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Notes Receivable

What Are Notes Receivable?

Notes receivable are a variation of accounts receivable, in which a business essentially makes a loan or note to a customer that allows them an extended period of time to pay for the product or service they have received.

Accounts receivable refers generally to any transaction in which the customer has not paid in full for what they have received. The business extends credit to the customer, and they are given terms to pay off the debt.

When customers are unable to pay off the credit in the normal timeframe, a note receivable allows them more time to make payments, and interest is applied.

Notes receivable are also distinct from other forms of accounts receivable because a promissory note is involved. This is a legally binding document that adds another layer of commitment to pay on the part of the customer, which is not normally associated with other types of credit purchases.

What Are Accounts Receivable?

Accounts receivable is an accounting term that refers to sales for which payment has not yet been received.

The customer has not paid for the good or service received at the time of the transaction. Instead, the business has extended credit to the customer and expects to receive payment for the transaction at some point in the future.

Accounts receivable are an important accounting metric. They represent convertible assets owed to the company. That is, they describe a financial resource that can be converted to cash soon, once the customer has paid. Similarly, they are the basis for measuring the business’s ability to convert sales into cash.

Accounts receivable are typically collected in two months or less. For this reason, they are considered a “short-term asset” which refers to any financial resource that can be converted to cash in one year or less.

A business that extends credit to customers is demonstrating trust and extending goodwill. This can help the business expand its customer base, which will generate more revenue.

When customers are unable to meet their obligations to pay for accounts receivable in the normal time that is allotted, a promissory note is sometimes offered to the customer, allowing an extended period of time to meet the payment obligations, but with interest. When this happens, the accounts receivable has been converted to notes receivable.

What Are the Key Components of Notes Receivable?

Notes receivable typically contain certain detailed information to help document the payment obligations of the customer. These include:

  • Payee: The payee is the business or organization that is owed the principal and interest that will accrue.  The payee “holds” the note receivable.

  • Maker: The maker of the note is the customer who has the obligation to pay back the note. This will typically be either a person or a business, and may also be referred to as the borrower or debtor.

  • Principal: The original amount of the note, or principal, is the cash value that is effectively loaned by the payee to the maker, which is expected to be paid back by the end of the time period defined.

  • Maturity date: Speaking of the time period, the amount of time that the maker has to pay back the note is often referred to as the term.  The note will mature at the end of its time frame or duration.  This is often referred to as the maturity date or end date.

  • Interest: This is additional money paid by the maker to the payee, on top of the original principal amount. All loans accrue interest, and a note payable is no exception. 

  • Interest rate: Interest is accrued or calculated based on the interest rate,which is a percentage that is applied to the principal balance and which is set by the terms of the original note.

How Are Notes Receivable Recorded?

Like accounts receivable, notes receivable are recorded as an asset because they represent monetary value that the business expects to collect.

They will be considered short-term assets if they can be expected to be collected in full within twelve months or less.

If the duration is longer than twelve months, they will be considered as a non-current asset.

Notes receivable will be listed first in the balance sheet along with other assets, followed by liabilities and equity, according to the fundamental accounting equation, which is represented as: Assets = Liability + Equity.

Notes Receivable and Notes Payable

The inverse of notes receivable are notes payable.  While notes receivable represent an outstanding debt that is to be collected by a business or payee, notes payable represent the opposite side of the same transaction, which is the obligation to pay the note by the customer or maker.

While notes receivable and accounts receivable are similar and, in some ways, variations of the same thing, there are some important distinctions:

How Notes Receivable and Accounts Receivable Are Similar:

  • Both describe unpaid balances owed to the company or business.

  • Both are considered assets because they represent monetary value that the business expects to collect or receive at some point in the future.

How Notes Receivable and Accounts Receivable Are Different:

  • Accounts receivable refer to informal (not interest-bearing) credit that is extended to a customer and which is expected to be paid off at some point in the future, usually in the short-term.  The term is typically less than one year, and often two months or less.

  • Notes receivable are formal extensions of credit that involve a written promissory note that is legally enforceable.  Interest accrues and the balance is often paid off in longer terms, sometimes more than one year.


Where Can Notes Receivable Be Found in the Balance Sheet?

Notes receivable are reported in the balance sheet in the assets column. They will be reported as either current or non-current assets depending on the timeframe in which there are expected to be paid.

The principal part of a note receivable that is expected to be collected within one year of the balance sheet date is reported in the current asset section of the lender's balance sheet. The remaining principal of the note receivable is reported in the noncurrent asset section entitled Investments.

What Is an Example of a Note Receivable?

If a restaurant purchases $25,000 of new equipment on credit from a restaurant supply store, the supplier will send the restaurant owner an invoice for the purchase.

The invoice is due in 60 days, which is the normal procedure for the supply store.

However, in this case, the restaurant only recently opened, and a consistent cash flow has yet to be established. The restaurant requests an extended payback, and the supply store issues a promissory note with very specific terms. These include a one-year maturity date with eight percent interest accrued over the term.

The supply store will record a journal entry of $25,000 in the debit column of the general ledger for notes receivable. This represents the asset of the note. At the same time, it will also enter a credit of the same amount for the original accounts receivable to cancel out that transaction.

Later, when the note is paid in full, the store will record a journal entry of the same amount plus interest in the debit column for cash. It will also record a $25,000 entry as a debit for notes receivable to cancel out the original transaction.

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