Accounting for Non-Interest & Interest-Bearing Notes

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  • 0:03 The Dilemma
  • 1:04 Interest-Bearing Notes
  • 2:38 Non-Interest Bearing Notes
  • 5:16 Comparing Notes
  • 5:38 Lesson Summary
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Lesson Transcript
Instructor: Douglas Stockbridge

DJ Stockbridge is currently pursuing a Masters degree in Accounting.

In this lesson, you will learn how to account for interest-bearing and non-interest bearing notes. We will walk through the journal entries as we try and decide which bank, First National Bank or Ordinary Bank, we wish to borrow money from to start a food truck business.

The Dilemma

''We have to decide within the next hour!'' shouted Liz, your business partner. She had just burst through the door of the coffee shop. It was 2:00 PM. The one hour deadline meant you had until just 3:00 PM to decide which bank you would lend money from to start your food truck business. You and Liz had been planning this business for a while. She is a fantastic chef, and you are pretty good with numbers. Earlier in the day, Liz visited two local banks about lending money to help you buy a food truck.

Liz told both banks you need to borrow $10,000 to pay back in 9 months. First National Bank said they will lend you the $10,000 at 12% interest through an interest-bearing note; it's due with a maturity date of July 1 (9 months from today). Ordinary Bank also agreed to lend you the money, but they insisted the note be non-interest bearing. If you decide to go with them, you will need to pay $10,900 on July 1 at an implied interest rate of 11%. You are the numbers person. Which bank should you lend the money from?

Interest-Bearing Notes

In this situation, the best way to compare the two offers is to write some accounting entries. Let's first start with the interest-bearing note from First National Bank. If you borrow the money starting today, you will receive $10,000 and will record a liability, or a note payable, to reflect the fact. As the months go on, you will accrue interest. This basically means you have use of the $10,000 and need to pay 'rent' for it.

In our case, this 'rent' is called interest. The 12% interest rate the bank stated is an annual rate. If the note payable remained outstanding for 1 year (or 12 months) your interest expense for that year would be $10,000 x 12% x 12/12 = $1,200. But if you pay it back in 9 months instead of 12, you would multiply $10,000 x 12% x 9/12 = $900. In this situation, on July 1, 2016, you will pay the bank back the $10,000 you borrowed and include $900 in interest expense for a total cash payment of $10,900.

The journal entries for the interest-bearing note look like this:

Accounting for an interest bearing note

On Oct. 1, 2015, your balance sheet will show $10,000 of cash and $10,000 of notes payable. The income statement will have nothing recorded because no time has passed for the interest to accrue.

On June 30, 2016 (the following year), your balance sheet will show $10,900 of cash and $10,000 of notes payable. The income statement will have $900 of interest expense accrued, which will lower your net income.

Non-Interest Bearing Notes

Now, let's explore the Ordinary Bank and their non-interest bearing note. They are asking you to pay them $10,900 in 9 months. The implied interest rate is 11%. You first must figure out how much cash you'll receive from them today (Oct. 1). To do this, you take $10,900 and subtract it by a discount on note payable.

Even though the bank is not charging you direct interest, there is an implicit interest rate because they will give you slightly less than $10,900 today. It's like asking your brother for money. If you ask him for $100 today and say that you will return $100 in 20 years, he won't be happy. If you gave him back $300 in 20 years, he may lend you the money. There is an implicit interest rate in this transaction - $200. This compensates him for that fact that you will have the $100 and he will not.

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