The capital structure of a company speaks a lot about the financial position and future prospects of growth. The capital structure of a business entity represents the source of funding. More generally, it is recommended to keep the debt financing at a lower level as compared to equity financing. But there are many instances when debt financing is a more viable option for business entities to raise funds.
For instance, if a company is a privately held organization and wants to raise capital for a market opportunity, that can result in rapid market capitalization. After meeting partners, the management comes to know that the partners cannot finance the required amount of equity. In this scenario, there are two options: adding more partners to contribute equity and losing control of the business management or taking a loan from the bank or a financial institution to invest in market opportunities.
If the company opts for a bank loan, it will not have to lose its control, and the gap for investment will also be filled. In a nutshell, there are many benefits of debt financing over equity financing. The choice of equity or debt entirely depends on the situation, priority, and opportunity. This article will talk about loans and their recognition in the balance sheet of a business entity.
What Are Bank Loans?
When a business entity wants to raise capital for its different capital expenditures, taking a loan from financial institutions against a mortgage is common practice. We can define bank loans as,
Bank loans are contractual obligations of the borrower that he will pay the amount taken from the bank. The agreement takes place when the bank or another financial institution issues finance to the business entity or individual. A bank loan comprises principal amount and interest payment. Interest is a type of fee or compensation for borrowing money from lenders.
The bank loans are current as well as non-current. The short-term bank loans are often not backed with a mortgage and recorded as current liabilities. Another specification of short-term loans is that they are recorded as the line of credits or bank overdrafts.
In this article, we will talk about bank loans that are long-term liabilities of the companies.
Classification Of Bank Loans In The Balance Sheet
The bank loans that are due in more than 12 months are recorded as the non-current liabilities of the business entity. In other words, we classify bank loans under the liability side of a balance sheet within the head of non-current liabilities.
According to the IASB Framework, liability is defined as,
A liability is a present obligation of the enterprise. It arises from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits.
Most times, bank loans are part of a single line item that is debt & borrowings. However, some companies adopt separate reporting of bank loans under the long-term liabilities.
Bank Loans Vs. Debt(Borrowing)
Most people get confused about debt and loans, but basically, both terms are
a synonym for long-term liabilities. Both items are recorded under the non-current liabilities of the balance sheet. However, both items are differentiated based on the nature of liability, repayment system, and loan tenure.
Bank loans are part of a larger debt & borrowings of the business entity. The debt and borrowing comprise of different items that include bonds, debenture, mortgages, financial leases, and bank loans. Bonds and debentures are issued to raise debt finance from the general public through marketable securities.
However, if a business entity borrows money from banks or financial institutions, it is considered a bank loan. The loan is repaid to the lender in installments, and each installment consists of the principal amount & interest due. In the case of other debt items, the interest is paid at regular intervals, and the principal amount(face value of debt security) is paid to the debenture/bondholder on maturity.
Different Costs Of Borrowings
Most bank loans include five direct costs that are capitalized if material. Following are the types of direct costs:
- Arrangement fees
- Interest
- Insurance costs
- Covenant compliance costs
- Professional consultancy
The primary cost of the bank loan is interest that is periodically paid for the owed amount. Arrangement fees are administration charges paid by the borrower to the lender for fund reserves and loan opening costs. The amount of arrangement fees varies according to business type, nature of the loan, amount of loan, etc. Insurance costs are incurred as a preliminary requirement by the bank loans. There are other professional costs like legal fees, financial consultancy fees, etc.
Recognition Of Bank Loans
According to the IFRS Standards, any liability will be recognized as long-term or short-term liability if it fulfills the following requirements of frameworks. Following requirements must be fulfilled to recognize as a liability:
- A financial obligation arises from outflow of resources that brings economic benefits to the organization in the present or future.
- It is possible to measure the cost of financial benefits with reliability and practicality.
If the bank loans doot meet the following requirements, they are not recognized as the long-term liability in the company’s balance sheet. It will be shown as notes to the financial statement, and disclosures are required in the financial statements. An obligation that cannot be measured reliably will most probably be recognized as a contingent liability for the business entity.
