Definitions and meanings:
The notes payable is a liability account maintained in the company’s general ledger. When a company lacks cash, it may issue a promissory note to a financial institution or a vendor to borrow funds or acquire assets.
In a promissory note arrangement, the borrower is the maker of the note who makes an unconditional promise to pay, an individual, a financial institution or a vendor who has lent money or from whom an asset has been acquired, a certain amount of principle money plus any interest thereon at a certain specified date in future.
The usual items that may be specified in a promissory note issued to a party are the interest rate, maturity date, collateral, and any limitations imposed by the lender or creditor. These limitations might include restrictive covenants like not paying dividends unless this promissory note has been settled.
The notes payable account in general ledger keeps a record of all the promissory notes issued by the company to lenders of funds or vendors of assets. Since the notes payable is a liability account, the normal course of entry is crediting notes payable, and debiting cash or another asset received against it. On maturity date, the company has to pay the principle amount plus interest at the rate mention in the note. The payment is recorded by debiting notes payable account, interest account and crediting cash account.
If the company has issued a number of notes to different parties, it can also maintain a notes payable subsidiary ledger to keep a separate record of each note issued by it.
The balance in the notes payable account is representative of the total amount that still needs to be paid against all promissory notes issued by the company. Under most circumstances, promissory note is made payable in a year’s time and the balance in notes payable account is therefore reported as a current liability in the balance sheet.
Handling notes payable well means committing to the payments that are supposed to be made on maturity dates. If a company fails to abide by the promised terms and conditions, it will not only lead to a bad reputation but also might adversely impact its overall credit score.
The accounts payable account is an account in the general ledger which is mostly used to record purchase of goods and services on credit. It is a liability account and normally has a credit balance. The accounts payable account is mainly used for recording the purchase of goods and services and hence it has relevant entries to show the incoming of goods and payments to creditors. The double entry for noting accounts payable is that the accounts payable is credited and the respective account will be debited. When the amount is settled for a creditor, the accounts payable account is debited and cash is credited.
Mostly accounts payable have to be settled within a window of 12 months and are therefore recorded as current liability in the balance sheet. Accounts payable need to be managed very carefully as they impact company’s cash position, credit rating, and overall relationship with creditors or suppliers of goods and services.
In case the company is running out of cash and faces a difficulty in making its short term payments, its creditors may ask the company to accept a promissory note for the outstanding balance payable at a certain future date. If the terms and conditions of the note are agreed upon between company and creditor, the note is written, signed and issued to the creditor. This arrangement converts an account payable into a note payable. To jounalize this transaction, the accounts payable account is debited and notes payable account is credited. This way, the company gets a time relaxation for making cash payment and the creditor earns an interest income on the outstanding balance until a cash payment against the issued note is made.
Difference between notes payable and accounts payable
There are certain key differences between notes payable and accounts payable. They are as follows:
1. Maturity time period
Notes payable can be short-term or long term obligations for the business. However, accounts payable are always considered short term obligations which need to be settled within one year period.
Notes payable are generally not converted into accounts payable. However, the same does not hold true for accounts payable. Accounts payable can be converted into notes payable, upon mutual consent and understanding of the parties involved.
3. Parties involved
Notes payable are mostly created and issued for debt arrangements and are payable to financial institutions and credit companies. Accounts payable are generally the suppliers of inventory and services.
Accounts payable account is used to maintain purchase of goods and services while notes payable account is used to record incoming and outgoings from financial institutions.
4. Note of terms and conditions
Accounts payable do not normally require a written note or document which specifies terms and conditions. However, an invoice issued by the seller is attached to each order. Notes payable, on the other hand, have specific terms and conditions pertaining to payment of debt. They include terms and conditions, including interest rates, collateral information, and maturity date etc.
5. Uses and application
Accounts payable, as mentioned before, are mainly used for purchase of inventory. This is mostly done in cases where the company has managed to establish itself as a reliable partner in the supplier’s value chain, against which he is ready to provide inventory on credit. However, with notes payable, the amount is mainly used to finance the purchase of assets like property, plant and equipment.
6. Involvement of financial costs
There are no caveats in case of accounts payable. In most cases, it is a verbal understanding between both the parties without any associated finance costs. However, there might be trade discounts available. On the other hand, it can be seen that notes payable do have an interest component attached to them. There are two accounts that are supposed to be maintained when a company asks for a short term debt i.e., notes payable and interest costs. Therefore, there is a financing element involved with interest costs as far as notes payable are concerned. This is not the case with accounts payable.
7. Impact on working capital management
Accounts payable is always used in working capital management. It also has an impact on the company’s cash conversion cycle. However, notes payable may, or may not be included as part of the company’s working capital management.
Notes payable vs accounts payable – tabular comparison
A tabular comparison between notes payable and accounts payable is given below:
|Short term liability against which a company signs promissory note. Mainly used for purchase of assets.||Short term liability mainly used to record purchase of goods and services.|
|To record the transactions of receipts and payments from creditors against the finance they provide.||To record the amount owed to creditors in exchange for their goods and services.|
|Interest charges.||No interest charges.|
|Short term or long term|
|Can be short term or long term both.||Only short term.|
|Verbal or written|
|Has got to be a written note with terms and conditions specified.||Does not have to be a written agreement – can be verbal as well.|
|Can be converted or not|
|Are normally not converted to accounts payable.||Can be converted to Notes payable.|
Conclusion – notes payable vs accounts payable
Despite the fact that both notes payable and accounts payable can be referred to as current liabilities, both of these accounts differ on numerous grounds. It needs to be highlighted that both the liabilities have a relative impact on the company’s overall liquidity and should be managed with responsibility and efficiency.
Additionally, it is best to keep the overall cash conversion cycle in check, and ensure that all liabilities are honored as per commitment for maintaining a good repute in the industry. It will also prevent a company from hampering its credit score, which otherwise can act as a very detrimental disincentive for lenders and suppliers to extend credit facilities in the near future.