Jimbo P.

Manalastas BSA 1-1

Notes Receivable
Definition of Notes Receivable
Notes receivable is an asset of a company, bank or other organization that holds a written promissory
note from another party. (The other party will have a note payable.)
The principal part of a note receivable that is expected to be collected within one year of the balance
sheet date is reported in the current asset section of the lender's balance sheet. The remaining principal
of the note receivable is reported in the noncurrent asset section entitled Investments.
Examples of Notes Receivable
A company lends one of its important suppliers $10,000 and the supplier gives the company a
written promissory note to repay the amount in six months along with interest at 8% per year.
The company will debit its current asset account Notes Receivable for the principal amount of
$10,000. The credit of $10,000 will be to Cash.
If a company borrows $100,000 from its bank and signs a promissory note to pay 6% interest
quarterly and the principal amount in 9 months, the bank will debit its current asset account
Notes Receivable and will credit Cash or Customers' Deposits for the principal amount of
$100,000.
Key Points
 A notes receivable normally requires the debtor to pay interest and extends for time
periods of 30 days or longer.
 Often a business will allow a customer to convert their overdue accounts into a notes
receivable. Doing so gives the debtor more time to pay.
 The principle is the face value of the note. The principle equals the initial amount of
credit provided.
 The maker of a note is the party who receives the credit and promises to pay the note’s
holder.
 Notes generally specify an interest rate, which is used to determine how much interest
the maker of the note must pay in addition to the principal.
Key Terms
 debtor: One who owes another anything, or is under obligation, arising from express
agreement, implication of law, or principles of natural justice, to pay money or to fulfill some
other obligation; in bankruptcy or similar proceedings, the person who is the subject of the
proceeding.
 promissory: Stipulating the future actions required of the parties to an insurance policy or
other business agreement.
 promissory note: a document saying that someone owes a specific amount of money to
someone else, often with the deadline and interest fees
  maker: the party issuing a promissory note
 payee: the party receiving the promissory note

Recognition
Notes receivable are recognized on the balance sheet at the present value of all future cash flows.
This process is relatively straightforward except when a non-interest bearing note, or a note bearing an
unreasonable rate of interest, is created.
If the note bears a reasonable rate of interest, the following rules apply:
 Short-Term Notes: since the interest collected will be immaterial, these notes are
recorded at face value.
 Long-Term Notes: reported on the balance sheet at the present value of the associated
cash flows. If the rate of interest on the note is higher than the market rate, the
company will record the premium paid by the customer. If the rate of interest is lower
than the market rate, the company will record the discount provided the customer.
Accounting rules require companies to record transactions that reflect the true economic value of the
arrangement. Non-interest bearing notes, or those with unreasonable rates, are candidates to be restated
at their current present value. This can occur under a variety of conditions, including:
Notes Received for Cash: the difference between the face value of the note and its present value should
be recorded, along with the calculated discount or premium.
Notes Received for Goods or Services: the interest rate is assumed to be fair, and the transaction is
valued at the present value of the fair market value of the goods or services promised.
Key Points
 To record a journal entry for a sale on account, one must debit a receivable and credit a
revenue account.
 When the receivable is payed off, debit the cash account and credit the receivable account.
 To estimate the net value of accounts receivable, subtract the balance of an allowance account
from the accounts receivable account.
 Account for bad debts by either the allowance method or the direct write-off method.
Key Terms
 journal entry: A journal entry, in accounting, is a logging of transactions into accounting
journal items. The journal entry can consist of several items, each of which is either a debit or a
credit. The total of the debits must equal the total of the credits or the journal entry is said to be
“unbalanced. ” Journal entries can record unique items or recurring items, such as depreciation or
bond amortization.
 bad debt: A debt which cannot be recovered from the debtor, either because the debtor doesn’t
have the money to pay or because the debtor cannot be found and/or forced to pay.
  balance sheet: A summary of a person’s or organization’s assets, liabilities. and equity as of a
specific date.

