Notes Receivable Recognition and Valuation

Notes Receivable Recognition and Valuation

Notes receivable are written promises by borrowers to repay a specific amount in the future. They represent financial assets on a company’s balance sheet.

What Is Notes Receivable Recognition?

The note receivable is supported by a formal promissory note, a written promise to pay a certain sum of money at a specific future date.

Such a note is a negotiable instrument that a maker signs in favor of a designated payee who may legally and readily sell or otherwise transfer the note to others. Although all notes contain interest elements, because of the time value of money, companies classify them as interest-bearing or non-interest-bearing. Interest-bearing notes have a stated rate of interest.

Zero-interest-bearing notes (non-interest-bearing) include interest as part of their face amount.

Notes receivable are considered fairly liquid, even if long-term, because companies may easily convert them to cash (although they might pay a fee to do so). Companies frequently accept notes receivable from customers who need to extend an outstanding receivable payment period.

Or they require notes from high-risk or new customers. In addition, companies often use notes in loans to employees and subsidiaries and the sales of property, plant, and equipment.

In some industries (e.g., the pleasure and sport boat industry), notes support all credit sales. The majority of notes, however, originate from lending transactions. The basic issues in accounting for notes receivable are the same as those for accounts receivable:(recognition, valuation, and disposition.

Companies generally record short-term notes at face value (fewer allowances) because the interest implicit in the maturity value is immaterial.

A general rule is that notes treated as cash equivalents (three months or fewer maturities and easily converted to cash) are not subject to premium or discount amortization.

However, companies should record and report long-term notes receivable at the present value of the cash they expect to collect.

When the interest stated on an interest-bearing note equals the effective (market) rate of interest, the note sells at face value 9 When the stated rate differs from the market rate, the cash exchanged (present value)differs from the face value of the note.

Companies then record this difference, either a discount or a premium, and amortize it over the life of a note to approximate the effective (market) interest rate. This illustrates one of the many situations in which time value of money concepts are applied to accounting measurement.

Note Issued at Face Value

To illustrate the discounting of a note issued at face value, assume that AzCorp lends KaImports $10,000 in exchange for a $10,000, three-year note bearing interest at 10 percent annually. The market rate of interest for a note of similar risk is also 10 percent.

YearCash InflowsCash Outflows
Year 0$10,000 (Loan)
Year 1
Year 2
Year 3$10,000 (Principal)$1,000 (Interest)

Here in this table;

  • In Year 0, AzCorp lends $10,000 to KaImports, which is the initial loan amount.
  • In Year 3, KaImports repays the principal amount of $10,000 to AzCorp.
  • Additionally, over the three-year period, KaImports pays annual interest on the loan at a rate of 10 percent. The interest payment for each year is $1,000, which accumulates to $3,000 in total.

Note Not Issued at Face Value

“Note Not Issued at Face Value” is a term used to describe a financial document like a promissory note or bond. It means the document is being sold or traded in the market at a price lower than its worth.

The worth of the document called the face value or par value, is the value stated on it. It represents the main amount of money the issuer promises to pay back when it matures. However, different factors can change the document’s price from its face value.

When a document is sold at a price lower than its face value, it is called “not issued at face value.”

This happens when the interest rate offered by the document is lower than the interest rates in the market. Investors may want a discount to compensate for their expected lower return. This discount causes the document to be sold for less than its face value.

For example, a company releases a bond with a face value of $1,000 and an annual interest rate of 5%.

But the interest rates in the market have increased, making other bonds with higher interest rates more appealing.

So, investors might buy the company’s bond for a discounted price of $900. In this case, the bond is not issued at face value because it’s sold for less than its stated value of $1,000.

YearCash InflowsCash Outflows
Year 0$900 (Investment)
Year 1
Year 2
Year 3$1,000 (Principal)$50 (Interest)

The table show;

  • In Year 0, investors purchase the bond for $900, which is the initial investment amount.
  • In Year 3, the bond reaches its maturity, and the company repays the principal amount of $1,000 to the investors.
  • Throughout the three-year period, the bond pays annual interest at a rate of 5 percent. The interest payment for each year is $50, accumulating to a total of $150.

The difference between the discounted price and the face value shows the potential return or profit for the investor. The buyer will still receive the full face value when the document matures, but the lower purchase price allows for a higher effective return.

There are different types to consider when it comes to financial instruments that are not issued at face value.

  1. Discounted Notes: These are promissory notes or bonds that are sold for less than their face value. The difference between the purchase price and the face value is like interest or profit for the investor.
  2. Zero-Coupon Bonds: These bonds have regular interest or coupon payments. Instead, they are sold at a lower price than their face value and reach their full value at maturity. The gap between the purchase price and the face value determines the investor’s return.
  3. Deep Discount Bonds: Like zero-coupon bonds, deep discount bonds are sold at significantly lower than their face value. The discount offered is usually higher than what is typically seen in other bonds.
  4. Premium Bonds: Unlike the previous types, premium bonds are sold at a price higher than their face value. This means that investors pay more than the nominal value of the instrument. The premium is usually a result of the bond offering a higher interest rate compared to prevailing market rates.
  5. Convertible Securities: These are financial instruments, such as convertible bonds, that can be converted into a different security, often common stock, at a predetermined conversion price. The ability to convert adds value to the instrument, resulting in a price above its face value.

