Effects of Notes Payable on Cash Flow
A note payable is similar to a loan. The borrower agrees to make regular interest payments and pay back the principal with interest within a specified period. Companies may use notes payable for asset purchases or for other funding needs. Notes maturing in a year or less are current liabilities while those maturing in a longer period are long-term liabilities. Notes payable have an effect on cash flow when a company receives or pays back the proceeds and when it makes regular interest payments.
When a company receives the note proceeds, it debits cash and credits notes payable. For a long-term note, it credits long-term notes payable. For a short-term note, the company records the cash inflow in the operating activities section of the statement of cash flows. For a long-term note, the company records the inflow in the financing activities section. The operating activities section records the net income and adjustments for noncash items and changes in working capital, which is the difference between current assets and current liabilities. The financing activities section records transactions between a company and its creditors and investors.
The interest rate and frequency of payments are parts of the note agreement. Regardless of the frequency of interest payments, a company must record the interest expense in the same period it accrues the interest by debiting interest expense and crediting interest payable. When it makes the interest payments, it debits interest payable and credits cash. These transactions affect the operating cash flow section of the statement of cash flows.
There is an impact on cash flow when a company repays the note. The repayment accounting entries are to debit notes payable by the principal amount of the note and credit cash. For a short-term note, a company records the cash outflow in the operating activities section of the statement of cash flows. For a long-term note, a company records the outflow in the financing activities section.
According to Steven Bragg of the "AccountingTools" website, lenders may impose restrictive covenants in the note agreement, such as collateral and not paying dividends to investors while the note payable is outstanding. If a company fails to make its interest payments or returns the principal on schedule, the lender may take possession of the collateral assets.
Debits increase asset and expense accounts and also decrease revenue, liability and shareholders' equity accounts. Credits decrease asset and expense accounts and increase revenue, liability and shareholders' equity accounts.