I'm Larry Walther, this is principlesofaccounting.com, Chapter 12.
And in this module, we will be looking at the accounting for notes payable.
Now, notes payable are formal short-term borrowings, they could be long-term but
we're gonna focus on short-term here in this chapter.
A formal short-term borrowings, usually evidenced by a specific written agreement,
or a promise to pay.
Some terminology that's important to consider,
the party who agrees to pay is termed the maker of the note.
These notes are typically structured sets that they are negotiable instruments
enabling the holder of the note to transfer it to another party for
consideration.
The note, in addition to the amount that's due on the note or
the face amount of the note, would also typically involve an interest for
the appropriate amount of time.
So in this case, we have a maker of the note who has agreed to pay BancZone
$10,000 plus interest of $400 on June 30, 20X8.
This interest is calculated, or represents,
8% of the $10,000 note for half a year.
I'm assuming the note was created on January 1 and runs through June 30th.
Here's a picture of the note, here we have a promissory note for value received.
The undersigned promises to pay to the order of BancZone the sum of $10,000.
So $10,000 is the face amount of the note,
the interest rate stated in the note is 8%.
So we're gonna pay the 10,000 along
with annual interest of 8% on the unpaid balance.
The note shall mature and be payable, along with accrued interest, on June 30th.
So if we look at the duration or term of the note, it was issued or
created on January 1, due in payable on June 30th, six months later.
And so we would calculate the interest $10,000, the principle of the note,
or the face of the note, times the 8% interest rate, times half a year,
or six-twelfths of a year, to come up with $400.
So the total amount due on this $10,000 note will be $10,400.
I wanna point out that a correct legal form for
a note would typically be more expansive than the note I've just illustrated here.
It would include things such as what happens in the event of default,
who pays legal fees, requirements for demand and settlement, and so forth.
Here's a journal entry for this note, first, the note was created on January 1,
and we debited cash and
credited notes payable $10,000, this records the note at its inception.
On the payment date June 30th, when we pay the $10,400 in cash,
the credit to cash, that's offset with a $10,000
debit to the note payable that was established on January 1.
And the $400 interest is also recorded at that time with a debit
to interest expense.
Let's revise our note just a bit to consider the entries that would be
appropriate if the note were created on October 1.
So on October 1,
we're going to debit cash and credit note payable to reflect the $10,000 note.
I'm gonna assume that at December 31, year ends, so we have October, November, and
December goes by, three months go by, a half of the six-month life of the note.
So $200 of interest will have accrued, if we wanna do the calculations,
that's $10,000 times 8% times one-fourth of a year, that is three out of 12 months,
or one-fourth of a year, would give us the 200 interest expense.
It's not being paid yet, however, because the payments aren't due on this note until
maturity, so in this case, we're gonna credit interest payable.
On March 31, when the note is then paid, the 10,400 that's paid,
10,000 is debited to notes payable, 200 is debited to interest payable,
that amount that was accrued at the end of the prior year.
And 200 is recorded as interest expense, reflecting interest for
January, February, and March, that three-month period.
Let's see how notes payable would appear in the balance sheet,
here's an example of a current liability section.
I've got some other items like payable, salary payable, and so forth, but
I'm showing a $10,000 note since it's due within the current operating cycle,
or current year.
$10,000 note payable, and I've also got $200 of accrued interest.
This is the December 31 disclosure showing both the note and
the accumulated interest.
The order of these current liabilities is typically according to their due dates,
from earliest to latest.
Another alternative is based on maturity value,
from the largest to the smallest, however.
Interest calculations, we've looked at that basically now,
some short-term borrowings may stipulate that a year is assumed to have 360 days.
It might be justified as simplification of calculations, but
lenders may use it to sorta take advantage of borrowers because, for
example, if we had $100,000, 8%, 180-day note,
and if we assumed a 360-day year, look at the calculations.
$100,000 X .08 X 180/360 days would yield 4,000 of interest expense,
whereas if we took the 180 days divided by an assumed 365-day year,
total interest would only come to 3,945.
So it's very important in note agreements that you pay attention to the details.
Are we gonna assume a 360- or a 365-day year, for example.
There's another method of allocating interest called Rules of 78s
that you really should try to avoid.
It's based on the notion that a year has 12 months and
the sum of 12 + 11 + 10 + 9 through 1 = 78.
And under the rule of 78s, we would
take the total interest and allocate twelve-seventy-eighths of it to the first
month, eleven-seventy-eighths to the next month, and so forth, so what happens here?
Assume we have a $100,000, 8% note for 12 months.
$8,000 would be the annual interest that's entailed, but
if the borrower prepaid after only two months, using the Rule of 78s,
what we would have is interest for that period of time, $2,359.
That is 12 + 11, the first month and the second month,
23 divided by 78 times the annual $8,000 interest would give you $2,359.
If we had simply done this on a monthly basis,
two-twelfths of the $8,000 would be much less, $1,333.
So Rule of 78s tips the interest allocation
to the front-end of the note, probably an unfair method in many respects.
We also need to consider simple versus compounding, simple interest is just
the loan amount, or the principal, times the interest rate times the time.
Compound interest assumes that we pay interest on accumulated interest.
Compounding can occur annually, quarterly, monthly, daily, or using calculus,
even continuously.
Obviously, with compound interest, more accumulates
during a similar period of time than you would under simple interest.
The narrower the frequency of compounding, the greater the amount of the interest
that is calculated to be associated with a note.
Some notes will have interest paid up front,
a note may be issued with interest included in the face value.
You need to be careful with these instruments as well,
they're also known as notes issued at a discount.
Let's assume we have a $10,000, 10% note for a year, 10% of $10,000 is $1,000.
If this note is a note issued at a discount, the interest is taken out up
front, so while we borrow $9,000, we simply repay $10,000 in maturity.
If we look at the effect here, that's actually, while we said it was a 10% note,
it's actually much higher, it's an 11.11% note because what we did is
paid $1,000 of interest on $9,000 that we borrowed.
So the true effective interest rate was much higher where
the interest was taken by the lender up front.
Here's journal entries for a discounted note, initially, we credit notes payable
10,000, we debit cash 9,000, we left the $1,000 at the bank for
prepaid interest, if you will, and we'll debit account discount on note.
Over the year, we'll then amortize the discount, credit the discount, and
transfer it or recognize it as interest expense over the life of the borrowing,
at end of maturity, we simply repay the $10,000.
So it looks like a fairly simple accounting, and
it is indeed a fairly simple situation.
The problem here is really having to do with the effective interest cost,
the 10% interest rate again being much higher than it appears to be.
Now, as you've seen, there are a number of tricks, if you will,
to actually cause borrowing cost to be higher than they might appear to be
to an unsophisticated borrower.
Lenders can use unique interest calculations to tilt the benefit of
a bargain to their advantage.
As a result, statues have increasingly required fuller disclosure or
even limited certain practices on the parts of lenders.
And not only that, lenders need to be sure when they engage in
lending transactions to understand the legal rules that apply.
There are actual rules that say that lenders who overcharge interest or violate
other lending laws may lose the right to collect not only interest on the loans but
the principle amount that's due.
So these are attempts to sort of relevel the playing field, but fundamentally,
one should be very careful with their borrowing practices to make sure that
they're entering into reasonable and fair agreements.