Accounting for Non-Interest Bearing Note

Non-interest bearing notes are usually short-term debt instruments that offer no interest to lenders. The return on investment for investors comes through a discount at the par value of these notes.

The accounting treatment for these non-interest bearing notes is similar to zero-coupon bonds for issuers. It’s important to calculate the effective interest rate or discount for proper bookkeeping purposes.

What Are Non-Interest Bearing Notes?

A non-interest bearing note is a debt instrument that has no documented interest rate. Thus, the borrower has no legal obligation to pay interest payments periodically.

In practice, these non-interest notes carry implicit interest rates. It means although there is no declared interest rate, the interest on the face value of the note does exist.

These notes can be short-term promissory notes or long-term bonds. Long-term bonds with no interest rates are also commonly used, these are also called zero-coupon bonds.

The non-interest bearing notes are usually short-term in nature and recorded under current liabilities for the borrowers.

These notes are issued at a discount to par value to attract investors. The difference between the face or par value and the par value of a note is the cumulative interest for the term of the note.

If the issuer of a non-interest bearing note does not offer a discount to investors, they wouldn’t invest in these notes. So, like any other short-term debt instruments, these are also marketable securities.

How Do Non-Interest Bearing Notes Work?

Borrowers use non-interest bearing notes to fetch quick and short-term investments usually.

A borrower looking for alternative debts other than commercial loans will typically issue these notes with no interest rates.

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Issuers of these notes will specifically design discounts to par value that equal or exceed the market interest rates effectively. Investors can then retain these notes to maturity and earn the difference as interest or sell them quickly for short-term gains.

As these notes near their maturity term, their face value decreases as there is little time to earn interest. So, the longer the maturity date of these notes higher the demand in the market.

It also means that these notes do carry interest rates implicitly. The difference in the par value and face value of these notes is practically compounded interest for investors.

This way, the issuer does not need to pay periodic interest payments. However, the issuer must repay the full value of the notes to investors at maturity.

Accounting for Non-Interest Bearing Notes

When a borrower issues non-interest bearing notes, they must be recorded in the accounts books by using the imputed interest rate technique.

Both parties may agree to a hypothetical (usually market interest rate) interest rate for easier calculations. The other way is to simply describe the face value of the note as a percentage discount to the par value.

For instance, a short-term promissory note with a par value of $10,000 can be offered to investors at 90% of the par, meaning at a 10% discount.

Once both parties know the par and book values of the non-interest bearing note, they can then use the present value formula to calculate the effective interest rate even when it is not given.

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The journal entry to record the non-interest bearing note at the issue date will be:

AccountDebitCredit
Cash$XXX 
Discount to the Notes$XXX 
Notes Payable $XXX

The carrying value of these notes will be:

Notes Payable$XXX
Less: Discount to Notes($XXX)
Carrying Value of Notes$XXX

The issuer will need to amortize the notes over the maturity period for reporting purposes. If the notes are payable within a year, the reporting entity can record only one transaction.

AccountDebitCredit
Interest Expense$XXX 
Discount to the Notes $XXX

At maturity, the issuer will record the reversal entry for these notes:

AccountDebitCredit
Notes Payable$XXX 
Cash $XXX

Since there were no periodic interest payments, the issuer must repay the par value of the notes to the investors at maturity.

Example

Suppose a borrower company Blue Star Co. issues a short-term non-interest bearing note with a par value of $1 million at a 7% discount rate and with a one-year maturity date.

Let us do the accounting for the issuance of this short-term note for Blue Star Co.

  • Par Value = $1 million        
  • Discount = $70,000           
  • Carrying Value = $930,000

It means the total implicit interest for the issuer is $70,000 for one year. We can also use the present value formula to calculate the effective interest rate.

FV = PV * (1 + r)^n

Rearranging this formula for “r” will give us:

R =[(FV/PV)^1/n] – 1

R = [(1,000,000/930,000)^1/1] – 1 = 7.52%

The journal entry to record the issuance of the non-interest bearing note will be:

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AccountDebitCredit
Cash$930,000 
Discount to the Notes$70,000 
Notes Payable $1,000,000

The journal entry to record the interest expense will be:

AccountDebitCredit
Interest Expense$70,000 
Discount to the Notes $70,000

At maturity, Blue Star Co. will record the following journal entry:

AccountDebitCredit
Notes Payable$1,000,000 
Cash $1,000,000

This transaction will reduce the assets and liabilities equally at redemption of the non-interest bearing notes.

Pricing Issues for Non-Interest Bearing Notes

Since there is no explicit interest rate associated with these notes, pricing them can be tricky.

For a starting point, both parties can agree to use the market interest rate for similar securities with the same features.

Then, the present value formula can be used to calculate the present value of the non-interest bearing note with the maturity period in mind.

Suppose a borrower issues a non-interest bearing note with a par value of $1 million due after one year. The market interest rate for similar debt instruments is 10%.

Then using the present value (PV) formula, we can calculate the current value of this note by:

FV = PV ✕ (1 + r)^n

PV = FV/(1+r)^n = 1 million/(1+10%)^1

PV = 9,090,909.

So, both parties can use this price as a starting point. However, since this price value equals the return on other similar marketable securities, investors will look for further discounts.

Therefore, the issuer will offer a further discount on this price to attract investors. That will effectively raise the implicit interest rate of the note as well.

Importantly, the implicit interest rate is different from the discount rate offered on the par value of the note. Both terms do not represent the same value for investors.

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