Trade transactions in commercial entities, especially those of high volume and high value, often take place on credit basis. Sellers extend credit period to their customers, allowing them a specified time period to make payment for their purchases. When customers are unable to clear their dues within the credit period, they may often request the seller to accept promissory notes as a surety for subsequent payment. Promissory notes are also issued by borrowers to lenders as a surety to enable financing. They are a legally binding, financial instrument that contain a promise by the drawer (i.e., debtor or borrower) to pay a specified sum to the drawee (i.e., creditor or lender) or holder on demand or on a specified date in the future and at specified terms.
Definitions and meanings
A note payable is a financial instrument that contains a promise by the drawer to pay a specified sum of money to the drawee, or to the holder of the note, on demand or at a specified date. It may also specifies any other important terms of payment. The note payable is essentially an undertaking which serves as a surety of payment by the borrower or debtor for the amount owed.
If a buyer owes his seller a sum of money on account of purchase of goods and requires some more time to clear the payment, he may issue a note payable in favor of the seller. Similarly, if a borrower is looking to raise money, he may do so by issuing a note payable in favor of the lender. Once such note is issued and signed by the drawer, it serves as a legally binding undertaking for payment of the amount due at the terms specified therein.
A note payable generally contains the following information:
- Name of drawer: the person who issues the note and is obligated to make the payment i.e., the buyer or the borrower of funds.
- Name of the drawee: the person in whose favor the note is issued and who is entitled to receive the payment i.e., the lender or the creditor. A note payable may also specify that the amount is payable to the holder to support endorsement to another person.
- Amount to be paid to creditor (i.e., a seller of goods or a lender of funds)
- Date/period after which payment is to be made
- Interest to be paid, if any
- Date and place of issue
- Sign of the drawer
- Other payment terms, if any
Metro Inc. requires $50,000 to meet its short-term working capital needs. It approaches Mr. Steward, a financer, for the same. The terms are mutually agreed upon and Metro Inc. issues a note payable in favor of Mr. Steward on October 1, 2021, undertaking to pay the borrowed amount on March 31, 2022 including interest @ 12% per annum.
Metro Inc. would pass the following journal entries regarding the issuance of note on October 1, 2021 and the payment of the same on March 31, 2022:
Journal entry on October 1, 2021 (for obtaining the amount of loan and issuing the note):
Notes payable…..50,000 [Cr]
(Being $50,000 borrowed and promissory note issued in favor of the lender, Mr. Steward)
Journal entry on March 31, 2022 (for making payment of both interest and principle amount):
Notes payable a/c…..50,000 [Dr]
Interest expense a/c…..3,000 [Dr]
Cash a/c…..53,000 [Cr]
(Being note payable honored along with interest of $3,000)
Notes payable can either be short-term or long-term depending on their maturity period.
Notes receivable is a financial instrument that entitles the holder to receive a specified sum of money, from the drawer at terms specified therein. Notes receivable are received by lenders or debtors for amounts due to them.
Once a drawer issues a note payable and sends the same to the drawee, it becomes a notes receivable for the drawee. The drawee may either hold the note till maturity or may choose to discount it earlier in which case the note receivable is endorsed in favor of another party who then becomes the holder or payee. Either on demand (in case of on-demand notes) or on maturity date of the note, the holder presents the notes receivable to the drawer. Against this, the drawer is obligated to pay the amount specified therein to the holder along with interest, if any as per the terms of the note.
Notes receivables is essentially the drawee end of the same notes payable issued by the drawer. It thus contains all the same information as specified for notes payable.
Continuing the same example as above, the accounting entries to record the note receivable in the books of the holder, Mr. Steward are as follows:
Journal entry on October 1, 2021 (for granting the loan and receiving the note):
Notes receivable a/c…..50,000 [Dr]
Cash a/c…..50,000 [Cr]
(Being $50,000 lent to Metro Inc. on surety of notes receivable)
Being a short-term receivable, this note receivable qualifies as a current asset and will be reported as such on the asset side of Mr. Steward’s balance sheet.
Journal entry on March 31, 2022 (for receiving the repayment of loan including interest thereon):
Cash a/c…..53,000 [Dr]
Notes receivable a/c…..50,000 [Cr]
Interest income a/c…..3,000 [Cr]
(Being note receivable presented to and honored by Metro Inc., along with an interest payment of $3,000)
Difference between notes payable and notes receivable
Eight key points of difference between notes payable and notes receivable have been listed below:
- Notes payable is negotiable instrument issued by the drawer/borrower, containing a promise to pay a specified sum of money at specified terms to the drawee/holder of the instrument.
- Notes receivable is a negotiable instrument received by the drawee/lender/holder that enables him to receive a specified sum of money at specified terms from the issuing drawer/borrower.
2. Relevant parties
- In case of notes payable, the payer and drawer are the same party i.e., the person who issues the note is liable to honor it.
- In case of notes receivable, the payee and drawee may not be the same party. The drawee is the person who has originally received the note and the payee can be another person to whom the note has been subsequently endorsed i.e., the holder.
3. Accounted by
- A note payable is accounted for in the books of the drawer who is the borrower or the debtor.
- A notes receivable, on the other hand, is accounted for in drawee’s books whose position in relation to the note is that of a lender or a creditor.
4. Accounting of instrument
- Notes payable has a credit balance and is accounted for as a liability which can be a current or non-current liability depending on whether it is a short-term or a long-term note.
- Notes receivable has a debit balance and is accounted for as an asset which can be a current or non-current asset depending on whether it is a short-term or a long-term note.
5. Accounting of related interest
- Notes payable result in interest becoming payable as well. Such interest is thus recorded as an expense in drawer’s books.
- Notes receivables result in interest becoming receivable. Such interest is thus recorded as an income in drawee’s books.
- A note payable is created when issued and signed by the drawer. Thus, it is the first leg in a promissory note transaction.
- When this note is received by the drawee, it becomes a notes receivable. Thus, notes receivable is the second leg of the promissory note transaction.
7. Need for acceptance
- In order for a note payable to become legally binding, it needs to be signed and authenticated by the drawer.
- Notes receivable does not require any formal acceptance by the drawee for it to become legally binding.
8. Impact on cash flow
- Being a commitment to pay, notes payable eventually result in cash outflow for the drawer.
- Being a surety to receive, notes receivable eventually result in cash inflow for the holder.
Notes payable and notes receivable represent two sides of the same transaction. A business may however have both notes payables and notes receivables – for moneys owed by them as well as money owed to them. How efficiently a business is able to manage its notes has a direct impact on the health of its working capital. Financing through notes is more commonly seen in transactions between individuals or between smaller businesses that take place without any other formal loan agreement or without the involvement of a bank or some other financial institution.