TOPIC 4A
ACCOUNTING FOR
CONVENTIONAL FINANCING
INSTRUMENTS
ABDIFATAH MAYGAG
TOPIC
4
A
ACCOUNTING FOR CONVENTIONAL
FINANCING INSTRUMENTS
Contents
1. Interest
2. Accounting for Simple Interest Loans
3. Accounting for Discount Loans
4. Accounting for Amortized Loans
ACCOUNTING FOR DEPOSIT INSTRUMENTS
Accounting Wadi’ah Deposit Product: Illustration
▪ Presentation
Dr. Cash
$5,000
Cr. Wadi’ah Deposit Accounts
$5,000
Cash (Assets) in the Statement of Financial Position.
Deposits (Liabilities) in the Statement of Financial Position
INTEREST
INTEREST
Concept of Interest
▪ Interest – is a fee charged by a lender to a borrower for the
use of borrowed money;
- Cost of borrowing money
▪ Typically expressed as an annual percentage of the principal;
▪ Ratio of interest to the amount lent
▪ Rate is dependent upon the time value of money, the credit
risk of the borrower, and the inflation rate.
▪ Interest is also defined as the return earned on an investment.
INTEREST
Bank Interest
▪ The amount of money that banks receive when they extend
credit.
▪ The rate of interest is the price of credit.
▪ Most of the time, that benchmark is the prime interest rate.
− The prime interest rate – is the interest rate a bank
charges its most creditworthy customers.
− Another important interest rate is the London Interbank
Offered Rate (LIBOR)
INTEREST
Simple Interest
▪ Form of computing interest on an annual basis.
▪ Formula
Interest = Principal x
Interest Rate
x
Time
▪ Illustration
If Mr. X borrows $10,000 from Ms. Y at a simple interest of
10% per year, and is due for repayment in 3 years, how much
does Mr. X owe Ms. Y on repayment date?
Answer: Interest = $3,000
Total Amount Due = $13,000
INTEREST
Loan Price
▪ Corresponds to the total amount a borrower will pay for what
he borrowed; the total amount due.
▪ Formula
Loan Price = Principal + Interest
INTEREST
Loan Price and Simple Interest Rates
▪ Simple interest where time (t) is expressed in months:
Example: Compute the simple interest of a 6-months
$100,000 loan with 7% interest rate.
Solution:
I = P
x R x
T
= $100,000 . 0.07 . 6/12
= $3,500
▪ Simple interest where time (t) is expressed in weeks:
Example: Compute the simple interest and loan price of a 6months $100,000 loan with 0.2% per week.
Solution: Interest = $5,200
Loan Price = $105,200
INTEREST
Loan Price and Simple Interest Rates
▪ Simple interest where time (t) is expressed between 2 Dates:
Deposit Example:
Compute the simple interest of a $100,000 deposit at 7%
granted from 10-15-20X0 until 1-20-20x1.
Solution:
Month
Oct.(31days)
Nov.(30days)
Dec.(31days)
Jan.
Total
No. of days
16 (31–15)
30
31
20
97
I = P
x
R
x
T
= $100,000 . 0.07 . 97/365
= $1,860.27
F = P+ I
= $100,000+$1,886.11
= $101,860.27
Note: Banks use 365 days for deposits
INTEREST
Different Time Factors
▪ Different time factors:
1. Exact time ÷ 360
2. Ordinary time ÷ 360
3. Exact time ÷ 365
4. Ordinary time ÷ 365
▪ Note: No. of days in a year used by banks:
− For loans = 360 days in 1 year
− For deposits = 365 days in 1 year
INTEREST
Basic Elements of Loan Pricing
▪ Types of Interest Computation
1. Ordinary interest
– interest is paid at maturity date.
2. Discounted interest
– interest is paid in advance.
▪ Note: In both instances, one may use the simple interest rate
formula.
INTEREST
Basic Elements of Loan Pricing
▪ Types of Interest Computation
1. Ordinary interest
– interest is paid at maturity date.
2. Discounted interest
– interest is paid in advance.
▪ Note: In both instances, one may use the simple interest rate
formula.
INTEREST
Basic Elements of Loan Pricing
▪ Types of Interest Computation
Comparison
Simple interest
Simple discount
Interest
I=P x R x T
I=F x D x T
Principal
P=F/(1+rt)
Pr=F(1–dt)
Amount
F=P(1+rt)
F=Pr/(1–dt)
▪ I = Interest
r = Interest Rate
▪ F = Final Amount
P = Principal
Pr = Proceeds
d= Discount Rate
INTEREST
Compound Interest
▪ The Final Amount (FA or simply F) in a compound interest is
said to be the loan price (in a loan transaction) or future value
(in an investment).
▪ Formula: FA = P (1 + r) n
Where: P = Principal
r = Rate of interest
n = Compounding period
▪ Example:
In a $10,000 loan, if the 10% is compounded annually for 3
years, what is the total amount due on maturity date?
Final Amount = 10,000 (1 + 0.10)3
= $13,310
ACCOUNTING FOR SIMPLE INTEREST LOANS
ACCOUNTING FOR SIMPLE INTEREST LOANS
Simple Interest Applications
▪ Simple interest application include
− Consumer Loans
• Auto Loans
− Money Market Instruments
• Certificate of Deposits (CDs)
• Term Deposits
▪ Simple interest is more advantageous for borrowers than
compound interest, as it keeps overall interest payments lower.
ACCOUNTING FOR SIMPLE INTEREST LOANS
Simple Interest Applications: Auto Loans Amortization
▪ Example:
Bank X granted a car loan for $20,000 to John with interest rate
of 4% for 5 years. John will make the payments on monthly
basis.
