Notes receivable are formal promises to pay a specific amount on a set date. They're a key financial instrument for companies extending credit or lending money, typically involving fixed payment schedules and interest rates.

Accounting for notes receivable involves initial recognition, valuation, and derecognition. Companies must track interest accrual, assess collectibility, and handle impairment. Understanding notes receivable is crucial for managing a company's financial assets and cash flow.

Definition of notes receivable

• Notes receivable are written promises from a customer or borrower to pay a specific amount of money to the company on a specified future date
• Represent a formal agreement between the company and the customer or borrower, typically with a fixed payment schedule and interest rate
• Notes receivable are a type of financial instrument that arises when a company extends credit to a customer or lends money to another entity

Accounting for notes receivable

Initial recognition of notes receivable

• When a company issues a note receivable, it records the transaction by debiting the Notes Receivable account and crediting the appropriate account (e.g., Cash, Sales, or Accounts Receivable)
• The initial recognition of notes receivable is recorded at the face value of the note, which is the amount that the borrower promises to pay at maturity
• Any associated costs, such as legal fees or origination fees, are typically expensed as incurred or amortized over the life of the note

Valuation of notes receivable

• After initial recognition, notes receivable are typically carried at their amortized cost, which is the face value of the note adjusted for any premium or discount and any allowance for uncollectible amounts
• If the note bears interest, the company must accrue interest revenue over the life of the note using the effective interest method
• The company should assess the collectibility of notes receivable periodically and establish an allowance for doubtful accounts if necessary

Derecognition of notes receivable

• A company derecognizes a note receivable when it has been paid in full by the borrower or when it has been sold or transferred to another party
• If the note is paid in full, the company debits Cash and credits Notes Receivable for the face value of the note, and recognizes any remaining interest revenue
• If the note is sold or transferred, the company debits Cash or the appropriate asset account for the proceeds received, credits Notes Receivable for the carrying value of the note, and recognizes any gain or loss on the transaction

Types of notes receivable

Interest-bearing vs non-interest-bearing notes

• Interest-bearing notes require the borrower to pay interest to the company in addition to the principal amount of the note (typically at a stated interest rate and on a specified schedule)
• Non-interest-bearing notes, also known as zero-interest notes, do not require the borrower to pay interest (the time value of money is incorporated into the face value of the note)

Secured vs unsecured notes

• Secured notes are backed by collateral, such as property or equipment, which the company can seize if the borrower defaults on the note
• Unsecured notes are not backed by collateral and represent a higher risk to the company (the company may have limited recourse if the borrower fails to pay)

Short-term vs long-term notes

• Short-term notes are those with a maturity date of one year or less from the date of issuance (presented as a current asset on the balance sheet)
• Long-term notes are those with a maturity date of more than one year from the date of issuance (presented as a non-current asset on the balance sheet)

Calculating interest on notes receivable

Simple interest method

• Under the simple interest method, interest is calculated based on the principal amount of the note and the stated interest rate, without considering compounding effects
• The formula for calculating simple interest is: $Interest = Principal \times Interest Rate \times Time$
• Simple interest is rarely used in practice, as most notes receivable involve compound interest

Effective interest method

• The effective interest method is the preferred method for calculating interest on notes receivable under both IFRS and US GAAP
• This method calculates interest based on the carrying value of the note (which includes any unamortized discount or premium) and the effective interest rate (which equates the present value of the note's cash flows to its carrying value)
• The effective interest rate is determined at the inception of the note and remains constant over the life of the note
• Interest revenue is recognized each period based on the carrying value of the note multiplied by the effective interest rate, and the carrying value is adjusted for any cash payments received and interest revenue recognized

Accounting for dishonored notes

Recognition of dishonored notes

• A note is considered dishonored when the borrower fails to make a required payment on the note by the due date
• When a company determines that a note receivable has been dishonored, it should reclassify the note as past due or delinquent
• The company should also assess the collectibility of the dishonored note and consider establishing an allowance for doubtful accounts

Accounting for dishonored notes receivable

• If a dishonored note is subsequently collected, the company reverses any allowance for doubtful accounts related to the note and recognizes interest revenue for the period
• If a dishonored note is determined to be uncollectible, the company writes off the note by debiting the Allowance for Doubtful Accounts and crediting Notes Receivable
• Any collateral associated with the dishonored note should be seized and recorded at its fair value, with any deficiency recognized as a loss

