A non interest bearing note is a debt for which there is no documented requirement for the borrower to pay the lender any rate of interest. If such a note were to be resold to a third party, the debt would be sold at a discount to its face amount, so that the third party purchaser would eventually realize a gain when it was redeemed by the borrower at its face amount.
If a non interest bearing note is a bond, the issuer is selling the bond at a deep discount and committing to pay back the face amount of the bond on its maturity date. This approach allows the issuer to avoid making periodic interest payments on the bond. Instead, all cash payment obligations by the issuer are concentrated at the maturity date of the bond.
The holder of a non interest bearing note should recognize imputed interest income on the instrument. This requires the following steps:
- Calculate the present value of the note, discounted based on the market rate of interest.
- Multiply the market rate of interest by the present value of the note to arrive at the amount of interest income.
- Record the interest income as a credit to interest income and a debit to an asset account for the investment in the note. Over time, the ongoing series of debits associated with the recognition of interest income will increase the asset amount to the face value of the note.
- When the issuer pays off the note, record a debit to cash and a credit to the asset account for the investment in the note.
The same approach is used by the issuer of the note, except that interest expense is recorded, and the value of a note payable liability account is gradually increased until such time as the debt is paid off at its face value.
A non interest bearing note is also known as a zero-coupon bond.