Notes Payable - Online Tutor, Practice Problems & Exam Prep

Notes payable represent a formal liability supported by a written contract, differing from accounts payable, which typically involves invoices without interest. The principal is the borrowed amount, while interest is calculated using the formula: $Prt$, where P is the principal, r is the annual interest rate, and t is the time factor. Short-term notes usually require interest payment at maturity, while long-term notes involve periodic interest payments, impacting cash flow and financial statements.

Acquiring Notes Payable

Alright, so let's see some of the journal entries related to notes payable. How we acquire them, deal with the interest and finally pay them back. I think it'd be really cool after you guys watch this lesson to go back and review the notes receivable lesson, and you'll see how similar notes payable are to notes receivable. Right? Because when you think about it, one person's note receivable is another person's note payable. So some kind of old adage like that. Let's dive in here to notes payable. So it's similar to Accounts Payable (AP). Right? Because it's a liability. It's money that we owe, except it's supported by a formal written contract. With AP, it might be just that we got an invoice that we have to pay. Well, here we've signed an actual note, right? A note payable. We've signed the contract. That's the note. And the difference here with AP is that these notes, well, they're going to have a maturity date. So there's going to be a specific date in the contract, a maturity date and it has to be paid back and they earn interest. OK? So accounts payable, think about it. When we receive an invoice from a supplier, it's not like they tell us we're going to have to pay interest. No. They just give us a few, maybe a few weeks to pay and then we just pay it back. No interest included there. So the note payable interest is a big part of this.

So we've got two terms here. First, we've got the principal, right? The principal, that's the actual amount of money borrowed, that we actually borrowed. So the principal of the loan, if we borrowed $100,000 well the principal is $100,000 and then we pay interest on the borrowing, right? There's going to be an interest rate and that's the cost of borrowing, right? That's why the bank will lend us money is because they're going to earn interest. We have a formula here, for calculating interest interest and what we have is the face value of the note. So that's the principal right there. It's going to be stated, this is going to be given to you. You borrowed $100,000, whatever it might be. There's going to be an interest rate and this interest rate is always going to be an annual rate that they give you. Even if it's a note that's 5 years long or 6 months long, 9 months, they always tell you the full year's interest. Even if you're not going to pay that much, or if you're going to pay it for several years. You're going to have an annual interest rate, and then we're going to multiply it by a time factor. This time factor is usually a proportion of a year. Proportion of the year that we're calculating the interest, right? Because if, let's say, we took a loan out on September 1st, and we're preparing December 31st financial statements. Well, we only have we don't have a full year there, right? We only want to calculate interest for that portion of the year. So we'll see some examples about that.

But let's go ahead and start with acquiring the note. Let's see what the journal entry looks like when we acquire a note from the bank, so we actually sign a contract to borrow some money and we get the money. On October 1st year 1, the Goods company signed a $100,000 12 percent 8-month note payable maturing on May 1st year 2. So, there's a lot of information there, but it's all valuable. Here, they tell us the interest rate 12%, right? And that's annual. Annual interest rate. They tell us the term, right? This is the term of the loan. It's going to be 8 months total, right? But it's not 8 months this year. It's 8 months between today, October 1st, and May 1st when we're finally going to pay it back next year. So right here, we have the maturity date, right? That's going to be the maturity date, May 1st. And what about that $100,000 over here? The $100,000 Well, that's the principal of the loan, right? That's the principal, the face amount that we borrowed. So the journal entry, when we first acquire the note payable, it's pretty easy, right? What did we receive? We received cash from the bank, right? They gave us cash and we signed this note. So we're going to debit cash and that's going to be for the face amount. The $100,000 in principal that we took out. $100,000 that is our debit. What's going to be our credit? We've got this liability. We signed the note. We owe this money. It's a note payable, right? So we're going to credit notes payable. And now, we have this liability on our books for the $100,000 that we borrowed, right? So now we got this cash. Our cash went up by $100,000, and our liabilities for the note payable also went up by $100,000, right? So we stay balanced here. Everything makes sense in there. Cool. So this is a pretty simple journal entry when we acquire a note payable. It gets a little more interesting when we start dealing with the interest. So let's go ahead and do that in the next video.

