Notes Payable

What is the Definition of Notes Payable?

The “Notes Payable” line item is recorded on the balance sheet as a current liability – and represents a written agreement between a borrower and lender specifying the obligation of repayment at a later date.

Contained within the notes payable are also the terms stipulated between the two parties, such as:

• Obligations ➝ The obligations to be fulfilled by each party must be clearly specified
• Lending Period ➝ The duration of the borrowing until repayment comes due is stated
• Interest Rate ➝ The interest rate at which interest expense is charged throughout the lending term is stated
• Collateral ➝ Often, the lender will require collateral to be included as an additional layer of protection

How Does the Notes Payable Accounting Process Work?

Capital Borrowing Journal Entry (Debit, Credit)

• Cash Account ➝ If a company borrows capital under a note payable, the cash account is debited for the amount received on the ledger.
• Notes Payable Account ➝ On the other hand, the notes payable account is credited to account for the liability.

Interest Expense Journal Entry (Debit, Credit)

• Interest Payable Account ➝ From the perspective of the company, the interest expense due on the notes payable is debited while the interest payable account is credited.
• Cash Account ➝ Once paid, the interest payable account is debited and the cash account is credited.

Maturity of Interest Payment Journal Entry (Debit, Credit)

• Notes Payable Account ➝ At maturity, the notes payable account is debited (i.e. the original amount).
• Cash Account ➝ The offsetting entry is a credit to cash.

Notes Payable vs. Accounts Payable: What is the Difference?

Similar to accounts payable, notes payable is an external source of financing (i.e. cash inflow until the date of repayment).

By contrast, accounts payable is a company’s accumulated owed payments to suppliers/vendors for products or services already received (i.e. an invoice was processed).

The difference between the two, however, is that the former carries more of a “contractual” feature, which we’ll expand upon in the subsequent section. In contrast, accounts payable (A/P) do not have any accompanying interest, nor is there typically a strict date by which payment must be made.

Nevertheless, some suppliers will charge companies fines for late payments, or discontinue their business relationship if deemed appropriate.

Often, if the dollar value of the notes payable is minimal, financial models will consolidate the two payables, or group the line item into the other current liabilities line item.

Notes Payable vs. Short Term Debt: What is the Difference?

Notes payable is relatively similar to short-term debt in the sense that both share the following characteristics:

• Current Liability ➝ Reported on the balance sheet as a current liability but can also be a long-term liability if the maturity is beyond one year from the date the original capital was provided
• Maturity Date ➝ The maturity period is specified in the contract – the obligations of the borrower must be met by the specified maturity date, or else the borrower is in technical default
• Interest Owed ➝ Interest expense is charged on the amount borrowed across the lending term
• Collateral Pledged ➝ Lenders often ask for collateral depending on the borrower’s default risk, so if the borrower goes bankrupt, the lender has a right to the assets of the borrower – but debt lenders are much higher in terms of priority
• Debt Covenants ➝ Some lenders might even impose covenants that require the borrower to maintain certain financial ratios and prevent specified actions (e.g. M&A, dividends) to minimize their downside risks

In conclusion, all three of the short-term liabilities mentioned represent cash outflows once the financial obligations to the lender are fulfilled. But the latter two come with more stringent lending terms and represent more formal sources of financing.