Confirming Pages
SUPPLEMENT 10D
SUPPLEMENT 10D INSTALLMENT NOTES PAYABLE
Installment Notes Payable
1
Learning Objective 10-S4
Pages 436–437 of Chapter 10 described how to account for promissory notes where the
amount borrowed (principal) is not repaid until the notes reach their maturity date. Because
the borrower pays only interest between the date of initial borrowing and its later maturity,
that type of note is known as an interest-only loan. In this chapter supplement, we describe a
different type of promissory note—an installment note—that is commonly used for student
loans, credit card loans, and home mortgages, as well as business loans.
Account for installment notes
payable.
Installment Notes
Like an interest-only note, an installment note requires the borrower to pay interest and principal to the lender over the note’s life to maturity. Unlike an interest-only note, however, an
installment note does not include a single “balloon” payment of principal at maturity because
principal is blended with interest within the payment made each period. In effect, the borrower makes an interest and principal payment each period, resulting in no liability for interest or principal after the final periodic repayment. The figure below illustrates a $60,000 loan
with 8% interest fully repaid in six equal annual installments.
$12,979
paid each
installment
$4,800
$60,000
principal
repaid in total
$8,179
$4,146
$8,833
Year 1
Year 2
Interest
Principal
$3,439
$9,540
Year 3
$2,676
$10,303
Year 4
$1,852
$11,127
Year 5
$961
$12,018
Year 6
Notice that each year’s installment payment is the same ($12,979), but the proportion
of interest decreases over the period while the proportion of principal increases. This pattern
occurs because the borrower repays some of the principal as part of each installment payment,
so multiplying the fixed interest rate by the remaining principal balance results in a smaller
dollar amount of interest in each following year.
You should be wondering how we determined the split between interest and principal
amounts shown above, as well as the amount of the equal annual payments of $12,979. All
amounts shown in the above figure were determined using basic spreadsheet calculations,
which are commonly depicted in a loan amortization schedule, as follows.
Year
1
2
3
4
5
6
Total
phi25915_ch10_SuppD_D1-D7.indd 1
Beginning Note
Payable
60,000
51,821
42,988
33,448
23,145
12,018
Interest Expense (8%)
4,800
4,146
3,439
2,676
1,852
961
17,874
Repaid Principal
on Note Payable
8,179
8,833
9,540
10,303
11,127
12,018
60,000
Ending Note
Payable
51,821
42,988
33,448
23,145
12,018
—
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2
SUPPLEMENT 10D
Installment Notes Payable
To create a loan amortization schedule yourself, you can use one of the thousands of loan
calculators available free online. For simple annual loan repayments, as in our example, try
the “loan calculator with annual payments” at mycalculators.com. After entering the original
principal amount ($60,000), number of years (6), interest rate (8.0), and compounding frequency (annual), click on the payment button. Within moments, the calculator will report that
an annual (rounded) payment of $12,979 fully repays the interest and principal by the end
of year 6. If you click on the button “view amortization schedule,” the loan calculator will
produce a table similar to that shown on page 1. Reading from left to right, our amortization
schedule shows the year of the loan, the amount owed at the beginning of the year, the interest
expense for a full year (calculated as 8% times the amount owed), the principal included in
the installment (calculated as the annual payment minus the interest portion), and the ending
loan balance (calculated as the beginning balance minus the repaid principal).
Of course, your knowledge of installment loans should not stop at merely generating
a loan amortization schedule. You also should understand the implications for a company’s
financial reporting. The amortization schedule indicates that, of the $12,979 annual payment,
the interest expense for the first year of the loan is $4,800 and the principal component is
$8,179. By repaying $8,179 of principal in the first year, the ending balance decreases by that
amount (to $51,821). Thus, in the second year, interest will be less ($51,821 3 8% 5 $4,146)
and the principal component will be larger ($8,833 5 $12,979 2 $4,146). Assuming the loan
was taken out on the first day of the fiscal year and the payment is made at year-end, the
following entries could be recorded at the end of years 1 and 2:
Year 1:
Debit
Interest Expense ....................................................................
Note Payable ...........................................................................
Cash ....................................................................................
Credit
4,800
8,179
12,979
(to record first annual installment payment)
Year 2:
Debit
Interest Expense ....................................................................
Note Payable ...........................................................................
Cash ....................................................................................
