Loans and advances are critical elements in financial accounting, impacting the financial statements and overall financial health of an organization. Proper treatment of these items ensures accurate financial reporting and compliance with accounting standards.
37.1 Classification and Measurement
c. Classification of Loans and Advances:
c. Loans:
Definition: Loans are amounts borrowed from external sources (such as banks, financial institutions, or individuals) that need to be repaid over time with interest.
Types of Loans:
- Short Term Loans: Loans that are repayable within one year or within the company’s operating cycle, whichever is longer.
- Long Term Loans: Loans with a repayment period extending beyond one year or the company’s operating cycle.
Classification in Financial Statements:
- Short Term Loans: Presented as current liabilities in the balance sheet.
- Long Term Loans: Presented as noncurrent liabilities.
b. Advances:
Definition: Advances are prepayments or amounts given to suppliers, employees, or other parties before the receipt of goods or services.
Types of Advances:
- Advance to Suppliers: Payments made to suppliers before receiving goods or services.
- Advance to Employees: Payments made to employees before the performance of services or as part of their salary.
- Other Advances: Includes advances given for various business purposes, such as rental deposits or advances for future expenses.
Classification in Financial Statements:
- Current Advances: Presented as current assets if they are expected to be settled within one year or within the operating cycle.
- Non Current Advances: Presented as noncurrent assets if they are expected to be settled after one year or beyond the operating cycle.
c. Measurement of Loans and Advances:
c. Loans:
- Initial Measurement: Recorded at the amount borrowed, including any fees or charges directly attributable to securing the loan.
- Subsequent Measurement: Loans are measured at amortized cost using the effective interest rate method. This involves recognizing interest expenses and adjusting the carrying amount for any repayments or changes in terms.
b. Advances:
- Initial Measurement: Recorded at the amount paid, which typically represents the fair value of the advance.
- Subsequent Measurement: Advances are generally not subject to subsequent measurement adjustments unless there is an impairment loss.
37.2 Interest Recognition
c. Interest on Loans:
c. Interest Expense:
Recognition: Interest expense on loans should be recognized in the financial statements over the loan term, typically on an accrual basis.
Journal Entries: Interest payments are recorded as expenses in the income statement and reduce the liability of the loan.
Example:
Loan Amount: HC 100,000
Interest Rate: 6% per annum
Interest Expense for the Year: HC 100,000 × 6% = HC 6,000
Journal Entries:
Debit: Interest Expense HC 6,000
Credit: Interest Payable (or Cash if paid) HC 6,000
b. Effective Interest Rate Method:
Description: This method allocates interest expense over the life of the loan in a manner that reflects a constant rate of return on the carrying amount of the loan.
Amortization of Loan Premiums/Discounts: Any difference between the initial amount of the loan and its principal repayment amount is amortized over the loan term.
c. Interest on Advances:
c. Interest Income:
Recognition: Interest income on advances (such as advances given to employees or other parties) should be recognized if it is expected to be received and is material to financial statements.
Example:
Advance Amount: HC 50,000
Interest Rate: 5% per annum
Interest Income for the Year: HC 50,000 × 5% = HC 2,500
Journal Entries:
Debit: Interest Receivable HC 2,500
Credit: Interest Income HC 2,500
c. Impairment and Provisioning:
Loans: If there is evidence that a loan may not be fully recoverable, an impairment loss should be recognized. This involves assessing the credit risk and potential losses on the loan.
Journal Entries for Impairment:
Debit: Impairment Loss (Expense)
Credit: Allowance for Loan Losses (Provision)
Advances: Advances that are not recoverable or have become doubtful should be reviewed for impairment. Any provision for loss should be recognized if necessary.
Journal Entries for Provision:
Debit: Provision for Doubtful Advances (Expense)
Credit: Allowance for Doubtful Advances (Provision)
4. Disclosures in Financial Statements:
Loans:
Disclosure Requirements: Information about the terms of the loan, interest rates, repayment schedules, and any covenants or conditions should be disclosed in the notes to the financial statements.
Advances:
Disclosure Requirements: Details about the nature of advances, amounts due, and any potential risks or uncertainties should be disclosed.