Short-term Note Payable:Interest Expense

Alright. So let's deal with the interest expense here. When we deal with interest with a notes payable, it's a little bit different whether we have a short-term note or a long-term note. Generally, the contract is going to have very specific details about how the interest is going to be paid. But in general, what we're going to see with a short-term note, something that's under a year, is that you usually don't make interest payments throughout the term. You usually just pay all the interest at the end. So, if you borrow something for, say, 6 months, you're not going to pay interest every month. You usually hold on to it and then at the end of the 6 months, you pay back the loan and the interest as well. So let's start here with a short-term note. And what we'll see is that the total amount of interest is usually paid at maturity, paid at maturity. Okay? So you're not going to be making interest payments as you go. But what we are going to be doing is making adjusting entries to accrue for interest, right? Because as time passes, we have to take the expense, right? Because we borrowed the money and we're getting the advantage of borrowing the money. Well, we need to take the expense when we're getting that advantage of having the money, right? So that interest expense has to be accrued when we're using it.

So let's go ahead and see this in an example. Building on our previous one, on October 1st, year 1, the Goods Company signed a $100,000 12% 8-month note payable maturing on May 1st, year 2. Prepare the adjusting entry to accrue interest on December 31st, year 1. Alright? So we borrowed this money on October 1st and we made that entry above where we created the liability. Now some time has passed, right? October has gone by, November, December. And we're preparing our financial statements. Well since some time has gone by, we've gotten some of the benefit, right? That interest has started accruing and we need to take the interest expense because we've borrowed the money, we've got to take the expense for the time that we've already borrowed it. Okay? So let's use our interest calculation to find out how much interest we have to accrue. So remember, to calculate the interest, what are we going to take first? We need our principal amount, right? The $100,000. And we're going to multiply that by our annual interest rate that's given to us, the 12%. So let's turn that into a decimal. 12% is 0.12, right? 0.12 for 12%. And now we have to multiply that by our time factor. So how much time have we actually had the note out, right? It's not going to be a full 12% that we owe in interest, right? Because it hasn't been a whole year. We've only had it for all of October, right? That's the way you always want to count on your fingers. This is like part of accounting. It's so funny. October, we had it out. November, December. Right? And now we're at December 31st and we're preparing the financial statements. So we've had it for 3 months, October, November, December, that we've had the loan. So that's 3 months out of the 12 months in a year, right? That's how much interest we've accrued at this point. How much we owe. So interest is going to be this $100,000 times 0.12 times the 3 out of the 12 months that we've had the money borrowed. So that's the proportion of the year that we borrowed the money. Let's go ahead and see how much that is. $100,000 times 0.12 so $12,000 would be the total amount we would owe in 1 year, but it hasn't been a whole year. So times 3 divided by 12, it comes out to $3,000. Right? $3,000 is the amount of interest incurred so far. Right? We didn't incur a whole year's worth of interest. It's only been 3 months. So we have 3 months worth of interest there at $3,000. So what does this $3,000 do? How are we going to use this in our journal entry? Well, we've incurred the expense, right? We've borrowed this money and time has passed. So we owe this interest. We need to take interest expense. Our debit is going to be the interest expense, right? Our expenses go up with a debit. So this makes sense here. So interest expense and that's going to be for the $3,000, right? $3,000 because $3,000 worth of interest has been incurred so far. What about our credit in this entry? It's not cash, right? We haven't paid it out yet. We need to accrue a liability for this interest. And that's going to be interest payable. Right? So now we have this new liability, separate from the note payable. So we have the note payable that's holding the principal amount of what we owe, and now we have the interest payable that holds the interest that we owe. So there's the `$3,000` that we owe up through December 31st. Right? And we're making this entry on December 31st year 1. Right? So we haven't paid back anything yet. We still borrowed all the money. We now owe them a little more money because time has passed, but we haven't paid them anything back in cash. Alright? So what do we see here? The interest expense, that goes into equity, right? Because that's going to flow through net income and lower our retained earnings. So I'm going to put the interest expense in here. And that's `$3,000` decrease, right? The expenses are going to decrease our net income and the interest payable. I'm going to just put `I payable` and that's going to be `$3,000` as well, right? And that's an increase here, right? So we stay balanced here, right? Because our liabilities let me get out of the way. Our liabilities went up by `$3,000`. Our equity went down by `$3,000`. So we stay balanced on this equation. Cool? All right. Let's go ahead and pause here and then we'll continue and we'll see interest from a long-term notes perspective. Alright. Let's check that out.

