Unit 12
Notes Receivable
12.1 Introduction
The term notes receivable (or promissory notes) is used in accounting to designate several types of credit instruments. A promissory note is a written contract containing an unconditional promise to pay a definite sum of money on demand or at a future date. Most promissory notes used as a basis for business transactions are negotiable, which means that a holder in due course may sell the notes, discount them, or borrow against them.
Notes receivable often are used when the goods have a high unit or aggregate value and the purchaser of the goods wants to extend payment beyond the normal 30 to 90 day period of trade credit. In the banking and commercial credit fields, notes are the typical form of credit instrument used to support lending transactions. Notes receivable also may result form sale of plant assets, or from a variety of other business transactions.
In accounting for notes receivable, it is important to know how to calculate the maturity date, duration of note, interest and interest rate, and maturity value. The accounting entries for promissory notes receivable fall into four categories: receipt of a note, collection of a note, recording of a dishonored note, and recording adjusting entries.
12.2 Accounting for Notes Receivable
For accounting purposes, the principal amount of a note is measured by the fair market value or cash equivalent value of goods or services provided in exchange for the note, if this value is known or the present (discounted) value of all cash payments required under the note using the market rate. The principal is also the amount initially subject to interest. The principal represents the sacrifice by the payee, and therefore the present value of the future payments, at the date of the transaction. Any amount paid in excess of the principal is interest. Short-term notes need not be reported at present value; the difference between present value and maturity value is generally not significant.
Notes may be categorized as interest-bearing or non interest-bearing. Interest-bearing notes specify the interest rate to be applied to the face amount in computing interest payments. Non-interest bearing notes do not state an interest rate but command interest through face values that exceed the principal amount.
Interest-bearing notes in turn can be divided into two categories according to the type of cash payment required: (1) notes whose cash payments are interest only, except for final maturity payment and (2) notes whose cash payments include both interest and principal.
Illustration of Accounting for notes receivable
Illustration of Accounting for Notes Receivable
12.2.1 Simple Interest Note:
On April 1, 1992, DOT Company loaned Br. 12,000 cash to Bayor Company and received a three-year, 10 percent note. Interest is payable each March 31, and the principal is payable at the end of the third year. The stated and market interest rates are equal. The entry to record the note is as follows:
1992 Notes receivable -----------2,000
April 1 Cash -------------------------------------12,000
The present value of the principal and interest payments on April 1, 1992 is Br. 12,000 because the stated and market rates are equal. Cash interest received also equals interest revenue recognized over the terms of the note, as indicated in the remaining entries.
Adjusting Entries: December 31, 1992, 1993, and 1994
Interest receivable (Br. 12,000 x 0.1 x 9/12) -------900
Interest revenue ----------------------------------------900
March 31, 1993 and 1994
Cash -----------------------------1200
Interest receivable -----------------------------900
Interest revenue (12,000 x 0.1 x 3/12) -----300
March 31, 1995:
Cash -----------------------------13,200
Notes receivable -------------------12,000
Interest receivable -----------------900
Interest revenue --------------------300
12.2.2 Different Market and Stated Rates
Fox company, which sells specialized machinery and equipment, sold equipment on January 1, 1992, and received a two-year, Br. 10,000 note with a 3 percent stated interest rate. Interest is payable each December 31, and the entire principal is payable December 31,1993.
The equipment does not have a ready market value. The market value (and principal) of the note is computed as follows (amounts are rounded to the nearest dollar)
Present value of the face value
Br. 10,000 x 0.82645 ---------------------------Br. 8,265
Present value of the nominal interest payments:
Br. 10,000 x 1.73554 -----------------------------521
Present value of the note at 10% ----------------Br. 8,786
Before APB opinion No. 21 there were no definitive guidelines to use when the stated and market rates were unequal. Some companies’ recorded notes at face value even though the market rate exceeded the stated rate, thereby inflating notes receivable and sales. APB opinion NO. 21, however, requires the recording of the substance of the transaction over its form.
