What’s the Difference Between Accounts and Notes Receivable?
Clarify the fundamental differences between two primary types of business receivables. Understand their distinct financial characteristics and reporting implications.
Receivables represent money owed to a business from transactions where payment is not received immediately. These financial claims are assets for a company, indicating future cash inflows. This article clarifies the distinctions between accounts receivable and notes receivable.
Understanding Accounts Receivable
Accounts receivable (AR) refers to amounts owed to a company for goods or services sold on credit during normal business operations. These are informal claims, often based on an invoice, and do not involve a formal, written promise to pay. For example, when a supplier sells products to a customer on credit, the amount owed becomes an accounts receivable for the supplier.
These receivables are short-term, with payment terms commonly ranging from 30 to 60 days, such as “Net 30” or “Net 60.” Accounts receivable do not bear interest. They are recorded as current assets on a company’s balance sheet, reflecting their expected conversion to cash within one year or the operating cycle.
Understanding Notes Receivable
Notes receivable represent a formal, legally enforceable written promise from another party to pay a specific sum of money on a specific future date. This promise is documented through a promissory note, which is a legal instrument. A promissory note includes details such as the principal amount, a stated interest rate, and a definite maturity date.
These notes can be short-term (due within a year) or long-term (extending beyond one year). Notes receivable commonly arise from transactions like a loan to an employee, the sale of high-value assets requiring structured payments, or when an overdue accounts receivable is converted into a more formal agreement. The inclusion of interest compensates the lender for the extended credit period.
Core Differences
The distinctions between accounts receivable and notes receivable lie in their formality, interest implications, term, legal enforceability, and purpose.
Formality and Legal Enforceability
Accounts receivable are informal, stemming from routine credit sales, without a written promise beyond an invoice. Notes receivable are formal, legally binding documents, such as promissory notes, that clearly outline payment terms. Accounts receivable have less formal legal standing, relying on sales agreements and invoices as proof of debt. Notes receivable offer stronger legal enforceability due to the written, signed promissory note, which can be presented as evidence in legal proceedings.
Interest and Term
Accounts receivable do not accrue interest if paid within standard terms, though late payment penalties might apply. Notes receivable include a specified interest rate, meaning the borrower pays back the principal amount plus interest. Accounts receivable are short-term, usually due within 30 to 90 days. Notes receivable can have short or long terms, ranging from a few months to several years.
Purpose
Accounts receivable facilitate everyday commercial transactions on credit, while notes receivable are used for significant financing arrangements, formalizing extended payment plans, or converting delinquent accounts into structured debts.
Implications for Financial Reporting
The differences between accounts receivable and notes receivable have distinct implications for their treatment and presentation on a company’s financial statements.
Classification and Presentation
Both are classified as assets on the balance sheet, with classification as current or non-current depending on their maturity date. Amounts due within one year are current assets; those due beyond one year are non-current. Notes receivable, especially long-term ones, are often presented separately from accounts receivable to provide clearer insight into the nature of a company’s assets.
Valuation and Interest Income
Valuation also varies. Accounts receivable are reported at their net realizable value, the amount expected to be collected after accounting for potential uncollectible amounts. This involves establishing an “allowance for doubtful accounts,” a contra-asset account that estimates the portion of receivables unlikely to be paid. Notes receivable may have specific provisions for bad debt. Interest income is recognized for notes receivable over their term, impacting a company’s income statement, whereas accounts receivable do not generate interest income.
Cash Flow Impact
The collection of these receivables impacts cash flows, with notes receivable providing more predictable cash inflows due to their structured payment schedules.