Notes receivable: accepting, accruing, collecting and dishonor

A note receivable is a written promise from someone else, usually a customer, to pay the business a fixed amount, normally with interest, by a fixed date. It is the mirror image of a note payable. Businesses accept notes when a customer needs longer to pay than normal credit terms allow, when they sell something expensive on extended terms, or when they lend money. Compared with an ordinary account receivable, a note is more formal, easier to enforce, and earns interest.

This page covers the full life of a note receivable: recording it, accruing the interest earned by year end, collecting principal and interest at maturity, and what to do when the customer does not pay. Interest throughout is simple interest, the kind used on most short-term notes:

Interest = Principal × Annual rate × Months ÷ 12

For example, a 3-month, 12% note on $29,600.00 earns $29,600.00 × 12% × 3 ÷ 12 = $888.00. Some notes count days instead of months, dividing by 360 or 365; the exercises use whole months and every problem states the term.

The accounts

• Notes Receivable: an asset for the principal. It is current if due within a year.
• Interest Receivable: an asset for interest earned but not yet collected.
• Interest Revenue: the income from lending, recognised as time passes.

As with notes payable, keep principal and interest apart. The note stays at its face value; interest is earned over time and has its own accounts.

1. Accepting a note from a customer

Fernwood Clinic could not pay its $29,600.00 account with Juniper Landscaping when it was due. Juniper Landscaping agreed to accept a 3-month, 12% note receivable for the full amount.

The customer owes exactly what it owed before; only the form of the debt has changed. No cash arrives and no new revenue is earned: the revenue was recorded when the original sale was made. If instead the business lends cash, the credit is to Cash.

2. Collecting at maturity

The 3-month, 12% note from Fernwood Clinic for $29,600.00 matured, and the customer paid the principal plus interest. No interest had been recorded yet.

Interest: $29,600.00 × 12% × 3 ÷ 12 = $888.00. Cash received: $30,488.00.

Using a full year's interest ($3,552.00) is the commonest arithmetic error: the 12% is an annual rate, and this note ran for three months.

3. Accruing interest at year end

When a note is still outstanding at the end of the fiscal year, the interest earned so far belongs to that year even though it has not been collected. An adjusting entry records it.

On November 1, Juniper Landscaping accepted a 12-month, 12% note receivable from Fernwood Clinic for $29,600.00. Interest is collected at maturity. Record the interest earned by December 31.

November and December are two months: $29,600.00 × 12% × 2 ÷ 12 = $592.00.

Debit Interest Receivable, not Notes Receivable. The note's face value has not changed; the business has simply earned some interest on it.

4. Collecting after an accrual

On June 1 last year, Juniper Landscaping accepted a 12-month, 12% note for $29,600.00. At December 31 it accrued $2,072.00 of interest; it does not use reversing entries. Today the customer paid the note and all the interest.

1. Total interest for 12 months: $29,600.00 × 12% = $3,552.00.
2. Already recorded last year (June to December, 7 months): $2,072.00, sitting in Interest Receivable.
3. New revenue this year (5 months): $3,552.00 − $2,072.00 = $1,480.00.
4. Cash: $29,600.00 + $3,552.00 = $33,152.00.

Crediting all $3,552.00 to Interest Revenue would count last year's $2,072.00 twice and leave it stranded in Interest Receivable. A business that uses reversing entries would have reversed the accrual on January 1 and could then credit the whole $3,552.00 to Interest Revenue; the result for the year is the same.

5. A dishonored note

A note is dishonored when the maker fails to pay it at maturity. The note itself is no longer a valid claim for future payment, so it comes off the books. But the customer still owes the money, and interest was earned right up to maturity, so if the business still expects to collect, it moves the full amount owed back to Accounts Receivable:

Juniper Landscaping holds a 3-month, 12% note from Fernwood Clinic for $29,600.00. At maturity the customer failed to pay. Juniper still expects to collect.

Moving the balance to the customer's account keeps a clear record of the default, which matters when deciding whether to extend credit to that customer again. Writing the note off straight to Bad Debt Expense is premature if collection is still expected; that decision comes later, through the business's normal bad-debt process.

Why accept a note at all?

From the seller's side, turning an overdue account into a note has three benefits. The customer acknowledges the debt in writing, which matters if the business ever has to pursue it. The business is compensated for waiting, through interest. And there is a clear new due date, which makes follow-up straightforward. The trade-off is that the cash arrives later still, so a note is a tool for customers the business expects to pay eventually, not a substitute for collecting what is due on time.

Following one note through two years

Seeing every entry for one note in a single place makes the pattern easier to remember. Take the 12-month, 12% note for $29,600.00 accepted on June 1 from a customer's overdue account, with a December 31 year end and no reversing entries:

Across both years, Interest Revenue totals $2,072.00 + $1,480.00 = $3,552.00, the full year's interest on the note, split seven months to five in line with when it was earned. Both receivable accounts end at zero once the customer pays. If either still has a balance afterwards, an entry is missing or doubled.

Checking interest quickly

• At 12% a year, interest is 1% a month: $296.00 a month on $29,600.00, so two months is $592.00 and three is $888.00.
• At 6%, it is half of 1% a month; at 9%, three-quarters of 1%.
• On a note shorter than a year, the interest must be less than principal × rate. If yours is larger, you have used too many months.

These quick checks catch most slips before you press Check, and they are worth using on real notes too, where the interest calculated by a lender or by software should always be sanity-checked against a rough figure.

Notes receivable vs accounts receivable

Common mistakes

1. Recording a note from a customer as revenue. The sale was already recorded; the note replaces the receivable.
2. Using a full year's interest on a shorter note. Multiply by months ÷ 12.
3. Leaving interest out of the collection or the dishonor entry.
4. Adding accrued interest to Notes Receivable. Use Interest Receivable.
5. Recording all the interest as revenue after an accrual. Clear Interest Receivable first.
6. Writing off a dishonored note too early. If collection is still expected, move it to Accounts Receivable.

How the practice works

Each exercise generates a new customer, principal, rate and term. You record the entry, press Check, and your answer is compared line by line with one computed from the same facts, with interest rounded to the cent. The lesson moves from accepting a note, through collection and year-end accrual, to collecting after an accrual and recording a dishonored note.