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Discounted Notes in Financial Accounting

In the example in the section "Interest-bearing notes", Random Enterprises borrowed $10 million by signing an interest-bearing note. Suppose that the note did not require periodic payments of interest. Instead, assume that Random Enterprises signs a note on January 1, 2000, promising to pay the lender $10 million in two years, and will not make periodic interest payments. In this case, the lender will be unwilling to provide Random the full $10 million face value of the note. No one is willing to loan money without interest and all long-term financing arrangements involve interest, even if it is not separately identified and paid periodically.

If a prospective lender instead invested some smaller amount (as yet to be determined) for two years to earn 12%, that initial investment would grow to $10 million by the end of 2001. How much would a lender be willing to loan in return for Random’s noninterest-bearing note? To answer this question, we must discount the note. Random Enterprises will receive only the present value of the note, computed at the current lending rate of 12%. The present value of the note is $7,970,000, computed as follows:

In other words, if the prospective lender instead deposited $7,970,000 at the beginning of 2000 in a bank account for two years to earn 12% per year, the initial deposit would grow to $10 million by the end of 2001. For this reason, lenders would be unwilling to loan more than $7,970,000 for Random Enterprise’s note. As a result, Random Enterprises must issue the note at a discount of $2,030,000 ($10,000,000 - $7,970,000).

The discount on Random’s note payable represents the interest that is associated with this transaction. It should be recognized as interest expense by Random Enterprises over the two-year term of the note. The discount also represents interest income to the lender over the same period. In each year, the amount of interest to be recognized is 12% of the value of the note at the start of the year. The yearly amounts of interest are calculated as follows:

Notice that the amount of interest expense increases between 2000 and 2001. This occurs because Random Enterprises makes no interest payment to the lender in 2000. As a result, the amount of the loan increases to include the unpaid interest. In other words, the lender is earning compound interest (interest on interest) in 2001. These events would affect Random Enterprise’s financial statements in the following manner.

The receipt of cash from the lender at the beginning of 2000 in exchange for Random’s note payable will increase cash and noncurrent liabilities:

Interest expense during 2000 and 2001 will decrease retained earnings and increase the reported value of noncurrent liabilities:

On January 1, 2001, the carrying value of the note is $8,926,400 ($7,970,000 + $956,400). In 2001, interest is again added to the loan balance:

On December 31, 2001 (the maturity date of the note), the carrying value of the note has been increased to $10,000,000 ($8,926,400 + $1,073,600). This amount is eliminated, and the lender is paid cash of $10 million.

The net result of these transactions is that slightly less than $8 million has been borrowed and used by Random Enterprises for two years, and interest expense of slightly more than $2 million has been incurred for the privilege of using the $8 million for two years. In the end, Random has repaid $10 million, which included both principal and interest.

Noncurrent Liabilities Topics

Long-Term Notes Payable

Bonds Payable (Long-Term Bonds Payable)

Financial Reporting for Income Taxes