A large portion of all business transactions are credit transactions. One way of extending credit is by the acceptance of a “promissory note“, a contract in which one person (the maker) promises to pay another person (the payee) a specific sum of money at a specific time “with or without interest“. A promissory note is a “note payable“ from the standpoint of the maker and it is a “note receivable“ from the standpoint of the payee. On this post, we are going to discuss about “Notes Payable and Receivable”. Read on…
A promissory note is used for the following three reasons:
- The holder of a note can usually obtain money by taking the note to the bank and selling it (discounting the note).
- The note is a written agreement of a debt and is better evidence than an open account.
- The note facilitates the sale of merchandise on long-term or installment plans.
For a note to be negotiable, it must meet the requirements of the “Uniform Negotiable Instrument Law“. This legislation states that the instrument:
- The note must be in writing and signed by the maker.
- The note must contain an order to pay a definite sum of money.
- The note must be payable to order on demand or at a fixed future time.
A note payable is a written promise to pay a creditor an amount of money in the future. Notes are used by a business to purchase items, settle an open account, or borrow money from a bank. Let’s go to some details of each by examples. Read on…
Assume that you bought office equipment costing $2,000 by giving a note. You would record the transaction with the following entry:
[Debit]. Office Equipment = $2,000
[Credit]. Notes Payable = $2,000
. Settle An Open Account
There are times when a note is issued in settlement of an account payable. Assume that you bought merchandise from Lie Dharma Co. for $500 and at the end of the month, the account balance remained in full. If the you are unable to pay, you may issue a note to Lie Dharma Co. for the $500 account payable, converting the account payable into a note payable. Note that you still owe the debt to Lie Dharma Co. However, it now becomes a different form of obligation, as it is a written, signed promise in the form of a “note payable“.
. Borrow Money From a Bank
On occasion, businesses find it necessary to borrow money by giving a note payable to a bank. Frequently, banks require the interest be paid in advance. This is accomplished by deducting the amount of the interest from the principal when the loan is made and is known as “discounting a note payable“. The proceeds will be that amount of money that the maker of the note receivable receives after the discount has been taken from the principal.
A note received from a customer is an asset because it becomes a claim against the buyer for the amount due. Assume that Lie Dharma Co. owe you $400 and you give them a 90-day, 15 percent note in settlement. Lie Dharma Co. still owe the debt, but their obligation is of a different type now. On your books the entry is:
[Debit]. Notes Receivable = $400
[Credit]. Accounts Receivable = $400
It is only the principal ($400) is recorded when the note is received, since it represents the amount of the unpaid account. The interest is not due until the date of collection, 90 days later. At that time, the interest earned will be part of the entry recognizing the receipt of the proceeds from the note:
[Debit]. Cash = $415
[Credit]. Notes Receivable = $400
[Credit]. Interest Income*) = $15
*)Interest = $400 × (15/100) × (90/360) = $15 (dicussed later in this post)
Discounts On A Note Receivable
The negotiability of a note receivable based upon its maturity value, enables the holder to receive cash from the bank before the due date. This is known as “discounting“. Once the interest to be paid has been determined, the procedure for discounting a note is quite simple. The maturity value of a note is:
- Maturity value = face of note + interest income where the face is the principal and interest income is computed (as discussed on later section of this post). The holder of a note may discount it at the bank prior to its due date. He or she will receive the maturity value, less the discount, or interest charge imposed by the bank for holding the note for the unexpired portion of its term.
- Discount = maturity value × discount rate × unexpired time, and
- Net Proceeds = maturity value – discount.
Example: Mr. Lie holds a $400, 90-day, 12 percent note written by Mr. Dharma on April 10. It is discounted at 12 percent on May 10. The interest on the note amounts to $12.
- Maturity value = $400 + $12 = $412. Since at the time of discounting, Mr. Lie has held the note for only 30 days, the bank will have to wait 60 days until it can receive the maturity value. The discount charge is then
- The “Discount charge” is then = $412 × (12/100) × (60/360) = $8.24
- Mr. Lie receives “Net Proceeds” = $412 – $8.24 = $403.76
Dishonored Notes Receivable
If the issuer of a note does not make payment on the due date, the note is said to be “dishonored“. It is no longer negotiable, and the amount is charged back to Accounts Receivable.
The reasons for transferring the dishonored notes receivable to the Accounts Receivable accounts are that the Notes Receivable account is then limited to current notes that have not yet matured and the Accounts Receivable account will then show the dishonoring of the note, giving a better picture of the transaction.
Example: a $500, 60-day, 12 percent note written by Lie Dharma was dishonored on the date of maturity. The entry is:
[Debit]. Accounts Receivable, Lie Dharma = $510
[Credit]. Notes Receivable = $500
[Credit]. Interest Income = $10
Observe that the interest income is recorded and is charged to the customer’s account. When a payee discounts a note receivable, he or she creates a contingent (potential) liability. This occurs because there is a possibility that the maker may dishonor the note. Bear in mind that the payee has already received payment from the bank in advance of the maturity date. The payee is, therefore, contingently liable to the bank to make good on the amount (maturity value) in the event of default by the maker. Any protest fee arising from the default of the note is charged to the maker of the note and is added to the amount to be charged against his or her account.
The concept known as discounting permits the negotiability of a note receivable based upon its maturity value to enable the holder to receive cash from the bank before the due date.
To make it a complete basic knowledge, let’s expand the topic a little bit to the “methods of computing interest” and “determining maturity date“. Read on….
Methods of Computing Interest
For the sake of simplicity, interest is commonly computed on the basis of a 360-day year divided into 12 months of 30 days each. Two widely used methods are: the “cancellation method” and “the 6 percent, 60-days method“. Let’s get into the deatils… read on…
.The Cancellation Method
Consider a note for $400 at 6 percent for 90 days. The principal is the face amount of the note ($400). The rate of interest is written as a fraction: 6/100. The time, if less than a year, is expressed as a fraction by dividing the number of days the note runs by the number of days in a year: 90/360. Thus:
Interest = $400 × (6/100) × (90 /360) = $6. Just that simple.
. The 6 Percent, 60-Days Method
The 6 percent, 60-days Method is a variation of the cancellation method, based on the fact that 60 days, or 1/6 of a year, at 6 percent is equivalent to 1 percent, so that the interest is obtained by shifting the decimal point of the principal two places to the left.
Determining Maturity Date
The maturity days are the number of days after the note has been issued and may be determined by:
- Subtracting the date of the note from the number of days in the month in which it was written.
- Adding the succeeding full months (in terms of days), stopping with the last full month before the number of days in the note are exceeded.
- Subtracting the total days of the result of steps 1 and 2 above from the time of the note. The resulting number is the due date in the upcoming month.
- If the due date is expressed in months, the maturity date can be determined by counting that number of expressed months from the date of writing.