Is notes receivable debit or credit? Many businesses sell goods or render services to customers on credit. After the sale, they simply send an invoice to the customer and the customer pays later. However, for certainty, some transactions are better completed with a more formal promise from the customer assuring the seller of payment. This formal promise from the customer is called a promissory note. When a business owner receives a promissory note, he records the amount due on his accounting books as a note receivable, which is reported as an asset on the balance sheet.
Companies and businesses of all sizes and industries use notes receivable, which benefit both sides of the purchase equation. However, when recording notes receivable in the accounting books, these companies must use the accrual method of accounting and follow some specific rules. They should ensure notes receivable are recorded according to the debit and credit rules. Hence, in this article, we will discuss notes receivable, the debit and credit rules applicable to it in accounting, and its journal entries.
Related: Supplies expense debit or credit?
Understanding notes receivable
A note receivable is a written promise from another party to receive a specific amount of cash on a future date. Therefore, the holder of the note treats it as an asset in his books. The other party that issues the promissory note, however, doesn’t treat it as an asset but as a liability known as a note payable. Sometimes, overdue accounts receivable are converted into notes receivable, thereby giving the debtor more time to pay.
Notes receivable is, therefore, an asset of a company, organization, or bank that holds a written promissory note from another party. A business should classify a note receivable in the balance sheet as a current asset if it is due within 12 months. However, if the note receivable is due more than 12 months, it should be classified as a non-current (long-term) asset.
The party that receives payment under the terms of the promissory note is referred to as the payee, while the party that is obligated to send money to the payee is the maker. The amount of payment to be made is the principal and is usually listed in the terms of the note. There is also a maturity date on the note on which the principal has to be paid. More so, a note receivable usually comes with a specific interest rate or a rate that is tied to another interest rate, such as a bank’s prime rate. This interest rate that is earned on a note receivable is calculated as:
Interest earned = Principal x Interest rate x Time period
The principal part of a note receivable that is expected to be collected within one year of the balance sheet date should be reported in the current asset section of the note holder’s balance sheet. While the remaining principal part of the note receivable should be reported in the non-current asset section as Investments.
Furthermore, if a business has a large number of outstanding notes receivable, it should consider setting up an allowance for doubtful notes receivable. So, it can accrue a bad debt balance which it can use to write off any notes receivable that later becomes uncollectible. An uncollectible note receivable is referred to as a dishonored note. Hence, a dishonored note is a note that the maker defaulted to pay at maturity.
An example of notes receivable
In order to understand notes receivable from a practical perspective, let’s look at an example of how notes receivable work:
Peter Publishing Group purchases $100,000 worth of computers on credit from Techbuddy Technology Supply. Techbuddy sends Peter an invoice that is due in 60 days, in accordance with Techbuddy’s normal billing terms. Unfortunately, Peter is unable to make prompt payment and negotiates a promissory note with the following terms:
- Payee: Techbuddy Technology Supply
- Maker: Peter Publishing Group
- Principal: $100,000
- Time frame: 6 months due at maturity
- Interest rate: 6% per year
You can check out some samples of what a promissory note looks like on Pinterest.
From this session, we know that notes receivable is recorded as an asset and we also know it can be dishonored. However, as an asset what are the debit and credit rules that are applicable to notes receivable when making a journal entry? Is notes receivable debit or credit? In order to answer this, let’s look at the debit and credit rules that are applicable to notes receivable.
Debit and credit rules (applicable to notes receivable)
In order to record a transaction, an amount must be entered as a debit entry in one account and as a credit entry in another account. That is, for every transaction, the totals of the debits and credits must always equal each other for the transaction to be in balance. This is one of the most important debit and credit rules. The other debit and credit rules are:
- Debits increase assets, expenses, and dividends accounts
- Credits increase equity, liabilities, and revenue accounts
- Contra accounts reduce the paired accounts’ natural debit or credit balance
According to these rules, we record assets, dividends, and expenses as a debit and not a credit. This means that assets such as notes receivable and accounts receivable will be recorded as a debit and not a credit.
Increase to notes receivable; debit or credit?
