Simple Explanation of Notes Payable

Simple Explanation of Notes Payable

Simple Explanation of Notes Payable

Overview

Notes Payable is a liability on the Balance sheet. It is a loan with interest, where you borrow money and you are charged interest. The borrower promises to pay the money back on demand or at a fixed or determinable future time. The interest rate is determined based on the time frame for which the loan is taken. In addition, the best customers can get prime rates.

Although a majority of notes payable are interest-bearing, sometimes this document does not have an interest percentage on it and that is known as a zero interest-bearing note. That is somewhat misleading because there really is interest on that note, it is just built into it. For example, if you borrow $7,000 today and promise to pay back $8,500 in ten months, that means you are paying the lender $1,500 worth of interest.

Simple Explanation of Notes Payable

These loans are usually short-term, but can be long-term loans as well. Typically, these notes are signed for:

  • purchases of large amounts of goods
  • financing of something
  • refinancing of Accounts Payable
  • short or long-term loan.

Notes payable are often confused with Accounts payable. Although both are liabilities, notes payable represent a loan from a bank or any other financial institution against a security or a personal guarantee. It also requires a formal loan agreement. Accounts payable, on the other hand, refers to the amount of money that is owed by a business to its supplier.

Example

Bricks Corporation issued a 120-day, 6% note for $40,000 to Sky Company. The word issued is another word for borrowed. So, in simple words, Bricks Corporation borrowed money from Sky Company. To journalize this financial event, you should compute the interest.

Simple Explanation of Notes Payable

For Bricks Company, interest is the cost to borrow money. First, you need to convert the interest into a decimal format and express the time in years (e.g. 8 years is 8, 3 months is 3/12, and 60 days is 60/360). Thus, the interest equals to $40,000 x 0.06 x 120/360 days or $800.

Now, let’s journalize it. When the company borrows the money, it will get cash and acquire a liability.

Account

Debit

Credit

Cash

$40,000

Notes Payable

$40,000

Issuance of note.

When the company will be repaying the loan, first it will want to take the Notes Payable off its accounts to show that it does not owe anything. So, you will debit this account. Next, you will record the cost to borrow the money by debiting the Interest Expense. The Cash account will reflect payment of not only the amount the Bricks Company initially received but also the interest expense it had to pay to use that money.

Account

Debit

Credit

Notes Payable

$40,000

Interest Expense

$800

Cash

$40,800

Repayment of note.