Calculating Discounts on Notes Payable

A note payable is a written agreement between a lender and borrower. Notes payable are thus promissory notes that spell out the terms of the loan, including payment schedules and interest rates. A note payable has a par or face value, which is the amount the borrower must repay when the note matures. Only interest payments are typically due on notes payable until maturity, as is the case with the bonds used as examples here. Borrowers sometimes receive less cash than the par value. When this occurs, the difference is called a discount.

Discounts on notes payable can arise for several reasons. The discount may be part of a contractual agreement. For instance, underwriters buy bonds issued by governments or corporations and accept responsibility for marketing them to investors. In return, the underwriter gets a discount. When market interest rates are higher than a bond’s interest rate, investors won’t pay the full par value, resulting in a discount. In some cases, the issuer of notes payable simply issues the securities at a discount. The Treasury Department does this with Treasury bills. T-bills don’t pay interest as such. Instead, investors pay a discounted price and receive the par value at maturity.

Calculating the dollar value of a discount is simply a matter of subtracting the par value from the amount of cash actually received by the borrower. Suppose a bond issuer gets $950 each for bonds with a par value of $1,000. Subtract $1,000 from $950 to get -$50. A discount on notes payable is expressed as a negative, because it represents an expense for the issuer.

When notes payable are issued at a discount, the effect is to increase the effective interest rate, because the lender both gets back more money than was originally lent and pays less for the same amount of interest. Suppose a $1,000 par value bond matures in 6 months and pays 4 percent interest. The bondholder will receive $20 in interest for the six-month life of the bond. However, if the bond price is discounted to $980, the bondholder will get an extra $20 at maturity for a total of $40 in earnings. Since the price was $980, divide $40 by $980 and double the result to find the effective annual rate of interest, which here works out to 8.16 percent.

For accounting purposes, discounts on notes payable are treated as an interest expense. The dollar amount of the discount is entered on the issuer’s books over the life of the note. Suppose a note payable for $1,000 is issued at discount price of $950 and pays 4 percent annual interest. The maturity is 5 years. Each year, the interest recorded is $40 plus one-fifth of the discount, or $10. This brings the interest expense to $50 per year.