6.5 Notes Receivables

Notes Receivables

Notes Receivables Overview

  • Companies use notes receivables when customers need to extend payment beyond the typical account receivable period.
  • A note receivable is a formal written promise to pay, including interest.
  • The note specifies payment amounts and due dates.
  • Long-term notes receivables are reported at present value on the balance sheet to reflect the expected cash collection.
  • Future cash flows are discounted to present value to remove unearned interest.
  • The market rate is used for discounting cash flows.
  • All notes have an interest element due to the time value of money.

Interest-Bearing vs. Non-Interest-Bearing Notes

  • Interest-Bearing Notes:
    • Have a stated interest rate explicitly written into the agreement.
  • Non-Interest-Bearing Notes:
    • Do not have a stated interest rate.
    • The interest for the entire term is included in the face value of the note.

Issuance of Notes

  • Similar to bonds payable, notes receivable can be issued at par, at a discount, or at a premium.
Issued at Face Value (Par)
  • The stated interest rate equals the market rate.
  • The present value of the cash flows equals the face value.
  • No present value calculations are required.
  • Face value represents the principal amount.
  • Interest is repaid in addition to the principal over the duration of the lending agreement.
Issued at a Discount
  • The stated interest rate is less than the market rate.
  • The present value of the cash flows is less than the face value.
  • The discount is the difference between the present value and the face value at issuance.
  • The discount converts into interest revenue for the lender over time.
Issued at a Premium
  • The stated interest rate is greater than the market rate.
  • The present value of the cash flows exceeds the face value.
  • The premium equals the difference between the present value and the face value.
  • A premium represents prepaid interest.

Recap of Note Issuance

  • When the stated interest rate equals the market rate, the note is issued at par (face value).
  • When the stated rate differs from the market rate, the present value differs from the face value.
  • The difference is recorded as a discount or premium.
  • The discount or premium is amortized over the life of the note using the effective interest method.
  • Effective interest method: applying a constant rate of interest to a changing carrying value.

Accounting for Interest-Bearing Notes

  • A stated rate of interest is explicitly written into the lending agreement.
  • Two interest rates:
    • Stated rate: given in the lending agreement.
    • Effective rate: the customer's normal cost to borrow.
  • If only the stated rate is given, it is presumed to equal the effective rate, and the note is issued at par.
  • If the stated rate equals the effective rate, the note is issued at par, where face value equals present value, and face value represents principal only.
  • If the stated rate does not equal the effective rate, the note is issued at a discount or a premium.
  • The note is always recorded at its face value.
  • The note is reported on the balance sheet at its present value.

Example: Interest-Bearing Note Issued at Par

  • Scenario: ABC performed services for a customer and accepts a 50,00050,000, 8% note.
  • The 8% is the stated rate.
  • Face value: 50,00050,000.
  • Term: Three years.
  • Interest paid annually each March 31.
  • Principal repaid at maturity.
  • The 8% interest is considered reasonable (equal to the market rate).
Cash Flows
  • Lump sum cash flow at maturity (principal).
  • Periodic interest payments (ordinary annuity).
Calculations
  • Interest payment: 50,000∗850,000 * 8% = $4,000 per year.
  • Since the stated rate equals the market rate, the present value of the cash flows is 50,00050,000.
Present Value Calculation (Demonstration):
  • Present value of future value (principal):
    • Factor from the present value of a dollar table at 8% for three periods: 0.79383.
    • PV = $50,000 * 0.79383 = $39,692
  • Present value of periodic interest payments:
    • Factor from the present value of an ordinary annuity table at 8% for three periods.
    • PV = $4,000 * factor = $10,308
  • Sum of present values: 39,692 + 10,308 = $50,000
  • This confirms that the present value equals the face value when the stated rate equals the market rate.
TVM Solver
  • N = 3
  • I = 8
  • PV = ?
  • PMT = 4000
  • FV = 50000
  • The TVM solver result confirms that present value is equal to the face value of the note.
Journal Entries
  • The note receivable is recorded at its face value (50,00050,000).
  • The service revenue is recorded at the present value of the cash flows (which equals the face value).
Year-End Accrual (Partial Year)
  • Note issued on April 1, company's year-end is December 31.
  • Accrue interest for nine months (April 1 to December 31).
Journal Entry at December 31 (Year 1)
  • Interest receivable: Debit
  • Interest revenue: Credit
  • Amount: 50,000∗850,000 * 8% * (9/12) = $3,000
Journal Entry at March 31
  • Cash: Debit 4,0004,000
  • Interest receivable: Credit 3,0003,000
  • Interest revenue: Credit 1,0001,000 (for the additional three months)
  • Calculation:
    • 50,000∗850,000 * 8% * (3/12) = $1,000
Journal Entry at Maturity
  • Cash: Debit 50,00050,000
  • Note receivable: Credit 50,00050,000
  • All terms of the lending agreement have been satisfied.