What are notes payable on a balance sheet

Loans (also called liabilities) are a part of everyday operations for businesses, so they put accounting systems in place to differentiate between each type of liability. Two of the most common liability accounts are accounts payable and notes payable, and while these have a lot in common, they’re actually used for two different purposes.

In this article, we’ll explain exactly what the differences between notes payable and accounts payable are and provide you with real examples of each.

Key Takeaways

• Accounts payable is an account that tracks a company’s obligations to pay off a short-term debt to suppliers and lenders.

• Notes payable is an account that tracks a company’s obligations to pay off specific amounts of more formal debts to banks and lenders within an agreed period of time.

• Accounts payable is usually used in companies’ day-to-day operations while notes payable is typically used for larger, long-term assets such as buildings and equipment.

What Is the Difference Between Notes Payable and Accounts Payable?

Although notes payable and accounts payable are both liability accounts that represent the amounts payable to creditors, there are several significant differences between the two:

• Written agreements. Accounts payable involve no written agreements between a company and its vendors. Both parties will enter a verbal agreement on when the amount is expected to be paid.

  Supplies and services are simply bought on credit and then paid off within a promised period of time, up to a year away.

  Notes payable always involves a formal contract that contains a direct written promise to pay off a loan.

• Conversion. Accounts payable may be converted into notes payable upon agreement between a company and its vendor.

  This typically happens if a company decides it’s unable to fulfill its short-term debt obligations.

  Lenders may decide that it’s a better idea to convert the amount owed to notes payable rather than pursue immediate legal action.

  Notes payable can never be converted into accounts payable.

• Source of credit. The amount debited to a company’s notes payable is usually received from banks, credit companies, and other financial institutions.

  On the other hand, accounts payable typically represent amounts due to suppliers and vendors of a company.

• Purchased assets. Accounts payable usually represent normal day-to-day business expenses, such as raw materials and inventory.

  Notes payable often represent significant borrowing for long-lived assets such as buildings, equipment, and other costly infrastructure.

• Risk. Transactions recorded in accounts payable are often between two trustworthy companies.

  If a company has good credit or is already an established business partner, there is low risk involved with lending them money.

  Notes payable are created for high-risk situations that demand a formal contract. The amounts of money involved are often much higher and for riskier investments, like buying a new business property.

• Calculation of working capital. Accounts payable are always a vital component during the calculation of working capital.

  Notes payable may or may not be taken into account in calculating working capital, depending on whether it’s booked as a current or non-current liability.

• Liability classification. Accounts payable are always booked as a short-term liability on a company’s balance sheet. Each amount credited is due and payable within 12 months.

  Notes payable, in contrast, can be classified as either a short-term or long-term liability. The company issuing the promissory note and its lender may agree to a due date longer than one year ahead.

• Additional terms. There are typically no specific terms under a company’s accounts payable. There are no payment obligations to creditors other than the repayment of the principal within a year.

  Notes payable often come with various additional terms, such as:

  1. Maturity period

  2. Interest rate

  3. Restrictive clauses (e.g., no stock buybacks or dividend payments)

  4. Non-payment penalties

What Is Accounts Payable?

Accounts payable is a liability account recorded on a company’s general ledger that tracks its obligations to pay off a short-term debt to its suppliers and lenders.

The items purchased and booked under accounts payable are typically those that are needed regularly to fulfill normal business operations, such as inventory and utilities.

Larger obligations, such as pension liabilities and capital leases, are instead usually tracked under long-term liabilities.

Debts marked under accounts payable must be repaid within a given time period, usually under a year, to avoid default. There are rarely ever fixed payment terms or interest rates involved.

The accounts payable is basically an IOU between two businesses. Rather than creating a formal contract to cover the debt, both parties typically just come to a verbal agreement.

Effective accounts payable management is a crucial part of managing a company’s cash flow.

If a business’ accounts payable increase over a period of time, it means that the company has been purchasing more services or goods on credit rather than with cash.

If their accounts payable decrease, they’ve been paying off their previous debts more quickly than they’re purchasing new items with credit.

Improperly managing this cycle can lead to liquidity issues that hamper an organization’s ability to conduct business.

For any entry into a company’s accounts receivable, the party rendering supplies or services would record the transaction under its accounts receivable by the same amount.

Examples of Accounts Payable

Common examples of items purchased and recorded under accounts payable include:

• Leases. Companies will lease equipment when they can’t afford the immediate capital expenditure involved with directly purchasing it.

  For example, airline operators typically lease, rather than purchase, planes from aircraft manufacturers due to their extreme cost.

• Licensing. The cost to license software scales quickly with the size of a business and its number of users.

  If a company suddenly needs to license a program and cannot immediately find enough liquidity, it’ll instead pay for the license using credit.

• Travel. When a company flies out its employees to attend a convention or meeting, the travel expenses and accommodations are often booked under accounts payable.

• Transportation and logistics. Many companies do not directly own the vehicles and logistic infrastructure to transport their finished goods and instead rely on service providers who already have already built such a network.

  Any expenses that are not paid in cash are usually recorded under accounts payable.

• Raw materials and fuel. Manufacturing companies require raw materials and power during the production and manufacturing process.

  These items are often consumed in large quantities and cannot be purchased solely with cash due to the liquidity required, and therefore are bought using credit.

