A very common problem I see in QuickBooks files is this...
- A business takes out a bank loan.
- Monthly payments are made on the loan
- The entry in QuickBooks to record the payment is wrong, with the end result being the distortion of the profit and loss report (in some cases, a BIG distortion) and a distortion of the balance sheet report (which shows what a business owns and what it owes).
Some accounting concepts you need to know...
- Every monthly payment to the bank includes some loan principal and also interest (unless it is an interest only loan - if so, that is not the topic of our discussion).
- The only portion of that monthly payment that qualifies as an expense to the business is the interest portion. No matter how much you want it to, the repayment of the principal is NOT an expense of the business and should NOT show up on your profit and loss report.
- The bank (or your tax CPA) should provide you with what is called an "amortization table" (now there is a mind-numbing term if ever there was one!) that details out how much of each payment is principal and how much is interest. Having this information makes the monthly entry in QuickBooks a snap.
Let's say that your business is making monthly payments of $250 on its' loan. To keep our example very simple, let's also say that the bank has told you that of each $250 payment, $35 is interest and $215 is principal (the reality is that the interest portion usually decreases over time and the principal portion increases).
When you write the check in QuickBooks to record this payment, three things need to happen:
- The balance of your bank account will decrease by $250
- The balance of your bank loan will decrease by $215 (not $250), the principal portion of the payment. If the loan was set up properly, you should have an account in your chart of accounts in the "long term liability" section called "Bank Loan"
- Your interest expense will increase by $35. This $35 should show up as "Interest Expense" on your profit and loss report.
What I often see is this - the checking account goes down by $250 and the interest expense goes up by $250. Not correct at all.
So, in accounting-speak, to recap the above, you have a credit to your checking account for $250, a debit to your bank loan liability account for $215 and a debit to your interest expense account for $35. Voila - your debits and credits equal!
RUN, DON'T WALK!!!
If any of the discussion above gives you a headache, it is essential that you run (do not walk) to a QuickBooks expert to get your loans and loan payments set up properly.
Naturally, the more loans (and various types of loans) a business has, the more complicated this process can get.
In a future post, I'll discuss the QuickBooks Loan Manager that may help simplify the administration of your bank loans.