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At the end of each fiscal year, companies must report the balance of the notes payable account on a balance sheet. Since most promissory notes require the payment of interest, companies must also report the accrued and paid interest balances. Depending on the size of the company, the balance of each account can change on a daily basis so you must prepare journal entries to reflect all increases and decreases to the accounts.
Record the outstanding balance of all promissory notes. When a company representative signs a promissory note, accountants record a journal entry to reflect the inflow of cash and the increase in company debt. This requires a credit entry to the notes payable account for the amount of the loan and a corresponding debit entry to the cash account for the same amount.
Record the accrual of interest on the notes. When companies borrow money, the terms of the note will provide the interest rate the lender charges and the frequency at which it accrues. For example, if your company borrows $100,000 with interest accruing at the rate of 2 percent on the last day of each quarter, journal entries are necessary to report this interest payment liability. This requires a credit entry to the interest payable account on the last day of each quarter and a corresponding debit entry to the interest expense account.
Prepare a journal entry for each interest payment. The date a company accrues a liability to pay interest is usually different from the date it actually pays it. At the time the company makes an interest payment to the lender, an additional journal entry is necessary to reduce the interest payable balance and to report the reduction in cash. The entry requires a debit to the interest payable account reflecting the amount of the interest payment and a corresponding credit entry to the cash account.
Eliminate the notes payable balance for each loan payment. Each time a company pays off all or part of the note’s principal balance, you must reduce the balance in the notes payable account to reflect the reduction in the payoff amount. To do this, you record a debit entry for the amount of each payment to the notes payable account and a corresponding credit entry to the cash account.
Most companies use the accrual method of accounting for financial statement purposes. This is why it’s necessary to make two separate journal entries for the interest a company accrues and the interest it pays. However, if the terms of the note require the interest payment on the same day the company accrues it, only a single entry for interest expense and cash is necessary.