Is a Loan an Expense?

A loan itself is not an expense. When a business or individual borrows money, the transaction changes the composition of their finances, but it does not immediately reduce their net worth in the way a typical expense does. Receiving loan funds is an exchange; you receive cash that you can use, but you also take on an obligation to pay it back. This initial event does not impact profit or loss.

The Accounting Treatment of Loan Principal

When you receive a loan, the principal, or the amount you borrowed, is not recorded as revenue or a gain. Instead, it is documented on the balance sheet, a financial statement that provides a snapshot of what a company owns and owes at a single point in time. The cash received increases the asset side of the balance sheet, while a corresponding liability, often called “loans payable,” is created on the other side to represent the new debt. This dual entry ensures the fundamental accounting equation, Assets = Liabilities + Equity, remains in balance.

This transaction does not alter the borrower’s net worth. Because the increase in assets is offset by an equal increase in liabilities, there is no change in the company’s overall value. This is why the principal amount of a loan does not appear on the income statement.

As you begin to repay the loan, each payment is carefully divided into two parts. The portion of the payment that goes toward reducing the original borrowed amount is the principal repayment. When this payment is made, it reduces your cash (an asset) and also reduces the loans payable account (a liability) by the same amount. This transaction occurs entirely on the balance sheet, leaving the income statement and your calculated profit or loss for the period unaffected.

Understanding Loan Interest as an Expense

The part of a loan that is considered an expense is the interest. Interest is the cost of borrowing the principal amount, representing the fee a lender charges for the use of their money. Unlike the principal, interest is a true cost incurred during an accounting period.

This cost is recorded as “interest expense” on the income statement. The income statement’s purpose is to show a company’s financial performance over a period by summarizing revenues and matching them with the expenses incurred to generate them. Because interest expense reduces a company’s earnings, it directly lowers the reported net income or profit for that period. This treatment reflects the consumption of economic resources.

For businesses, properly tracking interest expense is important for tax purposes. While interest on business debt can be a deductible expense, federal tax law places significant limits on this deduction. For many businesses, the annual interest deduction is capped at the sum of their business interest income plus 30% of their adjusted taxable income. This change means that companies, especially larger ones, can no longer assume all of their interest expense is immediately deductible.

However, an exemption exists for most small businesses. Companies with average annual gross receipts of $31 million or less for the prior three-year period are generally exempt from this limitation and can typically deduct their full interest expense. For businesses that are subject to the cap, any interest that cannot be deducted in the current year can be carried forward and potentially deducted in future years. This tax treatment is a significant reason why businesses meticulously separate interest payments from principal repayments in their accounting records.

How Loan Payments are Recorded

To see how these concepts work together, consider a business that takes out a $10,000 loan. When the loan is received, the company’s cash increases by $10,000 and its loans payable liability also increases by $10,000. Now, imagine the first monthly payment is $500. This payment is not a single transaction in the accounting records but must be split between principal and interest.

The lender provides a loan amortization schedule that details this split for every payment. For this first $500 payment, the schedule might show that $100 is for interest and the remaining $400 is for principal. The two parts are recorded differently to reflect their distinct financial nature.

The $100 interest portion is recorded as an interest expense on the income statement, which will reduce the company’s profit for the month by that amount. The $400 principal portion is used to decrease the loans payable account on the balance sheet. After this payment, the company’s cash is down by $500, its loan liability is now $9,600 ($10,000 – $400), and its net income has been reduced by the $100 interest expense.