OCW041: Notes Receivable

Components of a Note

Notes Receivable represents claims for which formal instruments of credit are issued as evidence of debt, such as a promissory note.

Learning Objectives

Explain the purpose of a note receivable and its format

Key Takeaways

Key Points

  • A notes receivable normally requires the debtor to pay interest and extends for time periods of 30 days or longer.
  • Often a business will allow a customer to convert their overdue accounts into a notes receivable. Doing so gives the debtor more time to pay.
  • The principle is the face value of the note. The principle equals the initial amount of credit provided.
  • The maker of a note is the party who receives the credit and promises to pay the note’s holder.
  • Notes generally specify an interest rate, which is used to determine how much interest the maker of the note must pay in addition to the principal.

Key Terms

  • debtor: One who owes another anything, or is under obligation, arising from express agreement, implication of law, or principles of natural justice, to pay money or to fulfill some other obligation; in bankruptcy or similar proceedings, the person who is the subject of the proceeding.
  • promissory: Stipulating the future actions required of the parties to an insurance policy or other business agreement.
  • promissory note: a document saying that someone owes a specific amount of money to someone else, often with the deadline and interest fees
  • maker: the party issuing a promisory note
  • payee: the party receiving the promisory note

Notes Receivable

Notes Receivable represents claims for which formal instruments of credit are issued as evidence of debt, such as a promissory note. Often a business will allow a customer to convert their overdue accounts into a notes receivable. Doing so gives the debtor more time to pay. Occasionally, the notes receivable will include a personal guarantee by the owner of the debtor.

A notes receivable normally requires the debtor to pay interest and extends for time periods of 30 days or longer. Notes receivable are considered current assets if they are to be paid within 1 year and non-current if they are expected to be paid after one year.

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Confederate Note Receivable: A One Hundred Dollar Confederate States of America banknote dated December 22, 1862. Issued during the American Civil War (1861–1865).

Components of a Note Receivable

Principle-the principle is the face value of the note. The principle equals the initial amount of credit provided.

Maker-the maker of a note is the party who receives the credit and promises to pay the note’s holder. The maker classifies the note as a note payable.

Payee -the payee is the party that holds the note and receives payment from the maker when the note is due. The payee classifies the note as a note receivable.

Interest-notes generally specify an interest rate, which is used to determine how much interest the maker of the note must pay in addition to the principal.

Calculating interest-interest on short-term notes is calculated according to the following formula:

principle x annual interest rate x time period in years = interest

Example: interest on a four-month, 9%, $1,000 note equals $30

Recognizing Notes Receivable

In accounting, notes receivables are accounts to keep track of accrued assets that have been earned but not yet received.

Learning Objectives

Describe the difference between using the allowance method vs. the write off method when recording a note receivable

Key Takeaways

Key Points

  • To record a journal entry for a sale on account, one must debit a receivable and credit a revenue account.
  • When the receivable is payed off, debit the cash account and credit the receivable account.
  • To estimate the net value of accounts receivable, subtract the balance of an allowance account from the accounts receivable account.
  • Account for bad debts by either the allowance method or the direct write-off method.

Key Terms

  • journal entry: A journal entry, in accounting, is a logging of transactions into accounting journal items. The journal entry can consist of several items, each of which is either a debit or a credit. The total of the debits must equal the total of the credits or the journal entry is said to be “unbalanced. ” Journal entries can record unique items or recurring items, such as depreciation or bond amortization.
  • bad debt: A debt which cannot be recovered from the debtor, either because the debtor doesn’t have the money to pay or because the debtor cannot be found and/or forced to pay.
  • balance sheet: A summary of a person’s or organization’s assets, liabilities. and equity as of a specific date.

In accounting, notes receivables are accounts to keep track of accrued assets that have been earned but not yet received.

Accrued Assets

Accrued assets are assets, such as interest receivable or accounts receivable, that have not been recorded by the end of an accounting period. These assets represent rights to receive future payments that are not due at the balance sheet date. To present an accurate picture of the affairs of the business on the balance sheet, firms recognize these rights at the end of an accounting period by preparing an adjusting entry to correct the account balances. To indicate the dual nature of these adjustments, they record a related revenue in addition to the asset. We also call these adjustments ‘ accrued revenues ‘ because the revenues must be recorded.

