Recognition of Notes Receivable

Definition

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.

Explanation

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:

  • Short-Term Notes:  since the interest collected will be immaterial, these notes are recorded at face value.
  • Long-Term Notes: reported on the balance sheet at the present value of the associated cash flows.  If the rate of interest on the note is higher than the market rate, the company will record the premium paid by the customer.  If the rate of interest is lower than the market rate, the company will record the discount provided the customer.

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:

  • Notes Received for Cash:  the difference between the face value of the note and its present value should be recorded, along with the calculated discount or premium.
  • Notes Received for Goods or Services:  the interest rate is assumed to be fair, and the transaction is valued at the present value of the fair market value of the goods or services promised.

Example

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)
= $13,612

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
Delta   $0

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.

Related Terms

balance sheet, current assets, factoring, assignment of accounts receivable, disposition of accounts receivable, allowance for doubtful accounts, special allowance accounts