Long-term Note Payable:Interest Expense

Alright. So we're going to continue with a similar example, except now we're going to turn it into a long-term note. Alright? So let's see how that interest expense gets dealt with in a long-term note and what happens in long-term notes, since we owe the money for so long, usually 5 years, 10 years, 20 years. Well, the bank doesn't want to wait that long to collect some of the cash. They're going to periodically want some of that interest. They're going to say, "Okay, it's been maybe every 6 months." They'll say, "Okay, pay us whatever interest you owe us. You don't have to pay back any principal yet, but pay us that interest that you owe us." Or after 12 months or, you know, they're going to tell you when you have to pay the interest. And it's usually going to be every 6 months or 12 months in these problems. So with these long-term notes, interest is paid to the bank periodically here, right? You don't wait until the very end to pay it back. So you still could make those adjusting entries when we have the financial statement date, but then you're going to be paying it off as time goes on. Alright? So let's see this example here. On October 1st, year 1, the Goods Company signed a $100,012 10-year note. So notice, now it's a 10-year note. Right? Before we were dealing with, I think it was an 8-month note in the previous video, but now we're talking about a long-term note, right? 10 years, and it's maturing on October 1st, year 11. Okay? So on October 1st, year 11, we have to pay back the $100,000. Cool? Notice what it says here, interest is payable annually on October 1st. So every year on October 1st, whatever interest we owe, we are going to pay it to the bank in cash.

Prepare the adjusting entry on December 31st, year 1, and the journal entry on October 1st, year 2, for the payment of interest. Okay? So the adjusting entry on December 31st, year 1, is going to be very similar to what we did previously, right? Because we signed this note on October 1st, year 1. Some months have passed, and we have to accrue the interest in year 1 for the time that has passed in year 1 in which we borrowed the money. So let's go ahead and calculate that interest again. So, this is going to be the December 31st interest calculation, and this is for the interest payable, right? We're going to be accruing some interest that we haven't paid yet. So let's see what that is. There's a $100,000 note just like before, 12%, 0.12. And we're accruing for the same proportion of the year, right? We still took it out on October 1st. So it's been out all of October, November, December, right? We're reaching December 31st, year 1. So it's still 3 months out of the total 12 months in a year. And we found that to be $3,000 in interest, right? So that's the amount of interest incurred during year 1 from October through December. So let's go ahead and make that entry again. Just like we did before, we had interest expense, right? And this is so that we match in year 1 the time, right? The time that we've borrowed it in year 1. So interest expense for the $3,000, and we haven't paid it in cash yet, right? It's only payable on October 1st. So we're not going to pay until October 1st, year 2. We're not going to pay this interest that we're accruing. So we're going to increase a payable, right? We have our liability for this interest that we're accruing in year 1. Cool? So that's just like we did before.

