Difficulty: Intermediate | Prerequisites: Chapter 13 (bonds payable), present value concepts, time value of money.
Long-term notes payable are a core debt instrument alongside bonds, and this chapter extends the bond-accounting logic you already know into notes with different structures: interest-bearing, non-interest bearing, and notes exchanged for assets or services. The unifying principle is that every long-term liability is valued at the present value of its future cash flows. If you are comfortable with present value calculations and basic bond journal entries, you have the foundation for everything here. This material feeds directly into Chapter 15 (leases) and any exam question involving debt valuation.
A long-term note payable is debt issued for cash, assets, or services, always valued at the present value of future cash flows. When a note carries the market interest rate, it is recorded at face value (no discount or premium). When a note carries no stated interest, it is issued at a discount and interest expense is recognised over its life using the effective interest method. When a note is exchanged for an asset whose fair value is unknown, the interest rate is imputed from comparable transactions.
Note payable
Debt issued in exchange for cash, assets, or services, reported on the balance sheet as a liability. In simple terms, it is a formal written promise to pay a specified amount at a future date, with or without periodic interest payments.
Present value of future cash flows
The amount a future payment is worth today after discounting it at an appropriate interest rate. Think of it as the price you would pay right now for the right to receive that future cash.
Stated (coupon) rate
The interest rate written on the face of the note, used to calculate the periodic cash interest payments. In simple terms, it is the rate the borrower agreed to pay in the contract.
Market (effective) rate
The rate of return lenders demand for notes of similar risk and maturity. When the stated rate equals the market rate, the note is issued at par (face value).
Non-interest bearing note
A note that makes no periodic cash interest payments. The borrower receives less than face value at issuance and repays the full face value at maturity. The difference is the implicit interest, sometimes called a zero-coupon note.
Implicit (effective) interest rate
The interest rate embedded in a non-interest bearing note, derived by solving for the discount rate that equates the present value of the face amount to the issue price. Think of it as the hidden cost of borrowing even though no interest cheques are written.
Discount on notes payable
A contra-liability account that represents the difference between the face value and the issue price of a note issued below par. It is amortised over the life of the note as interest expense.
Imputed interest rate
An interest rate assigned to a transaction when the stated rate is absent or unreasonable, based on rates for similar financing arrangements. In simple terms, if the deal does not spell out a rate, you look at what comparable deals charge and use that.
Amortisation schedule
A table that shows, period by period, how interest expense, cash payments, and the carrying amount of a note change over its life. Think of it as the debt's roadmap from issuance to maturity.
When a company borrows cash and signs a note at the market interest rate, the accounting mirrors a bond issued at par. There is no discount or premium because the stated rate equals what the market demands.
At issuance: the company debits Cash and credits Notes Payable for the face amount.
Interest payment dates: the company debits Interest Expense (stated rate x face amount) and credits Cash.
If the financial statement date falls between payment dates: the company accrues interest expense for the elapsed period, debiting Interest Expense and crediting Interest Payable.
At maturity: the company debits Notes Payable and credits Cash for the face amount, retiring the note.
The journal entries are identical to those for bonds issued at par. The key point is that when stated rate = market rate, the note's carrying value on the balance sheet equals its face value from day one through maturity.
Some notes carry no stated interest rate and make no periodic cash interest payments. Instead, they are issued at a deep discount to face value. The difference between the face value and the issue price is the total interest the borrower will recognise over the note's life.
If you know the face value, the issue price, and the term, you can solve for the implicit rate:
Face Value x PV factor = Issue Price
PV factor = Issue Price / Face Value
Look up (or solve for) the rate that produces that PV factor for the given number of periods.
Worked example: A 3-year, non-interest bearing note with a face value of $10,000 is issued for $8,890.
PV factor = 8,890 / 10,000 = 0.8890
This is the PV of $1 factor for n = 3, i = 4%.
The implicit effective annual interest rate is 4%.
