In this brief guide, we will take you through a detailed overview of what Notes Payable actually is. No, it’s not similar to accounts payable. It’s quite different and it has a unique place in the accounting world.
Without any ado, let’s get started.
What is Notes Payable?
In simple terms, notes payable is a promissory note. This promissory note is offered by the lender to the borrower for an agreement between these two. Under this agreement, the borrower is bound to pay a certain amount to the lender within a stipulated time period along with an interest.
The interest rate is fixed by looking at two factors.
- First, the lender looks at the time period for which the amount is being loaned.
- Second, the lender looks at her best customers and then sees what’s the prime rate is. If you’re wondering what prime rate is, prime rate is the interest rate that the commercial banks charges their best customers.
Depending on these two factors, the interest rate for the such payables with a specific customer is decided.
Before we go into detail about how notes payable in the balance sheet is treated, let’s first talk about the difference between notes payable and accounts payable.
Differences between notes payable and accounts payable
In usual terms, both notes payable and accounts payable serve one purpose. It forces the customers to pay off the loaned amount. But notes payable and accounts payable are not similar.
They have many differences. Here are the major ones –
- Promissory note: The major difference between accounts payable and notes payable is the matter of promissory note. Notes payable is a promissory note received by the borrower from the lender. But in the case of accounts payable, there’s no promissory note involved.
- Interest rate: In the case of accounts payable, the customer doesn’t need to pay any interest. But in the case of notes payable, the customer needs to pay interest and it is decided by the lender.
- Penalty: In the case of notes payable, if the customer delays the payment, the interest will increase. But in the case of accounts payable, a penalty amount is added to the loaned amount if the customer delays the payment.
- Extension: Notes payable is an extension of accounts payable. When a customer isn’t able to pay the required amount within the time frame, the customer needs to sign a note. This note is issued by the lender to the borrower to increase the time period and as a result, the customer needs to pay the loaned amount plus an interest over and above the principal amount. That means when a customer is unable to pay the amount due on time, her liability transfers from accounts payable to notes payable.
Notes payable on balance sheet
Every company treats the notes payable in the balance sheet as per its nature.
Usually, the company treats it in two ways.
Short-Term Notes Payable
Firstly, the company puts notes payable as a short-term liability. The company puts it as a short-term liability when the duration of that particular note payable is due within a year. As we see from the short term notes payable example, CBRE has a current portion of notes of 133.94 million and $10.26 million in 2005 and 2004, respectively.
Long-Term Notes Payable
On the other hand, if the note payable is due after 12 months or more, This is considered as a long-term liability. As an example, CBRE has long-term notes payable of 106.21 million and $110.02 million in 2005 and 2004, respectively.
In the next section, we will see how to pass journal entries.
It is important to understand the journal entries for notes payable. Doing so will enable an individual to comprehend the nitty-gritty of notes payable.
Let’s get started.
Please note that the entry is being recorded in the journal of the payee (meaning who is entering the notes on the balance sheet, meaning the customer).
The first entry would be –
Cash A/C ………………..Dr 1000 –
To Notes Payable A/C ….Cr – 1000
Here we have passed this entry in the books of the customers because it indicates that the customer has borrowed the money in lieu of the notes payable.
Here, we have debited cash because cash is an asset. And when we receive cash, the asset gets increased. When an asset gets increased, we debit the account. At the same time, we credited it because it is a liability. As a liability, it gets increased. When liabilities get increased, we credit the account.
The next entry would be an entry for interest expenses.
From the customer’s point of view, interest payment is an expense; but the customer is yet to pay the interest. So here’s the journal entry we will pass in the books of accounts of the customer –
Interest expense A/C ………………..Dr 150 –
To Interest Payable A/C ….Cr – 50
To Cash A/C…………………Cr – 100
In this journal entry, we have debited interest expense. Interest expense is an expense. When expense increases, we debit the account. At the same time, we have credited interest payable. Why? Because interest expense is not yet being paid off in full. That’s why we’re treating it as a liability. When liability increases, we credit the account. Here the company has paid off part of the interest; that’s why we credited cash account because when asset decreases, we credit the account.
Then, there would be a journal entry when the amount would be paid in full along with interest payable.
In this case, we will pass the following journal entry –
Notes Payable A/C ………………….Dr 1000 –
Interest payable A/C ………………..Dr 50 –
To Cash A/C ….Cr – 1050
Please note that the above journal entry will be passed only at the time of paying off the entire amount.
Here, we will debit it because there will be no liability anymore once the full amount is being paid off. We will also debit the interest payable because a portion of interest was due, but not now.
And we are crediting the cash account because cash as an asset is going out from the company. Since cash is an asset, when it decreases, we will debit the account
This has been a guide to Notes Payables, how it is different from accounts payables and how it is accounted on the balance sheet as short-term and long term. You may also have a look at these articles below to learn more about accounting –
- Subprime Loans | Top 4 Types
- Current Portion of Long-Term Debt in Balance Sheet
- Subordination Debt Types
- Accounting for Convertible Bonds Example
- Debit vs Credit in Accounting
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