The term recognition of notes receivable is used to describe the process of acknowledging the existence of a notes receivable on the balance sheet of a company. Accounting practices dictate that companies record notes receivable using the present value of all future cash flows.
Notes receivable are oftentimes accepted from customers that may need to extend the payment period over which a receivable is repaid. Notes receivable involve the creation of a promissory note, which is the promise to repay a prescribed amount of money at, or over, a predetermined timeframe.
Notes receivable are recognized on the balance sheet at the present value of all future cash flows. This process is relatively straightforward except when a non-interest bearing note, or a note bearing an unreasonable rate of interest, is created.
If the note bears a reasonable rate of interest, the following rules apply:
Accounting rules require companies to record transactions that reflect the true economic value of the arrangement. Non-interest bearing notes, or those with unreasonable rates, are candidates to be restated at their current present value. This can occur under a variety of conditions, including:
Company A lends Company XYZ $20,000 in exchange for a notes payable in five years at 8% interest. The rate of interest charged is assumed to be reasonable. The present value of the note is calculated as:
= $20,000 / (1 + 0.08)5
= $20,000 / (1.08)5
= $20,000 / (0.68058)
Therefore the value of the transaction is as follows:
|Face Value of Note Payable||$20,000|
|Present Value of Principle||$13,612|
|Present Value of Interest||$6,388|
|Present Value of Note Payable||$20,000|
Note: In the above example, because the rate of interest charged was assumed to be reasonable, the face value and present value of the note are equal.