Notes with stated interest rates below market may be used by companies to increase sales. The FOX company note, for example, uses nominal (stated) interest rate offset by an increased face value. Many buyers of big-ticket items, including automobiles, home appliances and ever houses, are more concerned about the monthly payment than the final maturity payment the balloon payment, at it is called. A note with a Br. 8,786 face value and a 10 percent stated rate achieves the same present value to FOX Company. A 3 percent interest payment on Br. 10,000 (Br. 300) may be more attractive than a 10 percent payment on Br. 8,786 (Br. 879). Fox earns 10 percent over the two-year term either way.
As the Fox company example illustrates, when the stated and market interest rates are different, the face value and principal differ. Notes are recorded at gross (face) value plus a premium or minus a discount amount (the gross method), or at the net principal value (the net method). The two methods are illustrated for the Fox example:
1992 January 1:
Gross Method Net Method
Notes receivable ---------------------------10,000 -----------------------------8,786
Discount on notes receivable --------------------1214----------------- 0
Sales ------------------------------------------------8786 ----------------------------8786
Under either method, the net book value of the note is Br. 8,786 the principal value. Discount on notes receivable is a contra account to notes receivable. The gross method discloses both the notes face value and the interest to be received over the remaining term.
The entries at the end of the fiscal year are as follows:
December 31, 1992 Gross Method Net Method
Cash (Br. 10,000 x 0.03) -------------------300 300
Discount on note receivable --------------579
Notes receivable ----------------------------------------------------------579
Interest revenue (Br. 8,786 x 0.1) ---------------879 ----------------879
The balance sheet dated December 31, 1992, discloses the following:
Gross Method Net Method
Notes receivable -------------------------------Br. 10,000
Discount on notes receivable ------------------------635*
Net notes receivable ----------------------------Br. 9,365 9365+
* Br. 1214 – Br. 579 = 635
+ Br. 8786 + Br. 579 = 9365
Under both methods, the previous entry increases net notes receivable by Br. 579. Under the gross method, the discount account is amortized increasing net notes receivable.
A substantial portion of the interest revenue is reflected in the increase in net notes receivable. The present value of the note on January 1, 1992, is the net note receivable, namely Br. 9,365.
This value can also be computed as
Br. 10,300 x 0.90909 = Br. 9365
The market rate of interest is applied to the beginning balance in the net note receivable to compute interest revenue. This approach, called the interest method, results in a constant rate of interest throughout the life of the note. Another method, the straight-line method, which amortizes a constant amount of discount each period but which produces a varying rate of interest, is allowed only if the results are not materially different from the interest method. In this example, the straight-line method results in discount amortization of Br. 607 (Br. 1214/12 years) and interest revenue of Br. 907 (Br. 607 + Br. 300) in both years.
Continuing with the interest method, the entry at the end of 1993 is the following:
December 31,1993 Gross Method Net Method
Cash (Br. 10,000 x 0.03) 300 300
Discount on note receivable 636
Notes receivable 636
Interest revenue (Br. 9,365 x 0.1) 936 936
After the December 31,1993, entry, the net notes receivable balance is Br. 10,000, the present value at that date. The discount account balance is now zero (rounded), and the note is collected at this time:
December 31, 1993 Gross Method Net Method
Cash 10,000 10,000
Notes receivable 10,000 10,000
12.2.3 Note issued for non-cash consideration
Munna Company sold specialized equipment originally costing Br. 20,000 with a net book value of Br. 16,000 on January 1, 1990 to Damot Company. The market value of the equipment was not readily determinable.
Munna Company received a Br. 5000 down payment and a Br. 10,000 4 percent note payable in four equal annual installments starting December 31, 1990. The current market rate on notes of a similar nature and risk is 10 percent. With the stated rate of 4 percent the payment (P) is determined as follows:
Br. 10,000 = P (3.62990)
P = Br. 2,755
N.B. 3.6299 is taken from compound interest table.
