Installment Notes

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.

Furthermore a 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 Payment 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.

By way of illustration 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. As can be seen the first payment is due at the end of the accounting period (December 31).

Firstly calculate the interest and principal repayments for each accounting period by using an amortization table as shown below.

Installment Notes – Amortization Table

As can be seen 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.

Furthermore the amortization table clearly shows how with each installment payment, the opening balance outstanding reduces, the interest expense reduces, and the principal repayment increases.

Following this the installment notes journal entries can now be generated as follows:

Issuing an Installment Note for Cash Journal

Firstly record the issue of the new borrowing.

As can be seen the debit is to cash as the installment note was issued in respect of new borrowings, and cash is received by the business. Furthermore 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 Payment Journal Entry

Subsequently the journals at the end of each year record each installment payment split between interest and principal in accordance with the amortization table shown above.

As can be seen 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.

Finally at the end of year 4, the final payment reduces the principal balance of the installment notes to zero, and the liability is extinguished.