What are Installment Notes?
Installment notes are liabilities and represent amounts owed by a business to a third party, like notes payable, they are issued as a promissory note.
The distinguishing feature of installment notes is that they are repayable by regular periodic installments throughout the term. Each installment payment is of an equal amount and includes the interest payment calculated on the outstanding balance of the note, and a part repayment of the principal amount.
As each installment payment is made, the balance outstanding on the note is reduced and as a result the interest charge starts to fall. Since each installment payment is a fixed amount, the principal repaid increases with each payment.
Installment Note Example
As the principal and interest are changing with each installment payment, when accounting for installment notes it is necessary to first calculate the amount of interest and principal repaid for a particular accounting period.
To see this in action, suppose a business borrows 40,000 at the start of an accounting period (January 1) by signing a 5% installment note that is to be repaid in 4 annual end of year payments of 11,280. The first payment is due at the end of the accounting period (December 31).
The first step is to calculate the interest and principal repayments for each accounting period by using an amortization table as shown below.
Installment Notes – Amortization Table
|Year 1||Year 2||Year 3||Year 4|
|Interest at 5%||2,000||1,536||1,049||537|
The principal repayment is simply the difference between the fixed installment and the interest. For example, the principal repayment in year 1 is 11,280 – 2,000 = 9,280 as shown.
The amortization table clearly shows how with each installment payment, the opening balance outstanding reduces, the interest expense reduces, and the principal repayment increases.
The installment notes journals can now be generated as follows:
Installment Notes – Issue of New Borrowing Journal
The first journal is to record the issue of the new borrowing.
The debit is to cash as the installment note was issued in respect of new borrowings, and cash is received by the business. The credit entry represents a liability of the business to repay the note in accordance with the terms agreed. In the balance sheet, the installments notes will either be current or long term liabilities depending on whether or not the amount outstanding is due within one year.
Installment Notes – Repayment Journals
The subsequent journals at the end of each year, record each installment payment split between interest and principal in accordance with the amortization table shown above.
The debit to interest represents the interest expense for the year, the debit to installment notes is the repayment of the principal amount outstanding, and the credit to cash represents cash leaving the business to make the payment.
At the end of year 4, the final payment reduces the principal balance of the installment notes to zero, and the liability is extinguished.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.