Accounting Fundamentals II: Lesson 5 Page 1 of 8

Accounting Fundamentals II: Lesson 5 (printer-friendly version)

Your Instructor: Charlene Messier

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Chapter 1

Introduction

In this lesson, you will learn about Notes Payable, Notes

Receivable, and interest. At the end of the lesson, you will be
able to calculate interest for a partial or full year, and determine
the maturity date of a Note Payable or Note Receivable (when it
is due to be paid). Although most notes are interest bearing,
some may be non-interest bearing, meaning that the borrower
need only repay the initial amount borrowed on the maturity
date.

Most notes carry an interest amount that is, in effect, the fee for
being able to borrow money for a specified period of time, or to
pay a bill at a later date. Although a business usually extends
credit to a customer for up to 30 days, the customer should
expect to pay interest on the outstanding balance after that time frame.

In addition to calculating the amount of interest due on a Note Receivable and Note Payable, and
determining the maturity date, you will be journalizing entries to record Notes Receivable and Notes
Payable, and the interest.

Keeping accurate records regarding Notes Receivable and Notes Payable is of great importance to the
business. Remember, money owed to the business and money that the business owes others has a
tremendous bearing on the overall success of the business. There are always times when a business
needs to borrow money; likewise, there are always times when a customer may need to be extended
credit. However, careful consideration must be given in both areas to keep the business profitable and
thriving. With these points in mind, let's move on to Chapter 2 and get started!

You won't need to print out any new forms for this lesson, but be sure to check your work against the
solutions in the Supplementary Material before you move on to Lesson 6.

Chapter 2

Promissory Notes

A promissory note is a document that a customer signs, promising to pay a sum of money at a specific
time. A promissory note is often referred to simply as a note. It may be for funds borrowed from a bank
or some other lending institution, or it may be a note from a customer who requests credit beyond the
normal time given by the business.

Notes differ from the usual Accounts Receivable in that a note can be endorsed and transferred to a

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bank for cash. Therefore, a business can, if desired, receive the cash from a note receivable prior to its
maturity date. In addition, a signed, written note is proof of the debt in the event that the situation goes
to court for collection.

Many businesses use a preprinted note form that makes the writing of a note payable easier and
ensures that all vital information is included. Pertinent information includes:

z Date of the note: The date that the note was issued.

z Time of the note: The days, months, or years from the date of issue until the note is to be paid.

z Payee of the note: The person or business to whom the amount of a note is payable.

z Principal of the note: The original amount of the note, sometimes referred to as the face
amount of the note.

z Interest rate of the note: The percentage of the principal that is paid for use of the money.

z Maturity date of the note: The date that the note is due.

z Maker of the note: The person or business who signs a note and thus promises to make
payment.

z Number of the note: The number assigned by the maker to identify a specific note.

Interest is the amount that a borrower pays for the use of money over a specified period of time.
Lending institutions and banks usually charge interest on the money they loan. The interest rate is
stated as a percent, and the dollar amount of the interest depends on the amount borrowed and the
length of time that the borrower wishes to take to repay the money.

A note that includes interest in the repayment is referred to as an interest-bearing promissory note.
Occasionally, only the principal is due on the note. This is referred to as a non-interest-bearing note.

Sometimes the borrower makes monthly payments to the bank or lending institution. This is particularly
true in the purchase of a car or home. In this case, the monthly payment includes an amount of the
principal and an amount of the interest. The total of all of the payments equals the total amount
borrowed plus the total interest on the loan.

Calculating Interest

The dollar amount for interest is determined by multiplying the

amount borrowed by the interest rate. That total is the interest
for one year. For example, if you borrow $10,000.00 for one
year at a rate of 8%, the interest amount would be $800.00
($10,000.00 × .08). The total amount you would have to pay
back is $10,800.00. The bank would receive $800.00 for
lending you the $10,000.00 for one year.

If you borrow money for less than one year, the interest rate must be reduced to reflect the amount of
time that the money will be borrowed for. For example, if you borrowed $5,000.00 for 90 days at a rate
of 6%, the interest would be calculated as follows: $5,000.00 × .06 = $300.00. $300.00 × 90/360 =
$75.00. After 90 days, you would owe $75.00 in interest. The total amount you would have to pay back
in 90 days would be $5,075.00.

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When figuring interest on a note under a year in length, the time is expressed as a fraction of a year. In
the example above, 90/360 is equivalent to one quarter of a year. Likewise, 180 days would be the
same as half a year (180/360). The federal government generally uses a 365-day year in calculating
interest, but most businesses and banks use a 360-day year. Therefore, in this course, we will use a
360-day year to determine interest amounts.

