Source: Bonds Examples, Journal Entries, Amortization Schedules & Calculations
Tags: installment notes, notes payable, annuity payments, amortisation schedule, early extinguishment, bond redemption, call price, gain or loss on redemption
Difficulty: Intermediate | Prerequisites: Present value of an ordinary annuity, basic journal entries. Familiarity with bond accounting (discount and premium bonds) is helpful but not strictly required for the installment notes portion.
Installment notes and early bond extinguishment round out the long-term liabilities chapter. Installment notes use the same present-value annuity logic as bond pricing, but the structure is different: each payment includes both principal and interest, and the total payment stays constant while the split between interest and principal shifts over time. Early extinguishment, meanwhile, is a short but heavily tested topic: what happens when a company retires debt before maturity, and how to record the resulting gain or loss.
An installment note is repaid in equal periodic payments that each cover interest on the outstanding balance plus a portion of principal. The annual payment is found using the present value of an ordinary annuity formula, solved for the payment amount. An amortisation schedule shows how each payment splits between interest (declining) and principal (increasing). Early extinguishment of bonds means retiring them before maturity at a call price; the difference between the carrying value and the call price is a gain or loss reported on the income statement.
Installment note (amortising note / self-amortising loan)
A note payable repaid through a series of equal periodic payments that include both interest and principal. By the final payment, the entire principal is retired. Think of it as a car loan or mortgage: same payment each month, but the interest portion shrinks and the principal portion grows.
Annuity payment
The fixed periodic cash payment on an installment note. Calculated so that the present value of all payments, discounted at the note's interest rate, equals the principal borrowed.
Early extinguishment of debt
Retiring a bond or note before its scheduled maturity date. This typically occurs when the issuer exercises a call provision, purchasing the bonds back from holders at a specified call price.
Call price
The price the issuer pays to redeem bonds early. Often expressed as a percentage of face value (e.g., "102" means 102% of face value). The call price may be above or below the carrying value, producing a loss or gain respectively.
Gain or loss on extinguishment
The difference between the carrying value of the debt at the redemption date and the amount paid to retire it (the call price). Reported on the income statement. In simple terms, if the company pays more than the book value to get rid of the debt, it is a loss; if it pays less, it is a gain.
Worked example:
Matrix, Inc. issues a 4-year note for $50,000 at 9% interest, with equal annual payments at each year-end.
The note's principal equals the present value of the annuity of payments. Solve for the payment:
Payment = Principal / PV ordinary annuity factor (9%, 4 years)
PV annuity factor (9%, 4) = 3.23972
Payment = $50,000 / 3.23972 = $15,433 (rounded)
Each year, Matrix pays $15,433, which covers interest on the outstanding balance plus a portion of principal.
Each period: interest = outstanding balance × 9%. Principal repaid = payment minus interest. The balance drops by the principal portion.
Year | Balance (start) | Payment | Interest (9%) | Principal Repaid | Balance (end) |
|---|---|---|---|---|---|
1 | $50,000 | $15,433 | $4,500 | $10,933 | $39,067 |
2 | $39,067 | $15,433 | $3,516 | $11,917 | $27,150 |
3 | $27,150 | $15,433 | $2,444 | $12,989 | $14,161 |
4 | $14,161 | $15,434* | $1,273 | $14,161 | $0 |
*Final payment adjusted by $1 for rounding so the balance reaches exactly zero.
Notice the pattern: interest decreases each year (because the outstanding balance shrinks), and the principal portion increases. The total payment stays constant.
Matrix, Inc. (the borrower):
At issuance (January 1, 2019):
Dr. Truck: $50,000
Cr. Notes Payable: $50,000
First annual payment (December 31, 2019):
Dr. Interest Expense: $4,500
Dr. Notes Payable: $10,933
Cr. Cash: $15,433
Apex Motors (the lender/payee):
At issuance (January 1, 2019):
Dr. Notes Receivable: $50,000
Cr. Sales Revenue: $50,000
(If Apex is a dealer, it would also remove the truck from inventory. The credit might be to Inventory with a separate revenue/COGS entry depending on the accounting treatment.)
First annual payment received (December 31, 2019):
Dr. Cash: $15,433
Cr. Interest Revenue: $4,500
Cr. Notes Receivable: $10,933
Worked example:
Indian River Electronics has $90 million face value bonds with a remaining discount of $3 million at December 31, 2019. On January 1, 2020, the bonds are called at 102 (meaning 102% of face value).
