Many times in business we will find that the time has come to take on a loan in order to catalyze our ideas and turn them into a reality. A good idea will only go so far if it requires capital and you don’t have it. Loans can come in many forms. The first choice of course is that the owner or shareholder of the company makes a loan to the company. This was covered in a previous blog post so this time especially since someone recently wrote in and asked why I don’t have a post on loans from 3rd parties, I am talking about how to account for loans to your company. My answer to him was that I just haven’t done a post on loans to the company where the lender is an outside enterprise. Like a bank! Or an investor. Actually an investor would make an investment and that would show up in the Equity section of the balance sheet. Since we are talking about loans we are talking about the liability section of the balance sheet. Loans are actually pretty simple but they are often screwed up by inexperienced bookkeepers!
When you borrow money there is usually a document that supports the fact that someone is lending you the money. Generally the document, sometimes called a “Loan Agreement” will state a few important pieces of information:
- The amount you are borrowing aka “Principal”
- The interest rate you are being charged – this is the cost of borrowing and will show up as an expense, often called “Interest Expense” or “Loan Interest” on your Profit and Loss (P&L) statement.
- The Loan Term – how long do you have to pay it back? 1 year? 5 years, 100 years?
- Other covenants – sometimes there will be restrictions such as “you can’t borrow any money from anyone else until this loan is paid back”
- Any collateral pledged to secure the loan such as “Accounts Receivable” or a bank may require you to secure the loan with cash in a CD.
Once all of these details are hashed out and the document(s) are signed the bank will either issue you a check or simply drop the money into your account (if you already bank with them). So there is an initial deposit associated with the loan. I cannot tell you how many times I have discovered loan payments from a business owner and actually had to ask where the initial principal went!
After you’ve borrowed money it follows that you have to pay it back. There is usually an effective interest schedule that can be obtained or created that shows the repayment schedule for the life of the loan. If the interest rate is fixed this can be laid out for the entire life of the loan right at the start. If the interest rate on the loan is variable then that means it may change. In most cases where the interest rate on a loan is variable it is based on the prime rate. Still you can set up the payment schedule, but you want to structure it a little differently so that at any point in the time line you can adjust the rate.
When you received the loan from the bank you had to record the deposit in your bank account. The offsetting account would be “Loan Payable – iBank” (let’s say). That loan payable is a liability and it represents how much you owe the bank. Every payment you make is made up of 2 parts; principal and interest. The interest is an expense (the cost of borrowing money from the bank) and the principal is a reduction in the amount you owe the bank. So with each payment you are recording an expense and reducing the principal. The screen cast on this will demonstrate the following:
- How to use my effective interest template (available in my School of Answers) in excel to calculate your loan re-payment schedule.
- How to record the initial loan when you receive the loan from the bank.
- 2 methods for recording the re-payment of the loan with principal and interest properly taken into account.
Post your comments and questions below!
Download the Effective Interest table in my School of Answers
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