Measurement Of Bank Loans
A bank loan to be recorded in the balance sheet is recorded according to the loan modeling and amortization schedule as agreed upon between the lender and the borrower. Following will be the measurement for the bank loans in the balance sheet and income statement:
- The non-current part of bank loan is recorded under the long-term liabilities as part of debt & borrowings
- The current part of the bank loan that has to be paid within 12 months is recorded in current liabilities. The current part of liabilities is calculated from the amortization schedule.
- The interest due for the current financial period is recorded in the income statement as an interest expense. If not paid in cash, the interest expense will also be recorded under current liabilities as interest payable.
Calculation Of Bank Loans
For calculating bank loans, most companies develop an amortization schedule for individual loans with different lenders. We will understand the calculation of bank loans with the help of an example.
An amortization schedule is a complete plan of periodic payments of outstanding debt and loans. Each installment consists of a part of the principal amount and interest due for the current financial period. The tenure of the amortization schedule is the same as the tenure of a bank loan.
Let’s take an example of ABC Corporation that owes $300,000, 30-year fixed-rate mortgage with Alfredo Bank. 5% is the fixed interest rate for the tenure of the loan. What will be the periodic payment?
Interest rate = 5% per annum
Interest rate per month = 5 X 1/12 = 0.416%
Monthly payment = $1500
Amortization Table
| Month | Month 1 | Month 2 | Month 3 | Month 4 | Month 5 | Month 6 |
| Total Payment | 1,568.20 | 1,568.20 | 1,568.20 | 1,568.20 | 1,568.20 | 1,568.20 |
| Principal Payment | 318.40 | 321.25 | 322.30 | 323.36 | 324.4242 | 325.48 |
| Interest Payment | 1,249.8 | 1,246.95 | 1,245.90 | 1,244.84 | 1,243.788 | 1,242.722 |
| Interest To Date | 1,249.8 | 2,496.75 | 3,742.65 | 4,987.49 | 6,321.278 | 7,474 |
| Outstanding Loan Balance | 299,681.6 | 299,359.75 | 299,037.45 | 298,714.09 | 298,389.66 | 298,064.18 |
For the monthly payments, multiply the total debt with the interest rate and divide the answer by 12. However, you can also convert per annum interest rate into per month rate as done in the above example.
For the calculation of principal payment, the following formula is used:
Principal payment = Total payment per month – [Oustanding loan balance X Interest rate per month)
Or
Principal payment = Total payment per month – [Oustanding loan balance X Annual Interest rate/ 12)
Calculation Of Monthly Payment
Most commonly, the number of monthly payments is decided when the loan is initiated. It is decided with the agreement between the lender and borrower. However, for the total monthly payment, different factors are considered.
You can use the following formula to calculate the amount of each monthly payment.
i= annual interest rate = 5%
Total Monthly Payment = Loan Amount[i(1+i)^ n/{(1+i)^n) – 1}]
For the above example following monthly payment will be due every month
Total Monthly payment = $300,000[0.00416(1.00416)^360/{(1.00416^360)-1}]
Total Monthly payment = $300,000[0.00416(4.457)/4.457-1]
Total Monthly payment =$300,000(0.005)
Total Monthly payment =1,568.20
Modification And Restructuring Of Debt
A business entity must account for and recognize any modification or restructuring of debt and borrowing. The recognition includes:
- Adjustment in the carrying amount of the loan as a result of the modification in loan terms
- Change in the amount of interest expense due to the modification must be recognized in the income statement of the business entity. Any unpaid interest will be recorded in liabilities.
- If the interest rate change is applicable to prior periods, the business entity should record gain or loss of interest in the income statement.
- Any expenses incurred to execute the modifications in changes are recorded in the income statement.
Conclusion
This article comprehensively covered the recognition, measurement, calculation, and recording of long-term bank loans of a business entity in the financial position statement.
