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Unearned Income

Hi guys,

If a lender issues a loan to a borrower for $1m, repayable in equal $250,000 chunks each quarter, but they can repay the principal balance at whatever point in the quarter they want to. If interest is 1% on the loan, and first quarter interest is based from 31/12 - 31/03 = $2,500.

If they decide to pay the principal and interest early, say 31/01, what criteria does the remaining 31/01-31/03 portion received in advance, count as unearned income, therefore adding a liability to the Balance sheet? Is it just automatically counted as unearned income, or can it be taken to P&L in January under any circumstances?

Thanks

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I am not sure if this kind of question is part of any cfa level. 

In any case, following is the answer.

Principal prepayment adjustment effect depends on the terms of the financing agreements. If it is written in the agreement that principal prepayments are applied in the inverse order (which is usually the case in corporate loans) then last principal instalment is adjusted and tenor of the loan is reduced. Borrower has to follow the agreed repayment schedule otherwise and again pay principal on the scheduled instalment date. On the other hand if the agreements says prepayment is adjusted from the next instalment then tenor will remain the same and borrower will not pay principal on the next instalment date.

As far as markup is concerned; borrowers will be stupid (which i am sure not the case) if they pay entire markup amount of next instalment for early adjustment. However borrowers can deposit markup payment in an escrow account just to make sure that cash flows are available on the next instalment date. Banks pay markup to the borrowers on this amount so that borrowers do not lose opportunity cost of funds by depositing payment early. On the instalment date the amount is adjusted to pay the scheduled markup payment. 

So in theory banks may record unearned income in the case in question but practically i havent experienced it.