Notes Receivable

Notes receivable are financial assets of a business which arise when other parties make a documented promise to pay a certain sum on demand or on a specific date. Notes receivable are different from accounts receivable because they are formally documented and signed by the promising party, known as the maker of the note, to the party who receives the payment, known as the payee.

Since notes receivable have a longer duration than accounts receivable, they usually require the maker to pay interest in addition to the principle at the maturity of the note. Interest receivable is recognized on balance sheet in addition to the face value of notes receivable.

Notes receivable usually arise when accounts receivable are converted to notes receivable when the customer wants to extend the date of payment and in return agrees to pay interest. Such agreement is recorded formally as a promissory note. Notes receivable also arise when a business lends an amount to another party against a documented promise to pay it back.

The amount promised on a note may be receivable in single sum or in multiple installments. Notes receivable appear in balances sheet either as current asset or a non-current asset. The amount that is due within 12 months is recorded as current asset and the rest is recognized as non-current asset.

The accounting treatment of the interest that is accrued but remains unpaid up to balance sheet date depends on whether the interest is compounded or not. If it is compound interest, the accrued interest that remains unpaid is added to the principal of notes receivable and carried over to the next accounting period. If it is simple interest, it is recorded separately as interest receivable on the balance sheet.

Journal Entries

When accounts receivable are converted to notes receivable, the following journal entry is required:

Notes receivableABC
Accounts receivableABC

When a business lends money to other parties against promissory notes, it is recognized as follows:

Notes receivableDEF
CashDEF

Interest accrued on a note receivable is calculated as per following formula:

Interest Accrued = Principal Amount × Interest Rate × Time Periods

If a note carries simple interest, it is journalized as:

Interest receivableGHI
Interest incomeGHI

If a note carried compound interest, the accrued interest is debited to the notes receivable account itself because the future period interest is calculated based on the principal amount of note plus any past interest accrued:

Notes receivableJKL
Interest incomeJKL

When the principal amount and interest accrued on a note is received, it is recorded as follows:

Cash/BankMN+O
Notes receivableMN
Interest receivable/interest incomeO

Cash or bank is debited by the sum of principal amount and interest not yet received. Interest receivable account is credited where the note carried simple interest. Interest income account is credit when the interest received has not been recognized. No interest receivable or interest income account is used when the note carries compound interest because in that case the carrying amount of notes receivable already includes interest accrued.

Example

On 1 May 2014, PQR, Inc. lent $2 million to ABC, LLC for 2 years against a documented promissory note. DEF, Inc., another client of PQR, Inc. issued a 2-month promissory note against their outstanding balance of $3 million on 1 November 2014. ABC LLC note receivable carried 5% simple interest rate payable annually while the note receivable from DEF Inc. carried 8% interest compounded monthly. PQR financial year ends on 31 December.

On 1 May 2014, PQR make the following journal entry:

Notes receivable$2 million
Cash$2 million

Notes receivable form DEF is recognized as follows, on 1 November 2014:

Notes receivable$3 million
Accounts receivable$3 million

Note receivable from DEF carries interest compounded monthly, so at the end of November, interest is accrued as follows:

Notes receivable ($3,000,000*8%*1/12)20,000
Interest income20,000

At the end of December 2014, interest is accrued on both ABC and DEF notes receivable:

Notes receivable ($3,020,000*8%*1/12)20,133
Interest receivable ($2,000,000*5%*8/12)66,667
Interest income86,800

The amount debited to notes receivable represent the interest earned in month of December on the carrying amount at the end of November because the note carries compound interest. The amount debited to interest receivable represent simple interest earned on note receivable from ABC.

At the end of December when DEF pays off the notes receivable, the following journal entry is needed:

Bank ($3,000,000+$20,000+$20,133)3,040,133
Notes receivable3,040,133

As at 31 December, note receivable from ABC is classified as a non-current asset because it is due after 12 months from 31 December. Interest receivable on the note as a 31 December is reported as current asset because it is to be received at the end of April 2015.

Written by Irfanullah Jan