## Friday, 26 October 2012

### LOAN REPAYMENT METHODS

When money is lent, is is done in two ways.

Equal Interest Method

1. The principal is expected to be repaid at the end of the loam term. Regular equal interest payments are done at a specified interest. This done in loans like some collateralised loans (eg: gold loan), company loans like bonds etc. Loans can be made with or without a discount/premium.

for eg: suppose a loan is given for an amount of \$50000, for 5 yrs with an interest of 10%

jan 1 19x1

notes receivable          50000
cash                                                        50000

dec 31

cash                                10000
interest receivable                             10000

dec 31 19x5

cash                                10000
interest receivable                             10000

cash                                50000
notes receivable                                 50000

WITH DISCOUNT

Consider a bond issued at a rated interest of 4%. Since the market rate prevailing is 5%, the 1% difference has to be compensated to the lender by issuing the bond at a discount in order to compensate the 1% difference. This is illustrated in the following example..

The bond of \$100000 par is issued at a rated interest of 4%, with a maturity period of 8 periods and the market rate is 5%. The interest payment of \$4000 has to be paid to the lender, because that is what is mentioned in the bond. But in order to compensate the 1%, the bond is issued at a discount

We find the present value of the principal by finding the present value of the principal and the payments at the actual interest rate which is the market rate ie at 5% for 8 periods..

Present value of \$100000 @ 5% int for 8 years+ the present value of all the \$4000 payments (8 payments)
= \$93552.

This means that when we finally pay the \$100000 and the 8 payments of \$4000  after 8 years has only a real value for the lender of \$93552. But he needs to get his \$100000 at the end of the period. The interest payment of \$4000 is only to maintain the value of his \$10000 at the end of the period. In order to compensate for the deficit of \$6448, the lender is allowed to lend only \$93552 in the beginning and is assured to be paid with \$100000 at the end of the term.
So at the date of receipt of cash, the entry is

cash                                93552
discount                            6448
bond payable                                        100000

At this point the amount liable to the lender is only \$93552. (whatever he has paid if there is no prepayment charge)

Now when the first interest which has to be paid in cash according to the bond conditions, payed at 4% after 1 year, the entry is

interest expense              4000
cash                                                        4000

But we have to pay 5% ie at the market rate of \$93552 ( this was the actual amount liable at the beginning of the year ). This will amount to \$4678. But since \$4000 has already been paid, the amount to be paid is only \$678. This \$678 is added to the amount to be paid ie \$93552 instead of paying in cash and the actual amount to be paid at the end of the period is calculated as \$ 94230.  The entry is

interest expense               \$678
discount                                                  \$678

Now the amount payable at the end of the year to the lender is increased to \$100000-\$5770=\$94230. The balance of the various accounts at the end of the year is

Bond payable                                 \$100000
minus discount                                ( \$5770 )
Net liability in the balance sheet       \$94230

At this point if the loan is closed, then the cash given is only \$94230 ( if there is no loan pre payment charge)

Bond payable                   \$100000
discount                                                  \$5770
cash                                                       \$94230

The complete table of payments is given below

 Interest Period Interest Paid (4% of Par) Interest Expense (5% of Book Value) Amortisation Discount Balance Book Value Issue date \$4000 ------------------- ------------------- 6448 93552 1 4000 4678 678 5770 94230 2 4000 4712 712 5058 94942 3 4000 4747 747 4311 95689 4 4000 4784 784 3527 96473 5 4000 4824 824 2703 97297 6 4000 4865 865 1838 98162 7 4000 4908 908 930 99070 8 4000 4930 930 0 100000

Here the discount is also AMORTIZED over the period.

If bond of \$100000 is issued @4% for 8 years and the market rate is only 3%, then we are over compensating the lender by 1%. In order to compensate for this extra interest payment to the lender, we issue the bonds at the premium.

By applying the same logic in a discount situation, the present value of \$100000 and and \$4000 interest at the actual rate of 5%= \$106980. This additional \$6980 is a premium we demand from the lender to compensate for the additional 1% interest we give him.

cash                             106980
bond payable                                   100000

At this point the amount liable to the lender is \$106980 ( if there is no prepayment charge)

Now when the first interest which has to be paid in cash according to the bond conditions, payed at 4% after 1 year, the entry is

interest expense              4000
cash                                                        4000

