What is an Installment Note?

Installment Notes

An installment note Liability requiring a series of periodic payments to the lender. is an obligation requiring a series of payments to the lender. Installment notes are common for franchises and other businesses when lenders and borrowers agree to spread payments over several periods. To illustrate, assume that Foghog borrows $60,000 from a bank to purchase equipment. It signs an 8% installment note requiring six annual payments of principal plus interest and it records the note’s issuance at January 1, 2011, as follows.
 
 

Payments on an installment note normally include the accrued interest expense plus a portion of the amount borrowed (the principal). This section describes an installment note with equal payments.

Point: Most consumer notes are installment notes that require equal total payments.

The equal total payments pattern consists of changing amounts of both interest and principal. To illustrate, assume that Foghog borrows $60,000 by signing a $60,000 note that requires six equal payments of $12,979 at the end of each year. (The present value of an annuity of six annual payments of $12,979, discounted at 8%, equals $60,000; we show this computation in footnote 2 on the next page.) The $12,979 includes both interest and principal, the amounts of which change with each payment. Exhibit 14.14 shows the pattern of equal total payments and its two parts, interest and principal. Column A shows the note’s beginning balance. Column B shows accrued interest for each year at 8% of the beginning note balance. Column C shows the impact on the note’s principal, which equals the difference between the total payment in column D and the interest expense in column B. Column E shows the note’s year-end balance.

EXHIBIT 14.14 Installment Note: Equal Total Payments

 

Decision Insight Hidden Debt A study reports that 13% of employees in finance and accounting witnessed the falsifying or manipulating of accounting information in the past year (KPMG 2009). This is of special concern with long-term liabilities. For example, Enron violated GAAP to keep debt off its balance sheet. This concern extends to hidden environment liabilities. That same study reports 27% of employees in quality, safety, and environmental areas observed violations of environmental standards, which can yield massive liabilities. ▪

P5 Prepare entries to account for notes.

Although the six cash payments are equal, accrued interest decreases each year because the principal balance of the note declines. As the amount of interest decreases each year, the portion of each payment applied to principal increases. This pattern is graphed in the lower part of Exhibit 14.14. Foghog uses the amounts in Exhibit 14.14 to record its first two payments (for years 2011 and 2012) as follows:

 


 
 





Foghog records similar entries but with different amounts for each of the remaining four payments. After six years, the Notes Payable account balance is zero.²