Published in: Accounting

Is Notes Payable a Debit or a Credit?

Author Obotu Agape Oguche

Published on: October 30, 2022

Is notes payable debit or credit? Notes payable is a liability account on the balance sheet of a business that issued a written promise to repay a lender. Businesses may borrow money or purchase a piece of equipment on credit from another party. Such transactions are sometimes completed with a more formal promise from the borrower assuring the lender of payment. This formal promise from the borrower is called a promissory note. When a business owner issues a promissory note, he records the amount due on his accounting books as notes payable, which is reported as a liability on the balance sheet.

The lender, on the other hand, that receives the promissory note records it in his accounting book as notes receivable, which is an asset on the balance sheet. When accounting for notes payable, the party issuing the note incurs liability by borrowing from another party, promising to repay with interest. When recording notes receivable in the accounting books, the issuer of the note must use the accrual method of accounting and follow some specific rules, ensuring notes payable are recorded accordingly.

Hence, in this article, we will discuss notes payable, the debit and credit rules applicable to it in accounting, and its journal entries.

Related: Supplies expense debit or credit?

The company or party that issues the promissory note and is obligated to pay money to the lender is the maker while the party or lender that receives payment under the terms of the promissory note is referred to as the payee. The notes payable account, therefore, reflects the money owed under the terms of the issued promissory note.

Under this agreement, the maker obtains a specific amount of money from the payee and promises to pay it back with interest over a predetermined time period. This specific amount of money that is obtained is the principal amount which is usually listed in the terms of the note. The predetermined time period is the maturity date on the note on which the principal amount has to be paid.

The interest rate on the notes payable may be fixed over the life of the note or vary in accordance with the interest rate charged by the lender to its customer such as a prime rate. The interest rate on notes payable is calculated as:

Interest = Principal x Interest rate x Time period

Therefore, any written note included in the notes payable account should include basic information about the debt such as:

• Principal amount
• Maturity date
• Interest owed
• Collateral pledged
• Creditor limitations

At the maturity date of the note, the maker or borrower is obligated to pay the principal amount plus the interest. Notes payable are therefore classified as a current or long-term liability depending on their due date. The notes payable that are due within the next 12 months are considered to be current or short-term liabilities, whereas the notes that are due after one year are considered to be long-term or non-current liabilities.

If a company uses the accrual method of accounting to record notes payable, it will need to supplement notes payable with an interest payable account. This is because the promissory note requires the note maker to pay interest, creating an additional interest expense. In the interest payable account, the company will then record any interest incurred during the accounting period that has not yet been paid.

It is important to note that notes payable are different from accounts payable. With accounts payable, there is no promissory note and there is no interest rate to be paid; though a penalty may be assessed if payment is made after a designated due date. Notes payable is a liability account in a company’s books that tracks its promises to pay specific amounts of money within a predetermined period. Accounts payable, on the other hand, is a liability account in the company’s book that tracks the amount of money owed to its creditors or suppliers, that has not yet been paid.

Terms and conditions

As promissory notes normally specify a given interest rate, maturity date, etc, they can also have limitations or conditions set by the lender. The note payable agreement may require collateral, such as a company-owned building, or a guarantee by an individual or another entity. Hence, many notes payable agreements require formal approval by a company’s board of directors before a lender will issue funds.

In several cases, the maker or issuer of the note may be restricted from paying dividends or performing stock buybacks until the promissory note has been repaid. The note maker must have paid back the initial principal amount plus the specified interest rate by the note’s maturity date before being allowed to pay dividends or buyback shares.

That is, as part of the note payable agreement, the lender may require restrictive covenants that require the borrower not to pay dividends to investors while any part of the loan is still unpaid. If this covenant is breached, the lender has the right to call the loan. However, the lender may waive the breach and continue to accept periodic debt payments from the borrower.

The accrued interest on the notes may be paid as a lump sum when the full amount is due or as regular payments done on a monthly or quarterly period, depending on the settled terms. In most cases, promissory notes are usually made payable within 12 months. Nevertheless, the maker and payee are free to agree to a longer maturity period.

