Definition
Notes payable or promissory note is a promise in writing that a certain amount will be paid in the future. In other words, it’s a promise to pay off a certain amount in the future from one party to another. It’s classified as a liability on the balance sheet as current/non-current, depending on the date of maturity.
Financial institutions such as banks and funds that receive a loan issue note payable/promissory note. It’s a promise to pay back principal value and interest after a specific time.
Related article – What is notes receivable?
Detailed concept
The issuer of the notes payable borrows the funds from the payee. The issuers can be any financial institution, Government authority, corporate business, or other entity that raises the money by issuing notes payable.
It is a general ledger liability account that includes the face amounts of the promissory note issued by a company. The balance of this account shows the amount that is payable by an entity.
Since it’s an interest-bearing financial instrument and the issuer of the notes/borrower has to pay interest, which is classified as expenses in the business’s income statement. On the other hand, the movement of the principal amount can be tracked in the liability account of the balance sheet.
Another important account is Interest payable, representing the amount of Interest incurred by the entity but not yet paid. The notes payable is accounted for as a liability in the borrower’s books, and at the same time, the payee records it as an asset on the balance sheet (i.e. notes receivable).
Notes payable example
Suppose Company A obtains a loan of $100,000 from a bank at an interest rate of 10 % per annum, and the loan is due in three months. We assume the company reports quarterly performance, and our calculation will follow the same assumption.
Notes payable journal entry
Here is the step-wise guide for recording journal entries for the above details of the notes payable.
Step-1: Recording of the principal amount for the notes payable.
| Account Title | Debit | Credit |
| Cash | 100,000 | |
| Notes payable | 100,000 |
The debit impact of this transaction is the collection of the funds as the business has borrowed the amount under notes payable. Similarly, the credit impact of the transaction is a recording of the liability brought by notes payable.
The notes payable is issued for borrowing of the funds. There may be different purposes of the business to borrow the funds, including expansion, development, or working capital management.
Step -2: Interest accrued for the period
Calculation of Interest expense for three months
Interest payable= Borrowed amount * interest rate *months
Interest payable= 100,000*10%*3/12
= $2,500
We have assumed that the business reports quarterly figures and notes payable were issues on the first day of an accounting period.
Company A will record the interest expense for three months as follow:
| Account Title | Debit | Credit |
| Interest expense | 2,500 | |
| Interest payable | 2,500 |
The debit impact of the journal entry is to record interest expense; it will increase the interest expense for the accounting period under consideration. At the same time, a current liability will also be created under the heading of Interest payable with the credit side of the transaction.
Step -3: Repayment at the end of three months
Following journal entry is passed in the books of accounts when making payment for the notes payable and the Interest accrued.
| Account Title | Debit | Credit |
| Notes payable | 100,000 | |
| Interest Payable | 2,500 | |
| Cash | 102,500 |
The first debit of the transaction removes liability from the books under the account of notes payable; it’s the principal amount that has been paid back. The second debit removes Interest accrued in the balance sheet of the business.
The credit impact is the outflow of cash as it has been paid back to remove liability from the books of accounts.
Interest payable
The Interest payable is a liability account in the balance sheet. This account is created to reflect interest expense that has not been paid as of now; the non-repayment may be due to extended time agreed by the parties in the loan contract. The amount is recorded in this liability account to ensure recording of the obligations that exist on the business and will be settled by an outflow of the economic benefits.
The interest payable account may include both accrued Interest and the billed expenses. Further, this liability account contains Interest pertaining to both short-term and long-term loans with only a condition that the Interest has not been paid off.
Journal entry for Interest payable
| Particulars | Debit | Credit |
| Interest expense | XXX | |
| Interest payable | XXX |
The debit impact of the transaction is to record interest expense pertaining to the loan raised under consideration. This expense is deducted from the profit before interest and tax in the income statement.
The credit impact of this journal entry is recording for the liability that has been billed/accrued but not paid at the date of the closing of the accounting period under consideration.
Notes payable long term or short term
The companies record Interest payable and note payable as a current or non-current liability on the following basis.
- If the amount payable is due within one year, then it will be classified as a current liability, &
- If the amount is not due within a year from the balance sheet date, then it will be a non-current liability.
The business has to disclose the information related to the amount owed in notes to the financial statement. It generally includes maturity dates of notes, security against note or collateral pledge, interest rate, restrictions imposed by the creditor, or any other covenant in the agreement.
Long-term notes payable.
Long-term notes payable are those where the amount is due to be repaid in more than a year. For example, an entity obtained a loan against a note payable for $1,000,000. The amount is repayable in 4 years with interest payable at the rate of 7% semiannually. This is an example of a long-term note payable.
