PROFESSOR S CLASS NOTES FOR UNIT 16 COB 241 Sections 13, 14, 15 Class on November 12, 2018

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1 PROFESSOR S CLASS NOTES FOR UNIT 16 COB 241 Sections 13, 14, 15 Class on November 12, 2018 INSTALLMENT LOANS Definition and Comparison to Notes Payable An installment loan is a Promissory Note. It differs from the Notes Payable we ve already discussed in three very important ways: 1. An installment loan requires that the borrower make periodic payments against the loan. 2. The payment made every period is more than just the interest for that period, and 3. The payment is a fixed amount every period, and is set to an amount which will actually pay off the loan at exactly the end of the loan period. 4. Since the periodic payment is always more than the interest for the period, the interest calculation each period is simple interest, -- but it is calculated on the beginning balance of that period. Example of an Installment Loan Richard Healy purchases a car from Honest Orson s Used Car Emporium. The car s price to Richard is $20,000, and Richard makes a down-payment of $6,000. The remainder of the selling price is financed by Honest Orson using an installment loan. The note for the loan specifies interest an an annual percentage rate (APR) of 6.0%. The loan term is two years, and Richard must make a monthly payment of $ Richard will pay $ every month for two years (24 months). At the end of two years, after Richard has made the 24 th payment, the loan will have been completely paid back to Honest Orson. The analysis below explains how this works.

2 Analysis of the Installment Loan Review the facts of the loan: First, the principal of the loan is $14,000. (Selling price downpayment) Second, the annual interest rate is 6%, but the monthly rate is 6%/12, or 0.5%. Thus, interest will be calculated at the end of each month, multiplying the 0.50% monthly interest rate times that month s beginning balance. Richard will pay $ every month for the 24 months of the loan. FIRST MONTH At the end of the first month, interest will be calculated as 0.50% of $14,000. This works out to $70. Beginning Month's Month Balance Interest 1 $14, $70.00 Rather than just pay the interest, however, the note specifies that Richard will pay a monthly payment of $ Beginning Month's Month's Month Balance Interest Payment 1 $14, $70.00 $ This payment covers the $70.00 interest. But the remainder of the payment is applied to the outstanding balance of the loan. The $ payment, after covering the $70 interest, leaves $550,49 to apply to the outstanding loan. Beginning Month's Month's Applied to Month Balance Interest Payment Principal 1 $14, $70.00 $ $ After applying the $ to the $14,000 loan balance, this means the remaining outstanding loan balance after the first monthly payment is only $13,

3 SECOND MONTH The ending balance from the first month is now the beginning balance of the second month. 2 $13, In the second month, the interest is calculated as 0.5% of the new balance. This works out to be 0.5% of $13,449.51, or $ $13, $67.25 Again, Richard is required to make a monthly payment of $ at the end of the second month: 2 $13, $67.25 $ The payment of $ covers the $67.25 interest, and leaves $553,24 remaining to reduce the amount of the loan: 2 $13, $67.25 $ $ Which means the ending balance of the loan after making the second payment is: 2 $13, $67.25 $ $ $12,896.27

4 THIRD MONTH Each month, the opening balance is the prior month s ending balance: 2 $13, $67.25 $ $ $12, $12, Each month, the interest is calculated on that new beginning balance. 2 $13, $67.25 $ $ $12, $12, $64.48 Each month, the same monthly payment is made, and the remainder of that payment amount, after covering interest, is available to reduce the loan balance. 2 $13, $67.25 $ $ $12, $12, $64.48 $ $ $12, FOURTH AND SUBSEQUENT MONTHS Every month, interest is calculated on the month s beginning loan balance, the monthly payment covers the interest, with enough left over to reduce the loan balance. The new ending balance after applying that reduction is used the following month as the new beginning balance, on which to calculate interest again. 2 $13, $67.25 $ $ $12, $12, $64.48 $ $ $12, $12, $61.70 $ $ $11, $11,780.47