Recognizing and Reporting Notes Receivable

To record a journal entry for a sale on account, one must debit a receivable and credit a revenue account. When the customer pays off their accounts, one debits cash and credits the receivable in the journal entry. For example, a sale on account would be recorded similarly to the following interest receivable journal entry:

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Notes Receivable Example: Recording an interest receivable journal entry

The ending balance on the trial balance sheet for accounts receivable is usually a debit. Business organizations which have become too large to perform such tasks by hand (or small ones that could but prefer not to) will generally use accounting software on a computer to perform this task. Companies have two methods available to them for measuring the net value of accounts receivable, which is generally computed by subtracting the balance of an allowance account from the accounts receivable account.

Allowance method

The first method is the allowance method, which establishes a contra-asset account, allowance for doubtful accounts, or bad debt provision, that has the effect of reducing the balance for accounts receivable.

The amount of the bad debt provision can be computed in two ways, either (1) by reviewing each individual debt and deciding whether it is doubtful (a specific provision); or (2) by providing for a fixed percentage (e.g. 2%) of total debtors (a general provision). The change in the bad debt provision from year to year is posted to the bad debt expense account in the income statement.

Direct write-off method

This second method is simpler than the allowance method in that it allows for one simple entry to reduce accounts receivable to its net realizable value. The entry would consist of debiting a bad debt expense account and crediting the respective accounts receivable in the sales ledger.

The two methods are not mutually exclusive, and some businesses will have a provision for doubtful debts, writing off specific debts that they know to be bad (for example, if the debtor has gone into liquidation. )

Valuing Notes Receivable

Companies have two methods available to them for measuring the net value of accounts receivable: the allowance method and the direct write-off method.

Learning Objectives

Differentiate between the allowance method and the write off method for valuing notes receivable

Key Takeaways

Key Points

  • Notes Receivable represents claims for which formal instruments of credit are issued as evidence of debt, such as a promissory note.
  • The direct write-off method is simpler than the allowance method in that it allows for one simple entry to reduce accounts receivable to its net realizable value.
  • The allowance method, which establishes a contra- asset account, allowance for doubtful accounts, or bad debt provision, that has the effect of reducing the balance for accounts receivable.
  • The two methods are not mutually exclusive, and some businesses will have a provision for doubtful debts, writing off specific debts that they know to be bad.

Key Terms

  • revenue: Income that a company receives from its normal business activities, usually from the sale of goods and services to customers.
  • write-off: To remove a portion of a debt or an amount of an account owed to you counting it as a loss (as a gesture of goodwill for example)

Notes Receivable

Notes Receivable represents claims for which formal instruments of credit are issued as evidence of debt, such as a promissory note. The credit instrument normally requires the debtor to pay interest and extends for time periods of 30 days or longer. Notes receivable are considered current assets if they are to be paid within 1 year and non-current if they are expected to be paid after one year.

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Compound Interest Treasury Note: Notes are short-term investment vehicles.

Reporting of Cash and Receivables

Accrued revenue (or accrued assets) is an asset such as proceeds from a delivery of goods or services, at which such income item is earned and the related revenue item is recognized, while cash for them is to be received in a latter accounting period. At that point its amount is deducted from accrued revenues.

Valuing Notes/Accounts Receivable

Companies have two methods available to them for measuring the net value of accounts receivable–the allowance method and the direct write-off method.

The Allowance Method

The first method is the allowance method, which establishes a contra-asset account, allowance for doubtful accounts, or bad debt provision, that has the effect of reducing the balance for accounts receivable. The amount of the bad debt provision can be computed in two ways:

  1. by reviewing each individual debt and deciding whether it is doubtful (a specific provision)
  2. by providing for a fixed percentage (e.g. 2%) of total debtors (a general provision)

The Direct Write Off Method

The second method is the direct write off method. It is simpler than the allowance method in that it allows for one simple entry to reduce accounts receivable to its net realizable value. The entry would consist of debiting a bad debt expense account and crediting the respective accounts receivable in the sales ledger.

Write-Offs

Companies use two methods for handling uncollectible accounts: the allowance method and the direct write-off method.

Learning Objectives

Explain how to write off an uncollectible account using both the direct write-off and the allowance method.

Key Takeaways

Key Points

  • The direct write-off method is simpler than the allowance method in that it allows for one simple entry to reduce accounts receivable to its net realizable value.
  • When using the allowance method, an estimate is made at the end of each fiscal year of the amount of bad debt.
  • The portion of the account receivable that is estimated to be not collectible is set aside in a contra-asset account called Allowance for Doubtful Accounts.
  • At the end of each accounting cycle, adjusting entries are made to charge uncollectible receivable as expense.
  • The actual amount of uncollectible receivables is written off as an expense from Allowance for Doubtful Accounts.

