9.6 Explain How Notes Receivable and Accounts Receivable Differ

Accounts Receivable and Notes Receivable

Both accounts receivable and notes receivable represent money owed to a business, but they differ in formality, terms, and how you account for them. Grasping these differences matters because it affects how a company manages credit risk, records interest, and reports assets on the balance sheet.

Accounts vs. Notes Receivable

Accounts receivable arise when a company sells goods or services on credit. They're informal: the customer makes an oral (or implied) promise to pay, typically within 30 to 60 days (net 30, net 60). They don't carry interest charges and are recorded as current assets on the balance sheet.

Notes receivable are more formal. They involve a written promissory note signed by the borrower, and they can arise from sales, lending, or financing arrangements. Key features:

• May be short-term (due within one year) or long-term
• Usually include an interest rate, so the holder earns interest over the note's life
• Provide a stronger legal claim than accounts receivable because the written document is enforceable in court
• Can be used as collateral for borrowing

Because of their formal, written nature and potential collateral backing, notes receivable generally carry lower credit risk than accounts receivable.

Interest Calculation for Notes Receivable

The formula for calculating interest on a note is:

$Interest = Principal \times Rate \times Time$

• Principal is the face value (original amount) of the note.
• Rate is the annual interest rate stated on the note.
• Time is the fraction of the year the note is outstanding, expressed as days/360 or days/365 depending on the method your course uses.

For example, a 90-day, $10{,}000$ note at 6% annual interest (using a 360-day year) earns:

$Interest = 10{,}000 \times 0.06 \times \frac{90}{360} = 150$

Journal entries for interest on notes receivable:

1. When the note is first received: No entry is made for interest yet, since none has been earned.

2. At the end of an accounting period (adjusting entry for accrued interest):

   • Debit Interest Receivable (to recognize interest earned but not yet collected)
   • Credit Interest Revenue (to record the interest income for the period)

3. When the note is collected in full:

   • Debit Cash for the total amount received (principal + all interest)
   • Credit Notes Receivable for the principal
   • Credit Interest Receivable for any interest previously accrued
   • Credit Interest Revenue for any additional interest earned since the last adjustment

Accounting for Note Transactions

Honored notes are paid in full by the borrower on the maturity date. The entry at collection:

• Debit Cash (principal + total interest)
• Credit Notes Receivable (principal)
• Credit Interest Receivable (for any interest accrued in a prior period)
• Credit Interest Revenue (for interest earned in the current period)

Dishonored notes occur when the borrower fails to pay on the due date. When a note is dishonored, you reclassify the amount owed back to Accounts Receivable (because you still intend to collect, but the formal note agreement has been broken):

1. Debit Accounts Receivable for the full amount owed (principal + any accrued interest)
2. Credit Notes Receivable for the principal
3. Credit Interest Receivable for any interest previously accrued

The total debited to Accounts Receivable includes the accrued interest because the borrower now owes that amount as well. You do not reverse Interest Revenue that was legitimately earned in a prior period.

Converting between accounts receivable and notes receivable:

• Accounts receivable → Notes receivable (a customer signs a promissory note to formalize an existing debt):
  • Debit Notes Receivable
  • Credit Accounts Receivable
• Notes receivable → Accounts receivable (a note is dishonored):
  • Follow the dishonored note entry described above

Additional Considerations

• Collectibility: Notes receivable tend to be more collectible than accounts receivable because the written, signed agreement creates a stronger legal obligation.
• Liquidity: Accounts receivable are generally more liquid. They convert to cash faster since they have shorter payment terms and no formal maturity date to wait for.
• Discounting: A company can sell (discount) a note receivable to a bank before its maturity date to get cash sooner. The bank charges a discount fee, so the company receives less than the note's maturity value. This is a common way to improve short-term cash flow.