2.2 Notes Payable and Interest Calculations
4 min read•july 30, 2024
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 , accruing interest, and making proper journal entries. These calculations impact financial statements, affecting liabilities, expenses, and cash flows.
Bonds vs Notes Payable
Key Differences
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- 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 (), 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 × 0.05 × (6/12) = $1,250
- 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 × 0.04 × (2/12) = $667
- Accrued interest is recorded as a on the and as an adjustment to interest expense on the
- 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
- Example: Issued a $75,000, 6-month note payable
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
- Example: Paid $2,000 interest at maturity
- 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
- Example: Paid $500 monthly interest
- 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
- Example: Repaid $75,000 principal at maturity
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: 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: 75,000 principal repayment reported as a cash outflow under Financing Activities
Key Terms to Review (20)
Accrual accounting: Accrual accounting is an accounting method that records revenues and expenses when they are incurred, regardless of when cash transactions occur. This approach provides a more accurate picture of a company's financial position and performance, as it recognizes economic events as they happen rather than when cash is exchanged. Understanding accrual accounting is essential for properly managing notes payable, comprehending asset, liability, and equity accounts, and preparing for professional certifications in finance and accounting.
Accrued interest: Accrued interest is the amount of interest that has accumulated on a financial obligation, such as a loan or bond, but has not yet been paid. This concept is crucial in understanding how interest expense is recorded and calculated in financial statements, particularly when dealing with notes payable and other forms of debt. Accrued interest reflects the time value of money, emphasizing that interest costs are incurred over time, even if payment is deferred until a later date.
Amortization schedule: An amortization schedule is a table that details each periodic payment on a loan, breaking down the amount that goes towards interest and the amount that goes towards the principal balance. This schedule allows borrowers to see how their payments change over time, providing clarity on how much of their payment is reducing the principal versus how much is paying off interest. It is particularly relevant for loans like mortgages and notes payable, where understanding the impact of interest calculations is crucial.
Balance Sheet: A balance sheet is a financial statement that provides a snapshot of a company's assets, liabilities, and equity at a specific point in time. It shows what the company owns and owes, offering insight into its financial health and stability.
Bank note: A bank note is a type of promissory note issued by a bank, serving as a form of currency that can be used to pay for goods and services. It represents a promise to pay the bearer a specific amount of money upon demand, typically backed by the government or central bank. Bank notes are a crucial element of the monetary system, facilitating transactions and providing a convenient means of payment.
Collateral: Collateral is an asset pledged by a borrower to secure a loan or credit, which can be seized by the lender if the borrower fails to repay the loan. This reduces the risk for lenders, as it provides them with a form of protection in case of default. Collateral can take many forms, including real estate, vehicles, or financial securities, and is often used in conjunction with notes payable to ensure that lenders can recover their funds if necessary.
Compound interest: Compound interest is the interest calculated on the initial principal and also on the accumulated interest from previous periods. This means that the amount of interest earned grows exponentially over time, as interest is earned on both the principal and the interest that has been added to it. This concept is crucial when dealing with loans and notes payable, as it affects how much borrowers will eventually repay over time.
Current Liability: A current liability is a financial obligation that a company is required to settle within one year or within its operating cycle, whichever is longer. These liabilities are essential for understanding a company's short-term financial health and include various types of debts and obligations that the business needs to pay in the near future.
Default: Default refers to the failure to fulfill a financial obligation, particularly the inability to make scheduled payments on a loan or debt. When it comes to notes payable, default can occur when the borrower is unable to pay back the principal or interest as agreed. This situation can lead to severe consequences, including legal action from creditors, loss of assets, or increased interest rates.
Effective Interest Method: The effective interest method is a way to calculate interest expense or revenue that reflects the true cost of borrowing or the actual yield on an investment. This method uses the effective interest rate, which is based on the bond's carrying value and provides a more accurate representation of interest over time compared to other methods. It is especially important for accurately amortizing bond premiums and discounts, ensuring that financial statements reflect the correct financial position.
Fixed rate: A fixed rate refers to an interest rate on a loan or financial product that remains constant throughout the duration of the agreement. This stability allows borrowers to predict their future payment obligations, making it easier to budget and manage finances. Unlike variable rates, which can fluctuate based on market conditions, fixed rates provide a sense of security for both lenders and borrowers.
Income Statement: An income statement is a financial report that summarizes a company's revenues, expenses, and profits or losses over a specific period, typically a quarter or a year. It provides key insights into the company's operational performance, allowing stakeholders to assess profitability and efficiency in generating income.
Interest expense: Interest expense is the cost incurred by an entity for borrowed funds, representing the interest payable on any borrowings such as loans and credit lines. This expense is crucial in assessing a company's financial health, as it reflects the cost of financing and affects net income. It is calculated based on the principal amount borrowed, the interest rate, and the duration of the loan.
Interest Formula: The interest formula is a mathematical expression used to calculate the interest on a loan or investment based on the principal amount, interest rate, and time period. It is vital in financial accounting, especially when dealing with notes payable, as it helps determine how much interest will accumulate over a specific duration. Understanding this formula is crucial for accurately reporting liabilities and managing cash flows in any organization.
Long-term liability: A long-term liability is a financial obligation that is due for payment over a period longer than one year. These obligations are recorded on a company's balance sheet and typically involve significant amounts of money, impacting the firm's financial health and cash flow. They can include loans, bonds payable, and other debts that require repayment in the future, making them crucial for understanding a company's long-term financial commitments.
Matching Principle: The matching principle is an accounting concept that requires expenses to be recorded in the same period as the revenues they help generate. This principle ensures that a company's financial statements accurately reflect its financial performance, linking income and related expenses for a clearer view of profitability over specific time frames.
Present Value Formula: The present value formula is a financial calculation used to determine the current worth of a future sum of money or stream of cash flows given a specific rate of return. This concept is essential for understanding how interest rates and the time value of money affect financial decisions, particularly in evaluating notes payable and calculating interest on loans. It helps individuals and businesses make informed decisions by allowing them to assess the value of future payments in today's dollars.
Promissory Note: A promissory note is a written, unconditional promise to pay a specific amount of money to a designated person or entity at a future date or on demand. It serves as a formal instrument that outlines the terms of the loan, including the interest rate and payment schedule, which are crucial for both the lender and borrower. This financial document is commonly used in various transactions, such as loans or credit arrangements, and establishes a clear obligation for repayment.
Simple interest: Simple interest is the method of calculating the interest charged or earned on a principal amount over a specified period of time. This type of interest is calculated only on the original principal, not on any interest that has already been added to it, making it straightforward to compute. Understanding simple interest is essential for managing notes payable and accurately calculating interest expenses and revenues in financial accounting.
Variable Rate: A variable rate refers to an interest rate on a loan or financial product that can change over time based on market conditions or an index. This means that the amount of interest paid can fluctuate, impacting the overall cost of borrowing and the payments owed by the borrower. Variable rates are commonly associated with loans like mortgages and lines of credit, where they can lead to varying monthly payments depending on the rate adjustments.