Definition of Principal: Balance of a Debt

Understanding the Difference Between an Expense on the Income Statement and Reducing the Principal on a Loan, a Reduction of Debt on the Balance Sheet

Definition of principal: balance of a debt

1. Question 1: You are about to start a business, fiscal year-end 12/31/08. You, personally, loan your business $10,000 (to simplify, 0% interest rate) on December 1, 2008, due on September 1, 2009. There is no equity. For all of fiscal year 2008 the business has no revenue or expenses. In fiscal year 2009, the business has revenue of $20,000, COGS of $5,000, and SG&A (i.e., operating expenses) expenses of $5,000. Additionally, the business pays back the $10,000 loan in fiscal year 2009. To simplify, assume a 0% tax bracket.

Create the following for your business:

1. 12/31/08 balance sheet
2. 12 Month 2009 Income Statement including interest expense and income tax lines even though both items = $0
3. 12/31/09 balance sheet

2. Question 2: Your company just signed a $10,000, 10-year loan @ 10%-- an annual interest payment at the end of each year along with the principal reduction of $1,000 per year at the end of each year. Please complete the table below.

Period/Year / Principal Payment-
adjustment to balance sheet / Principal Amount
End of Year
(on balance sheet) / Interest Expense
(on income statement)
0 / NA / $10,000
(starting loan balance) / NA
1
2
3
4
5
6
7
8
9
10

Note: Solutions and discussion is on the following pages

Solutions

Question 1

1. 12/31/08 balance sheet

Cash$10,000

Current Assets$10,000

PP&E$0

Total Assets$10,000

ST Loan$10,000

Current Liab.$10,000

LT Liabilities$0

Total Liab.$10,000

Equity$0

TL + Equity$10,000

1. 12 Month 2009 Income Statement including interest expense and income tax lines even though both items = $0

Revenue$20,000

COGS$5,000

Gross Profit$15,000

SGA$5,000

Operating Income$10,000

Interest Expense$0

Earnings Before Taxes$10,000

Income Taxes$0

Net Income$10,000

1. 12/31/09 balance sheet

Cash$10,000—Cash goes up $10,000 from profit, down $10,000 paying back loan

Current Assets$10,000

PP&E$0

Total Assets$10,000

ST Loan$0—loan paid off

Current Liab.$0

LT Liabilities$0

Total Liab.$0

Equity$10,000—net income increases equity from $0 to $10,000

TL + Equity$10,000

Lessons:

1. Paying back a debt (principal) is not an expense on the income statement
2. Example 1: You buy $10,000 of inventory in December, 2008 and actually sell the goods in December 2008, but you do not pay for the inventory until January. Because the inventory is sold in December, the expense (COGS) occurs in the 2008 fiscal year. That is, you match the revenue with COGS. When you pay for the inventory in January, cash and accounts payable both decrease on the balance sheet by $10,000. There is no expense in fiscal year 2009. You already expensed the inventory in fiscal year 2008.
3. Example2: You buy $10,000 of inventory in December, 2008 and sell the inventory in January, 2009 and you also pay for the inventoryin January, 2009. Because the inventory is sold in January, the purchase of the inventory is expensed in January, again matching revenue and expense. The expense (COGS) occurs in the 2009 fiscal year. When you pay for the inventory is another matter. In this case, you pay for the inventory in January so cash and accounts payable decrease in January. This paying off the debt—accounts payable—is unrelated to when the expense shows up on the income statement.

Note: This is a bit of an oversimplification, but the point is that paying off debt is not an expense on the income statement.

1. Interest Expense is an expense and is listed on the income statement. Principal reduction or the reduction of debt is not an expense. It is simply paying off a debt which changes the balance sheet.

Question 2

Period/Year / Principal Payment-
adjustment to balance sheet / Principal Amount
End of Year
(on balance sheet) / Interest Expense
(on income statement)
0 / NA / $10,000
(starting loan balance) / NA
1 / $1000 / $9,000 / $1,000 ($10,000 * 10%)
2 / $1,000 / $8,000 / $900 ($9,000 * 10%)
3 / $1,000 / $7,000 / $800
4 / $1,000 / $6,000 / $700
5 / $1,000 / $5,000 / $600
6 / $1,000 / $4,000 / $500
7 / $1,000 / $3,000 / $400
8 / $1,000 / $2,000 / $300
9 / $1,000 / $1,000 / $200
10 / $1,000 / $0 / $100