What is Notes Receivable?
Notes Receivable is a written promise that gives the entitlement to the lender or holder of notes to receive the principal amount along with the specified interest rate from the borrower at the future date. They’re shown in the balance sheet of the holder as the current assets in case the note is due within the period of one year, else will be shown under the now- current head in the balance sheet if the note is due after the period of one year.
Components of Notes Receivable
Following are the different components –
- Principal Value: It is the note’s face value.
- Maker: The maker is the person who prepares the note. He, by preparing notes, promises to pay the specified amount to the holder of notes. For the maker, the note will be classified as the note payable.
- Payee: The person to whom the maker issues the note is known as the payee. The payee holds the note with the right to receive the payment from the maker. For the maker, the note will be classified as the note receivable.
- Stated Interest: In addition to the principal amount, the maker of note has an obligation to pay the interest amount due at the rate of interest, which is predetermined in the notes receivable. This predetermined interest rate is known as the stated interest.
- Time Frame: Length of time for within which note needs to be repaid is known as the time frame.
Example of Notes Receivable
X ltd. sold machinery to Y Ltd for an amount of $ 500,000 with the terms that payment against purchase will be made within 35 days from the date of sale. Even after 35 days, Y ltd was not able to make the payment of the specified amount to the X ltd. Hence, with the consent of both of the parties, it was decided that the X ltd will receive the notes receivable with a principal amount of $ 500,000 and a 10% interest rate to be issued by Y Ltd. It had a condition that $ 125,000 will be paid along with interest due at the end of each month for the next four months.
It is the example where the same note issued by Y Ltd. and received by X ltd. will be treated as notes receivable in the balance sheet of X ltd. (payee) and will be treated as notes payable in the balance sheet of Y Ltd. (maker). The principal value of the note is $ 500,000, $125,000 of which will be paid monthly for four months (time frame) along with the agreed annual interest rate of 10% (stated interest).
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- All the terms and conditions are in writing, so there will not be any doubt about obligations which the borrower assumes after making notes. Also, it outlines clearly the rights of the lender.
- The borrower must sign the notes which provide a layer of protection against the fraudulent alterations to the notes receivable.
- The notes avoid the risk of default for the business as they have everything mentioned.
- If the borrower is not able to pay the specified amount even after the due date, then he is liable to pay the principal as well as interest for the whole period, and the same keeps on accumulating until all the dues get cleared.
- If the amount remains unpaid even after the due date, then the holder can even sue the maker in the court as the notes receivable is the written document, which makes it risky for the maker.
- Usually, the note receivable is not subject to the prepayment penalties. In this case, the maker of note can pay off the amount on before the maturity date freely, which can save the interest amount.
- They generally require a debtor who makes the notes to pay the interest, and the period of the notes extends typically for the 30 days or more.
- Businesses often allow their customer or the debtors to convert their accounts, which are overdue into the notes receivable due to which it provides more time to the debtor for the repayment. They are shown in the balance sheet of the holder as the current assets in case the note is due within one year, else will be shown under the non-current head in the balance sheet if the note is due after one year.
- The Interest portion received by the holder is shown as the interest expense in its profit and loss account. Thus such receivables that have an interest as well affect both balance sheet and profit and loss account of the holder of the same.
Notes receivable is the written promise which gives the rights to the holder of the note for receiving a specific sum of money at a specified future date. From the side of the maker of the notes, it is known as the notes payable as he has an obligation to pay the specific sum of money at a specified future date to the holder of the notes receivable. The note provides all the terms and conditions clearly so that there should not be any ambiguity in the future between the two parties. It also clearly mentions the interest which is required to be paid along with the principal amount, which is the face value of the notes. So, it is an asset for the bank, company, or the other organization which holds it in the form of a written promissory note given by another party.
This article has been the guide to what is note receivable and its definition. Here we discuss an example and components of notes receivable along with their advantages and limitations. You may refer to the following articles to learn more about finance –