Accounting for loans

Loans are a little more straightforward than leases. You do not have to worry about the type of loan because every loan is used to finance business assets or operations.

There are two main types of loans: those with fixed payments that have differing interest and principal components, and those with fixed principal repayments and a floating interest component.

Let's start with the easy type first: those with fixed principal repayments. For example, let's say the original loan is for $20,000 at 5 percent interest for a five-year term. Repayment terms stipulate that you have to pay back principal of $333.33 per month, plus interest. In the books, the setup for the initial loan would look like this:

            DR     Cash                                $20,000

            CR     Loan payable                                      $20,000

 

This entry records the reality of the situation. You have debited cash because you now have $20,000 in loan proceeds sitting in your bank account. You also have a liability to payoff the $20,000 over the next five years. Note that this loan would be set up in the long-term liabilities section of your ledger because it will last longer than 12 months.

In this example, the loan is advanced by the bank at which you have your business account. Every month, your bank will withdraw from your account the $333.33 principal repayment and the interest. The interest will drop every month as the principal amount decreases. In the first month, the bank takes out ­

Principal                    $333.33

Interest                        83.33

 

The accounting entry to record this is ­

DR     Loan payable                        $333.33

DR     Interest expense                       83.33

CR Bank                                                            $416.66

 

It's important to remember that the loan liability balance will decrease only by the principal portion of the payment. The interest portion is recorded as an expense of the period in which the payment is made.

The second type of loan is a loan with fixed - usually monthly - payments. These payments are blended: a portion is principal and a portion is interest. Most mortgages are set up this way. To determine how much belongs to each category, you must look at an amortization table.

An amortization table calculates interest based on the terms of the loan and allocates the rest of the fixed payment to principal. Because the interest portion will decrease with every payment (it's being calculated on a decreasing loan balance), the principal portion will increase.

The easiest way to obtain an amortization schedule is to ask your lender to provide one. This way, you know that the amounts set out in the table will match your actual payments exactly. If your lender is unwilling or unable to provide you with an amortization table, you will have to create one yourself.

The entry to record the payment is the same as the entry for the first type of loan (fixed principal repayments) described above. However, the interest and principal in the entry will change with each payment. You will find the split between principal and interest by using the amortization table and apportion the payment accordingly.

The entry to record a payment on the table would be ­

DR Loan payable

DR Interest expense

CR Bank