Accounting: The Language of Business - Vol. 2 (Intermediate: Part 147)

It is God who gives you the ability to produce wealth (Deuteronomy 8:18)

Short-Term Operating Assets: Cash and Receivables (Part L)

by

Charles Lamson

Accounting for Short-Term Notes Receivable

This post introduces the key features of notes receivable and reviews the accounting message used to record notes receivable, which depend on whether the stated interest rate is at or below the market interest rate. A detailed discussion of this will be provided in a future part covering investing assets.

Basic Features of Notes Receivable

A note receivable is a formal kind of written promise to receive a fixed sum of money at a specified date (or dates) in the future, usually with a stated interest rate. The fixed sum of money that will be received at a specified date in the future is the face value of the note receivable. Notes receivable are classified as current or non-current on the balance sheet based on the expected collection date. Notes originate from either trade or nontrade transactions. Nontrade notes receivable include loans made to officers or employees and special financing arrangements with customers or vendors. Notes receivable can be interest bearing or non-interest bearing---but all notes include an interest element. The holder of an interest-bearing note receives periodic interest over the low term. Conversely, the holder of a non-interest-bearing note does not receive periodic interest over the term of the note.

When a company accepts a note in exchange for goods and services, the note may have a stated rate of interest, may not specify an interest rate, or may have a stated rate of interest that is significantly different than the current market rate. The stated rate is the interest rate that the holder of the note will receive and is expressed as an annual rate. The market rate is the interest rate on a similar investment in the market. Regardless of the note's stated interest rate, companies always report the note receivable at the present value of the future cash flows discounted at the market rate on the balance sheet. Similarly, if the note does not specify an interest rate, the note receivable is reported at the present value of the future cash flows discounted at the market rate. Interest is recorded on the note over its life by the amortization of a discount. [Amortization of a discount is a non-cash expense that gradually reduces a discount over time. It's a process that can apply to notes payable and bonds payable:

• Notes payable

  In each accounting period, a portion of the discount is recognized as interest expense until the note matures and the discount reaches zero.
• Bonds payable

  When an investor pays less than the face value of a bond because the stated interest rate is lower than the market rate, the difference is recorded in a contra liability account called "Discount on Bonds Payable". Over the life of the bond, the discount is amortized, or divided, and the balance in the account decreases. As the discount is amortized, the carrying value of the bond increases and interest expense increases when semiannual interest payments are recorded (superfastcpa.com).]

Next, we present the accounting for a note receivable with a stated interest rate equal to the market interest rate. Then, we discuss accounting for a note with a stated interest rate that is below the market interest rate.

Stated Interest Rate Equal to the Market Rate

When short-term notes are interest bearing at the current market rate of interest when issued, the face amount of the note is the same as its present value. In this case, the company records the note at its face value and interest accrues over the life of the note as illustrated in Example 9.12.

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 464-465*

end