Businesses often secure sales by offering credit to their customers. This helps expand their market and makes prices more manageable. Some of these credit agreements, such as notes receivable, are different than typical credit sales in terms of their time to maturity and the amount that is charged in interest. Managers of small businesses should understand notes receivable income to help inform decisions about extending credit to customers.
Notes Receivable and Credit Sales
When a business extends credit to a customer, it usually does so on a fairly short-term basis and expects to earn little interest. Accounts receivable income consists mainly of work that's been invoiced but has not yet been returned with payment. In some cases, a business may find it necessary to finance a customer's purchase on a longer-term basis or to extend a customer's due date and accommodate unusual circumstances. In either of these cases, the company often earns interest income and records the account as a note receivable.
Revenue From Notes Receivable
Whether or not a business recognizes income from a note receivable transaction depends somewhat on the circumstances. If the business issues a note receivable in a new sale -- like when it finances a large purchase for example -- it will recognize the amount of the note as revenue at the time of purchase. In other cases, the note may extend a previous account receivable, giving a customer more time to pay off an invoice in exchange for the possibility of interest. In this case, the income from the note itself is not usually recorded, as the revenue was already recognized at the original time of purchase.
Because notes receivable represent a longer-term debt owed to the company, it is common for businesses to charge interest on them. Although the interest is obligated when the debtor signs the note, the company does not actually earn the interest until the note reaches maturity. This means that the company can either recognize the interest income as unearned revenue until maturity, and make adjusting entries as time passes, or it can recognize the interest revenue only when the note is paid. In either case, interest is a source of income attached to the note, though it is not reported as income until the note matures.
Unfortunately, some of a business's credit customers will sometimes fail to pay their debts. If the entity that owes money on a note -- called a maker -- dishonors their obligation, both the note and its associated receivable interest are debited back to the customer's account. The company will recognize the note and the interest as income because it is still owed both by the maker. If the maker never pays the note, though, the income is lost, and the note's value and interest is recorded as a bad debt expense.
- "Intermediate Accounting eBook"; Cash and Receivables -- Notes Receivable; J. David Spiceland, et al.; 2011
- CliffsNotes; Notes Receivable; 2011
- CliffsNotes; Recording Notes Receivable Transactions; 2011
- SimpleStudies; Accounting for Advanced Accruals; 2011
- Harper College; Accounting for Receivables; July 2008
Matt Petryni has been writing since 2007. He was the environmental issues columnist at the "Oregon Daily Emerald" and has experience in environmental and land-use planning. Petryni holds a Bachelor of Science of planning, public policy and management from the University of Oregon.