12 Debt and Leverage
A Primer on Risk and Reward
Journal Entries
Now that you have a good idea of how these loans work and the contractual cash flows for interest and principal, let’s see how a company makes changes to their books. We will start with Daisy Ltd., your retail company borrowing $50,000 on a three year term at a semi-annual interest rate of 3%.
Option 1: principal plus interest loan
You are not sure about future cash flow, so have decided on the less risky alternative. You will receive $50,000 from the bank on January 1, 20X1, and make interest payments on June 30 and December 31 of each year (20X1, 20X2, and 20X3). You have asked your accountant to give you a schedule with all the required journal entries for this three-year period. This is what your accountant sends you:
01 Jan. 20X1:
| DR | Cash in Bank | 50,000 | ||
| CR | Bank Loan Payable (Long-Term) | 50,000 |
30 Jun. 20X1:
| DR | Interest Expense | 1,500 | ||
| CR | Cash in Bank | 1,500 |
31 Dec. 20X1:
| DR | Interest Expense | 1,500 | ||
| CR | Cash in Bank | 1,500 |
30 Jun. 20X2:
| DR | Interest Expense | 1,500 | ||
| CR | Cash in Bank | 1,500 |
31 Dec. 20X2:
| DR | Interest Expense | 1,500 | ||
| CR | Cash in Bank | 1,500 |
30 Jun. 20X3:
| DR | Interest Expense | 1,500 | ||
| CR | Cash in Bank | 1,500 |
31 Dec. 20X3:
| DR | Interest Expense | 1,500 | ||
| DR | Bank Loan Payable (Long-Term) | 50,000 | ||
| CR | Cash in Bank | 51,500 |
These journal entries record the events in the amortization table that was completed earlier in the chapter. Notice that there are six interest payments and one principal repayment.
Option 2: Blended interest-principal loan
You want to keep as much value in the company as possible, so you have chosen the alternative that has the least amount of interest paid over the loan term. You will receive $50,000 from the bank on January 1, 20X1, and make blended interest-principal payments on June 30 and December 31 of each year (20X1, 20X2, and 20X3). Principal owing is declining over the loan term, so it will be helpful to refer to our amortization table to track how interest expense is calculated. Your accountant to gives you a schedule with all the required journal entries for this three-year period:
01 Jan. 20X1:
| DR | Cash in Bank | 50,000 | ||
| CR | Bank Loan Payable (Long-Term) | 50,000 |
30 Jun. 20X1:
| DR | Interest Expense | 1,500 | ||
| DR | Bank Loan Payable (Long-Term) | 7,730 | ||
| CR | Cash in Bank | 9,230 |
31 Dec. 20X1:
| DR | Interest Expense | 1,268 | ||
| DR | Bank Loan Payable (Long-Term) | 7,962 | ||
| CR | Cash in Bank | 9,230 |
30 Jun. 20X2:
| DR | Interest Expense | 1,029 | ||
| DR | Bank Loan Payable (Long-Term) | 8,201 | ||
| CR | Cash in Bank | 9,230 |
31 Dec. 20X2:
| DR | Interest Expense | 783 | ||
| DR | Bank Loan Payable (Long-Term) | 8,447 | ||
| CR | Cash in Bank | 9,230 |
30 Jun. 20X3:
| DR | Interest Expense | 530 | ||
| DR | Bank Loan Payable (Long-Term) | 8,700 | ||
| CR | Cash in Bank | 9,230 |
31 Dec. 20X3:
| DR | Interest Expense | 270 | ||
| DR | Bank Loan Payable (Long-Term) | 8,960 | ||
| CR | Cash in Bank | 9,230 |
Great! Now that you have seen both methods, let’s go through each method separately so you can practice. Remember Good Eats, Cleo’s Swimwear, and Mindful Media from earlier in the chapter? We are going to create journal entries for these loans. Excited? Me too!
My Turn: Prepare all necessary journal entries for Good Eats Inc.’s bank loan under the following options:
- Principal Plus Interest Loan
- Blended Interest-Principal Loan
Option 1: Principal Plus Interest Loan
01 Jan. 20X1:
| DR | Cash in Bank | 80,000 | ||
| CR | Bank Loan Payable (Long-Term) | 80,000 |
31 Mar. 20X1:
| DR | Interest Expense | 1,600 | ||
| CR | Cash in Bank | 1,600 |
30 Jun. 20X1:
| DR | Interest Expense | 1,600 | ||
| CR | Cash in Bank | 1,600 |
30 Sep. 20X1:
| DR | Interest Expense | 1,600 | ||
| CR | Cash in Bank | 1,600 |
31 Dec. 20X1:
| DR | Interest Expense | 1,600 | ||
| CR | Cash in Bank | 1,600 |
31 Mar. 20X2:
| DR | Interest Expense | 1,600 | ||
| CR | Cash in Bank | 1,600 |
30 Jun. 20X2:
| DR | Interest Expense | 1,600 | ||
| CR | Cash in Bank | 1,600 |
30 Sep. 20X2:
| DR | Interest Expense | 1,600 | ||
| CR | Cash in Bank | 1,600 |
31 Dec. 20X2:
| DR | Interest Expense | 1,600 | ||
| DR | Bank Loan Payable (Long-Term) | 80,000 | ||
| CR | Cash in Bank | 81,600 |
Option 2: Blended interest-principal loan
01 Jan. 20X1:
| DR | Cash in Bank | 80,000 | ||
| CR | Bank Loan Payable | 80,000 |
31 Mar. 20X1:
| DR | Interest Expense | 1,600 | ||
| DR | Bank Loan Payable | 9,321 | ||
| CR | Cash in Bank | 10,921 |
30 Jun. 20X1:
| DR | Interest Expense | 1,414 | ||
| DR | Bank Loan Payable | 9,507 | ||
| CR | Cash in Bank | 10,921 |
30 Sep. 20X1:
| DR | Interest Expense | 1,224 | ||
| DR | Bank Loan Payable | 9,697 | ||
| CR | Cash in Bank | 10,921 |
31 Dec. 20X1:
| DR | Interest Expense | 1,030 | ||
| DR | Bank Loan Payable | 9,891 | ||
| CR | Cash in Bank | 10,921 |
31 Mar. 20X2:
| DR | Interest Expense | 832 | ||
| DR | Bank Loan Payable | 10,089 | ||
| CR | Cash in Bank | 10,921 |
30 Jun. 20X2:
| DR | Interest Expense | 630 | ||
| DR | Bank Loan Payable | 10,291 | ||
| CR | Cash in Bank | 10,921 |
30 Sep. 20X2:
| DR | Interest Expense | 424 | ||
| DR | Bank Loan Payable | 10,497 | ||
| CR | Cash in Bank | 10,921 |
31 Dec. 20X2:
| DR | Interest Expense | 214 | ||
| DR | Bank Loan Payable | 10,707 | ||
| CR | Cash in Bank | 10,921 |
Alright – I believe you can do this. Give Cloe’s Swimwear a try.
Great work! Now try Mindful Media. You’ve got this!
Excellent! You know how to change the balance of loan payable, and how to put interest expense on the income statement. The next step is to see how these balances show up on the financial statements.