Notes Payable: Definition, Examples and Types

When it comes to meeting your commitments as a borrower, managing your payments is a major responsibility. You'll be able to appropriately reflect payments and overdue amounts if you completely grasp how notes payable function.

 

For a variety of reasons, a company may issue a long-term note payable. Notes may be issued, for example, to acquire equipment or other assets, or to borrow money from a bank for working capital purposes.

 

In general, there are no unique issues to address while accounting for these notes. The receiving asset is deducted, and the note is credited. As interest accumulates, it is recorded on a regular basis and finally paid.

 

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What are Notes Payable?

 

A note payable is a written agreement in which a borrower commits to repay a sum of money to a lender, generally with interest, within a certain time frame. Notes payable are represented on the balance sheet as either short-term or long-term business obligations, depending on their terms.

 

However, an issue arises when an obligation has no declared interest or the interest rate is significantly lower than the prevailing rate on comparable notes. This situation might arise when a vendor raises the list or cash price of an item in order to make a detail look more attractive, yet provides the customer interest-free repayment terms.

 

Notes Payable are a crucial financial instrument that business owners may utilize to develop their organization, as well as an investment alternative.

 

Payables are liabilities that develop when a firm borrows money and enters into a formal arrangement with a lender to repay the borrowed amount of money with interest at a future date.

 

A note payable account is a financial liability in which a borrower registers a written agreement to repay the lender. When carrying out and accounting for notes payable, the "maker" creates liabilities by borrowing from another business and promising to return the recipient with interest. The loan is then recorded as a note due on the balance sheet by the manufacturer.

 

When recording notes payable, it is necessary to clarify the circumstances of the matter. The printed statement normally includes the principal amount borrowed, the payment due date, and the interest to be paid.

 

These agreements frequently have varied periods, such as less than a year or five years. Payment durations for notes payable may be divided into two types: short-term and long-term. Short-term notes payable have a one-year maturity date. Long-term notes payable mature in more than one year, but generally in five years or fewer.

 

Note payables are a type of debt that must be registered with the Securities and Exchange Commission and the state in which they are sold. They can give a consistent return to investors who are ready to bear the risk, but investors should be on the watch for frauds in this field.

 

Also Read | What is Debenture?

 

 

Examples of Notes Payable

 

Few of the most relevant examples of notes payable could be:- 

 

• Example 1

 

Tina borrows $5,000 from Keisha to obtain a down payment for the mortgage on her new business. Tina signs the note as the maker and pledges to make $500 payments to Keisha every month, plus $50 interest, until the note is paid off. She will use this information to complete the following tasks on her balance sheet:

 

The $5,000 loan will be recorded as a debit to notes payable and a credit to the cash account. The $50 in interest will then be recorded as a debit to interest payable and a credit to the cash account.

 

• Example 2

 

Rodrick, a buddy of yours, is launching a new firm, and you lend him $10,000 as one of his investors. Rodrick signs the note as the manufacturer, promising to return the loan in the amount of $225 every month. Each monthly payment is accompanied by a $60 interest payment under the terms of the agreement. Rodrick's balance sheet will show the following as the borrower:

 

The $10,000 loan will be recorded as a debit in notes payable and a credit in the cash account.

 

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Working and Types Of Notes Payable

 

Notes payable contain provisions that have been agreed upon by both parties—the note's payee and the note's issuer—such as the principal, interest, maturity (payable date), and the issuer's signature.

 

There are several sorts of notes payable, which differ in terms of amount, interest rate and other terms, and repayment duration. They are all legally binding contracts in the same way that IOU's  or loans are.

 

Some of the major types of Notes Payables are:-

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Types of Notes Payable

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Types of Notes Payable

 

1. Single-Payment Notes Payable

 

Single- Payment Notes payables are  payables wherein the users must repay the lender the principle borrowed plus the interest charged in one lump-sum payment by the due date indicated in the note

 

2. Amortized Notes Payable

 

This type of note payable is most typically used for bank house, property, or building loans. You must make specified monthly payments toward the principal balance and interest on Amortized promissory notes. As the loan is paid down, a larger portion of the payment is applied to the principal and less to the interest.

 

3. Negative Amortization Notes Payable

 

The borrower can use negative amortization to make payments that are less than the interest expenses, and the unpaid interest is added to the principal balance. Borrowers will face higher overall loan expenses as a result of this change.

 

4. Interest- Only Notes Payables

 

The borrower's monthly payments on these notes simply cover the interest. The borrower must guarantee that he or she will repay the whole principal amount at the conclusion of the loan.

 

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Notes Payables Vs Accounts Payables 

 

Though notes payable and accounts payable are both liability accounts, they each have their own distinct characteristics and serve their own distinct function.

 

1. While notes payable contain the specifics of a borrowed amount in note form, accounts payable are generally used to record obligations in the form of purchases on credit from company suppliers. 

 

2. Though notes payable involve a formal agreement to repay what was borrowed (with interest) by a certain date, accounts payable do not. This is likely the most significant discrepancy between the two narratives, as there is no written pledge.

 

3. Another obvious distinction between notes payable and accounts payable is how they are documented.

 

The following are the balance-sheet discrepancies between the two accounts:

 

• Notes Payables

 

A loan documented as notes due on a corporate balance statement contains the following accounts:

 

• Cash

• Notes payable

• The cost of interest

• Payable interest

 

When a loan is repaid, the corporation debits notes payable and credits the cash account, which is represented as a liability on the balance sheet. 

 

Following that, the company must assess the loan's interest rate. This amount will be recorded as a debit in the interest cost account, and the same amount will be entered as a credit in the interest payable account.

 

• Accounts Payable

 

Accounts payable refers to specific goods that are considered obligations to the firm, as opposed to notes payable, which comprises four distinct accounts when repaying a loan. On the liability side of the balance sheet, these are counted as different entries from the same account. 

 

There is no interest paid because they are resources utilized rather than borrowed funds. Furthermore, the price paid for each item is liable to alter depending on the amount utilized and the frequency with which it was used. 

 

The following are some of the most frequent liabilities found on a company's balance sheet:

 

• Electricity
• Internet
• Gas/heat
• Services for consulting
• Legal assistance

 

Also Read | Secured vs Unsecured Loans

 

Notes payable are required when a company borrows money from a bank or other lender. Notes payable may also be part of a transaction to acquire expensive equipment.