7. Notes Receivable

Let's talk about notes receivable. Notes receivable have a couple of different components. The first one is the principal. This is usually something like $1,000. This is the amount of money borrowed. That's the first component. The second component is the interest, and interest is just the cost of borrowing. So if you're borrowing $1,000, you can't borrow $1,000 for free, at least not from any reasonable institution. So interest becomes the cost of borrowing. And to the person that's borrowing, it's an expense, but to the person that's lending, it's a revenue. So if a bank loans you $100,000 to buy a house, the interest that you pay them is interest revenue.

To you, that's an interest expense. So depending on what side of the equation you're on, this becomes your revenue or your expense. The third one is called the maturity value. Now, the maturity value is pretty simple. It's one plus two. It's your principal plus your interest. So if you borrowed $1,000 and you have $80 of interest, your maturity value is $1,080. The last part about a note receivable is it has some time period, and that's always gonna be the annual percentage rate. So it's always gonna be for a year. So if you're dealing with a note that's 60 days or even six months, you're gonna have to convert the annual percentage rate down to a 60-day or a six-month percentage rate.

So enough of this nonsense. Let's take a look at something. So if you have a note for $1,000 and it is a 90-day, let's say 6% note. So this is 90 days later. And this is day zero. So you loan someone $1,000 for 90 days at 6%. Now, don't be tempted to come over here and put $1,060 is what you're gonna get paid back, because you saw the 6%, and in your head you went 1,000, 6, $1,060. I'm a genius. You are a genius, but the problem is that 6% is the annual percentage rate.

Remember I told you annual percentage rate? I guess in my head I was thinking annual percentage yield. Typically, you'll see APR. APY is a thing, but don't worry about that. So what you need to do is you need to say $1,000 times 6% times 90 days divided by 360 days, because this right here, this adjustment will take our 6% from an annual percentage rate and put it down on this 90-day rate. So if we do that and we get 1,000 times .06 times 90 divided by 360, we get 15. So what this tells us is the interest is $15.

We will receive $15 for letting this company or this person borrow the money for 90 days. $15 is the interest. So at the end of the 90 days, we will get $1,015 back. And in financial accounting, or at least on all your tests and quizzes, you're typically gonna be using 360 because it makes it a lot simpler. It makes it very divisible. 'Cause if you have 12 months and we assume that all of them are 30 days, you end up with 360 days, and that just makes the math work out so much nicer.

Now let's look and see how this would work if we were doing the journal entries for it. The first journal entry would be we would increase our note receivable by $1,000 because this is an asset. We're loaning $1,000 out, but in exchange we're getting a $1,000 note receivable, so we're just swapping assets around. But we also loaned out $1,000 cash, so we have to decrease our cash. So that takes care of this guy right here. And then when we get over to here, we get $1,000 back plus an extra $15. So what we need to do is we need to decrease our note receivable because now the note is paid off and increase our cash.

But hang on, we got $1,015 in cash, didn't we? Those two don't match. We need another $15 over here. And what we call that is we call that one interest revenue. So we earned $15. And anytime you hear the word earned, that should set off a little alarm in your head that says revenue. So when you earn something, it becomes a revenue. So the interest revenue plus the note receivable gives us our $1,015. And I'm sure you know what's coming next. If we have an amount of money that we're earning over a period of time, what's the next question?

What happens when the end of the year falls in the middle? Same song, second verse. So if we make a loan or put out a note of $3,000 on December 1, and it's also a 90-day note. So let's say 90 days at 6%.

That's 12/1. The question will say something like, "On 12/31, what's the adjusting entry?" And then it'll also say, "On March 1, what is the entry at maturity?" So it's asking for two entries. What's the adjusting entry at 12/31, and what's the entry at maturity when the note is paid off? So let's do this again and see if we can figure out, over the life of this note, how much interest is going to be earned. So we have $3,000 times 0.6%, and that's per year, so we also wanna multiply that by 90 days over 360 days to find out, over the life of our note, what's it gonna be.

And to spare you from any mistakes, I'm gonna go ahead and just calculate it. Times 90 divided by 360. $45. Would not have been able to do that in my head. So the interest comes out to be $45. So this is a good start. Over the life, we know it's gonna be $45.

But the question says, "What's the adjusting entry?" So what's the entry that happens right here? So we know that over the life we're gonna earn $45, but how much do we earn in the month of December? So in the month of December, it's gonna look more like this. $3,000 times our 6% times one month worth of interest earning, and that's gonna come out to $15. So our adjusting entry on 12/31, we need to recognize the fact that over this month right here, we've earned $15 of interest. We haven't been paid that $15, but hey, we earned it. So we record an interest receivable at $15, and we record interest revenue at $15 because at 12/31 we've legitimately earned that revenue.

Now, the rest of the question says, "On 3/1, at maturity, what is the entry gonna be?" So at 3/1, on maturity, we know that we're gonna get $3,045 of cash. Because we know that the principal was $3,000, the interest was $45, so we get $3,045 worth of cash at maturity.

So we get $3,045. We know our note receivable goes down by $3,000 because that's the principal amount, and the note receivable always and only ever stores the principal amount. Don't ever put your interest in there. Don't ever put anything else in there. Only principal goes in the note receivable account.

So we know that note receivable goes down by $3,000 because now we have received it. We also know that this interest receivable right here is also gonna go down by $15 because at 12/31 we put it into the receivable account because we hadn't yet received it. Now that we have received it, we need to decrease our interest receivable by the $15.

So now we're at $3,015, and the other $30 is the interest revenue that we earned in these first two months of the new year. So this $30 right here hasn't yet been recorded anywhere, and that becomes our interest revenue for the new year.

So let's walk this through again. Start with cash because you know how much cash you're gonna get. You're gonna get the principal amount plus the interest amount, which is gonna give you your maturity value of $3,045. You need to take all of the principal out of your note receivable because now that you have received it, you decrease your note receivable account. Then on 12/31 we recognized $15 of revenue and said, "We've earned it, but we haven't yet received it, so let's put it in this receivable bucket." Now that we have received it, we need to decrease that receivable bucket. And finally, during this new year, we earned another $30 in interest, and so we recognize that as revenue in the new year.

In the year before, we earned $15. In the current year, we earned $30. So this all together gives us our $3,045, which makes our debits and credits match.