Notes receivable receivables supported by a formal agreement or note that specifies payment terms. are formal credit arrangements between a creditor (lender) and a debtor (borrower). Notes arise from loans to other entities including affiliated companies and to stockholders and employees, from the extension of the credit period to trade customers, and occasionally from the sale of merchandise, other assets, or services. Notes receivable are classified as either current or noncurrent depending on the expected collection date(s).
Our examples below illustrate short-term notes. When the term of a note is longer than a year, it is reported as a long-term note. Long-term notes receivable are discussed in conjunction with long-term notes payable in Chapter 14.
The typical note receivable requires payment of a specified face amount, also called principal, at a specified maturity date or dates. In addition, interest is paid at a stated percentage of the face amount. Interest on notes is calculated as:
For an example, consider Illustration 7-4.
The Stridewell Wholesale Shoe Company manufactures athletic shoes that it sells to retailers. On May 1, 2011, the company sold shoes to Harmon Sporting Goods. Stridewell agreed to accept a $700,000, 6-month, 12% note in payment for the shoes. Interest is payable at maturity.
Stridewell would account for the note as follows:*
* To focus on recording the note we intentionally omit the entry required for the cost of the goods sold if the perpetual inventory system is used.
If the sale in the illustration occurs on August 1, 2011, and the company's fiscal year-end is December 31, a year-end adjusting entry accrues interest earned.
The February 1 collection is then recorded as follows:
Sometimes a receivable assumes the form of a so-called noninterest-bearing notenotes that bear interest, but the interest is deducted (or discounted) from the face amount to determine the cash proceeds made available to the borrower at the outset.. The name is a misnomer, though. Noninterest-bearing notes actually do bear interest, but the interest is deducted (or discounted) from the face amount to determine the cash proceeds made available to the borrower at the outset. For example, the preceding note could be packaged as a $700,000 noninterest-bearing note, with a 12% discount rate. In that case, the $42,000 interest would be discounted at the outset rather than explicitly stated. As a result, the selling price of the shoes would have been only $658,000. Assuming a May 1, 2011 sale, the transaction is recorded as follows:12
The discount becomes interest revenue in a noninterest-bearing note.
The discount on note receivable is a contra account to the note receivable account. That is, the note receivable would be reported in the balance sheet net (less) any remaining discount. The discount represents future interest revenue that will be recognized as it is earned over time. The sales revenue under this arrangement is only $658,000, but the interest is calculated as the discount rate times the $700,000 face amount. This causes the effective interest rate to be higher than the 12% stated rate.
* Two 6-month periods
When interest is discounted from the face amount of a note, the effective interest rate is higher than the stated discount rate.
As we discussed earlier in the chapter, receivables, other than normal trade receivables, should be valued at the present value of future cash receipts. The present value of $700,000 to be received in six months using an effective interest rate of 6.383% is $658,000 ($700,000 ÷ 1.06383 = $658,000). The use of present value techniques for valuation purposes was introduced in Chapter 6, and we'll use these techniques extensively in subsequent chapters to value various long-term liabilities.
In the illustration, if the sale occurs on August 1, the December 31, 2011, adjusting entry and the entry to record the cash collection on February 1, 2012, are recorded as follows:
In the December 31, 2011 balance sheet, the note receivable is shown at $693,000, face amount ($700,000) less remaining discount ($7,000).
Choice Hotels, Inc., accepts noninterest-bearing notes from franchisees who open new hotels. The 2009 disclosure note shown in Graphic 7-5 describes the company's revenue recognition policy for these notes.
Disclosure of Revenue Recognition for License Agreements—Choice Hotels, Inc.
Real World Financials
When a noninterestbearing note is received solely in exchange for cash, the amount of cash exchanged is the basis for valuing the note.
Note 2: Notes Receivable (in part)
The Company has provided financing to franchisees in support of the development of Cambria Suites properties. These notes include noninterest-bearing receivables as well as notes bearing market interest and are due upon maturity. Noninterest-bearing notes receivable at December 31, 2008, were recorded net of their unamortized discounts totaling $0.02 million. Interest income associated with these notes receivable is reflected in the accompanying consolidated statements of income under the caption interest and other investment (income) loss.
NOTES RECEIVED SOLELY FOR CASH. If a note with an unrealistic interest rate—even a noninterest-bearing note—is received solely in exchange for cash, the cash paid to the issuer is considered to be its present value.13 Even if this means recording interest at a ridiculously low or zero rate, the amount of cash exchanged is the basis for valuing the note. When a non-cash asset is exchanged for a note with a low stated rate, we can argue that its real value is less than it's purported to be, but we can't argue that the present value of a sum of cash currently exchanged is less than that sum. If the noninterest-bearing note in the previous example had been received solely in exchange for $700,000 cash, the transaction would be recorded as follows:
Subsequent Valuation of Notes Receivable
Similar to accounts receivable, if a company anticipates bad debts on short-term notes receivable, it uses an allowance account to reduce the receivable to net realizable value. The process of recording bad debt expense is the same as with accounts receivable.
