Welcome to Long-Term Borrowings!
Hello! Today we are diving into the world of Long-term borrowings. Think of this as the business version of taking out a mortgage for a house. Sometimes, a business needs more money than it currently has to grow—perhaps to buy a new warehouse or a fleet of delivery trucks. That is where long-term loans come in!
Don't worry if this seems a bit heavy at first. We will break it down into bite-sized pieces so you can master this chapter in no time.
1. What are Long-term Borrowings?
Long-term borrowings (often called Bank Loans) are debts that a business expects to pay back over a period longer than one year.
Why do businesses do this?
Businesses obtain these loans to finance their operations. This could mean expansion, buying expensive non-current assets, or starting a massive new project.
Analogy: Imagine you want to buy a high-end gaming computer that costs \$3,000, but you only save \$100 a month. You might take a loan from your parents and pay them back over three years. That is a "long-term borrowing" because it takes more than a year to clear!
Important Distinction: Bank Loan vs. Bank Overdraft
It is very easy to confuse these two, but they are treated differently in your accounts:
- Bank Loan: Usually a Non-current Liability. It is a fixed amount borrowed for a long time.
- Bank Overdraft: A Current Liability. It happens when you spend more money than you have in your bank account. It is meant to be temporary.
Quick Review: Long-term borrowings = Money borrowed for > 12 months.
2. The "Rules" of the Game (Accounting Theories)
To keep our accounts honest and accurate, we follow two main "theories" when dealing with loans:
1. Accrual Basis of Accounting Theory:
We record the interest expense in the period it is incurred (when the "cost" of the loan happens), regardless of whether we have actually paid the cash yet.
2. Matching Theory:
We want to match the interest expense (the cost of using the loan) against the income generated by the assets we bought with that loan during the same period.
3. Recording the Loan and Repayments
When a business takes a loan or pays it back, we need to record it in the General Journal and Ledger.
Taking a New Loan
When you receive the money from the bank:
Debit: Cash at Bank (Asset increases)
Credit: Bank Loan (Liability increases)
Repaying the Loan (The Principal)
The Principal is the original amount you borrowed (not including interest). When you pay a portion of it back:
Debit: Bank Loan (Liability decreases)
Credit: Cash at Bank (Asset decreases)
Key Takeaway: Repaying the principal reduces your debt, while receiving the loan increases it.
4. The Cost of Borrowing: Interest Expense
Banks don't give money for free! They charge Interest. In your syllabus, loans are usually repaid in equal installments.
Calculating Interest:
Interest is usually a percentage of the amount borrowed.
\( \text{Annual Interest Expense} = \text{Amount of Loan} \times \text{Interest Rate (%) } \times \text{Time} \)
Recording Interest
There are two parts to this:
- Interest Expense: The "cost" shown in the Statement of Financial Performance.
- Interest Expense Payable: If we owe interest at the end of the year but haven't paid it yet, this is a Current Liability in the Statement of Financial Position.
Did you know? Even if you haven't written the check for the interest yet, if the time has passed, the Accrual Basis says you must record it as an expense!
5. The "Magic" of Reclassification
This is the part that trips up many students, but it’s quite simple once you see the logic!
A long-term loan is a Non-current Liability. However, any portion of that loan that you must pay within the next 12 months must be moved (reclassified) to Current Liabilities.
Example:
You have a \$50,000 loan. You pay \$10,000 every year on Dec 31.
On your Statement of Financial Position:
- Current Liability: \$10,000 (The amount due next year)
- Non-current Liability: \$40,000 (The remaining balance)
Memory Aid: Think of it like a "Waiting Room." The part of the debt that is "up next" to be paid goes into the Current Liability room. The rest stays in the Non-current lounge.
6. Presentation in Financial Statements
When you prepare your final accounts, here is where things go:
Statement of Financial Performance (The "Income Statement")
Under Other Expenses, you list:
- Interest Expense (The total interest cost for that specific year).
Statement of Financial Position (The "Balance Sheet")
Under Current Liabilities:
- Current portion of Bank Loan (The principal due within 1 year).
- Interest Expense Payable (Any interest you haven't paid yet).
Under Non-current Liabilities:
- Bank Loan (The remaining principal due after 1 year).
7. Common Mistakes to Avoid
Mistake 1: Including Interest in the Loan Ledger Account.
The Bank Loan account should only show the Principal. Keep the Interest Expense in its own separate ledger!
Mistake 2: Forgetting to Reclassify.
Always check if a portion of the loan is due within the next year. If you leave it all in "Non-current," you will lose marks!
Mistake 3: Mixing up "Paid" vs "Incurred".
If the question says the annual interest is \$500 but only \$400 was paid, your Interest Expense is still \$500. The \$100 difference goes to Interest Expense Payable.
Quick Summary Box
- Bank Loan: Money borrowed for long-term use. Debit bank when receiving, Credit bank when paying principal.
- Interest: The cost of borrowing. Record as an expense even if not yet paid (Accrual Basis).
- Reclassification: Move the next 12 months of payments to Current Liabilities.
- Year End: In your syllabus, the financial year usually ends on 31 December.
You're doing great! Practice a few ledger entries for a \$10,000 loan, and you'll be an expert on Long-term Borrowings in no time!