Collins Company borrowed $1,250,000 from BankTwo on January 1, 2016 in order to expand its mining capabilities. The five-year note required annual payments of $325,545 and carried an annual interest rate of 9.5%. What is the amount of expense Collins must recognize on its 2017 income statement

Collins Company must recognize $118,750 (which is annual interest paid on the capital) in its 2017 income statement as an expense item if the method of computing the interest is the flat rate method.

If it is reducing balance rate, then the amount deducted will equal $ 87,823

Explanation:

According to the principles of Financial Accounting, the interest portion of any loan must be entered as an expense item. The portion of the principal being paid back is recorded as part of the liability of the company in the period under consideration. It often goes by the term Loan Payable or Notes Payable.

Hence to arrive at the answers given above, you must note that the year in question is 2017 and that the loan took effect from January 2016.

When computing for interest payable, two methods may be used:

Flat rate method: which requires that the interest rate applicable is computed on the capital and multiplied by the number of years the loan will run.

That is, $1,250,000 x 9.5% x 5 = Total Interest Rate Applicable.

= $593,750 so going by this method, the interest rate to be entered is

= $593, 750/5

= $118,750

2. Reducing balance rate method: This requires the rate of interest to be applied each year succesievely having taken into account the capital which way paid in the previous year.

That is, [Initial Capital-Annual Payments] * 9.5%

For year 2016, annual payment will be Zero. Given that the loan started in that year. In 2017 however, the annual payment will apply as shown below:

= [$1,250,000-$325,545] * 9.5%

= $924, 455 * 9.5%

= $87,823 (approximately)

Cheers!