Example of notes payable

Notes payable usually represent a mix of current (shorter-term) liabilities and longer-term obligations. Some examples of when shorter-term promissory notes may be issued would be bulk purchasing of materials from suppliers and manufacturers and bulk licensing of software to cover a company’s large user base.

Also, companies may issue longer-term promissory notes whose maturity date is usually longer than one year. Such an example would be receiving a significant loan from a bank or financial institution. Another example would be purchasing pieces of heavy equipment or collecting money to build expensive infrastructure, such as a manufacturing plant.

In order to understand notes payable from a practical perspective, let’s look at an example of how notes payable work:

ABC Construction Company purchases $100,000 worth of cement on credit from XYZ Cement Plc. ABC construction company receives an invoice from XYZ Cement Plc that is due in 60 days, in accordance with XYZ Cement Plc’s normal billing terms. Unfortunately, ABC Construction Company is unable to make prompt payment and negotiates a promissory note with the following terms:

• Payee: XYZ Cement Plc
• Maker: ABC Construction Company
• Principal: $100,000
• Time frame: 6 months due at maturity
• Interest rate: 6% per year

After ABC Construction Company has issued the promissory note to the cement company, it will now record the $100,000 owed to the notes payable account as a current liability.

From this session, it is evident that notes payable is recorded as a current or long-term liability depending on the maturity date. However, when making a journal entry for notes payable as a liability, what are the applicable debit and credit rules? Is notes payable a debit or credit? In order to answer this, let’s look at the debit and credit rules that are applicable to notes payable.

See also: Decrease in accounts payable debit or credit?

Understanding debit and credit

Is notes payable debit or credit? In order to record notes payable as a transaction, an amount must be entered as a debit entry in one account and as a credit entry in another account. This is the rule in double-entry bookkeeping. For every transaction in double-entry bookkeeping, the totals of the debits and credits must always equal each other for the transaction to be in balance. This is one of the most important debit and credit rules in accounting. The other rules are:

• A debit increases assets, dividends, and expenses accounts
• A credit increase liabilities, equity, and revenue accounts
• A contra account reduces the paired account’s natural debit or credit balance

According to these debit and credit rules, we record liabilities, equity, and revenue accounts as credit and not debit. This means that liabilities such as notes payable and accounts payable will be entered as a credit and not a debit.

Increase in notes payable; debit or credit?

The debit and credit rules reflect the balance sheet equation which is expressed as:

Assets = Liabilities + Equity

According to this equation, assets which is on the left side of the equation would be increased by a debit. Whereas, liabilities and equity, which are on the right side of the equation would be increased by a credit. That is assets are debits while liabilities and equity are credits.

Is the increase in notes payable debit or credit? According to the equation above, all accounts that contain a credit balance will increase when a credit entry is added to them and will decrease when a debit entry is added to them. This particular accounting rule is applicable to liabilities such as notes payable. Notes payable contain a credit balance that will increase in amount when credited and reduce when debited. Therefore, an increase in notes payable account is not a debit but a credit.

Decrease in notes payable; debit or credit?

Is the decrease in notes payable debit or credit? According to the balance sheet equation, liabilities will increase when a credit entry is added to them and will decrease when a debit entry is added to them. This is applicable to notes payable, meaning that notes payable will decrease in amount when debited. Therefore, a decrease in notes payable is a debit and not a credit.

Related: Is Purchase Debit or Credit?

All the transactions related to notes payable will involve multiple accounts on a company’s balance sheet. There are basically four accounts impacted by the issue and payment of a promissory note. They include Interest expense, Interest payable, Notes payable, and Cash accounts.

1. Cash account: This account is debited with the size of the loan received and credited with the size of the loan paid (including interest).
2. Notes payable: This account is credited with the size of the loan received and debited with the size of the loan paid.
3. Interest expense: This account is debited with the interest percentage on the note
4. Interest payable: This account is credited with the same interest amount and debited by the interest amount when interest is paid.

