3.7 Notes Receivable

So far, our discussion of receivables has focused solely on accounts receivable. Companies, however, can expand their business models to include more than one type of receivable. This receivable expansion allows a company to attract a more diverse clientele and increase asset potential to further grow the business.

As you’ve learned, accounts receivable is typically a more informal arrangement between a company and customer that is resolved within a year and does not include interest payments. In contrast, notes receivable (an asset) is a more formal legal contract between the buyer and the company, which requires a specific payment amount at a predetermined future date. The length of contract is typically over a year, or beyond one operating cycle. There is also generally an interest requirement because the financial loan amount may be larger than accounts receivable, and the length of contract is possibly longer. A note can be requested or extended in exchange for products and services or in exchange for cash (usually in the case of a financial lender). Several characteristics of notes receivable further define the contract elements and scope of use.

Table 3.3 Accounts and Notes Receivable By: Rice University OpenStax CC BY-NC-SA 4.0
Accounts Receivable Notes Receivable
  • An informal agreement between customer and company
  • Receivable in less than one year or within a company’s operating cycle
  • Does not include interest
  • A legal contract with established payment terms
  • Receivable beyond one year and outside of a company’s operating cycle
  • Includes interest

Characteristics of Notes Receivable

Notes receivable have several defining characteristics that include principal, length of contract terms, and interest. The principal of a note is the initial loan amount, not including interest, requested by the customer. If a customer approaches a lender, requesting $2,000, this amount is the principal. The date on which the security agreement is initially established is the issue date. A note’s maturity date is the date at which the principal and interest become due and payable. The maturity date is established in the initial note contract. For example, when the previously mentioned customer requested the $2,000 loan on January 1, 2018, terms of repayment included a maturity date of 24 months. 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. The first entry shows a note receivable in exchange for a product or service, and the second entry illustrates the note from the point of view that a $2,000 loan was issued by a financial institution to a customer (borrower).

Journal Entry: January 1, 2018 debit Notes Receivable 2,000, credit Sales Revenue 2,000. Explanation: “To record sale in exchange for notes receivable.” Journal Entry: January 1, 2018 debit Notes Receivable 2,000, credit Cash 2,000. Explanation: “To record sale in exchange for a cash loan.”
Figure 3.58 By: Rice University Source: Openstax CC BY-NC-SA

Before realization of the maturity date, the note is accumulating interest revenue for the lender. Interest is a monetary incentive to the lender that justifies loan risk. An annual interest rate is established with the loan terms. The interest rate is the part of a loan charged to the borrower, expressed as an annual percentage of the outstanding loan amount. Interest is accrued daily, and this accumulation must be recorded periodically (each month for example). The Revenue Recognition Principle requires that the interest revenue accrued is recorded in the period when earned. Periodic interest accrued is recorded in Interest Revenue and Interest Receivable. To calculate interest, the company can use the following formulas. The following example uses months but the calculation could also be based on a 365-day year.

Formula: Interest equals Annual interest rate times loan principle times part of year where Part of year equals Number of accrued interest months divided by12 months.
Figure 3.59 By: Rice University Source: Openstax CC BY-NC-SA

Another common way to state the interest formula is Interest = Principal × Rate × Time. From the previous example, the company offered a $2,000 note with a maturity date of 24 months. The annual interest rate on the loan is 10%. Each period the company needs to record an entry for accumulated interest during the period. In this example, the first year’s interest revenue accumulation is computed as 10% × $2,000 × (12 ÷ 12) = $200. The $200 is recognized in Interest Revenue and Interest Receivable.

Journal entry: December 31, 2018 debit Interest Receivable 200, credit Interest Revenue 200. Explanation: “To record interest accumulated after first 12 months.”
Figure 3.60 By: Rice University Source: Openstax CC BY-NC-SA

When interest is due at the end of the note (24 months), the company may record the collection of the loan principal and the accumulated interest. These transactions can be recorded as one entry or two. The first set of entries show collection of principal, followed by collection of the interest.

Journal entries: December 31, 2019 debit Cash 2,000, credit Notes Receivable 2,000. Explanation: “To record collection of note principle.” December 31, 2019 debit Cash 400, credit Interest Receivable 200, credit Interest Revenue 200. Explanation: “To record interest collection after 24-month term.”
Figure 3.61 By: Rice University Source: Openstax CC BY-NC-SA

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 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.

Journal entry: December 31, 2019 debit Cash 2,400, credit Notes Receivable 2,000, credit Interest Receivable 200, credit Interest Revenue 200. Explanation: “To record collection of principle and accumulated interest.”
Figure 3.62 By: Rice University Source: Openstax CC BY-NC-SA

If the note term does not exceed one accounting period, the entry showing note collection may not reflect interest receivable. For example, let’s say the company’s note maturity date was 12 months instead of 24 (payment in full occurs December 31, 2018). The entry to record collection of the principal and interest follows.

Journal entry: December 31, 2018 debit Cash 2,200, credit Notes Receivable 2,000, credit Interest Revenue 200. Explanation: “To record collection of principle and interest.”
Figure 3.63 By: Rice University Source: Openstax CC BY-NC-SA

The examples provided account for collection of the note in full on the maturity date, which is considered an honored note. But what if the customer does not pay within the specified contract length? This situation is considered a dishonored note. A lender will still pursue collection of the note but will not maintain a long-term receivable on its books. Instead, the lender will convert the notes receivable and interest due into an account receivable. Sometimes a company will classify and label the uncollected account as a Dishonored Note Receivable. Using our example, if the company was unable to collect the $2,000 from the customer at the 12-month maturity date, the following entry would occur.

