A company may borrow money from lenders to finance an important investment, cover operating expenses, or support business expansion. Notes Payable are one form of such debt; these promissory notes are legal obligations, meaning that they must be repaid on time. Below, we are going to explain how Notes Payable work, their different types, and how they can be recorded on a balance sheet.
Highlights/ Key Takeaways
- Notes Payable are a type of written promissory note that covers a borrower’s promise to pay a lender back over a certain period of time.
- Different types of Notes Payable are available, depending on the agreed payback period and other factors.
- Notes Payable fall under either current liabilities (a repayment period of one year or under) or long-term liabilities (a repayment period over one year).
- A company’s Notes Payable amounts must be included on its balance sheet. Double-entry accounting should be used for accurate records.
What Are Notes Payable in Accounting?
In accounting, the term “Notes Payable” describes a type of legally-binding promissory note. Under this agreement, a borrower receives a certain amount of money from a lender and promises to repay it along with the interest over an agreed period of time.
In a nutshell, Notes Payable are legal contracts signed by a borrower and a lender, which outline loan repayment details. They are considered to be either a current or long-term liability and are recorded on the balance sheet.
“Notes Payable are legal contracts signed by a borrower and a lender, which outline loan repayment details.”
Notes Payable Terms
Notes Payable contracts include a number of different loan terms agreed upon by both a lender and a borrower, such as:
- Obligations: the obligations that must be met by both parties
- Repayment period: the period over which the borrowed amount must be repaid
- Payment schedule: the exact schedule of repayments
- Interest rate: the interest rate that must be repaid along with the original borrowed amount
- Collateral: whether the loan is secured by collateral as an additional layer of protection
- Information related to non-payment: repercussions if the borrower fails to make payments on time, - for example, late payment fees
Short-Term Notes Payable
Short-term Notes Payable have a repayment period of one year or less. This means that they fall under current liabilities on a balance sheet. If a longer-term note payable has a short-term component, the exact amount due in the next year must be stated separately as a current liability.
Long-Term Notes Payable
Any Notes Payable with a repayment term of over one year are considered long-term liabilities. Even so, the typical repayment period of notes payable rarely exceeds five years.
As mentioned above, if a long-term note payable includes a short-term component, it must be recorded separately on a balance sheet, under current liabilities.
Types of Notes Payable
Notes payable can come in all shapes and forms, varying by payback periods, loan amounts, interest rates, and other conditions. The four main types of Notes Payable are amortized, interest-only, negative amortization, and single-payment promissory notes.
1. Amortized Notes Payable
Amortized Notes Payable require the borrower to pay fixed monthly amounts that will be applied toward the principal balance of a loan and its interest. As the loan is paid down more and more, a larger portion of the payment goes toward the principal, and a smaller portion - toward interest.
Typical examples of amortized Notes Payable include bank loans for homes, buildings, and other types of properties.
2. Interest-Only Notes Payable
With this type of promissory note, a borrower agrees to pay back the full principal amount at the end of the loan term. However, interest payments are still deducted every month.
One common example of an interest-only Note Payable is an interest-only mortgage, where regular payments include interest charges alone.
3. Negative Amortization Notes Payable
Remember, with amortized Notes Payable, the borrower makes regular loan payments that cover both the loan principal and the associated interest charges.
Negative amortization occurs when the principal payments of a loan are smaller than the interest costs. As a result, the loan balance continues to increase, as unpaid interest charges are added to the principal amount.
Negative amortization is possible with any type of loan but is especially common among real estate and student loans.
4. Single-Payment Notes Payable
Just as the name suggests, single-payment Notes Payable must be repaid with one lump payment before the loan’s maturity date. This lump payment will include both the principal borrowed and the interest accumulated over the loan's lifetime.
Single-payment Notes Payable are the simplest type of promissory note. This setup is often more practical for smaller and informal loans.
Notes Payable vs. Accounts Payable
Both Notes Payable and Accounts Payable are liabilities recorded on a company’s balance sheet. While the two terms often go hand-in-hand, they are not exactly the same.
- Notes Payable are typically funded by banks, but they may also be issued by other financial institutions. Some examples of Notes Payable include receiving a loan from a bank, purchasing a building, or financing a company car.
