Bookkeeping – Loan Accounting (Lesson 54)

Almost every small business borrows money. The most common reason is to purchase a fixed asset of some sort. The amount borrowed is most often a long-term liability. There are several steps involved in recording the original loan and then processing the respective payments. This article introduces the bookkeeper to long-term debt; how the original entry is recorded and reported; and how the note is reconciled for accounting purposes.

Loan Accounting – Introduction to Long-Term Debt

Debt is divided into two groups for presentation purposes. The first and most common is short-term debt. This is any form of a liability that is due (payable) within 12 months. They are classed as current liabilities and include:

• Accounts Payable
• Credit Card Accounts
• Taxes Payable
• Accrued Expenses
• Lines of Credit

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The second group of debt is long-term in nature and is classed into secured and unsecured status. Secured status is when an asset of some sort, usually a fixed asset, is the collateral for the loan. Unsecured customarily refers to a loan whereby there is no collateral tendered in case of default. Unsecured loans typically have higher interest rates and shorter pay back periods. If interested in learning more read: Types of Bank Loans in the finance section of this website.

A typical bottom half of a balance sheet looks like this:

                           XYZ Company
                   Limited Balance Sheet
                Liabilities and Equity Only
                               Date
Current Liabilities
    Accounts Payable                     $ZZ,ZZZ
    Credit Cards                               ZZ,ZZZ
    Accrued Payroll                            Z,ZZZ
    Accrued Expenses                        Z,ZZZ
    Taxes Payable                               Z,ZZZ
    Line of Credit                             ZZ,ZZZ
    Sub-Total Current Liabilities                       $ZZ,ZZZ
Long-Term Liabilities
    Secured Notes:
       Loan #5742 (Truck #2)         $ZZ,ZZZ
       Loan #6115 (Truck #3)             Z,ZZZ
       Loan #8660 (Backhoe)           ZZ,ZZZ
       Sub-Total Secured Notes                           ZZ,ZZZ
    Unsecured Notes:
        Shareholder’s Loan                 $Z,ZZZ
        Uncle Jim’s Note                    ZZ,ZZZ
        Sub-Total Unsecured Notes                      ZZ,ZZZ
TOTAL LIABILITIES                                   ZZZ,ZZZ
EQUITY
     Common Stock                        $ZZ,ZZZ
     Retained Earnings                   ZZZ,ZZZ
     Distributions                              (Z,ZZZ)
     Current Earnings                       ZZ,ZZZ
TOTAL EQUITY                                            ZZZ,ZZZ
TOTAL LIABILITIES & EQUITY              $ZZZ,ZZZ

It is important to note that secured notes are generally presented first. This is because any unsecured long-term note more closely resembles equity as it relates to risk.

Loan Accounting – Note Organization, Entry and Reporting

There are several different ways to organize the information related to long-term debt. If the total number of notes is less than five, I encourage you to simply create an individual account identification as a loan with the last four digits of the loan number as the nomenclature description of the account. Add a simple connection to the asset as illustrated above or something like ‘Loan #1018-2014 F150 P/U’ or ‘Ram 2500 Dually #5417’ will work well too.

If more than five assets, you may want to organize them into functional groups like this illustration:

Long-Term Notes:
    Transportation                        $ZZZ,ZZZ
    Equipment                                ZZZ,ZZZ
    Office Technology/Fixtures          Z,ZZZ
    Sub-Total Long-Term Notes                     $ZZZ,ZZZ

Each of the above three accounts is in a parent-child structure and can have many child accounts (an account for each note).

If the business carries more than 20 notes, I would advocate using spreadsheets with a workbook for each major group of notes. Then the summation spreadsheet for each group will match the balance as reported on the trial balance.

Loan Accounting – Current Portion of Long-Term Debt

This is covered in more detail in the advanced skills section of bookkeeping. But I will introduce the concept here so that you have some basic understanding of the subject matter.

Generally Accepted Accounting Principles divide all liabilities into two distinct age groups. The first group is the amount which is due over the next twelve calendar months and the second group is any principal balance due beyond twelve months. A typical long-term note is composed of both age groups customarily referred to as the short-term portion and the long-term amount. Remember, every loan payment made has principal and interest components. Therefore the next twelve principal payments are technically short-term debt; that is, the current portion of long-term debt.

Based on the above, there is another account in the current section of liabilities on the balance sheet called ‘Current Portion of Long-Term Debt‘ and its balance is all the principal values for all long-term notes due over the next twelve months.

