1. Interest Bearing Notes

Let's talk about notes payable. And in this one, we're gonna talk about interest bearing. There's another video that we'll go over that's non-interest bearing. But in this one, we're gonna talk about interest bearing notes payable. And interest bearing notes payable are the ones that you typically think of. It's where you get $1,000 up front and then you pay back $1,000 plus some interest at the end. So this is what the interest bearing ones are. Non-interest bearing you don't see typically in your real life. It's something like you borrow $1,000, but they only give you $900, and then at the end you have to pay back $1,000.

So in non-interest bearing, they take the interest out up front in the form of less cash received by you. So when you see interest bearing note payable, this is the one that you typically think of as a loan. You get $1,000, you pay back $1,000, and you pay back some sort of interest. So let's take a look at one of those. Let's say at the beginning of the year you borrowed $60,000 on a six-month, 10% loan. Okay, and the first thing you need to look out for is when they say six months or three months or one year, because this is always gonna be a one-year period.

So when they say six months at 10%, this 10% here is the annual percentage rate. It's the APR. So if it's a six-month loan, you're not actually gonna pay a full 10%. You're gonna pay a portion of 10%. If this was a year instead of six months, it would be super easy. You would just say, okay, the interest is gonna be $6,000 because 10% times $60,000 is $6,000. But since this is a six-month note, we don't have to pay the full 10% 'cause we didn't hold on to the money for a full year.

So right off the bat, you wanna make sure that you are watching out for the period. So you're gonna say times 10% and then times one half of a year, or you could say 6 months over 12 months, whatever you wanna do here. But what we're gonna do is we're gonna say, "I borrowed $60,000. The rate was 10% per year and I only borrowed it for one half of one year." So that is gonna come out to, instead of $6,000, that's gonna come out to $3,000. So what we've just done is we've figured out that at the beginning we got $60,000 and then six months later we're gonna have to pay $60,000 back because it's a loan, so we have to pay that much back.

And then this $3,000 is the price we're paying to the bank to be able to borrow their money for six months. So they gave us $60,000 and said, "Hey, you can have that for six months. Don't worry about it. Just hang on to it for six months and six months later pay us back." But banks are smart and they don't do that for free. So at the end of six months, this is the fee that you have to pay them. You have to pay them $3,000 for the privilege of holding on to their money for that long. Now when you get the money, right here, when you get the money, you record this journal entry.

This one is really straightforward. Your cash goes up by $60,000 and your note payable goes up by $60,000. So you've increased an asset and you've increased a liability because now this is a payable back to the bank. You owe the bank this $60,000, but you also got $60,000 in cash. Then when you pay it off, it's gonna look like this. Your note payable is going to decrease by $60,000, right? Because you paid off this $60,000 right here. But you also have to pay off this $3,000. So your cash is gonna be 60 plus the 3,000.

So right now we're unbalanced. You've got 60 on the left and you've got 63 on the right. So this $3,000 right here, this is what we're gonna call an interest expense. This is the money that we've paid the bank for the privilege of borrowing their money. Now you could, if you wanted, split that up and do note payable, 60,000; cash, 60,000, and then do interest expense, 3,000; cash, 3,000. That's totally okay. This right here, this is not wrong. This is still good. The reason I like to do it like this is because I like to think what happened with my cash.

So when I'm solving a problem, I try to start with cash because cash is an easy one typically to figure out. So here I would say if I was working this problem on the test, I would say at the end of six months I will pay the bank $63,000. I know that for sure. And so even if I didn't know, like I couldn't remember this right here, I would write down cash, $63,000, and then I would look back to my first entry and say, okay, well I know that 60 of that went to pay off my note payable. Now what this does is this tells me that I have $3,000 that's missing.

Had I done it like this, it's totally conceivable that I would have just remembered this top entry up here and that would have been half right and I don't know if you would have gotten full credit for that. So I like to do 63 and then put this $3,000 in here to make it balance out, and that makes it very obvious then that, oh yeah, I forgot about the interest expense, the amount of money that we have to pay the bank for letting us borrow their money. So step one here was figuring out what is our interest going to be? How much are we gonna actually end up paying the bank to borrow that money, to have that money for six months?

And you do that by saying the principal times the annual percentage rate times whatever portion of a year we're working with. So in this problem, we were working with one half of a year. Now, if this had said 12 months, we would just put a 1 there, which effectively makes it go away, and it becomes $60,000 times 10%. Once we know the interest, then you can do the entry at the end of the note's life and do the $60,000 principal. So this is the principal, and this is the interest. Now, the last thing I wanted to make note of is, of course, you may have a problem where the year ends right in the middle or something like that.

This is a favorite of 229 teachers. They like to say, "You took out a loan here, you pay it back here, but aha, the year ends, we're in the middle." And so all that you have to do there is you have to record that interest expense as an adjusting entry. And so you just put that interest expense into a payable to be paid next year. So we have to recognize it in the year that we incurred it, but we're not actually gonna pay it until the end of the life of the note. So what you do is you just put it into that interest payable bucket, and you pay it off later.

So in that case, it would look like this. You would have note payable, 60,000, and then interest payable, 1,500. That's half of it. Interest expense, the other half. So this is Year 1. This is Year 2. And then finally, your cash for the total amount. So if you see a problem where the year splits the life of the note, make sure that you're recording any interest expense incurred in Year 1 in Year 1. And that's what we did here. We recorded this interest expense in the proper year and then just shoved it into this payable and said, "I'll take care of actually paying it later," but I have to record expenses in the period in which they were incurred.