Debt accounting
/What is Debt?
Debt is defined as an amount owed for funds borrowed. The lender agrees to lend funds to the borrower upon a promise by the borrower to pay interest on the debt, usually with the interest to be paid at regular intervals. A person or business acquires debt in order to use the funds for operating needs or capital purchases.
How to Account for Debt
There are several issues that the borrower must be aware of when accounting for debt. The initial issue is how to classify the debt in the accounting records. Here are the main areas to be concerned about:
If the debt is payable within one year, record the debt in a short-term debt account. This is a liability account. The typical line of credit is payable within one year, and so is classified as short-term debt.
If the debt is payable in more than one year, record the debt in a long-term debt account. This is a liability account.
If the debt is in the form of a credit card statement, this is typically handled as an account payable, and so is simply recorded through the accounts payable module in the accounting software.
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Accounting for Interest Expense
The next debt accounting issue is how to determine the amount of interest expense associated with debt. This is usually quite easy, since the lender includes the amount of the interest expense on its periodic billing statements to the company. In the case of a line of credit, the borrower is probably required to maintain its primary checking account with the lending bank, so the bank simply deducts the interest from the checking account once a month. This amount is usually identified as an interest charge on the bank statement, so the bookkeeper can easily identify it and record it as part of the monthly bank reconciliation adjustments. Alternatively, the lender may provide an amortization schedule to the borrower, which states the proportions of interest expense and loan repayment that will comprise each subsequent payment made to the lender.
Accounting for Debt-Related Transactions
The next issue is how to account for the various debt-related transactions. They are as follows:
Initial loan. When a loan is first taken out, debit the cash account and credit either the short-term debt account or long-term debt account, depending on the nature of the loan.
Interest payment. If there is no immediate loan repayment, with only interest being paid, then the entry is a debit to the interest expense account and a credit to the cash account.
Mixed payment. If a payment is being made that includes both interest expense and a loan repayment, debit the interest expense account, debit the applicable loan liability account, and credit the cash account.
Final payment. If there is a final balloon payment where most or all of the debt is repaid, debit the applicable loan liability account and credit the cash account.
Presentation of Debt
The portion of debt that is payable within the next twelve months is presented within the current liabilities section of the balance sheet. The remaining debt (which is payable in more than twelve months) is presented within the long-term liabilities section of the balance sheet. In addition, any interest expense is presented on the income statement as a non-operating expense. If the interest expense is incurred in order to construct a fixed asset, then the expense may instead be capitalized into the cost of the asset, so that it appears within the fixed assets line item on the balance sheet.
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