In accounting, you don't treat paying for a loan like paying for office furniture. Suppose you pay your bank $100,000 tomorrow to take out a three-year, $3 million loan. Rather than treat the $100,000 as a regular business expense, the accounting treatment of loan processing fees requires claiming it gradually over the life of the loan.
TL;DR (Too Long; Didn't Read)
Upfront loan costs can include underwriting, origination fees and application fees. Accounting amortizes the fees to spread the expense over the life of the loan. If you have $400,000 in fees on a five-year loan, you amortize one-fifth of the fees, or $80,000, each year. You amortize the loan interest the same way.
Accounting's Matching Principle
The accounting treatment of loan processing fees is based on the matching principle of accounting. This guideline says that if there's a cause-and-effect relationship between revenue and expenses, you match them to the same accounting period. Otherwise, you record the money you pay as a regular expense.
Depreciation is one example. Say you buy a piece of computer equipment that, according to accounting rules, has a projected useful life of four years. Rather than report the purchase price as an expense, you depreciate the cost over the four years.
The same matching principle applies to the accounting treatment of loan processing fees. Any costs you pay upfront are matched to the time frame of the loan. If you have a five-year loan, you account for loan fees amortization over five years; for a 10-year-loan, the amortization of financing fees lasts 10 years.
One of the goals of the Generally Accepted Accounting Principles (GAAP) in the U.S. is that your accounting should give investors and lenders an accurate view of your finances. That's the reason for the matching principle.
Say you pay $100,000 in January to take out a $1.5 million seven-year loan. If you report the loan costs as an expense, you have abnormally high expenses that month, making your company look less profitable than it is. You'll benefit from the loan over the seven years before you pay it all back. So, matching the accounting treatment of the loan origination fees to the seven-year period gives a more realistic view of your finances.
Past Amortization of Financing Fees
Upfront loan fees can include origination fees, points, placement fees, application fees, management fees and more. Under GAAP, the rules on accounting for fees changed in 2015.
Suppose you take out a $100,000 four-year loan with $3,500 in application fees and another $1,500 in management fees. Before 2015, you'd have recorded the $5,000 in upfront costs as an asset. As you amortized the cost of the loan, you'd reduce the asset account and transfer the money to Amortization Expense.
Amortization of Fees Now
The Financial Accounting Standards Board (FASB) changed the rules in 2015 to simplify accounting for loan costs. The change also makes GAAP rules closer to international standards.
Under the new rules, a $100,000 four-year loan with $5,000 in upfront costs goes into your ledgers as a $95,000 loan. You deduct the costs from the loan rather than create a separate asset entry. Then you include the amortized cost of the loan as part of the journal entries for interest payments.
Suppose your $100,000 loan has a 4% interest rate, so you pay $4,000 in interest over the four-year life of the loan. The bank may include more interest than principal in your initial loan payments, but as far as accounting is concerned, you pay the interest evenly.
Calculating the loan fees amortization is relatively simple. The costs are $5,000, which on a four-year loan translates into amortizing $1,250 of the costs each year. You also amortize $4,000 in interest at a rate of $1,000 a year. That's a total $2,250 in loan expense to amortize each year, with $187.50, or a twelfth of that amount, amortized each month.
Before 2015, you'd have recorded two separate entries, one for amortizing interest and one for loan costs. Under the latest FASB rules, the loan interest entry covers both expenses.
Accounting for Loan Origination Fees
Suppose you take out a $500,000 five-year loan with $10,000 in fees and $20,000 in interest. You'd record $490,000 in your cash account and a corresponding $490,000 as Net Loan Debt. A memo in the journal details the gross debt, with the debt cost recorded as a contra account, matched against gross debt.
Every year that follows, you reduce debt cost by $2,000 in amortization. On the balance sheet, you deduct the amortized cost of the loan from retained earnings along with the $4,000 in interest for the year, using one single entry. This makes your accounting considerably simpler.
One way in which this approach is more complicated is that the change is retroactive. If you already had loans that predated the change, you have to revise the accounting to match the new FASB rules. As 2015 recedes in the rear-view mirror, that will eventually stop being an issue.
