Definition of Notes Payable
Purchases and loans create notes payable. Any written instrument with interest is usually long-term debt.
Explaining Payable Notes
A company may issue a long-term note for many reasons. Notes can be used to buy equipment or borrow working capital from the bank.
Accounting for these notes rarely presents any challenges. Debit the asset and credit the note. Interest is periodically recorded and paid.
When an obligation has no declared interest or a rate far lower than equivalent notes, a problem arises.
A merchant may raise the list or cash price of an item but provide interest-free repayment arrangements to make it seem better.
The APB says:
An interest rate that differs from the prevailing interest rate requires consideration of whether a note or obligation’s face amount and claimed interest rate provide trustworthy proof of properly documenting the exchange and accompanying interest.
In such cases, the APB requires that the note, sales price, and cost of property, goods, or services exchanged for the note be documented at the cash-equivalent price or market value (if easier to estimate).
If neither amount is known, the note should be recorded at its present value using a note-specific interest rate.
Example
Ng Corporation bought custom equipment on January 2, 2019.
The deal requires Ng to pay $18,935 in three equal annual instalments of $6,245 over three years. The arrangement provides no interest.
If bought cash, the piece would have cost $15,000.
Since Ng will pay $18,735 over three years for what it might have bought for $15,000, this transaction has an implicit interest rate.
The present value method shows that this indicated interest rate is 12%.
This transaction should not debit Equipment and credit Notes Payable for $18,735 (the total cash outflows).
This entry would exaggerate equipment acquisition cost and depreciation and understate interest expense.
Journal Entry for Equipment Purchase and Notes Payable
The discount is applied to Interest Expense over three years.
The table below illustrates this.
Interest and principle are split in each $6,245 payment. Beginning each year, interest is 12% of the note’s carrying value.
Interest is $1,800 in 2019, or $15,000 x 0.12. Interest is $1267 in 2020, or $10,555 x 0.12. The total payment less interest is the principle.
Annual interest expense reduces the unamortized discount. This treatment accounts for interest apart from asset cost.
Entry methods would be the same in subsequent years.
Remember these key points:
Current depreciation is based on a $15,000 cash-equivalent acquisition cost.
Interest expense of $3,735 is reported over the 3-year notes due.
As with notes receivable, notes payable can come from a variety of transactions, although trade notes payable and bank loans are the most common.
Bank notes are our focus. These notes’ concepts can be extended to other notes payable.
Payment Notes to Bank
All sorts and sizes of businesses rely on bank loans. Banks can get two notes:
One has a main and interest components.
Another drawn with interest included in the face amount.
Examples of both types of notes follow.
Case 1’s note has a $5,000 principal. Interest of 12% is individually indicated.
The interest on Case 2’s $5,200 debt is not specified.
The interest of $200 (12% of $5,000 for 120 days) is included in the note’s face but deducted from the profits at issuance.
S. F. Giant receives $5,000 instead of the note’s face value of $5,200. Discounted notes payable are shown second.
Case 1’s adjusting journal item resembles accrued interest entries. This debits Interest Expense and credits Interest Payable for three months of accrued interest.
Case 2 entry needs clarification.
At the note’s genesis, the Discount on Notes Payable account represents future accounting period interest.
The discount account balance is 0 when all interest costs are realized at the end of the note’s period. The Discount on Notes Payable account is written off over the note’s life.
This write-off is discount amortization.
Case 2 journal entries amortize discounts straight-line. Thus, interest expense equals the discount ($200 / 4 = $50) each month.
Due to the 3-month amortization, the entrance is $150. Only $50 remains in the discount account after 31 December.
This brings the net liabilities to $5,150, which includes $5,000 from the note and $150 in interest since the loan began.
Both partial balance sheets show $5,150 in note and interest liabilities.
Payment upon Note Maturity
S. F. Giant must pay the principal and, in the first case, interest when the note matures on 31 January 2020. Both cases acknowledge $50 for the final month’s interest. The journal entries for both cases follow.
Overall, both situations show different note-taking styles. The firm receives $5,000 face value and repays $5,200 principle and interest in the first case.
Second, the firm receives $5,000 but writes a $5,200 note. At origin, interest is deducted from the note. Finally, the firm must refund $5,200.
Note issuance
Case 1 entry is simple. Cash is deducted and Notes Payable credited for $5,000.
Case 2 credits Notes Payable with $5,200, the note’s maturity value, but S. F. Giant receives just $5,000.
Discount on Notes Payable is deducted $200. This contra-liability account offsets the balance sheet Notes Payable.
Interest expense is not charged because it varies with time. The discount represents the entire interest expense if the note is unpaid for 120 days.