12.4 Prepare Journal Entries to Record Short-Term Notes Payable

Short-Term Notes Payable

Short-term notes payable are formal written promises to pay a specific amount within one year. Companies use them in two main situations: converting overdue accounts payable into a note, or borrowing from a bank. Recording these correctly requires tracking the principal, interest, and timing of each transaction.

Short-Term Notes from Overdue Accounts

When a company can't pay an account payable on time, the supplier may agree to convert it into a short-term note payable. This doesn't create new debt; it replaces one liability (Accounts Payable) with another (Notes Payable) that includes a formal repayment timeline and usually interest.

The journal entry to convert an overdue account payable into a note:

• Debit: Accounts Payable (removes the old liability)
• Credit: Notes Payable (records the new, formal liability)

The note typically matures in less than one year. Interest on the note is tracked separately from the principal amount.

Interest Expense on Short-Term Notes

Interest expense is calculated using three variables: the principal (face value of the note), the annual interest rate, and the time period the note is outstanding.

$\text{Interest Expense} = \text{Principal} \times \text{Interest Rate} \times \text{Time}$

Time is expressed as a fraction of a year. For example, a 3-month note uses $\frac{3}{12} = 0.25$.

Example: A $\$10{,}000$ note at 6% annual interest for 90 days:

$\$10{,}000 \times 0.06 \times \frac{90}{360} = \$150$

(Many textbooks use a 360-day year for these calculations. Check which convention your course uses.)

Recording interest as it accrues: Under accrual accounting, you record interest expense in the period it's incurred, even if you haven't paid it yet.

• Debit: Interest Expense
• Credit: Interest Payable

Paying interest at maturity: When the note comes due and you pay the accrued interest:

• Debit: Interest Payable
• Credit: Cash

If interest hasn't been previously accrued (for instance, a note issued and paid within the same period), you'd debit Interest Expense directly instead of Interest Payable.

Short-Term Bank Loan Transactions

When a company borrows from a bank, the entry records cash coming in and the new obligation going out.

Recording the initial borrowing:

• Debit: Cash (amount received)
• Credit: Notes Payable (face value of the loan)

Recording repayment with interest at maturity:

• Debit: Notes Payable (principal amount)
• Debit: Interest Expense (interest for the period, if not previously accrued)
• Credit: Cash (total amount paid: principal + interest)

If interest was already accrued in a prior adjusting entry, you'd debit Interest Payable instead of Interest Expense for that portion.

Valuation and Discounting of Short-Term Notes

Most short-term notes payable are recorded at face value because the difference between face value and present value is small over such a short time frame. However, some notes are issued at a discount, meaning the borrower receives less cash than the face value of the note.

For a discounted note, the difference between the face value and the cash received represents interest. For example, if a bank issues a $\$10{,}000$, 90-day note but only gives the borrower $\$9{,}850$, the $\$150$ difference is the interest cost, paid upfront by receiving less cash.

Recording a discounted note:

• Debit: Cash (amount actually received)
• Debit: Discount on Notes Payable (the difference)
• Credit: Notes Payable (face value)

The discount is amortized to Interest Expense over the life of the note. At maturity, the borrower repays the full face value.

Because short-term notes mature quickly, they're considered highly liquid liabilities on the balance sheet.