Learn It
When a business borrows money, two things happen at once: cash goes up, and a liability goes up. The business has more money in the bank, but it also owes that money back. This is the accounting equation at work: assets increase, and liabilities increase by the same amount.
Loan proceeds are not revenue. The business did not earn anything. It borrowed. Recording loan money as revenue would overstate income and make the business look more profitable than it is.
As we saw in Banking Transactions, a $10,000 deposit could be revenue, a customer payment, or a loan. The bookkeeper must understand the business event to record it correctly.
Principal vs. Interest
When a business makes a loan payment, the payment is split into two parts:
Principal
The principal is the portion of the payment that reduces the loan balance. It is not an expense. The business is paying back money it borrowed — reducing a liability. Principal does not appear on the profit and loss statement because it is not a cost of doing business.
Interest
Interest is the cost of borrowing the money. It is an expense. The business pays interest to the lender for the use of the money. Interest appears on the profit and loss statement as an expense.
Every loan payment = principal + interest. The principal reduces the loan liability. The interest is an expense. The total payment reduces cash.
See It
Let's follow a business that borrows $20,000 and then makes three monthly payments.
1. Borrow $20,000
The business receives $20,000 into its checking account. Cash goes up. The business also owes $20,000 — a liability is created.
| Account | Debit | Credit |
|---|---|---|
| Cash | 20,000 | — |
| Loan Payable | — | 20,000 |
Notice: no revenue account is involved. The business borrowed money, not earned it.
2. Make the first payment of $850
The $850 payment includes $167 of interest and $683 of principal. Cash goes down by $850. Interest Expense is recorded for $167. The loan balance is reduced by $683.
| Account | Debit | Credit |
|---|---|---|
| Interest Expense | 167 | — |
| Loan Payable | 683 | — |
| Cash | — | 850 |
The loan balance after this payment: $20,000 − $683 = $19,317. Only $167 hits the profit and loss as an expense. The $683 principal reduces the liability on the balance sheet.
3. Three payments over time
| Month | Payment | Interest | Principal | Ending Balance |
|---|---|---|---|---|
| Start | — | — | — | $20,000 |
| Month 1 | $850 | $167 | $683 | $19,317 |
| Month 2 | $850 | $161 | $689 | $18,628 |
| Month 3 | $850 | $155 | $695 | $17,933 |
Notice that as the loan balance goes down, the interest portion gets smaller and the principal portion gets larger. The total payment stays the same at $850.
Current vs. Long-Term Debt
Loan balances are often split into two parts on the balance sheet:
- • Current portion: the principal that will be paid within the next 12 months. This is a current liability.
- • Long-term portion: the principal that will be paid after 12 months. This is a long-term liability.
A line of credit works similarly — it is a liability that goes up when the business borrows and down when it repays. The difference is that a line of credit can be borrowed against repeatedly, like a credit card with a higher limit.
Do It
Complete the loan payment worksheet below. Enter the interest expense, principal reduction, and ending balance for each month. For Month 3, calculate the principal yourself.
Do It — Complete the Loan Payment Worksheet
A business has a loan with a starting balance of $20,000. The business makes three monthly payments of $850 each. For each payment, enter the interest expense, the principal reduction, and the ending loan balance.
For Month 3, you must calculate the principal yourself: Total Payment − Interest = Principal. The balance must carry forward from month to month.
| Month | Total Payment | Prev. Balance | Interest Expense (type) | Principal Reduction (type) | Ending Balance (type) |
|---|---|---|---|---|---|
| Starting Balance | $20,000 | ||||
| Month 1 | $850 | $20,000 | $ | $683 | $ |
| Month 2 | $850 | $19,317 | $ | $689 | $ |
| Month 3 | $850 | $18,628 | $ | $ | $ |
Prove It
Answer each question, then read the explanation. There's no score — this is just to help the ideas stick.
Question 1
A business borrows $20,000 from a bank. How should the loan proceeds be recorded?
Question 2
The business makes a $500 monthly loan payment. The payment includes $450 of principal and $50 of interest. What is the effect?
Question 3
Why is a principal payment not an expense?
Ready for more than a short exercise?
This exercise gives you three loan payments with the information clearly laid out. Real bookkeeping requires you to read loan statements, split payments correctly, track changing balances over many months, and reconcile the loan liability to the lender's records. QBO Dojo practice clients let you apply these skills across realistic business activity inside QuickBooks Online.
Explore QBO Dojo Practice ClientsKey Takeaways
- Loan proceeds are not revenue — they increase cash and increase a liability.
- Every loan payment has two parts: principal (reduces the loan) and interest (an expense).
- Principal payments are not expenses — they reduce a liability on the balance sheet.
- Interest is the cost of borrowing and is recorded as an expense on the profit and loss.
- As the loan balance decreases, the interest portion of each payment gets smaller.
- Loan balances are often split into current (due within 12 months) and long-term portions.