Accounting for Revolving Credit
One reason FASB changed the rules was that treating loan costs as an asset didn't make sense. Assets, in accounting, generate revenue. After you pay the fees for the loan, they no longer generate any revenue for you.
The FASB sees upfront costs on a line of credit differently. A line of credit is ongoing; even if you max it out, you can start drawing against it after you pay it off. The costs of setting up the line are a gift that keeps on giving, so the costs can qualify as an asset.
For example, suppose you apply to your bank for a $5 million credit line, accessible for the next three years, with upfront costs of $100,000. When you sign all the paperwork, you report the $100,000 as an asset, then amortize the amount over three years. FASB accepts the amortization of finance fees this way, even if you never draw on the credit line.
One side effect of the new rules is that if you're working on mergers, acquisitions or leveraged buyouts, you may have to change your financial models. The new FASB rules change how the fees flow through the model when you finance your merger with borrowed money. The financial models need to reflect that to give you accurate predictions.
Loan Costs and Taxes
If you use GAAP, you'll probably need a second set of journals covering your tax accounting. Federal tax rules don't follow GAAP, so you have to treat loan costs differently. For example, you can only deduct interest you've actually paid; if the loan payments include more interest in the early years, you get a larger deduction, followed by a smaller one later.
Repayment of principal is never deductible, just as you never pay income tax on the loan when you receive it. Interest is deductible on most business loans, but some of your fees may not be. For example, if you pay a standby fee to have a line of credit available, you can't deduct it as an interest payment.
If you take out a loan for multiple purposes, you may have to break down the loan and account for each part separately. For example, suppose you're a sole proprietor, and you take out a $200,000 loan. $100,000 is for new equipment, $50,000 is for investment in a limited partnership, $20,000 for a personal expense, and $30,000 stays in your checking account.
- The $100,000 is a legitimate business expense. You deduct the interest on that part of the loan accordingly.
- The $50,000 invested in the limited partnership is a passive activity, one you don't participate in actively. You have to account for the interest separately from the equipment purchase.
- Interest on the $20,000 you spent on personal expenses isn't deductible.
- The $30,000 that stays in your account is treated separately too, as "property held for investment."
- Accounting Coach: Why Are Loan Costs Amortized?
- Accounting Tools: The Matching Principle
- EGG: Capitalization of Interest and Loan Fees
- Meaden & Moore: Accounting for Loan Origination Fees
- Aprio: Simplifying the Presentation of Debt Issuance Costs and the Imputation of Interest
- Wall Street Prep: Debt Accounting: Financing Fees
- Forbes: Are Your Business Loans Tax Deductible?
- IRS: Business Expenses
- Debt.org. "What Is a Loan Agreement?" Accessed Oct. 23, 2020.
- U.S. Department of Education Federal Student Aid. "The Standard Repayment Plan is the basic repayment plan for loans from the William D. Ford Federal Direct Loan (Direct Loan) Program and Federal Family Education Loan (FFEL) Program." Accessed Oct. 23, 2020.
- Corporate Finance Institute (CFI). "Amortization Schedule." Accessed Oct. 23, 2020.
- Consumer Financial Protection Bureau. "What is a prepayment penalty?" Accessed Oct. 23, 2020.
- Consumer Financial Protection Bureau. "Loan Estimate and Closing Disclosure: Your guides in choosing the right home loan." Accessed Oct. 23, 2020.
- Consumer Financial Protection Bureau. "What is a balloon payment? When is one allowed?" Accessed Oct. 23, 2020.
- Accion.org. "2 Different Types of Personal Guarantees Your Business Needs to Understand." Accessed Oct. 23, 2020.
- Consumer Financial Protection Bureau. "Know what is negotiable." Accessed Oct. 23, 2020.
- Each loan payment generally includes both principle and interest. Loan principle is not an expense, but is deducted from the loan balance. Loan interest is deductible as it is paid or accrued. Set up a separate amortization schedule for loan payments.
Fraser Sherman has written about every aspect of business: how to start one, how to keep one in the black, the best business structure, the details of financial statements. He's also run a couple of small businesses of his own. He lives in Durham NC with his awesome wife and two wonderful dogs. His website is frasersherman.com