Notes receivable refers to an asset presented in the balance sheet of a company or business representing the value of all promissory notes issued by it. A promissory note is a financial instrument that consists of a written promise from its issuer to pay the company. Usually, it also includes the terms and conditions related to the arrangement as well.
Notes receivable are similar to accounts receivable. While accounts receivable balances represent any amount owed to the company by its customers, notes receivable represent loans to third parties. Usually, notes receivable balances are current assets, which companies expect to receive within 12 months. Sometimes, however, they can also be non-current assets that have a lifespan of more than a year.
Usually, notes receivable balances are common for financial institutions, such as banks. These institutions provide loans to customers along with a note stating they will pay the institution within a specific amount of time. Some notes may also come with interest payments that the lender will receive based on a predetermined rate.
Discount on Notes Receivable
Discount on notes receivable happens when a company discounts its notes receivables before their maturity date. For example, if a company needs cash, it may discount its notes receivables to another party, usually a financial institution. This process is known as discounting. It is similar to when companies discount their account receivables.
Furthermore, usually, companies sell the note with recourse, which means the company discounting the note is responsible for its eventual repayment. In case the party that promised the payment fails to pay the noteholder, the company will have to pay the financial institution to whom it discounted the note.
While both notes receivable and accounts receivable are similar as both represent assets, the accounting treatment for both is different. Due to its better liquidity, companies can dispose of their notes receivable to other parties. At that moment, the company will need to calculate various amounts to determine the accounting treatment of the discounted notes receivable.
First of all, it must determine the maturity value of the bond. Then, the company must calculate the discount, which equals the discount rate multiplied by the maturity value. Similarly, it must calculate the proceed by subtracting the discount from the maturity value. From there, the company can determine whether it has a net interest income or expense.
Based on whether there is a net interest income or expense, the journal entries will differ. First of all, for a net interest income on the note receivable, the journal entry will be as follows.
If there is a net interest expense, the journal entry will be as follows.
BC Co. has a note receivable with a face value of $25,000 on Jan 1st, 20×1. The borrower has promised to repay the company in the next three months. The note receivable comes with a predetermined interest rate of 10%. ABC Co. needs to have cash for an upcoming project. Therefore, it decides to discount the notes receivable to a local bank, which agrees on a 15% discount rate.
ABC Co. must pass the journal entries for the transaction. First of all, the company must calculate the maturity value of the note. Since the note has a face value of 25,000 and an interest rate of 10%, its maturity value will be as follows.
Maturity value = $25,000 + ($25,000 x 10% x 3/12 months)
Maturity value = $25,625
Next, it must calculate the discount. The discount will be as follows.
Discount = $25,625 x 15% x 3/12 months
Discount = $961
The next step for ABC Co. is to calculate the proceed. The proceed will be equal to the maturity value minus the discount.
Proceed = $25,625 – $961
Proceed = $24,664
Finally, the company can determine whether there is an interest in income or expense. Since the proceeding is lower than the face value of the bond, ABC Co. will suffer an interest expense of $336 ($25,000 – $24,644). Therefore, the journal entry that ABC Co. will use is as follows.
Notes receivable is a type of debt that companies provide in exchange for a promissory note. Sometimes, companies may sell the note before its maturity date, known as discounting.
The accounting treatment for the process consists of the company determining the maturity value, discount, and procedures of the note. From those, the company can calculate whether there is a net interest income or expense and pass journal entries accordingly.