Notes receivable are short-term financial instruments issued by companies to document money owed to them by customers or trade partners. Investing in notes receivable can provide steady interest income. However, there are risks, such as non-payment. To earn interest, the notes must specify an interest rate. The rate may be fixed or variable. Higher rates compensate for higher debtor risk. Companies holding notes receivable list them as current assets on their balance sheets. Proper accounting is needed to track interest earned.
Notes receivable provide liquidity and interest revenue to investors
Companies issue notes receivable rather than extending pure credit to reduce risk. By documenting the debt formally, they gain legal recourse if customers do not pay. For investors, notes receivable are more liquid than holding the accounts receivable directly, while providing modest interest. However, the notes do entail risk of non-payment. Investors can reduce this risk by diversifying across many notes or by only buying high quality notes that are backed by collateral.
Interest accrues according to terms stated in the notes
For notes receivable to earn interest for investors, the notes must specify an interest rate. This rate may be fixed for the duration of the note, such as 5% interest. Or it may be variable, changing along with a benchmark rate such as LIBOR. Higher interest rates compensate investors for higher perceived risk of non-payment. Companies holding notes receivable as investments will account for interest revenue based on the note terms and recognize it as the interest accrues.
Proper accounting treatment is essential for notes receivable investments
Companies that hold significant notes receivable investments must track them carefully for accounting and risk management purposes. As the notes earn interest revenue, this must be recorded separately from the original investment principal. Notes receivable are typically classified as current assets, while accrued interest receivable is usually listed separately. Appropriate allowance accounts should offset notes and interest receivable balances to reflect risk of non-payment based on the perceived creditworthiness of the debtors.
Investing in notes receivable can provide liquidity and modest interest revenue for companies with excess cash. By lending money in this way rather than extending pure credit, they gain legal standing and potential collateral. To earn interest, notes receivable must specify an interest rate which may be fixed or floating. Careful accounting is essential to track principal, accrued interest, and non-payment risk associated with the notes.