Ch. 3 Assets and Liabilities
3.5 Notes Payable and Interest
Learning Objectives
After finishing this section, students will be able to:
- Understand how notes payable is classified on a balance sheet.
- Calculate interest on debt.
Liabilities often include the word “payable.” So, when you see “payable” in the account title, know these are amounts owed in the future. Examples of personal liabilities include credit cards, student loans, or car loans. You have borrowed money that you are “liable” to “pay” back in the future.
A business may borrow money from a bank, vendor, or individual to finance operations on a temporary or long-term basis or to purchase assets. Notes Payable is used to keep track of amounts that are owed as short-term or long-term business loans. Notes payable is a loan contract that specifies the principal (amount of the loan), the interest rate stated as an annual percentage, and the terms stated in number of days, months, or years. Notes payable may be either short term (less than one year) or long term (more than one year).
Short-Term Notes Payable
Loans or lines of credit may be short term, due to be repaid by the business within one year. These are current liabilities. There are two types of short-term notes payable: interest bearing and discounted. The difference lies basically in when the borrower pays the interest to the lender. For an interest-bearing note, the interest is paid at the end of the term of the loan. For a discounted note, the interest is paid up front when the note is issued. For this class, we will only calculate interest bearing notes.
In the following example, a company secures a line of credit for $5,000 with a 12% interest rate. On April 1, the company immediately transfers $1,200 to use in the business. Cash increases for $1,200 because money is received and Notes Payable increases because the company is liable to pay the line of credit back later.
| Balance Sheet | Income Statement | Stmt of Cash Flows | |||||||||||
| Cash | + | Noncash Asset | = | Notes Payable | + | Retained Earnings | Revenue | – | Expense | = | Net Income | Cash | OA,IA,FA |
| 1,200 | = | 1,200 | 1,200 | FA | |||||||||
Calculating Interest
On May 15, interest will be due for the money borrowed on the line of credit in April. To simplify the math, we will assume every month has 30 days and each year has 360 days. The interest on a $1,200 note would be $12 per month, calculated as follows: 1,200 x 12% x 30/360 = $12
Note that since the 12% is an annual rate (for 12 months), it must be prorated for the number of months or days (30/360 days or 1/12 months) in the term of the loan.
Interest Expense increases for $12 because the expense increased and Interest Payable increases because the company is liable to pay the interest back later.
| Balance Sheet | Income Statement | Stmt of Cash Flows | |||||||||||
| Cash | + | Noncash Asset | = | Interest Payable | + | Retained Earnings | Revenue | – | Interest Expense | = | Net Income | Cash | OA,IA,FA |
| = | 12 | -12 | – | 12 | = | -12 | – | – | |||||
Future Borrowing or Payback
Each month as money is borrowed or paid back, the balance due on the line of credit will change causing the month interest amount to change. As the goal is to not pay interest to other companies, it is suggested that you pay back as much on the line of credit as is allowed.
Long-term Notes Payable
Long-term notes payable are often paid back in periodic payments of equal amounts, called installments. Each installment includes repayment of part of the principal and an amount due for interest. The principal is repaid annually over the life of the loan rather than all on the maturity date.
Installments that are due within the coming year are classified as a current liability on the balance sheet. Installments due after the coming year are classified as a long-term liability on the balance sheet.
Prime Rate
The prime rate is the interest rate that financial institutions charge their most creditworthy customers on loans and credit accounts. Prime rate is normally higher than the federal funds rate and is based on the bank’s desired rate of return and general economic conditions. The prime rate is typically reserved for large corporations and high-net-worth individuals. However, banks may price loans to their customers at, above, or below the prime rate.
3.5a Example
Rusty’s secures a $50,000 line of credit for 8.5% interest rate. The company has the following transactions occur on the last day of each month: January borrows $25,000; February pays back $10,000; and March borrows $15,000. Interest will be paid on the 15th day of the following month. To simplify the math, we will assume every month has 30 days and each year has 360 days.
Instructions:
- How much is due on the line of credit at the end of March?
- How much interest is due based on the line of credit balance the end of February?
3.5a Homework
The following transactions for Forest Furniture occurred.
| Feb. 1 | Forest Furniture secured a line of credit for $75,000 at 9% interest with First Bank. They immediately borrowed $35,000 to use in their business. |
|---|---|
| Feb. 28 | Interest for February was calculated and recorded as payable on March 15. |
| Mar. 2 | Forest Furniture borrowed an additional $10,000. |
| Mar. 15 | February’s interest was paid to First Bank. |
| Apr. 1 | Interest for March was calculated and recorded as payable on April 15. Forest Furniture then paid back $15,000 on the line of credit. |
| Apr. 15 | March’s interest was paid to First Bank. |
Instructions:
- Using the Horizontal Model, prepare entries for the above transactions.
- How much is due on the line of credit at the end of April?
- How much interest is due based on the line of credit balance the end of April?
- Create a partial Balance Sheet of current liabilities as of April 30.
Licensing and Attribution
Content in this page is remixed from the following openly licensed resource(s):
Principles of Financial Accounting By Christine Jonick, Ed. D. licensed under a Creative Commons Attribution-ShareAlike 4.0 International License
is used to keep track of amounts that are owed as short-term or long-term business loans.
is normally higher than the federal funds rate and is based on the bank's desired rate of return and general economic conditions.
