The Face of Notes Payable
Face is the easiest type of note to account for. With this type of note, the present value of the note payable is the same as its face, which is the amount stated on the note. Notes payable are formal written documents that spell out how money is being borrowed.
This type of agreement between a lender and a borrower specifies principal (amount borrowed), rate (interest percentage the company pays to borrow the money), frequency of payments, and term (the amount of time the company has to pay off the loan).
The effective interest rate of face notes, which is the market interest rate, and the stated interest rate (what’s printed on the face of the note payable) are the same.
Market is the interest rate for a note of similar risk. The level of risk refers to the creditworthiness of the borrower — the ability to repay principal (face amount) and interest on time.
For example, if one company loans another company $5,000 at an effective and stated rate of 10 percent due in three years, the journal entry for the borrower to record issuance of the note is to debit cash and credit notes payable for $5,000.
Each year, the borrower records interest expense at $500 ($5,000 x 0.10). The journal entry is to debit interest expense and credit cash for $500. When the company pays off the debt at the end of the three years, the borrower records a credit to cash and a debit (reduction) to notes payable for $5,000.