4.3: Note Receivable
A business may lend money to an individual or to a customer. These loans are typically short term, due to be repaid to the business within one year. In this case, the current asset account Note Receivable is used to keep track of amounts that are owed to the business.
A note receivable is a loan contract that specifies the principal (amount of the loan), the interest rate stated as an annual percentage, and the terms stated in number of days or months.
4.3.1 Issue Date
There are two situations where a company may receive a short-term note.
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A direct short-term loan for cash when an employee or other individual asks to borrow money and the company agrees and distributes cash.
In the following example, a company received a 60-day, 12% note for $1,000 from one of its executives on January 1.
Date Account Debit Credit 1/1 Note Receivable 1,000 ▲ Note Receivable is an asset account that is increasing . Cash 1,000 ▼ Cash is an asset account that is decreasing . -
The transfer of what a customer already owes the company for services or products it had previously purchased on account. The following would be a sample sequence of events.
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A company sells merchandise to a customer on account and gives the customer 30 days to pay.
Date Account Debit Credit 1/1 Accounts Receivable 1,000 ▲ Accounts Receivable is an asset account that is increasing . Sales 1,000 ▲ Sales is a revenue account that is increasing . -
After 30 days the customer’s accounts receivable amount of $1,000 is due, but the customer is unable to pay. If both parties agree, the customer’s
Accounts Receivable
account balance can be transferred to the
Note Receivable
account on that date. This gives the customer an extension of time in which to pay, but from this point on an interest charge will be imposed.
Interest is essentially the cost of renting money from its owner, similar to the cost of renting an apartment from a landlord. The borrower is paying to use someone else’s money. There is no need, however, to include the interest amount on the issue date—wait until the note comes due.
On the issue date, debit Note Receivable to increase it; credit Accounts Receivable to decrease it.
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A company sells merchandise to a customer on account and gives the customer 30 days to pay.
In the following example, a company received a 60-day, 12% note for $1,000 from a customer on account on January 1.
| Date | Account | Debit | Credit | ||
| 1/1 | Note Receivable | 1,000 | ▲ Note Receivable is an asset account that is increasing . | ||
| Accounts Receivable | 1,000 | ▼ Accounts Receivable is an asset account that is decreasing . |
This journal entry causes the balance in Accounts Receivable to decrease and the balance in Note Receivable to increase. The same $1,000 that the customer owes is now classified as an interest-bearing loan rather than just aninterest-free amount owed on an invoice.
4.3.2 Maturity (Due) Date
At the end of the term of the loan, on the maturity date, the note is void. At that time the Note Receivable account must be credited for the principle amount. In addition, the amount of interest earned must be recorded in the journal entry as Interest Revenue . The amount of interest is calculated using the following equation:
Principal x Rate x Time = Interest Earned
To simplify the math, we will assume every month has 30 days and each year has 360 days.
For a 12% interest rate on a 60-day note, the interest on a $1,000 note would be $20, calculated as follows:
$1,000 x 12% x 60/360 = $20
Note that since the 12% is an annual rate (for 12 months), it must be pro- rated for the number of months or days (60/360 days or 2/12 months) in the term of the loan.
On the maturity date, both the Note Receivable and Interest Revenue accounts are credited. Note Receivable is credited because it is no longer valid and its balance must be set back to zero. Interest Revenue is credited because it is now earned, regardless of whether the company receives the cash.
| Date | Account | Debit | Credit | ||
| 2/28 | ???? | 1,020 | ▲ One of three asset accounts will be increasing . | ||
| Note Receivable | 1,000 | ▼ Note Receivable is an asset account that is decreasing . | |||
| Interest Revenue | 20 | ▲ Interest Revenue is a revenue account that is increasing . |
The asset that the lender debits after 60 days depends on what the customer does on the maturity date of the note. There are the three possibilities:
- Cash – customer pays what is owed
- Note Receivable – customer issues a new note to replace the first note for another extension
- Accounts Receivable – customer does not pay or make arrangements for an extension of time
Situation 1 – The customer pays off the note with cash.
