Bank loans can simply be defined as loans that are taken by the organization from a bank, or any other financial institution. Generally, bank loans are classified as a long-term liability, primarily because of the fact that they spread over a considerable number of years (more than twelve months). In other words, the maturity term for bank loans is higher as compared to other financing instruments.
Bank loan write-off is defined as the process of removing bank loans from the financial statements. In this aspect, it can be seen that normally, bank loans are of considerably high volume, and therefore, writing off bank loans is considered to be a significant task, since it impacts the liabilities quite significantly.
Loan write-offs are considered to be an important part of financial statement presentation, predominantly because of the fact it gives an idea to the investor regarding the liabilities that are undertaken by the company. It is important to include all liabilities so that an accurate picture can be presented in front of the decision-makers of the company.
This adjustment of the long-term debt on the balance sheet requires some journal entries, as well as calculation of interest. Interest is normally payable every year (on an annual basis).
On the other hand, the principal can either be paid in a lump sum amount at the end of the loan term, or it can be paid in installments. For both these scenarios, accounting treatment tends to differ.
Classification of Bank Loans
As mentioned earlier, it can be seen that Bank Loans tend to be classified as Long-Term Liabilities. Long-Term Liabilities are financial obligations that are incurred by the company for a considerably longer time duration, greater than 12 months.
Bank Loans normally span across a period of 5 years, or 10 years. However, this is variable and can change depending on the agreement between the bank and the organization (the lending party).
Bank Loans also have a recurring interest rate. This means that there is a financial cost associated with long-term debt, in the form of interest rate. This is payable on a recurring basis, most every year. When interest is due, it is classified as a Current Liability in the Balance Sheet, whereas if it is due for a period longer than 1 year, it is classified as a Long-Term Liability only.
In the same manner, the repayment scheme can either be designed as a balloon payment, or it can comprise installments. In the case of installments, the installment that is supposed to be paid in the current year (i.e. in a time frame of less than 12 months) is classified as a Current Liability.
On the other hand, if the installment is supposed to be paid at a time duration of more than 12 months, it is classified as a Long-term Liability.
Therefore, the criteria of classification as a Current Liability or a Long-Term Liability is contingent on the timeline of payment.
Accounting Treatment for Bank Loans
In order to understand the accounting treatment involved for Bank Loans, it is important to consider the actual record-keeping process that undergoes when a loan is first issued by the bank.
The journal entries that are required to record the inclusion of a bank loan are as follows:
|Bank (Amount received from Bank Loan)||xxx|
|Bank Loan (Long-Term Liability)||xxx|
In the same manner, the interest component account is also maintained separately in order to ensure that there is proper record keeping and accounting involved.
|Interest Payable (Expense)||xxx|
|Accrued Interest Payable||xxx|
In the same manner, once the interest payment has been made, the following journal entries are required:
|Accrued Interest Payable||xxx|
Likewise, when the loan (or any other long-term debt instrument) is charged, the following transactions are required:
The journal entries above show a blueprint of the accounting process required when dealing with bank loans. However, this is subject to change and can change depending on the actual interest recorded.
Example of Bank Loan Adjustment and Write-Off
The concept of bank loans and the accounting treatment required is mentioned in the following illustration:
Feliz Inc. has taken on a bank loan equivalent to $10,000 for a period of 5 years. The loan tenure begins on 1st January 2018. The loan bears an interest charge of 10% every year, on the principal amount. Interest is Payable on 31st December every year for the year.
For repayment of the loan, Feliz Inc. is required to pay back the lump sum principal amount at the end of the loan tenure. In order to accumulate funds for loan repayment, Feliz Inc. created a reserve account.
In the situation mentioned above, it can be seen that Feliz Inc. needs to record both, the debt, as well as the interest payment involved.
In order to record the loan, the following journal entries are made:
|Bank – Loan Amount Received||$10,000|
|Bank Loan – Long Term Liability||$10,000|
Subsequently, the total interest that is payable on this bank loan, at a rate of 10% per annum amounts to $5,000, across the 5 years. This is going to be recorded in the form of the following journal entries:
|Interest Payable (Expense)||$1,000|
|Accrued Interest Expense||$1,000|
However, interest payments are due every year. Therefore, in order to record the interest payment and expense for the particular year, the following transaction is required:
|Accrued Interest Expense||$1,000|
Similarly, in order to pay back this particular loan, Feliz Inc. has created a loan reserve account. This requires them to create a special account, primarily for the purpose of loan repayment. This would require them to make the following transactions:
|Loan Reserve Account||$2,000|
These would be the journal entries required every year, till the maturity date of the loan instrument.
The purpose to do this is two-fold. Firstly, it helps organizations in preparing for loan repayment. Getting a lump sum amount in the last year might be a cumbersome task for the organization. Secondly, arranging this amount beforehand would not impact the actual cash flows of the company.
At the end of the tenure, once Feliz needs to repay the amount back to the bank, the following journal entries will be done:
|Loan Reserve Account||$10,000|
The above journal entry is required in order to ensure that all the transactions are properly recorded so that the loan can be formally written off from the financial statements.
It is also important to consider the fact that writing off the loan from the financial statement requires procedural journal entries so that all the accounts that were created when the loan was undertaken in the first place are subsequently settled and closed.
Let’s suppose Feliz Inc. had to pay the principal back in form of installments. In this case, installment for a given year is going to be treated as a Current Liability, alongside interest. In order to reflect this situation, the following journal entries are required:
|Bank Loan – Long Term (Non-Current) Liability||$2,000|
|Bank Loan – Current Liability||$2,000|
After this transaction, the Long-Term liability for Feliz Inc. would continue to decrease by $2000 every year, till all 5 installments are paid for.