Know the Difference Between What You Owe and What You Spend
When you take out a loan, two things happen: you receive money that you'll need to pay back (the principal), and over time you pay extra for the privilege of borrowing it (the interest). These might feel like one thing, but in accounting they're treated very differently. Understanding this distinction helps you make better financial decisions and keeps your records accurate.
What Is a Liability?
A liability is money your business owes to someone else. It's a debt that needs to be repaid. When you borrow $10,000 from a bank, that $10,000 is a liability because it belongs to the bank until you pay it back.
Liabilities don't reduce your profit. They represent an obligation, not a cost. Think of it this way: you received $10,000, and you need to return $10,000. The money simply moved from the lender to you and will eventually move back.
What Is an Expense?
An expense is a cost your business pays to operate. Rent, salaries, utilities, and interest on loans are all expenses. Unlike liabilities, expenses reduce your profit because they represent money spent that you won't get back.
When you pay interest on a loan, that money goes to the lender as their fee for lending to you. You don't get that money back, and it doesn't reduce your loan balance. It's simply a cost of borrowing.
A Practical Example
Imagine you take out a $10,000 loan with a monthly repayment of $500, where $400 goes toward the principal and $100 is interest.
- The $400 principal payment reduces your liability. You now owe $9,600 instead of $10,000.
- The $100 interest payment is an expense. Your liability is still based on the original $10,000, minus only the principal payments you've made.
After this payment, your loan balance shows $9,600 (principal remaining), and your expenses include $100 (interest paid).
How This Works in Officaid
Officaid keeps these concepts separate to give you accurate financial records:
- Loan principal is tracked in the Loans module. Each repayment you record reduces your outstanding balance.
- Interest payments are recorded in Expenses using the Interest Expense category. This appears in your profit and loss reports as a business cost.
Why This Matters for Your Business
Separating liabilities from expenses gives you a clearer picture of your finances:
- Your balance sheet shows what you own and what you owe. Loan principal appears here as a liability.
- Your profit and loss shows your income minus expenses. Interest appears here, affecting your net profit.
- Tax reporting often treats interest as a deductible expense, separate from loan repayments. Accurate records make tax time easier.
Frequently Asked Questions
Most loan statements break down each payment into principal and interest components. Check your statement or loan agreement for this breakdown. If your repayment is $500 and $100 is interest, record $400 as a loan repayment in the Loans module and $100 as an expense using the Interest Expense category.
Interest payments are typically tax-deductible as a business expense, while principal repayments are not. By keeping them separate in Officaid, you have clear records for tax reporting. Consult your accountant for specific advice on your situation.
Bank fees, processing charges, or late payment penalties are also expenses, not liabilities. Record these in Expenses with an appropriate category such as Bank Charges or Interest Expense, depending on the nature of the fee.
What's Next?
Now that you understand the difference between liabilities and expenses, you're ready to:
- Add a Loan to start tracking your principal balance
- Record Loan Repayments as you pay down your loan
- Record Loan Interest to track the cost of borrowing