Notes payable and interest: borrowing, accruing and repaying

A note payable is a written promise to pay a specific amount, usually with interest, by a specific date. Businesses sign notes when they borrow from a bank, when they buy equipment on longer credit, and sometimes when a supplier agrees to turn an overdue bill into a formal loan. For the bookkeeper, a note means four kinds of entry over its life: recording the note when it is signed, accruing interest at the end of each accounting period it spans, and finally paying off the principal and the interest at maturity.

This page walks through each one with numbers from our practice set. All interest here is simple interest, the kind used on most short-term notes:

Interest = Principal × Annual rate × Time (in years)

For a note measured in months, time is months ÷ 12. A 6-month note at 8% on $4,500.00 earns $4,500.00 × 8% × 6 ÷ 12 = $180.00. Some lenders count days instead (dividing by 360 or 365); the exercises use whole months so the arithmetic stays clear, and each problem tells you the term.

Notes payable vs accounts payable

Both are amounts the business owes, but they differ in form. An account payable is an informal, usually interest-free balance with a supplier, arising from everyday purchases and settled within weeks. A note payable is a signed, written promise with a stated principal, rate and maturity date, and it normally carries interest. That is why converting an overdue account into a note changes nothing about the total owed on the day it happens: it only changes the kind of liability, and starts interest running from that day.

The accounts

• Notes Payable: a liability for the principal, the amount borrowed. Credited when the note is signed, debited when it is paid.
• Interest Expense: the cost of borrowing, recognised as time passes.
• Interest Payable: a liability for interest that has built up but has not been paid yet.

Keep principal and interest in separate accounts. The principal is what you promised to repay; interest is the price of using the money, and it belongs to the periods in which you used it.

Signing the note

Borrowing cash from a bank

Harbor Bakery borrowed $4,500.00 from Midstate Bank, signing a 6-month, 8% note payable. The cash was deposited today. Interest is paid with the principal at maturity.

No interest is recorded on day one. Interest is earned by the lender, and incurred by the borrower, as time passes, so there is none yet. Recording the full $180.00 of interest up front would put six months of cost into the first day.

Replacing an account payable with a note

Harbor Bakery could not pay its $4,500.00 account with Sunvale Supply Co. on time. The supplier agreed to accept a 6-month, 8% note payable for the full amount. No cash changed hands.

One liability replaces another. The goods were recorded when they were bought; recording them again would double the inventory.

Repaying a note that stays inside one period

Harbor Bakery signed a 6-month, 8% note payable to Midstate Bank for $4,500.00. No interest has been recorded on it yet. Today the note matured and Harbor Bakery paid the principal plus interest in cash.

Interest for the term: $4,500.00 × 8% × 6 ÷ 12 = $180.00. Total paid: $4,680.00.

The most common error here is forgetting that the rate is annual. Using a full year's interest, $360.00, doubles the cost of a six-month note.

Accruing interest at year end

When a note runs past the end of the fiscal year, the interest that has built up by year end belongs to that year, even though it will not be paid until later. An adjusting entry records it.

On September 1, Harbor Bakery signed a 12-month, 8% note payable to Midstate Bank for $8,000.00. Interest is paid at maturity. Record the adjusting entry for the interest owed on December 31, the end of the fiscal year.

1. Months from September 1 to December 31: September, October, November and December, so 4 months.
2. Interest: $8,000.00 × 8% × 4 ÷ 12 = $213.333…, which rounds to $213.33.

Interest owed goes to Interest Payable, not Notes Payable. Notes Payable stays at the $8,000.00 principal, which is what the note says is owed.

Repaying a note after an accrual

This is the hardest entry in the lesson, because part of the interest has already been expensed.

On July 1 last year, Harbor Bakery signed a 9-month, 8% note payable to Midstate Bank for $8,000.00. At December 31 it accrued $320.00 of interest. Today the note matured and Harbor Bakery paid the principal and all the interest in cash.

1. Total interest for 9 months: $8,000.00 × 8% × 9 ÷ 12 = $480.00.
2. Already accrued last year (July to December, 6 months): $320.00, sitting in Interest Payable.
3. New expense this year (January to March, 3 months): $480.00 − $320.00 = $160.00.
4. Cash paid: $8,000.00 + $480.00 = $8,480.00.

Debiting Interest Expense for the full $480.00 would count last year's $320.00 a second time and leave a stale $320.00 in Interest Payable forever. Some businesses avoid this split with a reversing entry on the first day of the new year; that technique has its own lesson in the closing module.

Where notes appear on the balance sheet

A note due within a year of the balance sheet date is a current liability; one due later is long-term, with any part due in the next year shown as current. Accrued interest is almost always current. Longer notes repaid in equal instalments, where each payment mixes interest and principal, are covered in the long-term liabilities module.

One note from start to finish

It helps to see every entry for a single note side by side. Take the 9-month, 8%, $8,000.00 note signed on July 1, with a December 31 year end:

Across the two years, Interest Expense totals $320.00 + $160.00 = $480.00, exactly the interest on the note. The first year carries six months of it and the second year three, matching the time the money was used in each year. Both liabilities end at zero once the note is paid. If either one is left with a balance after repayment, something was recorded twice or not at all.

Checking interest in your head

A few shortcuts catch most arithmetic slips before you press Check:

• A 12% annual rate is 1% a month. An 8% rate is two-thirds of 1% a month, so $8,000.00 costs about $53.33 a month.
• Six months is half a year, so the interest is half the annual figure.
• If your interest is larger than principal × rate, you have used more than a year. On a note shorter than a year, it must be smaller.

Common mistakes

1. Treating borrowed money as revenue. It has to be repaid, so it is a liability.
2. Recording interest on the day the note is signed. Interest builds up over time.
3. Using a full year's interest on a shorter note. Multiply by months ÷ 12.
4. Leaving interest out of the repayment. The lender gets principal plus interest.
5. Adding accrued interest to Notes Payable. Use Interest Payable.
6. Expensing accrued interest twice. Clear Interest Payable at repayment and expense only the rest.

How the practice works

Each exercise generates a new principal, rate and term. You record the entry, press Check, and your answer is compared line by line with one computed from the same facts; interest is rounded to the cent. The set runs from signing a note, through converting a supplier account, repaying with interest and accruing at year end, to repaying a note after an accrual.