What Does Notes Receivable Mean in Accounting?

Notes receivable represent a formal promise of payment from one party to another. These financial instruments are recorded as assets on a company’s balance sheet, indicating amounts owed to the business. They often arise from business transactions or loans extended to customers, employees, or other entities.

Defining Notes Receivable

Notes receivable are formal, written promises to pay a specific sum of money, known as the principal, on a definite future date, referred to as the maturity date. This formal agreement is typically documented through a promissory note, which is a legally enforceable instrument. Unlike less formal agreements, promissory notes almost always include a provision for interest, which is the cost of borrowing the principal amount over time. The legal enforceability of a promissory note stems from its written nature and the clear terms it outlines, including the principal amount, interest rate, and repayment schedule. The party promising to pay is known as the maker, while the party to whom the payment is to be made is the payee.

Common Origins of Notes Receivable

Businesses acquire notes receivable through various transactions. One common scenario involves extending loans, such as when a company lends money to an employee, another business, or an individual. These loans are formalized with a promissory note, detailing the repayment terms and any applicable interest.

Another origin is the conversion of overdue accounts receivable. When a customer’s outstanding balance becomes significantly past due, a business may formalize the debt by accepting a promissory note. This provides the customer with extended payment terms while allowing the business to earn interest on the overdue amount.

Notes receivable also arise from high-value sales, particularly for large equipment or property. In such instances, a formal payment plan with interest is established, rather than a simple credit sale, to secure the substantial amount owed.

Accounting for Notes Receivable

When a note is initially received, the company records the transaction by debiting the Notes Receivable account and crediting an account such as Cash, Sales Revenue, or Accounts Receivable, depending on how the note originated. The note is typically recorded at its face value, which is the principal amount. Interest income is earned over the life of the note and must be recognized periodically, even if cash has not yet been received. This process, known as interest accrual, aligns with accrual accounting principles, which require revenues to be recognized when earned, regardless of when cash is exchanged. To record accrued interest, the company debits Interest Receivable, an asset account, and credits Interest Revenue. When the note matures and is paid, the principal and any remaining interest are collected. The accounting entry involves debiting Cash for the total amount received, crediting Notes Receivable for the principal, and crediting Interest Revenue for the interest earned since the last accrual. If the note is not paid at maturity, it is considered a dishonored note. In this situation, the note is typically removed from Notes Receivable, and the amount due, including any accrued interest, is transferred back to Accounts Receivable.

Notes Receivable Versus Accounts Receivable

Notes receivable and accounts receivable both represent amounts owed to a business, but they differ significantly in their characteristics. A primary distinction lies in their formality; notes receivable are formal, written promises to pay, evidenced by a promissory note, whereas accounts receivable are informal, unwritten promises, usually arising from sales on credit. Another key difference is the presence of interest. Notes receivable almost always bear interest, meaning the borrower pays an additional amount for the use of the funds. Conversely, accounts receivable generally do not accrue interest, although late payment penalties may sometimes apply. Furthermore, notes receivable have a specific maturity date, indicating when the principal and interest are due. Accounts receivable, however, are typically due within a shorter, less specific period, such as 30 or 60 days, without a formally stated maturity date.