12 4: Prepare Journal Entries to Record Short-Term Notes Payable Business LibreTexts

If the amount of notes receivable is significant, a company should establish a separate allowance for bad debts account for notes receivable. Notes payable is a liability account written up as part of a company’s general ledger. By contrast, the lender would record this same written promise in their notes receivable account. You should classify a note receivable in the balance sheet as a current asset if it is due within 12 months or as non-current (i.e., long-term) if it is due in more than 12 months. The debit of $2,500 in the interest payable account here is to eliminate the payable that the company has previously recorded at period-end adjusting entry on December 31, 2020.

In the preceding entries, notice that interest for three months was accrued at December 31, representing accumulated interest that must be paid at maturity on March 31, 20X9. The cash payment included $400 for interest, half relating to the amount previously accrued in 20X8 and half relating to 20X9. A company’s auditors will examine the classification of notes receivable from the most conservative perspective, and so will insist on their classification as short-term if there are reasonable grounds for doing so. For example, the maker owes $200,000 to the payee at a 10% interest rate, and pays no interest during the first year.

Types of Notes Receivable

The supplier might require a new agreement

that converts the overdue accounts payable into a short-term note

payable (see

Figure 12.13), with interest added. This gives the company more

time to make good on outstanding debt and gives the supplier an

incentive for delaying payment. Also, the creation of the note

payable creates a stronger legal position for the owner of the

note, since the note is a negotiable legal instrument that can be

more easily enforced in court actions.

Sierra does not

have enough cash on hand currently to pay for the machine, but the

company does not need long-term financing. Sierra borrows $150,000

from the bank on October 1, with payment due within three months

(December 31), at a 12% annual interest rate. To illustrate, let’s revisit Sierra Sports’ purchase of soccer

equipment on August 1. Sierra Sports purchased $12,000 of soccer

equipment from a supplier on credit.

Introduction to notes payable

Likewise, the company needs to make the notes payable journal entry when it signs the promissory note to borrow money from the creditor. When the maker of a promissory note fails to pay, the note is said to be dishonored. Assuming D. Brown dishonors the note but payment is expected, the company records the event by debiting accounts receivable from D.

Another similar scenario is the assumption of a loan payment to take possession of property. Secured Promissory Note – It is based on the maker’s ability to repay, but it is secured making a payment with a collateral such as an automobile, land or a house. Now, assuming the same facts as in Example 2, suppose that the note is assigned originally on 30 June 20×1.

Accounting for Discount on Notes Receivable

Notes receivable refers to a written, unconditional promise made by an individual or business to pay a definite amount at a definite date or on demand. We’re firm believers in the Golden Rule, which is why editorial opinions are ours alone and have not been previously reviewed, approved, or endorsed by included advertisers. Editorial content from The Ascent is separate from The Motley Fool editorial content and is created by a different analyst team. As your business grows, you may find yourself in the position of applying for and securing loans for equipment, to purchase a building, or perhaps just to help your business expand. Accounts payable on the other hand is less formal and is a result of the credit that has been extended to your business from suppliers and vendors. Accounts payable are always considered short-term liabilities which are due and payable within one year.

The rest of the notes payable formula includes that interest due to date is accrued at the end of each financial period by debiting the interest expense account and crediting the interest payable liability account. Sierra Sports requires a new apparel printing machine after experiencing an increase in custom uniform orders. Sierra does not have enough cash on hand currently to pay for the machine, but the company does not need long-term financing. Sierra borrows $150,000 from the bank on October 1, with payment due within three months (December 31), at a 12% annual interest rate.

Template for Promissory Note

We now consider two short-term notes payable situations; one is created by a purchase, and the other is created by a loan. A common practice for government entities, particularly schools,

is to issue short-term (promissory) notes to cover daily

expenditures until revenues are received from tax collection,

lottery funds, and other sources. School boards approve the note

issuances, with repayments of principal and interest typically met

within a few months. We now consider two short-term notes payable situations; one is

created by a purchase, and the other is created by a loan.

In many cases, the interest rate is lower than long-term debt, because the loan is considered less risky with the shorter payback period. This shorter payback period is also beneficial with amortization expenses; short-term debt typically does not amortize, unlike long-term debt. Short-Term Notes Payable decreases (a debit) for the principal

amount of the loan ($150,000). Interest Expense increases (a debit)

for $4,500 (calculated as $150,000 principal × 12% annual interest

rate × [3/12 months]). Short-term debt may be preferred over long-term debt when the

entity does not want to devote resources to pay interest over an

extended period of time. In many cases, the interest rate is lower

than long-term debt, because the loan is considered less risky with

the shorter payback period.