Notes payable are a type of short-term or long-term liability found on a company’s balance sheet. They represent amounts that the company owes and has promised to pay in the future, typically through a formal, written agreement called a promissory note.
Notes payable are similar to accounts payable, but they usually involve a written contract and often require the debtor to pay the lender interest. This interest is typically stated in the promissory note as an annual percentage rate (APR). The note also includes the principal amount that was borrowed, the date by which the note must be paid back, and any other terms and conditions of the loan.
Short-term notes payable (due within one year or one operating cycle if longer) are listed under “current liabilities” on the balance sheet, while long-term notes payable (due after one year or one operating cycle) are listed under “long-term liabilities.
The distinction between notes payable and accounts payable is primarily the formality of the debt and the presence of an interest component. Notes payable generally have a more formal agreement attached to them and often involve interest payments, whereas accounts payable do not usually have a formal agreement or involve interest payments.
Example of Notes Payable
Imagine that XYZ Manufacturing Company needs to purchase a piece of machinery costing $50,000. However, the company doesn’t have enough cash on hand to buy the machine outright. So, XYZ Manufacturing decides to obtain a loan from a bank.
The bank agrees to lend XYZ Manufacturing the $50,000, and the two parties sign a promissory note outlining the terms of the loan. According to the terms of the note, XYZ Manufacturing agrees to repay the $50,000 in full within two years, with an annual interest rate of 5%.
Upon signing the note, the bank gives XYZ Manufacturing the $50,000, and XYZ Manufacturing records a $50,000 increase in their machinery assets and a $50,000 increase in their notes payable liability.
Over the next two years, XYZ Manufacturing will make payments to the bank, including both principal and interest. These payments will reduce the notes payable liability on XYZ Manufacturing’s balance sheet.
If, at the end of the first year, XYZ Manufacturing pays back $10,000 of the principal plus $2,500 in interest (5% of $50,000), the notes payable balance would decrease from $50,000 to $40,000 ($50,000 – $10,000). The $2,500 in interest would be recorded as interest expense.
By the end of the two-year period, XYZ Manufacturing is expected to have paid back the full $50,000 plus accumulated interest, bringing their notes payable balance back down to zero. If they fail to make their payments on time, they would be in default, and the bank could take legal action to recover the funds.