Chapter 16 Lecture Notes

In this chapter you will learn how to record notes payable and notes receivable, how to determine whether an instrument meets the requirements of negotiability, and how businesses use promissory notes, drafts or trade acceptances to pay a large amount over a period of time.

Notes may be described in terms of months or days. When calculating interest the formula is Principle x Rate x Time, so for a two month (or 60 day) $1000 note with 10% interest you would either calculate this as 1000 x .10 x 2/12 (two months out of twelve) or 1000 x .10 x 60/360. Notice that a 360 day (bank’s year) is used for simplicities sake when calculating based on days. Also note that when calculating the maturity date of a note you do not include the issue date itself.

Recording the note payable involves a debit to the asset account and a credit to the notes payable account; when payment is made on the note you will debit notes payable for the amount of the note, debitinterest expense for the amount of the interest and cash for the total of the note plus the interest. If interest is deducted in advance from the note (so you receive the face amount of the note less the interest charge) it is called discounting. In this case you would debit cash for the amount of the note minus the amount of the interest, debit interest expense for the total interest, and credit notes payable for the face value of the note. When the note is paid you will debit notes payable for the face value and credit cash for the full amount – there is no need to make an entry for interest because it has already been recorded.

Notes receivable can be interest or non-interest bearing and can be issued either at the point of sale or to replace an overdue accounts receivable. If a note receivable is not collected at maturity, however, and arrangements have not been made for renewal, then it is considered “dishonored” and an entry must be made to transfer the balance out of notes receivable and back to accounts receivable: debit accounts receivable/account name for the value of the note and interest, credit notes receivable for the face value of the note, and credit interest income for the amount of interest. A company can discount (sell) a notes receivable if they have an immediate need for cash because a note receivable is an asset; however, remember that notes-receivable discounted represents a contingent liability. A detailed description of how to calculate and apply discounts can be found on pages 592-595.

Important internal controls for notes payable, notes receivable, and drafts are:

Limit the number of people who can sign notes for the firm.
Record all notes payable immediately.
Identify a specific person or department to be responsible for prompt payment of interest and principal for notes payable.
When paid, mark the note payable “Canceled” or “Paid” and file the note.
Handle drafts as carefully as checks.
Authorize certain persons only to accept notes.
Record all notes receivable in the accounting records.
Store notes receivable securely in a safe or fireproof vault to which access is limited.
Verify and compare the actual notes receivable to the notes receivable register.
Near the maturity date, inform the issuer of the approaching due date and the amount owed.
If payment is not received on the due date, contact the issuer immediately.
Review all past-due notes promptly and take necessary steps, including legal action, to ensure payment.