What Is a Note Receivable in Accounting?

A note receivable represents a written promise to pay a specific sum of money, with interest, by a future date. Notes receivable are assets, representing amounts owed to a company that it expects to collect. They provide a legally enforceable claim to future cash flows, offering security that informal agreements lack. Businesses use notes receivable to manage credit extended to customers, facilitate loans, or structure payments for high-value transactions.

Understanding Notes Receivable

A note receivable is a written promise to pay a definite sum of money on a specific future date, often with interest. This formalized agreement, known as a promissory note, distinguishes it from an account receivable. While an account receivable is an informal, short-term, and non-interest-bearing amount owed by a customer for goods or services, a note receivable is a more structured legal contract. It generally bears interest and can have longer repayment terms, sometimes extending beyond a standard business operating cycle.

Key components include the principal amount (original sum owed) and the stated interest rate (annual percentage charged). The maturity date specifies when the principal and accrued interest become due. The maker is the debtor who promises to pay, while the payee is the creditor who receives the promise of payment. This structure makes the note a legally binding document, providing clear terms for both parties.

How Notes Receivable Arise

Notes receivable originate from various business transactions that require a formal, legally binding promise of payment. One common scenario involves a business lending money to another entity or individual. In such cases, a promissory note formalizes the loan terms, including the repayment schedule and interest.

Another way notes receivable arise is through the sale of high-value assets, such as land, buildings, or equipment. Instead of receiving immediate cash, the selling business may accept a promissory note from the buyer, allowing payments to be spread over time. This arrangement provides the seller with a structured payment plan and an interest income stream.

Businesses also convert overdue accounts receivable into notes receivable. If a customer struggles to pay an outstanding account within the standard credit terms, the business might offer an extended payment period, formalized by a promissory note that includes interest. This conversion strengthens the legal claim for collection and provides the business with interest revenue on the previously non-interest-bearing debt. Some installment sales, particularly for higher-priced items, may involve the use of notes receivable to formalize the payment schedule and ensure legal enforceability.

Recording Notes Receivable

The accounting treatment of notes receivable involves specific journal entries at various stages, from initial recognition to collection. When a business receives a note receivable, it is recorded at its face value, which is the principal amount. For example, if a company lends $10,000 cash and receives a note, the entry would be to debit Notes Receivable for $10,000 and credit Cash for $10,000. Alternatively, if a $10,000 account receivable is converted, Notes Receivable would be debited and Accounts Receivable credited.

Interest on notes receivable accrues over time, and businesses recognize this interest revenue periodically, such as monthly or quarterly, even if cash has not yet been received. The interest earned but not yet collected is recorded by debiting an asset account called Interest Receivable and crediting an income account called Interest Revenue.

When the note matures and the principal along with all accrued interest is collected, the business records the cash inflow. The journal entry involves debiting Cash for the total amount received. Notes Receivable is credited to remove the principal, Interest Receivable is credited for previously accrued interest, and Interest Revenue is credited for current period interest. If a note is not paid at maturity, it is considered dishonored. A dishonored note is reclassified by removing it from Notes Receivable and transferring the amount, including accrued interest, to Accounts Receivable, often with potential penalties.

Presenting Notes Receivable on Financial Statements

Notes receivable are presented on a company’s balance sheet, which provides a snapshot of its assets, liabilities, and equity at a specific point in time. Their classification on the balance sheet depends on their maturity date.

Notes receivable due to be collected within one year from the balance sheet date or within the company’s normal operating cycle, whichever is longer, are classified as current assets. Conversely, notes receivable with maturity dates extending beyond one year are classified as non-current or long-term assets.

Accrued interest earned but not yet collected on notes receivable also appears on the balance sheet as “Interest Receivable,” typically a current asset. Companies are required to provide additional details about their notes receivable in the financial statement notes. These disclosures include interest rates, maturity dates, and any collateral securing the notes, offering transparency to users.