On April 1, 20X1, Pizzini Company, a calendar-year company sold merchandise to Easton Company on credit and received in return an interest-bearing note receivable from Easton Company. Pizzini Company will receive interest at the prevailing rate for note of this type. Both the principal and interest are due in one lump on March 31, 20X2. When should Pizzini Company report interest revenue from the note receivable? Discuss the rationale for your answer.
A note receivable is a formal, written promise to receive a specific amount of cash from another party in the future. In this case, the party who receives payment under the terms of the note is Pizzini Company while the maker who is obligated to send funds to the payee is Easton Company. The amount of payment to be made, ...view middle of the document...
Contrarily, under the cash basis of accounting, interest revenue would only be recorded when a cash payment for interest is received by the entity. Companies will often record short-term notes at face value because the interest implicit in the maturity value is immaterial. Notes can be treated as cash equivalents, maturities of three months or less and easily converted to cash. However, since the notes receivable in this case is a year-long note, Pizzini should record and report this long-term notes receivable at the present value of the cash they expect to collect.
Since Pizzini is a calendar-year company, that means its accounting cycle begins on January 1 and ends December 31 every year. The notes receivable was assigned on April 1, 20X1, so it will recognize interest revenue in the financial statements of year 20X1 even though it will not be received until the next accounting period, as it relates to the current period. This follows the revenue recognition principle, which states that revenues are recognized when they are realized and when they are earned, no matter when the cash is received. Even though the interest is being paid out only once in the year as a lump sum, a little bit of that interest expense is incurred each and every day, so Pizzini would most likely prepare updated internal income statements to report interest revenue as the year progresses while Easton will report interest expense on their own internal reports. The accrued interest from April 1 until December 31 would be reported as revenues earned by Pizzini’s company’s efforts during the current period. The rest of the interest would be reported earned revenues for the following period of 20X2 until March 31.