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Lesson

In Chapter 9, we learned that promissory notes associated with Notes Payable, are notes (a contract) that is signed, when a business receives a loan from a bank. In this chapter, we will continue to look at promissory notes, but this time, we will be looking at how businesses sometimes have their customers sign promissory notes. Businesses do not generally offer loans to customers, but there are times promissory notes are needed, such as ...

1. To allow a customer extra time to pay on account. This is not standard practice, but if we allow extra time, we expect to be compensated with interest, and we want it in writing that the customer promises to pay. This is referred to as extension of time on account.
2. A customer may be purchasing an expensive item from us and the only way they can purchase it is if they are allowed to pay over time. In this case, we would have the customer sign a promissory note, and expect the customer pay interest for these terms. A note would be signed at the time the sale is made.

In the transactions below, the terms of the note are provided (how many days the customer has to pay the amount back, the interest rate due when the note is paid), but we disregard that information when journalizing the note. That information is important when the note is paid. Notes Receivable is a new account for us; it is considered a current asset and is debited when we increase how much the customer owes us.

Issuing a Note Receivable for an Accounts Receivable

Issuing a Note for a Sale

Interest is collected the day the note is due. Interest collected is revenue to the business that initiated the note. Interest Income is classified as an Other Revenue account. The day the note is paid, the Notes Receivable account is decreased with a credit, the Interest Income account is increased with a credit, and Cash is increased with a debit. As always, debits must equal credits.

Receiving Cash for a Note Receivable

Dishonored Notes
In a perfect world, loans would always be paid and on time. Having a customer sign a Note Receivable does not guarantee payment. What it does do for the business that initiates it, is that it gets the loan in writing. If a customer refuses to pay, the note can be used as a contract in a court of law as proof the customer owes.

Sometimes customers do not honor a Note Receivable that is signed. When that happens, that is called dishonoring a note. The value of the note cannot continue to be a debit in Notes Receivable if the note is no longer valid. At this point, the business has a choice—get the customer to sign a new note, or transfer the note back into Accounts Receivable. If the note is transferred back to Accounts Receivable, it is expected that the customer owes the amount of original note PLUS the interest. Transferring the amount back to Account Receivable does NOT cancel the debt, it just reclassifies it. The business will continue trying to collect. Eventually, if the note is not collectible, the business may choose to write-off the account (as described in
Chapter 7).

Collecting on Dishonored Notes
It doesn't happen very often, but sometimes a note is dishonored and then the customer eventually pays. When this happens, the amount of the original note plus interest (which was already transferred into Account Receivable) is collected, but the customer will be expected to pay additional interest for the extra length of time it took to pay the note off.

Watch the video(s) below for a demonstration of how to issue notes receivable, dishonor notes, and record payment from dishonored notes.

Journalize Entries to Issue Notes Receivable Journalize Entry to Dishonor a Notes Receivable Journalize Entry to Record Payment of Dishonored Note Click HERE or on camera to start video

Application (using Aplia)

• Work Together 10-1
• On Your Own 10-1

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