Credit
4,146
8,833
12,979
(to record second annual installment payment)
In reality, it’s unlikely that your company only establishes an installment loan on the
first day of the year and records interest on the last day of the year. Instead, installment
loans could start midyear and the company is likely to record interest monthly or quarterly
as well as at year-end. In this more realistic situation, the accounting is a little more complex. To illustrate, we will continue to use the information from the previous amortization
schedule, but we will assume the loan was taken out on September 1, 2015, and that
the company adjusts its records each quarter. The first payment does not occur until
August 31, 2016—one year after the loan is taken out—so the company will need to adjust
its records each quarter to show the interest expense that results from having had the loan
outstanding each quarter. The following timeline illustrates how the $4,800 of interest from
the amortization schedule for the first year of the loan would be allocated to the fiscal quarters to which it relates.
The timeline shows that, since the loan was taken out on September 1, 2015, it is outstanding only for one month before the end of the first financial statement reporting period.
Consequently, one-twelfth of the $4,800 will need to be recorded on September 30. Similarly,
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Confirming Pages
SUPPLEMENT 10D
Installment Notes Payable
3
three-twelfths of the $4,800 of interest will need to be reported during the quarterly periods
that end on December 31, March 31, and June 30. The final two-twelfths of the $4,800 ($800
2 3 $4,800) will be recorded when the first annual installment is paid on August 31, 2016.
5 ___
12
$4,800
Sept. 1, 2015
$400 $1,200
Sept. 30
$1,200
Dec. 31
Aug. 31, 2016
$1,200
Mar. 31
$800
June 30
Sept. 30
The journal entries to record on each of the preceding dates follow.
September 1, 2015—Receive the loan proceeds and establish the liability
Debit
Cash ........................................................................................
Note Payable ......................................................................
Credit
60,000
60,000
September 30, 2015—Accrue interest for a one-month period
Debit
Interest Expense ....................................................................
Interest Payable ....................................................................
Credit
400
400
1 3 $4,800 from amortization schedule)
(___
12
December 31, 2015 (and March 31 and June 30, 2016)—Accrue interest for a three-month period
Debit
Interest Expense ....................................................................
Interest Payable ....................................................................
Credit
1,200
1,200
3 3 $4,800 from amortization schedule)
(___
12
On March 31 and June 30, 2016, journal entries would be made identical to the one above
made on December 31, 2015. After doing so, the Interest Payable account would show a balance of $4,000 at June 30, 2016 ($4,000 5 $400 1 $1,200 1 $1,200 1 $1,200). The next date
for recording interest would occur when the first installment is paid on August 31, 2016. One
approach for recording the interest and the installment on August 31, 2016, is to accrue the interest owed from June 30 to August 31 (as follows in the first journal entry below) and then record
the $12,979 installment payment in a separate journal entry (in the second journal entry below):
August 31, 2016—Accrue interest and record the first installment payment
Debit
Interest Expense ....................................................................
Interest Payable ....................................................................
Credit
800
800
2 3 $4,146 from amortization schedule)
(___
12
Debit
Interest Payable .....................................................................
Note Payable ...........................................................................
Cash ....................................................................................
Credit
4,800
8,179
12,979
(to record first annual installment payment)
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4
SUPPLEMENT 10D
Installment Notes Payable
The steps for recording interest and installment payments in years 2–6 are identical to
that shown above for year 1, except that the amounts for annual interest and principal change
each year as shown in the amortization schedule. The following timeline shows how the year 2
interest would be allocated across the reporting quarters to which it relates. The first quarter
ended September 30, 2016, includes only one month of the $4,146 year 2 interest, which is
1 3 $4,146 5 $345.50 which rounds to $346). The quarters ended December 31,
$346 (___
12
3 3 $4,146 5
2016, and March 31 and June 30, 2017, include three months of interest each ( ___
12
$1036.50, which rounds to $1,036 or $1,037). The installment payment on August 31, 2017,
2 3 4,146 5 $691).
includes just two months of interest (___
12
$4,146
Aug. 31, 2016
Sept. 1, 2015
$400
$1,200
Sept. 30
$1,200
Dec. 31
$1,200
Mar. 31
$800 $346
June 30
Aug. 31, 2017
$1,036
Sept. 30
$1,036
Dec. 31
$1,037
Mar. 31
$691
June 30
Sept. 30
The journal entries to be made at the end of each quarter follow.
September 30, 2016—Accrue interest for a one-month period
Debit
Interest Expense ....................................................................
Interest Payable ....................................................................
Credit
345.50
345.50
1 3 $4,146 from amortization schedule)
(___
12
December 31, 2016 (and March 31 and June 30, 2017)—Accrue interest for a three-month period
Debit
Interest Expense ..................................................................
Interest Payable ..................................................................
