Notes receivable is the written promise to receive principal and interest in the future. In simple words, note receivable is a written, unconditional promise by another party that they will pay a certain amount to the business at a definite time in the future.
Since the settlement of the note receivable is expected to bring economic benefit to the business. Hence, it’s classified as an asset in the balance sheet of the company. The amount to be received is dependent on the amount mentioned in the legal document. In other words, notes receivables are recorded as an asset of a company as it is the value that a business is owed on a promissory note. The holder of the promissory note is allowed to receive the amount mentioned in the legal document.
If the amount expected to be collected from note receivable is due within one year from the date of a balance sheet, it’s classified as a current asset in the company’s balance sheet. However, if the principal amount to be collected is expected to take more than a year, it is reported as a Non-current Asset in the balance sheet (under the investment section).
Sometimes, the businesses allow their customers to convert their outstanding accounts into notes receivable. In this way, a debtor is allowed more time to pay their debts. So, it’s mutually beneficial for the business and customers in the following ways,
- The debtor gets more time to make the payment.
- Businesses make a profit on their overdue balances.
Let’s discuss some of the terms associated with the notes receivables.
1-Principal value
It is the face value of a promissory note payable at the end of a certain period. It’s an original amount that the borrower owes to the lender. The principal value of the promissory note is used in the calculation of the rate of interest.
2-Interest income
Its revenue is generated by the instrument, the maker of the instrument has to pay interest on the amount due. This interest is in addition to the principal amount and earnings for the holder of the promissory note.
3-Maker
Maker is the person/individual/organization that issues promissory notes.
4-Payee
A payee is a person who holds the right to receive the payment from the maker of the promissory note.
5-Timeframe
It is the length of time during which the note has to be repaid. The maker of the note receivable has to pay the amount due on the note on or before the maturity date.
Notes Receivable Journal entry
1-Direct recording of notes receivable
| Particulars | Debit | Credit |
| Note receivable | XXX | |
| Cash/bank | XXX |
The debit impact of this transaction is recognition of the notes receivables in the balance sheet. This debit amount is expected to be settled once cash/economic benefit is received. On the other hand, credit impact is an outflow of the economic benefits from the business.
2-Conversion of accounts receivables to notes receivables
| Particulars | Debit | Credit |
| Notes receivable | XXX | |
| Account Receivable | XXX |
The debit impact of this transaction is a recording of the notes receivables in the books. This recording is due to receipt of a promissory note from the party and recorded in the books. On the flip side, the credit impact of this journal entry is the removal of the receivable balance as it has been provided in exchange for the promissory note.
3-Journal entry when the promissory note is settled along with earned interest
| Particulars | Debit | Credit |
| Cash | XXX | |
| Notes receivable | XXX | |
| Interest income | XXX |
The debit impact of the transaction is the receipt of cash/economic resources. On the other hand, first credit removes the notes receivables from the books as cash has been received against it. Similarly, the last credit records income as the cash received is more than the principal amount of the promissory note that has been written off.
Example of Notes receivable
Mr. X has sold a vehicle to Mr. Z for $600,000 (payment due within 60 days). After 75 days of non-payment by Mr. Z, both of them decided that Mr. Z will issue a note payable for the principal amount of $600,000, at an interest rate of 8%, and principal repayment of $200,000 plus interest is to be paid at the end of every month for next three months. Alternatively, note receivable may state that interest amount is to be made along with final principal payment of 3rd month.
In the above example, Mr. X will record the entry of note receivable on its balance sheet, whereas Mr. Z will record the note payable entry. The principal value is $600,000 and $200,000 of which will be paid monthly for three months. In addition to this, interest @ 8% is to be paid. Let’s understand how this accounting will be done in this situation.
Journal entry for note recievable
By using the data of the above example, we will clarify it with journal entries..
A note receivable of $600,000 is due in the next few months. Monthly payments are to be made for $200,000/month for the next three months since Mr.X is to receive the notes receivable by giving off accounts receivable.
The journal entries in the books of Mr. X are as follows:
| Particulars | Debit | Credit |
| Notes receivable | $600,000 | |
| Accounts receivable | $600,000 |
The impact of this journal entry is the conversion of accounts receivable to notes receivables in the books of Mr. X. This entry is to be posted in the accounting system once an agreement is reached between the parties to issue the promissory note.