Journal entry: December 31, 2018 debit Accounts Receivable 2,200, credit Notes Receivable 2,000, credit Interest Revenue 200. Explanation: “To record conversion of note to AR.”
Figure 3.64 By: Rice University Source: Openstax CC BY-NC-SA

If it is still unable to collect, the company may consider selling the receivable to a collection agency. When this occurs, the collection agency pays the company a fraction of the note’s value, and the company would write off any difference as a factoring (third-party debt collection) expense. Let’s say that our example company turned over the $2,200 accounts receivable to a collection agency on March 5, 2019 and received only $500 for its value. The difference between $2,200 and $500 of $1,700 is the factoring expense.

Journal entry: March 5, 2019 debit Cash 500, debit Factoring Expense 1,700, credit Accounts Receivable 2,200. Explanation: “To record sale of AR to third-party factor.”
Figure 3.65 By: Rice University Source: Openstax CC BY-NC-SA

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. In this case, the company could extend the payment period and require interest.

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. The company records the following entry at contract establishment.

Journal entry: June 1 debit Cash 250, debit Notes Receivable 750, credit Accounts Receivable 1,000. Explanation: “To record conversion of AR to NR.”
Figure 3.66 By: Rice University Source: Openstax CC BY-NC-SA


Illustrated Examples of Notes Receivable

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. First, BWW agrees to accept a note payable issued by Waterways. 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%. On January 1, 2018, BWW records the following entry.

Journal entry: January 1, 2018 debit Notes Receivable: Waterways 250,000, credit Sales Revenue 250,000. Explanation: “To record sale in exchange for notes receivable 24 month maturity, 12 percent interest rate.”
Figure 3.67 By: Rice University Source: Openstax CC BY-NC-SA

Notes Receivable: Waterways increases (debit), and Sales Revenue increases (credit) for the principal amount of $250,000. On December 31, 2018, BWW records interest accumulated on the note for 12 months.

Journal entry: December 31, 2018 debit Interest Receivable 30,000, credit Interest Revenue 30,000. Explanation: “To record interest accumulated after first 12 months.”
Figure 3.68 By: Rice University Source: Openstax CC BY-NC-SA

Interest Receivable: Waterways increases (debit) as does Interest Revenue (credit) for 12 months of interest computed as $250,000 × 12% × (12 ÷ 12). On December 31, 2019, Waterways Corporation honors the note; BWW records this collection as a single entry.

Journal entry: December 31, 2019 debit Cash 310,000, credit Notes Receivable: Waterways 250,000, credit Interest Receivable: Waterways 30,000, credit Interest Revenue 30,000. Explanation: “To record collection of principle and accumulated interest.”
Figure 3.69 By: Rice University Source: Openstax CC BY-NC-SA

Cash increases (debit) for the principal and interest total of $310,000, Notes Receivable: Waterways decreases (credit) for the principal amount of $250,000, Interest Receivable: Waterways decreases (credit) for the 2018 accumulated interest amount of $30,000, and Interest Revenue increases (credit) for the 2019 interest collection amount of $30,000.

BWW does business with Sea Ferries Inc. BWW issued Sea Ferries a note in the amount of $100,000 on January 1, 2018, with a maturity date of six months, at a 10% annual interest rate. On July 2, BWW determined that Sea Ferries dishonored its note and recorded the following entry to convert this debt into accounts receivable.

Journal entry: June 2, 2018 debit Accounts Receivable: Sea Ferries 105,000, credit Notes Receivable: Sea Ferries 100,000, credit Interest Revenue 5,000. Explanation: “To record conversion of note to Accounts Receivable, dishonored note.”
Figure 3.70 By: Rice University Source: Openstax CC BY-NC-SA

Accounts Receivable: Sea Ferries increases (debit) for the principal note amount plus interest, Notes Receivable: Sea Ferries decreases (credit) for the principal amount due, and Interest Revenue increases (credit) for interest earned at maturity. Interest is computed as $100,000 × 10% × (6 ÷ 12). On September 1, 2018, BWW determines that Sea Ferries’s account will be uncollectible and sells the balance to a collection agency for a total of $35,000.

Journal entry: September 1, 2018 debit Cash 35,000, debit Factoring Expense 70,000, credit Accounts Receivable 105,000. Explanation: “To record sale of Accounts Receivable to third-party factor.”
Figure 3.71 By: Rice University Source: Openstax CC BY-NC-SA

Cash increases (debit) for the agreed-upon discounted value of $35,000, Factoring Expense increases (debit) for the outstanding amount and the discounted sales price, and Accounts Receivable: Sea Ferries decreases (credit) for the original amount owed.

Alliance Cruises is a customer of BWW with an outstanding accounts receivable balance of $50,000. Alliance is unable to pay in full on schedule, so it negotiates with BWW on March 1 to convert its accounts receivable into a notes receivable. BWW agrees to the following terms: six-month note maturity date, 18% annual interest rate, and $10,000 cash up front. BWW records the following entry at contract establishment.

Journal entry: March 1 debit Cash 10,000, debit Notes Receivable: Alliance 40,000, credit Accounts Receivable: Alliance 50,000. Explanation: “To record conversion of Accounts Receivable to Notes Receivable.”
Figure 3.72 By: Rice University Source: Openstax CC BY-NC-SA

Cash increases (debit) for the up-front collection of $10,000, Notes Receivable: Alliance increases (debit) for the principal amount on the note of $40,000, and Accounts Receivable: Alliance decreases (credit) for the original amount Alliance owed of $50,000.

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