Instead, investors purchase discount notes at a discounted price and receive the note’s face value (also called “par value”) at maturity. 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. 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. For example, on January 1, 2021, Empire Construction Ltd. signed a $200,000, four-year, non-interest-bearing note payable with Second National Bank.
- The difference between the face value and the actual amount received represents the added interest over the life of the note.
- It also has a face value, or par value, which is the amount the borrower must pay back when the note matures.
- Discount notes are similar to zero-coupon bonds and Treasury bills (T-Bills) and are typically issued by government-sponsored agencies or highly-rated corporate borrowers.
- To calculate the effective rate earned on the bond, the interest earned can be divided by the product of the purchase value and time to maturity.
- 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.
Journal entries for zero-interest-bearing note:
The purchase of discount notes may also prove to be advantageous for investors who would need access to the funds after a short period of time. The difference between the face value of a note and the amount paid for it is recorded in a Discount on Notes Payable account. This is classified as a contra liability account; as such, it is paired with and offsets the Notes Payable account. The amount in the Discount on Notes Payable account is gradually amortized over the remaining life of the note, so that the difference is eliminated as of the maturity date. To summarize, the present value (discounted cash flow) of $4,208.40 is the fair value of the $5,000 note at the time of the purchase. The additional amount received of $791.60 ($5,000.00 – $4,208.40) is the interest component paid to the creditor over the life of the two-year note.
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. 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. On February 1, 2019, the company must charge the remaining balance of discount on notes payable to expense by making the following journal entry.
Example of a Discount on Notes Payable
Observe that the $1,000 difference is initially recorded as a discount on note payable. On a balance sheet, the discount would be reported as contra liability. The $1,000 discount would be offset against the $10,000 note payable, resulting in a $9,000 net liability.
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Higher-risk investments have the potential of offering investors a greater profit from the same principal investment, but they also carry a greater risk of loss as well. One of the advantages of discount notes is that they are not as volatile as other debt instruments. They are, therefore, perceived to be a safe investment for investors looking to preserve their capital in a low-risk investable security. On the maturity date, only the Note Payable account is debited for the principal amount. Note that since the 12% is an annual rate (for 12 months), it must be pro- rated for the number of months or days (60/360 days or 2/12 months) in the term of the loan.
- The long term-notes payable are classified as long term-obligations of a company because the loan obtained against them is normally repayable after one year period.
- The amount in the Discount on Notes Payable account is gradually amortized over the remaining life of the note, so that the difference is eliminated as of the maturity date.
- In the following example, a company issues a 60-day, 12% interest-bearing note for $1,000 to a bank on January 1.
- As a result, interest expense is generally separate from the principal amount.
- The following entry is required at the time of repayment of the face value of note to the lender on the date of maturity which is February 1, 2019.
Related Terms
In practice, companies must carefully manage the amortization of the discount to ensure accurate financial reporting. In Canada, the accounting for notes payable issued at a discount is governed by the International Financial Reporting Standards (IFRS) as adopted in Canada. Specifically, IFRS 9 – Financial Instruments provides guidance on the recognition and measurement of financial liabilities, including notes payable.
The issue date discount in Case 2 is equal to 65% of the lowest trade accrued over the preceding 10 Trading Days. This loan is typically a long-term one, lasting longer than 12 months. As a result, interest expense is generally separate from the principal amount.
Discounts on Notes Payable
The preceding illustration should not be used as a model for constructing a legal document; it is merely an abbreviated form to focus on the accounting issues. In the preceding note, Oliva has agreed to pay to BancZone $10,000 plus interest of $400 on June 30, 20X8. The interest represents 8% of $10,000 for half of a year (January 1 through June 30). The face of the note payable or promissory note should show the following information.
For the past 52 years, Harold Averkamp (CPA, MBA) hasworked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. For the past 52 years, Harold Averkamp (CPA, MBA) has worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. 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. Shaun Conrad is a Certified Public Accountant and CPA exam expert with a passion for teaching.
The difference between the face value of the note and the loan obtained against it is debited to discount on notes payable. Be aware that discount amortization occurs not only at the date of repayment, but also at the end of an accounting period. If the preceding example had a maturity date at other than the December 31 year-end, the discount on notes payable $1,000 of total interest expense would need to be recorded partially in one period and partially in another.