Problem 11 - Accounting

Question

On January 1, 2010, Guiado Company obtained a \(140,000, 10-year, 11% installment note from Best Bank. The note requires annual payments of \)23,772, beginning on December 31, 2010. Journalize the entries to record the following: 2010 Jan. 1 Issued the notes for cash at their face amount. Dec. 31 Paid the annual payment on the note, which consisted of interest of \(15,400 and principal of \)8,372. 2019 Dec. 31 Paid the annual payment on the note, which consisted of interest of \(2,353 and principal of \)21,419.

Step-by-Step Solution

Answer

Guiado Company issued a note and made annual payments reducing both interest and principal over the term.

Step 1: Recording Note Issuance Entry

On January 1, 2010, Guiado Company issued a $140,000 note for cash. The entry involves debiting the Cash account and crediting the Notes Payable account for the note's face value. **Journal Entry:** - **Debit:** Cash: 140,000 - **Credit:** Notes Payable: 140,000

Step 2: Recording the First Annual Payment

For December 31, 2010, we have an annual payment of $23,772 which includes $15,400 in interest and $8,372 in principal. The interest portion is recorded as Interest Expense and the principal portion reduces the Notes Payable. **Journal Entry:** - **Debit:** Interest Expense: 15,400 - **Debit:** Notes Payable: 8,372 - **Credit:** Cash: 23,772

Step 3: Recording the Annual Payment in 2019

On December 31, 2019, the annual payment of $23,772 includes $2,353 in interest and $21,419 in principal. This entry involves debiting Interest Expense and Notes Payable, and crediting Cash. **Journal Entry:** - **Debit:** Interest Expense: 2,353 - **Debit:** Notes Payable: 21,419 - **Credit:** Cash: 23,772

Key Concepts

Notes Payable

When a company borrows money, it often creates what is known as a "note payable." This is essentially an agreement between the borrower and the lender. In our example, Guiado Company borrows $140,000 from Best Bank. Here are a few key points to understand:

• **Legal Obligation:** A note payable represents a legal obligation for the borrower to repay the designated amount of money, often with interest, to the lender.
• **Documentation:** This transaction is formalized through a written document called a promissory note, which outlines the loan details, including the amount borrowed, interest rate, repayment schedule, etc.
• **Balance Sheet Impact:** In the financial statements, the note payable will initially be recorded as a liability. This indicates that the company has an obligation to pay back the borrowed funds.

Understanding notes payable is crucial because it explains how companies manage their debt obligations and how these are recorded in the accounting books.

Interest Expense

Interest expense can be thought of as the cost of borrowing money. When you take a loan, it's not free; you have to pay interest, which represents the lender's compensation for the risk of lending out their money. Here's what you need to know:

• **Accumulation over Time:** Interest is calculated based on the outstanding principal balance over a specific period. In the first year, Guiado Company pays $15,400, which decreases as they pay back more principal over time.
• **Impact on Income Statement:** Interest expense is recorded on the income statement and represents a business cost, reducing the company's net income.
• **Variable Costs:** As we can see from the exercise, the amount of interest paid can change each year. As the principal decreases, so does the interest.

Keeping track of interest expense is an important part of financial planning, helping businesses understand their true borrowing costs.

Accounting for Installment Notes

Installment notes are loans where the borrower repays in periodic payments, typically monthly or annually. Each payment includes both interest and principal. This differs from bullet loans, where the borrower repays the interest periodically and the entire principal at the end of the loan. Here's a deeper look:

• **Amortization Schedule:** This is a table that details each payment on an installment note over time. It shows how much of each payment goes towards interest and how much goes towards reducing the principal.
• **Decreasing Interest Payments:** Over time, as the principal decreases with each payment, the interest part of each payment also decreases. This was seen in the 2010 versus 2019 payments for Guiado Company.
• **Principal Reduction:** A key feature of installment notes is that with every payment, the principal amount is reduced, which means the borrower becomes less in debt over time.

Properly accounting for installment notes is crucial for maintaining accurate financial records and managing cash flows effectively.