Notes receivable 

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:

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: