Customers frequently sign promissory notes to settle overdue accounts receivable balances. For example, if a customer named D. Brown signs a six‐month, 10%, $2,500 promissory note after falling 90 days past due on her account, the business records the event by debiting notes receivable for $2,500 and crediting accounts receivable from D. Brown for $2,500. Notice that the entry does not include interest revenue, which is not recorded until it is earned.
If a customer signs a promissory note in exchange for merchandise, the entry is recorded by debiting notes receivable and crediting sales.
A company that frequently exchanges goods or services for notes would probably include a debit column for notes receivable in the sales journal so that such transactions would not need to be recorded in the general journal. A separate subsidiary ledger for notes receivable may also be created. If the amount of notes receivable is significant, a company should establish a separate allowance for bad debts account for notes receivable.
When a note's maker pays according to the terms specified on the note, the note is said to be honored. Assuming that no adjusting entries have been made to accrue interest revenue, the honored note is recorded by debiting cash for the amount the customer pays, crediting notes receivable for the principal value of the note, and crediting interest revenue for the interest earned. The total interest on a six‐month, 10%, $2,500 note is $125, so if D. Brown honors her note, the entry includes a $2,625 debit to cash, a $2,500 credit to notes receivable, and a $125 credit to interest revenue.
If some of the interest has already been accrued (through adjusting entries that debited interest receivable and credited interest revenue), then the previously accrued interest is credited to interest receivable and the remainder of the interest is credited to interest revenue.
When the maker of a promissory note fails to pay, the note is said to be dishonored. The dishonored note may be recorded in one of two ways, depending upon whether or not the payee expects to collect the debt If payment is expected, the company transfers the principal and interest to accounts receivable, removes the face value of the note from notes receivable, and recognizes the interest revenue. Assuming D. Brown dishonors the note but payment is expected, the company records the event by debiting accounts receivable from D. Brown for $2,625, crediting notes receivable for $2,500, and crediting interest revenue for $125.
If D. Brown dishonors the note and the company believes the note is a bad debt, allowance for bad debts is debited for $2,500 and notes receivable is credited for $2,500. No interest revenue is recognized because none will ever be received.
If interest on a bad debt had previously been accrued, then a correcting entry is needed to remove the accrued interest from interest revenue and interest receivable (by debiting interest revenue and crediting interest receivable). Although interest revenue would have been overstated in the accounting periods when the interest was accrued and would be understated in the period when the correcting entry occurs, efforts to amend prior statements or recognize the error in footnotes on forthcoming statements are not necessary except in rare situations where the bad debt changes reported revenue so much that the judgment of those who use financial statements is materially affected by the disclosure.
Companies classify the promissory notes they hold as notes receivable. A simple promissory note appears below.
The face value of a note is called the principal, which equals the initial amount of credit provided. The maker of a note is the party who receives the credit and promises to pay the note's holder. The maker classifies the note as a note payable. The payee is the party that holds the note and receives payment from the maker when the note is due. The payee classifies the note as a note receivable.
Calculating interest. Notes generally specify an interest rate, which is used to determine how much interest the maker of the note must pay in addition to the principal. Interest on short‐term notes is calculated according to the following formula:
For example, interest on a four-month, 9%, $1,000 note equals $30.
When a note's due date is expressed in days, the specified number of days is divided by 360 or 365 in the interest calculation. You may see either of these figures because accountants used a 360‐day year to simplify their calculations before computers and calculators became widely available, and many textbooks still follow this convention. In current practice, however, financial institutions and other companies generally use a 365‐day year to calculate interest. Therefore, you should be prepared to calculate interest either way.
The interest on a 90‐day, 12%, $10,000 note equals $300 if a 360‐day year is used to calculate interest, and the interest equals $295.89 if a 365‐day year is used.
Even when a note's due date is not expressed in days, adjusting entries that recognize accrued interest are often calculated in terms of days. Suppose a company holds a four‐month, 10%, $10,000 note dated October 19, 20X2. If the company uses an annual accounting period that ends on December 31, an adjusting entry that recognizes 73 days of accrued interest revenue must be made on December 31, 20X2. To determine the number of days in this situation, subtract the date of issue from the number of days in October and then add the result to the number of days in November and December (31 ‐ 19 = 12; 12 + 30 + 31 = 73). Notice that when you count days, you omit the note's issue date but include the note's due date or, in this situation, the date that the adjusting entry is made. Assuming the interest calculation uses a 365‐day year, the accrued interest revenue equals $200.
The adjusting entry debits interest receivable and credits interest revenue.
Interest on long‐term notes is calculated using the same formula that is used with short‐term notes, but unpaid interest is usually added to the principal to determine interest in subsequent years. For example, a two‐year, 10%, $10,000 note accrues $1,000 in interest during the first year. The principal and first year's interest equal $11,000 when compounded, so $1,100 in interest accrues during the second year.