Therefore, the note’s principal equals the present value of four Br. 2755 payments at 10 percent:
Br. 2,755 (3.16987) = Br. 8,733
The present value of the consideration received is Br. 13,733 (Br. 5000 + Br. 8,733), which is therefore the agreed-upon value of the equipment. The entry to record the sale (net method) is the following
January 1, 1992
Cash -------------------------------------------------------------------5000
Notes receivable -----------------------------------------------------8733
Accumulated depreciation (Br. 20,000 – Br. 16,000) -----------4000
Loss on sale of equipment -----------------------------------------2,267
Equipment ------------------------------------------------------------20,000
The loss on sale equals the net book value of the equipment (Br. 16,000) less the present value of consideration received (Br. 13,733).
The following entry is made at the end of the fiscal year:
December 31, 1992
Cash ----------------------------------------------------------2755
Interest revenue (Br. 8733 x 0.1) --------------------------------873
Notes receivable -------------------------------------------------1882
The notes book value on January 1, 1993 is Br. 6,851 (Br. 8733 – Br. 1882). Therefore, 1993 interest revenue is br. 685 (0.1 x Br. 6,851)
12.2.4 Notes Exchanged for cash and other privileges
Long-term notes must be recorded at their present value using the appropriate interest rate. Companies may accept a note with a stated interest rate lower than the market rate in exchange for cash or other consideration worth the face value of the note. To make this a fair transaction, other rights or privileges must be received by the party accepting the note, beyond the cash payments required in the note.
On January 1, 1992, Vienacava Corporation loaned SISA Co. Br. 10,000 and accepted a Br. 10,000 note due December 31, 1993, with interest payable annually each December 31, beginning 1992. The market interest rate is 12 percent. SISA Company agreed to provide Vienacava Corporation with agricultural materials at a discount price over the note term.
Two-thirds of the supplies are to be furnished during the first year. The present value of the note itself is significantly less than Br. 10,000
Principal value of note: Br. 10,000 (0.79719) + Br. 10,000 (0.05) (1.69005)
= Br. 8,817
In this example, vienacava would lend only Br. 8,817 if the note alone were received in exchange. The additional Br. 1,183 (Br. 10,000 – Br. 8,817) is a prepayment for discount pricing. Vienacava thus receives two payments of Br. 500, one payment of Br. 10,000, and discount pricing on purchases over the note term. The value of the other privileges should be recorded as an asset equal to the difference between the note’s present and face values. The entries on vienacava’s books using the gross method are:
January 1,1992
Notes receivable -----------------------------10, 000
Prepaid purchases ------------------------------1183
Discount on notes receivable ----------------------1183
Cash -------------------------------------------------10,000
Two-thirds of the prepaid purchases account is a current asset on January 1, 1992, and one-third is a long-term asset. The entries to record receipt of cash and to recognize two-thirds of the discount are:
December 31, 1992
Cash ------------------------------------------500
Discount on notes receivable -------------558
Interest revenue (Br. 8,817 x 0.12) ------------------1058
Purchases (2/3 x 1,183)-------------------------------789
Prepaid purchases ----------------------------------------789
The remaining prepaid purchases account is now a current asset for 1993. the entries when the contract concludes are:
December 31, 1993
Cash ---------------------------------------------500
Discount on notes receivable ----------------625
Interest revenue (0.12 x Br. 8,817 + Br. 558) -----------------1,125
Purchases (1/3 x Br. 1183) -------------------394
Prepaid purchases ----------------------------------394
Cash ------------------------------------------10,000
Notes receivable ---------------------------------10,000
12.3 computation of present value of a note receivable
The current fair rate of interest used to compute the present value of a note receivable depends on factors such as the credit standing of the issuer, terms of the note, the quality of collateral offered by the issuer, and the general level of interest rates. The interest rate selected for this purpose should approximate the rate at which the debtor could obtain similar financing from other sources.
