Loans are an item that can easily be accounted for incorrectly. This is a common occurrence for items that affect the Balance Sheet (assets, liabilities, and equity). The majority of folks without an accounting background are more familiar with – and potential only aware of – their Profit and Loss.
The incorrect way to account for a loan is to simply expense each payment as it’s made. A loan does not qualify as a deductible business expense, however, the interest you pay on it does. It is important to set-up the loan once the funds are received and appropriately allocate the principal and interest portions of the recurring payments. Let’s go over an example using a $10,000 loan, with monthly recurring payments that include both interest and principal.
Creating a General Ledger Account
If you haven’t already, you will want to create a new General Ledger account for the loan. To do so, click on the gear icon in the upper right-hand corner, then on Chart of Accounts. You can also use the left-hand menu, clicking on Transactions, then Chart of Accounts. Click New. Category Type will be Long Term Liabilities (if the loan repayment is further than a year out, otherwise choose Other Current Liabilities). We will name it Loan Payable for this example. Click Save and Close.
Setting Up the Loan
The most likely scenario when obtaining a loan is to receive the funds (by cash, check, ACH, etc.). This is a simple entry. Simply record a deposit (more detail on deposits HERE), choosing the lender as the “Received From”, which you’ll want to have set up as a Vendor (more detail on Vendors HERE). The Account will be Loan Payable that we set up earlier and the amount will be the principal portion of the loan. Let’s assume for simplicity’s sake that we are only dealing with principal and interest on this loan. Save the deposit.
Making Loan Payments
For this example, we will pay the loan by check (more information on entering bills and then bill payments HERE). Our Payee will be the lender. For the Accounts, it will be broken out between principal and interest. For our example, the payment total is $500 with $350 being interest. The remaining $150 will go against the Loan Payable, reducing the balance that is outstanding.
**Efficiency tip: Use your loan amortization schedule to set up ALL the bills once your loan is funded. You can set each one up with the appropriate date in the future and allocate the principal and interest for each according to the schedule. When you make each payment, you simple do a bill payment for the full payment amount.
Loans may not always be a straight-forward as this example, so if you’d like assistance setting up and accounting for a more complex loan, please contact me and I’d be happy to lend a hand!