5 Installment Loan Amortization Table At the end of the loan period (24 months in this case), the loan is completely paid off. The table of values showing each month s beginning balance, interest for that month, payment made, amount applied towards the loan balance, and ending balance after payment, is known as the loan s Amortization Table. Beginning Month's Month's Applied to Remaining 2 $13, $67.25 $ $ $12, $12, $64.48 $ $ $12, $12, $61.70 $ $ $11, $11, $58.91 $ $ $11, $11, $56.10 $ $ $10, $10, $53.28 $ $ $10, $10, $50.44 $ $ $9, $9, $47.59 $ $ $8, $8, $44.73 $ $ $8, $8, $41.85 $ $ $7, $7, $38.95 $ $ $7, $7, $36.05 $ $ $6, $6, $33.12 $ $ $6, $6, $30.19 $ $ $5, $5, $27.24 $ $ $4, $4, $24.27 $ $ $4, $4, $21.29 $ $ $3, $3, $18.29 $ $ $3, $3, $15.28 $ $ $2, $2, $12.26 $ $ $1, $1, $9.21 $ $ $1, $1, $6.16 $ $ $ $ $3.09 $ $ $0.04 You will notice in this example, Richard paid the same amount ($620.49) each month. The loan is automatically completely paid off at the end of the 24 th month. (The balance of negative 4 cents is immaterial. Typically, the last payment is adjusted to pay off the loan exactly after interest. In this example, the last payment would be $620.45, rather than $ )

6 Accounting for the Installment Loan At the time the car is purchased, Richard records the acquisition of the asset for $20,000, the down-payment from cash, and the remainder as a $14,000 Installment Note Payable. DATE INVOICE NUMBER OR CHECK NUMBER DEBIT CREDIT 1-Apr Long-Term Asset: Automobile Cash (downpayment) 6000 Installment Loan Payable (24 mos. at 6% APR The details of the loan should be disclosed in the disclosure notes which accompany the financial statements. Thereafter, every month as the payment is made, the following adjusting entry is made, with the amounts changing from month to month as the loan is paid down. The first month s adjusting entry is: DATE INVOICE NUMBER OR CHECK NUMBER DEBIT CREDIT 1-Apr Interest Expense Installment Loan Payable Cash Find all three of the above amounts on the amortization table shown on page 2 above. The second month s adjusting entry would be: DATE INVOICE NUMBER OR CHECK NUMBER DEBIT CREDIT 1-Apr Interest Expense Installment Loan Payable Cash Again, find all three of these numbers on the amortization table to see where these numbers come from. What will be the journal entry at the end of the fourth month? See the amortization table for the amounts. After the adjusting entry in the 24 th month, the Note Payable account is zero. No more interest expense and no more cash payments need be made. There is no ending journal entry to be made other than the normal monthly entry for the 24 th month.

7 MORTGAGES A Mortgage is a loan where a borrower obtains money from a lender for the express purpose of purchasing a specified parcel of real estate or a building. The land and/or building is known as Real Property. The amount borrowed is known by the borrower as the loan proceeds. The loan agreement note the use of the proceeds to purchasing the specific parcel or building. Repayment of Mortgage The repayment terms of a mortgage loan are sometimes available for a certain amount of negotiation, but most of the time a mortgage is repaid in the exact same manner as an installment loan. That is, the borrower makes periodic payments which exceed the amount of interest, with the remainder of each payment being applied to reduce the outstanding principal, thus reducing the outstanding balance of the loan. Mortgages generally allow the borrower to pay off the outstanding balance of the loan at any time. Sometimes early prepayment results in a fee or penalty. Other Terms Commonly Found in Mortgage Notes Generally, the outstanding balance of the loan must be paid off in full before the specified property can be sold. Mortgages are always secured by the property purchased with the proceeds. If the borrower misses a specified number of installment payments (default), the lender has the legal right to seize the property. This process is called foreclosure. Additionally, almost all mortgages contain a requirement that the borrower maintain the property so that its current market value is always above the outstanding balance of the loan. If the market value of the property drops below the outstanding loan balance, the lender usually has the right to foreclose on the property. (Normally, property values generally increase over time, so this is typically not a problem, and most foreclosures historically have been for non-payment rather than lower market values. There was one notable exception in history, however.)

