Business loans are a common source of bookkeeping errors, and the errors are expensive: profit is understated when principal is expensed, overstated when proceeds are recorded as income, and debt on the balance sheet stops matching the lender's statement.
Loan proceeds are not income
When a loan is funded, cash increases and a loan payable liability increases by the same amount. Nothing touches the profit and loss. Recording loan proceeds as revenue overstates income and can create a tax problem.
Split each payment
A typical loan payment includes:
- Interest, which is generally a deductible business expense
- Principal, which reduces the loan balance and is not an expense
- Sometimes escrow, fees or insurance, which each have their own treatment
Use the lender's amortization schedule or monthly statement to split each payment. If the payment is recorded entirely as an expense, the loan balance in the books never goes down and profit is understated.
The IRS explains when interest is deductible as a business expense in its guidance for small businesses, including Publication 334. Interest on money borrowed for personal purposes is not a business expense, even if the loan is in the business's name.
Equipment and vehicle loans
When equipment is financed, record the asset at its full cost in the fixed asset register and the loan as a liability. The asset's depreciation is separate from the loan payments. Dealers often bundle a trade-in, fees and add-ons into one contract; break the contract into its parts.
Lines of credit
Draws on a line of credit increase the liability; repayments reduce it. Interest charged is an expense. Reconcile the balance to the bank's statement monthly.
Loans from owners
Money an owner lends to the business is a liability to the owner, not a contribution, if it is documented as a loan with repayment terms. Treat it differently from capital contributions; see owner draw vs salary. The documentation matters for tax purposes.
Current and long-term portions
On the balance sheet, the principal due within the next 12 months is a current liability; the rest is long-term. Lenders and buyers look at this split.
Reconcile every loan monthly
Compare the balance in the books with the lender's statement each month. If they differ, look for:
- Payments recorded entirely as expense
- Fees or insurance added by the lender
- Payments made but not recorded
- Opening balance errors
Our bookkeeping services reconcile loans along with bank and card accounts; see our monthly bank reconciliation guide.
Year-end loan check
Compare the loan balance in your books with the lender's year-end statement, and split the balance between current and long-term portions on the balance sheet.
Loan fees
Fees paid to obtain a loan are often amortized over the loan term rather than expensed at once. Record them separately so your preparer can apply the correct treatment.
Key terms
Definitions for terms used in this guide, from our small business glossary:
- Amortization: Amortization spreads the cost of an intangible asset, or the repayment of a loan, over time.
- Line of Credit: A business line of credit is a revolving loan that lets a business borrow up to a set limit, repay and borrow again.
- Balance Sheet: A balance sheet shows what a business owns, what it owes and the owners' equity at a specific date.
- Depreciation: Depreciation spreads the cost of a long-lived business asset over the years it is used, rather than deducting it all at once.
