Liabilities (2)

Preparing and using an Amortization Table, year-end balances and adjusting journal entries

On April 1, 2005, Mike's Bikes, Inc. signed a 5-year, $50,000 note payable to 6th National Bank in conjunction with the purchase of equipment. The note calls for interest at an annual rate of 8%, with payments of $ 1,013.82 per month starting May 1, 2005. The note is fully amortizing over a period of 60 months. The bank sent Mike an amortization table showing the allocation of monthly payments between interest and principal over the life of the loan. A small part of this amortization table is illustrated below.

In Chapter 7 we prepared a Bank Reconciliation to dertermine the correct Cash account balance. We also entered journal entries to correct any errors and journalize any unrecorded transactions.

In Chapter 10 we are going to verify the correct account balances for Notes Payable and Interest Payable, that is, the balance these accounts should be as of year-end on December 31. This is one of our standard and ordinary year-end procedures.

We determine correct loan and interest payable balances by creating an amortization table. We will write adjusting entries to bring the account balances into agreement with the amortization table.

Let's look at some journal entries over the life of a loan and see how they relate to the amortization table.

Journal entry to record the original note payable of $50,000 on April 1, 2005. We have increased Cash (Debit) and increased Notes Payable (Credit). No interest has accrued yet. Interest is related to time, so at least one day must pass before we can calculate (accrue) interest.

Date	Account	Debit	Credit
Apr-1	Cash	$50,000
	Notes Payable		$50,000
	To record 8% 60-month note with 6th National Bank

Monthly payments and principal balances

Interest calculation
Beginning Balance * Annual Interest Rate * Time Factor
$50,000 * 8% * 1/12 = $333.33

Principal payment = Payment amount - Interest
$1,013.82 - $333.33 = $680.49

Principal balance reduction
Beginning Balance - Principal payment = Ending Balance
$50,000 - $680.49 = $49,319.51

Journal entry to record the first monthly payment on this note, May 1, 2005, payment 1 from the amortization table above.

Date	Account	Debit	Credit
May-1	Notes Payable	$680.49
	Interest Expense	333.33
	Cash		$1013.82
	To record monthly note payment for May.

Balances at December 31, 2006 (year end)

Making Year-End Adjusting Journal Entries
Adjusting journal entries should be made to bring account balances to the correct amount before preparing financial statements. The Books are not always correct or accurate. This situation needs to be corrected at the end of the year, or anytime we need to prepare Financial Statements

At the end of each year we organize our adjusting entries on a Working Trial Balance (WTB) before preparing financial statements. You can see an example of the WTB in Comprehensive Problem 1, in your text. Let's look at an example of year-end adjusting entries.

Example - adjusting Notes Payable at year-end

Assume the following: We look at the WTB and see that the loan balance is recorded as a credit balance of $ 44,329.16. We compare this with our amortization table and see that the correct balance should be a credit balance of $ 44,427.38. We need to make an adjusting entry to bring the books to the correct balance.

In this case we need to credit Notes Payable for $ 98.22 to bring the books into agreement with the amortization table. In some cases we would have to debit Notes Payable. When do you think that would be the case? If an amortization table was used for each monthly loan payment, the books should agree with the amortization table, and no adjusting entry would be needed in that case.

What account should we debit? We must review the related journal entries for the year and see which accounts were debited and credited each month. In most cases we will make the adjustment to the Interest Expense account (look at the monthly entries above). In some cases we may find that a different account was used by mistake. We would correct that error as well, when making the year end adjustments. Let's assume that the only two accounts effected in this example are Notes Payable and Interest Expense. The adjusting journal entry would be.

Date	Account	Debit	Credit
Dec-31	Interest Expense	$ 98.22
	Notes Payable		$ 98.22
	To adjust Notes Payable to agree with amortization table

Proof:

	Debit	Credit
Notes Payable balance		44,329.16
Adjustment		98.22
Corrected NP balance		44,427.38
Balance per amortization table		44,427.38
Difference		0

The same approach can be used to reconcile and adjust Interest Expense. But generally speaking we are more concerned with having the correct Notes Payable balance on the balance sheet.

Large businesses record transactions daily, sometimes in Real Time, as they happen. Smaller businesses may record transactions less frequently, perhaps at the end of the day, week or month. Bookkeepers often have to make estimates, especially when they don't have enough information to write a correct entry. This is common in the business world.

Here's a common example, and one I see on a regular basis as an accountant and tax preparer. A client or their bookkeeper records a loan payment as a debit to "Loan Payment" and a credit to "Cash." You should know by now that accountants don't use an account called "Loan Payment." We record a loan payment with debits to Interest Expense and Notes Payable and a credit to Cash, as shown in the examples above. To correct the bookkeeper's error we would write an adjusting entry to debit the correct accounts and bring the "bogus" account to a zero balance.

Present Value
If you owe me $1000 I would like to have it paid as soon as possible. I am losing the use of my money as long as you owe me.

If I fall on hard times I might prefer to get my money paid back sooner, rather than later, because I need the money now. I might be inclined to settle for less than the full amount of the debt, in order to get the cash I need as soon as possible.

Let's say I could earn 10% interest if I had the money you owe me. In one year I would lose:

$1000 x 10% x 1 = $100 interest

if you paid me back now I could accept

$1000 - $100 = $900

Investing that money in an interest bearing account, which compounds daily (typical bank method), the $900 would grow to $1000 in a year. I would be in the same position at the end of a year, either way. But one way I have my money available in case I need it, which may be preferable.

The long and short of this story is simple. Money has a value, over time. It can be calculated fairly easily. If we don't have our money, we lose the use of it. Having money now is better than having it in the future, because I can put it to better use if it is available to me.

The business world accepts these simple facts about money, and business managers assume that interest should be earned or paid whenever appropriate in the situation. Federal tax law mandates that interest be charged where appropriate. Zero interest loans are not recognized for federal tax purposes.

Contingencies
A contingent situation is one that may arise in the future, based on some past event. For instance, if I sell lawnmowers one of them might break in the warranty period, and I will have to replace it. The warranty claim will arise in the future, from a sale made today.

There may be contingent gains or losses. Contingent gains are ignored until they are finalized. Contingent losses are recognized as soon as they can be identified and measured.

GAAP places a couple of requirements on contingent losses. They should be reported in the financial statements if they meet BOTH of two criteria:
1) the loss is probable,
2) the amount can be reasonably estimated.

It must also be a material amount, in order to have a reportable effect on the financial statements. Some are just a normal part of business, called general business risk, and are not reported. For instance, we all know that airplanes can crash. Airlines don't consider this a reportable contingency, because it is impossible to predict the occurrence or amount of loss in advance.

On the other hand, the company may be involved in a lawsuit. Their attorney advises them that they will probably lose, based on other cases and the probable loss will be $100,000. The loss is probable, and the amount can be reasonably estimated. The loss would be entered into the books, with a journal entry, and disclosed in the financial statements.