# Notes Receivable Accounting

By Yuriy Smirnov Ph.D.

## Definition

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:

• a promissory note is a legal document being stronger evidence of a debt than accounts receivable or commercial papers
• notes receivable have a longer duration than accounts receivable and usually require interest to be paid
• notes receivable are negotiable financial instruments, and a holder can easily transfer them to other parties (e.g., holder can sell it to a financial institute at a discount)

## Terms

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.

## Formula

The formula to calculate the interest charge on notes receivable is as follows:

 Interest = Principal × Interest Rate × Time Period 365

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!

## Journal Entries

### Recognition of Notes Receivable

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.

### Cash collection

When the principal amount as well as accrued interest are paid by the client, it should be recorded as follows:

• Debit Cash account by the principal amount and interest accrued
• Credit Notes receivable by the principal amount
• Credit Interest income by the amount of accrued interest

### Notes Receivable Write-off

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:

• Debit Accounts receivable by the principal amount and accrued interest
• Credit Notes receivable by the principal amount
• Credit Interest income by amount of accrued interest

If some specific note was recognized as uncollectible, it should be written off against Allowance for doubtful accounts as follows:

• Debit Allowance for doubtful accounts by the principal amount and accrued interest
• Credit Notes receivable by the principal amount
• Credit Interest receivable by the amount of accrued interest

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:

## Example

To illustrate notes receivable accounting, assume that RetailX LTD has made the following transactions in the 4th financial quarter:

• 10/05/20X7 BMG LTD issued a promissory note to RetailX LTD for the past due account in the amount of \$30,000 at an annual interest rate of 10% to mature in 60 days
• 10/17/20X7 RetailX LTD lent \$50,000 to EstroZ LDT against a promissory note for 120 days at an annual interest rate of 7%
• 10/26/20X7 Xander LDT issued a promissory note to RetailX LTD for the past due account in the amount of \$15,000 at an annual interest rate of 8% to mature in 60 days
• 11/15/20X7 RetailX LTD collected a promissory note in the amount of \$25,000 and related interest issued by Smith LDT on 08/18/20X7 at an annual interest rate of 7%
• 12/03/20X7 BMG LTD was unable to pay the promissory note issued on 10/05/20X7
• 12/24/20X7 RetailX LTD collected the promissory note issued by Xander LDT on 10/26/20X7

Assuming that RetailX LTD reports financial statements at the end of each quarter, the following entries should be made in the general journal:

10/05/20X7

RetailX LTD recognized converting of past due account of BMG LTD to notes receivable in the amount of \$30,000.

10/17/20X7

RetailX LTD recognized promissory note issued by EstroZ LDT in the amount of \$50,000.

10/26/20X7

RetailX LTD recognized converting of past due account of BMG LTD to notes receivable in the amount of \$15,000.

11/15/20X7

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).

12/03/20X7

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

12/24/20X7

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

12/31/20X7

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