What is line of credit, how to take care and account the line of credit? That is all about this post.
A line of credit is like a loan that a company can use if and when the need arises. The advantage of a line of credit over a loan is that interest is charged only on the amount of the line of credit that the company have drawn from the total amount available.
A line of credit is issued with a maximum amount, but you only need to track the amount you’ve drawn and is therefore outstanding.
There are a variety of plans that financial institutions use to award and track a line of credit, but for this discussion I’ll assume your line of credit follows the common scenario:
1. When you need to draw on the line of credit, the financial institution transfers the amount you request into your bank account.
2. The financial institution collects interest on the amount currently drawn. (Frequently the interest is automatically deducted from your bank account).
3. There are no regularly scheduled payments for repaying principal.
Entering a Draw on Your Line of Credit
You need to create a liability account for your line of credit. Most of the time, a line of credit is categorized as a long-term liability, but the terms of your agreement with the financial institution, and the maximum amount available, may permit your accountant to suggest a current liability account.
Every time you draw on the line of credit, the transaction is a deposit to your bank account that is posted to the line of credit liability account, as seen below:
[Debit]. Bank Account = $3,000
Note: When you draw on a line of credit, your bank account and your liability are increased.
As you write checks from your bank account to pay expenses, the payments have nothing to do with the line of credit. You post the transactions normally, ignoring the fact that the money came from a line of credit.
Paying Interest on a Line of Credit
The interest on your line of credit is based on the amount you’ve drawn. If you write a check for interest to the financial institution, post the check to your Interest expense account.
If the money is automatically withdrawn from your bank account, create a “fake” check, which is a check with no number or with the text EFT (electronic funds transfer) used as the number.
Either way, the transaction journal shows the same posting. As you can see on the next journal entry, interest payments don’t post to the liability account you created to track the line of credit.
[Debit]. Interest Expense = $110
[Credit]. Bank Account = $110
Note: Interest paid on the funds drawn from a line of credit is posted just like any other interest payment.
Repaying Line of Credit Principal
When you want to reduce your interest expense, you pay down your line of credit to reduce the balance. Your payment is posted to the liability account, as seen below:
[Debit]. Line of Credit #0001 = $2,800
[Credit]. Bank Account = $2,800
Note: Post principal payments to the liability account for the line of credit
Of course, future interest payments are based on the remaining balance in the liability account.