The Mystery of Notes Receivable

How Is Notes Receivable Accounted? Let’s Settle It

So, your business sells stuff or provides services on credit. You send an invoice and politely wait for the customer to pay you back. Congrats, you’ve basically just given out an interest-free loan with a friendly suggestion to please, please repay.

For a little more certainty in this chaotic world, some deals need a more formal IOU. This grown-up, legally-binding promise from a customer is called a promissory note.

When you get a promissory note, you don’t just shove it in a drawer. You record that future cash on your books as a note receivable. Think of it as an asset – a piece of paper that represents real money you’re owed. It gets its own special spot on the balance sheet.

What is Notes Receivable in Accounting, Really?

Companies of all sizes use notes receivable. It’s the corporate version of an ‘I owe you,’ where everyone meticulously follows the rules to make sure the promise of money looks like actual money on paper.

This isn’t just about keeping up appearances; it’s smart business. Relying only on invoices can be risky. A promissory note is a legally binding document that gives you, the seller, enforceable protection if things go south. It formalizes the debt and sets a clear repayment path, which helps avoid ugly disputes later.

When you log these notes, you have to use the accrual method of accounting and play by the specific debit and credit rules. This ensures your financial statements are an accurate snapshot of your health, even if the cash hasn’t hit your bank account yet.

So, let’s get into the weeds of notes receivable, the debit and credit rules that apply, and the all-important journal entries.

So, What Are Notes Receivable, Exactly?

A note receivable is a formal IOU – a written promise that you’ll receive a specific amount of cash from someone on a future date. For you, the holder of the note, it’s an asset. For the party who has to pay up, it’s a liability known as a note payable.

Sometimes, when a customer is taking forever to pay their invoice, their overdue accounts receivable gets converted into a note receivable. This just gives the debtor a more structured way (and more time) to pay you back.

Let’s be real. You didn’t get paid. You just got a signed apology that expires later.

Notes Receivable: Current or Non-Current?

On your balance sheet, a note receivable is classified based on when you expect to get paid.

Current Asset: If the note is due within 12 months.
Non-Current Asset: If the note is due in more than 12 months. This long-term portion is often reported under Investments.

In this arrangement, the party getting the cash is the payee (that’s you), and the one obligated to pay is the maker. The note will specify the principal (the amount owed) and the maturity date (when it’s due).

Most notes receivable also come with interest, which is a nice little bonus for your patience. You can figure out how much you’ll earn with a simple formula for calculating interest on notes receivable:

Interest Earned = Principal x Interest Rate x Time Period

When a Promise Gets Broken

If your business is swimming in these IOUs, it’s wise to set up an “allowance for doubtful notes receivable.” This is basically a ‘we knew they might screw us’ fund.

You accrue a bad debt balance to write off any notes that eventually become uncollectible. An uncollectible note is officially called a dishonored note – because “deadbeat” doesn’t look as professional on the balance sheet.

Notes Receivable in the Wild: An Example

Let’s see how this works in practice.

Peter Publishing Group buys $100,000 worth of computers on credit from Techbuddy Technology Supply. The invoice is due in 60 days. Peter can’t make the payment on time, so they negotiate a promissory note with Techbuddy.

Payee: Techbuddy Technology Supply
Maker: Peter Publishing Group
Principal: $100,000
Time frame: 6 months, due at maturity
Interest rate: 6% per year

This formalizes the debt and gives Peter a clear path to repayment, while Techbuddy gets a legally enforceable asset.

Is an Increase to Notes Receivable a Debit or Credit?

Alright, let’s get to the core of notes receivable accounting. When you get a new note, is that a debit or a credit?

Here’s the rule: Assets have a natural debit balance. To increase an asset account, you debit it. To decrease it, you credit it.

Since notes receivable is an asset, an increase to the account is always a debit. Simple as that.

The Golden Rule: Is Notes Receivable Increasing by a Debit or a Credit?

