12 Debt and Leverage
A Primer on Risk and Reward
Interest Payable: Accruing Loan Interest
In all the previous examples, the company’s fiscal year end date was December 31. This was convenient because an interest payment was made on that same date. What happens if the company has a different year-end date? We know that the income statement reflects all costs a company expends to create value over the fiscal year. What about loans? A loan has a cost: interest. And loans create value in a company by financing operations. So it makes sense that all interest for a fiscal year should be expensed whether or not it has been paid. Accruals will be necessary under both methods if interest is not due and paid on the fiscal year end date.
How is accrued interest calculated and journalized? This is a great question that is best answered by revisiting the company examples from earlier in this chapter. 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%.
Here are the journal entries for the principal plus interest method. The entries on the left-hand side should look familiar: they are Daisy’s journal entries with a December 31 year end, which we did previously. On the right-hand side are Daisy’s journal entries where Daisy’s year end is October 31, which does not coincide with the interest cash flow. In this method, because the principal amount does not change, the June, October, and December journal entries for interest will be the same every year. There are four important differences in the scenario with interest accruals:
- A journal entry is entered at October 31 each year, coinciding with the year end
- Interest is prorated for the number of months the loan has been outstanding since the last interest payment date. In the Daisy Ltd. example, the last interest payment date was June 30, so 4 months have passed at the year-end of October 31. Because the interest payments are semi-annual, or every 6 months, 4/6 months of interest is outstanding. Interest expense is therefore calculated as $1,500 × 4/6 = $1,000 every October 31.
- Interest is not paid at October 31, rather it is payable at a later date. Use the account interest payable to reflect interest that has been accrued and not paid.
- The December 31 journal entry will be different because part of the interest paid at this date has already been expensed. In the Daisy Ltd. example, $1,000 has been expensed. So at December 31 the remaining $500 will be expensed as interest expense: calculated as $1,500 – $1,000 or $1,500 × 2/6 months. You will need a debit of $1,000 to balance your entry. Fortunately interest payable has a balance of $1,000 and is no longer payable because Daisy is paying their interest owing in full at this date!
Of course, cash isn’t paid at the fiscal year end. That’s because the loan payment dates are the same as before. We’re simply adding an accrual entry at October 31, and reversing the payable on the next cash payment date. Take a look:
Next are journal entries for the blended interest-principal payment loans. Accrued interest is calculated the exact same way as before, except in the principal plus interest loan example the interest payments didn’t change. That’s not the case for blended interest-principal loans. Take a look:
Excellent. Ready to move on to the other problems: Good Eats, Cleo’s Swimwear, and Mindful Media? I will start.
Excellent. Ready to move on to the other problems: Good Eats, Cleo’s Swimwear, and Mindful Media? I will start.
- My Turn:
- Good Eats Inc. has a fiscal year end of May 31. Prepare Good Eats’ journal entries with year-end accruals for their loan under options 1 and 2. Your previous journal entries for this company – without accruals – are provided for reference.
Option 1: Principal Plus Interest Loan Journal Entries for Good Eats
Option 2: Blended Interest-Principal Loan Journal Entries for Good Eats
| Dec 31 Year-End (No Year-End Accruals) | May 31 Year-End (Interest Accruals) | ||||
|---|---|---|---|---|---|
| Jan 1, 20X1 | DR Cash in bank | 80,000 | 80,000 | ||
| CR Bank loan payable | 80,000 | 80,000 | |||
| (to record issuance of bank loan) | |||||
| Mar 31, 20X1 | DR Interest expense | 1,600 | 1,600 | ||
| DR Bank loan payable (long-term) | 9,321 | 9,321 | |||
| CR Cash in bank | 10,921 | 10,921 | |||
| (to record payment of interest and principal on loan) | |||||
| May 31, 20X1 | DR Interest expense | – | 943 | ||
| CR Interest payable | – | 943 | |||
| (to record year-end interest accrual: 1,414 x 2/3 months) | |||||
| Jun 30, 20X1 | DR Interest expense | 1,414 | 471 | ||
| DR Interest payable | – | 943 | |||
| DR Bank loan payable | 9,507 | 9,507 | |||
| CR Cash in bank | 10,921 | 10,921 | |||
| (to record payment of interest and principal on loan) | |||||
| Sep 30, 20X1 | DR Interest expense | 1,224 | 1,224 | ||
| DR Bank loan payable (long-term) | 9,698 | 9,697 | |||
| CR Cash in bank | 10,921 | 10,921 | |||
| (to record payment of interest and principal on loan) | |||||
| Dec 31, 20X1 | DR Interest expense | 1,030 | 1,030 | ||
| DR Bank loan payable | 9,891 | 9,891 | |||
| CR Cash in bank | 10,921 | 10,921 | |||
| (to record payment of interest and principal on loan) | |||||
| Mar 31, 20X2 | DR Interest expense | 832 | 832 | ||
| DR Bank loan payable | 10,089 | 10,089 | |||
| CR Cash in bank | 10,921 | 10,921 | |||
| (to record payment of interest and principal on loan) | |||||
| CR Interest payable | – | 420 | |||
| (to record year-end interest accrual: 630 x 2/3 months) | |||||
| Jun 30, 20X2 | DR Interest expense | 630 | 210 | ||
| DR Interest payable | – | 420 | |||
| DR Bank loan payable | 10,291 | 10,291 | |||
| CR Cash in bank | 10,921 | 10,921 | |||
| (to record payment of interest and principal on loan) | |||||
| Sep 30, 20X2 | DR Interest expense | 424 | 424 | ||
| DR Bank loan payable | 10,497 | 10,497 | |||
| CR Cash in bank | 10,921 | 10,921 | |||
| (to record payment of interest and principal on loan) | |||||
| Dec 31, 20X2 | DR Interest expense | 214 | 214 | ||
| DR Bank loan payable | 10,707 | 10,707 | |||
| CR Cash in bank | 10,921 | 10,921 | |||
| (to record payment of interest and principal on loan) | |||||
Here’s one for you.
Great work! Now try Mindful Media. You’ve got this!
That’s it for journal entries and accounting for debt. Now let’s learn how to evaluate how companies use debt.