Notes Payable

A note payable is a written promissory note that guarantees payment of a specific sum of money by a particular date. A company taking out a loan or a financial entity like a bank can issue a promissory note. Both parties must sign the promissory note.

Written promissory notes are known as notes payable. A borrower receives a certain sum from a lender under this arrangement and promises to pay it back with interest over a predetermined time frame.

The interest rate may be set for the note's duration, or it may change according to the interest rate the lender charges its most valuable clients (known as the prime rate).

A note payable is a written contract in which the borrower commits to returning the borrowed funds to the lender within the specified time frame, typically with interest.

In the general ledger liability account, known as promissory notes in accounting, a business records the face amounts of the promissory notes it has issued. The balance in promissory notes represents the sums owed.

The issuing corporation will incur interest expense since a note payable requires the issuer/borrower to pay interest.

The business will additionally have another liability account called Interest Payable under the accrual method of accounting. At the end of the accounting quarter, the corporation records the interest it has accrued but has not yet paid in this account.

Basic details concerning the debt should be given on any written note recorded in this account. Some of the details include the following:

• Principal amount
• Due date
• Interest owed
• Collateral pledged
• Creditor limitations

Businesses may borrow this money to purchase items like tools, equipment, and automobiles that will likely be used, depreciated, and replaced within five years.

Some promissory notes are secured, which means that if the payment terms are not met, the creditor may have a claim against the borrower's assets. The payback period could be extended if secured.

Business owners can utilize promissory notes as a beneficial financial instrument to grow their company and as a form of investment.

example

A liability account recorded in a company's general ledger is called a "Promissory Note." It is when borrowers formally commit themselves to paying back lenders.

When a company takes out a loan from a lender, it must record the transaction in the promissory notes account. The borrower will be requested to sign a formal loan agreement by the lender.

Imagine the following example to see how this operates.

To help open a grocery store, a businessman called Shawn borrows $10,000 from his credit union. To borrow money, Shawn would have to sign a formal loan agreement committing him to monthly installments of $500 plus interest of $250.

First, two accounts will be used to record this agreement:

• $10,000 would be credited to Cash.
• A $10,000 debit would be made to the promissory notes.

The interest must also be recorded with an extra $250 debit to the interest payable account and an adjusting cash entry in addition to these entries.

This demonstrates that each loan agreement must be represented on the balance sheet in Cash, payables, and interest payments. This aids in keeping the balance until the loan is repaid.

Accounting for Notes Payable

On the balance sheet, accounts payable and other short-term liabilities like credit card payments are always listed under current liabilities.

However, if the balance is due within a year, promissory notes on a balance sheet might be listed in either current liabilities or long-term obligations.

Here is an illustration of a journal entry that records a note payable, along with the associated interest. You recently applied for and were granted an $80,000 loan from Bank of America.

The promissory note is due on September 31, 2022, two years after the note's original issue, which is dated October 1, 2020. Additionally, an 8% interest rate is due every three months.

Since your cash increases, once you receive the loan, you will debit your cash account for $80,000 in the first journal entry. To record the loan, you will also need credit notes payable.

On promissory notes, interest always needs to be reported individually. In this illustration, the interest rate is set at 8% and is paid to the bank every three months.

Since the interest is paid everyquarterly and is deemed short-term, this will be set up as an Interest Payable account and listed under current obligations. 

Since interest is 8% of $80,000 ($6400) and paid quarterly for two years in 8 installments, interest per quarter is $6400/8. The journal entry might appear as follows:

The interest on the note payable for the first quarter is due on January 1. This is how the journal entry might appear:

For the two-year term of the note, interest expenditure will need to be recorded and paid every three months.

The promissory note specifies that the principal will be paid off in September 2022 if you haven't been paying the debt monthly. The journal entry might appear as follows:

How Do Notes Payable Function?

Promissory notes become a liability when a company borrows money and enters into a formal agreement with a lender to repay the borrowed amount plus interest at a specific future date.

The terms the note's payee and issuer have agreed upon are the principal, interest, maturity (payable date), and the issuer's signature.

There are numerous varieties of payable notes, each with unique amounts, interest rates, terms, and payback durations. However, they are all enforceable contracts, like loans or IOUs.

1. Single-Payment

With these promissory notes, you must make a single lump sum payment to the lender by the due date, covering both the principal borrowed and the interest accrued.

2. Amortized

Bank loans for homes, buildings, or another real estate typically employ this promissory note.

Amortized promissory notes require you to make predetermined monthly payments toward the principal balance and interest. As the loan balance decreases, a larger portion of the payment is applied to the principal and less to the interest.

3. Negative Amortization

Negative amortization allows borrowers to make payments that are less than the interest cost, with the unpaid interest added to the main balance. The drawback for borrowers is that their overall loan expenses will increase.

4. Interest-Only

With these notes, the borrower's monthly payments only cover the interest. The borrower must guarantee to repay the principal balance when the loan is paid off.

Notes payable vs. Accounts payable

There are some significant differences between these two liability accounts, even though both accounts payable and notes payable are liabilities. Both indicate the sum owed and payable to a vendor or financial institution.

Although legally, both promissory notes and accounts payable fall under the category of corporate debt, they are frequently confused with one another.

Accounts payable can be viewed as relatively short-term debts that a business may incur to pay for goods or services received from a third party. They are normally repaid within a month, as opposed to promissory notes, which may have periods of several years.

Accounts payable, which often reflect materials or services acquired on credit that have been granted to you by vendors you regularly do business with, do not require written agreements.

Accounts payable include all regular business expenses, including office supplies, utilities, items utilized as inventory, and professional services like legal and other consulting services.

A formal contract, known as a promissory note, contains a written pledge to repay a loan. Written promissory notes include loans for corporate expenses like buying a company car, a building, or a bank loan.

If a note's due date is within a year of when it was issued, it is considered a short-term liability; otherwise, it is considered a long-term liability.

Conclusion

Promissory notes are written agreements between a borrower and a lender in which the borrower undertakes to pay back the borrowed amount of money and interest at a specific period in the future. Notes payable are also known as promissory notes.

In most cases, interest is accrued on promissory notes, and payment terms can vary.

If the note's maturity date is less than one year from the date it was issued, then it is considered a short-term liability; otherwise, it is considered long-term debt.

Promissory notes can come in various forms, including interest-only agreements, single-payment notes, amortized notes, and even negative amortization. 

Promissory notes are essential for business owners because they enable those owners to get loans, which the owners can then put toward the growth and expansion of their companies.

On a balance sheet, promissory notes can be located in either the current or long-term liabilities, depending on whether the outstanding balance is due within the next year.

Promissory notes are deemed current as of the balance sheet date if they are due within the next 12 months, but they are considered non-current if they are due in more than 12 months.

Researched and authored by Shriya Chapagain | LinkedIn

Reviewed and Edited by Abhijeet Avhale | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Full Disclosure Principle
• Funds From Operations
• Intangible Assets
• Interest Expense
• Interest Payable