Many businesses sell their products or services to customers on credit. They simply send an invoice to the customer after the sale and the customer (theoretically) pays it. However, some transactions are better completed with a more formal promise to pay, called a promissory note. When a promissory note is accepted, a business records the amount due on its accounting books as a note receivable, meaning an asset.
Companies of all sizes and industries use notes receivable, which benefit both sides of the purchase equation. Note receivable “makers” — often but not always a customer — get extra time to pay, and note holders receive interest income plus a better likelihood they’ll get paid due to the firmer commitment that a note formalizes. However, companies must use the accrual method of accounting and follow some specific rules when recording notes receivable. This can make bookkeeping cumbersome, especially for companies that hold multiple notes receivable.
What Are Notes Receivable?
Notes receivable are asset accounts tied to an underlying promissory note, which details in writing the payment terms for a purchase between the “payee” (typically a company, and sometimes called a creditor) and the “maker” of the note (usually a customer or employee, and sometimes called a debtor). Notes receivable can be between a business and any other party — another business, a financial institution or an individual. Most often, they come about when a customer needs more time to pay for a sale than the standard billing terms. As a trade-off for agreeing to slower payment, payees charge interest and require a signed promissory note for legal purposes. Employee cash advances where the company asks the employee to sign a promissory note are another way notes receivable come about.
Notes receivable have a higher probability of payment than purchases made on simple credit, which are known as open trade receivables. That’s because of the signed promissory note, which can be presented as evidence in a legal proceeding. In addition, notes receivable can potentially be sold to third parties. By reducing unpaid, “bad” debts, collecting interest income and facilitating contract sales, notes receivable can be a tool for enhancing cash flow.
For accounting purposes, a payee records a note receivable as an asset on its balance sheet and the related interest income on its income statement. The portion of the note receivable due to be repaid within one year is classified as a current asset and the balance as a long-term asset.
Notes Receivable vs. Notes Payable
Notes receivable and notes payable are mirror images of one another. Notes receivable are assets on a payee’s books that represent principal owed to them. Notes payable are the corresponding liabilities on a maker’s books, also in the amount of outstanding principal. The business entity doing the lending has a note receivable and the entity doing the borrowing has a note payable.
Notes Receivable vs. Accounts Receivable
Notes receivable and accounts receivable are both assets representing amounts owed to a creditor. However, notes receivable are based on formal, interest-bearing promissory notes while accounts receivable are informal amounts owed by customers in the normal course of business: Debtors repay accounts receivable according to the invoice’s billing terms and don’t incur interest charges when paid on time.
Accounts receivable are current assets because they usually have a single, short-term due date, such as 30 or 60 days from invoice date. Notes receivable usually have longer terms, with payments made over regular intervals during the note’s term or in full at the maturity date. Notes receivable can be classified as current or long-term assets or both: Amounts due within 12 months are classified as short-term and any amounts beyond that are classified as long-term.
- Companies of all sizes and industries use notes receivable to facilitate sales with longer, interest-bearing payment terms.
- For the entity doing the lending, also known as a payee or creditor, notes receivable can improve cash flow.
- Notes receivable are recorded as an asset account for the amount owed by the note “maker,” also known as the debtor.
- Key aspects like time frame, formal documentation and interest differentiate notes receivable from accounts receivable.
- Each note receivable is unique, which can challenge manual bookkeeping.
Key Components of Notes Receivable
It’s important to formalize all the key components of a note receivable so the terms are clear for the maker. A note receivable may also be used as evidence if the payee needs to pursue legal action. The underlying promissory note typically includes six key components:
Payee: The entity that is owed the principal and ensuing interest. The payee “holds” the note receivable.
Maker: The entity required to pay back the note, also known as the borrower or debtor.
Principal: The original amount of the note. In a simple case, the principal is the amount of cash — or equivalent value — the payee gives to the maker, who pays back the amount by the end of the term, either in installments or a lump sum.
Term/time frame: The amount of time the maker has to pay back the note. The note’s maturity, or stated, date, occurs at the end of the note receivable time frame or duration.
Interest: The money the maker pays the payee, in addition to the principal. It’s the cost of borrowing the money.
Interest rate: The note’s stated rate of interest, expressed on an annual basis. The interest rate is applied to the outstanding principal to determine the amount of interest owed by the maker.
What Is an Example of Notes Receivable?
A simple, hypothetical example illustrates how notes receivable work. Joe Publishing Group purchases $50,000 of computers on credit from Sparky Technology Supply. Sparky sends Joe an invoice that is due in 60 days, in accordance with Sparky’s normal billing terms. Unfortunately, Joe is unable to make prompt payment and negotiates a promissory note with the following terms:
- Payee: Sparky Technology Supply
- Maker: Joe Publishing Group
- Principal: $50,000
- Time frame: 6 months due at maturity
- Interest rate: 6% per year
Example of Journal Entries for Notes Receivable
Sparky Technology Supply’s accounting journal entries for the hypothetical note receivable are as follows:
Easily Manage Notes Receivable With Accounting Software
More sophisticated terms and real-world circumstances can quickly complicate the straightforward example above and cause Sparky exponential accounting work. For example, a note receivable indicating monthly payments would require six journal entries similar to #2, instead of one, and entail more complicated interest calculations each time Joe pays down the outstanding principal. If Sparky’s fiscal year ends during the note receivable term, additional journal entries are required for interest accruals. And if Joe fails to pay any part of the note, Sparky would need journal entries to record write-offs. While using notes receivable benefitted Sparky’s cash flow and collection effort, it’s easy to see how labor-intensive and potentially error-prone manual bookkeeping can become from just a single transaction.
An automated financial management system, such as NetSuite Cloud Accounting Software, simplifies the journal entry process and integrates with cash management to more easily manage notes receivable.
Notes receivable are useful asset accounts for businesses to understand. They play a part in increasing collectability of amounts owed, plus they generate revenue in the form of interest. Accounting for notes receivable can be burdensome and error-prone if approached manually.
Notes Receivable FAQs
What is considered a notes receivable?
A note receivable is an asset account tied to an underlying promissory note, which details in writing the payment terms for a purchase between a “payee” (typically a company, and sometimes called a creditor) and the “maker” of the note (usually a customer or employee, and sometimes called a debtor). Most often, it comes about when a maker needs more time to pay for a sale than the standard billing terms. As a trade-off for agreeing to slower payment, payees charge interest and require a signed promissory note. The amount of the note appears on a payee’s balance sheet, and the related interest income is recorded on its income statement.
What is an example of notes receivable?
Examples of notes receivable include employee cash advances with a written promise to pay and uncollected trade accounts receivable (sales owed to a company on credit) converted into promissory notes.
What is the difference between an accounts receivable and a notes receivable?
The differences between accounts receivable and notes receivable relate to formality, duration and interest. Accounts receivable are informal, short-term and non-interest-bearing amounts owed by a customer. Notes receivable have the backing of a promissory note, bear interest and have longer terms, sometimes exceeding a full business cycle. Accounts receivable are short-term current assets while notes receivable can be short-term, long-term or both, depending on the repayment schedule.
Is notes receivable a debit or credit?
The normal balance of notes receivable is a debit. Like all assets, debits increase notes receivable and credits reduce them.