All businesses need some type of financing. Often this financing will come as a loan from a commercial bank. A loan must be repaid with interest over an established period of time. It can be short term or long term; a short-term loan is scheduled to be repaid in less than one year, while a long-term loan is for more than one year. Commercial bank loans appear on the balance sheet of the borrower as a note payable and will be classified as either a short-term or long-term liability.
Record the loan in the general ledger. You will debit cash for the amount of the loan and credit short-term notes payable for the amount of the loan that will be paid during the year and long-term notes payable for the portion that is not due to be paid during the year. If the entire amount of the loan is due to be repaid in less than one year, then there is no long-term note payable.
Record periodic payments on the short-term notes payable. Usually there will either be monthly payments or quarterly payments. When payments are made, the two components to consider are principal and interest. Principal is the original amount borrowed or the amount left outstanding once payments have been made. Interest is the cost of borrowing the money calculated on the amount outstanding each period. You make the entry by debiting notes payable for the principal amount being paid, debiting interest expense for the interest amount being paid, and crediting cash for the total payment.
Repeat the previous step for each periodic payment made during the year. The monthly interest is calculated by multiplying the principal outstanding by the interest rate and then dividing by 12.
Record accrued interest. If the note transcends accounting periods and payments are made quarterly or annually, then accrued interest must be recorded. Let’s say your company closes its books monthly and payments are made on the note quarterly. Each month of accrued interest must be recorded. You make the entry by debiting interest expense and crediting interest payable. Then at the end of the quarter you will debit interest expense for the final month of the quarter, debit interest payable for the accrued interest from the first two months of the quarter, debit notes payable for the principal portion of the note being paid, and credit cash for the total amount paid.
Reclassify the portion of the long-term note payable that will be paid in the coming year to the short-term note payable. You make the entry by debiting non-current note payable and crediting short-term note payable for the amount that will be paid during the year. This process is continued until the note is totally repaid.