Financing a Purchase? Follow These Accounting Basics

Accounting for financed asset purchases is likely the most complicated bookkeeping procedure to untangle.

Where should you start? To avoid missing vital details in your books, you must record the entire cost of an asset, including the part you pay in the future as loan payments. This allows you to deduct asset costs appropriately and sidestep future errors when recording loan payments.

Use the following procedures to keep your books in order.

Lingering Liability

Loan payments do not belong on your Income Statement, which includes revenue and expenses. Repayment of loan principal applies to a liability on the Balance Sheet. Only the interest portion of a loan payment is recorded on the Income Statement as an expense.

For this structure to function correctly, the loan liability must appear on the Balance Sheet when the money is initially borrowed. Without this element, you have no Balance Sheet liability to reduce as the loan principal is repaid.

Judicious accounting of your loan payments ensures that the liability account on your business Balance Sheet precisely matches the lender’s record of what you owe. Periodically reconciling the loan balance on your books to a report from the lender is as essential as reconciling your checking account balance to a monthly statement from the bank.

Capitalized Curiosities

Most costs of doing business are recorded as expenses on the Income Statement. However, a capitalized cost is a special exception.

Capitalized costs are assets such as equipment, furniture, machinery, buildings, and improvements to rented business space. Some of these items, however, may cost so little that they are accounted for as expenses. Rely on your tax accountant to determine the cost threshold that requires you to capitalize a purchase.

Capitalized costs are recorded in an account on the Balance Sheet. The amount spent is deducted over time as depreciation. When this happens, your financial statements simultaneously document depreciation expense on the Income Statement and a reduction of capital costs on the Balance Sheet.

Financing Formalities

Cash that leaves the business bank account for a purchase is recorded as either an expense on the Income Statement or a capitalized asset on the Balance Sheet. Accounting software automatically deploys this double-entry process.

Since capitalized costs are typically larger than ordinary expenses, their purchase often involves borrowed money. Funding from a lender must be identified along with the amount spent by the business. Paying a capitalized cost with borrowed money does not change the amount paid for the asset. You depreciate the total cost, regardless of how much company cash is spent at the time of purchase.

Journal entries are used with computer bookkeeping programs to record the full cost for a capitalized asset along with the borrowed part of that purchase, which creates a new liability. Consequently, business owners must provide bookkeepers with all the information about the cost for an asset purchase and any loans incurred to buy it. This will allow for accurate accounting of your financed purchase.

Fact or Fiction? Small-Business Myths Debunked

Not all advice is good advice. To succeed, entrepreneurs must discern what counsel is sound and what is pure fiction. Following are three of the most common myths that can lead small-business owners astray.

Tax myth: Topping the list of management mythology is the notion of increased spending to reduce taxes. It’s true that the timing of expenditures sometimes yields beneficial tax consequences. But this does not mean that unnecessary costs are a good idea simply because they’re tax deductible. Especially disastrous is borrowing to pay for things that don’t add to business productivity. Burning $1,000 to obtain a $300 tax deduction simply results in a $700 net cost.

Image myth: Some people encourage frivolous spending on things the customers never see. For instance, retail stores need visible locations with plenty of parking, but a fancy office suite will not impress clients who interact with a business remotely. In addition, despite the importance of reliable transportation to jobsites or a decent car for client meetings, frequent upgrading to the latest model is wasteful. Remember, image cannot replace performance.

Payroll myth: Perhaps the most important myth to dispel is that you should always reinvest in your business before paying yourself. Instead, focus on operating a profitable business. If you have invested the right amount to launch the enterprise, it should provide some amount of compensation for your work. Always plan to pay yourself something first and expand with what’s left. If you aren’t getting paid for running a profitable operation, you’re only reinvesting in an unprofitable endeavor.