Is the increase to notes receivable debit or credit? According to the rules stated above, all accounts that contain a debit balance will increase when a debit entry is added to them and will decrease when a credit entry is added to them. This particular accounting rule is applicable to assets such as notes receivable. Notes receivable contain a debit balance that will increase in amount when debited and reduce when credited. Therefore, an increase to the notes receivable account is a debit and not a credit.
Is notes receivable debit or credit?
Notes receivable is a debit and not a credit because it is an asset. When a note is received from a maker or customer, the Notes Receivable account has to be debited and a credit entry is made to the Cash, Sales, or Accounts Receivable account, depending on the transaction that gave rise to the promissory note.
At the maturity date of the note, the maker is obligated to pay the principal plus interest. Hence, the holder records the interest earned and removes the note from its Notes Receivable account. Therefore, the holder of the note will debit its Accounts Receivable account for the maturity value of the note and credit its Notes Receivable account for the note’s face value, and also credit its Interest Revenue account for the interest.
Also, if a note has a duration that is longer than one year, and the maker does not pay interest on the note during the first year, it is a usual practice to add the unpaid interest to the beginning principal balance in the second year, and use the beginning principal balance as the basis upon which to calculate interest in the second year.
In a case whereby the note has matured and has become a dishonored note, the holder or payee records this dishonored note in one of two ways depending on whether or not the holder expects to collect the debt. If payment is expected, the holder removes the note from Notes Receivable and records the amount due in Accounts Receivable. That is, the holder transfers the principal and interest to accounts receivable, removes the face value of the note from notes receivable, and recognizes the interest revenue.
On the other hand, if payment is not expected, the holder believes the note is a bad debt, so he will credit the notes receivable account to remove the amount not paid and then debit the allowance for bad debts account to record the amount. In this case, no interest revenue is recognized because none will ever be received.
Receipt of the note
If X on 1st July accepts a note receivable from the Y in settlement of an open account receivable. In order to record the receipt of the note which is the initial recording of notes receivable, the journal entry will be:
Debit and credit journal entry for notes receivable
|1st July||Notes Receivable: Y||00|
|Accounts Receivable: Y||00|
In some situations, the receipt of the note arises from the sale of merchandise. In a case whereby a sale is made to a customer for a trade note receivable the following two journal entries are made:
Also, it is possible to combine the previous two entries in one journal entry by debiting Notes Receivable and crediting Sales. Nevertheless, doing so will result in a loss of information because not all the sales made to a particular customer are recorded in the customer’s subsidiary accounts receivable ledger. Hence, it is best to make the two journal entries as shown above.
Payment of the note
When the payment on a note is received, the Cash account is debited, the Notes Receivable account is credited, and the Interest Revenue account is credited. If the note from Y recorded on 1 July is paid in full on 31st October. The entry would be:
Debit and credit journal entry for notes receivable to record payment of note and interest
There are some instances, whereby the note is received in one accounting period and collected in another. In such instances, interest must be accrued at year-end. That is if, for example, Company ABC has received a 3-month, 18% note for $5,000 dated 1st November 2021 in exchange for cash. The company’s year-end is 31st December, and the note will mature on 31st January 2022.
ABC’s journal entries for this transaction dated 1st November 2021, 31st December 2021, and 31st January 2022 will be:
Debit and credit journal entry for notes receivable to record receipt of 3-month, 18% note for $5,000
|1st November 2021||Notes Receivable||$5,000|
Debit and credit journal entry for notes receivable to record interest revenue for Nov and Dec, 2021
|31st December 2021||Interest Receivable||$150|
That is, Interest earned = $5,000 x 0.18 x 2/12 = $150
Debit and credit journal entry for notes receivable to record full payment of note and interest
|31st January 2022||Cash||$5,225|
- Interest accured to 31st December 2021 = $5,000 x 0.18 x 2/12 = $150
- Interest revenue for January, 2022 = $5,000 x 0.18 x 1/12 =$75
- Total interest = $5,000 x 0.18 x 3/12 = $225
- Principal + Total interest = $5,225 (the amount ABC receives from the note maker)
Defaulted notes receivable
When the maker of a note fails to make the required payment at the maturity date, the note is considered to be dishonored. At this point, the note should be transferred from the notes receivable to an open account receivable. The accounts receivable account is debited for the full maturity value, plus the principal and unpaid interest.
