Finance is one of the important and integral parts of business, and it plays a major role in every part of the business activities. It is used in all the area of the activities under the different names. However, a company may arrange the necessary finance from two major sources, such as:
- Equity Capital
- Debt Capital (Loan)
Loans are provided the major portion of financial requirements because the cost of the loan is comparatively cheaper than Equity capital. Cost of the loan is cheaper because it gives more tax benefits than any other finance i.e Interest on Loan is an allowable expenditure but dividends are subject to tax. Hence, Loan is preferable financing tools for the business owner.
However, now we will discuss the accounting treatment of Loan. The journal entries of this loan are as follows:
Journal Entry when the loan is sanctioned
The Journal Entry for the loan received is :
| Bank Account | Debit | Increase the Assets |
| Loan Account | Credit | Increase Liability |
*Assuming that the money was deposited directly in the company’s bank account.
Examples of Loan Received
Assumed that ABC Ltd submitted a proposal to UCBL Bank Ltd for $ 125,000 to purchase a piece of important machinery. After verifying all the compliance UCBL Ltd Sanctioned the above-mentioned amount.
Show this journal entry for this amount received:
| ABC Bank A/c | Debit | 125,000 |
| Loan Account | Credit | 125,000 |
(Loan received for the purchase of Machinery)
Impact on Accounting Equation
As per the Accounting Equation, the Total Assets of the company are the total sum of total Capital and total liabilities.
Accounting Equation is:
Assets = Capital + Liabilities
$125,000 = 0 + $ 125,000
Journal Entry when the repayment is made
The compound Journal entry for loan repayment including both principal and interest are as follows:
| Loan Account | Debit | Decrease the Liability |
| Interest on Loan Account | Debit | Increases the Expenses |
| To, Bank Account | Credit | Decrease the Assets |
*Assuming that the money was due to be paid to ABC Bank Ltd.
Examples
Assumed that total repayment including the interest is $ 167,500 where the principal is $ 125,000 and the interest is $ 42,500. The Journal Entry is :
| Loan Account | Debit | 125,000 |
| Interest on Loan Account | Debit | 42,500 |
| To, Bank Account | Credit | 167,500 |
Impact on Accounting Equation
After the loan is paid off the net effect of these transactions on the accounting equation will be as follows:
The assets of the company decreased by $ 167,500. Liabilities reduced by a $ 125,000 and simultaneously owner’s capital went down by the interest amount i.e $42,500.
Accounting Equation Effect:
Assets = Capital + Liabilities
($167,500) = $ (42,500 + 125,000)
(The impact has been assessed at the end of all transactions)
Loan in Financial Statements
Loan increases the liability of the company and this is the obligation of the company to be paid at later. The long-term loan is shown on the liability side of the Balance Sheet.
Conclusion
Loan received from a bank may be payable in short-term or long-term depending on the terms mentioned in the Loan Sanction Letter imposed by the Bank. The repayment of the loan depends on the schedule agreed upon between both parties. A short-term loan is considered as a Current Liability, whereas a long-term loan is capitalized and classified as a Long Term Liability.