Accounting for Advanced Accruals

The amount of discount is recorded in a separate contra liability account called Discount on Notes Payable. The balance in this account is subtracted from the Notes Payable account to arrive at the book value of Notes Payable. In our example, the amount of Notes Payable is $5,000 and the amount of Discount on Notes Payable is $350. Therefore, the book (carrying) value is calculated as follows:

Illustration 6-26: Book (carrying) value of a discount note

Liabilities
Notes Payable	$5,000
Less: Discount on Notes Payable	(350)
Carrying Value of Liability	$4,650

At the end of period 20X7, Safe Life must record interest accrued for 8 months (from May to December). A monthly interest is calculated by dividing the total amount of discount ($350) by 12 months: $350 / 12 = $29.17. Accordingly, the amount for 8 months is $233.3 = $29.17 x 8. We recognize the interest expense (decrease equity) and, at the same time, increase liabilities. The increase in liabilities is accomplished by reducing the contra liability account Discount on Notes Payable. The adjusting entry removes the $233.3 of interest from Discount on Notes Payable and records it in the expense account. Thus, $116.7 ($350 - $233.3) is left in the Discount on Notes Payable account. Recall that before the entry was made, the Discount on Notes Payable account had a $350 balance, and, therefore, the total liabilities were $4,650 ($5,000 - $350). However, after the adjusting entry is made, the total liabilities are increased. Now the discount amount balance is $116.7 and as a result, the total liabilities are $4,883.3 ($5,000 - $116.7). Liabilities have increased. See below for the summary of balances before and after recording the interest expense for 8 months:

Illustration 6-27: Book (carrying) balances before and after recording interest expense

	Before Interest Expense	After Interest Expense	Difference
Notes Payable	$5,000	$5,000	0
Less: Discount on Notes Payable	(350)	(116.7)	233.3
Carrying Value of Liability	$4,650	$4,883.3	233.3

The process of converting discounts on notes payable to interest expense over a specified period of time is called discount amortization.

The effect of discount amortization for 8 months is shown below:

Illustration 6-28: Effect of discount amortization in the horizontal model

Event No.

Assets

Liabilities

Equity

Rev.

Exp.

Net Inc.

Cash Flow

n/a

233.3

(233.3)

n/a

(233.3)

n/a

T-accounts (without a closing entry) of the discount note example are presented here:

Illustration 6-29: T-accounts for the discount amortization process

Assets	=	Liabilities		+	Equity
Cash		Notes Payable			Interest Expense
(1) 4,650			(1) 5,000		(2) 233.3
Bal. 4,650			Bal. 5,000		Bal. 233.3

		Discount on Note
		Payable
		(1) 350	(2) 233.3
		Bal. 116.7

6.7.2 Illustration #2 of accounting for discount bonds

We are moving to the next accounting period (20X8). Recall that in 20X7 we only recorded interest expense for 8 months and the maturity term of the note is 1 year. Thus, in period 20X8 we need to recognize 4 more months of interest expense. The adjusting entry acts to increase liabilities (reduce the discount account to zero) and decrease equity (by increasing the Interest Expense account):

Illustration 6-30: Effect of discount amortization in the horizontal model

Event No.

Assets

Liabilities

Equity

Rev.

Exp.

Net Inc.

Cash Flow

n/a

116.7

(116.7)

n/a

(116.7)

n/a

Note that the total liabilities are $5,000 now:

Notes Payable	$5,000
Less: Discount on Notes Payable	(0)
Carrying Value of Liability	$5,000

Finally, at the note maturity date (April 31, 20X8), settlement for the face value of the note is made. The face value includes both the principal ($4,650) and interest ($350):