Chapter 7: Notes Receivable

Key Aspects of Notes Receivable A note receivable is a promissory note where the borrower promises to pay a specified amount (principal) along with interest, either on demand or by a set maturity date. Notes receivable arise in various transactions, such as lending, paying for products and services, or extending payment time for overdue accounts. It provides a formal, written promise that can assist in legal collection efforts if needed. Components of a Note Receivable 1. 2. 3. 4. 5. Principal: The amount borrowed or the amount stated on the note. Maker: The person or entity who promises to pay (borrower). Payee: The person or entity to whom payment is owed (lender). Interest Rate: The annual rate charged for borrowing. Maturity Date: The date by which the principal and interest must be repaid. Computing the Maturity Date • • • • The maturity date is the deadline for repayment, including principal and interest. Counting Days: When computing the maturity date for notes specified in days, start counting from the day after the issue date, and include the due date. Example: For a 90-day note issued on July 10, the maturity date would be October 8. For notes in months, the maturity date is the same day of the month as the issue date (e.g., a 9-month note issued on July 10 is due on April 10 of the following year). Interest Computation • • • Formula: Interest is calculated as: \text{Interest} = \text{Principal} \times \text{Interest Rate} \times \frac{\text{Days / 360}} Example: For a 90-day, $1,000 note at 12% interest, interest is computed as: 1000×0.12×90360=30 Banker's Rule: Interest is often simplified by using a 360-day year, which makes calculations consistent across industries. Recording Notes Receivable 1. Recording a Note: When a note is received, it is recorded in the Notes Receivable account. For example, if TechCom accepts a $1,000, 90-day, 12% note from a customer for a product sale, it records the note as an asset. o Journal Entry:  Debit Notes Receivable $1,000 Credit Sales or Accounts Receivable $1,000 2. Converting Overdue Accounts Receivable: If an overdue account receivable is replaced with a note, the business may collect a partial cash payment upfront. o Example: If TechCom accepts $232 in cash and a $600 note for a $832 overdue account, it records the cash and note receivable, crediting the original account receivable. 3. End-of-Period Adjustments for Accrued Interest: When interest accrues on notes before the end of the accounting period, an adjusting entry records the accrued interest revenue. o Example: On December 16, TechCom accepts a $3,000, 60-day, 12% note. By December 31, 15 days of interest ($15) have accrued, recorded as:  Debit Interest Receivable $15  Credit Interest Revenue $15  Settling Notes Receivable 1. Honoring a Note: When the maker pays the note in full at maturity, the principal and interest are recorded as cash received, recognizing any accrued interest and additional interest revenue. 2. Dishonoring a Note: If the maker fails to pay at maturity, the note is considered dishonored. The note’s amount is transferred from Notes Receivable to Accounts Receivable under the maker’s name, showing the debt remains unpaid but is tracked separately from notes. Disposal of Receivables Companies may convert receivables to cash before maturity to improve liquidity: • • Selling Receivables: A company sells its receivables to a factor (usually a finance company), receiving immediate cash minus a factoring fee. The factor takes over collection efforts and assumes the risk of bad debt. Pledging Receivables: Receivables are used as collateral to secure a loan. If the company defaults, the lender collects from the pledged receivables. This must be disclosed in financial statements. These transactions provide flexibility in managing cash flow and handling outstanding receivables, particularly for businesses needing immediate liquidity or aiming to minimize collection efforts.