Definition: A note payable is a liability in writing that promises to pay a specific amount of money at future date or on demand. In other words, a note payable is a loan between two entities.
What Does Note Payable Mean?
The maker of the note creates the liability by borrowing funds from the payee. The maker promises to pay the payee back with interest at a future date. The maker then records the loan as a note payable on its balance sheet. The payee, on the other hand records the loan as a note receivable on its balance sheet because they will receive payment in the future.
Let’s take a look at an example.
Example
Todd borrow $100,000 from Grace to purchase this year’s inventory. Todd signs the noteas the maker and agrees to pay Grace back with monthly payments of $2,000 including $500 of monthly interest until the note is paid off.
Todd debits his cash account for $100,000 and credits his notes payable account for the loan balance. Grace does the opposite. She debits her notes receivable account and credits her cash account.
At the beginning of each month, Todd makes the $2,000 loan payment and debits the loan account for $1,500, debits interest expense for $500, and credits cash for $2,000. Again, Grace records the reverse side of the transaction. She debits cash for $2,000 and credits notes receivable for $1,500 and interest income for $500.
This set of journal entries happen every year until the note is completely paid off. Notes are usually reported on the balance sheet in two categories: current and long-term. The current portion of the note is the amount due within the next year. The long-term portion is due is more than a year.
Many inventory notes like the one in our example are only one year notes, so they entire balance would be reported on the financial statements as a current liability.