8 Negative Amortization Mortgages The subject of negative amortization is not in the book, nor will it be on the examinations. But it is interesting because it is the primary reason behind the late-2000s housing crisis which led to one of the largest and longest economic recessions since the 1920s. As mentioned above, mortgages are paid off in the same manner as installment loans. The periodic (usually monthly) payment paid by the borrower usually covers interest, with the remainder of the payment being applied to reduce the loan balance. However, in certain areas of the United States, notably high-cost of living areas such as San Francisco, Hawai i, New York, and boom towns like Houston, housing prices rose so much that the average citizen could no longer afford the payments on a mortgage for a home. To make the mortgages affordable, lenders began writing five-year balloon mortgages which specified payments which were so low that they did not even cover the interest on the loan. These are known as Negative Amortization Mortgages. Since the payment was not even covering the interest, this meant that instead of the ending balance going down over time, the ending balance was going up over time. But the thinking by lenders was that the huge rise in real estate prices would continue. Within the five year balloon period, the borrower could sell his or her house for much more than the increased mortgage balance. Example: Cathy Sullivan purchased a two-bedroom, one-bath home for $1 million in San Francisco in She financed the purchase with a five-year balloon mortgage, with an interest rate of 6% per year. If this mortgage were amortized over a normal 30-year mortgage period, this would result in a monthly payment of $7,165. This amount is far above what Cathy earns each month. The monthly interest alone on a $1 million loan at 6% is $5,000. But Cathy s bank unscrupulously wrote a mortgage specifying a monthly installment payment of only $3000, which Cathy can afford. By making this monthly payment, Cathy s outstanding loan balance is being increased every month by the unpaid interest of $2000. Thus, in four years, Cathy s mortgage balance has increased to $1,048,000. After four years, however, Cathy takes a better job in another city, and sells her house. Because of the increase in housing prices, Cathy is able to sell her house for $1.2 million. Cathy sells her house, pays off the $1,048,000 mortgage balance, and pockets a profit of $152,000.

9 The Housing Bubble and Great Recession Because of the potential for profits, people were buying houses at prices far above what was reasonable. Because of the popularity of these low-payment mortgages, banks were able to increase interest rates, earning more revenue. To increase revenue even further, banks lowered their minimum standards for obtaining a loan, writing mortgages for people who should not have qualified for such a high mortgage balance. The demand for million-dollar plus mortgages tied up the banks money which might have been loaned to businesses to build the economy. Thus, businesses began tightening their belts, especially in boom areas where more capital was needed to operate. As businesses began slowing their operations, they stopped their hiring, which caused a decrease in the demand for housing, since the disappearance of new jobs meant a slowdown in the influx of new residents. The drop in the number of new residents moving into these areas caused a slowdown in the increase of housing prices. As the balloon mortgages began coming due, homeowners had to sell their property to pay off the balloon mortgages. The decrease in demand and the increase of supply of houses on the market results in a sudden drop in housing prices. Housing prices dropped dramatically starting around This meant that the market value of other houses even ones whose balloon payments were not coming due dropped below the inflated balances of the mortgages. This triggered a wave of foreclosures. Upon foreclosure, homeowners lost their homes and their investment in downpayments, as well as having wasted their monthly payments on a house they couldn t have afforded in the first place. To avoid foreclosure, homeowners tried to sell their houses for whatever they could get for them, further increasing supply, and dropping prices further, cascading into more foreclosures. The rapid rise in housing prices in the 1990s and early 2000s was known as the housing bubble, and when it burst, it had a far-reaching effect. Banks had high Mortgages Receivables on their balance sheets that now had to be converted to property assets. Under the lower of cost or market rule, these properties has to be listed on the balance sheet at the lower market value of the property, resulting in huge losses on the banks income statements. The losses were exacerbated by the legal costs of foreclosures. Banks earnings dropped, which caused them to loan less money, cooling the economy further. As employers could not longer borrow money to finance their operations, these companies also began losing money and shutting down operations, putting employees out of work, which meant that employees now had less money to spend, so consumer spending dropped. This further cooled the economy, sending the western world into what is now called the Great Recession.