At the end of the First Month, the following entry will be posted in the books of Mr.-X.
1st month
Mr. X will receive $200,000 per month as principal repayment along with interest income. Interest is calculated by:
Interest income = $600,000 * 8% * 30/365
Interest income = $3,945
| Particulars | Debit | Credit |
| Cash | $203,945 | |
| Accounts receivable | $200,000 | |
Interest Income | $3,945 |
On the debit side, cash received pertains to receipt of the principal repayment and the interest income, the credit side pertains to the removal of the portion for promissory note as cash has been received against it. Similarly, the last credit records income that has been earned with the promissory note in the first year.
2nd month
For the second Month, Mr. Z will collect an additional $200,000 along with interest. The interest calculation is as follows:
Interest income= $400,0008%30/365
Interest income=$2,630
Here you need to notice that the amount of interest is lower than the first month. This is because the outstanding amount of notes receivable has decreased from $600,000 to $400,000. The calculation of outstanding principal amount is:
Principal value= $(600,000 -200,000)
Principal value = $400,000
| Particulars | Debit | Credit |
| Cash | $202,630 | |
| Notes receivable | $200,000 | |
| Interest income | $2,630 |
The debit impact of the transaction is recording receipt of the principal and the interest income. Since $200,000 has been collected at the end of the month along with interest income. The credit impact provides a breakup of the cash received on the debit side.
3rd month
For the third Month, Mr. Z will pay the remaining principal amount as well as interest payment.
Interest payment = $200,0008%30/365
Interest payment = $1,315
| Particulars | Debit | Credit |
| Cash | 201,315 | |
Notes Receivable | $ 200,000 | |
Interest Income | $ 1,315 |
The debit impact of the transaction is receipt of the final portion for the principal along with interest income. Similarly, the credit side shows the recording of the interest income and the final receipt of the promissory note’s portion.
Related article, US GAAP
Notes receivable VS Accounts receivable
Here’s the comparison of notes receivable with accounts receivable.
| Note receivables | Accounts receivables |
|---|---|
| Interest is earned on the promissory notes and recorded as income in the financial statement. | It does not lead to earning of the interest for the business. |
| It is a legal contract that includes established payment terms. | It is an informal agreement between the company and the customer. Although, terms of the repayment, like the timing of the repayment, are agreed upon. |
| It is not included in a company’s operating cycle and is receivable beyond one year. | Accounts receivable are paid in less than one year, and it is included in operating cycles. |
| Notes receivables are presented as an investment in the balance sheet of the company. | Accounts receivable are not an investment. |
Discount on notes receivable
Discount on notes receivable arises when the present value of the future cash flows (principal repayment + interest income) is less than the face value of the note receivable. In other words, if the PV of the future cash flow is less than the value of the notes receivable at the time of the agreement, the situation is said to create the discount on the notes receivables.
Accrued interest on notes receivable
If the lender has issued a note to some party, the time to collect the interest has passed. Still, the cash has not been collected; the earned interest is recorded as a current asset in the balance sheet, referred to as accrued interest on the notes receivable.
The accrued interest on notes receivable is recorded as a current asset in the balance sheet if it is expected that interest will be collected within one year. On the other hand, if the accrued interest on the note is not expected to be received in one year, it is reported as a long-term asset.
Notes receivable debit or credit
Notes receivable is a debit balance in the financial statement of the company. It’s classified as an asset because the settlement of the notes receivable is expected to bring economic benefits to the business. Further, it’s an interest-bearing financial instrument that creates earnings for the business.
Parties in the arrangement for note receivable
There are two main parties in the note receivable; these include the lender and borrower of the funds. The borrower of the note payable records the note as a liability and needs to pay in the future. It has to pay the interest on the liability and record an expense of the business.
On the other hand, the lender is the one who receives a promissory note to receive the interest and principal repayment. The lender records note as an asset of the business under-investment (line item).
Conclusion:
Notes receivable is a financial instrument that helps the business earn interest and its classified as under-investment head of the balance sheet in the company’s financial statement. The interest earned on the note receivable is recorded as income in the income statement.
The business may enter into a direct agreement to acquire the note receivable. On the other hand, it may agree with the customer to convert their receivable balance to the note receivables, It’s usually the case when customer requests for some more time to settle their obligations.
