If the amount of cash on hand is more than a company needs to meet its obligations, it might consider other options for the surplus. The business might invest the money in another company, or it might lend the money to another entity. Lending the money generates interest revenue for the business.
When a business decides to lend money to another entity, it needs to consider the terms with which it lends the money and create a lending agreement. The lending agreement outlines the terms, such as the loan amount, the interest rate and the payment schedule. Both the business and the entity borrowing the money need to agree to the terms and sign the agreement. The signed lending agreement creates a legal document for both parties.
When the business provides the cash to the borrower, it needs to record the transaction in its financial records. It uses several financial accounts to record the loan, including cash, loan receivable and interest revenue. All transactions recorded in the financial records use a system of debits and credits, with each account maintaining a normal debit or a normal credit balance. The cash account and the loan receivable account represent assets for the business and have normal debit balances. Interest revenue represents an income account for the business and has a normal credit balance.
The first journal entry in the financial records recognizes the loan made by the business. The impact on each account is recorded using a debit or a credit. Debits and credits need to equal every journal entry. The journal entry to record the original loan includes a debit to loan receivable for the amount of the loan and a credit to cash for the amount provided to the borrower. These two amounts need to be the same.
As the borrower makes each payment, the business needs to record the receipt of each payment. Each payment requires a journal entry in the accounting records. The business records a debit to the cash account for the amount of money received. The business also records a credit to the note receivable account for the portion of the payment applied to the loan principal and a credit to interest revenue for the portion of the payment earned for making the loan.