DEFINITION of Unearned Discount
An unearned discount is interest or a fee that has been collected on a loan by a lending institution but has not yet been counted as income (or earnings). Instead, it is initially recorded as a liability. As the life of the loan progresses, proportionate parts of the fee or interest collected up front are removed from the liability side of the balance sheet and counted as income. If the loan is paid off early, the unearned interest portion must be returned to the borrower.
Also called unearned interest.
BREAKING DOWN Unearned Discount
An unearned discount account recognizes interest deductions before being classified as income earned throughout the term of the outstanding debt. Over time, then, the unearned discount creates an increase in the lender's profit and a subsequent decrease in liability.
Example of unearned discount
Snuffy's Bank and Trust has made a loan to Ernie's Brokerage. As part of the up-front costs of the loan, Erinie was required to pay a financing charge of 6% of the total loan amount. The total loan amount is $10,000 and will be repaid over 5 years in monthly installments. The amount of the finance charge paid up front by Ernie was $600. Initially Snuffy's Bank and Trust records the $600 unearned discount as a liability on its books. As Ernie pays each of the 60 loan payments (12 per year for 5 years), 1/60th of the $600 will be removed from the liability side of the balance sheet and recognized as income.