Discount on notes receivable definition
Suppose the company holds the note for 60 days before discounting it. After 60 days, the company has earned interest revenue of $73.97. My Accounting Course is a world-class educational resource developed by experts to simplify accounting, finance, & investment analysis topics, so students and professionals can learn and propel their careers. The articles and research support materials available on this site are educational and are not intended to be investment or tax advice. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly.
The $1,000 difference between the amount received and the amount owed is considered the discount. It also represents the amount of interest the company is paying the bank to borrow the $9,000 principle. Because they are perceived as safer investments, the amount an investor can earn with them is less compared to other investments. Higher-risk investments have the potential of offering investors a greater profit from the same principal investment, but they also carry a greater risk of loss as well.
Suppose that the same note in Example 1 is discounted on 1 April 20×2 instead of 15 May. This type of liability is not disclosed in the balance sheet but should be described in a footnote if it is material. For tax purposes, any gain made from the sale or redemption of the discount bond is treated as ordinary income up to the amount of the ratable share of the bond.
Understanding Discounted Notes
One of the advantages of discount notes is that they are not as volatile as other debt instruments. They are, therefore, perceived to be a safe investment for investors looking to preserve their capital in a low-risk investable security. The price discount received by the bondholder at maturity can also be taken as the imputed interest earned on the bond.
- As the note is paid off, the discount account will be amortized to interest expense over the life of the note.
- The purchase of discount notes may also prove to be advantageous for investors who would need access to the funds after a short period of time.
- The price discount received by the bondholder at maturity can also be taken as the imputed interest earned on the bond.
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A discount on notes receivable arises when the present value of the payments to be received from a note are less than its face amount. This difference is gradually amortized over the remaining life of the note, with the offset going to interest revenue. The discount rate is the annual percentage rate that the financial institution charges for buying a note and collecting the debt. The discount period is the length of time between a note’s sale and its due date. The discount, which is the fee that the financial institution charges, is found by multiplying the note’s maturity value by the discount rate and the discount period.
Accounting Principles I
A holder of a note can readily convert it to cash by discounting it at a bank, either with or without recourse. The term “discount” is used because the bank deducts the interest it charges from the note’s maturity value and thus discounts the note. The company records this transaction by debiting cash for $5,047.95, debiting interest expense for $26.02, crediting notes receivable for $5,000.00, and crediting interest revenue for $73.97.
The example entries show the credit being made directly to the notes receivable account, just as if the note had been collected. This approach is always appropriate if the discounting takes place without recourse. By discounting a note with recourse, the endorser has a contingent liability. A contingent liability is a possible liability that may or may not occur depending on some future event.
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It is possible to use notes receivable to obtain immediate cash. This is done by giving a discount on notes receivable to a bank or other lender prior to their maturity date. For notes discounted with recourse, the original holder is contingently liable for paying the note.
- Notes payable are debts a business owes to another company, usually a supplier or vendor.
- By discounting a note with recourse, the endorser has a contingent liability.
- If the note is not paid and was discounted without recourse, no further entry is needed.
His monthly payment is only one sixth of his earnings and his FICO score is 815. There was a survey done recently and you know what they found out? When you lose your job, you can’t make your house payment with your FICO score. Remember that next time somebody tells you you’ll never foreclose if you do your homework. You will foreclose if you’re investing consistently in notes over a long period of years.
Now, assuming the same facts as in Example 2, suppose that the note is assigned originally on 30 June 20×1. Never stop learning when it comes to protecting your hard-earned money and investing for your future. Finance Strategists is a leading financial literacy non-profit organization priding itself on providing accurate and reliable financial information to millions of readers each year. Disclosure of receivables, including footnote details (related-party receivables), are shown for Scott’s Liquid Gold Inc. below. To provide additional information, the debit could be recorded to an account entitled “Notes Receivable—Dishonored.”
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A discount note is a short-term debt obligation issued at a discount to par. Discount notes are similar to zero-coupon bonds and Treasury bills (T-Bills) and are typically issued by government-sponsored agencies or highly-rated corporate borrowers. This means that the company discounting the note, known as the endorser, guarantees the eventual full payment of its maturity value. The biggest issuers of discount notes are government-sponsored agencies, such as the Federal Home Loan Mortgage Corporation (Freddie Mac) and the Federal Home Loan Bank (FHLB). These agencies issue notes to investors as a way to raise short-term capital for different projects.
Given that most discounted notes are reviewed for their creditworthiness by both the bank and the endorser, contingent liability rarely turns into a real liability. Rather, they are usually referred to in the footnotes of the financial statements. If the maker pays the bank, the contingent liability will end; if the maker defaults, the contingent liability will become a real liability.
Discount notes do not offer investors periodic interest payments. Instead, investors purchase discount notes at a discounted price and receive the note’s face value (also called “par value”) at maturity. Discounted notes use the discount on notes payable account to record the discount and keep track of it was the note is repaid. The discount account is a contra liability account with a debit balance that reduces the recorded face value of the note to the actual amount received.
Anybody that tells you otherwise either thinks you are naive, or they are. We’re going to continue this series on notes, but I think that’s enough for today. Just as accounts receivable can be factored, notes can be converted into cash by selling them to a financial institution at a discount. Notes are usually sold (discounted) with recourse, which means the company discounting the note agrees to pay the financial institution if the maker dishonors the note.
As the note is paid off, the discount account will be amortized to interest expense over the life of the note. In addition, these debt instruments are considered safe investments due to the fact that they are backed by the full faith and credit of the U.S. government. The purchase of discount notes may also prove to be advantageous for investors who would need access to the funds after a short period of time. Discount notes have no periodic interest payments; the investor receives the note’s face value at maturity. For example, a one-year, $1,000 face value discount note purchased at issue at a price of $950, would yield $50 or 5.26% ($50/$950). A discount on notes payable arises when the amount paid for a note by investors is less than its face value.
The difference between the two values is the amount of the discount. This difference is gradually amortized over the remaining life of the note, so that the difference is eliminated as of the maturity date. The amount of this discount is especially large when the stated interest rate on a note is well below the market rate of interest.
So if that note is for $50,000 and you paid $40,000, that means you got a 20% discount on that note and yet, you’re receiving interest based on $50,000 even though you only have $40,000 in it. So if you were making, if that note called for 5% interest but you only have $40,000 invested, clearly you’re making more than 5%. So when you’re buying notes, and you’re buying them for your retirement income, there are many things you want to look at. One of them is what position that note possesses against that property. Now they have first position notes, those are the notes that I recommend.
Discount notes issued by Freddie Mac, for example, have maturities that range from overnight to one year. The notes are issued and maintained in book-entry form through the Federal Reserve Bank of New York, and investors may acquire the notes in denominations as small as $1,000. Most institutional fixed-income buyers will compare the yield-to-maturity (YTM) of various zero-coupon debt offerings with standard coupon bonds in order to find yield pickup in discount bonds. There are many examples of discounted note, but zero interest notes are most common.
If the maker fails to make the required payments, the bank will present the note to the endorser and demand full payment. Discounting means selling or pledging a customer’s notes receivable to the bank at some point prior to the note’s maturity date. Since the note’s due date is 30 days away, the bank’s discount is $63.01. The bank subtracts the discount from the note’s maturity value and pays the company $5,047.95 for the note.