Reading: Lesson 4 - Short-term financing through notes payable

A company sometimes needs short-term financing. This situation may occur when (1) the company's cash receipts are delayed because of lenient credit terms granted customers, or (2) the company needs cash to finance the buildup of seasonal inventories, such as before Christmas. To secure short-term financing, companies issue interest-bearing or non interest-bearing notes.

Interest-bearing notes To receive short-term financing, a company may issue an interest-bearing note to a bank. An interest-bearing note specifies the interest rate charged on the principal borrowed. The company receives from the bank the principal borrowed; when the note matures, the company pays the bank the principal plus the interest.

Accounting for an interest-bearing note is simple. For example, assume the company's accounting year ends on December 31. Needham Company issued a USD 10,000, 90-day, 9 percent note on 2009 December 1. The following entries would record the loan, the accrual of interest on 2009 December 31 and its payment on 2010 March 1:

Non interest-bearing notes (discounting notes payable) A company may also issue a non interest-bearing note to receive short-term financing from a bank. A non interest-bearing note does not have a stated interest rate applied to the face value of the note. Instead, the note is drawn for a maturity amount less a bank discount; the borrower receives the proceeds. A bank discount is the difference between the maturity value of the note and the cash proceeds given to the borrower. The cash proceeds are equal to the maturity amount of a note less the bank discount. This entire process is called discounting a note payable. The purpose of this process is to introduce interest into what appears to be a non interest-bearing note. The meaning of discounting here is to deduct interest in advance 

Needham credits Notes Payable for the face value of the note. Discount on notes payable is a contra account used to reduce Notes Payable from face value to the net amount of the debt. The balance in the Discount on Notes Payable account appears on the balance sheet as a deduction from the balance in the Notes Payable account. Over time, the discount becomes interest expense. If Needham paid the note before the end of the fiscal year, it would charge the entire USD 225 discount to Interest Expense and credit Discount on Notes Payable. However, if Needham's fiscal year ended on December 31, an adjusting entry would be required as follows:

This entry records the interest expense incurred by Needham for the 30 days the note has been outstanding. The expense can be calculated as USD 10,000 X 0.09 X 30/360, or 30/90 X USD 225. Notice that for entries involving discounted notes payable, no separate Interest Payable account is needed. The Notes Payable account already contains the total liability that will be paid at maturity, USD 10,000. From the date the proceeds are given to the borrower to the maturity date, the liability grows by reducing the balance in the Discount on Notes Payable contra account. Thus, the current liability section of the 2009 December 31, balance sheet would show:

When the note is paid at maturity, the entry is:

The T-accounts for Discount on Notes Payable and for Interest Expense appear as follows:

In Exhibit 3, we compare the journal entries for interest-bearing notes and noninterest-bearing notes used by Needham Company.

Exhibit 3: Comparison between interest-bearing notes and noninterest-bearing notes