RECORDING INTEREST

I often think about the theoretical issues pertaining to Business Management accounting and bookkeeping.  I believe in a proactive approach to managing the accounting where one anticipates the future informational needs of those who rely on the financial database.  You then devise strategies for populating the database with the data needed to make sound strategic decisions. The greater the detail and transparency in the data, the better the analysis. All journal entries are not created equal and some convey far more information than others.  Consider the recording of interest expense on a debt.

There are two approaches to recording interest expense associated with a debt:  1) the expense payment method (otherwise known as, the wrong way) and 2) the balance sheet accrual method (aka, the right way).

  • Expense payment method:  Interest expense is recorded at the time a payment is made against the underlying debt.  Cash is credited and the offsetting debit is distributed between the portion of the payment representing interest and the piece representing the net reduction in principal.  The payment is therefore assigned to both a balance sheet liability account (the debt) and to a P&L expense account (interest expense).  The posting of interest expense is therefore inseparable from the execution of the check written to make a payment on the debt.
     
  • Liability accrual (amortization) method:  Interest is accrued independently of any payments against the debt.  A journal entry is posted as of the date on which the interest is payable or accruable, typically the last day of the month.  Interest expense is debited and the debt principal is credited for the computed accrued interest.  Any and all payments made on the debt are debited and allocated in full to a single account: debt principal.  The payments made on the debt instrument are therefore recorded independently of the accrual of interest.

Virtually all Business Management firms and Family Offices employ the former approach to account for interest expense on a debt.  A principal weakness with the expense payment method is that at least one of the elements of the transaction is likely to be inaccurate: the date on which interest effectively accrues.  By inextricably linking the posting of interest expense to the processing of a check, the timing of the accrual becomes subject to the vagaries of the work flow in an accounting office.  If interest on a mortgage is due and payable as of January 31 but the check is not cut until February 5, the date when the account manager returns from a bout with the flu, then interest expense will be recorded five days late.  On the other hand, the mortgage check may be cut two weeks early in anticipation of the bookkeeper’s upcoming vacation to Bora Bora.  Once again, the date on which interest expense is recorded is inaccurate.

The liability accrual method is consistent with a Proactive approach to accounting.  The primary advantage of this approach is that periodic interest is accrued and recorded independently of any payments made against the debt.  This methodology simplifies the accounting: 100% of any payment on the liability is allocated to principal, thereby eliminating the mathematical computations associated with the interest payment method.  When a bookkeeper cuts a check or otherwise records the mortgage payment the entire amount is posted to a single account.  The timing of the execution of the payment is generally irrelevant as long as it falls within the grace period.

As another advantage, the liability accrual method accurately replicates the loan amortization schedule within the general ledger.  Consistent with a standard payoff schedule, interest is accrued and added to principal within the debt register.  The register therefore tracks, as of any period in time, the beginning balance of the debt, the recurring accrual of interest, the level payment of principal and the ending balance.  The accrual method therefore generates a one-to-one correspondence between the amounts computed in the amortization spreadsheet and the numerical entries in the debt register.  Discrepancies are more easily detected and errors more effortlessly corrected.  In contrast, the expense payment method only records the net marginal reduction of principal in the debt register.  The amount of periodic interest accrued never shows up in the debt register.

The advantages of the amortization approach are magnified when debt servicing falls into arrears.  Under the legacy approach interest is recorded only when a payment is executed and that linkage will inevitably lead to an understated liability. The magnitude of the understatement steadily increases for each month that the obligation remains in default.

Informational deficiencies with the expense method

The expense method register records the marginal reduction in the balance of the loan as of the date a payment is executed.  For a typical calendar year the debt register shows twelve consecutive entries coinciding with the twelve checks written.  The information content associated with this approach is limited.  A manager reviewing the register or transaction report can confirm that the debt balance is steadily declining concurrent with the principal payments.  But neither the magnitude of the interest paid nor the mount of the monthly payment is revealed.  For a particular month is the $800 reduction in principal the net of a $10,900 payment and interest of $10,100 or is the net principal the difference between a $5,400 payment and interest of $4,600?  This information is absent.

In contrast, the accrual approach delivers an informative debt register revealing the two key items of data pertinent to analysis of the loan:  the amount of interest accrued for the month and the amount of the principal payment.  Periodic interest is recorded on the proper accrual date, independently of the execution of the payment on the debt.   The manager can glean the approximate interest rate by viewing the register, something impossible to estimate in the legacy debt register where there is insufficient data to provide a frame of reference.  The point is that the accrual method has delivered a balance sheet account that conveys significantly more information and data than the comparable account as reflected in the expense approach.  Furthermore, the entries in the accrual debt register can be ticked and tied to the entries in an amortization schedule.

The loan amortization method is superior to the interest payment method for yet another reason: error correction.  Loan invoices typically report both the interest recorded from the previous period and interest accrued and payable as of the current period.  Under the expense payment method if a bookkeeper inadvertently assigns the interest for a previous period to the current period, correction of the error requires that each check be reposted to redistribute the debit between interest expense and the principal reduction.  Using the amortization approach, the entire amount of the check is debited to principal thereby eliminating a requirement to redistribute the payment between accounts.

Late payment fees

If the monthly payment on a trust deed or mortgage is paid outside of the grace period (typically the fifteen day period beginning with the due date of the payment), a late fee is assessed.  The penalty will be shown as an additional charge on the subsequent monthly statement.  How is a late payment penalty recorded?  The late payment should be accrued to the debt liability register via a journal entry:

            Dr.       Interest expense          Fee on 09/10 late payment

            Cr.       Trust deed                    Fee on 09/10 late payment

The check to make the monthly payment would be increased by the amount of the assessment.  The account should be split into two records, both of which are posted to the debt liability account:

            Dr.       Trust deed                   Standard level payment

            Dr.       Trust deed                   Fee on 09/10 late payment

Why split the payment into two components when both records post to the same balance sheet account?  The payment split conveys information:  the register will have an entry for the standard level payment.  The additional “principal” directly offsets the late fee accrued to the debt balance.  This facilitates review.  An outlier in the middle of a string of level monthly payments conveys information – the larger than standard payment means that something out of the ordinary has occurred.  Splitting the payment aids in analysis because the reviewer can see the accrued late fee offset directly by an additional principal payment in equal value.

Payments of Additional Principal

The debt holder may elect to pay additional principal on the debt.  The additional payment does not alter the contractual requirement to continue making a set level payment.  After additional principal is remitted the amortization schedule is adjusted.  Any additional payments of principal should be recorded in a second record or account split.