Question

Assume that on 1/1/X1, Collins Co. obtained a $100,000 loan from Hattiesburg Bank. Under the terms of the loan contract, Collins will make equal annual payments of $A on 1/1/X2, 1/1/X3, and 1/1/X4. The loan interest rate is 4%. The Collins loan is scheduled to mature on 1/1/X4. On 12/31/X1, the market interest rate for similar loans was 4.5%. On 12/31/X2, the market interest rate was 4.3% Required: 1. Calculate the amount of the anntual loan payments (A) to be received by Hattiesburg Bank. Hint: The equal loan payments create annuity so the present value factor can be determined from interest tables using the 4% interest rate and 3 periods. 2. Based on your calculation of the loan payments, prepare Hattiesburg Bank's entries to record the loan origination and to accrue interest on 12/31X1, 12/31/X2, and 12/31/X3. Assume that that Hattiesburg Bank expects to hold the Collins Co. loan until maturity on 1/1/X4 and uses the effective interest method. 3. Prepare Hattiesburg Bank's entries to record the collection loan principal and interest on 1/1/2, 1/1/X3, and 1/1/X4. 4. Prepare Collins Co.'s entries to record the loan origination and to accrue interest for years X1, X2, and X3 and to record loan payments on 1/1 of X2, X3, and X4. 5. Assume that Hattiesburg Bank elected to use AFS accounting for the loan. Make the necessary journal entries for years X1 and X2 6. Assume that Collins Company elected to use fair value accounting for the loan. Make the necessary journal entries for years X1 and X2.

Answer 1

1. The equated annual instalment for the loan using annuity factor is as follows:

$Equated annual instalment = \frac{Principal amount}{Annuity factor}$

Annual loan payment (A) = 100,000 USD / 2.7751 (from the Present Value of annuity table)

A = 36,034.74 USD

2. The following table will be useful to obtain the amounts for the preparation of journal entries in Bank's books.

	Opening balance	Annual Payment	Interest @ 4%	Principal paid	Closing balance
	B	A	C = B*4%	D = A-C	E = B-D
Year1	100,000.00	36,034.74	4,000.00	32,034.74	67,965.26
Year2	67,965.26	36,034.74	2,718.61	33,316.13	34,649.14
Year3	34,649.14	36,034.74	1,385.97	34,649.14	-             0.00
		108,104.21	8,104.58	100,000.00

The references A, B etc are continued from the first table to maintain consistency and to link the figures in both the tables. Following table depicts the calculation of discount / (premium) with effective interest rate method. If the value of H is positive, it means the Bank has give the loan at a discount and the accounting entry will be taken care of accordingly. If the value of H is negative, premium will be recorded in the books.

Year ending	Opening balance	Market interest rate	Interest income	Coupon	Discount / (Premium)
	B	F	G = B*F	C	H = G-C
31/12/2001	100,000.00	4.50%	4,500.00	4,000.00	500.00
31/12/2002	67,965.26	4.30%	2,922.51	2,718.61	203.90
31/12/2003	34,649.14	**4.00%	1,385.97	1,385.97	-
			8,808.47	8,104.58	703.90

**The market interest in the 3rd year is assumed to be same as the loan interest rate, hence no discount/premium recorded in 3rd year.

Following are the accounting entries in the books of Bank, the debit and credit amounts are taken from one of the above tables.

Date	Account Title and Explanation	Debit	Credit
01/01/2001	Loan given	100,000.00
	Cash		100,000.00
	(To record loan given to Collins Co.)
31/12/2001	Interest receivable	4,000.00
	Discount on loan	500.00
	Interest income		4,500.00
	(To record interest receivable {100,000*4%} and Interest income calculated by effective interest rate method {100,000*4.5%})
31/12/2002	Interest receivable	2,718.61
	Discount on loan	203.90
	Interest income		2,922.51
	(To record interest receivable {67,965.26*4%} and Interest income calculated by effective interest rate method {67,965.26*4.3%})
31/12/2003	Interset receivable	1,385.97
	Interest income		1,385.97
	(To record Interest receivable {34,649.14*4%})

Date	Account Title and Explanation	Debit	Credit
01/01/2002	Cash	36,034.74
	Interest receivable		4,000.00
	Loan given		32,034.74
	(To record receipt of 1st equal annual payment)
01/01/2003	Cash	36,034.74
	Interest receivable		2,718.61
	Loan given		33,316.13
	(To record receipt of 2nd equal annual payment)
01/01/2004	Cash	36,034.74
	Interest receivable		1,385.97
	Loan given		34,648.77
	(To record receipt of 3rd equal annual payment)

3. Following are the accounting entries for the collection of loan principal and interest.

Date	Account Title and Explanation	Debit	Credit
01/01/2002	Cash	36,034.74
	Interest receivable		4,000.00
	Loan given		32,034.74
	(To record receipt of 1st equal annual payment)
01/01/2003	Cash	36,034.74
	Interest receivable		2,718.61
	Loan given		33,316.13
	(To record receipt of 2nd equal annual payment)
01/01/2004	Cash	36,034.74
	Interest receivable		1,385.97
	Loan given		34,648.77
	(To record receipt of 3rd equal annual payment)

4. Following are the Accounting entries in the books of Collins Co.:

Date	Account Title and Explanation	Debit	Credit
01/01/2001	Cash	100,000.00
	Loan received		100,000.00
	(To record loan received from Hattiesburg Bank)
31/12/2001	Interest expense	4,000.00
	Interest payable		4,000.00
	(To record interest payable {100,000*4%})
01/01/2002	Interest payable	4,000.00
	Loan received	32,034.74
	Cash		36,034.74
	(To record payment of 1st annual loan payment)
31/12/2002	Interest expense	2,718.61
	Interest payable		2,718.61
	(To record interest payable {67,965.26*4%})
01/01/2003	Interest payable	2,718.61
	Loan received	33,316.13
	Cash		36,034.74
	(To record payment of 2nd annual loan payment)
31/12/2003	Interest expense	1,385.60
	Interest payable		1,385.60
	(To record interest payable {34,649.14*4%})
01/01/2004	Interest payable	1,385.60
	Loan received	34,649.14
	Cash		36,034.74
	(To record payment of 3rd annual loan payment)

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