Note receivable: Definition, Explanation, Journal entry, and Example

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 what are notes receivable earnings for the business. 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.

(b)”Four months after date, I promise to pay…” When the maturity is expressed in months, the note matures on the same date in the month of maturity. For example, one month from July 18 is August 18, and two months from  July 18 is  September 18. If a note is issued on the last day of a month and the month of maturity has fewer days than the month of issuance, the note matures on the last day of the month of maturity. You are the owner of a retail health food store and have several large companies with whom you do business. Many competitors in your industry are vying for your customers’ business.

Notes Receivable vs. Notes Payable

Maturity value is the amount that the company (maker) must pay on a note on its maturity date; typically, it includes principal and accrued interest, if any. (a)”One year after date, I promise to pay…” When the maturity is expressed in years, the note matures on the same day of the same month as the date of the note in the year of maturity. For example, the maker owes $200,000 to the payee at a 10% interest rate, and pays no interest during the first year. The note has now been completely paid off, and ABC has recorded a total of $246 in interest income over a three-month period. Its revenue is generated by the instrument, the maker of the instrument has to pay interest on the amount due.

The second possibility is one entry recognizing principal and interest collection. 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. 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). Notes receivable is the written promise to receive principal and interest in the future.

Using Notes Receivable to Generate Cash

Wage advances, formal loans to employees, or loans to other companies create other types of receivables. If significant, these nontrade receivables are usually listed in separate categories on the balance sheet because each type of nontrade receivable has distinct risk factors and liquidity characteristics. The examples provided account for collection of the note in full on the maturity date, which is considered an honored note. But what if the customer does not pay within the specified contract length? A lender will still pursue collection of the note but will not maintain a long-term receivable on its books. Instead, the lender will convert the notes receivable and interest due into an account receivable.

The journal entry will follow if a company pays another party directly in exchange for a note receivable. However, if any note is repayable after a year, companies must qualify it as non-current assets. A company should evaluate all its note receivables for classification at each reporting date. Company A sells machinery to Company B for $300,000, with payment due within 30 days. Alternatively, the note may state that the total amount of interest due is to be paid along with the third and final principal payment of $100,000. Often, a business will allow customers to convert their overdue accounts (the business’ accounts receivable) into notes receivable.

What is Accounts Receivable Collection Period? (Definition, Formula, and Example)

Several characteristics of notes receivable further define the contract elements and scope of use. For example, a company may have an outstanding account receivable in the amount of $1,000. The customer negotiates with the company on June 1 for a six-month note maturity date, 12% annual interest rate, and $250 cash up front. The interest rate is the part of a loan charged to the borrower, expressed as an annual percentage of the outstanding loan amount. In contrast, notes receivable (an asset) is a more formal legal contract between the buyer and the company, which requires a specific payment amount at a predetermined future date.

However, the customer will also pay an interest of $500 ($5,000 x 10%) on the note. Both parties agree that the customer must reimburse the principal amount and a 10% interest on the note. The maturity date of a note receivable is the date on which the final payment is due. The accounts receivable is just as valid a claim as are the notes receivable, as well as the interest. When the payment on a note is received, Cash is debited, Note Receivables is credited, and Interest Revenue is credited. When a note is received from a customer, the Notes Receivable account is debited.