• Subcontracted work. Businesses are rarely fully vertically-integrated. Various specific manufacturing processes require the subcontracted services of other companies.

  For example, most companies use the services of manufacturing plants in China to assemble their products. Pending service payments to these plants would be marked under the company’s accounts payable.

  Subcontracted work can also include consultants and freelance or contract workers that the company may hire.

• Legal services. When a company has to hire legal services to get them through a lawsuit or other legal issue, they generally don’t pay for the attorneys or law firm upfront, so often these types of services fall under accounts payable.

• Shipments from suppliers. Often companies will receive a shipment from a supplier before they officially cough up the cash for it. The company is usually planning to pay for the items as soon as they receive them, but these orders still fall under accounts payable until they do.

What Is Notes Payable?

Notes payable is a liability account maintained in a company’s general ledger that tracks its promises to pay specific amounts of money within a predetermined period.

Companies short on cash may issue promissory notes to vendors, banks, or other financial institutions to acquire assets or borrow funds.

This borrowed cash is typically used to fund large purchases rather than run a company’s day-to-day operations.

For example, a business might issue notes to purchase a new property or an expensive piece of equipment.

Promissory notes usually specify a given maturity date, interest rate, and any collateral. There may also be limitations or conditions set by the lender.

In many cases, a company may be restricted from paying dividends or performing stock buybacks until the promissory note has been repaid.

The company must have paid back the initial principal plus the specified interest rate by the note’s maturity date.

Accrued interest may be paid as a lump sum when the full amount is due or as regular payments on a monthly or quarterly period, depending on the settled terms.

In most cases, promissory notes are made payable within 12 months. However, companies and lenders are free to agree to a longer maturity period.

When a company issues a promissory note, it will debit a cash account for the amount of money received and then credit a notes payable account with the equivalent amount.
A loan detailed as notes payable also involves multiple other accounts on a company’s balance sheet:

• Cash. A cash account is credited with the size of the loan.

• Notes payable. The loan is recorded as a debit entry.

• Interest expense. The interest percentage is recorded as a debit entry.

• Interest payable. The same interest amount is entered as credit.

Examples of Notes Payable

Notes payable usually represent a mix of short-term liabilities, similar to those booked under accounts payable, and longer-term obligations.

Some circumstances when shorter-term promissory notes may be issued include:

• Bulk purchasing of materials from suppliers and manufacturers.

• Bulk licensing of software to cover a company’s large user base.

Companies may issue longer-term (maturity longer than one year) promissory notes for reasons such as for:

• Receiving a significant loan from a bank or other financial institution.

• Purchasing or building expensive infrastructure, such as a manufacturing plant, building, or piece of heavy equipment.

Consider these two real-world examples:

1. Example Notes Payable #1

   James borrows $10,000 from Erin to make a downpayment for his new store’s mortgage.

   James signs a note that obligates them to make a $300 payment to Erin each month, along with $40 interest until he pays off the note.

   On James’ company’s balance sheet, the $10,000 would be booked as a credit to a cash account and as a debit to notes payable.

   The $40 monthly interest would be recorded as a credit to the cash account and as a debit to interest payable.

   Account TitleDebitCreditCash$10,000Notes payable$10,000Account TitleDebitCreditCash$40Interest payable$40

2. Example Notes Payable #2

   You borrow $25,000 from the bank to renovate your business. You sign a note as the maker of and agree to monthly payments of $450. The loan also carries a 5% interest rate ($125).

   As the borrower, your balance sheet should show that your cash account has been credited $25,000 and that your notes payable has a debit entry of $25,000. After that, record your interest payable as a $125 debit and credit your cash account $125.

   Account TitleDebitCreditCash$25,000Notes payable$25,000Account TitleDebitCreditCash$125Notes payable$125

Accounts Payable and Notes Payable FAQ

1. What is an example of notes payable?

   Purchasing a building, obtaining a company car, or receiving a loan from a bank are all examples of notes payable. Notes payable can be referred to a short-term liability (lt;1 year) or a long-term liability (1+ year) depending on the loan’s due date.

2. What is notes payable in a balance sheet?

   In a balance sheet, notes payable should appear under your current or long-term liabilities, depending on the due dates.

3. Are notes payable an expense?

   No, technically notes payable and accounts payable are liability accounts, not expenses. That being said, accounts payable can be useful for projecting expenses in the future.

   What are examples of notes payable?

   What is an example of notes payable? Purchasing a building, obtaining a company car, or receiving a loan from a bank are all examples of notes payable. Notes payable can be referred to a short-term liability (lt;1 year) or a long-term liability (1+ year) depending on the loan's due date.

   Is notes payable an asset on a balance sheet?

   Notes payable appear as liabilities on a balance sheet. Additionally, they are classified as current liabilities when the amounts are due within a year.

   Is notes payable an asset or equity?

   Notes payable indicates money owed that has not yet been paid and usually is a long-term asset that might get paid down of the course of years. Notes payable appear on the right side of a balance sheet.

   What type of account is notes payable?

   Notes payable is a liability account that's part of the general ledger. Businesses use this account in their books to record their written promises to repay lenders. Likewise, lenders record the business's written promise to pay back funds in their notes receivable.