Definition
Notes receivables describe promissory notes that represent loans paid from a company or business to another party. The note comes with a promise from the borrower that it will repay the lender at a future point in time.
Similarly, a note receivable gives the holder, or the lender, the right to receive the amount from the borrower.
A note receivable shows a legal binding agreement between two parties. Usually, companies pay loans in exchange for a note for a short-term.
Therefore, note receivables are current assets. However, if any note is repayable after a year’s time, companies must qualify it as non-current assets. At each reporting date, a company should evaluate all its note receivables for classification.
Notes receivable can come from different sources. For example, a company may provide a loan to another company in exchange for a note. Mostly, however, it comes from customers who transfer or convert their overdue accounts receivable balance to notes.
Explanation
Notes receivable come in the form of a written document that borrowers pay to their lenders. Unlike usual trading balances and credits, notes receivable balances come with additional terms.
Notes receivables are similar to loans given by a company rather than credit due to its operations. Therefore, they have characteristics of a loan.
A note receivable will mention the two parties involved, the payee and the payer. The payee is the party that provides the loan, also known as the borrower.
The payee holds the note and is, therefore, due to receiving a payment from the payer. The payer, or the marker, is the borrower who gets the loan from the payee. The maker promises to pay the holder in the future.
A note receivable also comes with a predetermined interest rate after a mutual agreement of both the parties. The note may also consist of the terms of interest payments.
The maker of the note receivable, along a principal amount, must also pay interest on it. The principal amount of the note receivable represents its face value or the value that the payee will receive.
Finally, a note receivable will also mention the timeframe of the loan. It is similar to the maturity date of loans, which represents a future point in time at which the borrower will repay the lender.
For note receivable, the timeframe is the time before or on which the maker must reimburse the holder. Unlike other loans, note receivables do not usually come with prepayment penalties.
Journal entry
The journal entry for recording note receivable is straightforward. If a company pays another party directly in exchange for a note receivable, the journal entry will be as follows.
| Dr | Note receivable | x |
| Cr | Cash or Bank | x |
However, if the company converts an accounts receivable balance to a note receivable, the accounting entry will be as follows.
| Dr | Note receivable | x |
| Cr | Account receivable | x |
As mentioned above, the company must determine, using the timeframe of the note receivable, whether it classifies as a current asset or non-current.
For non-current asset classification, the company must reevaluate the note receivable at the end of each accounting period to identify if its classification has changed.
On repayment, the note holder will record the receipt and any associated interest on the note. The accounting entry to record repayment is as follows.
| Dr | Cash or bank | x |
| Cr | Note receivable | x |
| Cr | Interest income | x |
Example
A company, ABC Co., has total receivables of $20,000. Among these, one customer with a balance of $5,000 wants to convert the balance to a note receivable.
ABC Co. agrees to do so and changes the balance to note. The customer promises to repay the amount after one year. Both parties also agree that the customer must reimburse the principal amount and a 10% interest on the note.
To record the conversion of account receivable balance to note receivable, ABC Co. uses the following double entry.
| Dr | Accounts receivable | $5,000 |
| Cr | Revenues | $5,000 |
After a year’s time, when the customer repays the loan, ABC Co. must record the receipt. However, the customer will also pay an interest of $500 ($5,000 x 10%) on the note. Assuming the customer makes the repayment to ABC Co.’s bank account, ABC Co. can use the following journal entry to record the receipt.
| Dr | Cash or bank | $5,500 |
| Cr | Note receivable | $5,000 |
| Cr | Interest income | $500 |
Conclusion
A note receivable is a promissory note made by a maker to a payee promising to repay a specified amount at a future point in time.
Characteristically, notes are similar to loans because they come with an interest and principal amounts. Recording notes receivable is straightforward, as mentioned above.