But now, this is a long-term note. October 1st, year 2 rolls around. We don't have to pay back the principal. None of this $100,000 is being paid back, but the bank said, "Hey, you got to pay me whatever interest you owe me." Okay? So if we think about it, how long has it been since we borrowed the note from October 1st, year 1 to October 1st, year 2, when we finally have to pay interest the first time? It's been 1 year, right? We have to pay 1 full year's worth of interest. So when we pay the bank, the cash that we're going to pay the bank, it's 1 full year's worth of interest. So let's go ahead and calculate that. The cash, this is on 10/1, year 2, right? The cash we're going to pay to the bank, well that's going to be the total interest for a year. It's going to be the <$100,000_factored_into_debt> that we owe times the 12% interest. But the time factor this time, well, the time factor is just 1, right? Because it's 1 full year. We're not doing a proportion of the year. We owe them for a full year, and that comes out to be $12,000 in cash that's going to be going to the bank, right? So this $12,000 in cash, what does it represent? First, it represents this $3,000, right? There's the $3,000 from last year that we owed. But there's also the time that has passed this year, right? How about in year 2? There were January, February, March, April, May, June, July, August, September. 9 months, right? We had 9 months that have passed in year 2 that we owed interest. And that should make sense. So let's go ahead and look at that. The interest expense in year 2, that's going to be the same thing where we've got the $100,000 times the 12%, times 9/12, right? 9 months have passed in year 2, And that's going to come out to $9,000, right? $100,000 times 0.12×912, that's $9,000 in interest expense for year 2. Okay? So that's where all of these numbers come from. Let me get out of the way here. We've got the $12,000 total cash we're paying to the bank and $9,000 of that $12,000 is for interest that we've incurred this year. And the other $3,000 is the interest that we owe from last year, right? The interest liability that we accrued last year. So let's go ahead and make that entry. So like I said, we've got our interest expense for year 2 that we've incurred up to this point. So on October 1st, year 2, what we would have incurred $9,000 worth of interest expense, right, for those 9 months that have passed, and we have to get rid of that interest payable from last year, right? We had this interest payable. Well, we're finally paying it now, so we don't have that liability anymore. And that's that $3,000, and what's going to be the credit? The cash, right? We have to get rid of the cash. We're going to pay them in cash. So we have to lower our cash balance with a credit for the $12,000 in cash we're going to pay. Cool? So that's our journal entry in year 2 right there. And if you think about it, once it gets back to December 31st, year 2, so once it comes back around, and we're making our December 31st, year 2 entry, well, we're going to do the same thing. We're going to make this adjusting entry again, right? Because 3 more months will have passed again. October of year 2, November of year 2, December of year 2, three months. Well, we have to calculate our 3 months of interest that we owe, and we would make that entry again. And then in year 3, we would pay them cash, and we would get rid of the liability. So this would continue every year. We would basically make these same entries until we pay off the principal in the final year. Cool? So you can see it's a little different because we're paying off the interest as we go. With the short-term note, we're just going to keep accruing until the end and we'll make the final payment with the interest. Okay? So let's go ahead and in the next video, we'll start discussing when we pay back the principal at the maturity date of the loan. Cool? Let's go ahead and do that now.

