Debt versus equity, notes, and loan schedules

Learning goals

• Compare debt and equity from the business and investor perspectives.
• Record a note payable, accrued interest, and principal repayment.
• Build and verify a loan amortization schedule.
• Separate current and non-current portions of long-term debt.

Prerequisite check

Debt creates contractual principal and interest obligations. Equity gives a residual claim and may dilute control, but ordinary dividends are not the same fixed obligation.

Vocabulary

• Principal: amount borrowed and still outstanding.
• Interest: cost of using borrowed money over time.
• Amortization schedule: table dividing payments into interest and principal.
• Current portion of long-term debt: principal due within the next year.
• Covenant: contractual condition imposed by a lender.
• Leverage: use of debt to finance assets and potentially amplify owner returns and risk.

Core idea

Financing choice is a trade-off among cost, cash timing, risk, control, flexibility, and access. For every loan payment, interest is expense for the period and the rest reduces principal. The statement of financial position must separately present or disclose the amount due soon.

Why this treatment makes sense

Interest pays for time and risk; principal repayment returns borrowed capital and is not an expense. A schedule prevents the common mistake of treating the entire payment as interest and allows cash forecasting, covenant analysis, and current-debt classification.

A repeatable method

1. Identify amount, rate, compounding/payment dates, security, covenants, and fees.
2. Calculate period interest on opening principal at the applicable rate.
3. Determine principal reduction = payment − interest, or use the contract's fixed principal.
4. Calculate closing principal and repeat.
5. Check total principal reductions equal the original amount.
6. Record interest expense and principal reduction separately.
7. Compare financing options using after-contract cash needs, control, and risk—not rate alone.

Worked example

Kingston Kitchens borrows $100,000 at 6%, repaying $25,000 principal each December 31 for four years plus annual interest on opening principal.

Table: Four-year loan amortization schedule

At issue: debit Cash $100,000; credit Loan Payable $100,000. First payment: debit Interest Expense $6,000 and Loan Payable $25,000; credit Cash $31,000. Immediately after issue, $25,000 principal due within a year is current and $75,000 is non-current.

Journal, ledger, and statement connection

Interest lowers profit and retained earnings. Principal repayment lowers cash and the liability without affecting profit. On the cash-flow statement, interest follows the applicable framework/policy; principal repayment is financing. Disclose collateral, rates, maturity, and significant covenants as required.

Common mistakes

• Calculating every year's interest on the original principal.
• Expensing the full blended payment.
• Reporting all debt as non-current because the contract's final maturity is years away.
• Choosing equity as “free” because it has no stated interest; owners still expect returns and control may dilute.
• Comparing rates without fees, security, repayment timing, and covenant restrictions.

Guided practice

A $60,000 note bears 5% interest and requires a $15,000 principal payment after one year. First-year interest is $3,000 and cash paid is $18,000. Entry: debit Interest Expense $3,000, debit Note Payable $15,000, credit Cash $18,000.

Independent practice

1. Build the first two lines of a $80,000 loan with annual $20,000 principal payments and 7% interest.
2. Record the first payment.
3. Compare issuing shares with taking the loan using one advantage and one risk for each.
4. If a covenant requires current ratio at least 1.5, why should the current portion be classified accurately?

Self-check and solutions

1. Year 1 interest $5,600, payment $25,600, closing $60,000. Year 2 interest $4,200, payment $24,200, closing $40,000.
2. Debit Interest Expense $5,600; debit Loan Payable $20,000; credit Cash $25,600.
3. Debt can preserve ownership but forces payments and raises default risk. Equity avoids fixed repayment but dilutes ownership/control and future returns.
4. Misclassification can overstate working capital/current ratio and conceal a covenant breach.

Retrieval practice

1. Is principal repayment an expense?
2. On what balance is period interest calculated?
3. What makes debt “current”?

Answers: no; opening unpaid principal for the period; principal due within the next year/operating classification rule.

Exam-style application

Option A is a $200,000 secured loan at 6% with annual principal payments. Option B is $200,000 common shares. Give a recommendation framework, not a universal answer.

Model response: Forecast operating cash under downside cases, quantify loan interest/principal and covenant headroom, assess collateral and default consequences, then compare share dilution, voting control, expected owner return, and flexibility. Recommend only after identifying the firm's risk tolerance and funding purpose.

Lesson summary

Debt and equity exchange different costs and rights. A loan schedule separates time-based interest from principal, supports entries and cash forecasts, and reveals the current portion.