Example:
Assume that on December 31,1990, Nice corporation presents a Br. 39,930 invoice for services to a client. The client protested the amount of the invoice and as a compromise was allowed to pay the invoice in three annual installments of Br. 13,310 starting on December 31,1991. Nice Corporation received three non interest-bearing promissory notes for Br. 13,310 each, dated December 31, 1990. How should these notes be entered in the accounting records of Nice Corporation, if the current fair rate of interest is 10% a year? First, the present value of the three notes is computed from table 4 in the Appendix at the end of chapter 8, as follows:
Amount of annual receipts (notes) -----------------------------Br. 13,310
Multiply by present value of ordinary annuity of
three rents of 1 at 10% interest ----------------------------------2,486852
Present value of three annual receipts of Br. 13,310 at 10% Br. 33,100
The journal entries to record the original billing for services, the receipt of the notes by Nice Corporation on December 31,1990, and three annual receipts from the client are illustrated below. (We have assumed that the promissory notes are recorded at the face amount of Br. 39,930 and that a discount on Notes Receivable ledger account is used to record the Br. 6,830 implicit interest to be realized over the terms of the notes):
December 31,1990: To record billing for services
Accounts Receivable ----------------------------------39,930
Fees Revenue -------------------------------------------39,930
December 31,1990: To record receipt of non interest-bearing notes with a face amount of Br. 39,930 payable in three annual installments of Br. 13,310 each. The notes are recorded at their present value based on an interest rate of 10% a year.
Notes receivable ------------------------------------39,930
Fees revenue -----------------------------------------6,830
Discount on notes receivable ------------------------------------6,830
Accounts receivable --------------------------------------------39,930
12.4 Discounting Notes Receivable
Negotiable notes receivable may be sold or discounted. The term sale is appropriate when a note is indorsed to a bank or finance company on a without recourse basis, that is, in the event the maker of the note defaults, the bank or finance company has no recourse against the seller of the note. The term discounted applies when an enterprise borrows against notes receivable and indorses them on a with recourse basis, which means that the borrower must pay the note if the maker does not.
The process of discounting has three steps, as indicated in accompanying diagram. In the first step, the maker receives goods, services or cash from the payee in exchange for the note. In the second step, the payee discounts the note with a bank and receives the maturity value of the note less a discount (a fee) charged by the bank. In the third step, the maker pays the bank at the maturity of the note.
The proceeds received when a note is discounted are computed by deducting from the maturity value of the note the amount of interest (discount) charged by the bank or finance company. Banks usually compute the discount on the maturity value of the note rather than on the proceeds (amount actually borrowed), which gives the bank a higher effective rate of interest than the rate of interest used to discount the note.
Notes are discounted with or without recourse and are recorded as a borrowing or a sale depending on whether the conditions of SFAS No. 125 are met. If the note is discounted with recourse and treated as a sale, the payee records a gain or loss equal to the difference between the proceeds and book value of the note, including accrued interest, and has a contingent liability until the note is paid by the maker. If the note is discounted with out recourse, the payee has no contingent liability.
If a discounted note is recorded as a borrowing, a liability is recorded and interest expense is recognized over the term of borrowing. The proceeds to the payee are not affected by the reporting alternatives and are based on the total of principal value plus interest to maturity, whether or not the note is interest bearing. The bank charges its discount rate on this total amount for the period between the date of discounting and the date of maturity of the note.
Example 1
On April 1, 1992, Cook Company received a Br. 3,000, 10 percent one-year note form a sale of equipment to Nell Company. Interest on the note is due at maturity. Cook Company discounted the note on august 1, 1992, with recourse. Assume that the discounting qualifies as a sale and that the bank charges 15 percent. The precedes to cook company are as follows:
Principal value ----------------------------------------------Br. 3000
Interest to maturity (Br. 3000 x 0.1) ---------------------------300
Total maturity value subject to discount --------------------3,300
Interest charged by bank (Br. 3000 x 0.15 x 8/12) -----------330
Proceeds to cook company --------------------------------Br. 2,970
The bank charges interest on the maturity value a full eight months before, that value is reached, effectively raising the interest cost to cook company, which records the following entries to discount the note:
August 1, 1992
Interest receivable (Br. 3000 x 0.1 x 4/12) -------------------------100
Interest revenue ---------------------------------------------------------100
Cash ---------------------------------------------------------------------2170
Loss on discounting of note -------------------------------------------130
Notes receivable -------------------------------------------------------------3000
Interest receivable ------------------------------------------------------------100
The note is no longer an asset of Cook Company and is removed from the books. The loss equals the book value of the note plus accrued interest (Br. 3100) less the proceeds. Two factors contribute to the loss. The note was transferred relatively early in its tem, and the bank charged a higher interest rate.
