The face value of a note is called the principal, which 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. The payee is the party that holds the note and receives payment from the maker when the note is due. To log a note receivable, simply debit the notes receivable account and credit the cash account. For non-current asset classification, the company must reevaluate the note receivable at the end of each accounting period to identify if its classification has changed. For example, if a business wants to borrow $7,000, Square might charge a total of $7,910 for the loan.

The difference in recording is based on which side of the transaction a company is on. After a year, ABC Co. must record the receipt when the customer repays the loan. However, the customer will also pay an interest of $500 ($5,000 x 10%) on the note. Both parties agree that the customer must reimburse the principal amount and a 10% interest on the note. The maker of the note receivable, along with a principal amount, must also pay interest on it.

To illustrate notes receivable scenarios, let’s return to Billie’s Watercraft Warehouse (BWW) as the example. BWW has a customer, Waterways Corporation, that tends to have larger purchases that require an extended payment period. On January 1, 2018, Waterways purchased merchandise in the amount of $250,000. BWW agreed to lend the $250,000 purchase cost (sales price) to Waterways under the following conditions. The conditions of the note are that the principal amount is $250,000, the maturity date on the note is 24 months, and the annual interest rate is 12%. Notes receivable have several defining characteristics that include principal, length of contract terms, and interest.

  1. The payee is the party who receives payment under the terms of the note, and the maker is the party obligated to send funds to the payee.
  2. 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.
  3. This will be illustrated when non-interest-bearing long-term notes receivable are discussed later in this chapter.
  4. Once the promissory note is signed by both parties, it becomes an asset that can be sold or traded like any other financial instrument.

A case in point is the sale of equipment or other personal or real property in which payment terms are normally longer than is customary for an open account. The individual or business that signs the note is referred to as the maker of the note. Notes can also find application in the context of property, plant, and equipment sales or the exchange of long-term assets.

After issuance, long-term notes receivable are measured at amortized cost. Determining present values requires an analysis of cash flows using interest rates and time lines, as illustrated next. You are the owner of a retail health food store and have several large companies with whom you do business. Many competitors in your industry are vying for your customers’ business. For each sale, you issue a notes receivable to the company, with an interest rate of 10% and a maturity date 18 months after the issue date.

Advantages of Notes Receivables

The payee is the party that provides the loan, also known as the borrower. Notes can be converted to cash by discounting them to the financial institutions. If the maker dishonors the note, the company discounting the note pays to the financial institutions. Notice that the sign for the $7,835 PV is preceded by the +/- symbol, meaning that the PV amount is to have the opposite symbol to the $10,000 FV amount, shown as a positive value. This is because the FV is the cash received at maturity or cash inflow (positive value), while the PV is the cash lent or a cash outflow (opposite or negative value).

Characteristics of Notes Receivable

For this reason, notes are negotiable instruments the same as cheques and bank drafts. For example, a company may have an outstanding account receivable in the amount of $1,000. The customer negotiates with the company on June 1 for a six-month note maturity date, 12% annual interest rate, and $250 cash up front. Notes receivable can convert to accounts receivable, as illustrated, but accounts receivable can also convert to notes receivable. The transition from accounts receivable to notes receivable can occur when a customer misses a payment on a short-term credit line for products or services.

This means that the loan will mature in two years, and the principal and interest are due at that time. The following journal entries occur at the note’s established start date. A note receivable is a written promise to receive a specific amount of cash from another party on one or more future dates. This is treated as an asset by the holder of the note, and a liability by the borrower. Overdue accounts receivable are sometimes converted into notes receivable, thereby giving the debtor more time to pay, while also sometimes including a personal guarantee by the owner of the debtor entity.

To record a note receivable, you will need to debit the cash account and credit the notes receivable account. Other notes receivable result from cash loans to employees, stockholders, customers, or others. These notes find representation on the balance sheet, reflecting the monetary value of promissory notes owed to a business, anticipating future payments. Often, a business will allow customers to convert their overdue accounts (the business’ accounts receivable) into notes receivable.

What is the Normal Balance of Notes Receivable?

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. The first journal is to record the principal amount of the note receivable. Cash payments can be interest-only with the principal portion payable at the end or a mix of interest and principal throughout the term of the note.

Interest revenue from year one had already been recorded in 2018, but the interest revenue from 2019 is not recorded until the end of the note term. Thus, Interest Revenue is increasing (credit) by $200, the remaining revenue earned but not 5 skills every entrepreneur should have yet recognized. Interest Receivable decreasing (credit) reflects the 2018 interest owed from the customer that is paid to the company at the end of 2019. The second possibility is one entry recognizing principal and interest collection.

For example, if the interest rate (I/Y) is not known, it can be derived if all the other variables in the equation are known. This will be illustrated when non-interest-bearing long-term notes receivable are discussed later in this chapter. Ultimately, every company must evaluate its own financial situation when deciding whether or not to pursue notes receivable. Understanding both the advantages and disadvantages of this instrument is crucial for making informed decisions about how best to manage cash flow and extend credit while minimizing risks. Understanding how notes receivable procurement works can give businesses more flexibility in managing their finances and obtaining necessary cash flow when needed.

Frequently, businesses permit customers to transform overdue accounts (accounts receivable) into notes receivable, providing debtors with the advantage of an extended payment period. The journal entry will follow if a company pays another party directly in exchange for a note receivable. However, if any note is repayable after a year, companies must qualify it as non-current assets.

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