Long-Term Liabilities

Installment Notes

Installment notes are long-term liabilities that carry interest costs and must be paid back at specific points in time, typically in equal payments.

Installment notes are issued similarly to regular notes payable. An installment note is a long-term liability that is to be paid in set payments at specific points in time. However, the amortization schedule becomes important in showing the breakdown and changes in what the regular, fixed payment covers. Although the payments are in equal amounts, each payment of an installment note pays for a reduction in principal and a portion of interest. These payments can be scheduled to show the breakdown, known as an amortization schedule. Installment notes differ from bonds in that an installment loan is only equal payments while a bond has a face value to be settled at the end. Mortgages and car loans are common examples of installment notes, as both involve equal payments across the life of the loan that could be 5 years for a car and 30 years for a mortgage.

Suppose Al's Airplane Company has a $15,000,000 installment note upon which equal payments must be made after years 1, 2, and 3. Assume the annual interest is at a rate of 4%. The time value of money for annuities formula can be used to determine the amount of the three payments.
PMT=[r×PV]/[1(1+r)n{\rm{PMT}}=\lbrack{r}\times{\rm{PV}}\rbrack/\lbrack1-(1+r)^{-n}
In this case, r is the rate of interest at the annual rate, PV is $15,000,000, and n is 3.
PMT=[0.04×$15,000,000]/[1(1.04)3]PMT=$600,000/(1(0.888996359))PMT=$5,405,228\begin{aligned}\rm{PMT}&=\lbrack0.04\times\$15\rm{,}000\rm{,}000\rbrack/\lbrack1-(1.04{)^{-3}\rbrack}\\\rm{PMT}&=\$600\rm{,}000/(1-(0.888996359))\\\rm{PMT}&=\$5\rm{,}405\rm{,}228\end{aligned}
An amortization schedule is established.

Installment Note Amortization Table

PMT Payment Principal Interest Ending Principal Balance
Year 1 $5,405,228 $4,805,228 $600,000 $10,194,772
Year 2 $5,405,228 $4,997,437 $407,791 $5,197,335
Year 3 $5,405,228 $5,197,335 $207,893

The amount of principal paid is greater with respect to each payment, particularly as one approaches the end of the installment repayment period. Likewise, interest decreases later in the life of the installment note. Although these calculations can be done by hand, many programs exist that can dramatically decrease the amount of work required to calculate an amortization schedule.

Al's Airplane Company would make journal entries for each payment.

Installment Note First Payment Entry

Date Account Debit Credit
End of year 1 Interest Expense $600,000
Notes Payable $4,805,228
Cash $5,405,228

Installment Note Second Payment Entry

Date Account Debit Credit
End of year 2 Interest Expense $407,791
Notes Payable $4,997,437
Cash $5,405,228

Installment Note Third Payment Entry

Date Account Debit Credit
End of year 3 Interest Expense $207,893
Notes Payable $5,197,335
Cash $5,405,228