Notes payable represent a formal obligation to pay a specified amount of money, typically supported by a written contract. Unlike accounts payable, which may arise from invoices without interest, notes payable involve a maturity date and accrue interest over time. Understanding the relationship between notes payable and notes receivable is crucial, as one entity's note receivable is another's note payable.

When a company borrows money through a note payable, it incurs a principal amount, which is the actual sum borrowed. For example, if a company borrows $100,000, this amount is referred to as the principal. The cost of borrowing is represented by the interest rate, which is usually expressed as an annual percentage. The formula for calculating interest on a note payable is:

Interest = Principal \times Interest Rate \times Time

In this formula, the principal is the face value of the note, the interest rate is the annual rate provided by the lender, and the time is typically expressed as a fraction of the year. For instance, if a loan is taken out for 8 months, the time factor would be 8/12 or 2/3 of a year.

When a company acquires a note payable, it records the transaction in its accounting books. For example, on October 1 of Year 1, if a company signs a $100,000 note payable with a 12% annual interest rate maturing on May 1 of Year 2, the journal entry would involve debiting cash for the amount received and crediting notes payable for the same amount. This reflects an increase in cash and a corresponding liability:

Debit: Cash $100,000

Credit: Notes Payable $100,000

This entry ensures that the accounting equation remains balanced, with assets increasing by the cash received and liabilities increasing by the amount owed. As the company moves forward, it will need to account for the interest accrued on the note payable, which will be addressed in subsequent entries.