How Do Loans Work?

OK. So I'm sure everyone is thinking, "of course we understand how loans work". That's fair, you probably do from a business or a cash-in/cash-out perspective. However, do you understand how to account for loans? I can confidently say that many people do not. While accounting for loans is not terribly complicated, doing it incorrectly can understate your income in a given year. Getting this right can lead to less headaches in the future.

LOANS ARE LIABILTIES

To properly account for loans, you have to think of it as a cash transaction that only effects the balance sheet. This means that when you get a loan, your cash balance (asset) goes up and your loan balance (liabilities) also go up. So, for example, if you receive a $200,000 loan, you would increase your cash balance by $200,000 and increase your loan account balance to $200,000. Stepping back and thinking about this from a financial or business perspective, if you only had this item on your balance sheet, your asset to liability ratio would be 1:1. For every dollar in cash you have liquid and available to you, you have one dollar you owe to the bank.

PAYBACK OF LOAN PRINCIPAL IS NOT AN EXPENSE

If there is one item that most new small business owners get wrong, it is this. Most people assume that if the business pays cash out, in this case to reduce a loan balance, it must be an expense. That assumption would be incorrect. Remember above when I said that original loan transaction is a cash transaction that only hits the balance sheet? Well, that's because when you receive a loan, it increases your cash but it is not revenue to the business. So, the only way to reduce loan balance is to reverse the original entry. The transaction would be a decrease in cash and a subsequent decrease in loan balance for the amount of the principal paid. I often see small business owners attempt to classify the loan payback as an expense which understates income and can lead to problems if the understated income is reported on a tax return. Reporting the loan payback as an expense would also create a mismatch because you would reduce cash but would also leave the original loan balance on the books.

WHAT ABOUT INTEREST?

Unfortunately, interest is one of those of those necessary evils. Banks make money of off interest, and the IRS expects you to pay it. The positive thing about interest is that it is an expense of the company. Why? Well, because the bank as the payee is going to record the interest received as interest income. The flip side of that transaction is that you, as the payor of interest get to record that cash out as an expense, thus reducing your taxable net income.

CONCLUSION

Before get a loan from a bank or the SBA, please understand how that is going to affect

your balance sheet and your business operations from a cash flow standpoint. Please also make sure you understand the basics of accounting for a loan or contact West Highland so that you are not inadvertently understating income on your financials.

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