You may have come across the term Notes Payable in the Liabilities section of a Balance Sheet.
Like people, Businesses need money for various purposes (Expansion, purchase of new machinery, making an acquisition and so on).
Often, to fulfill its needs, the business borrows money from outside parties.
When a Business owes someone money, they have essentially created a Liability for themselves since the amount needs to be repaid at a later date.
But, not all borrowings are the same.
Due to the different nature of borrowings - they are classified differently in the Balance Sheet.
These borrowings are reflected in the Liabilities section of the Balance Sheet in the form of a Payable (Accounts Payable, Notes Payable, Other Payables being a few examples).
What is Notes Payable?
In a Business, a Note Payable is a 'special form' of I.O.U. from the Business to someone else.
Notes Payable is a 'special form' of I.O.U because it is backed by a legal document called a Promissory Note (In fact, the name 'Notes Payable' comes from the vital role the Promissory Note plays in the lending process.)
When a Business borrows money (usually from banks and lending institutions), it is required to sign a legal document called a Promissory Note.
The Promissory Note is a written Promise made by one party (called the note maker) to the other party (the note payee) for a certain amount of money by a specified date.
The Promissory Note makes the Notes Payable borrowings distinct from other typical borrowings of a business (such as borrowing from its suppliers which are usually classified as 'Account Payable' on the Balance Sheet and are not accompanied by a Note).
How is a Note Payable recorded?
In the Financial Statements of a Business, a Note Payable is a Liability since it is the amount a Business owes to someone else.
Based on the amount of time this money has been borrowed - you may see the borrowed amount in the Short Term Liabilities section or the Long-Term Liabilities section.
Short-term Notes payable are typically expected to be paid within the year (Example: A 6-month Term Loan).
Long-Term Notes Payable are longer in nature and typically reflect debt which is over a year (Example: A 10-year loan that the company takes to buy new equipment).
Journal Entry Example
Typically, Notes Payable of a company incur interest (however, there are non-interest bearing Notes as well).
A typical Short term interest bearing note would record journal entries as below -
Short Term Note Payable
On Jan 1, 20X8, Superpower Inc gets a Bank loan from Bank ABD for $50,000 at an interest rate of 12% and due in 3 months.
The Journal Entry when the loan is taken would be
Jan 01, 20X8 Cash A/c Debit $50,000
Notes Payable A/c Credit $50,000
(To record the principal amount of the Note Payable.)
The Journal Entry when the loan is repaid would be
Mar 31, 20X8 Notes Payable A/c Debit $50,000
Interest Expense A/c Debit $1,500
Cash A/c Credit $51,500
(To record the loan being repaid with interest.)
To calculate interest expense - we have used the formula
Interest = Principal x Interest Rate x Time
= $50,000 x 12% x 3/12
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