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Notes Payable in Financial Accounting
Short-term notes payable are obligations represented by promissory notes. A company may sign promissory notes to obtain bank loans, pay suppliers for goods and services, or secure credit from other sources.
Business firms frequently borrow funds from banks or other lenders by signing a formal note payable with a fixed repayment date, and notes payable may be either interest-bearing or discounted. To illustrate the accounting for an interest-bearing note, assume that a firm borrows $200,000 from a bank to be repaid in six months at an interest rate of 12% per year. Interest rates are usually stated on a yearly basis, even if the loan is for a shorter time period. This transaction increases cash and notes payable by $200,000.
Recall that the principal amount (P), the interest rate (r), and the time period (t) of the loan are used to determine the interest expense (I) in the following way:
When the note is repaid with interest, cash is reduced by $212,000, the notes payable balance is eliminated, and the firm incurs interest expense of $12,000.
At the date of payment:
To illustrate the accounting for a discounted note, assume that the firm signs a note promising to pay the bank $200,000 in six months. The bank discounts the note by deducting the interest charge in advance. Assuming the interest rate is 12%, the bank deducts interest of $12,000 ($200,000 * 12% * .5 (half year) = $12,000) in advance. The amount paid to the borrower upon signing the note is then $188,000 ($200,000 - $12,000 = $188,000). This transaction increases cash and notes payable by $188,000.
At the date of borrowing:
When the note is repaid, cash is reduced by $200,000 (the face amount of the note), the note payable balance is eliminated, and the firm incurs interest expense of $12,000.
At the date of payment:
Note in this case that the note was discounted at a nominal rate of 12%. The actual rate of interest is greater than 12%, however, because the firm only received $188,000 from the lender and paid $12,000 in interest expense for six months. The interest expense is thus 6.38% ($12,000 / $188,000 = 6.38%) for six months, or12.76% per year (2 * 6.38% = 12.76%).
Current Liabilities Topics
Managing Liquidity and Cash Flows
- Accounts payable
- Discounts in Current Liabilities
- Notes Payable
- Accrued Liabilities (Accrued Expenses)
- Current Maturities/Portion of Long-Term Debt
- Taxes Payable
- Accrued Restructuring Costs
- Advance Payments from Customers
- Obligations for Warranties
Commitments, Contingencies and Risks
