Notes payable are short-term debt instruments companies use to borrow money. They differ from bonds in duration, issuance method, and interest rate structure. Understanding these differences is crucial for managing a company's debt portfolio.

Calculating and recording interest on notes payable is a key accounting task. It involves determining interest expense, accruing interest, and making proper journal entries. These calculations impact financial statements, affecting liabilities, expenses, and cash flows.

Bonds vs Notes Payable

Key Differences

• Notes payable are short-term debt instruments typically issued for periods of less than one year (90-day commercial paper), while bonds are long-term debt securities usually issued for periods greater than one year (10-year corporate bond)
• Notes payable are often issued directly to a lender, such as a bank (promissory note), whereas bonds are typically issued to the public and traded on secondary markets (municipal bonds)
• Interest rates on notes payable are generally fixed and determined at issuance (6% interest rate), while bond interest rates can be fixed or variable, depending on the type of bond (fixed-rate vs. floating-rate bonds)

Issuance and Pricing

• Notes payable are typically issued at face value ($100,000 note issued at par), whereas bonds may be issued at a discount, at par, or at a premium, depending on market conditions and the bond's coupon rate
  • Discount: Bond's coupon rate is lower than the market interest rate
  • Par: Bond's coupon rate equals the market interest rate
  • Premium: Bond's coupon rate is higher than the market interest rate

Accrued Interest on Notes Payable

Calculating Interest Expense

• Interest expense is calculated by multiplying the principal amount of the note by the stated interest rate and the time period, expressed as a fraction of a year (months/12 or days/365)
  • Example: $50,000 note with 5% annual interest for 6 months: $50,000 × 0.05 × (6/12) = $1,250
• Accrued interest is the portion of interest expense that has been incurred but not yet paid as of a specific date, such as the end of an accounting period

Recording Accrued Interest

• To calculate accrued interest, multiply the principal amount by the interest rate and the fraction of the time period that has elapsed since the last interest payment date
  • Example: $100,000 note with 4% annual interest, 2 months since last payment: $100,000 × 0.04 × (2/12) = $667
• Accrued interest is recorded as a current liability on the balance sheet and as an adjustment to interest expense on the income statement
  • Debit Interest Expense and credit Interest Payable for the accrued amount

Journal Entries for Notes Payable

Issuance of Notes Payable

• When a note payable is issued, debit Cash for the principal amount received and credit Notes Payable for the same amount
  • Example: Issued a $75,000, 6-month note payable
    • Debit Cash $75,000
    • Credit Notes Payable $75,000

Payment of Interest and Principal

• If interest is paid at maturity, debit Interest Expense and credit Cash for the amount of interest paid on the payment date
  • Example: Paid $2,000 interest at maturity
    • Debit Interest Expense $2,000
    • Credit Cash $2,000
• If interest is paid periodically, such as monthly or quarterly, debit Interest Expense and credit Cash for the amount of interest paid on each payment date
  • Example: Paid $500 monthly interest
    • Debit Interest Expense $500
    • Credit Cash $500
• When the principal amount of the note is repaid at maturity, debit Notes Payable and credit Cash for the principal amount
  • Example: Repaid $75,000 principal at maturity
    • Debit Notes Payable $75,000
    • Credit Cash $75,000

Notes Payable on Financial Statements

Balance Sheet

• Notes payable are reported as a current liability on the balance sheet if they are due within one year or one operating cycle, whichever is longer
  • Example: $50,000 note payable due in 6 months reported under Current Liabilities
• Accrued interest on notes payable is reported as a current liability on the balance sheet, reflecting the company's obligation to pay interest in the near future
  • Example: $1,000 accrued interest reported under Current Liabilities

Income Statement

• Interest expense related to notes payable is reported on the income statement as a non-operating expense, reducing net income
  • Example: $3,000 interest expense reported under Non-Operating Expenses

Statement of Cash Flows

• Cash payments for interest and principal on notes payable are reported as financing cash outflows on the statement of cash flows
  • Example: $2,500 interest payment and $25,000 principal repayment reported under Financing Activities
• The issuance of notes payable is reported as a financing cash inflow on the statement of cash flows, while the repayment of principal is reported as a financing cash outflow
  • Example: $100,000 note payable issuance reported as a cash inflow and $75,000 principal repayment reported as a cash outflow under Financing Activities