Let’s cut to the chase: Notes receivable is an asset, so it has a natural debit balance.

When you receive a note from a customer, you debit the Notes Receivable account. The corresponding credit goes to Cash, Sales, or Accounts Receivable, depending on how the note came to be.

When the note matures, the maker pays you the principal plus any interest. You’ll record the interest earned and clear the note from your books. This involves debiting Accounts Receivable for the full maturity value and crediting Notes Receivable for the original face value, with another credit to Interest Revenue for the sweet, sweet interest.

What if the Note Matures and Becomes Dishonored?

So, someone stiffed you? Great. Now you get to perform accounting’s equivalent of bargaining with grief.

How you record this depends on your level of optimism.

You Expect to Get Paid (Eventually): If you’re still clinging to the fantasy that they’ll pay, you just shuffle the phantom debt. You move the note’s full value (principal and interest) from Notes Receivable to Accounts Receivable. You’re still recognizing the interest revenue, bless your heart.
You Don’t Expect to Get Paid (Ever): If you’ve accepted you’ve been thoroughly screwed, you write it off as a bad debt. You credit the Notes Receivable account to make it disappear and debit your Allowance for Bad Debts account. No interest revenue is recognized here, because even the ledger knows when to stop lying.

Notes Receivable Journal Entries: The Beginning

Let’s say on July 1st, Company X accepts a note from Company Y to settle an existing account receivable. Here is the initial notes receivable journal entry to get it on the books:

Date	Account	Debit	Credit
1st July	Notes Receivable: Y	00
	Accounts Receivable: Y		00

If the note comes directly from a sale, you should create two entries:

Account	Debit	Credit
Accounts Receivable	00
Sales		00

Debit and credit journal entry to record sale

Account	Debit	Credit
Notes Receivable	00
Accounts Receivable		00

Debit and credit journal entry to record receipt of note in exchange for open account receivable

Could you combine these into one entry? Sure. But thinking of combining journal entries for “efficiency”? Great! Now you’ve optimized for data loss, not profit. Keeping them separate ensures your customer’s subsidiary ledger is accurate.

Getting Paid: Journal Entries for Honored Notes

When you receive the payment, you’ll debit Cash, credit Notes Receivable, and credit Interest Revenue. If Company Y pays its note in full on October 31st, the entry looks like this:

Date	Account	Debit	Credit
31st October	Cash	00
	Notes Receivable		00
	Interest Revenue		00

When a Note Crosses Fiscal Years

Sometimes, a note’s life doesn’t fit neatly into one accounting period. This is a reminder to pause and account for what’s happened so far, even if the final payment is still months away.

For example, Company ABC gets a 3-month, 18% note for $5,000 on November 1, 2021. Their fiscal year ends December 31, but the note matures on January 31, 2022. They need to accrue the interest earned in 2021.

November 1, 2021: Record the receipt of the note:

Date	Account	Debit	Credit
1st November 2021	Notes Receivable	$5,000
	Cash		$5,000

December 31, 2021: Accrue interest for November and December:

Date	Account	Debit	Credit
31st December 2021	Interest Receivable	$150
	Interest Revenue		$150

Calculation: $5,000 x 0.18 x (2/12) = $150

January 31, 2022: Record the full payment:

Date	Account	Debit	Credit
31st January 2022	Cash	$5,225
	Interest Receivable		$150
	Notes Receivable		$5,000
	Interest Revenue		$75

Total Interest: $225 ($150 from 2021 + $75 from 2022) Total Received: $5,225 (Principal + Total Interest)

When Promises Break: Journal Entry for a Defaulted Note

If the maker defaults, the dishonored note is moved out of Notes Receivable and into Accounts Receivable. You debit Accounts Receivable for the full maturity value (principal + unpaid interest).