- Accounts Payable result from purchasing goods or services. These are simple short-term liability accounts incurred for purchases with suppliers and vendors on credit. Examples of Accounts Payable include bills a company must pay for staff uniforms, cleaning services, office supplies, or software subscriptions.
Repayment Terms and Conditions
- Notes Payable are relatively long-term obligations to lending institutions or vendors. They come with specific terms and maturity periods of either one year or below (short-term) or longer than one year (long-term). These promissory notes also include the principal amount, interest payment, payment schedule, and collateral terms, if any.
- Accounts Payable represent unsecured short-term debt. These credit purchases must be repaid within one year and do not incur interest during the repayment period. In fact, vendors might offer discounts for early payment instead.
Balance Sheet Classification
- Notes Payable are recorded under either current or long-term liabilities on the balance sheet. They are separated into “Bank Debt” and “Other Long-Term Notes Payable.” The specific payment details are outlined in the notes to the financial statements.
- Accounts Payable are recorded on the balance sheet under current liabilities.
Interpretation and Significance
- Notes Payable provide funds often necessary for business growth and expansion, as well as product development and innovation. The value of these accounts is important for finance or management teams in many types of businesses, as it indicates the amount of money a company owes to its lenders.
- Accounts Payable indicate the amount of money a company owes to its vendors and suppliers. Evaluating the Accounts Payable value can tell the management team whether a company is overspending with vendors or relying on credit too heavily.
What Are Some Examples of Notes Payable?
Companies may take out a business loan to purchase equipment, real estate, a business vehicle, and more. Such loans from banks or investors are all examples of Notes Payable.
Notes Payable Example
On January 1st, 2023, Michael borrowed $10,000 from an investor Bob to put down a deposit on a mortgage for his new retail store. Michael signed a Note Payable promising to make payments to Bob on the first date of every month consisting of $500 toward the principal amount and $50 toward interest until the loan is paid off in full.
Notes Payable on the Balance Sheet
Notes Payable appear on a company’s balance sheet. Recording this account properly will help you determine the total amount owed, which is a must to get an accurate picture of your company’s financial position. However, recording Notes Payable isn’t that simple and requires the use of double-entry accounting, - more on this below!
Is Notes Payable an Asset or a Liability?
The Notes Payable account is considered a liability. Short-term loans to be repaid in one year or under are considered current liabilities, while Notes Payable with a term of over one year are recorded as long-term liabilities.
Journal Entries to Record Notes Payable
Every Notes Payable transaction must be properly recorded in a general journal, to be later summarized on the balance sheet. This requires the use of double-entry accounting, which means that every financial transaction must have an equal and opposite effect in at least two other different accounts.
Going back to our previous example:
Michael took out a $10,000 loan from Bob. Because he now owes Bob $10,000, the credit under the Notes Payable account will increase by $10,000. However, the amount of cash in Michael’s bank account has increased by $10,000 and should be recorded accordingly. This constitutes the first Notes Payable journal entry:
The Note Payable interest must be recorded separately. The $50 monthly interest payments will be recorded as a $50 debit to Interest Payable and as a $50 credit to the Cash account.
Advantages of Notes Payable for Small Businesses
Using Notes Payable to finance small business operations offers several advantages, including:
- Notes Payable present a popular and easy way to raise money for business needs.
- These promissory notes are regulated by the terms outlined in the contract.
- Notes Payable come in different types and with varying term lengths, which allows for flexibility and convenience of repayment.
- Understanding the associated terms of repayment is relatively easy, which makes Notes Payable widely accessible to use.
What Happens if a Company Fails to Pay Its Notes Payable?
A Note Payable is a legally binding agreement, which means that a borrower must follow the lending terms. The contract will likely include information on fees that will apply should the borrower be late with payments. If the borrower continues not to pay the agreed amounts, the lender may send the loan to collections or pursue legal action.
Notes Payable are promissory notes or contracts that indicate the money a company owes to its lenders, - whether on a short- or a long-term basis. These contracts are legally binding, which means that the borrower is obligated to follow the repayment terms outlined in the note. All Notes Payable amounts must be properly recorded in the general journal and on the balance sheet.