How Bookkeepers Handle Long-Term Debt - dummies

How Bookkeepers Handle Long-Term Debt

By Consumer Dummies

Most companies take on some form of debt that will be paid over a period of time that is longer than 12 months. This debt may include car loans, mortgages, or promissory notes. A promissory note is a written agreement where you agree to repay someone a set amount of money at some point in the future at a particular interest rate.

It can be monthly, yearly, or some other term specified in the note. Most installment loans are types of promissory notes.

Recording a debt

When the company first takes on the debt, it’s recorded in the books in much the same way as a short-term debt:

Debit Credit
Cash XXX
Notes Payable XXX

This example shows how to record receipt of cash from an American Bank promissory note.

Payments are also recorded in a manner similar to short-term debt:

Debit Credit
Notes Payable XXX
Interest Expense XXX
Cash XXX

This example shows how to record payment on an American Bank promissory note.

You record the initial long-term debt and make payments the same way in QuickBooks as you do for short-term debt.

While how you enter the initial information isn’t very different, a big difference exists between how short- and long-term debt are shown on the financial statements. All short-term debt is shown in the Current Liability section of the balance sheet.

Long-term debt is split and shown in different line items. The portion of the debt due in the next 12 months is shown in the Current Liabilities section, which is usually a line item named something like “Current Portion of Long-Term Debt.” The remaining balance of the long-term debt due beyond the next 12 months appears in the Long-Term Liability section of the balance sheet as Notes Payable.

Major purchases and long-term debt

Sometimes a long-term liability is set up at the same time as you make a major purchase. You may pay some portion of the amount due in cash as a down payment and the remainder as a note. To show you how to record such a transaction, assume that a business has purchased a truck for $25,000, made a down payment of $5,000, and took a note at an interest rate of 6 percent for $20,000. Here’s how you record this purchase in the books:

Debit Credit
Vehicles 25,000
Cash 5,000
Notes Payable — Vehicles 20,000

This example shows how to record payment for the purchase of the blue truck.

You then record payments on the note in the same way as any other loan payment:

Debit Credit
Notes Payable — Vehicles XXX
Interest Expense XXX
Cash XXX

This example shows how to record payment on note for blue truck.

When recording the payment on a long-term debt for which you have a set installment payment, you may not get a breakdown of interest and principal with every payment. For example, many times when you take out a car loan, you get a coupon book with just the total payment due each month. Each payment includes both principal and interest, but you don’t get any breakdown detailing how much goes toward interest and how much goes toward principal.

Separating principal and interest

Why is this lack of separation a problem for recording payments? Each payment includes a different amount for principal and for interest. At the beginning of the loan, the principal is at its highest amount, so the amount of interest due is much higher than later in the loan payoff process when the balance is lower. Many times in the first year of notes payable on high-price items, such as a mortgage on a building, you’re paying more interest than principal.

In order to record long-term debt for which you don’t receive a breakdown each month, you need to ask the bank that gave you the loan for an amortization schedule. An amortization schedule lists the total payment, the amount of each payment that goes toward interest, the amount that goes toward principal, and the remaining balance to be paid on the note.

Some banks provide an amortization schedule automatically when you sign all the paperwork for the note. If your bank can’t give you one, you can easily get one online using an amortization calculator. You can find an amoritization schedule calculator online.

Using that calculator, the following table lists the principal/interest breakdown for the first six months of payment on the truck in a six-month amortization chart. You can see that the amount paid to principal on a long-term note gradually increases, while the amount of interest paid gradually decreases as the note balance is paid off. The calculator did calculate payments for all 60 months, but they’re not all shown here.

Six-Month Amortization Chart for Truck Payments
Total Payment Principal Interest Remaining Note Balance
$386.66 $286.66 100.00 $19,713.34
$386.66 $288.09 98.57 $19,425.25
$386.66 $289.53 97.13 $19.135.72
$386.66 $290.98 95.68 $18,844.75
$386.66 $292.43 94.23 $18,552.32
$386.66 $293.89 92.77 $18,258.42

Looking at the six-month amortization chart, here’s what you would need to record in the books for the first payment on the truck:

Debit Credit
Notes Payable – Vehicles 286.66
Interest Expense 100.00
Cash 386.66

This example shows how to record payment on note for a truck.

In reading the amortization chart, notice how the amount paid toward interest is slightly less each month as the balance on the note still due is gradually reduced. Also, the amount paid toward the principal of that note gradually increases as less of the payment is used to pay interest.

By the time you start making payments for the final year of the loan, interest costs drop dramatically because the balance is so much lower. For the first payment of Year 5, the amount paid in interest is $22.47, and the amount paid on principal is $364.19. The balance remaining after that payment is $4,128.34.

As you lower your principal balance, much less of your payment goes toward interest and much more goes toward reducing principal. That’s why many financial specialists advice you to pay down principal as fast as possible if you want to reduce the term of a loan.