Short-term Note Payable:Maturity

Alright. So let's continue here and see how we deal with the short-term note on the maturity date when we pay back the principal. Alright? So remember, with the short-term note, we're accruing all the interest and paying it back finally. When we pay back the principal, we pay back all the interest. So let's go ahead and do our example here. On October 1st, year 1, the goods company signed a $100, 012, 8-month note payable maturing on June 1st year 2. Prepare the entry to repay the note payable and all accrued interest on June 1st year 2. So notice, we haven't made any interest payments up to this point. We're repaying all the accrued interest as well as the principal on June 1st, year 2. So if you remember previously, we had accrued interest in year 1, right? We had our interest payable account. I'm going to put 'I payable' for interest payable. And we had accrued $3,000 of interest as a liability, right? Because 3 months had passed in year 1, October, November, December. Well, those 3 months, we accrued the interest for the interest expense in year 1. The rest of it is going to be in year 2, right? So 3 months were in year 1, well, 5 months are in year 2. So that's going to be January, February, March, April, May, right? 5 months and then we pay it back on June 1st. Alright? So I'm just reminding you here that we already have this $3,000 credit from the previous year as a liability. So let's go ahead and find out our interest expense in year 2. Right? And this is year 2 interest expense. And that's going to equal the same formula, right? We got our 100,000 times the 0.12, the 12% interest, 0.12. But now, how many months happened in year 2? The 5 months, right? January through May. So we're going to do 5 twelves. Right? 5/12 of that annual interest and that's going to come out to $5,000, right? So we have 5,000 in interest expense in year 2, okay? So that makes sense, right? Because there were 8 total months and as you can see, it's 1,000 in interest every month. We had those 3 months in year 1, 5 months in year 2. There's the 8,000 total interest. Well, we're going to go ahead and pay all of that back here on June 1st year 2 when we repay the loan. So let's go ahead and make our journal entry, right? Because we need to get rid of all the liabilities, right? We have the note payable liability that we're paying back. We need to get rid of the interest payable because we're going to finally pay for it and we've got to take our interest expense for this year. Okay? So let's go ahead and see what all of that's going to be. First, we're paying back the note payable. Let's get that off of our books. Note payable, that's coming off of our books and that was in the value of $100,000, right? We had previously had this liability for $100,000. Well, that was a credit balance, so we're going to debit it to get it off of our books, reduce this liability down to 0. We no longer owe this money; we're paying it back. Alright? How about the interest payable? Well, we're paying that back too, right? Interest payable, I'm going to put 'INT payable' and that's the $3,000 from last year, right? We're finally paying that back. So that's off of our books with a debit. What else? We've got the interest expense for this year, right? We've incurred some interest expense this year and we're paying it back this year. So we got to take that expense right now. And that's what we just calculated, that $5,000. We're going to take that expense right now. And this is everything we're paying back, right? This makes sense. We're paying back the note, the principal value of the note, and all the interest that we owe, which is last year's $3,000, this year's $5,000. So we're paying it all back and that's going to be the cash, right? The cash is going to be our credit here and that's going to be from the total of everything we're paying back, all of those. And that comes out to $108,000, right? $100,000 plus $3,000 plus $5,000. There's all the cash. So we're literally going to the bank and here's a $108,000 thanks for letting us borrow that money. Cool? So that's how we deal with the short-term note. We got to get rid of all of the liabilities, all the payables, associated with it and we got to make sure we accrue any additional interest expense during the current period. Cool? Alright. So let's go ahead and do the same thing with a long-term note in the next video.

