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What are notes payable? Definition with examples

What are notes payable? Definition with examples

Notes payable are often used when a business borrows money from a lender like a bank, institution, or individual. Essentially, they’re accounting entries on a balance sheet that show a company owes money to its financiers.

Notes payable usually include the borrowed amount, interest rate, schedule for payment, and signatures of the borrower and lender.

Borrowing accounted for as notes payable are usually accompanied by a promissory note. A promissory note is a written agreement issued by a lender stating that a borrower will pay the lender the debt it owes on a specific date with interest.

What type of account do notes payable fall under?

A notes payable account falls under liabilities. This means the business must pay a sum to a lender under specific terms on a particular date. If the loan due date is within 12 months, it’s considered a short-term liability. Loans due after one year are considered long-term liabilities.

Debts a business owes to its creditors are filed under liability accounts as a debit entry. Because in double-entry accounting, every financial transaction is recorded as a debit to one account and credit to another, along with recording notes payable in the liability account, the transaction also involves recording a credit entry in another account.

In a company’s balance sheet, the total debits and credits must equal or remain “balanced” over time.

How are interest rates determined on a note payable?

Interest rates on notes payable are usually negotiated between the borrower and the lender. Rates may be fixed, meaning they will be the same throughout the loan. Or, they may be variable, meaning they can fluctuate based on changes in interest rates by central banks.

Different factors can affect the rate of interest on notes payable. For example:

  • Creditworthiness of the borrower
  • Duration of the loan
  • Purpose of the loan
  • Lender’s internal policies

A low interest rate is possible for borrowers with a strong credit and financial profile. A borrower with a weak credit history and a relatively less healthy financial profile may be in for a higher interest rate.

Examples of other fees that may be included in the terms of a note payable:

  • Origination fee
  • Closing costs
  • Penalty fee

These fees can add to the overall cost of borrowing. Consider them carefully when negotiating the terms of a note payable.

Notes payable example

Suppose a company needs to borrow $40,000 to purchase standing desks for their staff. To buy new furniture, the company applies for a loan from a bank. The bank approves the loan and issues the company a promissory note with the details of the loan, like interest rates and the payment timeline.

On its balance sheet, the company records the loan as notes payable. It will make this entry in its liability account. The company makes a corresponding “furniture” entry in the asset account.

As the company pays off the loan, the amount under “notes payable” in its liability account will decrease. At the same time, the amount recorded for “furniture” under the asset account will also see some decrease by way of accounting for the depreciation of the asset (furniture) over time.

How to calculate notes payable with interest

A calculation for “notes payable” requires the following information:

  1. Loan amount
  2. Interest rate
  3. The schedule for payment (or, number of payments)

For a simple loan with fixed monthly payments, calculate notes payable using the following formula:

Notes payable = Amount of loan x (1 + rate of interest x no. of payments)

Note that the above formula assumes that the interest is simple and does not compound over time. It also assumes that payments will and can be made at regular intervals and are equal in amount.

For example, a business borrows $50,000 at an interest rate of 5 percent per year, with a schedule to pay the loan amount back in 60 monthly installments.

Note payable = $50,000 x (1 + 0.05 x 60) = $56,500

Loan calculators available online via the Internet work to give the amount of each payment and the total amount of interest paid over the term of a loan. These require users to share information like the loan amount, interest rate, and payment schedule.

Another related tool is an amortization calculator that breaks down every payment to repay a loan. It also shows the amount of interest paid each time and the remaining balance on the loan after each time.

Simply subtracting any payments already made from the total amount of notes payable can also show the current balance of notes payable or the portion of the borrowing still owed.

How to find notes payable on a balance sheet

Typically, businesses record notes payable under the liabilities section of the balance sheet. The liabilities section generally comes after the assets section on a balance sheet. If notes payable are listed under a category named “current liabilities,” it means the loan is due within one year. If it’s located as a record under a category called “long-term liabilities,” it means the loan is set to mature after one year.

Here is a good example. On April 1, company A borrowed $100,000 from a bank by signing a 6-month, 6 percent interest note. Below is how the transaction will appear in company A’s accounting books on April 1, when the note was issued.

Another entry on June 30 shows interest paid during that duration to prepare company A’s semi-annual financial statement.

Notes payable vs. accounts payable

Both notes payable and accounts payable appear as liabilities account. The two are used to record different types of transactions. A note payable serves as a record of a loan whenever a company borrows money from a bank, another financial institution, or an individual.

On the other hand, accounts payable are debts that a company owes to its suppliers. For example, products and services a company orders from vendors for which it receives an invoice in return will be recorded as accounts payable under liability on a company’s balance sheet.

Accounts payable typically do not have terms as specific as those for notes payable. Unlike a loan, they will not be issued with interest or have a fixed maturity date. No promissory notes are involved in a liability a company owes as accounts payable.

What happens when a company pays off notes payable?

Because the liability no longer exists once the loan is paid off, the note payable is removed as an outstanding debt from the balance sheet.

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