The notion of accounts receivable — invoices still owing from sales made on credit — is well understood by the majority of business and finance leaders. What about notes receivable?
It might be a far less commonly explored line on the balance sheet, but it's an important asset to understand nonetheless.
In this article, we’ll explain what notes receivable are, how they’re treated in financial accounting and reporting, and how they impact cash flow management.
Definition of notes receivable
Notes receivable are written promises to receive a specific amount of money at a future date. Typically, this includes interest on the amount owed.
Think of it as a requirement to pay back a loan, except it might not be cash that you’re lending out.
For example, a customer of yours might request to purchase $100,000 worth of goods right now but is unable to pay for them upfront or with your payment terms (net 30 days, say).
Instead of extending credit terms (where the sale would be entered as accounts receivable), you formalize the promise to repay the amount at a later date, including interest, through a promissory note.
These promissory notes — which are the notes we’re referring to when we say notes receivable — include key terms such as the principal amount, interest rate, and repayment schedule, just like a loan contract with a bank would.
Key components of notes receivable
Here’s what’s typically found on a promissory note
- Principal amount. This is the face value of the note, representing the original amount loaned or otherwise owed.
- Maturity date. This is the point when the principal and accrued interest must be repaid to the note holder. Notes receivable can have short-term (less than a year) or long-term maturity dates.
- Interest calculation and payment. This includes the interest rate, time period, and calculation of total interest to be paid.
- Repayment terms. Some notes receivable are payable in installments, whereas others only require the total amount to be paid by a given date. This must be stipulated in the promissory note.
- Default terms. The agreement often specifies penalties or consequences for failing to repay the note, such as late fees, additional interest, or legal action.
- Discounting. Notes receivable can often be sold or "discounted" to a third party before maturity. The note holder may receive cash at a discount to transfer the right to collect future payments.
Examples of notes receivable
Perhaps the best way to understand what notes receivable are all about is to look at some common examples.
1. Trade credit
A customer purchases goods worth $10,000 on credit and agrees to sign a 90-day promissory note with a 5% annual interest rate.
This is recorded not as accounts receivable, but as notes receivable.
2. Loans to employees or third parties
The business lends $5,000 to an employee, which is formalized with a 1-year promissory note at 6% annual interest.
The note receivable represents the company’s right to collect the principal and interest when the maturity date arrives.
3. Advance payments
A business provides an advanced payment to a vendor with an agreement to repay the amount later under specific terms.
This is often formalized as a note receivable.
4. Installment agreements
A customer wishes to purchase equipment now put wishes to pay the amount back in monthly installments, including interest on top of the principal amount.
The customer issues a promissory note to formalize the agreement, and the business enters it in its ledger as notes receivable.
Accounting treatment for notes receivable
Now that we’ve got an idea of what notes receivable are and how they work, let’s turn our attention to how they work in the accounting context and how they impact financial statements.
How notes receivable are recorded in accounting
Notes receivable are recorded as assets on the balance sheet.
They can be considered as either current assets or non-current assets, depending on their maturity dates.
Notes that have a due date within one year are considered current notes receivable and are categorized as current assets. Those that have repayment terms extending beyond one year are considered non-current notes receivable and are classified as non-current assets.
When the note receivable is issued it is recorded at its face value (the principal amount). Interest income is recognized over time as it accrues, ensuring alignment with the revenue recognition principle.
Journal entries for notes receivable
The journal entries required for notes receivable depend on the exact nature of the transaction you’re recording.
Here are a few common examples.
- Issuance of notes receivable some text
- Debit: Notes Receivable
- Credit: Sales (or Cash/Accounts Receivable)
- Interest accrual some text
- Debit: Interest Receivable
- Credit: Interest Income
- Receipt of payment at maturity some text
- Debit: Cash
- Credit: Notes Receivable
- Credit: Interest Income
- Dishonored notes receivable some text
- Debit: Accounts receivable
- Credit: Notes Receivable
Valuation and classification of notes receivable
Notes receivable are recorded at face value. Any accrued interest is added as interest receivable in the period for which it is accrued.
On the balance sheet, notes receivable are valued at their net realizable value (NRV). This is the total expected amount to be collected, adjusted for any potential uncollectible amounts.
Classification of notes receivable depends on the maturity date.