Notes payable vs. account payable
Notes Payables may sound similar to accounts payables as both of these are the liabilities of a company. However, certain differences will help you to distinguish the two accounts.
| Notes Payable | Account Payable |
| It is a written promise by an entity that they will pay a specified amount in the future. It’s a form of raising the finance to be used in the business. | It is an amount owed by an entity to suppliers (i.e., goods or services purchase cost). Broadly, it can be termed as financing for the working capital requirement of the business. |
| It can be a short-term or long-term liability depending on the contract between parties. | It’s typically recorded as a short-term liability because accounts payable is usually due within three months. |
| You cannot convert a note payable into an account payable. | Accounts payable can be converted to notes payable. |
| Notes payable are not included in the calculation of working capital. | Accounts payable are important in the calculation of working capital. |
| Notes payable have specific terms and conditions relevant to the Interest and debt repayment. There is a financing element in the note payable, and it can be used for any growth and development. | Accounts payable don’t include written promises or specified terms and conditions. Accounts payables don’t have an interest component. |
What are notes payable in QuickBooks?
Note payable accounting can be performed via Quickbooks. However, the accounting software does not carry the default setting/chart of accounts. To perform accounting for the same, the liability needs to be recorded manually.
Notes payable and legal issues
The lenders of the funds may require the business to comply with certain restrictive covenants. For instance, the borrower may not be able to pay a dividend until the amount for the note payable remains in the business books. The breach of the covenant may lead to full or part repayment of the loan.
The approval of the notes payable from lenders may also require some form of collateral; this may include owned building of the business, equipment, land, or some valuable assets. Further, the lenders may also require the personal guarantee of the company directors or board of directors as a whole.
Notes payable VS. Notes receivable
Following are some of the differences between notes payable and notes receivables.
| Notes payable | Notes receivables |
| It refers to funds borrowed by the business. | It refers to funds the lenders have issued to earn the profit. |
| The business has to meet interest expenses. | The business gets entitled to the income. |
| It’s recorded as an asset in the financial statement of the business. | It’s recorded as a liability in the financial statement of the business. |
| Recording of the notes payable results in an inflow of cash from the business. | Recording of the notes receivables results in the outflow of the cash from the business. |
Notes payable and cash flow impact
The borrower issues notes payable/promissory notes against receipt of the funds. The receipt of the cash leads to an increase in the cash balance. Although the interest expense decreases the cash flow business when some accounting periods are passed.
Upon entering in the contract for notes payable, the cash flow in the books of lender decrease because they have to pay the cash. Although, they collect Interest on their investment which leads to an increase in the cash balance in their books.
Accrued/billed interest expense
Accrued Interest is when the business has not received the bill and a loan in the balance sheet requires expense to be recorded in the financial statement. On the other hand, the billed Interest is one when the business has received the bill, and there is no uncertainty regarding the amount to be recorded in the financial statement.
Audit procedures for notes payable
Following audit procedures can be performed to obtain assurance on the notes payable.
- Review agreements/contracts for the funds obtained.
- Review if there is some covenant in the agreement/contract.
- Recalculate the interest expense.
- Review classification of the notes payable – if the amount is payable in the next twelve months, it should be classified as a current liability. On the other hand, its amount is payable after twelve months, and it’s classified as a non-current liability.
- Obtain management representation on account balances.
Conversion of accounts payable to notes payable
Sometimes, the business may not be able to pay off accounts payable. So, to get more time they agree on the conversion of accounts payable to notes payable. So, the business has to pay interest on the notes as an expense.
Conclusion
With a growing business activity, a company has to secure loans for purchasing equipment, constructing new buildings, and fill other commitments.
A promissory note has detailed information related to terms of loan, Interest, and repayment schedule. The inappropriate recording of notes payable will affect the accuracy of financial statements, and it will impact both the balance sheet (liability) and the income statement (expenses).
Although, accounts payable and note payable are both liabilities. However, there is some difference between the two. The differences include in terms of the liability payable, conversion, and cost of the Interest, etc.
Frequently asked questions
What is the journal entry for the Interest paid?
Following is the journal entry for payment of the Interest.
| Particulars | Debit | Credit |
| Interest payable account | XXX | |
| Cash | XXX |
The debit impact of the journal entry is a reduction in the liability from books of accounts. In simple words, it’s a settlement of the obligation. On the other hand, the credit impact of the transaction is an outflow of the economic benefits from the business.
What is the nature of the Interest payable account?
Interest payable carries the nature of liability and is recorded in the short-term/long-term section of the balance sheet. The reverse of the notes payable is the note receivable which is an asset of the lender.
What is the difference between notes payable and promissory notes?
The terms of the notes payable and promissory notes can be used interchangeably. So, notes payable and promissory notes are the same.
What’s the impact of issuing notes payable on the balance sheet and income statement of the business?
The issue of the notes payable leads to an increase in the liability of the business. There is no impact on the income statement immediately after the note is issued, but Interest is charged in the income statement with time as accrued/billed.
What is an Interest payable account?
The interest payable account is the liability account in the balance sheet, and it’s the place where accrued/billed interest expense is recorded that has not been paid as of the date of the balance sheet.