| Date | Account | Debit | Credit | ||
| 2/28 | Cash | 1,020 | ▲ Cash is an asset account that is increasing . | ||
| Note Receivable | 1,000 | ▼ Note Receivable is an asset account that is decreasing . | |||
| Interest Revenue | 20 | ▲ Interest Revenue is a revenue account that is increasing . |
Situation 2a – The company receives another note from the customer for the principal of the first note plus the interest. Assume the new note is for another 60 days at 10%.
| Date | Account | Debit | Credit | ||
| 2/28 | Note Receivable | 1,020 | ▲ Note Receivable is an asset account that is increasing . | ||
| Note Receivable | 1,000 | ▼ Note Receivable is an asset account that is decreasing . | |||
| Interest Revenue | 20 | ▲ Interest Revenue is a revenue account that is increasing . |
Situation 2b – The company receives another note from the customer for the principal and receives cash for the interest only. Assume the new note is for another 60 days at 10%.
| Date | Account | Debit | Credit | ||
| 2/28 | Cash | 20 | ▲ Cash is an asset account that is increasing . | ||
| Note Receivable | 1,000 | ▲ Note Receivable is an asset account that is increasing . | |||
| Note Receivable | 1,000 | ▼ Note Receivable is an asset account that is decreasing . | |||
| Interest Revenue | 20 | ▲ Interest Revenue is a revenue account that is increasing . |
Situation 3 - The customer dishonors the note and does not pay on the due date.
| Date | Account | Debit | Credit | ||
| 2/28 | Accounts Receivable | 1,020 | ▲ Accounts Receivable is an asset account that is increasing . | ||
| Note Receivable | 1,000 | ▼ Note Receivable is an asset account that is decreasing . | |||
| Interest Revenue | 20 | ▲ Interest Revenue is a revenue account that is increasing . |
Since the note is void but the customer did not pay or make arrangements for a new note, the only account remaining to record what is owed is Accounts Receivable . This will immediately indicate that the customer’s account is overdue.
Situation 2a – wrapping it up
This was the journal entry in Situation 2a above.
| Date | Account | Debit | Credit | ||
| 2/28 | Note Receivable | 1,020 | ▲ Note Receivable is an asset account that is increasing . | ||
| Note Receivable | 1,000 | ▼ Note Receivable is an asset account that is decreasing . | |||
| Interest Revenue | 20 | ▲ Interest Revenue is a revenue account that is increasing . |
Now let’s look at what happens when the customer in Situation 2a above finally pays the company back after the period. The new note was for another 60 days at 10%. Additional interest revenue earned on this second notes is $1,020 x 10% x 60/360, or $17.
| Date | Account | Debit | Credit | ||
| 4/30 | Cash | 1,037 | ▲ Cash is an asset account that is increasing . | ||
| Note Receivable | 1,020 | ▼ Note Receivable is an asset account that is decreasing . | |||
| Interest Revenue | 17 | ▲ Interest Revenue is a revenue account that is increasing . |
Situation 3 – wrapping it up
This was the journal entry in Situation 3 above.
| Date | Account | Debit | Credit | ||
| 2/28 | Accounts Receivable | 1,020 | ▲ Accounts Receivable is an asset account that is increasing . | ||
| Note Receivable | 1,000 | ▼ Note Receivable is an asset account that is decreasing . | |||
| Interest Revenue | 20 | ▲ Interest Revenue is a revenue account that is increasing . |
Assume two more months pass. Two possible things can happen now.
Possibility 1 - The customer finally pays on 4/30, two months after the original due date. The company charges a 10% penalty on the outstanding balance, which is $17 (1,020 x 10% x 60/360). A penalty is recorded as interest revenue.
| Date | Account | Debit | Credit | ||
| 4/30 | Cash | 1,037 | ▲ Cash is an asset account that is increasing . | ||
| Note Receivable | 1,020 | ▼ Note Receivable is an asset account that is decreasing . | |||
| Interest Revenue | 17 | ▲ Interest Revenue is a revenue account that is increasing . |
Possibility 2 - The company realizes the customer will NEVER be able to pay and writes him off.
| Date | Account | Debit | Credit | ||
| 4/30 | Allowance Doubtful Accounts | 1,037 | ▼ Allow Doubt Accts is a contra asset account that is decreasing . | ||
| Accounts Receivable | 1,020 | ▼ Accounts Receivable is an asset account that is decreasing . |
This will be covered in the next section.