Account | Debit | Credit |
|---|---|---|
Cash | 8,890 | |
Discount on Notes Payable | 1,110 | |
Notes Payable | 10,000 |
The $1,110 discount represents the total interest that will be recognised over three years.
Account | Debit | Credit |
|---|---|---|
Interest Expense | 356 | |
Discount on Notes Payable | 356 |
Interest expense = 4% x $8,890 (the opening carrying amount). No cash is paid. The debit to Interest Expense and credit to Discount on Notes Payable increases the carrying amount of the note.
Date | Cash Interest | Effective Interest | Amortisation of Discount | Outstanding Balance |
|---|---|---|---|---|
1/1/Year 1 | 8,890 | |||
12/31/Year 1 | 0 | 356 | 356 | 9,246 |
12/31/Year 2 | 0 | 370 | 370 | 9,615 |
12/31/Year 3 | 0 | 385 | 385 | 10,000 |
Notice how effective interest grows each year because the carrying amount (on which interest is calculated) increases as the discount is amortised. By maturity, the carrying amount equals the face value.
When a note is issued not for cash but in exchange for an asset or service, the transaction value is the more reliable of two measures:
The normal selling price of the asset or service in the market (the price at which it is ordinarily sold).
The present value of the note's future cash flows, discounted at the market rate for similar financing.
If equipment has a known selling price of $10,000 and the buyer issues a 3-year note for $10,000 at 4% annual interest (which equals the market rate):
Account | Debit | Credit |
|---|---|---|
Equipment | 10,000 | |
Notes Payable | 10,000 |
No discount is recorded because the stated rate on the note equals the market rate. Interest expense each year is simply $400 (4% x $10,000), paid in cash.
When the asset is custom-built or unique and has no observable market price, both the asset and the liability are valued at the present value of the note's future cash flows. An interest rate is imputed based on rates for similar financing arrangements.
Example, no interest payments: Company ABC agrees to pay $10,000 in 3 years for custom equipment, with no interest payments during the term. A market rate of 4% is imputed.
PV of $10,000 at 4% for 3 years = $8,890.
Account | Debit | Credit |
|---|---|---|
Equipment | 8,890 | |
Discount on Notes Payable | 1,110 | |
Notes Payable | 10,000 |
Both the asset and the liability are recorded at $8,890 (the present value). The $1,110 discount is amortised as interest expense over 3 years, exactly as with a non-interest bearing note for cash.
Example, with interest payments: Same custom equipment, but now with 4% annual interest paid at year-end alongside the $10,000 principal at maturity.
PV of $10,000 (n = 3, i = 4%) = $8,890
PV of ordinary annuity of $400 (n = 3, i = 4%) = $1,110
Total PV = $8,890 + $1,110 = $10,000
Account | Debit | Credit |
|---|---|---|
Equipment | 10,000 | |
Notes Payable | 10,000 |
Because the imputed rate equals the stated rate, there is no discount. This is the same result as Scenario 1 where the selling price was known.
Present value of a single sum: PV = FV x PV factor, where PV factor = 1 / (1 + i)^n
Implicit interest rate (non-interest bearing note): PV factor = Issue Price / Face Value, then look up the rate for the given n.
Interest expense (effective interest method): Interest Expense = Carrying Amount at Beginning of Period x Effective Interest Rate
Amortisation of discount: Discount Amortised = Interest Expense (calculated above), for a non-interest bearing note. For an interest-bearing note issued at a discount, Discount Amortised = Effective Interest Expense - Cash Interest Paid.
Present value of an ordinary annuity: Used when a note involves periodic equal payments (interest or installments). PV = Payment x PV annuity factor for the given i and n.
Non-interest bearing notes are common in vendor financing. A manufacturer might sell equipment to a buyer who cannot pay upfront, structuring the deal as a zero-interest note where the "interest" is baked into the price. The accounting here ensures the financial statements reflect the true economic cost of borrowing.
Imputed interest rates matter whenever a company acquires a custom-built asset through seller financing. Without an observable market price for the asset, the imputed rate determines both the value of the asset on the balance sheet and the interest expense recognised each period.