Measurement
Measurement of notes receivable initially
Conceptually, notes receivable should be measured initially at Present Value
Short term notes– at face value (not discounted because the effect of discounting to PV is usually not
material.
Long term notes:
1. Interest bearing long term notes – at face value, which is actually the Present Value upon
issuance.
2. Non-interest bearing long term notes – at PV which is the discounted value of the future
cash flows using the effective interest rate.
SUBSEQUENTLY Subsequent to initial recognition, long term notes receivable shall be measured at
“amortized cost”. “Amortized cost” = the amount at which the receivable is measured initially –
principal repayment+ or – the cumulative amortization of any difference between the initial carrying
amount and the principal maturity amount.

Transactions
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 receivable X
Accounts receivable X
When a business lends money to other parties against promissory notes, it is recognized as follows:
 Notes receivable X
Cash X
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 receivable X
Interest income X
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 receivable X
Interest income X
When the principal amount and interest accrued on a note is received, it is recorded as follows:
Cash/Bank X
Notes receivable X
Interest receivable/interest income X

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 income 20,000

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 income 86,800

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 receivable 3,040,133
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.

Presentation
Note receivable to be presented at its Present Value, needs to deduct what two things?
Deduct (1) Unearned interest and any (2) Finance charges
So:
Note receivable Face value
- Unearned Interest
- Finance charges
--------------------------------
= Present value
Key Points
 Notes Receivable represents claims for which formal instruments of credit are issued as
evidence of debt, such as a promissory note.
 The direct write-off method is simpler than the allowance method in that it allows for one
simple entry to reduce accounts receivable to its net realizable value.
  The allowance method, which establishes a contra- asset account, allowance for doubtful
accounts, or bad debt provision, that has the effect of reducing the balance for accounts
receivable.
 The two methods are not mutually exclusive, and some businesses will have a provision for
doubtful debts, writing off specific debts that they know to be bad.
Key Terms
 revenue: Income that a company receives from its normal business activities, usually from the
sale of goods and services to customers.
 write-off: To remove a portion of a debt or an amount of an account owed to you counting it as
a loss (as a gesture of goodwill for example)

Disclosure
GAAP Requirement
Disclosures Required
Significant categories of receivables should be presented separately in the statement of financial
position. If an organization has a material balance of notes receivable, it should be identified on a
separate line from other receivables, such as trade accounts receivable, contributions receivable, etc.
• The current portion of notes receivable should represent only the amounts that are collectible
within a year.
• Significant concentrations of credit risk (i.e. material note balances concentrated within a
specific borrower, geographical location, or industry) should be disclosed.
• Notes receivable that are pledged as collateral for other borrowings should be disclosed.
• Accounting treatment of notes receivable, such as discounts to impute a market rate of
interest, impairment losses and the method used to determine the fair value of loans held for
sale should be disclosed.
• Nonaccrual loans: policy for placing loans receivable on a nonaccrual status, amount of
nonaccrual status loans, amount of loans past due ninety days or more and still accruing should
be disclosed.
• For financing receivables, various disclosures about the factors that influenced management’s
judgment about credit quality of borrowers and the loan portfolio and activity in the loan
reserves should be included.
Sample Financial Statement Disclosures
The samples below illustrate two approaches to disclosing the notes receivable details: one presents
aggregated information by grouping large numbers of similar notes together and the other presents notes
individually.
NOTE 3 - NOTES RECEIVABLE ABC Developer, Inc. (the Company), as the sponsor of affiliated
entities that own the affordable housing developments, holds notes receivable from some of those
entities. The notes bear interest at various rates, are generally secured but subordinate to the first
mortgages on the properties and are typically payable from available cash flow.
Management makes an assessment of the ultimate realization of notes receivable on an annual basis
based upon the financial condition of the entities. Loans to properties that do not have sufficient cash
flow available to pay interest currently are deemed to be impaired due to uncertainty of the borrower’s
cash flow. An allowance for uncollectible notes receivable is recognized in the amount of the impaired
loans.
A summary of the notes receivable and accrued interest at year end is as follows: