Promissory note accounting mirrors on both sides of the deal: the lender books the instrument as Notes Receivable (an asset), and the borrower books the identical instrument as Notes Payable (a liability). Interest accrues each period whether cash moves or not, the balance is split between current and non-current based on when principal comes due, and dishonor or forgiveness triggers a reclassification and, in some cases, a tax event. What follows is how the entries work, how interest is measured, and the tax rules that most often bite.
What Qualifies as a Note Rather Than a Receivable
A promissory note is a written, unconditional promise to pay a fixed sum, either on demand or at a definite time, and it is governed by Article 3 of the Uniform Commercial Code.1Legal Information Institute. UCC 3-104 – Negotiable Instrument That is what separates it from an ordinary invoice sitting in accounts receivable and gives it its own balance-sheet line. The signer is the maker (the borrower), and the party entitled to payment is the payee (the lender).2Legal Information Institute. UCC 3-103 – Definitions A note does not have to charge interest to be valid, but a zero or below-market rate creates the tax problem discussed later.
The Journal Entries on Both Sides
How the initial entry is booked depends on why the note came into existence.
When a customer who cannot pay a large invoice signs a note in place of the existing receivable, the asset simply changes form on the lender’s books, and so does the liability on the borrower’s books:
- Payee: debit Notes Receivable, credit Accounts Receivable.
- Maker: debit Accounts Payable, credit Notes Payable.
When the note is issued in exchange for cash (a straight loan), the entries are simpler:
- Payee: debit Notes Receivable, credit Cash.
- Maker: debit Cash, credit Notes Payable.
From that point forward, the two sets of books stay in mirror. Every principal payment reduces Notes Receivable on the lender’s side and Notes Payable on the borrower’s side by the same amount.
Current or Non-Current on the Balance Sheet
Classification turns on maturity. A note coming due within twelve months of the balance sheet date is current; anything beyond that is non-current. When a note amortizes over several years, split it: the principal scheduled to be paid within the next twelve months sits in current, and the rest sits in non-current. Reassess this at each reporting date, because what was long-term last year can become current this year.
Acceleration changes the picture instantly. Most commercial notes include an acceleration clause that lets the lender demand the full outstanding balance if the borrower misses payments or breaches another term. Once the lender invokes that clause, the entire remaining balance moves to current on both sides, regardless of the original amortization schedule.
Accruing Interest Each Period
Interest does not wait for the payment date. At the end of each accounting period, both parties record an accrual so revenue and expense land in the period they were earned or incurred:
- Payee: debit Interest Receivable, credit Interest Revenue.
- Maker: debit Interest Expense, credit Interest Payable.
These entries are required whether or not any cash has changed hands. When cash finally arrives, the receipt clears Interest Receivable (or Interest Payable on the borrower’s side) rather than hitting revenue or expense a second time.
Calculating Interest and the Maturity Date
Most notes use simple interest: Principal × Rate × Time. The rate is annual, expressed as a decimal, and Time is the fraction of a year the principal is outstanding.
How that fraction is expressed depends on how the note states its term. A note stated in months uses 12 as the denominator, so a nine-month note runs on 9/12. A note stated in days can use a 360-day year (the banker’s method, which produces a slightly higher figure because each day is a larger fraction) or an exact 365-day year. The note itself should say which convention applies; if you don’t know which one the parties intended, ask before booking accruals, because the two produce different numbers.
Finding the maturity date means counting forward from the issue date, excluding the issue date itself. A 90-day note issued on May 10 matures on August 8: 21 days remaining in May, 30 in June, 31 in July, and 8 in August.
When the Borrower Doesn’t Pay
A note that goes unpaid at maturity (or on demand, for a demand note) is called dishonored. The lender removes it from Notes Receivable and reclassifies the whole balance (unpaid principal plus accrued interest through the maturity date) to Accounts Receivable or a dedicated Dishonored Notes Receivable account. The accrued interest does not disappear; the borrower still owes it, so it stays in the receivable balance.
If the note had an acceleration clause and the borrower had been paying in installments, the lender does not have to wait installment by installment. Invoking the clause pulls the entire remaining balance into a current receivable at once.
Below-Market Notes and Imputed Interest
Issuing a note at zero interest or below a market rate between related parties creates a federal tax problem that surprises a lot of first-time lenders. When the stated rate falls below the Applicable Federal Rate (AFR) that the IRS publishes each month, the IRS treats the missing interest as if it had actually been paid.3Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates The rule catches four common categories:
- Gift loans between family or friends where no interest is charged.
- Compensation-related loans between an employer and employee, or between a business and a contractor.
- Loans between a corporation and its shareholders.
- Any loan where a principal purpose of the interest arrangement is federal tax avoidance.
For a demand loan, the forgone interest is treated as transferred from the lender to the borrower and then retransferred back as interest on the last day of each calendar year. For a term loan, the imputed amount is recognized upfront on the date the loan is made.3Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates Either way, both parties end up with tax consequences on interest that was never actually charged.
There is a narrow exception. Gift loans directly between individuals are exempt from the imputed interest rules on any day the total outstanding balance between the two people stays at or below $10,000.4GovInfo. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates The exception disappears if the borrowed funds are used to buy income-producing assets like stocks or rental property.
As of January 2026, the AFRs (compounded annually) are 3.63% for short-term loans of up to three years, 3.81% for mid-term loans over three years but not more than nine, and 4.63% for long-term loans over nine years.5Internal Revenue Service. Rev. Rul. 2026-2 – Applicable Federal Rates These rates change monthly, so check the IRS revenue ruling for the month the loan is made.
Tax Treatment When a Note Is Forgiven
Canceling or forgiving a promissory note for less than the full amount generally creates taxable cancellation-of-debt income for the borrower in the year of the cancellation.6Internal Revenue Service. Topic No. 431, Canceled Debt – Is It Taxable or Not? The creditor may need to file Form 1099-C if the canceled amount reaches $600 or more.7Internal Revenue Service. Instructions for Forms 1099-A and 1099-C Whether or not the borrower actually receives a 1099-C, the reporting obligation remains.
Secured notes add a wrinkle. If the note was recourse (the borrower was personally liable) and secured by property, the transaction splits into two events: a sale of the property at fair market value, and cancellation-of-debt income for any balance the borrower cannot cover. If the debt was nonrecourse, the full debt amount is treated as the sales price and there is no separate cancellation-of-debt income.6Internal Revenue Service. Topic No. 431, Canceled Debt – Is It Taxable or Not?
Several exclusions can keep forgiven amounts out of taxable income. Debt canceled as a gift or inheritance is not taxable. Certain qualified student loan cancellations tied to working in specific professions may be excluded, as may student loan discharges occurring after December 31, 2020, and before January 1, 2026. Borrowers who are insolvent at the time of cancellation may also exclude some or all of the forgiven amount.6Internal Revenue Service. Topic No. 431, Canceled Debt – Is It Taxable or Not?