This discount is then amortized over the life of the note, typically using the effective interest method or the straight-line method. As the discount is amortized, it increases the interest expense recorded by the company, effectively raising the cost of borrowing to the market rate. Observe that the $1,000 difference is initially recorded as a discount on note payable. On a balance sheet, the discount would be discount on notes payable reported as contra liability. The $1,000 discount would be offset against the $10,000 note payable, resulting in a $9,000 net liability.
Advantages and Disadvantages of Discount Notes
The bondholder divides $40 by $980 to determine the effective annual rate of interest, which is 8.16 percent. For accounting purposes, discounts on notes payable are treated as an interest expense. The dollar amount of the discount is entered on the issuer’s books over the life of the note. Suppose a note payable for $1,000 is issued at discount price of $950 and pays 4 percent annual interest. Each year, the interest recorded is $40 plus one-fifth of the discount, or $10. The discount on notes payable account is a balance sheet contra liability account, as it is netted off against the notes payable account to show the net liability.
When a company borrows money this way, they have received cash that is less than the face value of the notes payable. The contra liability account, discounts on notes payable, is used to account for the difference between the cash received and the money owed on the note. The financial accounting term discounts on notes payable is used to describe a contra liability account that holds future interest charges that are included on the face value of a promissory note. In notes payable accounting there are a number of journal entries needed to record the note payable itself, accrued interest, and finally the repayment. Assume that the company issues a $1, day discounted note to a bank on January 1, the discount recorded in the account will be $1,000.
Issuance of notes payable to extend the period of the loan.
The difference between the face value of the notes payable and the cash received is referred to as the discount, and represents the cost to the business of issuing the note. Non interest bearing notes payable are issued by a business for cash, and are liabilities representing amounts owed by the business to a third party. While the risk of default is minimal with government-issued discount notes, notes issued by corporations have a higher risk of default.
The amount of the discount is written off over the life of the note, which is also known as amortization. The issue date discount in Case 2 is equal to 65% of the lowest trade accrued over the preceding 10 Trading Days. It is important to realize that the discount on a note payable account is a balance sheet contra liability account, as it is netted off against the note payable account to show the net liability. In the above example, the principal amount of the note payable was 15,000, and interest at 8% was payable in addition for the term of the notes.
A note payable has a par or face value, which is the amount the borrower must repay when the note matures. Only interest payments are typically due on notes payable until maturity, as is the case with the bonds used as examples here. Suppose a $1,000 par value bond matures in 6 months and pays 4 percent interest. The bondholder will receive $20 in interest for the six-month life of the bond. However, if the bond price is discounted to $980, the bondholder will get an extra $20 at maturity for a total of $40 in earnings. Since the price was $980, divide $40 by $980 and double the result to find the effective annual rate of interest, which here works out to 8.16 percent.
Related Terms
- Suppose a note payable for $1,000 is issued at discount price of $950 and pays 4 percent annual interest.
- The difference between the face value and the actual amount received represents the added interest over the life of the note.
- A note payable is a liability which can sometimes include the interest payable on the face of the note; meaning the face value of the note will include future interest charges.
- It reflects that the company can realize the cash in a good fashion.
Therefore, it should be charged to expense over the life of the note rather than at the time of obtaining the loan. For example, a company that is owed $600 in interest on a loan of $100,000 will have to pay $600 to a lender on the maturity date. If the company is still trying to get its money, it can convert a note payable into a short-term liability. But, if the debt is more than one year away, the note will be a long-term liability. An issue date discount on notes payable is a way to reduce interest costs over the life of the note.
At the end of the term, the loan is repaid for $950 and the $9,000 is recorded as an interest expense on the Note Payable. This debiting and crediting action reduces the principal amount the borrower receives in the beginning of the loan term. The discount on a note payable is a reduction in the face value incurred at the time of issuance. The amount is credited to an account that is contra-liability and offsets the Notes Payable account on the balance sheet.
