Accounting for a non-interest-bearing Note
How to Account for a Non-Interest Bearing Note
A non interest bearing note is a note that doesn’t require any interest payments. The interest of a non interest bearing note is deducted from the face value of the note at the time of issuing and after the maturity, the whole face value is repaid. Non interest bearing note is mostly great for children who are new to banking.
Example of a zero interest bearing note
Let’s say the company chocolate cucumbers issue a note promising to pay $25000, four years from today. Now here’s the catch, the note is going to be non-interest bearing which means the chocolate cucumbers is not going to have to make interest payments throughout the life of the note instead the note will be issued at a discount. What that means is this, chocolate cucumbers is promising to pay $25000 in four years, however, today when they’re borrowing the money they’re going to receive less than $25000. How much less than $25000? Well, we’re going to figure that out by discounting the $25000 face value to its present value.We’re going to do that using a discount rate that is the implicit interest rate on this note. In this example let’s say that it’s 7%.
So the amount the chocolate cucumbers is gonna receive is $19,072.38. I got that by just taking the present value of a single cash flow which is $25000 to be received four periods from now and then we had a discount rate of seven percent so $25000 divided by 1.07 to the fourth power. (If you’re not familiar with the time value of money I encourage you to check out the articles I have on the present value of a single cash flow).
What that means is this chocolate cucumbers is gonna promise to pay $25000 but they’re actually going to receive $19,072.38 today. The difference between the amount that they are promising to pay and the amount that they’re actually receiving is the discount in this example it’s $5927.62. Even though chocolate cucumbers is not making interest payments throughout the note, the difference between what they’re promising to pay and what they’re receiving is the interest.
Journal Entry for Non Interest Bearing Note
When they actually issue the note they’re gonna debit the cash account. The cash account is going to increase by $19,072.38 as we show before. Then we’ve got the discount, this is going to be debited $5927.62, and then we’re going to credit note payable for $25000.
Now at the end of year one you take the initial carrying value of the note which is $19,072.38, that’s going to change over time. So you take that and you multiply it by the implicit interest rate which in this case is 7%. So $19,072.38 times 7% gives you $1,335.07 which is the interest expenses recorded at the end of year one.
The company’s going to debit interest expense but they’re not going to credit cash because they’re not paying any interest. They’re going to reduce the discount on the note payable.