Updated July 17, 2023
Definition of Notes Payable
A note payable is a promissory note issued by a company to fulfill its short-term business needs whereby it(a borrower or an issuer) gets funds from a lender and agrees to pay back the principal and interest over an agreed time period.
Borrowing money for business needs, mostly short-term, against the issuance of a promissory note is done through notes payable. In simple words, notes payable is another loan with interest expense. The issuer of notes payable promises to pay the lender with the principal and interest based on a pre-determined future date.
Example of Notes Payable
A small company wants to raise $25,000 to manage the business’s inventory needs. The needed capital should be enough for inventory needs for the next 6 months. What should the financing be like? Should it be through a long-term loan, a short-term loan, or notes payable, or should the company negotiate for credit? Well, this depends completely on the characteristics of different financing options. The best-suited option will be the final choice of the company. The following points can consider in this respect:
- Capital needs and requirements
- Lender’s requirements
- Interest expense comparability among different options
John is an accountant in a furniture-selling company that wants to raise a short-term loan of $10,000 to manage the working capital needs for the next 3 months. John makes an inquiry with Grant’s Capital Co., which agrees to lend money to John’s company. John issues a note payable worth $10,000, which is a promise to pay back. Every month for the next 3 months, the interest payment will be made to Grant’s Capital. At the end of 3 months, $10,000 will return to Grant’s Capital.
Notes Payable on Balance Sheet
The treatment of notes payable can vary depending on the standards of accounting and company norms. However, notes payable are always mentioned as liabilities on the balance sheet. If the notes payable are due within a year, they include current liabilities items. In contrast, notes payable due for more than a year, which is a very rare condition, are marked as non-current liabilities.
Sometimes, notes payable also state as a combination of short-term and long-term liabilities when a long-term notes payable has a short-term liability when due within a year. It goes on the balance sheet, while the associated interest payable is mentioned on the income and cash flow statements.
Notes Payable Journal Entry
Journal entries for notes payable may differ depending upon the transactions carried out. Let us take a couple of examples.
1. Suppose that a company issue notes payable worth $100,000 that have a maturity of 6 months and feature an 8% interest rate. The following will be the entry of this transaction:
Note that this entry will only account for the principal issued
For the interest expense part, the journal entry will be as follows:
2. What should be the journal entry for the following transaction: Notes payable of $50,000 at 10% at the end of 1 year
As interest incurred on notes payable is $5,000, it will charge and enter separately on the balance sheet as follows:
Note that the journal entry should balance on both sides, i.e., debit and credit, to satisfy the double-entry bookkeeping fundamental. Maintaining journal entries until the issued note is paid off completely, the issuer keeps entering it every period in the journal book.
Notes Payable vs Accounts Payable
It is remarkable to note that there exists a difference between notes payable and accounts payable. Accounts payable arises when companies borrow money for the short term and usually carry nominal interest. However, notes payable come with interest rates and principal payback over a relatively greater period.
Both notes and accounts payable are treated as liabilities on the balance sheet. Since accounts payable have no interest accruing, the treatment of accounts payable generally does not reflect on the income statement. Accounts payable is also maintained on a cash flow statement within operating cash flow activities.
Below are some Advantages :
- Notes payable are a popular and easier source of raising money for business needs. Inventory note is a popular mechanism that businesses use to raise working capital for inventory needs
- These are regulated by the fact that they constitute a promise by the borrower to the lender
- It has simple terms of payment, making them accessible to use
- Businesses use notes payable to purchase inventory because of the flexibility of longer payment durations. As such, credit notes come with shorter payment durations.
Below are some Disadvantages :
- The simplicity involved in processing notes payable can pose challenges in complex situations.
- A major disadvantage is that notes payable incur interest charges while accounts payable are mostly free of interest liabilities.
- From the borrower’s perspective, notes payable become an instrument with stringent terms and are often a binding agreement.
Notes payable are a common instrument to raise funds for the short-term capital needs of businesses. These are current liabilities on the balance sheet. Some major elements associated with notes payable are the repayment dates, interest rate, default and penalty terms, and other formal needs.
It also incurs interest, which is an expense listed on both profit and loss and the cash flow statement. A distinguishing characteristic of notes payable is that it is termed a promissory note. These are also critical in terms of payment schedules and interest-bearing components.
These are also significant when businesses want to extend the payment or credit period and issue notes. It also features a discount that is the difference between the proceeds of a note payable and its face value and is written in a contra liability account.
This is a guide to Notes Payable. Here we also discuss the definition, notes payable journal entry, and advantages and disadvantages. You may also have a look at the following articles to learn more –