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.
Accounting for Notes Payable Issued at a Discount
During 2023, Empire Construction Ltd. experienced some serious financial difficulties. Based on the information provided by Empire Construction Ltd. management, the bank estimated that it was probable that it would receive only 75% of the 2023 balance at maturity. A note payable is a written agreement between a lender and a borrower.
Time Value of Money
- In Canada, the accounting for notes payable issued at a discount is governed by the International Financial Reporting Standards (IFRS) as adopted in Canada.
- For example, in case 1, Ng Corporation agreed to pay $6,245 in 3 equal annual payments for a total of $18,935 in the future.
- As a result, statutes have increasingly required fuller disclosure (“truth in lending”) and, in some cases, outright limits on certain practices.
- An interest-bearing note is a promissory note with a stated interest rate on its face.
- For instance, underwriters buy bonds issued by governments or corporations and accept responsibility for marketing them to investors.
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 discount on notes payable 1 through June 30). The face of the note payable or promissory note should show the following information.
- In scenario 1, the principal is not reduced until maturity and interest would accrue for the full five years of the note.
- National Company prepares its financial statements on December 31, each year.
- If the lender can reasonably estimate the impaired cash flows an entry is made to record the debt impairment.
Perseverance and Time Management: Achieving Balance in a Busy World
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 $1,000 of total interest expense would need to be recorded partially in one period and partially in another.
Notes Payable Issued at a Discount
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.
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.
Advantages and Disadvantages of Discount Notes
In the following example, a company issues a 60-day, 12% interest-bearing note for $1,000 to a bank on January 1. 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.
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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.
Short-Term Note Payable – Discounted
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.