Students often think a non-interest bearing note involves no interest cost. It does. The interest is implicit in the discount, and the issuer must recognise interest expense every period.
Students sometimes record a non-interest bearing note at face value. The correct initial carrying value is the present value of the future cash flows (the issue price), not the face value.
When the fair value of an asset is unknown and an interest rate is imputed, students often forget to record the discount. If there are no cash interest payments, a discount is required to bring the note to its present value.
Students confuse the stated rate with the effective rate. They are only equal when the note is issued at par. When a note is issued at a discount, the effective rate is the implicit rate derived from the present value calculation.
The carrying value of a long-term liability on the balance sheet is the present value of future cash flows, discounted at the appropriate rate. This is a frequently tested concept.
Be prepared to calculate the implicit interest rate from a non-interest bearing note's face value and issue price.
Know how to construct and read an amortisation schedule for a non-interest bearing note: cash interest is zero, effective interest grows each period, and the outstanding balance walks up to face value.
When a note is exchanged for a unique asset, both the asset and the note are recorded at the PV of the note's future cash flows. The imputed rate comes from comparable transactions.
If the stated rate equals the market rate, there is no discount or premium, regardless of whether the note was issued for cash or for an asset.
True or False: A non-interest bearing note has zero interest cost to the borrower.
False. The interest is implicit in the discount.
Fill in the blank: The carrying value of a long-term note payable on the balance sheet equals the ______ of its future cash flows.
Present value.
True or False: When the stated rate on a note equals the market rate, the note is recorded at a discount.
False. It is recorded at par (face value).
Fill in the blank: When the fair value of an asset received in exchange for a note is unknown, the interest rate is ______.
Imputed.
True or False: In a non-interest bearing note's amortisation schedule, effective interest expense stays constant each period.
False. It increases each period because the carrying amount grows.
Q: A company issues a 3-year, non-interest bearing note with a face value of $50,000. The market rate for similar instruments is 6%. What is the initial carrying value of the note?
A: The initial carrying value is the present value of $50,000 discounted at 6% for 3 years. PV factor for n=3, i=6% is 0.8396. Carrying value = $50,000 x 0.8396 = $41,981. It must be less than $50,000 because there is a discount.
Q: In the example above, what journal entry does the issuer record at the date of issue?
A: Debit Cash $41,981, debit Discount on Notes Payable $8,019, credit Notes Payable $50,000.
Q: Equipment with a known selling price of $25,000 is purchased by issuing a 5-year note at 5% annual interest (which equals the market rate). How are the equipment and note recorded?
A: Debit Equipment $25,000, credit Notes Payable $25,000. No discount is recorded because the stated rate equals the market rate. The selling price is reliable and determines both values.
Q: What is the carrying value of a long-term liability on the balance sheet?
A: The present value of future cash flows, discounted at the appropriate (effective) rate. It is not the face value and not the current market value of the debt.
Q: A company issues a non-interest bearing note and records interest expense of $356 in the first year on a carrying amount of $8,890. What is the implicit rate?
A: 4%. Interest expense / carrying amount = 356 / 8,890 = 0.04 = 4%.
This material connects directly to Chapter 13 (bonds payable) because notes payable use the same effective interest method and present value framework. The only difference is the instrument: a note is a bilateral agreement with a lender, while a bond is typically sold to many investors. Mastering discount amortisation here prepares you for lease accounting in Chapter 15, where the same PV logic determines lease liabilities. The fair value hierarchy (Levels 1, 2, 3) introduced for note disclosure also applies to every financial instrument covered later in the course.
Note payable, long-term notes, non-interest bearing note, zero-coupon note, implicit interest rate, imputed interest rate, discount on notes payable, effective interest method, present value of future cash flows, amortisation schedule, contra-liability, notes issued for assets, notes issued for services, PV factor, PV of ordinary annuity, ACCTG 472, intermediate accounting, Chapter 14, Penn State.