Credit
1,036.50
1,036.50
3 3 $4,146 from amortization schedule)
(___
12
August 31, 2017—Accrue interest and record the second installment payment
Debit
Interest Expense ....................................................................
Interest Payable ....................................................................
Credit
691
691
2 3 $4,146 from amortization schedule)
(___
12
Debit
Interest Payable .....................................................................
Note Payable ...........................................................................
Cash ....................................................................................
Credit
4,146
8,833
12,979
(to record first annual installment payment)
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SUPPLEMENT 10D
Year
60,000
51,821
42,988
33,448
23,145
12,018
Interest Expense
8,179
8,833
9,540
10,303
11,127
12,018
60,000
Ending Note
Payable
51,821
42,988
33,448
23,145
12,018
0
287
Credit
4,800
4,146
3,439
2,676
1,852
961
17,874
Repaid Principal
on Note Payable
Debit
287
1
2
3
4
5
6
Total
Beginning Note
Payable
Quiz Answers
For the preceding loan established on September 1, 2015, show the journal entry that would
be recorded on September 30, 2017, assuming the proper entries were made through August
31, 2017. The amortization schedule is reproduced below for your convenience.
Interest Expense ..............................................
Interest Payable ...........................................
A Self-Study Quiz
1 3 $3,439 5 $286.58, which rounds to $287).
(___
12
How’s it going?
5
Installment Notes Payable
Reporting Interest and Notes Payable on the Financial Statements
As you first learned in Chapter 4, most companies report interest expense on the income statement as a nonoperating expense. That is, it is included below the Income from Operations
line. Interest Payable is reported on the balance sheet as a current liability because it is paid
each time the company makes an installment payment. As discussed on pages 440–441, the
principal owed on a note payable is split between current and noncurrent liabilities on the balance sheet. The current portion includes the principal component of the installment that will
be paid during the next 12 months and the noncurrent portion includes all other remaining
principal to be paid on the note. The following financial statement excerpts show how the interest and liabilities for the note in our preceding example would be reported on December 31,
2016, in the year-end income statement and balance sheet.
Income Statement for the Year Ended Dec. 31, 2016
Sales Revenue
Cost of Goods Sold
Gross Profit
Selling and General Expenses
Other Operating Expenses
Income from Operations
Interest Expense
Income before Taxes
Income Tax Expense
Net Income
$100,000
60,000
40,000
22,000
3,000
15,000
4,582*
10,418
2,605
$ 7,813
8 3 $4,800) 1 (___
4 3 $4,146)]
* $4,582 5 [(___
12
12
phi25915_ch10_SuppD_D1-D7.indd 5
Balance Sheet at Dec. 31, 2016
Current Liabilities
Accounts Payable
$25,000
Interest Payable
1,382**
Current Portion of Note Payable
8,833
Total Current Liabilities
35,215
Note Payable (long-term)
42,988***
** $1,382 5 $346 1 $1,036
*** $42,988 5 $9,540 1 $10,303 1 $11,127 1
$12,018 (from amortization schedule)
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6
SUPPLEMENT 10D
Installment Notes Payable
MINI-EXERCISES
LO 10-S4
M10-18 (Supplement 10D) Interpreting an Amortization Schedule
The following amortization schedule indicates the interest and principal that Chip’s Cookie Corporation (CCC) must repay on an installment note established January 1, 2015. CCC has a December 31 year-end and makes the required annual payments on December 31. Use the amortization
schedule to determine (a) the amount of the (rounded) annual payment; (b) the amount of interest
expense to report in the year ended December 31, 2015; (c) the note payable balance at January 1,
2018; and (d) the total interest and total principal paid over the note’s entire life.
Year
Beginning Note Payable
1
2
3
4
Total
LO 10-S4
30,000
23,040
15,732
8,059
Interest Expense
Repaid Principal
on Note Payable
1,500
1,152
787
401
3,840
6,960
7,308
7,673
8,059
30,000
Ending Note
Payable
23,040
15,732
8,059
0
M10-19 (Supplement 10D) Preparing Journal Entries from an Installment Note
Amortization Schedule
Refer to M10-18. Prepare CCC’s required journal entries on (a) January 1, 2015; (b) December 31,
2015; (c) December 31, 2016; (d) December 31, 2017; and (e) December 31, 2018.
