The Financial Reporting of a Debt

Question: The financial reporting of a debt contract appears to be fairly straightforward. Assume, for example,

that Brisbane Company borrows $400,000 in cash from a local bank on May 1, Year One. The face value of this

loan is to be repaid in exactly five years. In the interim, interest payments at an annual rate of 6 percent will be

made every six months beginning on November 1, Year One. What journal entries are appropriate to record a debt

issued for a cash amount that is equal to the face value of the contract?

Answer: Brisbane receives $400,000 in cash but also accepts a noncurrent liability for the same amount.

May 1, Year One—Cash of $400,000 Borrowed on Long-term Note Payable

The first semiannual interest payment will be made on November 1, Year One. Because the 6 percent interest

rate stated in the contract is for a full year, it must be halved to calculate the payment that covers the six-month

intervals. Each of these cash disbursements is for $12,000 which is the $400,000 face value × the 6 percent annual stated interest rate × 1/2 year.

November 1, Year One—Payment of Interest for Six Months

By December 31, Year One, interest for two additional months (November and December) has accrued. This

amount ($4,000 or $400,000 × 6 percent × 2/12 year) is recognized so that the financial statements prepared at

that time will be presented fairly. No transaction occurs on that date but adjustment is necessary when preparing

the Year One statements to report both the expense and the liability for these two months.

When the next $12,000 interest payment is made by Brisbane on May 1, Year Two, the recorded $4,000 liability

is extinguished and interest for four additional months (January through April) is recognized. The appropriate

expense for this period is $8,000 or $400,000 × 6 percent × 4/12 year. Mechanically, this payment could be

recorded in more than one way but the following journal entry is probably the easiest to follow.