Notes payable represent obligations to banks or other creditors based on formal written agreements. A specific interest rate is usually identified in the agreement. Following the matching principle, if interest is owed but has not been paid, it is accrued prior to the preparation of the financial statements. Assume The Flower Lady signed a $10,000 three‐year note with interest of 10% on July 1 in exchange for a piece of equipment. The interest is due and payable quarterly on Oct. 1, Jan. 1, April 1, and July 1. The Flower Lady operates on a calendar‐year basis and issues financial statements at the end of each quarter. A long‐term note payable must be recorded as of July 1 with interest accrued at the end of each quarter. The entries related to the note for the current year are:
In the final year, the June 30 quarterly interest accrual and July 1 payoff would be as shown.
If interest is not paid until maturity of the note, the amount of interest accrued is often determined by compounding. The annual interest expense is the beginning of the year note principal plus accrued interest payable times the annual interest rate. Generally, it is assumed that in any arm's length transaction, the interest rate stated on a note signed in exchange for goods and services is a fair rate. If an interest rate is not stated, the exchange value is based on the value of the goods or services received. The difference between the exchange value and the face amount of the note signed is considered interest.