Chapter 10: Long-Term Notes Payable

Notes payable are a type of liability that a company takes on, typically for financing purposes, issued to a single lender (like a bank) in exchange for assets such as cash. They differ from bonds primarily in that they involve a single lender and are usually more personalized loan agreements. Notes can be issued at face value, at a discount, or at a premium, and they may include fixed or variable interest rates. Key types of notes include installment notes and mortgages. Types of Notes Payable and Accounting 1. Installment Notes o These require periodic (monthly or yearly) payments that consist of both principal and interest. Payments remain equal, but the interest portion decreases over time as the principal balance reduces, causing the principal portion to increase with each payment. o Example: Foghog borrows $60,000 at 8% interest for equipment. The loan requires three equal payments of $23,282 annually. Interest is calculated on the remaining principal at the beginning of each period. 2. Mortgages o A mortgage is a secured note where specific assets (like real estate) serve as collateral. If the borrower defaults, the lender can claim these assets to recover the outstanding amount. Mortgages are often used for long-term financing of property or plant assets. Example: Recording an Installment Note (Straight-Line Amortization) Scenario A company borrows $1,000 on January 1, 2021, by signing a four-year, 5% installment note, requiring four equal payments of $282 at the end of each year (December 31). The payment includes both interest and principal. Step 1: Prepare an Amortization Table Each payment consists of accrued interest (based on the beginning balance of each year) and a reduction in principal. Here is the amortization table: Date Beginning Balance 01/01/2021 $1,000 12/31/2021 $1,000 12/31/2022 $768 12/31/2023 $524.40 12/31/2024 $268.62 Step 2: Journal Entries Interest Expense (5%) $50 $38.40 $26.22 $13.43 Principal Reduction $232 $243.60 $255.78 $268.57 Total Payment $282 $282 $282 $282 Ending Balance $1,000 $768 $524.40 $268.62 $0 (a) Issuance of Note on January 1, 2021 The issuance of the note payable is recorded at face value: plaintext Cash Notes Payable 1,000 1,000 (b) Recording Annual Payments (Interest and Principal) Each December 31, we record the payment that includes both interest expense and a reduction in the principal. Below are entries for each year. First Payment - December 31, 2021 plaintext Interest Expense Notes Payable Cash 50 232 282 Second Payment - December 31, 2022 plaintext Interest Expense Notes Payable Cash 38.40 243.60 282 Third Payment - December 31, 2023 plaintext Interest Expense Notes Payable Cash 26.22 255.78 282 Fourth Payment - December 31, 2024 plaintext Interest Expense Notes Payable Cash 13.43 268.57 282 Summary of Installment Notes Accounting Each payment reduces the outstanding principal while covering the interest on the remaining balance. Over the life of the note, the interest expense decreases as the balance declines, and the portion applied to the principal increases, allowing for the balance to reach zero by the final payment.