Definition of Notes Payable
A notes payable is a promissory note issued by a company to fulfill its short-term business needs whereby it(termed as 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 of 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 kind of loan that comes 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 for managing the inventory needs of the business. The capital so needed 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, notes payable, or should the company negotiate for a credit? Well, this depends completely on the characteristics of different financing options. The best suited option will be final the choice of the company. The following points can be considered 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 for managing the working capital needs pertaining to the next 3 months. John makes an enquiry with Grant’s Capital Co. which agrees to lend money to John’s company. John issues notes payable worth $10,000 which is a promise to payback. Now, every month for the next 3 months, the interest payment will be made to Grant’s Capital. At the end of 3 months, the sum of $10,000 will be returned to Grant’s Capital.
Notes Payable on Balance Sheet
The treatment of notes payable can vary depending upon the standards of accounting and company norms. However, notes payable are always mentioned as liabilities on the balance sheet. In case, the notes payable are due within a year, they are included as a current liabilities item, and whereas notes payable due for more than a year, which is a very rare condition, are marked as non-current liabilities.
Sometimes, notes payable are also stated 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. Notes payable goes on the balance sheet while the associated interest payable is mentioned on the income statement and cashflow statement.
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 issues 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 be charged and entered separately on the balance sheet as follows:
Note that the journal entry should balance on both sides i.e. debit and credit in order to satisfy the double entry bookkeeping fundamental Regarding maintaining journal entries until the issued note is paid off completely, the issuer keeps on entering it every period on 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. Notes payable, however, come with interest rates and principal payback over a relatively greater time-period.
Both notes payable and accounts payable are treated as liabilities on the balance sheet. Since, accounts payable have no interest accruing, in general, the treatment of accounts payable is not reflected on the income statement. Accounts payable is also maintained on a cash flow statement within operating cashflow activities.
Some of the advantages are given below:
- Notes payable are a popular and easier source of raising money for business needs. Inventory note is a popular mechanism which businesses use to raise working capital for inventory needs
- Notes payable are regulated by the fact that they constitute a promise by the borrower to the lender
- Notes payable have simple terms of payment making them accessible to use
- Businesses use notes payable for the purchase of inventory because of the flexibility of longer payment durations. As such, credit notes come with shorter payment durations
Some of the disadvantages are given below:
- The simplicity involved in the processing of 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. Notes payable are current liabilities on the balance sheet. Some of the major elements that can be associated with notes payable are the repayment dates, interest rate, default and penalty terms, and other formal needs.
Notes payable also incur interest which is treated as an expense and is listed on both profit and loss as well as cash flow statement. A distinguishing characteristic of notes payable is that it is termed as a promissory note. Notes payable are also critical in terms of payment schedule while also being interest bearing component.
Notes payable are also significant when businesses want to extend the payment period or credit period and hence issue note. Notes payable also feature 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 and notes payable journal entry along with advantages and disadvantages. You may also have a look at the following articles to learn more –