- Explain the defining characteristics of a note receivable
A note receivable is evidenced by an actual written agreement, usually called a promissory note (promise to pay).
The promissory note will include the parties to the transaction, the dollar amount borrowed, the interest rate, and the due date. Figure 1 shows a very simple example of a promissory note.
Most promissory notes have an explicit interest charge. Interest is the fee charged for use of money over a period of time. 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. 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.
There are many circumstances in which a note receivable might arise. Here are three common ones:
- A company is in danger of defaulting on an account receivable and the two companies negotiate a settlement giving the debtor more time to pay.
- A company sells another company a large piece of equipment for a cash down payment and takes back a note for the balance. Willamette Industries has an old dump truck worth $10,000, so they sell it to Frank’s Disposal in Albany, Oregon, on October 1 for $2,000 down and a note for $8,000 with interest at 10% with the entire balance due on December 30 of that same year (a 90-day note).
- A company accepts a note receivable in exchange for loaning another company cash. For instance, a critical supplier might be in trouble financially, so the company that relies on the supplier for parts might loan that company money. Assume Cobalt Co. makes frozen food processing machines that sell worldwide and has a backlog of orders. The computer hardware that controls the machines is made by one company in Ohio, and that company, HWC, Inc. has run out of working capital (cash) and so the entire production of Cobalt Co. is in jeopardy. The bank won’t loan HWC any more money, and Cobalt doesn’t have time to take the production of the computer hardware in-house just yet, so Cobalt loans the supplier $200,000 via wire transfer on October 1 due in 90 days, evidenced by a promissory note with interest at 10%. Here’s what the journal entry for that transaction would look like:
|Oct 1||Notes Receivable||200,000.00|
|Oct 1||Checking Account||200,000.00|
|Oct 1||To record emergency loan to HWC, Inc.|
Companies usually do not establish a subsidiary ledger for notes. Instead, they maintain a file of the actual notes receivable and copies of notes payable.