Promissory Note: Meaning, Definition, Features, Examples, and Applications

 

Definition of Promissory Note

A Promissory Note is a written, unconditional promise made by one party (the maker) to pay a specific sum of money to another party (the payee) either on demand or at a future date. It acts as a legal financial instrument enforceable under law.

Meaning of Promissory Note in Detail

The promissory note is widely used in business, banking, trade, and finance as a tool for credit transactions. It serves as a written acknowledgment of debt and ensures that the lender has legal backing to recover the amount.

In simple terms, it’s like a signed "I owe you" document, but with a legal obligation to pay.

For example, if a business borrows money from another business or an individual, a promissory note may be issued stating the amount, due date, and terms of repayment.

Sub-sections for Better Understanding

Parties Involved

1. Maker (Issuer): The person who promises to pay.

2. Payee: The person to whom the payment is promised.

3. Endorsee/Holder in Due Course: In case the note is transferable.

Legal Framework

• In India, promissory notes are governed by the Negotiable Instruments Act, 1881.

• Globally, they are treated as negotiable instruments in banking and trade law.

Essential Conditions

• Must be in writing.

• Must contain a promise to pay.

• The amount must be certain.

• It should be signed by the maker.

• Payable on demand or fixed future date.

Formula / Calculation

Though a promissory note itself has no fixed formula, the calculation of repayment with interest is:

$$\text{Total Payable Amount} = \text{Principal Amount} + (\text{Principal Amount} \times \text{Rate of Interest} \times \text{Time})$$

Example Calculation

Suppose Mr. A issues a promissory note of ₹50,000 at 10% annual interest to Mr. B for 6 months.

$$\text{Interest} = 50,000 \times 10\% \times \frac{6}{12} = 2,500$$
$$\text{Total Payable} = 50,000 + 2,500 = ₹52,500$$

So, Mr. A must pay Mr. B ₹52,500 on the maturity date.

Journal Entry (Accounting Treatment)

When promissory note is issued:

• In the books of the Maker (Borrower):

Cash/Bank A/c…………Dr  
      To Bills Payable A/c  

• In the books of the Payee (Lender):

Bills Receivable A/c………Dr  
      To Debtor A/c  

At the time of payment:

• Maker:

Bills Payable A/c………Dr  
      To Cash/Bank A/c  

• Payee:

Cash/Bank A/c…………Dr  
      To Bills Receivable A/c  

Detailed Illustration

Company X takes a loan of ₹1,00,000 from Company Y on 01-01-2025, issuing a promissory note payable after 1 year at 12% interest.

• Interest = 1,00,000 × 12% × 1 = ₹12,000

• Total Payment = ₹1,00,000 + ₹12,000 = ₹1,12,000

Journal Entries in the books of Company X (Maker):

• On 01-01-2025:

Bank A/c…………Dr 1,00,000  
      To Bills Payable A/c 1,00,000  

• On 01-01-2026 (at maturity):

Bills Payable A/c…………Dr 1,00,000  
Interest A/c………………Dr   12,000  
      To Bank A/c 1,12,000  

In the books of Company Y (Payee):

• On 01-01-2025:

Bills Receivable A/c………Dr 1,00,000  
      To Bank A/c 1,00,000  

• On 01-01-2026:

Bank A/c………………Dr 1,12,000  
      To Bills Receivable A/c 1,00,000  
      To Interest A/c 12,000  

Key Features / Characteristics

• Written document.

• Unconditional promise to pay.

• Specific sum of money.

• Payable on demand or fixed date.

• Signed by maker.

• Legally enforceable.

Importance / Role in Business

• Facilitates credit transactions.

• Acts as legal proof of debt.

• Provides financial security to lenders.

• Ensures trust in trade and commerce.

• Useful in both domestic and international trade.

Advantages and Disadvantages

Advantages:

• Simple and legally valid.

• Reduces disputes in business.

• Acts as collateral security.

• Helps maintain credit flow.

Disadvantages:

• Risk of dishonor (default).

• Legal enforcement may be time-consuming.

• No guarantee if maker is insolvent.

Usage of Promissory Note

• Business loans.

• Trade credit.

• Personal borrowing.

• International trade financing.

• Banking transactions.

Case Study

Case: Infosys Vendor Credit System
Infosys issues promissory notes to certain suppliers against long-term service contracts. This provides suppliers with assured payments and helps Infosys manage working capital efficiently.

Practical Example

A small business owner takes a loan from a friend and issues a promissory note of ₹2,00,000 payable after 1 year with 8% interest. This note becomes a legal guarantee, giving confidence to the lender.

Common Mistakes / Misunderstandings

• Treating it like an informal IOU (it is a legal document).

• Not mentioning the due date or interest rate.

• Issuing without signature (invalid).

• Assuming it guarantees payment even if the maker is insolvent.

Real-Life Applications & Legal Implications

• Used in bank loans and trade financing.

• Important in international transactions where trust between buyer and seller is low.

• Legally enforceable under the Negotiable Instruments Act in India.

• Often used by startups and SMEs to raise short-term funds.

FAQs

Q1. Is a promissory note legally binding?
Yes, it is legally enforceable under law.

Q2. Is it the same as a bill of exchange?
No. A bill of exchange is an order to pay, while a promissory note is a promise to pay.

Q3. Can promissory notes be transferred?
Yes, they can be endorsed and transferred.

Q4. What happens if the maker defaults?
The payee can take legal action to recover the debt.

Expert Tip from Learn with Manika

👉 Always draft promissory notes clearly with amount, due date, and interest rate. Ambiguity weakens legal enforceability. Use it only with trusted parties and keep a notarized copy for safety.

Related Terms

• Bills of Exchange
• Cheque
• Negotiable Instruments
• Bills Payable
• Bills Receivable
• Debt Instrument