Overview
One common issue we see in private lending is the improper recording of payments on notes payable. This can misstate both the outstanding debt balance and the related interest expense.
When the debt agreement is an interest-only note or a term note with a balloon payment, accounting errors are less likely because the required periodic payments generally equal the interest expense for the period. Since principal is paid only upon maturity, the original principal balance remains unchanged throughout the term of the note.
However, when the debt is an amortizing note in which each periodic payment is allocated between interest and principal, errors are more likely to be made. The most common mistake is to record the periodic payment either entirely as a reduction of principal balance or entirely as interest expense, rather than allocating the payment between the two components. Such error could result in the misstatements of the note payable balance, interest expense for the period, or interest payable balance if accrual of interest is being done before payments are due.
Best Practices
To avoid errors in recording payments, businesses can follow these best practices:
- Use the loan or fixed-asset financing module within the accounting software, if one is available. A properly configured module may calculate the principal and interest allocation and post it directly to the general ledger.
- Use an amortization schedule supplied by the lender when it reflects the actual loan terms and payment history.
- Maintain a controlled spreadsheet for a small number of straightforward loans. The formulas should be protected and reviewed, and the schedule should be updated for new loans, rate changes, missed payments, modifications, and payoffs.
- Use an outside bookkeeper or accountant to maintain the schedules and record the monthly entries, with management reviewing the results.
Unusual Loan Terms
Certain loan terms require additional accounting consideration. A note with no stated interest rate, or a rate substantially below market, may require interest to be imputed for financial-reporting purposes, with the resulting discount recognized as interest expense over the life of the note. Similarly, under a negative-amortization loan, required payments may be less than the interest incurred, causing unpaid interest to be added to the outstanding loan balance. Because these arrangements can be recorded incorrectly using ordinary payment entries or standard amortization schedules, management should identify unusual loan terms when the debt is incurred and consult its accountant regarding the appropriate treatment.
Putting It All Together
It is also important for management to review the financial information at each key reporting date, such as quarterly, semiannual, year-end, and other reporting periods in compliance with lender reporting requirements, to ensure that interest expense on notes payable is accurate and properly accrued in the correct reporting period.
Properly recording debt payments and interest expense is especially important for businesses that also maintain lines of credit and other financing arrangements. These agreements often include loan covenants, so proper accounting ensures that the debt balance and interest expense are correctly stated, supports compliance with lender reporting requirements, and reduces the risk of violating loan covenants.
For a deeper dive into the accounting guidance, please contact us to schedule a free consultation.