Learn all about notes receivable in just a few minutes! Fabio Ambrosio, CPA, instructor of accounting at the Central Washington University, details the characteristics of notes receivable and the accounting transactions involved in the reporting of notes receivable.
Characteristics of Notes Receivable
Notes receivable represent formal promises to pay, and are usually evidenced by a credit instrument known as a promissory note. Features of these include face amount, date of issue, due date, term, interest rate, and maturity value.
Notes receivable arise from a written promise to pay a specific amount at some definitive time or on demand, typically a promissory note. The promissory note provides another vehicle through which a company can grant credit to individuals or customers. While the majority of notes receivable transactions originate from lending monies, notes receivable are often accepted in settlement of an account receivable where a customer requires an extension of time to make payment on that receivable.
The parties to a promissory note are the maker (or debtor) and the payee (or creditor). The maker is the party, or customer or individual, who makes the promise to pay, or to whom credit is being granted. The payee is the party to whom the payment will be made in a promissory note, or the company who grants the credit.
The promissory note contains several other features that are important to understand before exploring the accounting for notes receivable. The face amount, or the principal amount, is the sum of money the maker borrows or the payee loans in a note transaction. Because notes receivable are typically interest-bearing, the promissory note also includes the annual interest rate, which is used to compute interest earned on the face amount through the maturity date of the note. The maturity date represents the date on which the maker must pay the note balance to the payee. This note balance is known as the maturity value of the note, or the sum of both the face amount and interest due on the note. Finally, the term of the note is the time period extending from the note's issuance date to the note's maturity date.Promissory Note
Notes Receivable Transactions
Accounting transactions involved in the reporting of notes receivable include: issuance of the note, accruing periodic interest earned on the note, receipt of payment on the due date of the note including interest earned, and dishonor of the note when not paid timely.
Notes receivable transactions involve issuing the note, accruing interest earned, and receiving payment of the note including interest. For example, Shulte Company has had a $25,000 open account receivable balance for Labriola, Ltd., since January 31, 2019. On July 1, 2019, Shulte requires Labriola to issue a $25,000, 90-day, 12% promissory note to settle the account. Shulte would record an entry to record receipt of the note.
Issuance of Note Receivable Journal Entry
| Date | Description | Debit | Credit |
|---|---|---|---|
| July 1, 2019 | Notes Receivable | $25,000 | |
| Accounts Receivable | $25,000 | ||
| To record issuance of $25,000, 90-day, 12% note to settle open account receivable |
The note receivable is initially recorded on Shulte’s books at its face amount. As time passes, interest will be earned and recorded on the note. Shulte prepares monthly financial statements, so interest would need to be accrued at the end of each month. Because the note was issued on July 1, 2019, Shulte would have earned 30 days of interest through July 31, 2019. Accordingly, Shulte would need to record an adjusting entry to accrue 30 days of interest on the note when closing its books on July 31, 2019. Because the interest is not due to be paid until September 30, 2019, Shulte would also record a corresponding interest receivable as of July 31, 2019. Shulte would repeat this entry at the end of August as well.
30 Days of Interest Earned Journal Entry
| Date | Description | Debit | Credit |
|---|---|---|---|
| July 31, 2019 | Interest Receivable | $250 | |
| Interest Revenue | $250 | ||
| To accrue 30 days' interest earned on Labriola note (July 1–July 31) |
In most cases, the maker honors the note and makes payment to the payee when due. The amount due includes both the face amount and interest. When Labriola honors the note on September 30, 2019. Shulte would make an entry to record the payment.
Receipt of Payment on Due Date Journal Entry
| Date | Description | Debit | Credit |
|---|---|---|---|
| Sept 30, 2019 | Cash | $25,750 | |
| Notes Receivable | $25,000 | ||
| Interest Receivable | $500 | ||
| Interest Revenue | $250 | ||
| To record receipt of payment of July 1, 2019 Labriola, Ltd., note with interest |
As with accounts receivable, there is always a chance that a customer will not pay the note when due. When this occurs, the note is said to be dishonored. Nevertheless, the maker still has a financial obligation to the payee for the full amount owed. Accordingly, at the time of default, unless there is little to no possibility that the amount owed will be paid, the payee typically reclassifies this total amount to an account receivable. In the case of the Shulte/Labriola note, Labriola did not pay the note when due. On the due date, September 30, 2019, Shulte records the reclassification of the note to accounts receivable.
Dishonored Note Journal Entry
| Date | Description | Debit | Credit |
|---|---|---|---|
| Sept 30, 2019 | Accounts Receivable | $25,750 | |
| Notes Receivable | $25,000 | ||
| Interest Receivable | $500 | ||
| Interest Revenue | $250 | ||
| To record dishonored Labriola note on its September 30, 2019 maturity date |