- Current Asset: If the note matures within the next 12 months
- Non-Current Asset: If the note matures beyond 12 months
Impairment and bad debt considerations
What happens if it looks like our borrower isn’t going to repay the note?
If there is evidence for that, the note receivable is considered impaired. This impairment is measured as the difference between the note’s carrying amount and the expected future cash flows, discounted at the note’s original interest rate.
In the journal, this looks like:
- Debit: Bad debt expense
- Credit: Allowance for notes receivable
Once it is confirmed that the notes receivable is deemed uncollectible, it must be written off as a bed debt.
Here’s what happens in the journal:
- Debit: Allowance for notes receivable
- Credit: Notes receivable
How notes receivable and accounts receivable impact cash flow
Cash flow is the lifeblood of businesses of all sizes.
So, it's only natural to want to know how both notes receivable and accounts receivable impact cash flow. Let’s explore:
The impact of notes receivable on cash flow
While notes receivable are classified as assets on the balance sheet, they can still have an impact on cash flow.
This most depends on whether they are increasing or being converted into cash.
When a note receivable is issued, there is no cash immediately received. This has an indirect impact on cash flow, as your company’s liquid cash remains unchanged even though you’ve made a sale.
When you collect on a note received, both principal and interest payments are classified as cash flow. These can be investing cash flows (if the note was a loan) or operating cash flows (for trade notes). This has a direct positive impact on cash flow.
If you discount or sell notes receivable to a financial institution before maturity, this provides immediate cash but reduces the overall cash received compared to the alternative of holding the note to maturity. Thus, there is a direct impact on cash flow: immediate inflow, but at a reduced amount.
The impact of accounts receivable on cash flow
Accounts receivable, like notes receivable, impact cash flow by delaying the receipt of cash from customers. However, their impact is generally more immediate and shorter-term.
When a company makes a sale on credit, accounts receivable increase but cash remains unchanged, this reduces cash flow in the short term, having a negative impact on operating cash flow.
When a customer pays off their credit balances, the opposite occurs. Cash is received, increasing cash flow and improving the company’s liquidity.
Occasionally accounts receivable are converted to notes received. This has no immediate impact on cash flow, but it does further delay the inflow of cash.
If accounts receivable are written off as bad debt, this indirectly reduces cash flow by lowering the company’s net income.
Get on top of accounts and notes receivable
Notes receivable are an effective way to generate additional revenue by way of interest charges, though they should be applied with caution as they decrease cash flow in the short term.
The best practice here is to maintain a healthy balance of notes and accounts receivable and to stay on top of both with an effective financial operations platform like BILL.
Our accounts receivable automation software is packed with powerful features for keeping cash flowing in, like:
- Automated invoicing and invoice matching
- Cash flow forecasting
- Simplified AR tracking and follow-ups
FAQ
What’s the difference between notes receivable and notes payable?
Notes receivable represent a legal promise to receive money from another party at a future date. For your business, notes receivables are assets, as they signify money owed to you.
Notes payable represent a legal obligation to pay money to another party at a future date. For your business, notes payable are liabilities, as they signify money you owe.
What’s the difference between notes receivable and accounts receivable?
Accounts receivable represent unpaid invoices. It’s the amount that your customers owe you for sales for which you’ve extended informal credit terms.
They are typically short-term and tend to be interest-free, though overdue accounts may incur fees or interest charges. AR is easier to manage but less legally binding than notes receivable.
Notes receivable are the formalized, long-term alternative to accounts receivable. They are formalized with a promissory note that acts as a legally binding that states terms like the principal amount, interest rate, and maturity date.
Is notes receivable a current asset?
This depends on the specific note’s maturity date.
If the note matures within the next 12 months (or the business’s operating cycle, whichever is longer), then it is classified as a current asset.
If the maturity period of the note in question exceeds 12 months, the note receivable is instead classified as a non-current asset on the balance sheet.
How do you recognize notes receivable?
Notes receivable are recognized in the journal when a business:
- Issues a promissory note (Debit Notes receivable, Credit Cash/Sales/Accounts receivable)
- Accrues interest on the note (Debit Interest receivable, Credit Interest income)
- Receives payment at maturity (Debit Cash, Credit Notes receivable, Credit Interest income)
