When a business makes a loan to an employee or an associate it can be treated in a number of different ways depending on how the loan is expected to be paid back. If the loan was made to parties not closely related to the company, the journal entry should be made in a different ledger. It is therefore important to understand the background of the loan in order to know where to best record it.
All activities of the company will eventually impact the balance sheet. Everything the company does either creates debts or increases the amount of value in the company. These two categories are termed “assets” and “liabilities” in bookkeeping. The things of value that the company has are assets and the debts are liabilities. Recording a loan that the company has taken out is fairly straightforward. If the terms of the loan will last for longer than a year, it will be recorded in the “loans” class of the company’s liabilities. If it is a short-term loan, it will be recorded as part of “current liabilities.” By contrast, if the company makes a loan to someone else, it is not a debt and so not a liability. It is a credit that the company can claim back, and so it is categorised as an asset.
Whatever the circumstances of the loan, the likelihood is that the payment reduced the amount of cash in the business. The outgoing money should therefore result in a credit to the cash account. Double-entry bookkeeping uses the terminology in the reverse of that used in everyday life; you decrease the balance of an account with a credit and increase it with a debit.
Loans and advances
Companies have some choice about the level of detail they need to go into in their books. If the company is not very large, it is likely to lump several categories together in one journal. A loan made to an employee or associate of the company will eventually appear on the balance sheet as “loans and advancements.” However, you need to further break this down between long-term loans and short-term loans, which are called “current assets.” Even if the loan is long-term, the proportion of the loan that is expected to be paid back within a year has to be split out from the total amount and entered into the current assets journal. If the loan is to an employee and will be deducted from his wages it can be treated as an advance. It should be expected that advances are short-term loans and would therefore appear in current assets.
If your accounting system drills down to greater detail, there are several different accounts to which you would write this loan. In each case, bear in mind that the part of the loan expected to be repaid in the current year should be split out into the current assets version of that account. You could record loans to directors separately in a Directors loan account. Loans to employees would go in an Employee loans account or an advances account. Loans to customers should go into an account called “Loan to Customers.” In each case you could also create a sub account in the name of each loan recipient.
Interest paid by the receiver of the loan should be written to different accounts and kept apart from the record of the initial loans and the repayment of principal. Interest payments cause a debit to the current asset Interest Receivable and a credit to Interest Revenue. Principal repayments would cause a debit to the cash account, which will eventually match the original credit made in that account when the loan was first issued.
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