What Is Accounts and Notes Receivable?

Receivables represent money owed to a business. These financial claims arise when a business provides goods or services on credit, expecting payment at a later date. Managing these outstanding amounts is important for liquidity and operational needs. Understanding different types of receivables provides clarity on a company’s short-term financial position.

Understanding Accounts Receivable

Accounts receivable (AR) refers to money a business is owed by its customers for goods or services delivered on credit. These amounts arise from routine sales where customers agree to pay later. Accounts receivable are recorded as current assets on a company’s balance sheet, reflecting expected collection within one year or the normal operating cycle.

The common characteristics of accounts receivable include their short-term nature, usually requiring payment within a few days to 30, 60, or 90 days, or sometimes up to a year. They are generally informal, not backed by a formal promissory note, but by an invoice or implied agreement. Businesses extend credit, allowing customers to defer payment while the business records the claim.

Accounts receivable originate from business operations. For instance, a clothing manufacturer delivering products to a retail store with payment due in 30 days creates an accounts receivable for the manufacturer. Similarly, an electricity provider delivering services for a month before getting paid at the start of the next month generates an accounts receivable. When a customer uses a credit card to make a purchase, the merchant often records an accounts receivable until the payment is processed and received from the credit card company.

Managing accounts receivable is important for a company’s cash flow. Businesses regularly send invoices detailing the amount owed, payment terms, and due dates, initiating the collection process. Efficient management ensures a steady inflow of cash, which is necessary to meet operational expenses, invest in growth, and pay off debts. Without diligent monitoring and collection efforts, a high volume of outstanding receivables can lead to liquidity issues.

Understanding Notes Receivable

Notes receivable represent a formal financial claim: a written promise to pay a specific sum by a specific date. This promise is documented through a promissory note. The note outlines repayment terms, including the principal, interest rate, and maturity date.

Notes receivable accrue interest on the outstanding balance. This interest compensates the lender. For example, if a business extends credit to a customer for a large purchase with a 24-month repayment term and a 10% interest rate, this is a note receivable. The interest income is recognized on the company’s income statement as earned.

Notes receivable also differ from accounts receivable in their typical duration and formality. While accounts receivable are usually short-term, with payment expected within a year, notes receivable can be either short-term or long-term. If the note is due within one year, it is classified as a current asset; if it is due beyond one year, it is considered a non-current asset. The formal, legally binding nature of a promissory note provides a stronger legal claim for payment than an informal accounts receivable, often resulting in lower credit risk and higher collectibility.

Notes receivable often arise when a customer needs an extended period to pay for a purchase. Instead of carrying an overdue accounts receivable, a business might convert it into a note, formalizing the debt and adding interest for the longer payment period. Other scenarios include loans to employees or other businesses, or sales involving high-value items where a formal payment agreement is preferred.

Reporting Receivables on Financial Statements

Both accounts receivable and notes receivable are presented on a company’s balance sheet. These receivables are typically classified as current assets, expected to be converted into cash, consumed, or used up within one year or the normal operating cycle. This classification reflects their role in a company’s short-term liquidity and cash flow.

Receivables are reported on the balance sheet at their net realizable value (NRV). This is the estimated cash a company expects to collect from outstanding receivables. NRV is determined by taking the gross amount of accounts receivable and subtracting an estimated amount for uncollectible accounts. This approach ensures assets are not overstated, aligning with accurate financial reporting.

To account for potential uncollectible amounts, businesses establish an allowance for doubtful accounts. This contra-asset account reduces the gross accounts receivable balance to arrive at the net realizable value, helping present a more realistic financial picture by anticipating the impact of unpaid invoices.