How to Recognize a Face Value Notes Receivable
For the current asset section of the balance sheet, a note receivable is a short-term (coming due within 12 months of the balance sheet date) debt someone owes you. In many cases, this current asset arises from a trade receivable.
For example, a customer has cash flow problems that keep it from paying for purchases. So the customer asks the vendor for extended terms in the form of a formal written document, in place of the more informal agreement to pay for the goods or services per the terms of the invoice.
A note receivable has three major components:
Principal: The amount the debtor owes the lender
Rate: The amount of interest the debtor pays on the principal
Time: The period in which the debtor has to pay back the note
As with A/R, any note receivable (N/R) involves three important considerations: recognition, valuation, and disposition. Recognition involves booking the N/R at face value or other than face value.
Making sure the note receivable reflects properly (valuation) on the balance sheet involves the vexing subject of estimating plus impairment. Disposition is what happens ultimately to get the receivable off the books.
A note receivable reflects only in the current asset part of the balance sheet because the debt you anticipate will be paid back within 12 months of the balance sheet date. Any portion of the note receivable that extends past that 12-month period gets put in the long-term asset section of the balance sheet.
The easiest type of note to account for, the present value of the notes, is the same as its face value, which is the amount stated on the note. This fact is true because the effective (or market) interest rate and the stated (what’s printed on the face of the note receivable) interest rates are the same.
Market is what the interest rate is for a note of similar risk.
Easy-peasy to account for. Now consider that one company loans another $5,000 at an effective and stated rate of 10 percent due in three years. The journal entry for the lender to record issuance of the note is to debit notes receivable and credit cash for $5,000.
Then each year, the lender records interest revenue at $500 ($5,000 x .10). When the debtor pays at the end of the three years, the lender records a debit to cash and a credit to notes receivable for $5,000.