If you have ever taken out a payday loan, you may have
experienced a situation where your living expenses temporarily
exceeded your assets. You need enough money to cover your expenses
until you get your next paycheck. Once you receive that paycheck,
you can repay the lender the amount you borrowed, plus a little
extra for the lender’s assistance.
There is an ebb and flow to business that can sometimes produce
this same situation, where business expenses temporarily exceed
revenues. Even if a company finds itself in this situation, bills
still need to be paid. The company may consider a short-term note
payable to cover the difference.
A short-term note payable is a debt created and
due within a company’s operating period (less than a year). Some
key characteristics of this written promise to pay (see
Figure 12.12) include an established date for repayment, a
specific payable amount, interest terms, and the possibility of
debt resale to another party. A short-term note is classified as a
current liability because it is wholly honored within a company’s
operating period. This payable account would appear on the balance
sheet under Current Liabilities.
Debt sale to a third party is a possibility with any loan, which
includes a short-term note payable. The terms of the agreement will
state this resale possibility, and the new debt owner honors the
agreement terms of the original parties. A lender may choose this
option to collect cash quickly and reduce the overall outstanding
debt.
We now consider two short-term notes payable situations; one is
created by a purchase, and the other is created by a loan.
THINK IT THROUGH
Promissory Notes: Time to Issue More Debt?
A common practice for government entities, particularly schools,
is to issue short-term (promissory) notes to cover daily
expenditures until revenues are received from tax collection,
lottery funds, and other sources. School boards approve the note
issuances, with repayments of principal and interest typically met
within a few months.
The goal is to fully cover all expenses until revenues are
distributed from the state. However, revenues distributed fluctuate
due to changes in collection expectations, and schools may not be
able to cover their expenditures in the current period. This leads
to a dilemma—whether or not to issue more short-term notes to cover
the deficit.
Short-term debt may be preferred over long-term debt when the
entity does not want to devote resources to pay interest over an
extended period of time. In many cases, the interest rate is lower
than long-term debt, because the loan is considered less risky with
the shorter payback period. This shorter payback period is also
beneficial with amortization expenses; short-term debt typically
does not amortize, unlike long-term debt.
What would you do if you found your school in this situation?
Would you issue more debt? Are there alternatives? What are some
positives and negatives to the promissory note practice?
Recording Short-Term Notes Payable Created by a Purchase
A short-term notes payable created by a purchase typically
occurs when a payment to a supplier does not occur within the
established time frame. The supplier might require a new agreement
that converts the overdue accounts payable into a short-term note
payable (see
Figure 12.13), with interest added. This gives the company more
time to make good on outstanding debt and gives the supplier an
incentive for delaying payment. Also, the creation of the note
payable creates a stronger legal position for the owner of the
note, since the note is a negotiable legal instrument that can be
more easily enforced in court actions.
To illustrate, let’s revisit Sierra Sports’ purchase of soccer
equipment on August 1. Sierra Sports purchased $12,000 of soccer
equipment from a supplier on credit. Credit terms were 2/10, n/30,
invoice date August 1. Let’s assume that Sierra Sports was unable
to make the payment due within 30 days. On August 31, the supplier
renegotiates terms with Sierra and converts the accounts payable
into a written note, requiring full payment in two months,
beginning September 1. Interest is now included as part of the
payment terms at an annual rate of 10%. The conversion entry from
an account payable to a Short-Term Note Payable in Sierra’s journal
is shown.
Accounts Payable decreases (debit) and Short-Term Notes Payable
increases (credit) for the original amount owed of $12,000. When
Sierra pays cash for the full amount due, including interest, on
October 31, the following entry occurs.
Since Sierra paid the full amount due, Short-Term Notes Payable
decreases (debit) for the principal amount of the debt. Interest
Expense increases (debit) for two months of interest accumulation.
Interest Expense is found from our earlier equation, where Interest
= Principal × Annual interest rate × Part of year ($12,000 × 10% ×
[2/12]), which is $200. Cash decreases (credit) for $12,200, which
is the principal plus the interest due.
The other short-term note scenario is created by a loan.
Recording Short-Term Notes Payable Created by a Loan
A short-term notes payable created by a loan transpires when a
business incurs debt with a lender
Figure 12.14. A business may choose this path when it does not
have enough cash on hand to finance a capital expenditure
immediately but does not need long-term financing. The business may
also require an influx of cash to cover expenses temporarily. There
is a written promise to pay the principal balance and interest due
on or before a specific date. This payment period is within a
company’s operating period (less than a year). Consider a
short-term notes payable scenario for Sierra Sports.
Sierra Sports requires a new apparel printing machine after
experiencing an increase in custom uniform orders. Sierra does not
have enough cash on hand currently to pay for the machine, but the
company does not need long-term financing. Sierra borrows $150,000
from the bank on October 1, with payment due within three months
(December 31), at a 12% annual interest rate. The following entry
occurs when Sierra initially takes out the loan.
Cash increases (debit) as does Short-Term Notes Payable (credit)
for the principal amount of the loan, which is $150,000. When
Sierra pays in full on December 31, the following entry occurs.
Short-Term Notes Payable decreases (a debit) for the principal
amount of the loan ($150,000). Interest Expense increases (a debit)
for $4,500 (calculated as $150,000 principal × 12% annual interest
rate × [3/12 months]). Cash decreases (a credit) for the principal
amount plus interest due.
LINK TO LEARNING
Loan calculators can help businesses determine the amount they
are able to borrow from a lender given certain factors, such as
loan amount, terms, interest rate, and payback categorization
(payback periodically or at the end of the loan, for example). A
group of information technology professionals provides one such
loan
calculator with definitions and additional information and
tools to provide more information.