Long-term Note Payable:Maturity

Alright, so you're going to see this is very similar to paying back a short-term note because we still have to pay back any accrued interest, which we're usually going to have some interest accrued in that final year leading up to the final maturity date and principal repayment. So let's go ahead and dive into the problem here because here we're still going to repay the principal and repay any interest that hasn't been paid yet. On October 1st, year 1, The Goods Company signed a $100,000 12 percent 10-year note maturing on October 1st, year 11. Interest is payable annually on October 1st. Prepare the entry to repay the note payable. So now we're repaying the whole principal and all accrued interest on October 1st, year 11. So now we're talking about that final year, right? So every year has passed and we've been making interest payments, right? We've been making those entries like we did above for the interest payable, interest expense, and paying cash, right? And now it's finally the final year and we're going to do those same entries for the interest, but we're also going to repay the principal of the loan. Just like before, we're going to have our interest payable like we did with the short-term note. We would have still accrued, if you think about it, in the year at the end of year 10, October, November, December of year 10, after our previous interest payment, right, we made an interest payment on October 1st year 10. We had made an interest payment. And now one more year is passing where we're accruing interest. So we would have made that adjusting entry to accrue for those $3,000 of interest and then we would have to in year 11, take the remaining interest expense. So just like we did above, the interest expense in year 11, so I'm just showing you here, right? We have this liability already for 3,000 on our books from year 10 and that's October through December of year 10. Well, now we're talking about the interest expense for year 11 and that's going to be just like above those 9 months. January, February, March, April, May, June, July, August, September. 9 months of interest in year 11 before we pay everything back on October 1st year 11. Okay. So we've got the 100,000 that we borrowed times the 12%, 0.12 times 9/12ths, right? For the 9 months in year 11 and that's going to equal 9,000, right? We owe 9,000 in interest expense from year 11. So this is going to be it, right? We've got to get rid of the interest payable that we still owe, we got to get rid of the interest we got to pay the interest expense that we incurred this year and we got to repay the note payable, the principal, the 100,000. Cool? So let's go ahead and make this journal entry. First, we got to get rid of the note payable because we're going to pay them back, the principal amount. So we're going to put that with a debit, right? We're going to debit note payable to get that off of our books. We have that liability previously and we are paying it back. Cool? So now the note payable is off of our books with the debit. The interest payable, this 3,000 from the end of year 10, well, we got to pay that back now as well. So we got to get rid of that liability with as well. Interest payable and that's going to be the 3,000 related to the end of year 10. And then we've got interest expense for those 9 months that have happened in year 11, right, that we just calculated. So that's everything we have to pay back, right? We have to pay back the note payable, the principal. We have to pay back any accrued interest which is this full year's worth of interest right here. 3,000 from last year, October through December. 9,000 from this year, January through September leading up to October 1st. Cool? C=100000+3000+9000=112000. Cool? And that makes sense, right? We've got the 100,000 which was the principal amount and then the 12,000 which is a year's worth of interest. A=p·r Well, that's a year's worth of interest and that's how much since the last interest payment. Cool? Alright. So that's how we deal with notes payable. Let's go ahead and move on to the next topic.

Here’s what students ask on this topic:

What is the difference between notes payable and accounts payable?

Notes payable and accounts payable are both liabilities, but they differ in formality and interest. Notes payable are formal written contracts that specify the principal amount, interest rate, and maturity date. They often involve interest payments. Accounts payable, on the other hand, are informal obligations typically arising from invoices for goods or services received. They usually do not involve interest and are expected to be paid within a short period, such as 30 days. Understanding these differences is crucial for accurate financial reporting and managing company liabilities.

How do you calculate interest on a note payable?

To calculate interest on a note payable, use the formula:

$I=Prt$

where $I$ is the interest, $P$ is the principal amount, $r$ is the annual interest rate, and $t$ is the time factor, usually expressed as a fraction of a year. For example, if you have a $100,000 note with a 12% annual interest rate for 3 months, the interest would be calculated as:

$I=1000000.12\frac{3}{12}$

This results in $3,000 of interest.

What are the journal entries for acquiring a note payable?

When acquiring a note payable, the journal entry involves debiting cash and crediting notes payable. For example, if a company signs a $100,000 note payable, the entry would be:

Debit: Cash $100,000

Credit: Notes Payable $100,000

This entry reflects the receipt of cash from the lender and the creation of a liability for the amount borrowed.

How do you record interest expense for a short-term note payable?

For a short-term note payable, interest expense is accrued periodically. For example, if a company has a $100,000 note with a 12% annual interest rate for 3 months, the interest expense would be $3,000. The journal entry to record this on December 31st would be:

Debit: Interest Expense $3,000

Credit: Interest Payable $3,000

This entry recognizes the interest expense incurred and creates a liability for the interest payable.

What is the journal entry for repaying a note payable and accrued interest?

When repaying a note payable and accrued interest, the journal entry involves debiting the note payable and interest payable accounts and crediting cash. For example, if a company repays a $100,000 note with $8,000 in accrued interest, the entry would be:

Debit: Notes Payable $100,000

Debit: Interest Payable $8,000

Credit: Cash $108,000

This entry removes the liability from the books and reflects the cash outflow for repayment.