Notes Receivable – Recognition, Measurement, and Financial Reporting

Notes Receivable are formal financial instruments representing a written promise that a borrower will repay a specified sum on a future date, usually with interest. They differ from accounts receivable in their formality, duration, and potential for interest income.

This article covers the recognition, initial and subsequent measurement, interest calculation, impairment, presentation, and disclosure of notes receivable, with references to U.S. GAAP (ASC 310, ASC 835, ASC 326) and IFRS 9. Practical examples and journal entries are included to demonstrate key accounting mechanics.

1. What Are Notes Receivable?

Notes receivable arise when a business accepts a promissory note from a customer or borrower, typically in exchange for cash, goods, or services. These instruments are legally binding and may be interest-bearing or non-interest-bearing.

✦ Lending cash to a supplier or customer

✦ Converting an overdue account receivable into a formal note

✦ Selling goods on extended credit with formalized terms

✦ Accepting a promissory note as settlement in a transaction

They are reported as financial assets and classified as either current (due within 12 months) or noncurrent.

2. Initial Recognition

Notes receivable are recognized when the company obtains an enforceable legal claim to payment through the signed promissory note.

The note is recorded at its present value, which is usually equal to the face amount if interest is stated and the terms are at market rate.

To recognize a note issued in exchange for a sale: Dr. Notes Receivable – $100,000 / Cr. Sales Revenue – $100,000.

To convert an existing account receivable: Dr. Notes Receivable – $10,000 / Cr. Accounts Receivable – $10,000.

If the note is non-interest-bearing or issued at a discount, the note must be recorded at present value, and the difference is treated as a discount.

Dr. Notes Receivable – $50,000 / Cr. Discount on Notes Receivable – $2,831 / Cr. Sales Revenue – $47,169.

3. Initial Measurement

Notes receivable are measured at present value of future cash flows. When the stated interest rate is below market, or when no interest is stated, discounting is required.

Discount rate = the imputed market rate for a similar instrument.

Example – Zero-interest note:

✦ A $50,000 one-year note with no interest

✦ Market rate = 6%

✦ Present value = $50,000 ÷ (1.06) = $47,169 The $2,831 difference is recognized as a discount and amortized as interest income.

4. Subsequent Measurement and Interest Recognition

Over time, notes receivable accrue interest, which must be recognized as interest revenue using the effective interest method.

To record interest earned: Dr. Interest Receivable – $5,000 / Cr. Interest Revenue – $5,000.

To amortize discount: Dr. Discount on Notes Receivable – $1,416 / Cr. Interest Revenue – $1,416.

This ensures interest income reflects the true yield based on the present value.

5. Impairment of Notes Receivable

Both U.S. GAAP and IFRS require evaluation of expected credit losses.

Under U.S. GAAP (ASC 326 – CECL Model):

✦ Entities estimate lifetime expected credit losses from initial recognition.

✦ Historical, current, and forward-looking data must be incorporated.

Under IFRS 9:

✦ Trade-related notes qualify for the simplified approach: lifetime expected losses recognized from inception.

To record expected loss: Dr. Bad Debt Expense – $2,000 / Cr. Allowance for Notes Receivable – $2,000.

If a note is later deemed uncollectible: Dr. Allowance for Notes Receivable – $2,000 / Cr. Notes Receivable – $2,000.

6. Example – Full Lifecycle

A company sells machinery for $100,000 in exchange for a two-year note, 5% annual interest, payable at maturity.

Year 0: Note is issued

Dr. Notes Receivable – $100,000 / Cr. Sales Revenue – $100,000.

Year 1 and Year 2: Recognize interest

Dr. Interest Receivable – $5,000 / Cr. Interest Revenue – $5,000.

At maturity: Collect principal and interest

Dr. Cash – $110,000 / Cr. Notes Receivable – $100,000 / Cr. Interest Receivable – $10,000.

7. Presentation in the Financial Statements

Notes receivable appear on the balance sheet as:

✦ Current assets: if due within 12 months

✦ Noncurrent assets: if due after 12 months

✦ Presented net of allowance for credit losses and any unamortized discounts or premiums

Balance sheet format:

✦ Notes Receivable – $100,000

✦ Less: Allowance – ($2,000)

✦ Less: Unamortized Discount – ($1,000)

✦ Net Notes Receivable – $97,000

8. Disclosures

Under both GAAP and IFRS, companies must disclose:

✦ Total notes receivable, separated into current and noncurrent

✦ Credit risk management practices

✦ Rollforward of allowance for expected losses

✦ Interest income recognized

✦ Assumptions used in fair value measurement, if applicable

These disclosures provide insights into the quality, maturity, and collectibility of notes receivable.