receivable for the carrying value, and recognize any gain or loss as the difference between proceeds and carrying value.

Types of Notes Receivable

Interest-Bearing vs. Non-Interest-Bearing Notes

• Interest-bearing notes require the borrower to pay interest on top of the principal, at a stated rate and on a specified schedule.
• Non-interest-bearing (zero-interest) notes don't explicitly charge interest. Instead, the time value of money is built into the face value. The note is initially recorded at its present value, and the difference between face value and present value is recognized as interest revenue over the note's life.

Secured vs. Unsecured Notes

• Secured notes are backed by collateral (property, equipment, etc.) that the company can seize if the borrower defaults.
• Unsecured notes have no collateral backing, which means higher risk for the company and limited recourse if the borrower fails to pay.

Short-Term vs. Long-Term Notes

• Short-term notes mature within one year and appear as current assets on the balance sheet.
• Long-term notes mature in more than one year and appear as non-current assets.

Calculating Interest on Notes Receivable

Simple Interest Method

Simple interest is calculated on the original principal only, with no compounding. The formula is:

$\text{Interest} = \text{Principal} \times \text{Interest Rate} \times \text{Time}$

For example, a $\$10{,}000$ note at 6% annual interest for 90 days would generate:

$\text{Interest} = \$10{,}000 \times 0.06 \times \frac{90}{360} = \$150$

Note that many financial calculations use a 360-day year (called the "banker's year"), though some use 365 days. Pay attention to what your problem specifies.

Simple interest is straightforward but less common in practice for longer-term notes.

Effective Interest Method

The effective interest method is the preferred approach under both IFRS and US GAAP. Here's how it works:

1. Determine the effective interest rate at inception. This is the rate that equates the present value of the note's expected cash flows to its initial carrying value.
2. Each period, calculate interest revenue by multiplying the carrying value of the note by the effective interest rate.
3. Adjust the carrying value by adding the interest revenue recognized and subtracting any cash payments received during the period.

The effective rate stays constant over the note's life, but because the carrying value changes each period (especially for notes issued at a discount or premium), the dollar amount of interest revenue recognized will change from period to period. This is the key difference from the straight-line method.

Accounting for Dishonored Notes

Recognition of Dishonored Notes

A note is dishonored when the borrower fails to make a required payment by the due date. When this happens, the company should:

1. Reclassify the note as past due or delinquent.
2. Assess the likelihood of collection.
3. Consider whether an allowance for doubtful accounts is needed.

Accounting Treatment

The treatment depends on whether the company expects to eventually collect:

• If the dishonored note is later collected: Reverse any allowance previously recorded and recognize interest revenue for the period, including any penalty interest if applicable.
• If the note is deemed uncollectible: Write it off by debiting Allowance for Doubtful Accounts and crediting Notes Receivable.
• If collateral exists: Seize and record the collateral at fair value. If the collateral's fair value is less than the carrying value of the note, recognize the deficiency as a loss.

Discounting of Notes Receivable

Concept of Discounting

Discounting means selling a note receivable to a third party (often a bank) before its maturity date in exchange for immediate cash. The third party pays less than the note's maturity value because it's taking on the risk and the time value of money.

This is useful when a company needs cash now rather than waiting for the note to mature.

Calculating the Discount

The process for determining how much cash you'll receive works like this:

1. Calculate the maturity value of the note (face value plus total interest to maturity).
2. Calculate the bank discount. The bank applies its own discount rate to the maturity value for the remaining time until the note matures:

$\text{Bank Discount} = \text{Maturity Value} \times \text{Discount Rate} \times \text{Remaining Time}$

1. Calculate the proceeds:

$\text{Proceeds} = \text{Maturity Value} - \text{Bank Discount}$

1. Recognize a gain or loss as the difference between the proceeds and the note's carrying value at the date of discounting.

Recourse Considerations

If the company discounts the note with recourse, it retains the risk that the borrower might default. In that case, the company may need to recognize a contingent liability for the estimated potential loss. If discounted without recourse, the risk transfers entirely to the third party.

Impairment of Notes Receivable

Identifying Impaired Notes

A note receivable is impaired when it becomes probable that the company won't collect all amounts due under the original terms. Warning signs include:

• Significant financial difficulty of the borrower
• Breach of contract (default or delinquency in payments)
• Concessions granted to the borrower due to financial hardship

Companies should assess collectibility on a regular basis.

Measuring the Impairment Loss

The impairment loss equals the difference between the note's carrying value and the present value of expected future cash flows, discounted at the note's original effective interest rate (not the current market rate):

$\text{Impairment Loss} = \text{Carrying Value} - \text{PV of Expected Future Cash Flows}$

The expected future cash flows should reflect the company's best estimate of the amounts and timing of collections, based on all available evidence.

Recording Impairment

1. Debit Bad Debt Expense and credit Allowance for Doubtful Accounts for the impairment loss.
2. Reduce the carrying value of the note accordingly.
3. Going forward, calculate interest revenue on the new (reduced) carrying value using the original effective interest rate.

If conditions improve and expected future cash flows increase, the company may reverse some or all of the previously recognized impairment loss.

Presentation and Disclosure of Notes Receivable

Balance Sheet Presentation

• Short-term notes appear under current assets; long-term notes appear under non-current assets.
• Notes receivable are typically shown as a separate line item.
• The allowance for doubtful accounts is deducted to arrive at the net carrying value.

Disclosure Requirements

The notes to the financial statements should include:

• Significant terms of outstanding notes (interest rates, maturity dates, collateral, guarantees)
• Accounting policies for recognizing interest revenue and assessing impairment
• The amount of any discounted notes and related gains or losses
• The total allowance for doubtful accounts related to notes receivable

Notes Receivable vs. Accounts Receivable

These two asset types share some similarities but differ in important ways.

The main takeaway: notes receivable involve more formal documentation and more complex accounting because of their explicit interest terms and individual assessment requirements.