- The size of this discount is especially large when the stated interest rate on a note is well below the market rate of interest.
- On March 31, another three months of interest was charged to expense.
- A note payable is a legal contract between a lender and a borrower, and the lender will get the cash back if it fails to meet the terms.
- It is deducted from the bonds payable account on the balance sheet.
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The interest expense is recognized separately from the loaned amount, so it may not be included in cash flow management. In the balance sheet, the difference between the face value of the notes and the discount is debited to the Discount on Notes Payable account. Since it is a contra-liability, the amount is offset against Notes Payable on the balance sheet.
A discount on notes payable arises when the amount paid for a note by investors is less than its face value. The difference between the two values is the amount of the discount. The size of this discount is especially large when the stated interest rate on a note is well below the market rate of interest. For example, a bank might loan a business $9,000 with a 10-year, $10,000 zero interest note. This means the company borrows $9,000 from the bank and must pay back $10,000 over the course of 10 years.
In examining this illustration, one might wonder about the order in which specific current obligations are to be listed. One scheme is to list them according to their due dates, from the earliest to the latest. Another acceptable alternative is to list them by maturity value, from the largest to the smallest. For tax purposes, any gain made from the sale or redemption of the discount bond is treated as ordinary income up to the amount of the ratable share of the bond. For the past 52 years, Harold Averkamp (CPA, MBA) hasworked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online.
What Does Discount on Notes Payable Mean?
This account represents the total amount of potential interest expense for the notes. This includes the accrued interest for three months and interest charges for future accounting periods. A discount on notes payable is a reduction in the principal amount of a note that is given to the holder of the note. This reduction may be applied at the time the note is issued, or it may be applied at a later date. The discount on notes payable usually represents a percentage of the face value of the note, and it is typically expressed as a percentage of the original amount. A zero-interest-bearing note (also known as non-interest bearing note) is a promissory note on which the interest rate is not explicitly stated.
Since investors don’t get the added advantage of periodic interest income, the notes are offered at a discount to par. It must charge the discount of two months to expense by making the following adjusting entry on December 31, 2018. National Company must record the following journal entry at the time of obtaining loan and issuing note on November 1, 2018. The Discount on Notes Payable is the difference between the face value of a note and its discounted value at issuance. The interest expense on the note is allocated over time, so that a higher gain can be achieved from issuance of a note. The opinions and recommendations presented are solely those of the author, True Tamplin.
Because the interest charges relate to future accounting periods, this expense is not recorded in the current period. For instance, underwriters buy bonds issued by governments or corporations and accept responsibility for marketing them to investors. When market interest rates are higher than a bond’s interest rate, investors won’t pay the full par value, resulting in a discount.
The notes are issued and maintained in book-entry form through the Federal Reserve Bank of New York, and investors may acquire the notes in denominations as small as $1,000. On November 1, 2018, National Company obtains a loan of $100,000 from City Bank by signing a $102,250, 3 month, zero-interest-bearing note. National Company prepares its financial statements on December 31, each year. On November 1, 2018, National Company obtains a loan of $100,000 from City Bank by signing a $100,000, 6%, 3 month note.
Discount amortization transfers the discount to interest expense over the life of the loan. This means that the $1,000 discount should be recorded as interest expense by debiting Interest Expense and crediting Discount on Note Payable. In this way, the $10,000 paid at maturity (credit to Cash) will be entirely offset with a $10,000 reduction in the Note Payable account (debit). Notes payable is an instrument to extend loans or to avail fresh credit in the company.
Understanding a Discount Note
The $1,000 difference between the amount received and the amount owed is considered the discount. It also represents the amount of interest the company is paying the bank to borrow the $9,000 principle. Suppose for example, a business borrowed 7,273 cash from a lender by signing a 12 month, non interest bearing note payable with a face value of 8,000. The business receives cash of 7,273 in return for having to pay back the lender 8,000 in twelve months time.