LO 10-S4
M10-20 (Supplement 10D) Using an Online Calculator to Produce and Interpret an
Amortization Schedule
Access an online loan calculator with annual payments, such as the one at mycalculators.com, to
produce an amortization schedule for Welton Corp.’s installment note that has original principal of
$25,000, interest of 6% compounded annually, and a term of 3 years. (a) What is the annual payment (rounded to the nearest dollar)? (b) Of this amount, how much represents interest in year 1
(rounded to the nearest dollar)? (c) How much principal is included in the year 1 payment (rounded
to the nearest dollar)? (d) How much interest is included in the year 2 payment (rounded to the
nearest dollar)? (e) Over time, has the interest become a smaller or larger component of the annual
payment?
LO 10-S4
M10-21 (Supplement 10D) Preparing Journal Entries from an Installment Note
Amortization Schedule
Refer to M10-20. Welton Corp. established the note on the first day of its fiscal year and will fully
repay the note by the end of year 3 on its December 31 fiscal year-end. Prepare Welton Corp.’s
journal entries on (a) January 1, Year 1; (b) December 31, Year 1; (c) December 31, Year 2; and (d)
December 31, Year 3. Round amounts in Years 1 and 2 to the nearest dollar. In Year 3, ensure the
rounded amounts eliminate the Note Payable balance and maintain the same annual cash repayment.
EXERCISES
LO 10-S4
LEVEL
UP
E10-17 (Supplement 10D) Interpreting an Amortization Schedule
and Preparing Journal Entries
The following amortization schedule indicates the interest and principal to be repaid on an installment note established January 1, 2015, for a company with a March 31 year-end.
Year
1
2
3
4
Total
phi25915_ch10_SuppD_D1-D7.indd 6
Beginning Note Payable
10,000
7,645
5,196
2,649
Interest Expense
Repaid Principal
on Note Payable
Ending Note
Payable
400
306
208
106
1,020
2,355
2,449
2,547
2,649
10,000
7,645
5,196
2,649
0
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SUPPLEMENT 10D
Installment Notes Payable
7
Required:
1.
2.
Assuming the company makes the required annual payments on December 31, use the amortization schedule to determine (a) the amount of the (rounded) annual payment; (b) the amount
of Interest Expense to report in the year ended March 31, 2015; (c) the amount of Interest
Expense to report in the year ended March 31, 2016; (d) the Note Payable balance at January 1,
2018; and (e) the total interest and total principal paid over the note’s entire life.
Assuming the company makes adjustments at the end of each quarter, prepare the journal
entries required on (a) January 1, 2015, and (b) March 31, 2015.
GROUP A PROBLEMS
PA10-9 (Supplement 10D) Generating an Amortization Schedule
and Preparing Journal Entries
LO 10-S4
Cucina Corp. signed a new installment note on January 1, 2015, and deposited the proceeds of
$50,000 in its bank account. The note has a 3-year term, compounds 5% interest annually, and
requires an annual installment payment on December 31. Cucina Corp. has a December 31 yearend and adjusts its accounts only at year-end. Round calculations to the nearest dollar.
Required:
1.
2.
3.
Use an online application, such as the loan calculator with annual payments at mycalculators.
com, to generate an amortization schedule. Enter that information into an amortization schedule with the following headings: Year, Beginning Note Payable, Interest Expense, Repaid
Principal on Note Payable, and Ending Note Payable.
Prepare the journal entries on (a) January 1, 2015, and December 31 of (b) 2015, (c) 2016, and
(d) 2017.
If Cucina Corp.’s year-end were March 31, rather than December 31, what adjusting journal
entry would it make for this note on March 31, 2015?
GROUP B PROBLEMS
PB10-9 (Supplement 10D) Generating an Amortization Schedule
and Preparing Journal Entries
LO 10-S4
Zarina Corp. signed a new installment note on January 1, 2015, and deposited the proceeds of
$15,000 in its bank account. The note has a 2-year term, compounds 4% interest annually, and
requires an annual installment payment on December 31. Zarina Corp. has a March 31 year-end
and adjusts its accounts quarterly. Round calculations to the nearest dollar.
Required:
1.
2.
3.
4.
5.
Use an online application, such as the loan calculator with annual payments at mycalculators.
com, to generate an amortization schedule. Enter that information into an amortization schedule with the following headings: Year, Beginning Note Payable, Interest Expense, Repaid
Principal on Note Payable, and Ending Note Payable.
Prepare the journal entry on January 1, 2015.
Prepare the adjusting journal entry to accrue interest on March 31, 2015.
Assuming the journal entry from requirement 3 also is recorded on June 30, September 30,
and December 31, 2015, prepare the journal entry to record the first annual installment payment on December 31, 2015.
Calculate the amount of interest expense that should be accrued for the quarter ended March 31,
2016.
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