What Is a Note Receivable in Accounting?

A note receivable represents a formal, written promise from one party to another to pay a specified sum of money by a particular future date. This financial instrument typically includes interest and outlines clear terms for repayment. Businesses record notes receivable as assets on their balance sheet, signifying amounts owed to them. These notes often arise when a customer requires an extended period to settle a debt, or when a business formally lends money. A note receivable provides the creditor with stronger legal assurance of payment compared to less formal credit arrangements.

Fundamental Characteristics

A note receivable is defined by its written nature, often called a promissory note, which details the specific terms of the payment obligation, including the principal amount (the original sum of money loaned or owed, excluding any interest). The note also specifies an interest rate, the cost of borrowing, typically expressed as an annual percentage. A maturity date is the specific future date when the principal and any accrued interest must be repaid in full. The promissory note identifies the maker (debtor or borrower) obligated to pay, and the payee (creditor or lender) receiving payment. The terms also outline the repayment schedule, which can involve a single lump-sum payment at maturity or installment payments over the note’s term.

Accounting Treatment

When a business receives a note receivable, it records this transaction by debiting the Notes Receivable account and crediting Sales Revenue (for a new sale) or Accounts Receivable (if an existing account is converted). This entry establishes the note as an asset on the balance sheet, reflecting the principal amount owed. For interest-bearing notes, interest accrues over time and is recognized periodically by debiting an Interest Receivable account and crediting Interest Income. The interest calculation involves the principal amount, the annual interest rate, and the time period (e.g., 90/360 days). This accrual ensures that revenue is recognized in the period it is earned, aligning with the accrual basis of accounting.

When the maker pays the note at maturity, the business debits the Cash account for the total amount received, including both the principal and the accrued interest. The Notes Receivable account is credited to remove the principal, and Interest Income is credited for any interest earned since the last accrual. If interest was previously accrued to Interest Receivable, that account is credited. If a note receivable is dishonored (maker fails to pay at maturity), the business removes it from Notes Receivable by crediting the account. The total amount due (principal and accrued interest) is then debited to Accounts Receivable, indicating it’s still collectible but as a less formal claim.

Comparison with Accounts Receivable

Notes receivable and accounts receivable both represent amounts owed to a business, but they differ in their formality and characteristics. Accounts receivable typically arise from informal credit sales, such as when a customer purchases goods or services on credit with standard billing terms (e.g., 30 or 60 days). These are generally short-term obligations and do not usually bear interest. In contrast, notes receivable are based on a formal, written promise, known as a promissory note. This written agreement provides stronger legal backing and is often used for larger amounts or extended payment periods. Notes receivable almost always include a specified interest rate. They also have a definite maturity date, which can be short-term (due within one year) or long-term (due after one year). Accounts receivable, while having due dates, are typically expected to be collected within a shorter timeframe, usually less than 12 months. On the balance sheet, both are classified as assets, but notes receivable can be current or non-current depending on their maturity, whereas accounts receivable are almost always current assets.