A second acceptable method for recording the Nell Company note discounting is as follows:
August 1,1992
Cash -----------------------------------------------2970
Interest expense ------------------------------------30
Notes receivable --------------------------------------3000
When the contingency is removed (upon payment of the note by the maker), the following entry is made:
Notes receivable discounted ------------------------3000
Notes receivable -----------------------------------------3000
For a note discounted without recourse, the entries are the same (although the notes receivable discounted account is not used), but no contingent liability exists.
12.5 Dishonored Notes
A note receivable not renewed or collected at maturity is considered a dishonored note. Interest continues to accrue on the face value plus any previously accrued interest at the interest rate set by state laws. The payee generally transfers the note to a special receivable accounts and initiate collection efforts. If the Nell company note were held to maturity (i.e. not discounted), the default would be recorded as follows:
April 1,1993:
Notes receivable past due (Accounts Receivable) -------------------3,300
Notes receivable ------------------------------------------------------------3000
Interest receivable (Br. 3000 x 0.1 x 9/12) --------------------------------225
Interest revenue (Br. 3000 x 0.1 x 3/12) ------------------------------------75
The accounting for discounted notes dishonored by the maker depends on the discounting transaction. If the note was discounted without recourse and recorded as a sale, no entry is required and no contingent liability exists to be removed.
If the note was discounted with recourse (the more likely case) and recorded as a sale, the payee pays the maturity value, including interest and any fee charged by the bank, and debits a special receivable account for the amount paid.
Assume that the note discounted by Cook Company and recorded as a sale is dishonored. The bank charges a Br. 15 fee (called a protest fee) for the additional task of notifying Cook Company on the default. Assuming footnote disclosure of the contingent liability, the entry upon notification by the bank is as follows:
After April 1,1993
Notes receivable past due (Accounts Receivable) ---------------3315
Cash -------------------------------------------------------------------3315
This amount is the maturity value plus bank fee. If the account method of disclosing the contingent liability were used, the entry would be the following:
After April 1, 1993
Notes receivable past due---------------------------3315
Notes receivable discounted ----------------------3000
Cash --------------------------------------------3315
Notes receivable -----------------------------3000
This entry removes the contingent liability and establishes the special receivable
Finally, assume that the note cook company discounted is recorded as a liability and is then dishonored. The entry to record the default, with the Br. 15 protest fee, is:
Notes receivable past due ---------------------------------3315
Liability on discounted notes receivable ---------------3000
Cash ----------------------------------------------------------3315
Notes receivable --------------------------------------------3000
If efforts to collect the past-due note fail, the accounting for the loss depends on whether note are included in the bad debt estimation process. If notes are included the account is closed against the allowance for doubtful accounts at its carrying value. If notes are not included, the direct write-off method is used. The note is credited for the carrying value and a loss is debited.
12.6 valuation of notes receivable
As in the case of accounts receivable, the proper valuation of notes receivable and similar credit instruments is their current fair value (or present value) at the time of acquisition. Accountants can value notes receivable because their terms generally provide reliable evidence of the rights inherent in them. Except for question of collectibles, there is little uncertainty with respect to the amounts that will be received and the dates on which the amounts will be received.
Notes receivable, just as trade accounts receivable, may prove to be uncollectible. If a business enterprise uses notes as a regular credit medium and has a large volume outstanding the amounts of probable uncollectibles notes may be estimated, and an allowance for such notes established by procedures similar to those for accounts receivable.
