Definition: A discount on notes payable occurs when the note’s face value is greater than its carrying value. The difference between the greater face value and the lesser carrying value is considered the discount. It represents the added interest that must be paid over the life of the note.
There are many examples of discounted note, but zero interest notes are most common. These notes are called zero interest, but they do carry an implicit interest rate figured into the face value of the note. Let’s take a look at an example.
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. In this situation, a stated rate of interest isn’t needed. The interest is built into the loan agreement and principle.
Discounted notes use the discount on notes payable account to record the discount and keep track of it was the note is repaid. The discount account is a contra liability account with a debit balance that reduces the recorded face value of the note to the actual amount received. As the note is paid off, the discount account will be amortized to interest expense over the life of the note.
What Does Discount on Notes Payable Mean?
In our earlier example, the company would debit cash for $9,000, credit notes payable for $10,000, and debit discount on notes payable for $1,000. The $1,000 discount is reported with the note on the balance sheet to reduce its carrying price to the $9,000 amount borrowed.
What are Notes Payable?
Notes payable are liabilities and represent amounts owed by a business to a third party. What distinguishes a note payable from other liabilities is that it is issued as a promissory note.
With a promissory note, the business who issued the note (called the issuer) promises in writing, to pay an amount of money (principal and interest) to a third party (called the payee) at a given time or on demand.
The face of the note payable or promissory note should show the following information.
Information shown on a Note Payable
- Issuer or Maker: The person or business who promises to repay the principal and interest.
- Payee: The person or business who the note is payable to.
- Principal or face value: The amount being borrowed.
- Term of note: The amount of time the borrower has to repay the note.
- Issue date: The date on which the promissory note is written.
- Interest rate: The fee charged fro the use of the money; stated as a percentage of the principal.
- Maturity date: The due date on which the note is payable.
Notes Payable on Balance Sheet
Short term notes payable are due within one year from the balance sheet date and classified under current liabilities in the balance sheet, long term notes payable have terms exceeding one year and are classified as long term liabilities in the balance sheet.
Note Payable Example Journal Entry
A business will issue a note payable if for example, it wants to obtain a loan from a lender or to extend its payment terms on an overdue account with a supplier. In the first case the note payable is issued in return for cash, in the second case they are issued in return for cancelling an accounts payable balance.
Issued for Cash
In notes payable accounting there are a number of journal entries needed to record the note payable itself, accrued interest, and finally the repayment.
Suppose for example, a business issues a note payable for 15,000 due in 3 months at 8% simple interest in order to obtain a loan, then the total interest due at the end of the 3 months is 15,000 x 8% x 3 / 12 = 300.
The first journal is to record the principal amount of the note payable.
The debit is to cash as the note payable was issued in respect of new borrowings.
Issued to Extend Payment Terms
Had the note payable been issued in respect of an overdue supplier account in order to extend the terms of payment, then this would have converted an accounts payable to a note payable, and the debit would be to accounts payable as follows:
In this case the note payable is issued to replace an amount due to a supplier currently shown as accounts payable, so no cash is involved.
As the notes payable charge interest, each month interest of 300 / 3 = 100 needs to be accrued. At the end of the 3 month term the total interest of 300 would have been accrued.
Finally, at the end of the 3 month term the notes payable have to be paid together with the accrued interest, and the following journal completes the transaction.
Discount on Note Payable
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. Sometimes notes payable are issued for a fixed amount with interest already included in the amount. In this case the business will actually receive cash lower than the face value of the note payable.
Suppose for example, a business issued a note payable for 14,600 payable in 1 year and received cash of 13,744. The 14,600 is the total amount to be repaid and interest assumed to be included in this amount is 14,600 – 13,744 = 826.
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.
The present value of the notes payable is calculated using the present value formula PV = FV / (1 + i%)n, where FV = future value, in this case 14,600, i% = the interest rate, say 6% and n = the term in years, in this case 1 year.PV = FV / (1 + i%)n PV = 14,600 / 1.06 = 13,774
The note payable would be recorded as follows:
|Discount on note payable||826|
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.
Each month a portion of the discount on the note payable is charged as an interest expense. In the example above, the amount is 826 / 12 = 69 per month.
|Discount on notes payable||69|
At the end of the term, all the discount is included as an expense in the income statement, the balance on the discount on notes payable account is zero, and the balance on the notes payable account is paid.
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