These examples represent different financial instruments that may not be issued at face value. The specific characteristics and categories can vary based on the market, issuer, and prevailing economic conditions.

Type of InstrumentDescriptionExample
Discounted NotesNotes issued at a price below their face value, providing a discount as a form of yield for investors.Treasury bill sold at a discount of $95 for a face value of $100.
Zero-Coupon BondsBonds that do not pay regular interest but are issued at a discount to face value, maturing at their full face value.Zero-coupon corporate bond purchased for $800 with a face value of $1,000.
Deep Discount BondsBonds issued at a significant discount to their face value, typically higher than other bonds.Municipal bond sold at a discount of 30% with a face value of $1,000.
Premium BondsBonds issued at a price higher than their face value, reflecting a higher interest rate compared to prevailing market rates.Corporate bond purchased for $1,100 with a face value of $1,000.
Convertible SecuritiesFinancial instruments, such as convertible bonds, that can be converted into a different security, usually common stock, at a predetermined conversion price.Convertible bond allowing conversion into 100 shares of the issuer’s common stock at $10 per share.

Zero-Interest-Bearing Notes

If a company receives a zero-interest-bearing note, its present value is the cash paid to the issuer. Because the company knows both the future amount and the note’s present value, it can compute the interest rate. This rate is often referred to as the implicit interest rate. Companies record the difference between the future (face) amount and the present value (cash paid) as a discount and amortize it to interest revenue over the life of the note.

To demonstrate, ASUS Company receives a three-year, $10,000 zero-interest-bearing note, to present value of which is $7,721.8). The implicit rate equates to the total cash received.

Interest-Bearing Notes

Often the stated rate and the effective rate differ. The zero­interest-bearing note is one example.

To illustrate a more common situation, assume that Morgan Corp makes a loan to Marie Co. and receives in exchange a three-year, $10,000 note bearing interest at 10 percent annually. The market rate of interest for a note of similar risk is 12 percent.

Valuation of Notes Receivable

Like accounts receivable, companies record and report short-term notes receivable at their net realizable value—that is, at their face amount less all necessary allowances.

The primary notes receivable allowance account is Allowance for Doubtful Accounts. The computations and estimations involved in valuing short-term notes receivable and in recording bad debt expense and the related allowance exactly parallel that for trade accounts receivable.

Companies estimate the amount of uncollectible by using either a percentage of sales revenue or an analysis of the receivables.

Long-term note receivables involve additional estimation problems.

For example, the value of a note receivable can change significantly over time from its original cost. That is, with time, historical numbers become less and less relevant. FASB requires that companies disclose their cost and fair value in the notes to the financial statements for financial instruments such as receivables.

Fair Value Option

Recently the Board has taken the additional step of giving companies the option to use fair value as the basis of measurement in the financial statements.

The Board believes that fair value measurement for financial instruments provides more relevant and understandable information than historical cost. It considers fair value to be more relevant because it reflects the current cash equivalent value of financial instruments.

As a result, companies now have the option to record fair value in their accounts for most financial instruments, including receivables.

If companies choose the fair value option, the receivables are recorded at fair value, with unrealized holding gains or losses reported as part of net income.

An unrealized holding gain or loss is the net change in the fair value of the receivable from one period to another, exclusive of revenue recognized but not recorded. As a result, the company reports the receivables at fair value on each reporting date. In addition, it reports the change in value as part of net income.

Companies may elect to use the fair value option when the financial institution is originally recognized or when some event triggers a new basis of accounting (such as when a business acquisition occurs). Suppose a company elects the fair value option for a financial instrument.

In that case, it must continue using fair value measurement for that instrument until the company no longer owns it.

Suppose the company does not elect the fair value option for a given financial instrument at the date of recognition. In that case, it may not use this option on that specific instrument in subsequent periods.

Recording Fair Value Option

Assume that Escobar Company has notes receivable that have a fair value of $810,000 and a carrying amount of $620,000. Escobar decided on December 31, 2010, to use the fair value option for these receivables.

This is the first valuation of these recently acquired receivables. Having elected to use the fair value option, Escobar must value these receivables at fair value in all subsequent periods in which it holds these receivables.

Similarly, if Escobar does not use the fair value option, it must use its carrying amount for all future periods.

Escobar reports the receivables at fair value when using the fair value option, with any unrealized holding gains and losses reported as part of net income.

The unrealized holding gain is the difference between the fair value and the carrying amount on December 31, 2010, which for Escobar is $190,000 ($810,000 – $620,000). On December 31, 2010, Escobar made an adjusting entry to record the increase in value of Notes Receivable and to record the unrealized holding gain, as follows.

Notes Receivable$190,000
Unrealized Holding Gain$190,000

Escobar adds the difference between fair value and the cost of the notes receivable to arrive at the fair value reported on the balance sheet. In subsequent periods, the company will report any change in fair value as an unrealized holding gain or loss.

For example, Escobar would recognize an unrealized holding loss of Tk on December 31, 2011; the fair value of the notes receivable is $800,000 and 10,000 ($810,000 – $800,000) and reduce the Notes Receivable account.

A note receivable may become impaired. A note receivable is considered impaired when it is probable that the creditor cannot collect all amounts due (both principal and interest) according to the contractual terms of the receivable. In this case, a loss is recorded for the amount of the impairment.

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