But we have to pay only 3% ie at the market rate of \$106980 ( this was the actual amount liable at the beginning of the year ). This will amount to \$3209. But since \$4000 has already been paid, the amount to be retrieved bakc is \$791. This \$791 is subtracted to the amount to be paid ie \$106980, instead of paying in cash and the actual amount to be paid at the end of the period is calculated as \$ 106189.  The entry is

interest expense                                                  \$791

Now the amount payable at the end of the year to the lender is decreased to \$100000+\$6189=\$106189. The balance of the various accounts at the end of the year is

Bond payable                                 \$100000
Net liability in the balance sheet       \$106189

At this point if the loan is closed, then the cash given is only \$106189 ( if there is no loan pre payment charge)

Bond payable                   \$100000
cash                                                       \$106189

The complete table of payments is given below

 Interest Period Interest Paid (4% of Par) Interest Expense (5% of Book Value) Amortisation Discount Balance Book Value Issue date \$4000 ------------------- ------------------- 6980 106980 1 4000 \$3209 791 6189 106189 2 4000 3186 814 5375 105375 3 4000 3161 839 4536 104536 4 4000 3136 864 3672 103672 5 4000 3110 890 2782 102782 6 4000 3083 917 1865 101865 7 4000 3056 944 921 100921 8 4000 3079 921 0 100000

Here the premium is amortised over the period.

Equated Periodic Installments or Diminishing Interest Method.

WITHOUT DISCOUNT

2. The principal is expected to be received in installments along with the interest. This is normally done in loans like personal loans, vehicle and home loans etc

eg:  a loan is made for an amount of  \$25000 for 3 years, the interest is 10% and the principal and the interest is expected to be paid in equated yearly installments with first installment to be paid initially.

This is an annuity due situation. To find the annuity payments, we divide the principal \$25000 by the annuity due for \$1.

25000/2.73554= 9139

for loan

notes receivable          25000
cash                                                          25000

for the first payment received at the beginning of the first year,

cash                                   9139
notes receivable                                          9139

by the end of the year, an interest is accrued on the remaining notes receivable, which is recorded as an interest revenue as

notes receivable                1586
Interest revenue                                          1586

This process is repeated every year until the note is completely received. The interest revenue account gets accumulated with all the interest revenues of each year.

The full table of transactions in each accounts is given below

 Date Payment Interest Change in Receivable Balance of Receivable Yr 1 Beginning ----------------------- ---------------------- ---------------------- \$25000 Yr 1 Beginning \$9138.96 ---------------------- \$(9138.96) 15861.04 Yr 1 end ----------------------- \$1586.10 1586.1 17447.14 Yr 2 beginning 9138.96 ------------------------ (9138.96) 8308.18 Yr 2 end ----------------------- 830.82 830.82 9139.00 Yr 3 beginning 9138.96 ----------------------- (9138.96) -0-(rounded)

Here a few points may be noted

1. In the Equal Interest Method, the interest payments are all equal in amount and the principal outstanding always stands the same.

2. In the Equated Periodic Installment method, the payment amount always is the same every period.

3. The component which goes to the principal always increases when the payments progress, while the interest component always decreases. This is evident from the table of payments in the example.

WITH DISCOUNT

A bond like discount is never given in cases of equated periodic installments. This is because, only bonds are issued at a discount or premium to the par value, in order to compensate or get compensated for the difference in interest rate from the market rate.

There are situations where the loan incurred will be with a discount in a equated periodic installment situation.

For example

Suppose a machine is bought from a dealer for an amount of \$10000, and the dealer agrees to get paid in 5 equal installments, then a discount situation arises. On the face of it, this is a transaction in which the dealer does not charge interest on the delayed payments in installment and we might be surprised why he forfeits a portion of his profits in the decaying value of his payment. But he should have more than made up for it in marking up the price of the machine at the time of sale.

In order to estimate how much he might have possibly marked up in order to make up for the apparently forfeited interest, we find the present value of the payments with the imputed rate.

If the rate we use is 10%, present value of \$2000 for 5 periods is \$7582

Now we can see that there is a \$2418 loss for the dealer in interest had he not marked up the price of the machine by the same amount. So we make belief that has has done so and believe that he compensates the loss in the interest by amortizing the discount as seen below

The entry when the machine is delivered is

machine                   7582
discount                   2418
notes payable                           10000

At this point if the machine is returned the dealer will have to give only \$7582 at the maximum

At the end of the year, for the installment payment

notes payable           2000
cash                                          2000

At the end of the year to compensate the dealer, we add the interest onto the amount we owe him (\$7582) which is a non cash payment.

interest exp                 758
discount                                      758

Now the amount we owe him increases to   \$8430. The amortization table is given below