What actually shows up in the values for long-term liabilities is the principal portion due in 13 or more months into the future. A proper liabilities section for a small business looks like this:

Current Liabilities
     Accounts Payable                   $ZZ,ZZZ
     Credit Card accounts                  Z,ZZZ
    Accrued Payroll                           Z,ZZZ
    Accrued Expenses                       Z,ZZZ
    Taxes Payable                             Z,ZZZ
    Line of Credit                           ZZ,ZZZ
    Current Portion of Debt              Z,ZZZ
    Sub-Total Current Liabilities                    $ZZ,ZZZ
Long-Term Liabilities
    Secured Debt:
       Loan #1191                         $ZZ,ZZZ
      Loan #4317                              Z,ZZZ
       Loan #9263                             Z,ZZZ
       Sub-Total Secured Debt                         ZZ,ZZZ
    Unsecured Debt:
       Shareholder’s Loan             $ZZ,ZZZ
       Uncle Jim’s Note                  ZZ,ZZZ
       Sub-Total Unsecured Debt                      ZZ,ZZZ
TOTAL LIABILITIES                              $ZZZ,ZZZ

Therefore, the entire note amounts due equals current portion plus secured and unsecured long-term values.

The actual entry process and tracking is quite complicated and is explained in greater detail in the advanced skill sets section of this website. For you, the adjustment is done once a year as a function of year-end closing entries. For this lesson, the values as identified in the respective long-term section of notes is essentially the entire amount due for debt.

Loan Payments

In over 90% of all loan payments the loan payment is composed of two components. The first and typically the largest share is interest. The second component is the principal. The lending institution customarily provides an amortization schedule upfront and this schedule breaks out the two components for the bookkeeper. Sometimes the lending institution sends individual coupons for each payment breaking out the two primary components.

A side note is appropriate here. Some loans are complex in nature and the payment is composed of several elements and may include the following in addition to principal and interest:

• Escrow Payments for Taxes and Insurance
• Replacement Reserves
• Warranty Fees
• Interest Amount Due for Float Rates and Risk Issues
• Contractual Amounts (Discounts, Legal, Mortgage Insurance etc.)
• Assessments

When the entry is posted, usually to the cash disbursements journal, it looks like this:

Cash Disbursement Journal
Date         ID         Ledger           Description                             DR                CR
Today    38402       Loan #6115    Payment #37 Principal         197.42
              38402       Interest           Payment #37 Interest            128.16
              38402       Cash               Payment #37 Loan #6115                           325.58
                                                                                                    325.58           325.58

If the payment comprises additional items, simply post each item as a separate line item to the correct account. Escrow payments are posted to either escrow or prepaid expenses; warranty is usually to a maintenance expense account; contractual and assessments are also posted to expense accounts.

Notice that in the above entry, the principal is debited to the loan account ( a credit based account) decreasing its running balance. Some accountants create a contra account to each loan and post the principal portion of payments there. The two accounts combined reflect the actual remaining principal for the note. This works well with very large mortgage notes or bonds but is not as effective with smaller auto or equipment notes. This is because a separate offset account allows management to interpret cash flow for financing faster and with a better understanding of how much cash is used to pay principal. By the way, the debit value for principal paid is collapsed (summed into) with the actual note value at year-end. This way the contra value is solely a year to date amount and not lifetime to date.

Loan Accounting – Note Reconciliation

As with all reconciliations there are two different sources that need to agree with each other. The first is the note’s ledger balance, i.e. total remaining principal. The second source is a lender’s statement which is often provided at year-end. The interesting aspect of this is that with notes, the lender often provides a third document, a Form 1099-I for interest paid during the calendar year. If every entry is perfect for the year (which it never is) the balances for principal and interest paid for that note will match.

Almost every time I’ve reviewed them, the values never match. Here are the most common reasons or errors:

1. The final payment at year-end was in the mail to the lender, recorded in the ledgers but is not included in the lender’s balance for both principal and interest. I encourage clients to have cut-off dates for long-term debt payments by December 15 of each year.  In this situation, interest on the company’s books is more than the lender’s records, and principal balance is less than the lender’s balance.
2. The prior year balance is incorrect; making the current balance off. This is exactly the same issue as in number one above except now the lender’s recorded interest and principal paid is greater than the ledger balance.
3. Minor differences exist between the two main documents, I’m referring to pennies. This happens because banks often calculate to 1/10th of a penny and records are kept to a penny. Thus rounding errors exist. I simply adjust to the bank’s record(s), pennies are not going to make or break a company.
4. Date entry errors often occur during the year. Basically as you enter the principal and interest you accidentally reversed the values. If you look at your ledger for either principal or interest you’ll notice a pattern exists. With principal, each succeeding payment has increasing principal amounts which is normal under amortization of principal. If one of those principal payments is significantly different, you accidentally made the interest portion the principal amount. Simply open the entry and reset the two dollar values.
5. If there are several notes, it is not uncommon to unknowingly enter the wrong note account when generating the original source entry. A key indicator is when two notes are off from their lender statements.

The best method of minimizing errors is to review the balances monthly and vouch the principal balance to the vendor’s balance. Often vendors provide their information online.

Summary – Loan Accounting

Long-term debt is a liability presented on the balance sheet. It is often grouped into two classes: secured (collateralize) and unsecured. Each month a payment is made comprising two components, interest and principal. Interest is posted as a debit to the capital costs section of expenses. The principal is a debit reducing the liability value in its respective account.

A good bookkeeper reconciles the principal value either to a lender’s statement or an amortization schedule on a regular basis. ACT ON KNOWLEDGE.

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