Although notes are not inherently problematic for accounting purposes, they can be troublesome when interest rates are lower than what would normally apply to similar notes. The issue date discount on notes payable is a way to extend the life of a loan or to access fresh credit. An issue date discount on notes payable is a way to reduce interest costs over the life of the note. The amount of the discount is written off over the life of the note, which is also known as amortization.
Troubled Debt Restructurings
- These notes are called zero interest, but they do carry an implicit interest rate figured into the face value of the note.
- The note payable issued on November 1, 2018 matures on February 1, 2019.
- The carrying amount of the note payable, including the amortized discount, should equal the face value at this point.
- The $1,000 difference between the amount received and the amount owed is considered the discount.
The stated interest rate of these notes is lower than the market rate of interest, and therefore, the discount is large. 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.
Double Entry Bookkeeping
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. 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.
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. Discount on notes payable is treated as interest expense because the discount is recorded as an expense during the life of the note. Assume that a note payable of $1,000 is issued at a discount price of $950 and has a maturity of five years, at the end of the term, it will pay four percent annual interest. For the year ending on 30 June, the original holder must record a discount on notes payable payment to the bank, plus one-fifth of the discount, or $10.
Journal entries for zero-interest-bearing note:
They are bilateral agreements between issuing company and a financial institution or a trading partner. An interest-bearing note payable may also be issued on account rather than for cash. In this case, a company already owed for a product or service it previously was invoiced for on account. Rather than paying the account off on the due date, the company requests an extension and converts the accounts payable to a note payable. Over time, interest will accrue to the note, thereby lowering the balance of the discounts on accounts payable and increasing the balance of notes payable. The cash amount in fact represents the present value of the notes payable and the interest included is referred to as the discount on notes payable.
Balance Sheet
- The discount value is an important consideration when recording the interest expense on notes payable.
- The bondholder divides $40 by $980 to determine the effective annual rate of interest, which is 8.16 percent.
- He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries.
- As previously discussed, the difference between a short-term note and a long-term note is the length of time to maturity.
- A discount note is a short-term debt obligation issued at a discount to par.
A contra liability account arising when the proceeds of a note payable is less than the face amount of the note. The debit balance in this account will be amortized to interest expense over the life of the note. The company obtains a loan of $100,000 against a note with a face value of $102,250.
Journal entries for interest-bearing notes:
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. When a zero-interest-bearing note is issued, the lender lends to the borrower an amount less than the face value of the note. At maturity, the borrower repays to lender the amount equal to face vale of the note. Thus, the difference between the face value of the note and the amount lent to the borrower represents the interest charged by the lender. A note payable is a loan contract that specifies the principal (amount of the loan), the interest rate stated as an annual percentage, and the terms stated in number of days, months, or years. A note payable may be either short term (less than one year) or long term (more than one year).
These include the interest rate, property pledged as security, payment terms, due dates, and any restrictive covenants. Restrictive covenants are any quantifiable measures that are given minimum threshold values that the borrower must maintain. Maintenance of certain ratio thresholds, such as the current ratio or debt to equity ratios, are all common measures identified in restrictive covenants. Notes payable discounting is a common practice in various industries, including manufacturing, retail, and real estate. Companies often issue notes payable at a discount to attract investors or lenders by offering a higher effective interest rate. In conclusion, a discount on notes payable is a reduction in the amount of money that is owed to a creditor.
On a company’s balance sheet, the long term-notes appear in long-term liabilities section. 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. They are usually issued for buying property, plant, costly equipment and/or obtaining long-term loans from banks or other financial institutions. 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.