Notes Receivable

What are Notes Receivables?

Notes receivable represent assets associated with a written promissory note outlining the payment terms for a transaction between the "payee" (often a company, also known as a creditor) and the "maker" of the note (typically a customer or employee, also known a debtor).

Notes receivable can arise in various business relationships involving interactions with other businesses, financial institutions, or individuals. Typically, these situations occur when a buyer requires an extended period beyond the usual billing terms to settle payment for a purchase.

These notes find representation on the balance sheet, reflecting the monetary value of promissory notes owed to a business, anticipating future payments.

They grant the holder the entitlement to receive the specified amount stipulated in the contractual agreement. These notes essentially serve as written assurances of the debtor to remit cash to another party by a designated future date.

If a note receivable is expected to be collected within one year, it is classified as a current asset on the balance sheet. Otherwise, if the collection extends beyond one year, it is categorized as a non-current asset.

Frequently, businesses permit customers to transform overdue accounts (accounts receivable) into notes receivable, providing debtors with the advantage of an extended payment period.

Understanding Notes Receivables

Notes receivables constitute a written agreement where a borrower commits to repay a specific amount of money, including interest, to the lender on a set date in the future. Therefore, notes are considered negotiable instruments, like cheques and bank drafts.

Notes receivable may originate from various sources, such as loans granted to individuals or businesses, advances provided to employees, or customers with higher credit risk who require an extended payment period for outstanding accounts.

Notes can also find application in the context of property, plant, and equipment sales or the exchange of long-term assets.

In instances where notes stem from loans, they may specify collateral in the form of the borrower's assets, which the lender can take possession of if the note remains unpaid by the maturity date.

From the perspective of the note issuer, the document is referred to as notes payable, indicating the obligation to repay a designated amount on a predetermined future date to the holder of the notes receivable.

The note presents all terms and conditions transparently to remove any possible misunderstandings between the parties in the future.

Additionally, it explicitly specifies both the principal amount, equivalent to the face value of the notes, and the accompanying interest that must be paid.

Businesses worldwide commonly engage in buying and selling on credit. A formal commitment to make payment on a designated future date is generated when a supplier sells goods on credit.

These formal commitments, often referred to as promissory notes, are considered notes receivable upon acceptance.

Components of Notes Receivable

The following are the key components of notes receivable:

1. Principal Amount: The principal amount, also known as the face value or principal sum, is the initial sum of money the borrower agrees to repay the lender. It forms the basis for interest calculations and represents the primary amount lent or borrowed.
2. Interest Rate: The interest rate is the percentage applied to the initial amount for a designated duration, influencing the expense of borrowing or the earnings on an investment for the lender.
3. Maturity Date: The maturity date signifies the deadline by which the borrower must repay the principal amount and any accumulated interest to the lender. It establishes the repayment schedule, differentiating between short-term and long-term notes.
4. Terms of Repayment: The terms of repayment encompass the schedule and method by which the borrower will make payments. It includes details such as the frequency of payments (monthly, quarterly, annually) and whether payments are in equal installments or structured differently. Clearly defined repayment terms ensure both parties are aware of their obligations and help in financial planning.
5. Interest Accrual Method: The interest accrual method determines how interest is calculated and accrued over time. Common methods include simple interest or compound interest. The chosen method affects the total interest amount and the financial implications for both the borrower and the lender.
6. Collateral (if any): Collateral is an asset pledged by the borrower to secure the note. It serves as a form of security for the lender in case of default.
7. Default and Remedies: The terms outline what constitutes a default (failure to fulfill obligations) and the remedies available to the lender in case of default. Clearly defined default provisions help protect the lender's interests and provide a legal framework for addressing default situations.
8. Negotiability and Transferability: Notes may be negotiable or non-negotiable, and the terms of the note may restrict their transferability. This impacts the ease with which the note can be transferred to another party, potentially influencing liquidity.

Example of Notes Receivable

The following hypothetical example illustrates how notes receivable work:

Company XYZ sells machinery to Company ABC for $50,000; payment is initially expected within 60 days. However, Company B failed to make the payment within the given days. Both parties agree on a promissory note to settle the debt as per the following terms:

• Payee: XYZ
• Maker: Company ABC
• Principal: $50,000
• Time frame: 6 months due at maturity
• Interest rate: 6% per year

Example of Journal Entries for Notes Receivable

The accounting journal entries for the note receivable from Company XYZ can be summarized as follows:

Company XYZ's financial records no longer include the accounts receivable from 

Company ABC for the initial invoice. Instead, a new note receivable has been created, with a maturity date set for six months from now.

This record represents the complete settlement with cash upon maturity. It removes the notes receivable from Company ABC for the original amount and documents interest earnings based on the duration the note remained outstanding.

It is calculated as ($50,000 x 6%) multiplied by the ratio of days outstanding to 365 (183/365).

Notes Receivable vs Notes Payable

Let's comprehensively compare the differences between Notes Receivable and Notes Payable:

Advantages of Notes Receivables

The following are the advantages of a notes receivable account:

1. Formal Agreement: These notes establish a formal, written agreement between the creditor and debtor, clearly outlining essential terms such as the principal amount, interest rate, and repayment schedule.
2. Legal Protection: It can function as a legally recognized record, offering proof of the debtor's commitment to settle the owed sum. This documentation is significant in situations involving disputes or when legal proceedings are necessary.
3. Interest Income: If interest is charged on the note, the creditor can earn additional income beyond the principal amount. This interest can contribute to the overall profitability of the transaction.
4. Flexibility: They offer flexibility in negotiating terms. Creditors and debtors can adjust the repayment schedule, interest rates, and other terms based on their mutual agreement.
5. Financial Planning: The company can improve its cash flow planning by keeping notes receivables, indicating when they will receive payment.

Disadvantages of Notes Receivables

The following are the disadvantages of a notes receivable account:

1. Default Risk: Failure by the borrower to fulfill the responsibilities specified in the promissory note, such as delayed payments or non-repayment of the entire agreed-upon sum, can expose the lender to potential financial liabilities.
2. Liquidity Concerns: Unlike cash, promissory notes are not as liquid. It may take time to convert the promissory note into cash, especially if the debtor faces financial difficulties.
3. Interest Rate Risk: Creditors face a potential risk when interest rates change. With a fixed-interest rate loan, the creditor may lose the chance to capitalize on higher returns if the prevailing market rates increase.
4. Administrative Burden: Managing and tracking promissory notes can be administratively burdensome. This includes monitoring payment schedules, ensuring compliance with terms, and potentially dealing with late payments.
5. Dependence on Debtor's Financial Health: The effectiveness of promissory notes depends on the financial stability of the debtor. The debtor's financial challenges could impact their ability to fulfill the repayment obligations.

Accounts Receivable vs Notes Receivable

Let's understand the differences between Accounts Receivable and Notes Receivable:

Authored and researched by Rani Thakur ⎮LinkedIn

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