Most businesses borrow money for both long-term periods (periods of more than one year) and short-term periods (periods of one year or less). Long-term debt can include a 5-year car loan, 20-year mortgage, or any other type of debt that is paid over more than one year.
Most companies take on some form of long-term debt, such as 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 long-term debt, it’s recorded in the books like this:
| Debit | Credit | |
|---|---|---|
| Cash | $XXX | |
| Notes Payable | $XXX | |
| To record receipt of cash from American Bank promissory note. |
Payments on a long-term debt are recorded in this way:
| Debit | Credit | |
|---|---|---|
| Notes Payable | $XXX | |
| Interest Expense | $XXX | |
| Cash | $XXX | |
| To record payment on American Bank promissory note. |
The portion of the long-term debt due in the next 12 months is shown in the Current Liabilities section of the balance sheet, 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. In the following transaction, 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 | |
| To record payment on 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 | |
| To record payment on the purchase of the blue truck. |
Separating principal and interest
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.
Why is this 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 higher than later in the loan payoff process when the balance is lower.
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.
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.
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.