Calculating Maturity Dates

The maturity date is the date on which the note is due and payable. This time span can be expressed
in days, months, or years. When the time is expressed in months, simply count forward the number of
months that the note is written for to arrive at the maturity date. For example, a three-month note
written on March 11 would be due on June 11. A six-month note written on November 5 would be due
on May 5 of the next year.

For a note payable in days, you must determine on what date the note will become payable by
determining the days in each month until you reach the number of days that the note is written for. The
date on which the note is written is not counted, but the date on which it is due is counted in
determining the due date. For example, a note written on June 10 for 45 days would be determined as
follows:

June 10 through 30 = 20 days

July 1 through 25 = 25 days

This note would be due on July 25.

Let's do another one.

A note is written on May 15 for 90 days. The due date is determined as follows:

May 15 through 31 = 16 days

June 1 through 30 = 30 days
July 1 through 31 = 31 days
August 1 through 13 = 13 days

The note would be due on August 13.

Chapter 3

Notes Payable

A creditor is a person or organization to whom money is owed. A creditor might be a bank, credit union,
or credit card company. Notes Payable are promissory notes that a business issues to its bank or
lending institution. Current liabilities are liabilities due within a short period of time, usually a year or
less. Most Notes Payable are paid within one year, so they are classified as current liabilities.

One account affected when a business issues a Note Payable is Notes Payable. This is a liability
account that has a normal credit balance. It increases on the credit side and decreases on the debit
side. The second account to be affected is the Cash account, which increases with a debit entry when
the business receives the cash from the Note Payable. The bank or other lending institution will retain
the original note from the business until the note is paid. The business uses a copy of the note as the
source document when recording the transaction. The abbreviation NP stands for Note Payable.

Let's journalize a transaction for a Note Payable:

Transaction #48: Dec. 13, Issued a six-month note in the amount of $5,000.00, Note

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Payable No. #1.

To journalize this transaction, enter the date on the next available line in the Cash Receipts Journal. In
the Account Title column, enter Notes Payable and put the document number, NP1, in the Doc. No.
column. Enter $5,000.00 in the General Credit column and also in the Cash Debit column.

Let's do a couple more.

Transaction #49: Dec. 13, Issued a one-year note in the amount of $6,000.00, Note
Payable #2.

Transaction #50: Dec. 13, Issued a 90-day note in the amount of $3,000.00, Note
Payable #3.

When you have journalized these three transactions, post the amounts from the General Credit column
of the Cash Receipts Journal to the General Ledger.

Paying the Principal and Interest on a Note Payable

On the maturity date of a Note Payable, the borrower must pay the principal amount plus the interest
amount to the payee. Accrued interest on borrowed money is referred to as interest expense. This is a
direct expense to the business and has its own General Ledger account. Expense accounts have a
normal debit balance and increase with an entry on the debit side.

Let's do a few transactions involving paying Notes Payable with accrued interest. Even though it would
be at a later date, we will use December 14 as the date to keep all of our transactions for this course in
the month of December.

Transaction #51: Dec. 14, Paid cash for the maturity value of Note Payable #1: principal,
$5,000.00, plus interest, $200.00 — Total, $5,200.00, Check #15.

To journalize this transaction, enter the date on the next available line in the Cash Payments Journal.
In the Account Title column, enter Notes Payable, and put 15 in the Ck. No. column, for Check #15.
Enter $5,000.00 in the General Debit column. On that same line, enter $5,200.00 in the Cash Credit
column. On the next line, enter Interest Expense in the Account Title column, and put $200.00 in the
General Debit column. That's all there is to entering this transaction.

Let's do one more.

Transaction #52: Dec. 14, Paid cash for the maturity value of Note Payable #2: principal,
$6,000.00, plus interest, $480.00 — Total, $6,480.00, Check #16.

Now you should post from the General Debit column to the General Ledger.

Sometimes a business requires more time to pay a vendor than the usual terms that the vendor offers.
If the vendor agrees, an extension of time is granted for the payment of the amount due. In this case,
the business would issue a Note Payable to the vendor and take the amount of the Note Payable out of
the Accounts Payable account, then enter it into the Notes Payable account. Interest is usually charged
on the balance due from the date of the Note Payable until the specified maturity date.

Let's try a transaction of this type.

Transaction #53: Dec. 14, Issued a 60-day note to Certain Winners, Inc. for an
extension of time on this account payable, $2,000.00, Note Payable #4.

To journalize this transaction, enter the date on the next available line in the General Journal. In the

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Account Title column, enter Accounts Payable/Certain Winners, Inc. In the Doc. No. column, enter
NP4, and enter $2,000.00 in the Debit column. On the next line, put Notes Payable in the Account Title
column and enter $2,000.00 in the Credit column.