Long-term notes present a more significant measurement problem. The longer the duration of the note, the more likely are bad debts. One of the more difficult measurement problems facing banks and other lending institutions is the estimation of bad debts on their long-term notes (loans). As an example, Wells Fargo & Company, a large bank holding company, reported the following in the asset section of its March 31, 2009, quarter-end balance sheet:
A disclosure note, reproduced in Graphic 7-6, describes Wells Fargo's loan loss policy.
Disclosure of Allowance for Loan Losses—Wells Fargo & Company
Real World Financials
Allowance for Credit Losses
The allowance for credit losses, which consists of the allowance for loan losses and the reserve for unfunded credit commitments, is management's estimate of credit losses inherent in the loan portfolio at the balance sheet date and excludes loans carried at fair value. The process for determining the adequacy of the allowance for credit losses is critical to our financial results. It requires difficult, subjective and complex judgments, as a result of the need to make estimates about the effect of matters that are uncertain.
GAAP requires that companies disclose the fair value of their notes receivable in the disclosure notes (they don't have to disclose the fair value of accounts receivable when the carrying value of the receivables approximates their fair value).14 Also, GAAP recently changed to allow companies to choose to carry receivables at fair value in their balance sheets, with changes in fair value recognized as gains or losses in the income statements.15 This “fair value option” is discussed in Chapter 12.
When it becomes probable that a creditor will be unable to collect all amounts due according to the contractual terms of a note, the receivable is considered impaired. When a creditor's investment in a note receivable becomes impaired for any reason, the receivable is remeasured as the discounted present value of currently expected cash flows at the loan's original effective rate. Impairments of receivables are discussed in Appendix 7B.
INTERNATIONAL FINANCIAL REPORTING STANDARDS
Accounts Receivable. Until recently, IAS No. 3916 was the standard that specified appropriate accounting for accounts and notes receivables, under the category of Loans and Receivables. However, IFRS No. 9,17 issued November 12, 2009, will be required after January 1, 2013, and earlier adoption is allowed, so in the time period between 2010 and 2012 either standard could be in effect for a particular company that reports under IFRS. Still, both of the IFRS standards are very similar to U.S. GAAP with respect to accounting for accounts and notes receivable, with similar treatment of trade and cash discounts, sales returns, estimating bad debt expense, recognizing interest on notes receivable, and using an allowance for uncollectible accounts (which typically is called a “provision for bad debts” under IFRS). IFRS and U.S. GAAP allow a “fair value option” for accounting for receivables (although the IFRS standards restrict the circumstances in which that option is allowed). Also, IAS No. 39 permits accounting for receivables as “available for sale” investments if that approach is elected upon initial recognition of the receivable. IFRS No. 9 does not allow that option for receivables, and U.S. GAAP only allows “available for sale” accounting for investments in securities (so we discuss that approach further in Chapter 12). Finally, U.S. GAAP requires more disaggregation of accounts and notes receivable in the balance sheet or notes. For example, companies need to separately disclose accounts receivable from customers, from related parties, and from others. IFRS does not have that requirement.
12The entries shown assume the note is recorded by the gross method. By the net method, the interest component is netted against the face amount of the note as follows:
13This assumes that no other present or future considerations are included in the agreement. For example, a noninterest-bearing note might be given to a vendor in exchange for cash and a promise to provide future inventories at prices lower than anticipated market prices. The issuer values the note at the present value of cash payments using a realistic interest rate, and the difference between present value and cash payments is recognized as interest revenue over the life of the note. This difference also increases future inventory purchases to realistic market prices.
14FASB ASC 825–10–50–10: Financial Instruments—Overall—Disclosure—Fair Value of Financial Instruments (previously “Disclosures about Fair Value of Financial Instruments” Statement of Financial Accounting Standards No. 107 (Norwalk, Conn.: FASB, 1991)).
15FASB ASC 825–10–25: Financial Instruments—Overall—Recognition Fair Value Option (previously “The Fair Value Option for Financial Assets and Financial Liabilities” Statement of Financial Accounting Standards No. 159 (Norwalk, Conn.: FASB, 2007)).
16“Financial Instruments: Recognition and Measurement,” International Accounting Standard No. 39 (IASCF), as amended effective January 1, 2009.
17“Financial Instruments,” International Financial Reporting Standard No. 9 (IASCF), November 12, 2009.