Remember from earlier in the chapter, a note (also called a promissory note) is an unconditional written promise by a borrower to pay a definite sum of money to the lender (payee) on demand or on a specific date. On the balance sheet of the lender (payee), a note is a receivable. A customer may give a note to a business for an amount due on an account receivable or for the sale of a large item such as a refrigerator. Also, a business may give a note to a supplier in exchange for merchandise to sell or to a bank or an individual for a loan. Thus, a company may have notes receivable or notes payable arising from transactions with customers, suppliers, banks, or individuals.
Most promissory notes have an explicit interest charge. Interest is the fee charged for use of money over a period. To the maker of the note, or borrower, interest is an expense; to the payee of the note, or lender, interest is a revenue. A borrower incurs interest expense; a lender earns interest revenue. For convenience, bankers sometimes calculate interest on a 360-day year; we calculate it on that basis in this text. (Some companies use a 365-day year.)
The basic formula for computing interest is:
Principal x Interest Rate x Frequency of a year
Principal is the face value of the note. The interest rate is the annual stated interest rate on the note. Frequency of a year is the amount of time for the note and can be either days or months. We need the frequency of a year because the interest rate is an annual rate and we may not want interest for an entire year but just for the time period of the note.
To show how to calculate interest, assume a company borrowed $20,000 from a bank. The note has a principal (face value) of $20,000, an annual interest rate of 10%, and a life of 90 days. The interest calculation is:
$20,000 principal x 10% interest rate x (90 days / 360 days) = $500
Note that in this calculation we expressed the time period as a fraction of a 360-day year because the interest rate is an annual rate and the note life was days. If the note life was months, we would divide by 12 months for a year.
The maturity date is the date on which a note becomes due and must be paid. Sometimes notes require monthly installments (or payments) but usually all of the principal and interest must be paid at the same time. The wording in the note expresses the maturity date and determines when the note is to be paid. A note falling due on a Sunday or a holiday is due on the next business day. Examples of the maturity date wording are:
On demand. “On demand, I promise to pay…” When the maturity date is on demand, it is at the option of the holder and cannot be computed. The holder is the payee, or another person who legally acquired the note from the payee.
On a stated date. “On July 18, 2015, I promise to pay…” When the maturity date is designated, computing the maturity date is not necessary.
At the end of a stated period.
(a)”One year after date, I promise to pay…” When the maturity is expressed in years, the note matures on the same day of the same month as the date of the note in the year of maturity.
(b)”Four months after date, I promise to pay…” When the maturity is expressed in months, the note matures on the same date in the month of maturity. For example, one month from July 18 is August 18, and two months from July 18 is September 18. If a note is issued on the last day of a month and the month of maturity has fewer days than the month of issuance, the note matures on the last day of the month of maturity. A one-month note dated January 31, matures on February 28.
(c) “Ninety days after date, I promise to pay…” When the maturity is expressed in days, the exact number of days must be counted. The first day (date of origin) is omitted, and the last day (maturity date) is included in the count. For example, a 90-day note dated October 19 matures on January 17 of the next year, as shown here:
Life of note (days)
Days remaining in October not counting date of origin of note:
Days to count in October (31 – 19)
Total days in November
Total Days in December
Maturity date in January
(90 total days - 73 days from Oct to Dec)
Sometimes a company receives a note when it sells high-priced merchandise; more often, a note results from the conversion of an overdue account receivable. When a customer does not pay an account receivable that is due, the company may insist that the customer gives a note in place of the account receivable. This action allows the customer more time to pay the balance due, and the company earns interest on the balance until paid. Also, the company may be able to sell the note to a bank or other financial institution.
To illustrate the conversion of an account receivable to a note, assume that Price Company had purchased $18,000 of merchandise on August 1 from Cooper Company on account. The normal credit period has elapsed, and Price cannot pay the invoice. Cooper agrees to accept Price’s $18,000, 15%, 90-day note dated September 1 to settle Price’s open account. Assuming Price paid the note at maturity and both Cooper and Price have a December 31 year-end, the entries on the books of Cooper are:
Accounts Receivable—Price Company
To record sale of merchandise on account.