When you post this transaction to the Accounts Payable Ledger into Certain Winners' account, it will
decrease the credit balance by $2,000.00. In the General Ledger, it will increase the Notes Payable
account by $2,000.00, and will decrease the credit balance in Accounts Payable by $2,000.00. In
essence, this takes the $2,000.00 out of Accounts Payable and puts it into Notes Payable. Because
both Accounts Payable and Notes Payable are liability accounts, the liabilities of Teammates, Inc.
remain the same.

Issuing and Paying a Discounted Note Payable

Some lending institutions require that the interest on a note be

paid at the time that the note is written. When interest is collected
in advance of the maturity date, it is called a bank discount. The
note on which the interest is paid in advance is referred to as a
discounted note. The amount of the note after the interest has
been deducted is called the proceeds.

The interest is determined in the same manner as any Note

Payable. However, the interest is paid at the time that the note is
written and is deducted from the amount being borrowed. For
example, if a business borrows $5,000.00 for one year at a rate of
8%, the interest would be $400.00. The lending institution would give the business $4,600.00, which is
the amount requested minus the interest due ($5,000.00 − $400.00 = $4,600.00).

Let's journalize a discounted note:

Transaction #54: Dec. 14, Discounted at 8% a 12-month note, $3,000.00, proceeds,

$2,760.00, interest, $240.00, Note Payable #5.

To enter this transaction into the journal, enter the date on the next available line of the Cash Receipts
Journal. In the Account Title column, enter Interest Expense. Enter NP5 in the Document column and
put $240.00 in the General Debit column. On that same line, put the cash received, $2,760.00, in the
Cash Debit column. On the next line, enter Notes Payable in the Account Title column and put
$3,000.00 in the General Credit column. That's all there is to it!

Post the amounts from the General Debit and General Credit columns to the General Ledger.

Now let's do a transaction to pay off this note when it matures. Again, even though it would be at a
later date, we will use December 14 as the date so as to keep all our transactions for this course in the
month of December.

Transaction #55: Dec. 14, Paid cash for the maturity value of Note Payable #5,
$3,000.00, Check #17.

We will now enter this transaction into the journal. Enter the date on the next available line of the Cash
Payments Journal. In the Account Title column, put Notes Payable. Put 17 in the Ck. No. for Check
#17. Enter $3,000.00 in the General Debit column and also in the Cash Credit column.

Now go ahead and post the amount from the General Debit column to the General Ledger.

We're now ready to move on to Notes Receivable.

Chapter 4

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Notes Receivable

A Note Receivable is a promissory note that a business accepts from one of its customers. It
represents money that the business will receive at a later date. These notes are generally paid in full
within one year, so they are classified as current assets.

Some customers may not be able to pay their account on the due date that the business states in its
credit terms. They may, for many reasons, require more time to pay the bill in full. The business may
then decide to accept a Note Receivable from this customer.

A Note Receivable is a promissory note given to the business by a customer with the terms of future
payment. This does not mean that the customer's account is paid; it simply means that the customer
will pay the account balance over a longer period than is usually allowed credit customers. This
changes the status of the account from an Accounts Receivable account to a Notes Receivable
account. This is still an asset account with a normal debit balance; it simply extends the period of time
that the customer has in which to pay his or her account.

Let's journalize a transaction of this type.

Transaction #56: Dec. 14, Received a three-month, 10% note from William Johnson for
an extension of time on his account, $1,340.00, Note Receivable #1.

Let's journalize this transaction. First, enter the date on the next available line in the General Journal.
In the Account Title column, enter Notes Receivable and put NR1 in the Doc. No. column. Enter
$1,340.00 in the General Debit column. On the next line, enter Accounts Receivable/William Johnson,
and enter $1,340.00 in the General Credit column.

Now post those amounts to the General Ledger and also to William Johnson's account in the Accounts
Receivable Ledger. This will decrease Johnson's account balance to $1,000.00 in the Accounts
Receivable Ledger, and put the amount of the note, $1,340.00, into the Notes Receivable account in
the General Ledger.

Now let's say that the three-month period has passed and William Johnson has sent us a check for his
balance. First, the interest on his three-month note at a rate of 10% would be $33.50 ($1,340.00 × 10%
× ¼). So, the amount of William's check is $1,373.50. This amount includes the principal ($1,340.00)
and the interest ($33.50).

Even though we are using the date of December 14, we are assuming that three months have passed
and that William's Note Receivable is now due. Let's journalize the transaction.

