In the example in the section “Interest-bearing notes”, Random Enterprises borrowed $10 million by signing an interest-bearing note. Suppose that the note did not require periodic payments of interest. Instead, assume that Random Enterprises signs a note on January 1, 2000, promising to pay the lender $10 million in two years, and will not make periodic interest payments. In this case, the lender will be unwilling to provide Random the full $10 million face value of the note. No one is willing to loan money without interest and all long-term financing arrangements involve interest, even if it is not separately identified and paid periodically.
The discount on Random’s note payable represents the interest that is associated with this transaction. It should be recognized as interest expense by Random Enterprises over the two-year term of the note. The discount also represents interest income to the lender over the same period. In each year, the amount of interest to be recognized is 12% of the value of the note at the start of the year.