To record exchange of a note from Price Company for open account.
Interest Revenue [18,000 x 15% x (90/360)]
To record receipt of Price Company note principal and interest.
Note: Maturity date calculated as November 30 since it was a 90 day note - 29 days left in September (30 days in Sept - note day Sept 1) - 31 days in October leaves 30 days remaining in November.
The $18,675 paid by Price to Cooper is called the maturity value of the note. Maturity value is the amount that the company (maker) must pay on a note on its maturity date; typically, it includes principal and accrued interest, if any.
Sometimes the maker of a note does not pay the note when it becomes due. The next section describes how to record a note not paid at maturity.
A dishonored note is a note that the maker failed to pay at maturity. Since the note has matured, the holder or payee removes the note from Notes Receivable and records the amount due in Accounts Receivable.
At the maturity date of a note, the maker is responsible for the principal plus interest. The payee should record the interest earned and remove the note from its Notes Receivable account. Thus, the payee of the note should debit Accounts Receivable for the maturity value of the note and credit Notes Receivable for the note’s face value and Interest Revenue for the interest.
Accounts Receivable—Price Company
To record dishonor of Price Company note.
Accounting in the Headlines
How does Square account for the amounts it loans to small businesses?
Square, the mobile payments company, allows small businesses to take credit cards by swiping customer credit cards using a small square device attached to the audio jack found on mobile devices. Since its founding in 2009 and the launch of its first app in 2010, Square has found its way into many small businesses – and large businesses. Starbucks uses Square to process transactions with credit or debit card customers. In November 2014, Square announced that it would be accepting Apple Pay. Whole Foods uses Square in select locations.
Square has recently gotten into lending money to its customers through its Square Capital program. According to Business Insider (April 15, 2015 article), Square has paid out over $100 million in small business financing over the past year.
See Jack Dorsey, co-founder of Square, explain the small business loan concept in this CNN Money video (2:26 minutes) at http://money.cnn.com/video/technology/2014/05/28/t-square-capital-dorsey.cnnmoney/ Essentially, the business owner clicks on a link in the Square Capital app to let Square know that the business would like to borrow a certain amount of money. Square Capital calls this step “requesting capital.” The next morning, the funds are deposited in the checking account of that business. The business pays Square back the funds by having a certain percentage of each day’s receipts deducted for the payback.
For example, if a business wants to borrow $7,000, Square might charge a total of $7,910 for the loan. Upon approval, the $7,000 is deposited into the business’s checking account the next day and then Square charges 9% of the business’s credit card sales each day until the $7,910 is fully paid. Square says that the advantage of this percentage-of-sales method is that the business does not have to make large payments when business is slow. The percentage that Square charges stays constant until the loan is paid off fully.
Square determines the amount to be charged for the loan and the percentage to be charged each day using data analytics. Each Square account has potentially different terms based on its history and trends.
Square Capital states that the first step for business owners is to “request capital.” Are the business owners actually requesting capital?
In the example given in the blog post, the business borrows $7,000 and pays back $7,910 by paying 9% of its credit card receipts each day until paid in full. Is the 9% the interest rate charged? Why or why not?
Is the amount of cash deposited by Square Capital in its customers’ (the small businesses requesting funds) checking accounts classified as ACCOUNTS RECEIVABLE or NOTES RECEIVABLE by Square Capital? Explain.
What is the difference between the amount of funds deposited in the customers’ accounts and the total amount paid back by customers classified as by Square Capital?
What do you think of this practice by Square Capital?
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Accounting Principles: A Business Perspective.. Authored by: James Don Edwards, University of Georgia & Roger H. Hermanson, Georgia State University. . Provided by: Endeavour International Corporation.. Project: The Global Text Project.. License: CC BY: Attribution