Let’s say Company ABC has a $2,000, 12%, 4-month note from Company XYZ. If XYZ defaults on October 31st, ABC makes this entry:

1st October	Accounts receivable: XYZ	$2,080
	Notes Receivable: XYZ		$2,000
	Interest Revenue		$80

This keeps your Notes Receivable account clean, showing only notes that haven’t matured yet. The default is noted in XYZ’s account, and if it ultimately proves uncollectible, it gets written off against the Allowance account.

More Notes Receivable Accounting Examples: A Case Study

Let’s hammer this home. Notes receivable is an asset, which means it lives on the debit side of the ledger. Assets, expenses, and dividends are all debit accounts. They go up with a debit and down with a credit.

When you get a note, you debit Notes Receivable. When the customer pays you, you credit Notes Receivable to reduce the balance. Got it? Good.

Now, let’s walk through a real-world scenario.

From Overdue Invoice to Formal Promise

This isn’t just a transaction; it’s a story of negotiation, of finding a structured path forward when the original plan falters. Anne’s Apparel sells $15,000 worth of clothing to Jenny’s Online Store, with payment due in 30 days. After 60 days of radio silence, they agree to convert the debt into a formal promissory note. Jenny will pay back the $15,000 with 10% interest, in three monthly installments of $5,000.

First, Anne converts the original accounts receivable into a note receivable.

Journal entry to record receipt of the 3-month, 10% note for $15,000:

Account	Debit	Credit
Notes Receivable	$15,000
Accounts receivable		$15,000

Recording the Payments

Month 1: Jenny makes her first $5,000 payment, plus interest.

Interest Calculation: $15,000 x 10% x (30/365) = $123

Here’s the journal entry:

Account	Debit	Credit
Cash	$5,123
Notes Receivable		$5,000
Interest Revenue		$123

Month 2: Jenny pays another $5,000, plus interest on the remaining balance.

Interest Calculation: $10,000 x 10% x (30/365) = $82

Notice the interest dropped? That’s because it’s calculated on the outstanding principal, which is now only $10,000.

Account	Debit	Credit
Cash	$5,082
Notes Receivable		$5,000
Interest Revenue		$82

Month 3: Jenny pays the final $5,000 and the last bit of interest.

Interest Calculation: $5,000 x 10% x (30/365) = $41

Account	Debit	Credit
Cash	$5,041
Notes Receivable		$5,000
Interest Revenue		$41

With that final payment, the note is paid off, and Anne has pocketed an extra $246 in interest revenue.

When the Story Ends Badly

And here we are, at the end of the line, where good faith meets bad math. Let’s say Jenny couldn’t make that final $5,000 payment. Anne now has to write off the remaining balance and the related interest.

This is the journal entry for a broken promise:

Account	Debit	Credit
Allowance for doubtful accounts	$5,041
Notes Receivable		$5,000
Interest receivable		$41

Key Takeaways: Notes Receivable Edition

It’s a Formal IOU: A notes receivable isn’t just a friendly handshake; it’s a legally binding promise for future cash, elevating “please pay me” to “you will pay me.”
Asset, Always a Debit: In the grand scheme of your balance sheet, a note receivable is an asset. This means increasing it is always a debit, and decreasing it (when you finally get paid) is a credit.
Interest is Your Reward (for Patience): Most notes come with interest, a little bonus for acting as a benevolent lender. Remember the formula: Principal x Interest Rate x Time.
Prepare for the Worst (Dishonored Notes): Some promises are broken. Set up an “allowance for doubtful notes” because, let’s face it, not everyone pays up. When they don’t, it’s a “dishonored note” – which sounds much nicer than “deadbeat.”
Journal Entries Are Your Friend: Whether it’s the initial recording, accruing interest across fiscal years, or the painful process of writing off a defaulted note, meticulous journal entries keep your books honest (even if the debtor isn’t).
Converts from Accounts Receivable: Often, these notes are born from overdue invoices, offering a structured (and hopefully more reliable) path for customers to eventually pay their dues.