10 LINE OF CREDIT Getting back on topic: A line of credit is a special type of loan, with an indefinite term. Basically, it is a pre-approval for a loan up to a certain limit. A borrower rarely borrows the entire limit. Instead the borrower only borrows what is needed. The borrowing company can pay back any portion (or all) of the loan at any time, reducing the amount outstanding. Similarly, the company can draw more against the line of credit at any time, increasing the outstanding loan balance. Interest is calculated each day, based on the outstanding balance at the end of that day. What s more, the interest rate on a Line of Credit can change on any given day, because lines of credit typically charge interest based on some national or international standard, such as the U.S. Prime Rate, or the daily interest rate on U.S. Treasury Notes. Example of a Line of Credit: Assume that ABC Company is approved for a Line of Credit from their bank, up to a maximum of $1 million. However, ABC does not presently need $1 million, so it does not use any of the line of credit. The line of credit is sitting idle. On March 13, ABC decides to take advantage of an early payment cash discount on a purchase, by paying the vendor invoice early. But ABC does not presently have sufficient cash on hand to pay the invoice amount. ABC borrows against their line of credit by telephoning their bank manager, who transfers money into ABC s checking account. ABC borrows $40,000 against the line of credit. ABC records this deposit as follows: DATE INVOICE NUMBER OR CHECK NUMBER DEBIT CREDIT 13-Mar Cash $ 40,000 Line of Credit Payable $ 40,000 ABC can now pay off the vendor and take the early-payment discount, but now has a new $40,000 liability to the bank. Interest will be charged daily on this outstanding amount. Now assume that 10 days later, ABC receives cash from its customers and is able to pay back most of the $40,000. The entry to record a $32,000 payment against the line of credit is: DATE INVOICE NUMBER OR CHECK NUMBER DEBIT CREDIT 23-Mar Line of Credit Payable $ 32,000 Cash $ 32,000 After paying back $32,000, the line of credit balance is $8,000. ABC will now be charged interest on this $4,000 balance each day until ABC either pays back, or draws against, the line of credit. A line of credit often carries a higher interest rate than a Note Payable. But the advantage of a line of credit is that the company only pays interest on the amount it needs to have borrowed for the day, not the entire balance of Note Payable.

11 ADVANTAGES OF A LINE OF CREDIT You may be asking, Why would the ABC Company in the above example want to borrow money and pay interest expense, just to pay a vendor early --- when the company could wait a few days and then pay the vendor with cash collected from customers and save the interest expense? The answer lies in the difference between the interest paid to the bank against the line of credit, versus the effective rate of the early-payment discount. Example: On March 5, ABC Company purchases $40,000 of merchandise from its vendor under terms of 2-10-Net 30. This means that if ABC company pays on or before March 15, it can take a 2% discount on the $40,000 purchase price. In other words, by paying on March 13, ABC can take a discount of $800. Since ABC does not have the cash on March 13 to pay the invoice, it borrows money against the line of credit: $40,000. Assume the interest rate on the Line of Credit is 6%. This is the annual interest rate charged by the bank. But ABC only borrows the money for 10 days, whereupon it collects cash from its customers and can pay off $32,000 of the line of credit. And further, let s say that ABC can pay off the remaining $8,000 in another 10 days. Follow the logic: The 6% annual interest means the daily interest rate is 6%/365, or % per day. Since ABC owes $40,000 for 10 days, it pays interest of 10 x % x 40,000 = $65.75 total, for all 10 days of interest until it repays the $32,000 collected from customers. Once it repays $32,000, the remaining outstanding loan is $8000 for the next 10 days. The interest on these 10 days is 10 x % x 8000 = $13.12 total for the 10 days. The total amount of interest ABC has paid on its line of credit is $ $13.12 = $ By paying less than $79 in interest on its line of credit, ABC saved $800 by taking the early payment discount from its vendor. The art of analyzing sources of money with low interest rates to realize savings like this is the purview of the field of Finance. Thus, finance majors need to have a good handle on these concepts.

12 BONDS Bonds vs. Note Payable A Note Payable is a promissory note a company issues to a lender, usually a bank or another company, when it borrows money from that organization. By contrast, a Bond is a note that is made available to the general public. The usual terminology is for the issuing company to sell the bond to a buyer. Another difference is that Promissory Notes usually specify a term ranging from three months or less, all the way up to several years. It is unusual for Notes Payable to have terms longer than five to ten years. By contrast, Bonds usually have at least 10-year, and may have 20-year, 30-year, or even 40-year maturity terms. The issuance of Bonds is highly regulated, just like stocks. Bonds are liabilities and are (for the most part) treated just like Notes Payable. Bonds are always Long-Term Liabilities. Like Notes, Bonds can be secured, by specifying the collateral that can be seized by the lender if the company defaults (fails to repay on time). A bond which specifies collateral is called a secured bond. A bond which does not put up collateral is an unsecured bond, and is called a debenture. Other Bond Terminology Bonds can contain certain additional terms agreed to by the lender (the buyer of the bond) and the borrower (the issuer of the bond). A convertible bond is one that contains a clause allowing the lender to trade in the bond for a certain specified amount of shares of stock (ownership in the company). A callable bond is one that permits the borrower (the issuing company) to pay off the bond early. (Unless specified as a callable bond, a company can not pay off the loan early once they have issued a bond.) A serial bond is one where the amount of the loan is paid off in periodic payments (similar to an installment loan) over the term of the bond. Restrictive covenants are limitations the bond agreement places on the borrower. For example, if a bond specifies collateral (a secured bond), the note will often contain a clause prohibiting the borrower (the issuer) from disposing of the collateral before the bond is paid off. There may be other requirements, such as a requirement that the company properly maintain the collateral in good order until the bond is paid off. Some covenants restrict what the borrower can do with the money.