Requirements:
Compute the following items:
1. Simple interest per year
2. Total interest
3. Total payment per month
4. Monthly interest payment
5. Monthly principal payment
ACCOUNTING FOR SIMPLE INTEREST LOANS
Simple Interest Applications: Auto Loans Amortization
▪ Example:
Bank X granted an auto loan for $20,000 to John with interest
rate of 4% for 5 years. John will make the payments on monthly
basis.
Requirements:
Payment
No.
Payment
Date
Payment
Due
Interest
Payment
Principle
Payment
Ending
Balance
0
1-Jan-21
1
1-Feb-21
$400.00
$66.67
$333.33 $19,666.67
2
1-Mar-21
$400.00
$66.67
$333.33 $19,333.33
$20,000.0
0
ACCOUNTING FOR SIMPLE INTEREST LOANS
Simple Interest Applications: Accounting Recognition
Payment
No.
Payment
Date
0
1-Jan-21
1
1-Feb-21
Payment Due
Interest
Payment
Principle
Payment
Ending
Balance
$20,000.0
0
$400.00
1-Jan-2021 (Loan Grant Date)
$66.67
Dr. Consumer Loans (Auto Loans)
Cr. Cash
$333.33
$19,666.67
$20,000
$20,000
1-Feb-2021 (Payment No. 1 Date)
Dr. Cash
$400
Cr. Interest Revenue
Cr. Consumer Loans (Auto Loans)
$66.67
$333.33
ACCOUNTING FOR SIMPLE DISCOUNTED
LOANS
ACCOUNTING FOR SIMPLE DISCOUNTED LOANS
Simple Discounted Loans
▪ With a discount loan the lender calculates the interest and other
related charges and discounts them from the face amount before
lending to the borrower.
▪ The borrower has to pay back the whole amount – the principal,
the related charges and the interest.
▪ Interest is what the borrower has to pay on top of the principal
when he or she takes out a loan.
▪ Discount loans are typically issued for people who seek a shortterm loan.
ACCOUNTING FOR SIMPLE DISCOUNTED LOANS
Simple Discounted Loans Applications
▪ Example:
Bank X agreed to grant you a discount loan with a face value of
$20,000 and pay back 12 months later. The interest charge is
$2,000. The loan has been made on Jan-01-20X1
Requirements:
Compute the following items
1.
$18,000
Proceeds from the discount loan?
11.11%
2.Interest rate on the discount loan?
ACCOUNTING FOR SIMPLE DISCOUNTED LOANS
Simple Discounted Applications: Accounting Recognition
Payment Due
Interest Payment
Principle Payment
$20,000
$2,000
$18,000
1-Jan-2021 (Loan Grant Date)
Dr. Consumer Loans (Personal Loans) $18,000
Cr. Cash
$18,000
31-Dec-2021 (Payment Date)
Dr. Cash
$20,000
Cr. Interest Revenue
$2,000
Cr. Consumer Loans (Personal Loans)
$18,000
ACCOUNTING FOR AMORTIZED LOANS
ACCOUNTING FOR AMORTIZED LOANS
Amortized Loans
▪ Loan amortization is the process of scheduling out a fixed-rate
loan into equal payments.
▪ A portion of each installment covers interest and the remaining
portion goes toward the loan principal.
▪ More of each payment goes toward principal and less toward
interest until the loan is paid off.
▪ Loan amortization determines the minimum monthly payment.
▪ Any amount paid beyond the minimum monthly debt service
typically goes toward paying down the loan principal.
ACCOUNTING FOR AMORTIZED LOANS
Amortized Loans: Applications
▪ Typically for loan term loans.
▪ Common types of amortizing loans include:
− Mortgage loans
− Auto loans
− Student loans
− Personal loans
ACCOUNTING FOR AMORTIZED LOANS
Amortized Loans Application
Example
▪ Bank X has granted John an auto loan of $10,000 with annual
interest rate of 12% for a year. The John will make monthly
payments to the bank
Requirements:
Compute the following items
1.
Monthly payment amount?
2.Monthly interest payment?
3.Monthly principal payment?
ACCOUNTING FOR AMORTIZED LOANS
Amortized Loans Application
Payment
No.
0
1
2
3
4
5
6
7
8
9
10
11
12
Payment
Due
Interest
Payment
Principle
Payment
$888.49
$888.49
$888.49
$888.49
$888.49
$888.49
$888.49
$888.49
$888.49
$888.49
$888.49
888.49
$10,661.85
$100.00
$92.12
$84.15
$76.11
$67.98
$59.78
$51.49
$43.12
$34.67
$26.13
$17.51
$8.80
$661.85
$788.49
$796.37
$804.34
$812.38
$820.50
$828.71
$837.00
$845.37
$853.82
$862.36
$870.98
$879.69
$10,000.00
Ending
Balance
$10,000.00
$9,211.51
$8,415.14
$7,610.80
$6,798.42
$5,977.92
$5,149.21
$4,312.21
$3,466.85
$2,613.03
$1,750.67
$879.69
$0.00
ACCOUNTING FOR SIMPLE INTEREST LOANS
Amortized Loan Applications: Accounting Recognition
Payment
No.
Payment
Date
0
1-Jan-21
1
1-Feb-21
Payment Due
Interest
Payment
Ending
Balance
$10,000.0
0
$888.49
1-Jan-2021 (Loan Grant Date)
$100
Dr. Consumer Loans (Auto Loans)
Cr. Cash
Principle
Payment
$788.49
$9,211.51
$10,000
$10,000
1-Feb-2021 (Payment No. 1 Date)
Dr. Cash
$888.49
Cr. Interest Revenue
Cr. Consumer Loans (Auto Loans)
$100
$788.49