Every company or business requires capital to fund the operations, acquire equipment, or launch a new product. Unlike cash-basis accounting, accrual accounting suggests recording a transaction in financial records once it occurs, regardless of when cash is paid or received.
Under the accrual accounting system, the company records its outstanding liabilities and receivables irrespective of when a cash payment is made. The accrued transactions give rise to different assets and liabilities in the balance sheet of the company.
Similarly, when a business entity takes a loan from the bank, purchases bulk inventory from a supplier, or acquires equipment on credit, notes payables are often signed between the parties. The impact of promissory notes or notes payable appears in the company’s financial statements.
This blog will help you understand what notes payables are, who signs the notes, examples, and accounting treatment for the company’s notes payable.
What Is Note Payable?
A note payable can be defined as a written promise to pay a sum of the amount on the future date for the services or product.
We can suggest a note payable to be the written promissory note. Many business transactions result in notes payable to the debtor. However, the notes payable are written on the will of both parties.
What kind of transactions can be settled by issuing a note payable?
Notes payable are most generally issued by the borrower or the lender when a bank loan is taken. When a company purchases bulk inventory from suppliers, acquire machinery, plant & equipment, or take a loan from a financial institution.
A note payable might be written if the debtor has failed to pay the promised amount on the due date. The account payable might be converted into a note payable on non-payment beyond the due date.
The note payable is a liability for the borrowing business entity. However, the nature of liability depends on the amount, terms of payments, etc. For instance, a bank loan to be paid back in 3 years can be recorded by issuing a note payable. The nature of note payable as long-term or short-term liability entirely depends on the terms of payment.
What Is Included In Notes Payable?
The note payable is issued with the face value as the loan amount or amount due. The interest to be paid is also recorded in percentage on the written agreement. We can categorize the terms of payments mentioned on a note payable as,
The principal amount is the actual amount that is due on the debtor. For instance, a business entity purchased equipment worth $10,000. The principal amount to be recorded on note payable will be $10,000
The due date and allowed period are also mentioned on the note payable. The time allowed for payment is an agreed-upon timeline at the will of both parties to contracts. It can be three months, six months, one year, or as the parties consider feasible.
Interest is primarily the fee for allowing the debtor to make payment in the future. The interest percentage is also mentioned on the note payable. There was an older practice of adding interest expense to the face value of the note—however, the convention of fair disclosure under truth-in-lending law.
Parties Of Note Payable
There are usually two parties involved in the notes payable –the borrower and the lender. The borrower is the party that has taken inventory, equipment, plant, or machinery on credit or got a loan from a bank. On the other hand, the lender is the party, financial institution, or business entity that has allowed the borrower to pay the amount on a future date.
Let’s take an example of a company, Porter & Co. The company borrowed $20,000 from a bank due in six months with a 12% interest rate. The loan was taken on Nov 1st, 2019, and it would become payable on May 1st, 2020.
According to the calculations, the total amount due on May 1st will be the principal amount plus interest payable. Let’s calculate the interest amount on the principal.
Loan amount = $20,000
Due In = 6 months = ½ years = 6/12
Interest = 12% per annum = 12 x 6/12 = 6% for six months
Interest amount = Principal amount x Interest Percentage
Interest amount = $20,000 X 6%
Interest amount = $1200.
The total amount due on May 1st, 2020 will be $20,000+ $1200 = $21200.
How does a note payable look like?
Below is the image of how a note payable might look like. You can see the kind of information that is added to the note payable.
Let’s look at what entries are passed in the journal for notes payable.
The following entries will be passed in books of accounts:
The Journal Entry When The Note Payable Is Signed By Both Parties:
In the example discussed above, the loan of $20,000 was taken from the bank. The amount of the loan will be added to your bank. Therefore, cash will be debited. Whereas a subsequent liability arising will be recorded on the credit side.
|Notes Payable Account||$20,000|
One thing to be noted for the notes payable is that the interest payable or interest liability has not been recorded in the first entry. It’s because the interest amount was not due on the date of loan issuance. As time passes and the loan matures, the interest becomes due.
The Journal Entry When The Interest Become Due
It can be decided in terms of payments if the interest will be due annually, bi-annually, or quarterly. In this case, we will suppose that interest will become due on the date of loan payment. Therefore, the entry for interest will be passed as follow:
|Interest Expense Account||$1200|
|Interest Payable Account||$1200|
The Journal Entry For Payment Of Loan On The Due Date
As the loan will mature and be payable on the due date, the following entry will be passed in the books of account for recording it.
|Loan Payable Account||$20,000|
|Interest Payable Account||$1200|
One thing to take note of:
If the borrower decides to pay the loan before the due date of the note payable, the computation of interest will not be done for the pre-decided period. Instead, the interest expense will be calculated for an exact period until the loan was paid.
The journal entries for notes payable related to equipment, inventory, or account payable will also be similar to how we have made entries above.
Notes Payable Vs. Account Payable
Many of us get confused about why there is a need to record notes payable. Some people argue that notes payable can be adjusted under the head of account payables. Let’s differentiate the two for better understanding.
Notes payable and accounts payable do not differ in nature and classification. Both accounts are a liability for the business entity. However, the following things are different between the two accounts:
- Account payables are always short-term liabilities of a business entity due within one year. On the other hand, notes payable can be short-term liabilities or long-term liabilities of a business entity depending on payment terms.
- Account payables are not written agreements or promise to pay the money on a certain date. However, the notes payable are written agreement with a certain due date and payment terms.
- There is usually no interest in the accounts payable. However, there is a pre-decided interest rate for notes payables.
- Account payables are recorded for day-to-day operations and related expenses. For instance, stationery, supplies, utilities, goods, etc. Notes payable are usually for material amounts and formal contracts of loan repayment. Acquiring equipment, purchasing a vehicle, bulk supplies, taking a loan from financial institutions are recorded in notes payable.
Many people argue that if account payable is a short-term liability, why can’t the notes payable for less than one year be treated as account payable. It should be understood that a promissory note or note payable is a legal contract and formal agreement between the borrower and lender.
It has agreed-upon terms and conditions that must be satisfied to honor the agreement. However, the account payables are informal records, and the terms & conditions are not rigid. Since they’re not written agreements, the terms can be changed on the agreement between the vendor and the business entity.
Recording notes payable in their entirety is crucial for the fair and true representation of the financial statements. The notes payable of a company can also be added to project expenses when you’re budgeting for future periods. This establishes the importance of notes payable recording in financial statements.
We’ve comprehended the concept of notes payable, the right accounting treatment, journal entries, and examples to further elaborate the idea.