What Are Notes Payable in Accounting? A Guide to Recording Promissory Notes

Notes payable are formal written agreements, or promissory notes, where a company (the borrower) promises to pay back a lender a specific sum of money with interest over a predetermined period. For businesses, accurately recording these liabilities is critical for transparent financial reporting and understanding a company's true debt obligations. This guide explains what notes payable are, how they differ from other liabilities, and the step-by-step process for calculating and recording them on a balance sheet.

What Are Notes Payary and How Do They Appear on a Balance Sheet?

In accounting, notes payable is a general ledger liability account used to record the value of a formal promissory note that a company has issued. It represents the principal amount that remains unpaid. A key feature of a promissory note is that it includes an interest component, which is a cost to the borrower. Under the accrual basis of accounting, companies must also maintain a separate "Interest Payable" account to track any interest expense that has been incurred but not yet paid by the end of an accounting period.

Companies must disclose essential details about their notes payable, such as interest rates, maturity dates, and any collateral. On the balance sheet, these notes are categorized based on their due date:

• Current Liabilities: Amounts due within one year of the balance sheet date.
• Non-current (Long-term) Liabilities: Amounts not due within the next year.

How Do Notes Payable Differ from Accounts Payable?

It's essential to distinguish notes payable from accounts payable, as they represent different types of obligations.

Accounts Payable refers to short-term, informal obligations for purchases made on credit from suppliers, such as inventory or utilities. These typically do not involve a formal promissory note and often do not carry interest. In contrast, Notes Payable are formal, written debt contracts that always include a promise to pay interest. Based on our assessment experience, notes payable are used for larger, more structured financing, like bank loans or significant equipment purchases, while accounts payable manage day-to-day operational expenses.

What Is the Process for Calculating and Recording a Note Payable?

Properly recording a note payable ensures accurate financial statements. Here is a standard process:

1. Record the Initial Loan: When the loan is received, debit the "Cash" account for the total amount and credit the "Notes Payable" account. If the repayment period spans multiple years, the portion due after one year is credited to a "Long-term Notes Payable" account.

2. Record Periodic Payments: Each payment has two parts: principal (reducing the loan balance) and interest (the cost of borrowing). For a payment, you would:

   • Debit Notes Payable for the principal amount.
   • Debit Interest Expense for the interest cost.
   • Credit Cash for the total payment amount.

3. Account for Accrued Interest: If an accounting period ends before an interest payment is due, you must record the interest that has accrued. This involves debiting Interest Expense and crediting Interest Payable. When the payment is finally made, you debit Interest Payable to clear the accrued amount.

What Are Practical Examples of Notes Payable?

To illustrate, imagine a small business takes out a $50,000 bank loan at a 6% annual interest rate, with monthly payments over five years.

• Initial Recording: The company debits Cash for $50,000 and credits Notes Payable for $50,000.
• Monthly Payment Calculation: The monthly interest for the first payment would be $50,000 x (6%/12) = $250. If the total monthly payment is $966, then $716 goes toward the principal ($966 - $250).
• Recording the Payment: The entry would debit Notes Payable for $716, debit Interest Expense for $250, and credit Cash for $966.

To ensure accurate financial records, businesses should consistently apply the accrual accounting method, reclassify long-term notes to current liabilities as their due date approaches within one year, and maintain clear documentation for all promissory notes. Understanding notes payable is fundamental for assessing a company's leverage and financial health.