Carrying value = face value minus unamortised discount = $90,000,000 - $3,000,000 = $87,000,000
Call price = 102% × $90,000,000 = $91,800,000
The company pays $91,800,000 to retire a liability with a carrying value of $87,000,000. The difference is a loss:
Loss = $91,800,000 - $87,000,000 = $4,800,000
Journal entry (January 1, 2020):
Dr. Bonds Payable: $90,000,000
Dr. Loss on Early Extinguishment: $4,800,000
Cr. Discount on Bonds Payable: $3,000,000
Cr. Cash: $91,800,000
The entry removes the full face value of the bonds and the remaining discount from the books, records the cash paid, and plugs the loss. The loss appears on the income statement.
The logic: Bonds Payable ($90M) minus Discount ($3M) = $87M net liability being removed. Cash outflow = $91.8M. The $4.8M excess is the loss.
Installment note payment:
\text{Payment} = \frac{\text{Principal}}{\text{PV ordinary annuity factor}(r, n)}Where r = interest rate per period, n = number of periods.
Interest portion of each payment:
\text{Interest} = \text{Outstanding Balance} \times rPrincipal portion of each payment:
\text{Principal Repaid} = \text{Payment} - \text{Interest}Gain or loss on early extinguishment:
\text{Gain (Loss)} = \text{Carrying Value} - \text{Call Price}Carrying value = Face value - Unamortised discount (or + Unamortised premium).
Call price at "102" = Face value × 1.02.
Students often confuse installment notes with interest-only bonds. With a bond, the periodic payment is interest only, and the full principal is returned at maturity. With an installment note, each payment includes both interest and principal, so the balance declines gradually.
A common error is applying the interest rate to the original principal every year instead of the declining balance. The interest portion must be recalculated each period based on the current outstanding balance.
On early extinguishment, students sometimes forget to remove the unamortised discount (or premium) from the books. The entire discount or premium must be written off in the redemption entry, not just the face value.
"Call price of 102" does not mean $102. It means 102% of face value. For a $90 million bond, that is $91.8 million. This notation trips up students who have not seen it before.
⚠️ Installment note amortisation schedules are a staple exam question. You may be given partial schedules and asked to fill in missing cells, or asked to prepare one from scratch.
⚠️ Exams frequently require journal entries from both the borrower's and the lender's perspectives. Practise writing both.
⚠️ Early extinguishment is a short topic but carries high exam weight. Know how to compute the carrying value, the call price, and the resulting gain or loss.
⚠️ Pay close attention to the call price notation. "At 102" = 102% of face. "At a call price of $685,000" = the dollar amount directly.
Car loans, mortgages, and equipment financing all use installment note structures. Every time you see a fixed monthly payment on a loan statement, the same amortisation logic applies. Early extinguishment reflects how companies manage their capital structure: if interest rates drop, retiring expensive old debt and reissuing at lower rates can save millions.
True or false: In an installment note, the interest portion of each payment increases over time.
False. The interest portion decreases because the outstanding balance shrinks.
Fill in the blank: To find the annual payment on an installment note, divide the ______ by the PV ordinary annuity factor.
Principal (or present value of the note).
True or false: A call price of 102 on a $90 million bond means the issuer pays $90,200,000.
False. 102 means 102% of face value = $91,800,000.
Fill in the blank: On early extinguishment, if the carrying value is less than the call price, the issuer records a ______.
Loss on early extinguishment.
Q: Matrix issues a $50,000 note at 9% with 4 annual payments. What is the interest expense in Year 2?
A: After Year 1, the balance is $39,067. Interest in Year 2 = $39,067 × 9% = $3,516.
Q: In Year 3 of the installment note, what portion of the $15,433 payment goes toward principal?
A: Interest in Year 3 = $27,150 × 9% = $2,444. Principal = $15,433 - $2,444 = $12,989.
Q: Indian River Electronics has $90 million in bonds with a $3 million unamortised discount. It calls the bonds at 102. What is the loss?
A: Carrying value = $90M - $3M = $87M. Call price = $90M × 1.02 = $91.8M. Loss = $91.8M - $87M = $4.8 million.
Q: In the early extinguishment entry, why do we debit Bonds Payable for the full face value rather than the carrying value?
A: Bonds Payable is recorded at face value on the books. The discount (or premium) is tracked in a separate account. To remove the bond from the books, we debit the full face value of Bonds Payable and separately credit the Discount on Bonds Payable to remove the remaining discount. The net effect removes the carrying value.
Q: How does the journal entry differ for Apex Motors (the lender) versus Matrix (the borrower) when recording the first installment payment?
A: They are mirror images. Matrix debits Interest Expense and Notes Payable, credits Cash. Apex debits Cash, credits Interest Revenue and Notes Receivable. Same amounts, opposite sides.
Installment notes share the same present-value annuity framework as bond pricing. The difference is structural: bonds pay interest only and return principal at maturity, while installment notes blend interest and principal in each payment. Understanding one strengthens your grasp of the other.
Early extinguishment connects to the broader topic of gains and losses on debt retirement and their income statement classification. It also ties into treasury management decisions about refinancing and capital structure.
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