That is if Company ABC receives a $2,000, 12%, 4-month note receivable from Company XYZ on 1st July. If XYZ defaults on its note, ABC will make the following entry on 31st October:
Debit and credit journal entry for notes receivable to record default by XYZ on $2,000, 12%, 4-month note
|31st October||Accounts receivable: XYZ||$2,080|
|Notes Receivable: XYZ||$2,000|
By transferring the note to Accounts Receivable, the remaining balance in the notes receivable account would only contain the amounts of notes that are yet to mature. ABC Company will also indicate the default on Company XYZ’s subsidiary accounts receivable ledger. Subsequently, if the accounts receivable prove uncollectible, the amount will then be written off against the Allowances account.
Related: Is Purchase Debit or Credit?
Debit and Credit Examples on Notes Receivable
Notes receivable are recorded as a debit and not a credit. Notes receivable is an asset and as such would be recorded as a debit and not a credit. Assets, expense, and dividends accounts are all debit entries. Hence, they increase by a debit entry and decrease by a credit entry.
When a note is received from a customer, the Notes Receivable account has to be debited and the credit entry is made to the Cash, Sales, or Accounts Receivable account. Then, when the payment of the note has been made by the customer the Notes receivable account is credited to reduce the account.
Here are more examples to illustrate when notes receivable is debited and credited.
Anne’s Apparel sells some items of clothing to Jenny’s Online Store for $15,000, with payment due in 30 days. After 60 days of nonpayment, the two parties agree that Jenny will issue a promissory note to Anne for $15,000, at an interest rate of 10%, with a payment of $5,000 due at the end of each month for the next three months.
Initially, Anne’s Apparel recorded the transaction as accounts receivable. So after the agreement, she makes an entry to convert the account receivable to a note receivable:
Debit and credit journal entry for notes receivable to record receipt of 3-month, 10% note for $15,000
At the end of the month, Jenny pays $5,000 under the terms of the note, including interest. This is calculated as:
$15,000 x 0.10 x (30 days/365 days) = $123
The journal entry would be:
Debit and credit journal entry for notes receivable to record first-month payment of 3-month, 10% note for $15,000
At the end of the second month, Jenny pays another $5,000 under the terms of the note, plus interest. This is calculated as:
$10,000 x 0.10 x (30 days/365 days) = $82
As seen from the calculation done, the amount of interest has declined, because it is calculated on the remaining amount of outstanding principal which was only $10,000. Anne’s Apparel will make the entry of this payment as:
Debit and credit journal entry for notes receivable to record second-month payment of 3-month, 10% note for $15,000
At the end of the third month which is the final month, Jenny pays the remaining $5,000 under the terms of the note, as well as interest, which is calculated as:
$5,000 x 0.10 x 30 days/365 days = $41.
Anne’s Apparel will make the entry of this payment as:
Debit and credit journal entry for notes receivable to record third-month payment of 3-month, 10% note for $15,000
After the third month, the note has now been completely paid off, and Anne’s Apparel has recorded a total of $246 in interest revenue over the three-month period.
Let’s say Jenny had been unable to pay the final installment of $5,000 plus the related interest payment of $41. This means Anne would have to write off the remaining note balance, and the related interest income. She could do so with the following entry:
Debit and credit journal entry for notes receivable to record default on the third-month payment of a 3-month, 10% note for $15,000
|Allowance for doubtful accounts||$5,041|
In reference to our preceding example, assuming Jenny had agreed instead to pay all of the interest income on the maturity date of the note, which will be in 90 days. This would mean that Anne accrues the interest in each of the three months of the note.
That is, Anne would make these entries at the end of each month:
By the maturity date of the note, Anne would have accrued a total of $246 in interest income. When Jenny pays the interest on the maturity date, Anne’s entry to record the transaction would be:
That is, the journal for the final payment of $5000 after the last month plus interest would be:
See also: Is Depreciation Expense Debit or Credit?