Is notes payable debit or credit in trial balance

Is notes payable debit or credit in trial balance? Notes payable is a credit in the trial balance. The money a business borrows or owes by issuing a promissory must be repaid to the lender with interest. All the transactions related to the written promise and the exchange of cash between the borrower and lender must be recorded on the borrower’s books. These transactions would include the issuance of the note, the accrual and payment of interest, and the repayment of the note.

Here is how to adjust entries on a trial balance for notes payable:

Issuance of the note

When a business owner issues a note and incurs notes payable, he has to record this liability incurred in his books. The issuance of the note is therefore recorded on the borrower’s books by debiting the Cash account to increase the account for the cash received from the lender. Since the business has a legal commitment to pay its outstanding debt obligations, the liability account Notes payable is credited to increase the account.

Hence, the journal entry to record the issuance of the note would be:

Debit and credit journal entry for notes payable to record issuance of the note

Is notes payable debit or credit in trial balance? As shown in the above journal entry, notes payable is not a debit but a credit.

Accrue interest on the note

The issuance of notes payable is interest-bearing. Hence, the interest accrued on the notes payable is recorded to the books by debiting the Interest Expense account and crediting the liability account-Interest Expense Payable. Hence, in order to record the accrued interest on the note, the adjusting entry should look like this:

Debit and credit journal entry to record the accrued interest on notes payable

Payment of interest

When a business makes interest payments on the notes payable, the liability account- Interest Expense Payable should be debited to decrease the account, and the Cash account should be credited to reduce the account. In order to record the payment of interest on notes payable, the journal entry would look like this:

Debit and credit journal entry to record the payment of interest on notes payable

Payment of the note

At the time that the business pays off the notes payable, the trial balance is adjusted to reflect the full amount that has been paid. The liability account- Notes payable is debited to decrease the account of the face value amount of the note. Then, the Cash account is credited to decrease it by the same amount. That is, when notes payable are paid back to the lender, debit the Notes Payable account, and credit the Cash account:

Debit and credit journal entry of notes payable to record payment of the note

Related: Is Depreciation Expense Debit or Credit?

Is notes payable a debit or credit?- Examples

Notes payable is recorded not as a debit but as a credit. Notes payable is a liability and as such would be recorded as a credit and not a debit. Liabilities, equity, and revenue accounts are all credit entries. Hence, they increase by a credit entry and decrease by a debit entry.

When a note is issued to a lender, the Notes Payable account has to be credited and the debit entry is made to the Cash account. Then, when the payment of the note has been made to the lender, the Notes Payable account is debited to reduce the account.

Here are some examples to illustrate how notes payable is a debit and when it is a credit entry.

Example 1

Anne runs a restaurant and borrows $10,000 from Mr. Peter to make a downpayment for her new store’s mortgage. She signs a promissory note that obligates her to make a $300 payment to Mr. Peter each month, along with $40 interest, until she pays off the note.

On Anne’s business’s balance sheet, the journal entry for this $10,000 received would be recorded as a credit to her Cash account and as a debit to her Notes Payable account. The $40 monthly interest would be recorded as a credit to her Cash account and as a Debit to her Interest Payable account.

These are the journal entries:

Debit and credit journal entry for notes payable to record issuance of $10,000 note

Example 2

You run a farming business and purchase a loan of $1,000,000 from the bank to buy a tractor and some tractor implements. This loan has a 5% interest rate that is payable quarterly. Here are the journal entries for the notes payable:

First, you record the issuance of the note:

Debit and credit journal entry for notes payable to record issuance of $1,000,000 note

Then, you calculate and record the quarterly accrual of the interest expense:

$1,000,000 x 5% x 3 months/12 month

= $12,500

You send funds to the bank to pay for the interest expense and record the entry as:

On the maturity date of the agreement, you pay the $1,000,000 loan back to the bank, and record the following entry:

Debit and credit journal entry for notes payable to record payment of $1,000,000

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