Assume that Safe Life is a business specializing in security services. In 20X7 the company management decided to expand operations and hire more employees. To cover extra expenses, Safe Life issued a $5,000 face value discount note to the Companies Bank on May 1, 20X7. The note carried 7% discount rate and a 1-year term to maturity. In order to determine the amount of cash borrowed, we need to divide the face value into the principal and discount. The discount is computed by multiplying the face value by the interest rate by the time period. So, the discount equals: $350 = $5,000 x 7% x 1 period (year). The amount borrowed (principal) is determined by subtracting the discount from the face value. In our case, this amount is $4,650 (i.e., $5,000 - $350). We have come up with the principal of $4,650 and the discount of $350:

Illustration 24: Principal and discount amounts of a discount bond

To record the book value (also called carrying value) of the borrowing, assets (Cash) and liabilities (Notes Payable) are increased by $4,650. This is an asset source transaction:

Illustration 25: Effect of issuing a discount note in the horizontal model

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 26: Book (carrying) value of a discount note

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

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 28: Effect of discount amortization in the horizontal model

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

Illustration 29: T-accounts for the discount amortization process