Notes Receivable Defined: What It Is & Examples (2024)

Many businesses sell their products or services to customers on credit. They simply send aninvoice to the customer after the sale and the customer (theoretically) pays it. However,some transactions are better completed with a more formal promise to pay, called apromissory note. When a promissory note is accepted, a business records the amount due onits accounting books as a note receivable, meaning an asset.

Companies of all sizes and industries use notes receivable, which benefit both sides of thepurchase equation. Note receivable “makers” — often but not always acustomer — get extra time to pay, and note holders receive interest income plus abetter likelihood they’ll get paid due to the firmer commitment that a noteformalizes. However, companies must use the accrual method of accounting and follow somespecific rules when recording notes receivable. This can make bookkeeping cumbersome,especially for companies that hold multiple notes receivable.

What Are Notes Receivable?

Notes receivable are asset accounts tied to an underlying promissory note, which details inwriting the payment terms for a purchase between the “payee” (typically acompany, and sometimes called a creditor) and the “maker” of the note (usually acustomer or employee, and sometimes called a debtor). Notes receivable can be between abusiness and any other party — another business, a financial institution or anindividual. Most often, they come about when a customer needs more time to pay for a salethan the standard billing terms. As a trade-off for agreeing to slower payment, payeescharge interest and require a signed promissory note for legal purposes. Employee cashadvances where the company asks the employee to sign a promissory note are another way notesreceivable come about.

Notes receivable have a higher probability of payment than purchases made on simple credit,which are known as open trade receivables. That’s because of the signed promissorynote, which can be presented as evidence in a legal proceeding. In addition, notesreceivable can potentially be sold to third parties. By reducing unpaid, “bad”debts, collecting interest income and facilitating contract sales, notes receivable can be atool for enhancing cash flow.

For accounting purposes, a payee records a note receivable as an asset on its balance sheetand the related interest income on its income statement. The portion of the note receivabledue to be repaid within one year is classified as a current asset and the balance as along-term asset.

Notes Receivable vs. Notes Payable

Notes receivable and notes payable are mirror images of one another. Notes receivable areassets on a payee’s books that represent principal owed to them. Notes payable are thecorresponding liabilities on a maker’s books, also in the amount of outstandingprincipal. The business entity doing the lending has a note receivable and the entity doingthe borrowing has a note payable.

Notes Receivable vs. Accounts Receivable

Notes receivable and accounts receivable areboth assets representing amounts owed to a creditor. However, notes receivable are based onformal, interest-bearing promissory notes while accounts receivable are informal amountsowed by customers in the normal course of business: Debtors repay accounts receivableaccording to the invoice’s billing terms and don’t incur interest charges whenpaid on time.

Accounts receivable are current assets because they usually have a single, short-term duedate, such as 30 or 60 days from invoice date. Notes receivable usually have longer terms,with payments made over regular intervals during the note’s term or in full at thematurity date. Notes receivable can be classified as current or long-term assets or both:Amounts due within 12 months are classified as short-term and any amounts beyond that areclassified as long-term.

Key Takeaways

• Companies of all sizes and industries use notes receivable to facilitate sales withlonger, interest-bearing payment terms.
• For the entity doing the lending, also known as a payee or creditor, notes receivablecan improve cash flow.
• Notes receivable are recorded as an asset account for the amount owed by the note“maker,” also known as the debtor.
• Key aspects like time frame, formal documentation and interest differentiate notesreceivable from accounts receivable.
• Each note receivable is unique, which can challenge manual bookkeeping.

Key Components of Notes Receivable

It’s important to formalize all the key components of a note receivable so the termsare clear for the maker. A note receivable may also be used as evidence if the payee needsto pursue legal action. The underlying promissory note typically includes six keycomponents:

1. Payee: The entity that is owed the principal and ensuing interest.The payee “holds” the note receivable.

2. Maker: The entity required to pay back the note, also known as theborrower or debtor.

3. Principal: The original amount of the note. In a simple case, theprincipal is the amount of cash — or equivalent value — the payee givesto the maker, who pays back the amount by the end of the term, either ininstallments or a lump sum.

4. Term/time frame: The amount of time the maker has to pay back thenote. The note’s maturity, or stated, date, occurs at the end of the notereceivable time frame or duration.

5. Interest: The money the maker pays the payee, in addition to theprincipal. It’s the cost of borrowing the money.

6. Interest rate: The note’s stated rate of interest, expressedon an annual basis. The interest rate is applied to the outstanding principal todetermine the amount of interest owed by the maker.

What Is an Example of Notes Receivable?

A simple, hypothetical example illustrates how notes receivable work. Joe Publishing Grouppurchases $50,000 of computers on credit from Sparky Technology Supply. Sparky sends Joe aninvoice that is due in 60 days, in accordance with Sparky’s normal billing terms.Unfortunately, Joe is unable to make prompt payment and negotiates a promissory note withthe following terms:

• Payee: Sparky Technology Supply
• Maker: Joe Publishing Group
• Principal: $50,000
• Time frame: 6 months due at maturity
• Interest rate: 6% per year

Example of Journal Entries for Notes Receivable

Sparky Technology Supply’s accounting journal entries for the hypothetical notereceivable are as follows:

Easily Manage Notes Receivable With Accounting Software

More sophisticated terms and real-world circ*mstances can quickly complicate thestraightforward example above and cause Sparky exponential accounting work. For example, anote receivable indicating monthly payments would require six journal entries similar to #2,instead of one, and entail more complicated interest calculations each time Joe pays downthe outstanding principal. If Sparky’s fiscal year ends during the note receivableterm, additional journal entries are required for interest accruals. And if Joe fails to payany part of the note, Sparky would need journal entries to record write-offs. While usingnotes receivable benefitted Sparky’s cash flow and collection effort, it’s easyto see how labor-intensive and potentially error-prone manual bookkeeping can become fromjust a single transaction.

An automated financial management system, such as NetSuite Cloud AccountingSoftware, simplifies the journal entry process and integrates with cash managementto more easily manage notes receivable.

Conclusion

Notes receivable are useful asset accounts for businesses to understand. They play a part inincreasing collectability of amounts owed, plus they generate revenue in the form ofinterest. Accounting for notes receivable can be burdensome and error-prone if approachedmanually.

Notes Receivable FAQs

What is considered a notes receivable?

A note receivable is an asset account tied to an underlying promissory note, which details inwriting the payment terms for a purchase between a “payee” (typically a company,and sometimes called a creditor) and the “maker” of the note (usually a customeror employee, and sometimes called a debtor). Most often, it comes about when a maker needsmore time to pay for a sale than the standard billing terms. As a trade-off for agreeing toslower payment, payees charge interest and require a signed promissory note. The amount ofthe note appears on a payee’s balance sheet, and the related interest income isrecorded on its income statement.

What is an example of notes receivable?

Examples of notes receivable include employee cash advances with a written promise to pay anduncollected trade accounts receivable (sales owed to a company on credit) converted intopromissory notes.

What is the difference between an accounts receivable and a notesreceivable?

The differences between accounts receivable and notes receivable relate to formality,duration and interest. Accounts receivable are informal, short-term and non-interest-bearingamounts owed by a customer. Notes receivable have the backing of a promissory note, bearinterest and have longer terms, sometimes exceeding a full business cycle. Accountsreceivable are short-term current assets while notes receivable can be short-term, long-termor both, depending on the repayment schedule.

Is notes receivable a debit or credit?

The normal balance of notes receivable is a debit. Like all assets, debits increase notesreceivable and credits reduce them.