13 Bond Redemption When a company issues a bond, it promised to pay the holder of the bond the face value at the maturity date of the bond. Since bonds are sold to the general public, bonds can be traded on the open market. The company who originally issued the bond often does not care who owns the bond at any given time, until the maturity date. On the maturity date, whoever owns the bond will redeem the bond by presenting it to the issuing company, who will then pay off the loan by trading the mature bond for cash in the amount of the face value printed on the bond. Often, this is referred to as a bearer bond, because whoever has possession of the bond (the bearer) on its maturity date is the party who gets the face value of the bond in cash. Marketability of Bonds As stated above, since bonds are sold to the general public, the buyer of a bond can sell the bond on the open market. Whoever holds the bond at the time of its maturity will collect the face value of the bond when the borrower (the issuing company) pays off the loan. The holder of the bond at any time can trade the bond for cash to anyone willing to pay whatever price the holder asks. Example: John Keller purchases a 20-year bond from ABC company. The bond has a face value of $100,000, and carries an interest rate of 3%. John buys the bond from ABC for $100,000, expecting to earn $3000 per year interest. This is more interest than John could earn from his bank on a savings account. However, after a year or two, interest rates rise. John can now earn 5% from his bank on a 5-year Certificate of Deposit (a kind of savings account). John decides to sell his bond to get cash to put into a CD to earn higher interest. John is able to find someone willing to give him $96,000 for the bond. John is willing to take the $4000 loss on the bond, because he will make up for the difference in two years. The new buyer of the bond is willing to give John $96,000 for the $100,000 bond because the buyer thinks interest rates will be falling again soon, and wants to lock in the 3% bond s interest rate, as well as getting the $100,000 when the bond matures, yielding a profit at redemption of $4,000. Just like stock markets, there are bond markets in many major cities around the world where holders of bonds can sell or buy these notes among themselves, most of the time without even contacting the company who issued the bond.

14 Issuance of Bonds at Face Value Remember, the issuer of a Bond is the borrower. In the case of a bond, the money is going to come from the general public. A party will buy the bond, giving the money to the issuing company. The issuing company does NOT record revenue for this sale. The Bond is a Note Payable, and must be shown on the Balance Sheet as a Long-Term Liability. Being a printed note, bonds are a loan contract. The printed terms on the front of the bond specify the amount the lender (the bond buyer) will receive upon maturity of the bond (when the company pays the loan back). When a company issues a bond at its face value, the company records the creation of the liability at its face value, and the receipt of cash from the sale. DATE INVOICE NUMBER OR CHECK NUMBER DEBIT CREDIT 1-Jan Cash $ 100,000 Bond Payable -- January 1, 2035 $ 100,000 Recording the Interest on Bonds Issued at Face Value It is common for a bond to require the issuing company (the borrower) to pay interest on a regular or periodic basis. That way, the holder of the bond gets some income without having to wait the 20 or 30 years or longer until the bond matures. When a bond is issued at its face value, interest expense is calculated based on the printed rate shown on the bond s terms. Example: continuing the example above, John Keller purchased a bond being issued by ABC company on January 1, John purchases the bond at face value, paying $100,000 for the $100,000 bond, which carries a printed interest rate of 3%. At the end of each year, for 20 years, the issuer will pay interest to the holder of the bond. When the issuing company pays the periodic interest, the payment is recorded as follows: DATE INVOICE NUMBER OR CHECK NUMBER DEBIT CREDIT 31-Dec Interest Expense on bond $ 3,000 Cash $ 3,000 Some bonds will have detachable coupons so that the current owner of the bond can tear off one of the coupons to mail in to the issuing company to claim the interest. These are known as Coupon Bonds