 Date Payment Change in net payable (payable-discount) Balance of net payable Interest on the net payable in one year Change in net Payable (payable-discount) Balance of net payable Yr 1 Beginning ------------- ------------- ------------- -------------- \$(2418) \$7582 Yr 1 end \$2000 \$(2000) \$5582 \$758.2 \$758.2 6340.2 Yr 2 end 2000 (2000) 4340.2 634.02 634.02 4974.2 Yr 3 end 2000 (2000) 2974.2 497.4 497.4 3471.6 Yr 4 end 2000 (2000) 1471.6 347.2 347.2 1818.8 Yr 5 end 2000 (2000) (182) 182 182 -0-

### INVENTORY ACCOUNTING IN CONSTRUCTION BUSINESS

Two methods are generally used to recognise revenue for a construction business, the completed contract method and the percentage of sales method. In both cases, the revenue is recognised vem before the delivery of the product, if it is reasonably assured that the payment and its schedule by a buyer is reasonably assured.

In both methods, an inventory account called construction in process CIP, similar to the work in process account is used. This account is similar to COGS account used in a merchandise company when using the perpetual inventory method.  Some major difference are elucidated below.

1. In the construction industry, as the revenue is recognised before delivery, whenever a construction cost is incurred, it is debited to the CIP account, and credit goes to all the accounts utilised in the construction like cash, accounts payable, raw material inventory etc.
As the construction progresses, the total cost of construction gets accumulated in the CIP account. Whereas, when the cost of the goods sold gets debited to the COGS account, the credit goes only to the merchandise inventory. This is because, the cost of sales in a merchandise company consists of only the procured goods, while that of the construction industry consists of raw materials, labour and various other products and service costs.

For eg:

Construction in progress       xxx
Various acc                                             xxx

2. The construction in progress account is debited whenever a construction cost incurs, billing may or may not happen simultaniously. The billing is mostly done according to a schedule. COGS account (in the perpetual inventory system) is debited whenever a sale happens. The billing for construction which is treated as a contra account to CIPS is recorded as follows

accounts receivable                 xxx
billing on construction                        xxx

3. In completed contract method, the CIP is closed into the billing on construction and a gross income is derived same as the COGS, which is closed into the sales account to derive a gross income at the end of the construction, before delivery. But, if it is found out that the construction will end up in a loss ie of CIPS will be greater than the billings, then the loss is immediately booked and placed into the CIPS as follows.

If the CIPS acc balance is \$50000, and billings total comes to \$60000 then

billing on construction        60000
Construction in progress                      50000
income on construction                        10000

If the CIPS acc balance is \$50000 and billings comes to \$40000 then

Loss on construction           10000
construction in progress                      10000

Now the balance on CIPS is \$40000. At the end of the construction,

billing on construction        40000
Construction in progress                      40000

4. In percentage of completion method, all the costs and billings are done exactly as for the completed contract method. But the gross income is not recognised in bulk at the end of the construction, but accrued each year, according to an estimate. This estimated income becomes a part of the income statement each year, out of which various other expenses are subtracted to arrive at a net income. The estimated income is based on costs incurred thus far, total estimated cost of construction, estimated gross profit, previous year's income.
The estimated income each year is again placed onto the CIP account by debiting the CIP account and crediting the income from construction account which forms the part of income statement. The estimated income each year adds up to the total income. Thus the estimated income gets accumulated in the CIP account, making the CIP account equal to the accumulated billing on construction account. At the end of construction, both the CIP and the billing on construction account is closed into each other.

When a loss is calculated, it is placed into the CIP along with the deletion of previous accumulated estimated incomes.

Suppose the estimated income for the final  year of construction is \$10000, CIP account balance at the beginning of the final year is \$40000 and the billing on construction balance is \$50000 then

CIPS                                            10000
income from construction                       10000

At the end of construction

billing on construction         50000
Construction in progress                          50000

Suppose if the construction took 4 years to complete, the estimated income recognised for the first 2 years is \$10000 and \$25000. The total accumulated CIP at the beginning of the 3rd year is \$50000.  Therefore the actual construction cost till the end of 2 years is only \$15000. Suppose a total loss of \$5000 is calculated instead of a profit, ie the billing can be done only for \$10000, then

loss from construction         \$40000
CIP                                                                   \$40000

billing from construction     \$10000
CIP                                                                   \$10000

This means, since the actual loss is only \$5000, the previous incomes recognised  in the first two years of total \$35000 has to be reversed.
Hence the \$40000 loss from construction.