Problem 10 - Accounting

Question

On the first day of the fiscal year, Hammond Company obtained a \( 44,000, seven-year, 5% installment note from Vegas Bank. The note requires annual payments of \)7,604, with the first payment occurring on the last day of the fiscal year. The first payment consists of interest of \(2,200 and principal repayment of \)5,404. a. Journalize the entries to record the following: 1\. Issued the installment notes for cash on the first day of the fiscal year. 2\. Paid the first annual payment on the note. b. Determine the amount of bond interest expense for the first year.

Step-by-Step Solution

Answer

1. Journalize note issuance: Debit Cash 44,000, Credit Notes Payable 44,000. 2. First payment: Debit Interest Expense 2,200, Debit Notes Payable 5,404, Credit Cash 7,604. 3. Bond interest expense for the first year is 2,200.

Step 1: Journal Entry for Issuance of Installment Note

When the Hammond Company receives cash from the bank by issuing the installment note, you need to record the cash received and the liability created by the note. The journal entry will be:- **Debit** Cash: \(44,000\)- **Credit** Notes Payable: \(44,000\)This shows that the company received cash and now has the obligation to pay back the note.

Step 2: Calculating Components of the First Payment

The first annual payment includes both the interest and principal repayment. You already know that:- Interest on the first payment is \(2,200\).- Principal repayment is \(5,404\).Thus, the total payment already given is \(7,604\).

Step 3: Journal Entry for First Annual Payment

When the first payment is made, record both the payment of interest and the reduction in liability. The journal entry will be:- **Debit** Interest Expense: \(2,200\)- **Debit** Notes Payable: \(5,404\)- **Credit** Cash: \(7,604\)This shows that cash is credited for the total payment while the interest and principal accounts are debited appropriately.

Step 4: Determine Bond Interest Expense for the First Year

The bond interest expense for the first year is the amount of interest paid during the year. Given that the first payment included an interest component of \(2,200\), the bond interest expense for the first year is **\(2,200\)**.

Key Concepts

Installment Note

An installment note is a financial agreement whereby the borrower agrees to repay the principal amount plus interest over a set period. This type of note is popular for financing purchases, as it allows companies to spread out payments rather than pay a lump sum. It typically comprises of several equal payments that are due annually or monthly, and each payment includes both a portion of the principal and interest.
Unlike a standard loan, where only the interest is paid initially and the principal is paid at the end, an installment note requires both to be paid together regularly. The structure helps the borrower to slowly pay off the debt while the lender earns interest income over the life of the note.
When an installment note is first issued, the journal entry records the entire cash received as a debit to the cash account and a credit to the notes payable account. This demonstrates the increase in cash and the corresponding liability. In our exercise, Hammond Company recorded a credit entry of $44,000 to Notes Payable to reflect the liability incurred.

Bond Interest Expense

Bond interest expense represents the cost of borrowing funds, calculated as a percentage of the outstanding principal balance. It is a critical component in understanding the financial obligation that comes with borrowing long-term funds. For installment notes, the interest expense is usually determined by applying the stated interest rate to the outstanding principal balance at the beginning of the period.
For the fiscal year in question, the Hammond Company had an outstanding principal of $44,000 with a 5% interest rate. Hence, the interest expense for the first year amounted to $2,200.
It is crucial to note that the interest expense will decrease over time as the principal balance decreases due to partial repayments included in each installment. Therefore, understanding bond interest expense helps in budgeting and managing cash flows.

Principal Repayment

Principal repayment is the portion of the installment payment that goes towards reducing the original amount borrowed. It directly impacts the outstanding liability, as it decreases the notes payable balance. In every installment payment, a portion is designated to cover interest, while the remaining amount reduces the principal.
In the context of Hammond Company's transaction, the first annual payment included a principal repayment of $5,404.
Accounting for principal repayment accurately is vital because it affects the balance sheet, reducing the liability and ultimately lowering future interest expenses. Accurate recording and tracking ensure fiscal responsibility and credibility for the borrowing company in the financial markets. Furthermore, consistent principal repayments improve a company's creditworthiness over time.

• Reducing liability reflects on the balance sheet.
• Ensures disciplined debt management.
• Helps in easing future financial burden.