Key Terms

  • uncollectible: Receivables that cannot be collected.
  • write-off: The cancellation of an item; the amount cancelled or lost.

Write-offs

Because customers do not always keep their promises to pay, companies must provide for these uncollectible accounts in their records. This phenomenon is known, in the realm of accounting, as bad debt.

Companies use two methods for handling uncollectible accounts: the direct write-off method and the allowance method. The direct write-off method is simpler than the allowance method in that it allows for one simple entry to reduce accounts receivable to its net realizable value. The entry would consist of debiting a bad debt expense account and crediting the respective accounts receivable in the sales ledger. The bad debt is recognized as an expense at the point when judged to be uncollectible.

When using the allowance method, an estimate is made at the end of each fiscal year of the amount of bad debt. This amount is accumulated in a provision, which is then used to reduce specific receivable accounts when necessary. Note that the allowance method is the required method for federal income tax purposes (GAAP).

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Uncollectibles: Interesting Facts About Collection Agencies.

Because of the matching principle of accounting, revenues and expenses should be recorded in the period in which they are incurred. When a sale is made on account, revenue is recorded along with account receivable. Because there is an inherent risk that clients might default on payment, accounts receivable have to be recorded at net realizable value. The portion of the account receivable that is estimated to be not collectible is set aside in a contra-asset account called Allowance for Doubtful Accounts. At the end of each accounting cycle, adjusting entries are made to charge uncollectible receivable as expense. The actual amount of uncollectible receivables is written off as an expense from Allowance for Doubtful Accounts.

Allowance Method Example

As time passes and a firm considers a specific customer’s account to be uncollectible, it writes that account off. It debits the Allowance for Doubtful Accounts. The credit is to the Accounts Receivable control account in the general ledger and to the customer’s account in the accounts receivable subsidiary ledger. For example, assume Smith’s USD 750 account has been determined to be uncollectible. The entry to write off this account is:

Allowance for Uncollectible Accounts (-SE) 750

Accounts Receivable—Smith (-A) 750

The credit balance in Allowance for Doubtful Accounts before making this entry represented potential uncollectible accounts not yet specifically identified. Debiting the allowance account and crediting Accounts Receivable shows that the firm has identified Smith’s account as uncollectible. Notice that the debit in the entry to write off an account receivable does not involve recording an expense. The company recognized the uncollectible accounts expense in the same accounting period as the sale. If Smith’s USD 750 uncollectible account were recorded in Uncollectible Accounts Expense again, it would be counted as an expense twice.

A write-off does not affect the net realizable value of accounts receivable. For example, suppose that Amos Company has total accounts receivable of USD 50,000 and an allowance of USD 3,000 before the previous entry; the net realizable value of the accounts receivable is USD 47,000. After posting that entry, accounts receivable are USD 49,250, and the allowance is USD 2,250; net realizable value is still USD 47,000, as shown here:

Before Write-Off // Entry for After Write-Off // Write-Off

Accounts receivable 50,000 Dr. // 750 Cr. // $ 49,250 Dr.

Allowance for uncollectible accounts 3,000 Cr. // 750 Dr. // 2,250 Cr.

Net realizable value 47,000 Dr. // $47,000

You might wonder how the allowance account can develop a debit balance before adjustment. To explain this, assume that Jenkins Company began business on January 1, 2009, and decided to use the allowance method and make the adjusting entry for uncollectible accounts only at year-end. Thus, the allowance account would not have any balance at the beginning of 2009. If the company wrote off any uncollectible accounts during 2009, it would debit Allowance for Uncollectible Accounts and cause a debit balance in that account. At the end of 2009, the company would debit Uncollectible Accounts Expense and credit Allowance for Uncollectible Accounts. This adjusting entry would cause the allowance account to have a credit balance.

During 2010, the company would again begin debiting the allowance account for any write-offs of uncollectible accounts. Even if the adjustment at the end of 2009 was adequate to cover all accounts receivable existing at that time that would later become uncollectible, some accounts receivable from 2010 sales may be written off before the end of 2010. If so, the allowance account would again develop a debit balance before the end-of-year 2010 adjustment.


Source: Accounting