Transaction #57: Dec. 14, Received Cash for the maturity value of Note Receivable #1:
Principal, $1,340.00, plus interest, $33.50 — Total, $1,373.50, Receipt #8.

This transaction is journalized in the Cash Receipts Journal. Enter the date on the next available line.
In the Account Title column, enter Notes Receivable and put R8 in the Doc. No. column. Enter
$1,340.00 in the General Credit column. On that same line, put $1,373.50 in the Cash Debit column
because this is the amount of money that the business received. On the next line, enter Interest
Income in the Account Title column and put $33.50 in the General Credit column. Now post the
amounts from the General Credit column to the General Ledger. That's all there is to it!

Recording a Dishonored Note Receivable

A note that is not paid by its maturity date is referred to as a Dishonored Note Receivable. This amount
will probably never be collected, so it should be taken out of the Notes Receivable account in the
General Ledger, and re-entered into the Accounts Receivable Ledger in the customer's account. The

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amount of interest earned is also added to the amount that the customer owes. It is important to put the
amount back into the customer's account so that it is easily seen should that customer ask for credit in
the future, and also for easy reference for future collection.

Let's journalize and post a transaction of this type.

Transaction #58: Dec. 14, Roger Blackstone dishonored Note Receivable #2, a two-
month note maturity value due today; principal $300.00, interest $6.00 — Total, $306.00,
Memorandum #7.

To journalize this transaction, enter the date on the next available line in the General Journal. In the
Account Title column, enter Accounts Receivable/Roger Blackstone, and put M7 in the Doc. No. Enter
$306.00 in the Debit column. On the next line, put Notes Receivable in the Account Title column and
enter $300.00 in the Credit column. Finally, on the next line, enter Interest Income in the Account Title
column and put $6.00 in the Credit column.

Now you must post these amounts to the General Ledger and also to Roger Blackstone's account in
the Accounts Receivable Ledger.

Chapter 5

Conclusion

Wow, we have really learned a lot of new concepts in this lesson! We have learned how to determine
the maturity date and interest due on a Note Payable, and how to journalize and post them to the
various ledgers. Remember, a Note Payable is a promissory note from a business, promising to pay a
vendor or other lending institution—such as a bank—at a later date, with interest included. This
increases the amount due the vendor or lending institution, but makes the payment occur at a later
date. The interest that the business pays on a Note Payable is entered into the General Ledger
account, Interest Expense.

You have also learned how to determine the amount of interest on a Note Receivable, and how to
journalize and post a Note Receivable. A Note Receivable is a note from a customer to a business,
promising to pay the amount owed on a specified future date with interest. A Note Receivable earns
interest and is entered into a General Ledger account, Interest Income.

When you feel that you have mastered the concepts in this lesson, please take the quiz for Lesson 5.
Good luck!

Supplementary Material

Lesson 5 Solutions
/crs/pix/af2/L05-Solutions.pdf
All finished? Click here to check your work against this lesson's
solution forms. You can either print them or check the amounts
online. Unfortunately, some of the wider forms can only appear
sideways, so printing may be your better option. If you don't mind
tilting your head, you'll be able to see what you need to see on the
screen while saving some printer ink and paper! Note: Only those
forms and accounts with new entries in them will appear in each
lesson's solutions. If you're curious about a transaction in a
previous lesson, you'll have to go back to that lesson's Solution
link.

Liabilities
http://www.middlecity.com/ch10.shtml
This site explains notes in everyday terms easily understood by the

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beginner.

FAQs

Q: How is the amount of interest determined for less than one year?

A: The interest for less than one year is determined by first calculating the interest for
one year (principal amount times interest rate), and then multiplying that amount by the
fraction of the year or number of days that the money was borrowed for.

Q: How is the maturity date on a Note Payable determined?

A: The maturity date on a Note Payable is determined by counting forward, from the date
that the note was written, the number of years, months, or days that the note is written
for.

Q: How does a Note Payable differ from a Note Receivable?

A: A Note Payable is money that the business has borrowed and has to repay. A Note
Receivable is a note that the business has accepted from one of its customers and
represents money that the business will receive at a later date.

Q: Why must a dishonored Note Receivable be reentered into the Accounts Receivable
Ledger?

A: A dishonored Note Receivable is reentered into the customer's account in the

Accounts Receivable Ledger for future reference if the customer requests further credit,
and also for reference if the account is sent to a legal collection agency.

Q: Why is a Note Receivable considered a current asset?

A: A Note Receivable is considered a current asset because most Notes Receivable will
be paid in one year or less.

Course content © 1997-2007 by Charlene Messier. All rights reserved. Reproduction or redistribution
of any course material without prior written permission is prohibited.

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