Notes payable is a formal agreement, or promissory note, between your business and a bank, financial institution, or other lender.
Unlike accounts payable, which is considered a short-term liability, notes payable can be classified as either a short-term or long-term liability, depending on the repayment terms indicated in the promissory note.
Overview: What is notes payable?
Notes payable is a written promissory note that promises to pay a specified amount of money by a certain date. A promissory note can be issued by the business receiving the loan or by a financial institution such as a bank. A promissory note is always signed by both parties.
Here are some circ*mstances when a promissory note may be issued:
- You purchase materials in bulk from a supplier or manufacturer
- You decide to purchase a manufacturing plant, a building, or equipment for your business
- You receive a significant loan from a bank or financial institution
There are other instances when notes payable or a promissory note can be issued, depending on the type of business you have.
Any time that a promissory note is issued, your business bookkeeper or accountant should classify it as notes payable.
Notes payable is considered a written promise to repay the loan and usually specifies the exact terms of the agreement such as the amount that needs to be repaid, the due date for each payment, the interest rate included in the agreement, and the amount of interest that will need to be repaid.
If the loan is due to be repaid within a year, it would be considered a short-term liability. However, if the loan is not due for two years, it would be classified as a long-term liability.
Notes payable vs. accounts payable: What’s the difference?
While both accounts payable and notes payable are liability accounts and both represent the amount due and payable to a vendor or financial institution, there are several major differences between these two liability accounts.
Accounts payable are always considered short-term liabilities which are due and payable within one year.
There are no written agreements involved with accounts payable, which typically represent supplies or services purchased on credit that has been extended to you from vendors that you do business with on a regular basis. Your day-to-day business expenses such as office supplies, utilities, goods to be used as inventory, and professional services such as legal and other consulting services are all considered accounts payable.
Notes payable is a formal contract which contains a written promise to repay a loan. Purchasing a company vehicle, a building, or obtaining a loan from a bank for your business are all considered notes payable. Notes payable can be classified as either a short-term liability, if due within a year, or a long-term liability, if the due date is longer than one year from the date the note was issued.
An example of notes payable on the balance sheet
Accounts payable is always found under current liabilities on your balance sheet, along with other short-term liabilities such as credit card payments.
However, notes payable on a balance sheet can be found in either current liabilities or long-term liabilities, depending on whether the balance is due within one year.
This balance sheet displays three notes payable entries: Bank of Any City Loan, Equipment Loan, and Bank Loan. Image source: Author
In this case, the Bank of Anycity Loan, an equipment loan, and another bank loan are all classified as long-term liabilities, indicating that they are not due within a year.
A journal entry example of notes payable
The following is an example of notes payable and the corresponding interest, and how each is recorded as a journal entry. Of course, you will need to be using double-entry accounting in order to record the loan properly.
You recently applied for and obtained a loan from Northwest Bank in the amount of $50,000. The promissory note is payable two years from the initial issue of the note, which is dated January 1, 2020, so the note would be due December 31, 2022. In addition, there is a 6% interest rate, which is payable quarterly.
For the first journal entry, you would debit your cash account in the amount of the loan: $50,000, since your cash increases once the loan has been received. You will also credit notes payable to record the loan.
There is always interest on notes payable, which needs to be recorded separately. In this example, there is a 6% interest rate, which is paid quarterly to the bank.
This will be set up as an Interest Payable account, and placed under current liabilities, since the interest is paid quarterly, which is considered short-term. The journal entry would look like this:
Interest for the first quarter of the note payable is due April 1. The journal entry would look like this:
Interest expense will need to be entered and paid each quarter for the life of the note, which is two years.
If you have not been paying monthly on the note, you will pay off the principal in December of 2022, which is indicated on the promissory note. The journal entry would look like this:
Notes payable frequently asked questions
How do I account for interest expense if I need to pay it annually?
Instead of doing a quarterly journal entry, you would create a journal entry for your annual interest expense, which is $1,500. The journal entry would look like this:
When the interest is paid, the closing entry journal entry would be:
If my promissory note is for less than one year, why can’t I just put my notes payable amount in accounts payable?
Notes payable always indicates a formal agreement between your company and a financial institution or other lender. The promissory note, which outlines the formal agreement, always states the amount of the loan, the repayment terms, the interest rate, and the date the note is due.
Accounts payable on the other hand is less formal and is a result of the credit that has been extended to your business from suppliers and vendors.
Can you include notes payable when projecting expenses?
Yes, you can include notes payable when preparing financial projections for your business. This step includes reducing projections by the amount of payments made on principal, while also accounting for any new notes payable that may be added to the balance.
Accounting for notes payable properly
As your business grows, you may find yourself in the position of applying for and securing loans for equipment, to purchase a building, or perhaps just to help your business expand.
In many cases, these loans will be in the form of notes payable, which includes a promissory note that lays out in detail the terms of the loan, the loan amount, the interest rate, and when repayment is expected. Not recording notes payable properly can affect the accuracy of your financial statements, which is why it’s important to understand this concept.
If you’re looking for accounting software that can help you better track your business expenses and better track notes payable, be sure to check out The Ascent’s accounting software reviews.
