Notes Payable

Notes payable are liabilities that arise when a business signs a written promise, called a promissory note, to repay a specified sum of money to a lender or creditor on a set date or on demand, usually with interest. They are commonly used for bank loans, borrowing from shareholders, financing the purchase of equipment or vehicles, and converting an overdue supplier invoice into a formal debt. The legal instrument itself is described in the entry on the note; this entry covers how the borrower accounts for it.

Notes payable differ from accounts payable, which are informal, interest-free amounts owed to suppliers under normal trade terms. A note is a formal, written agreement that usually specifies the principal, interest rate, maturity date and any collateral, and it can be enforced and sometimes transferred. In some countries and older textbooks, short-term notes are called bills payable.

Notes due within one year are shown among current liabilities. Notes with longer terms are long-term liabilities, except for the principal due in the next twelve months, which is reclassified as the current portion of long-term debt. Accrued but unpaid interest is shown separately as interest payable. The notes to the financial statements disclose interest rates, maturities, security and covenants.

On 1 November, a retailer borrows $50,000 from its bank on a 90-day note at 6 percent annual interest, to buy holiday stock. The bank uses a 360-day year. Interest for the full term is:

Here $\text{Principal}$ is the face amount of the note, $\text{Rate}$ is the annual interest rate, and $\text{Days}$ is the number of days in the term. Interest is $50,000 times 0.06 times 90 divided by 360, which is $750.

• 1 November: debit cash $50,000; credit notes payable $50,000.
• 31 December (year end, 60 days elapsed): debit interest expense $500; credit interest payable $500.
• 30 January (maturity): debit notes payable $50,000, interest payable $500 and interest expense $250; credit cash $50,750.

The accrual at year end ensures that the interest cost is recognized in the period in which it is incurred, not when it is paid.

Some notes do not state a separate interest rate. Instead, the borrower receives less than the face value and repays the full face amount at maturity. If a company signs a one-year, $20,000 non-interest-bearing note and receives $18,868, the $1,132 difference is the interest. The borrower credits notes payable for $20,000 and debits a discount on notes payable for $1,132, a contra liability that is amortized to interest expense over the year. Under US GAAP, when a note is issued for goods or services and has no or an unreasonably low stated rate, it must be recorded at present value using a market rate, with the difference treated as imputed interest.

• Failing to accrue interest at period end, which understates both expenses and liabilities.
• Classifying the whole of a long-term note as noncurrent, ignoring the part due within a year.
• Overlooking covenants: a breach can make the full note due on demand and require it to be shown as current.
• Confusing a revolving line of credit with a term note; draws on a line are typically shown as short-term borrowings with their own disclosures.

Notes payable owed to related parties, such as owners or directors, must be disclosed separately because their terms may not be at arm's length.