A note receivable is a written promise to pay a specified amount of money at an agreed-upon future date. In this lesson, you will learn how to record notes receivable on the balance sheet.
What Is a Note Receivable?
It's Saturday afternoon and your child comes rushing out of the house excitedly telling you about the newest video game that's coming out next week. They just have to have it! When you ask how they're planning to pay for it, they explain that they have $50.00 saved up and were wondering if you could loan them the rest until they save up enough future allowances. Being the great parent you are, you agree but on one condition. You would like them to sign an IOU indicating at what future date the money will be repaid to you. A note receivable is very similar. It represents a future promise to pay a specified amount by a pre-determined date.
A note receivable can arise in one of two ways. It can be offered as a settlement for a sale, or it may be provided as payment for an outstanding accounts receivable. Accounts receivable is the money that a customer owes in a situation where the company buying the goods or services needs to extend payment of the receivable because of a short-term cash flow problem. Notes receivable are a current asset, meaning they provide economic benefit for only the next year on the balance sheet. The balance sheet shows assets, liabilities and shareholders' equity and the notes receivable represent something a company owns that is expected to be settled within the next 365 days. Since they're written promises to pay, notes receivable represent a stronger legal claim to assets than accounts receivable.
The maturity date of the note will be some point in the future and will specify a maturity value that includes the principal value of the note as well as interest for the period it was outstanding.
The formula for calculating interest is the principal value of the note times annual interest rate times the time period.
For example, let's assume that Company A received a $1,000 note from Company B on May 1 in settlement of Company B's outstanding accounts receivable. The note matures on July 31st, and the annual interest rate on the note is 6%.
The amount of interest collected by Company A at July 31st would be:
$1,000 * 6% * 3/12 (three months of the year) = $15.00
At maturity, Company B would have to pay Company A $1,000 principal + $15 interest in order to settle the note receivable.
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Accounting will be required by Company A when the note is received and when the note is paid, and interest would be recognized monthly as it is earned. Using the previous example, accounting would be required by Company A at the following dates:
The interest earned on the note by Company A every month would be recorded on Company A's income statement as interest revenue. Income statements report revenues and expenses.
Honoring vs. Dishonoring a Note
A note is considered honored when it is paid in full at the maturity date. Occasionally, the company providing the note is unable to a pay the note at maturity and at this point, the note would be considered dishonored. A dishonored note receivable is no longer negotiable. In most cases, a dishonored note is converted back to an accounts receivable balance at its maturity value - principal value plus interest on the note.
A note receivable represents a written, future promise to pay a specified amount. It's recorded as a current asset on the balance sheet of the company who receives or accepts it. The value of the note when it is first issued is known as the principal value. The maturity value is the principal amount of the note plus interest. The formula for calculating interest on a note receivable is the principal amount of the note times interest rate times period of time. When a note is paid in full, it is looked at as honored, versus a note that has not been paid at its maturity date, which is referred to as dishonored.
Recording Notes Receivable on a Balance Sheet: A Practical Exercise
The following exercise is designed to help students apply their knowledge on Notes Receivable obtained in the Lesson.
You are an accounting clerk for Yummy Foods, a company that produces packaged desserts that are sold in grocery stores across the state of Ohio. Recently, Yummy Foods decided to extend a loan to one of its suppliers of ingredients since their plant was damaged by a hurricane. Yummy Foods did this in good faith and because it has a good relationship with the supplier. This is, however, the first time that the company has had to deal with a Note Receivable. Meanwhile, it is now year-end, and the note is still outstanding. You are in charge of preparing the balance sheet for the 2019 fiscal year. The company's fiscal year ends on December 31, 2019. The supplier fully intends to honor the terms of the note. The terms of the note are available below.
Interest rate (annual)
Date of Note
October 1, 2019
March 31, 2020
Interest and principal due at maturity
Using the terms of the note receivable,
Illustrate how the note receivable will be presented on the 2019 balance sheet (hint: there is more than one line item!).
Is there any impact on the income statement? If so, describe it.
The note is short-term in nature because it is due in March (i.e., less than 1 year from balance sheet date). In addition, the interest receivable is computed as follows:
Interest receivable = Principal amount * Interest rate * number of months passed / 12
= 100,000 * 0.04 * 3/12
Yes, the income statement will be impacted because the interest on the note receivable is accrued revenue. Therefore, the Interest Revenue will increase by the same amount as the accrued Interest Receivable (i.e., $1,000).
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