Strictly speaking, there is no such thing as a non interest-bearing note, there are only notes that contain a stated provision for interest and notes that do not. The time value of money is present in any case, because the present value of a promise to pay a stated amount of cash on a fixed or determinable date is not as large as the amount to be paid at maturity. The so-called non interest-bearing note has a lower present value than its face amount by an amount equivalent to an interest charge. In contrast, if a note bears a fair rate of interest, its face amount and present value are the same on the date of issuance.
Example: Suppose that two promissory notes are received in connection with the sale of goods. In settlement of the first sale, customer W gives a one-year, 12% note, with a face amount of Br. 25,000. In settlement of the second sale, customer x gives a one-year note with a face amount of Br. 28,000 but with no interest provision specified in the note.
If accountants considered only the face amount of the notes, they might be tempted to record the two notes as follows:
Customer W Customer X
Notes receivable --------------25,000 Notes receivable ------28,000
Sales ---------------------------25,000 Sales ----------------28,000
A careful examination of the evidence indicates that the two promissory notes are identical, assuming that 12% is a reasonable annual rate of interest. Both customers have promised to pay Br. 28,000 at the end of one year, and both notes have a present value of Br. 25,000 (Br. 28,000 ¸) 12 = Br. 25,000. A logical method of accounting is to record both notes at Br. 25,000 and to record interest of Br. 3000 as it is realized. Thus, the note receivable from customer X may be recorded at Br. 25,000 (the same as note form customer W), or preferable by use of a Discount on Notes Receivable ledger account (resulting in a carrying amount of Br. 25,000) as illustrated below:
Notes Receivable ------------------------------28,000
Discount on Notes Receivable ----------------------------3000
Sales --------------------------------------------------------28,000
The discount on notes receivable is amortized periodically as interest revenue, and any unamourtized balance at the end of an accounting period is deducted from Notes receivable in the balance sheet.
In practice, non interest-bearing short-term notes received from customers often are recorded at the outset at face amount (maturity value). The foregoing analysis shows that this procedure overstates assets and fails to recognize interest revenue. Although GAAPs require that notes be recorded at present value, trade notes and accounts receivable with customary trade terms not exceeding one year may be recorded at face amount.
When the amount of the unearned implicit interest is substantial, this procedure may result in a significant overstatement of assets, stockholder’s equity, and net income in the accounting period that the notes and accounts receivable are recorded.
12.7 presentation of notes receivable in the balance sheet
In the current asset section of the balance sheet, material amounts of notes receivables arising from written negotiable contracts that will be due within a year or operating cycle whichever is longer are reported.
Any discount or premium relating to notes receivable is reported in the balance sheet as s deduction from or as an addition to the face amount of the note. The description of notes receivable should include the effective interest rate.
Notes receivable that will not be collected within a year of the operating cycle are excluded from the current assets category.
12.8 Summary
A note receivable is a written promise to pay specified amounts over a series of payment dates. Note receivable provides extended payment terms, more security than sales invoices and other commercial trade documents, a formal basis for charging interest and negotiability.
Note are classified as interest-bearing or non-interest bearing. Interest-bearing notes have a stated rate of interest, whereas non interest-bearing notes include the interest as part of their face amount instead of stating it explicitly. Notes receivable are recorded at the present value of the future cash inflows. There are three important categories in the accounting for notes receivable that have an unrealistic sated rate of interest. These categories are notes received solely for cash, notes received for cash, but with some right or privilege also being exchanged, and notes received in a non cash exchange of property, goods, or services.
Generating cash receipts from a note receivable before maturing can be accomplished by discounting the note at a bank. In most instances, the company discounting the note guarantees payment of the note to the bank at maturity. Thus, a company discounting note receivable under such an arrangement must disclose a contingent liability in its financial statements.
The presentation of notes receivables in the balance sheet includes the following considerations:
- Segregate the different notes receivables that an enterprise possesses, if material
- Insure that the valuation accounts are appropriately offset against the proper receivable accounts.
- Disclose any loss contingencies that exist on the notes receivable.
