What Is Notes Receivable? An Accounting Definition

Notes receivable represent a formal financial promise, a written agreement outlining a specific sum of money to be received by a business at a future date. Considered assets, they signify money owed to the company. They typically arise from transactions requiring extended credit, providing a structured repayment plan.

Notes receivable are important for businesses needing to formalize credit terms, especially when customers require more time to pay than standard billing allows. This formalization helps ensure payment and can even generate interest income for the note holder. They also play a role in managing a company’s cash flow and assessing credit risk.

Defining Notes Receivable

Notes receivable are formal, legally binding promises to pay a specific amount of money by a designated future date, often including interest. Businesses record these as assets on their balance sheet, representing amounts due from customers or other parties. The backing of a promissory note makes them legally enforceable, providing a stronger assurance of payment compared to informal agreements.

In contrast, accounts receivable represent informal amounts owed by customers, typically arising from regular sales on open credit terms. Accounts receivable are usually short-term, with payment expected within a brief period, such as 30 or 60 days, and generally do not bear interest. Notes receivable, however, are formalized by a written promissory note, which details payment terms, often includes interest charges, and can have longer repayment periods, sometimes extending beyond one year. This distinction highlights the more structured and legally robust nature of notes receivable, making them suitable for transactions requiring a stronger commitment to repayment or extended credit.

Key Elements of a Note

A promissory note, which forms the basis of a notes receivable, contains several essential components. The Principal Amount refers to the original sum of money borrowed or lent, representing the face value of the note. This is the amount the debtor promises to repay, not including any interest.

The Interest Rate specifies the percentage charged on the principal amount, compensating the lender for the use of their funds over time. This rate is typically expressed on an annual basis. The Maturity Date is the specific future date when the principal amount and any accrued interest are due and must be repaid in full.

The parties involved in a note are the Maker and the Payee. The Maker, also known as the debtor or borrower, is the party who signs the note and promises to pay the specified sum. Conversely, the Payee, or creditor/lender, is the party to whom the payment is to be made and who holds the note receivable. Occasionally, a note may include collateral, an asset pledged by the maker to secure the loan, providing the payee with a claim on that asset if the maker defaults.

Recording Notes Receivable

Recording notes receivable involves specific accounting entries at different stages of the note’s life. When a note is initially issued or accepted, such as for a loan or the conversion of an existing accounts receivable, the company recognizes the note as an asset. For example, converting an accounts receivable to a note involves recording the note and reducing the accounts receivable.

As time passes, interest revenue earned on the note must be recognized, even if it has not yet been received in cash. This is known as the accrual of interest. Periodically, an adjusting entry is made to record the amount of interest earned during that period.

Upon the note’s maturity, when the principal and any remaining interest are collected, a final entry is made. This entry records the total amount received, which includes both the principal and all earned interest. Concurrently, the note’s principal is removed from the books, and all earned interest is accounted for.

Presenting Notes Receivable on Financial Statements

Notes receivable are presented on a company’s balance sheet as assets, reflecting the amounts owed to the business. Their classification depends on their maturity date. Notes receivable due within one year are classified as current notes receivable and appear under current assets on the balance sheet.

Conversely, notes receivable with maturity dates extending beyond one year are classified as non-current notes receivable and are presented under non-current or long-term assets.

For valuation purposes, notes receivable are reported at their amortized cost, which represents their face value adjusted for any premium or discount. To reflect the estimated collectible amount, companies establish an Allowance for Doubtful Notes, also known as an Allowance for Uncollectible Notes. This allowance reduces the gross amount of notes receivable to their estimated realizable value. The purpose of this allowance is to present the notes receivable at the net amount the company expects to collect.