What are Notes Receivable?
Notes receivable are assets and represent amounts due to a business by a third party (usually a customer). What distinguishes notes receivables from accounts receivable is that they are issued as a promissory note (a written note promising to pay principal plus interest at a specific date).
With a promissory note, the third party who issued the note (called the maker) promises in writing, to pay an amount of money (principal and interest) to the business (called the payee) at a given time or on demand.
A customer will issue a note receivable if for example, it wants to extend its payment terms on an overdue account with the business.
Accounts and Notes Receivable
Short term notes receivable are due within one year from the balance sheet date and classified under current assets in the balance sheet, long term notes receivables have terms exceeding one year and are classified as long term assets in the balance sheet.
Notes Receivable Examples
In promissory note receivables accounting there are a number of journal entries needed to record the note receivable itself, accrued interest income, and finally the honoring (payment) of the note receivable by the third party.
As an example of notes receivables, suppose the notes had been issued by a customer in respect of an overdue account in order to extend the terms of payment with the business, then this would convert an accounts receivable to a notes receivable.
If the terms of the notes receivables were for 15,000 due in 3 months at 8% simple interest, then the calculation of total interest due at the end of the 3 months is as follows.
Interest = Principal x Rate x Term Interest = 15,000 x 8% x 3/12 = 300
The first journal is to record the principal amount of the note receivable.
In this case the note receivable is issued to replace an amount due from a customer currently shown as accounts receivable.
As the note receivable receives interest, each month interest of 300 / 3 = 100 needs to be accrued. At the end of the 3 month term the total interest of 300 would have been accrued.
Finally, at the end of the 3 month term the note receivable is honored by the customer together with the accrued interest, and the following journal completes the transaction.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years in all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.