This is principlesofaccounting.com, Chapter 7 on Accounts Receivable.
In this module, we will look at notes receivable and interest charges thereon.
We'll also consider how receivables,
accounts receivable might be converted to notes receivable.
So, that first requires us to consider the need to monitor and
manage accounts receivable.
First, companies must try to avoid bad debts
by carefully monitoring their credit policies.
We should consider the credit history of our customers.
We might secure payment in advance.
We might even receive a guarantee from a third party or a line of credit at a bank
that ensures or assures payment of the amounts that are due.
It's very important for a company to carefully monitor and
manage their accounts receivable as liquidity can be adversely impacted
if receivables are not collected in a timely manner.
Therefore, certain ratios have been developed,
such as the accounts receivable turnover ratio, which measures how many times
a firm's receivables are converted to cash during the year.
Very simply,
it's net credit sales divided by average net accounts receivable for the period.
A related ratio is days outstanding.
It measures how many dales sales are carried in the receivables category.
And it is 365 days divided by the accounts receivable turnover ratio from up above.
We also want to consider or compare our numbers to discern trends
against industry competitors, as well as against prior years.
They can provide an early warning, potential problems and
receivables management and rising bad debt risks.
If the receivables collection period is longer than the norm, or is growing in
length, it may suggest a growing credit problems for a particular company.
Now, sometimes a company will, when they're having trouble collecting
a receivable or needing to formalize a receivable, they'll actually have
the customer exchange the informal account receivable for a formal note receivable.
Which is a written promise from a client or customer to pay a definite amount of
money on a specific future date, perhaps with interest.
Their notes are formal, they're enforceable,
they may even become negotiable.
Certain terminology related to notes.
The maker is the party promising to make payment under the note.
The payee is the party to whom payment will be made.
The principal is the stated amount of the note.
The maturity date is the day on which the note is due.
And finally, interest is the charge for the use of the money,
it's usually reflected as principal times rate times time.
To look at an example, assume a $1,000, 60-day note bearing interest at 12%.
The interest for that 60 day period will be $20, that's $1,000
principal times 12% rate times, and I'm using a 360 year assumption.
So, times 60 days outstanding divided by 360 days.
So, the product of that multiplication is $20, the amount of interest.
Interest might be calculated on a 360 day or a 365 day year.
The 365 day is simpler for calculation purposes.
Typically used in textbook illustrations.
Maybe used in business applications as well.
It tends to benefit the lender or the payee of the note a bit since you're
assuming the interest accrues at a faster rate with a 360 day year.
Okay, assume that $10,000 of merchandise is sold on account to Hewlett.
Hewlett requests more time to pay and
agrees to give a formal three-month note bearing interest at 12% per year.
So, at the time, the account receivable is exchanged for the note receivable.
We're debiting notes receivable and crediting accounts receivable, $10,000.
That, of course, increases the one asset note receivable and
removes the account receivable, the other asset, from the books.
When the note matures, the collection is recorded.
We debit cash, 10,300.
We credit the principal amount of the note receivable, 10,000.
The differences is recorded as the interest income.
We should be able to verify that $300 amount of interest, $10,000 principal
times 12% times 90 over 360 days, or one-fourth of a year.
So that's 3%, or $300, net of interest.
Now, if Hewlett refused to pay at maturity,
the note is said to be dishonored.
We're gonna go after Hewlett and try to collect the note.
So now I'm coming back and debiting accounts receivable, 10,300.
I'll remove the note receivable that has been dishonored from the books.
I'll go ahead and record the interest income,
I'm still expecting to collect that.
If I'm in doubt about that, I might follow an alternative accounting path.
But I'm assuming, here, we're still gonna be able to find Hewlett and
collect the money that's due to us.
Now, like many other transactions,
notes receivable may give rise to adjusting entries for accrued interest.
The note we previously looked at, the $10,000 note,
that came in to existence on June 1, assume we have a June 30 year end.
So, in this particular case, we're going to record interest for
one month at the end of our year, or t the end of our month, June 30th.
That's $100 of interest.
We'll debit to interest receivable.
And credit interest income to reflect accrued interest income and
the related receivable associated with that.
When payment actually occurs on August 31, we'll be debiting cash,
10,300, recording the collection of the $10,000 note.
Recording collection of the $100 of interest receivable, and
recording the other $200 as interest income for the month of July and August.
And so this entry that demonstrates the final collection of the note
closes our consideration of the material in this particular chapter.