Discounting of notes receivable

Concept of discounting notes receivable

• Discounting of notes receivable refers to the sale of a note to a third party (such as a bank) before its maturity date in exchange for cash
• The third party purchases the note at a discount to its face value, reflecting the time value of money and the risk associated with the note
• Discounting allows the company to receive cash immediately rather than waiting until the maturity date of the note

Accounting for discounted notes receivable

• When a company discounts a note receivable, it derecognizes the note and recognizes the cash proceeds received from the third party
• The difference between the cash proceeds and the carrying value of the note is recognized as a gain or loss on the sale of the note
• If the company retains some risk related to the discounted note (such as the risk of default by the borrower), it may need to recognize a contingent liability for the estimated amount of the potential loss

Calculating discount on notes receivable

• The discount on a note receivable is the difference between the face value of the note and the present value of the note's future cash flows, calculated using the market interest rate for similar notes
• The formula for calculating the discount on a note receivable is: $Discount = Face Value - Present Value$
• The market interest rate used to calculate the present value should reflect the risk associated with the note and the time value of money over the remaining term of the note

Impairment of notes receivable

Identifying impaired notes receivable

• A note receivable is considered impaired when it is probable that the company will be unable to collect all amounts due according to the contractual terms of the note
• Indicators of impairment may include significant financial difficulty of the borrower, a breach of contract (such as a default or delinquency in payments), or a concession granted to the borrower due to economic or legal reasons
• The company should assess the collectibility of its notes receivable on a regular basis and identify any notes that may be impaired

Measuring impairment loss on notes receivable

• The impairment loss on a note receivable is the difference between the note's carrying value and the present value of its expected future cash flows, discounted at the note's original effective interest rate
• The formula for calculating the impairment loss is: $Impairment Loss = Carrying Value - Present Value of Expected Future Cash Flows$
• The expected future cash flows should be based on the company's best estimate of the amount and timing of future collections, considering all available evidence

Accounting for impairment of notes receivable

• When a note receivable is determined to be impaired, the company should recognize an impairment loss by debiting Bad Debt Expense and crediting Allowance for Doubtful Accounts
• The carrying value of the note should be reduced by the amount of the impairment loss, and future interest revenue should be calculated based on the new carrying value and the original effective interest rate
• If the expected future cash flows from the impaired note subsequently increase, the company may reverse some or all of the previously recognized impairment loss

Presentation and disclosure of notes receivable

Balance sheet presentation of notes receivable

• Notes receivable should be presented as a separate line item on the balance sheet, typically under current assets for short-term notes and non-current assets for long-term notes
• If the company has a significant amount of notes receivable, it may choose to present them in a separate section of the balance sheet or in the notes to the financial statements
• The notes to the financial statements should disclose the total amount of notes receivable, the allowance for doubtful accounts, and the net carrying value of the notes

Disclosure requirements for notes receivable

• The notes to the financial statements should disclose the significant terms of the notes receivable, including the interest rates, maturity dates, and any collateral or guarantees
• The company should also disclose its accounting policies related to notes receivable, including the methods used to recognize interest revenue and assess impairment
• If the company has discounted any notes receivable, it should disclose the amount of the discount and the gain or loss recognized on the sale of the notes

Notes receivable vs accounts receivable

Similarities between notes and accounts receivable

• Both notes receivable and accounts receivable represent amounts owed to the company by its customers or other third parties
• Both are typically recorded at their face value and may be subject to an allowance for doubtful accounts if they are deemed uncollectible
• Both generate interest revenue for the company, although the interest on accounts receivable is often implicit rather than explicitly stated

Differences between notes and accounts receivable

• Notes receivable are formal written promises to pay a specific amount on a specific date, while accounts receivable arise from the normal course of business and may not have a fixed payment date
• Notes receivable typically have a stated interest rate and a fixed maturity date, while accounts receivable may be non-interest bearing and have a more flexible payment schedule
• Notes receivable are often used for larger, one-time transactions or for extending credit to higher-risk customers, while accounts receivable are generated from the ongoing sale of goods or services to a wider range of customers
• Notes receivable may be secured by collateral or guaranteed by a third party, while accounts receivable are typically unsecured
• The accounting for notes receivable is generally more complex than for accounts receivable, due to the need to calculate interest revenue and assess impairment based on the specific terms of each note