Notes receivable is the amount a business has a legal right to receive on a specific date from another party backed by a written promise, which is also called a promissory note. Notes receivable is treated as an asset and classified as a current asset if it is due within 12 months and as a non-current asset if it is due after 12 month from the reporting date. The reasons why a business prefers to use notes receivable rather than accounts receivable are as follows:
Payee is a party entitled to claim payment against a promissory note at the maturity date.
Maker is a promising party legally obliged to pay principal and interest at the maturity date.
Maturity date is a date when principal and interest are to be paid.
Duration is a time period in days between the date of issue and the maturity date.
Principal is the amount stated in the promissory note (interest is not included).
Interest is the charge imposed on the maker for the use of funds provided by payee.
Interest rate is a rate agreed by a payee and maker expressed as a percentage of principal.
The formula to calculate the interest charge on notes receivable is as follows:
|Interest = Principal × Interest Rate ×||Time Period|
where Interest Rate is the annual interest rate, Time Period is a duration of notes receivable in days, and 365 is the number of days in a year.
Be aware that sometimes 360 days can be used instead of 365 days!
Common examples when notes receivable should be recognized are as follows:
Lending cash to other parties. If a business lends cash to another party against a promissory note, it should make an entry in the general journal by debiting Notes receivable and crediting the Cash account.
Converting accounts receivable to notes receivable. Sometimes, past due accounts receivable can be converted to notes receivable. Such an entry is recorded by debiting Notes receivable and crediting Accounts receivable.
When the principal amount as well as accrued interest are paid by the client, it should be recorded as follows:
If a client is unable to pay the principal amount and accrued interest at the maturity date, notes receivables can be converted back to accounts receivables as follows:
If some specific note was recognized as uncollectible, it should be written off against Allowance for doubtful accounts as follows:
At the end of each accounting period, the adjusting entry should be made to record accumulated interest on notes receivable outstanding and recognize interest income.
When such note is finally collected, it should be recognized as follows:
To illustrate notes receivable accounting, assume that RetailX LTD has made the following transactions in the 4th financial quarter:
Assuming that RetailX LTD reports financial statements at the end of each quarter, the following entries should be made in the general journal:
RetailX LTD recognized converting of past due account of BMG LTD to notes receivable in the amount of $30,000.
RetailX LTD recognized promissory note issued by EstroZ LDT in the amount of $50,000.
RetailX LTD recognized converting of past due account of BMG LTD to notes receivable in the amount of $15,000.
As far as promissory note had been issued in the 3rd financial quarter, the following adjusting entry was made at the end of the accounting period to recognize interest income.
Interest was accrued as follows:
Interest = $25,000 × 8% × 44 ÷ 365 = $210.96
where 44 is the number of days that the promissory note was outstanding in the 3rd financial quarter (from 08/18/20X7 till 09/30/20X7).
In the 4th financial quarter, interest was accrued as follows:
Interest = $25,000 × 8% × 46 ÷ 365 = $220.55
where 46 is the number of days that the promissory note was outstanding in the 4th financial quarter (from 10/01/20X7 till 11/15/20X7).
RetailX LTD identified notes receivable in the amount of $30,000 as uncollectable and decided to write it off against allowance for doubt account as well related interest in the amount of $493.15.
Interest = $30,000 × 10% × 60 ÷ 365 = $493.15
RetailX LTD recognized collection of the promissory note in the amount of $15,000 as well accrued interest in the amount of $197.26.
Interest = $15,000 × 8% × 60 ÷ 365 = $197.26
Since the promissory note issued on 10/17/20X7 by EstroZ LDT is still outstanding at the end of the accounting period, the adjusting entry should be made to recognize accrued interest in the amount of $719.18 as interest income.
Interest = $50,000 × 7% × 75 ÷ 365 = $719.18
where 75 is the number of days that the promissory note was outstanding in the 4th financial quarter (from 10/17/20X7 till 12/31/20X7).Notes receivable in T-account format
As an asset account, notes receivable increases by debiting and reduces by crediting. Let’s transform the general journal entries from the example above to a T-account format assuming that the balance on 10/01/20X7 was $25,000.
The ending balance of Notes receivable is calculated as follows:
Ending Balance = Beginning Balance + Debit Totals - Credit Totals
Ending Balance = $25,000 + $95,000 - $70,000 = $50,000