Notes receivable are amounts owed to a business that are backed by a formal written promise to pay, called a promissory note. The note names the borrower (the maker), the business that will receive payment (the payee), the principal amount, the interest rate and the maturity date. Businesses hold notes receivable when they lend money to customers, employees or other companies, when they sell large items such as equipment or property on extended credit, or when a customer with an overdue account agrees to convert it into a note. The general features of the instrument are covered in the entry on the note.
Notes receivable are more formal than ordinary accounts receivable. They usually carry interest, have a fixed repayment date, are easier to enforce in court and can sometimes be sold or used as security. Notes due within one year are reported as current assets; those due later are noncurrent.
Calculating interest and maturity value
Interest on a simple note is:
Here is the face amount, is the annual interest rate, and is the fraction of a year the note is outstanding, often measured in months over 12 or days over 360. The maturity value is the principal plus interest.
Worked example
On 1 October, an equipment dealer accepts a six-month, 8 percent note for $24,000 from a customer in settlement of an overdue account. Interest for the full term is $24,000 times 0.08 times 6 over 12, which is $960, and the maturity value is $24,960.
- 1 October: debit notes receivable $24,000; credit accounts receivable $24,000.
- 31 December (year end, three months elapsed): debit interest receivable $480; credit interest revenue $480.
- 1 April (maturity): debit cash $24,960; credit notes receivable $24,000, interest receivable $480 and interest revenue $480.
Total interest revenue of $960 is split between the two years in which it was earned.
Dishonored notes
If the maker fails to pay at maturity, the note is said to be dishonored. The payee usually removes the note and records the full amount owed, including the interest earned, as an account receivable from the customer, because it still has a legal claim. In the example, a dishonored note on 1 April would lead the dealer to debit accounts receivable $24,960 and credit notes receivable $24,000, interest receivable $480 and interest revenue $480. If collection then appears unlikely, the receivable is written off against the allowance for doubtful accounts.
Valuation, discounting and disclosure
Notes receivable are generally measured at amortized cost, less an allowance for expected credit losses. Since the adoption of the current expected credit loss model in ASC 326, US companies must estimate lifetime expected losses on notes from the date they are recognized, rather than waiting for a loss to become probable. Non-interest-bearing notes, or notes with an unrealistically low rate, are recorded at present value, with the difference recognized as interest over the term using a discount on notes receivable.
A business that needs cash before maturity can sell or pledge its notes to a bank, a practice known as discounting. If the bank has recourse to the business should the maker default, the business must disclose a contingent liability, and depending on the terms the transaction may be accounted for as a secured borrowing rather than a sale. Notes receivable from officers, directors and other related parties must be disclosed separately; public companies are generally prohibited from making personal loans to their executives under the Sarbanes-Oxley Act of 2002. Large balances of notes from customers can signal that a company is extending generous credit to support sales, so analysts watch them alongside bad debts expense.