Companies may grant credit in exchange for a promissory note.
When this happens a Notes Receivable is created.
Notes Receivable are often exchanged when money is lent,
or a transaction doesn't fall into the parameters of a normal Accounts Receivable,
or maybe in settlement of a past due accounts receivable.
The source document of a Notes Receivable is a promissory note.
A promissory note is a legal document that binds parties in a contract.
The student loan is a type of promissory note.
Here are some terms related to Notes Receivable that you will want to be familiar with.
You may want to pause the video and write these definitions down.
Computing interest is an important part of properly accounting for notes receivable.
You've probably learn how to do this calculation before in some business or financial math class.
but we will revisit it here.
Interest is calculated by taking the principle of the note,
times the annual interest rate of the note,
times the term of the note.
I remember this with the acronym PRT: principle, times rate, times time.
Make sure to remember that interest is always stated in terms of an annual rate,
so time must also be in terms of one year.
Here are some examples to reinforce that point.
We have three notes here. Let’s calculate interest for each of them.
For Note One the interest is $10,000,times 6% interest, times 120 three sixty-fifths.
which equals $197.
You can see that the term 120 days is converted into years by dividing 120 by 365.
For Note Two the interest is $50,000, times 4%, times 6/12, which equals a $1000.
You can see that the term "six months" is converted into years by dividing 6 by 12.
Finally Note Three is for one year, so it's just principle times rate times one.
Let's look at a typical example.
The Duran Duran company accepts a $5000 three month, 6% promissory note, dated May 1
in settlement of an open account from a customer.
The journal entry to record this note is a debit to Note Receivable for the $5000,
and a credit to Accounts Receivable, since the note was issued to settle a past due account.
And also the amount is $5000.
Assume that on August 1 Duran Duran receives payment
from the customer in settlement of the note.
The journal entry to record the settlement of the note is a debit to cash for $5,075.
This amount equals the principle plus the interest,
a credit to Notes Receivable for $5000 to remove that account from our books,
and a credit to interest revenue for $75.00
for the three months of interest earned.
You can see the interest calculation on the slide here.
So these are the basic entries for issuing and then settling a Note Receivable.
But before we wrap up this video let's complicate this example just a bit.
In this case, let's assume the transaction is dated December 1st rather than May 1st.
How does that change our journal entries?
Well, the issuance of the note is still the same.
But we have to make an adjusting entry on December 31st
to accrue the amount of interest revenue earned during the month of December.
So the adjusting entry would be for $25.00,
because that's one month of interest.
Finally, the collection of the note on March 1st is a lengthy journal entry,
but we can work through it.
Cash is still debited for $5,075, which is the principle plus the interest collected.
Notes Receivable is still credited for $5,000,
because that account balance needs to be zero after the customer pays it off.
Interest Receivable, which has a $25.00 debit balance from the December 31st adjusting entry,
also needs to be credited for $25,
because that account balance needs to be zero after the customer pays it off.
Finally, interest revenue is credited for $50.00
because that's the amount of interest earned in the new year.