Question

Explain why the following statement is false.

A zero-interest-bearing note payable that is issued at a discount will not result in any interest expense being recognized.

Answer 1

Interest-bearing and zero-interest-bearing notes payable: An interest-bearing note is a promissory note with a stated interest rate on its face. This note represents the principal amount of money that a lender lends to the borrower and on which the interest is to be accrued using the stated rate of interest

The note payable is a written promissory note in which the maker of the note makes an unconditional promise to pay a certain amount of money after a certain predetermined period of time or on demand. The purpose of issuing a note payable is to obtain loan form a lender (i.e., banks or other financial institution) or buy something on credit.

The companies usually issue notes payable when they:

• purchase merchandise or raw materials inventory from suppliers.
• acquire professional services from an individual or a firm.
• purchase plant, machinery, equipment, furniture or some other fixed assets.
• obtain loan from banks or other financial institutions.
• are required to issue a note as a substitution of a past-due account payable.

The notes payable are usually classified in two ways. These are:

• short-term and long-term notes payable and
• interest-bearing and zero-interest-bearing notes payable.

Interest-bearing and zero-interest-bearing notes payable:

An interest-bearing note is a promissory note with a stated interest rate on its face. This note represents the principal amount of money that a lender lends to the borrower and on which the interest is to be accrued using the stated rate of interest.

A zero-interest-bearing note (also known as non-interest bearing note) is a promissory note on which the interest rate is not explicitly stated. When a zero-interest-bearing note is issued, the lender lends to the borrower an amount of money which is less than the face value of the note. At maturity, the borrower is required to repay to the lender the amount equal to the face vale of the note. Thus, the difference between the face value of the note and the amount lent by the lender to the borrower is the interest charged by the lender. In other words, we can say that the borrower receives the amount equal to the present value of the note because the present value of a financial instrument is equal to the face value of the instrument less any interest or discount charged by the lender.

Important points to remember about discount on notes payable:

1. Timing of the fee or discount charged by the lender:
   In case of a zero-interest-bearing note, it is clear that the lender essentially receives its fee at the time of borrowing rather than at the date of maturity.
2. When the discount on notes payable is to be charged to expense:
   The amount of discount charged by the lender represents the cost of borrowing which must be expensed over the life of the note rather than at the time of obtaining the loan.
3. Impact of discount on notes payable on balance sheet:
   The discount on notes payable account normally has a debit balance because it is a contra account to notes payable account (a liability account). When financial statements are prepared, the balance of discount on notes payable account is deducted from notes payable in the balance sheet.