Difference between notes receivable and accounts receivable

Definitions and meanings

Notes receivable:

The note receivable is a formal promissory note issued by the maker or issuer to the payee. It may be defined as a written promise to pay an individual or organization a certain amount of money at a particular date in future. A promissory note is a properly written document which states clearly the names of issuer and payee, the principal amount, the location and date of payment and a fixed interest rate. After the note has been signed by issuer and payee, it becomes a legal document binding both the parties to the agreement and can be used as an evidence of the loan or credit.

A note receivable is usually received in result of granting a loan to someone or from a debtor who has previously bought some goods or services on credit and has not yet made the payment. An organization may receive notes receivable from a number of individuals and organizations during the course of its business. These notes are accounted for in a general ledger account known as notes receivable account. The notes receivable usually earn interest income for their holders or payees which is recorded in interest on notes payable account maintained in the general ledger.

When a note is received from a party, it is journalized as follows:

1. If the note is received against issuing a loan:
   Notes receivable – [Dr.]
   Cash – [Cr.]
2. If the note is received from a debtor:
   Note receivable – [Dr.]
   Accounts receivable – [Cr.]

Notes receivable are negotiable i.e., they are transferable instruments and can be used to meet current financial obligations by selling or transferring their ownership to someone else. The new bearer or holder of the note would have the same claim on the note as the original payee had.

The balance of notes receivable account is debit in nature and is therefore reported as an asset on the statement of financial position (or balance sheet). In case, it has been issued for a period of less than twelve months, the notes receivable is reported as a current asset. On the other hand, if a promissory note is issued for a time period of more than one year, the portion which is receivable within one year is recorded as current asset whereas the portion receivable after one year will be reported as a non-current asset.

The interest earned on a note receivable is recorded as interest income on the income statement.

Accounts receivable:

Accounts receivable also known as debtors is the value of sales that has been made but hasn’t been paid for yet i.e. goods or services that have been bought by customers on credit. It is the amount owed to the company by its clients against the sale of goods and services. Accounts receivable is recorded in the general ledger, and is debited against a credit on the sales account.

The journal entry to record accounts receivable is given below:

Accounts receivable – [Dr.]
Sales – [Cr.]

Debtors are payable to the company within the next thirty to ninety days of the issuance of invoice which is why it is classified as a current asset on the statement of financial position.

However, not all customers clear their dues within the due period. According to prudent concept of accounting, an account receivable should be expensed out if enough evidence exists regarding its uncollectibility.

According to the accounting principles, a contra accounts receivable account known as “allowance for doubtful accounts account” is maintained in the books of business. This account is credit in nature (i.e., has normally a credit balance) and reduces the accounts receivable value reported on the balance sheet. It means any balance in allowance for doubtful accounts account is deducted from the balance of accounts receivable account for the purpose of reporting accounts receivable in the balance sheet at their estimated net realizable value.

At the beginning of every accounting period, allowance for doubtful accounts account is credited with an expected or estimated amount of uncollectibles. This periodical addition to the allowance for doubtful accounts account is reported as revenue expense on the income statement of concerned period.

In case, a debtor goes bankrupt and the receivable amount is proved to be uncollectible, it’s referred to as a bad debt or uncollectible account. The amount of bad debt or uncollectible account is debited to the allowance for doubtful accounts account.

Often times, when a customer is struggling to pay off the debt, the company may offer to convert their accounts receivable balance to notes receivable by attaching a promissory note. The debtor’s balance owed to you will be subtracted from the accounts receivable balance and entered under notes receivable instead. This way, the debtor gets an extension of deadline for paying off the debt while the company earns interest income on outstanding amount.

Key differences between note receivable and accounts receivable:

Even though both are line items of the financial statements and fall under the same head – current assets; there exist some fundamental differences between them.

1. Meaning:

Note receivable is a written promissory note extending a line of credit to the other party, receivable in the future at a specified date along with interest.

On the other hand, money owed by customers for purchasing goods or services on credit is known as accounts receivable.

2. Time period:

Notes receivable can be either a current asset or a non-current asset. If it matures within one year period, it is reported under current assets. If it is payable over a period of more than one year, the portion maturing within one year will be reported under current assets whereas the rest of the amount will be reported under non-current assets.

Accounts receivable is a current asset since the amount is mostly payable within twelve months of issuance of invoice. Usually, a time period of thirty to ninety days is provided to clear the debt.

3. Legal impact:

Notes receivable is a legally binding agreement between the issuer and the payee.

Accounts receivable, on the other hand, has no written agreement between seller and customer. The only document available is the sales invoice.

4. Transferability:

Notes receivable is a negotiable instrument and can be transferred further to clear dues. It needs to be highlighted, though, that the transferability doesn’t affect the ownership of a notes receivable since each bearer has exactly the same claim over it as the original lender had.

Accounts receivable can be sold to a financial institution for a fee. This action is known as discounting or factoring accounts receivable. Accounts receivable can’t be used as a negotiable financial instrument like note receivable.

5. Financial cost:

Notes receivable is a financial instrument that has an interest component attached to it.

Accounts receivable has no financial component attached to it.

Notes receivable versus accounts receivable – tabular comparison:

A tabular comparison of notes receivable and accounts receivable is given below:

Accounts receivable vs Notes receivable
Meaning
Money owed to a company due to its credit sales of goods or services.	A legal instrument issued to the lender against money owed to him.
Purpose
To record the revenue earned but not yet received.	A written promise, which is legally binding, used as evidence of debt.
Finance cost
No Interest charges.	Interest charges.
Time period
Only short term.	Can be both short term or long term.
Legally binding
Has no written contract or document except the sales invoice.	Has a legally binding contract attached, properly written and signed by both the parties.
Transferability
Is not a negotiable instrument and cannot be transferred to meet financial obligations.	Is a negotiable instrument and can be transferred to anyone in order to meet financial obligations.

Conclusion – notes receivable vs accounts receivable

Accounts receivable and notes receivable are both financial statement line items and are categorized and reported as current assets in the balance sheet. However, both have various distinct features and are created and dealt with in different manners and circumstances.

Maintaining liquidity is a vital part of running a business and both the assets are equally important in terms of managing the working capital and liquidity position of the company. An illiquid company faces an imminent insolvency if immediate measures aren’t taken against the liquidity crisis. Both notes receivable and accounts receivable must be effectively managed to reduce the cash collection period, improve accounts receivable turnover ratio and, hence, the cash flow of the company. The procedure can be made easier and more effective by offering appealing incentives to debtors and issuers of notes receivable.