What is a Notes Payable? – Definition
Notes payable is a liability that results from purchases of goods and services or loans. Usually, a written instrument that includes interest.
As with notes receivable, notes payable can result from different types of transactions, but the most likely sources are from purchases of goods and services through trade notes payable or from bank loans through notes payable. We will concentrate on notes payable to banks. The concepts related to these notes can easily be applied to other forms of notes payable.
Notes Payable Issued to Bank
Bank loans are a major source of funding for all types and sizes of businesses. There are two different types of notes that can be issued to banks: one type is drawn to include the principal or face amount and a separate interest element, and the other type is drawn in such a way that the face amount also includes the interest charge. The following example shows both types of notes.
Case 1 – Interest Element Stated Separately
Case 2 – Interest Element Included
The note in Case I is drawn in the principal amount of $5,000. The interest element of 12% is stated separately. The note in Case 2 is drawn for $5,200, but the interest element is not stated separately. The interest of $200 (12% of $5,000 for 120 days) is included in the face of the Note at the time it is issued but is deducted from the proceeds at the time the note is issued. Thus, S. F. Giant receives only $5,000 instead of $5,200, the face value of the note. The second case is an example of a discounted notes payable.
Issuance of the Note
The journal entries to record this note under each of the two cases are:
The entry in Case 1 is straightforward. Cash is debited, and Notes Payable is credited for $5,000. In Case 2, Notes Payable is credited for $5,200, the maturity value of the note, but S. F, Giant receives only $5,000 cash. The $200 difference is debited to the account Discount on Notes Payable. This is a contra-liability account and is offset against the Notes Payable account on the balance sheet.
Interest expense is not debited, because interest is a function of time. The discount simply represents the total potential interest expense to be incurred if the note remains’ unpaid for the full 120 days. Over the life of the note, the discount is written off as interest expense is recognized. The partial balance sheets for both cases as of the date of the of note are presented below:
Because the interest on the notes is not payable until maturity, an interest accrual must be made at year-end. This accrual is for three months, as adjusting entries are Assumed to be made only at year-end, December 31. The entry in each case is:
The adjusting journal entry in Case 1 is similar to the entries to accrue interest. Interest Expense is debited, and Interest Payable is credited for three months of accrued interest. The entry in Case 2 needs additional explanation. At the origin of the note, the account Discount on Notes Payable represents interest charges related to future accounting periods. At the end of the note’s term, all of these interest charges have been recognized, and so the balance in this discount account becomes zero. To accomplish this process, the Discount on Notes Payable account is written off over the life of the note. This write-off is referred to as amortization of the discount.
In the journal entry in Case.2, the discount is amortized on a straight-line basis. That is, an equal amount of the discount ($200 / 4 = $50) is charged each month to interest expense. The entry is for $150 because the amortization entry is for a 3-month period. After the entry on December 31, the discount account has a balance of only $50. This increases the net liability to $5,150, which represents the $5,000 proceeds from the note plus $150 of interest incurred since the inception of the loan. Partial balance sheets at December 31, 2019 for Cases 1 and 2 appear as follows:
As these partial balance sheets show, the total liability related to notes and interest is $5,150 in both cases.
Payment at Maturity of the Note
When the note matures on January 31, 2020, S. F. Giant must pay the entire principal and, in the first case, the accrued interest. In both cases, the final month’s interest expense, $50, is recognized. The journal entries for both cases are presented below.
In summary, both cases represent different ways in which notes can be written. In the first case, the firm receives a total face value of $5,000 and ultimately repays principal and interest of $5,200. In the second case, the firm receives the same $5,000, but the note is written for $5,200. The interest is deducted from the note at the time of its origin. Eventually, however, the firm must repay the full $5,200.