Fixed income explained
Fixed income, as its name suggests, is a guaranteed amount of income a person, business or corporate body will receive. As such individuals or businesses may receive a fixed income the type and amount of which depends on the specific circumstances. In the real world it is mainly businesses that generate fixed income therefore this article will be focused on businesses as opposed to individuals.
Fixed income sounds great and it is, but where and how do businesses generate fixed income? How many sources of fixed income are there?
If a business has cash reserves that are held on deposit in a separate bank account, the cash will be generating interest. Many banks offer fixed rate interest where the interest earned is calculated using a pre agreed interest rate. The fixed rate interest is, as you would expect a source of fixed income for the business. Interest is compounded, which means you earn interest on interest therefore whilst the interest is fixed income the amount received is variable. It is possible to fix the amount of the fixed income and that is to draw out the interest as soon as it is earned, leaving the capital untouched.
If a business loans money to an employee, director or any other third party it can charge interest, the amount of which will generate a fixed income. If the business has the spare cash available lending it is a good way of generating some fixed income. Lending money is risky but the rewards, i.e. the fixed income generated, can be very high making it worthwhile. Lending money to employees is safer than lending money to third parties since you can always deduct the loan repayment from the employee’s salary which eliminates the chance of default and late payment. Suppose a business loans an employee $10,000 over a period of four years and charges interest of $2,000. This loan is to be paid monthly over the term of the loan. The business will receive a monthly fixed income of $250 per month for the next four years.
A business may let one of its properties to generate some rental income. Under the rental agreement the business will charge its tenant $750 per month for a period of three years. The $750 is fixed income that the business is guaranteed to receive for the duration of the rental agreement. Some business rent their premises but will sub-let unoccupied rooms to generate some fixed income.
There are numerous ways a business can generate a fixed income, but the above are the most common in the real world.
Fixed income is a business transaction that needs to be recorded in the business accounts. So the next question is “How does a business account for fixed income?” Providing you remember that for every credit there is a corresponding debit and vice versa, i.e. the double entry principle, you will have no problems recording fixed income in the business’ accounting records.
Where a business is receiving fixed income interest from cash held on deposit the accounting entry is to debit the bank control account in the balance sheet and credit the interest receivable code in the profit and loss account. The entries will be posted as the fixed income interest is received. You have to remember that the accounts have to be prepared on the accruals accounting concept therefore you may have to make a journal entry to account for any accrued interest at the year end.
Where a business loans an employee some money the initial loan has to be recorded in the accounting records. The loan is accounted for by crediting the bank control account and debiting the employee loan account, both of which are balance sheet entries. The initial entry should be for the amount loaned and not the total amount payable. Using our previous example, the amount of $10,000 would be recorded in the accounting records. As the employee makes the monthly repayments the double entry is to debit the bank in the balance sheet with $250, credit the employee loan account in the balance sheet with $208.33 and credit the interest receivable in the profit and loss with $41.67. This is a monthly journal to record the fixed income.
Where a business lets out a property or sub-lets some office space to generate a fixed income the transaction is recorded in the accounts by debiting the bank control account in the balance sheet and crediting the rents receivable account in the profit and loss account. As with the interest you may need to make a year-end adjustment to record any accrued income and ensure the accounts are prepared under the accruals accounting method.
There are some advantages of generating a fixed income. Fixed income is guaranteed and will not change. When a business has a fixed income source many things are made a whole lot easier. The business can be certain it will generate an income therefore it is easier to get bank loans and funding. The business can create forecasts and budgets with accurate fixed income figures. The business can plan when to pay suppliers as it knows how much fixed income it will receive and when the fixed income will be received. Similarly, the business can plan when to buy fixed assets and carry out investment plans.
Having a fixed income also carries some disadvantages. The main disadvantage is the business cannot increase the amount of fixed income when it wants to. Fixed income levels remain for a contractual period and it is not possible to change rates until the contract expires or there is a break clause. If costs rise, there is a VAT increase or an inflationary increase the business cannot pass these additional costs on therefore margins will be squeezed.
On the whole fixed income is a good thing and if a business can generate sources of fixed income it should grab the opportunity with both hands. That said, it is important not to put all your eggs in one basket and the business should ensure it also generates non fixed income, where it has greater control over the varying of prices and covering any increase in costs.