Key Concepts
In an exam you may be given a finished Bank loan account or Interest expense account and asked to explain what the entries mean. The trick is the same as for any ledger account.
Every transaction is recorded in two accounts — that is double entry. To interpret an account, check two things for each entry: whether it is a debit or a credit in this account, and the Particulars column, which names the other account in the entry. Together they tell you what the entry was for.
Reading the Bank loan account (a liability — normally a credit balance):
| Entry side | What it means |
|---|---|
| Credit | The business obtained a loan — cash received (Particulars: Cash at bank) |
| Debit | The business repaid part of the loan — cash paid (Particulars: Cash at bank) |
Reading the Interest expense account (assuming the business has a financial year end of 31 December). Over two years it shows a repeating pattern. The reversal at the start of the year can look confusing, so read it slowly:
| Date | Particulars | Side | What it means |
|---|---|---|---|
| 31 Dec (year 1) | Interest expense payable | Debit | Year-end adjustment — interest incurred but not yet paid is recorded |
| 31 Dec (year 1) | Income summary | Credit | Closing entry — the interest expense is transferred to the Income summary |
| 1 Jan (year 2) | Interest expense payable | Credit | Reversal of last year's adjustment, so the interest is not double-counted |
| (during year 2) | Cash at bank | Debit | Interest paid by cheque |
| 31 Dec (year 2) | Interest expense payable | Debit | Year-end adjustment for interest still owed at the new year-end |
| 31 Dec (year 2) | Income summary | Credit | Closing entry |
Finding the length of the loan. If a loan is repaid in equal instalments, divide the loan by one instalment:
Length of loanLength of loan (years) = Total loan ÷ Annual instalment
The effect of forgetting the interest expense payable adjustment. If the year-end adjustment for interest expense payable is left out:
- The current liability is understated (the amount owed is missing), and
- The profit is overstated (an expense is missing, so profit looks too high).
Both are wrong by the amount of the missing interest expense payable.
Read the Particulars — it names the other account. In a Bank loan account, "Cash at bank" on the credit side = loan taken; on the debit side = loan repaid. Loan ÷ instalment = number of years. In an Interest expense account, the first entry of the new financial year is the reversal of last year's year-end adjustment.
| Date | Particulars | Dr ($) | Cr ($) | Balance ($) |
|---|---|---|---|---|
| 20X6 | ||||
| 1 Sep | Cash at bank | 300,000 | 300,000 Cr | |
| 20X7 | ||||
| 1 Jan | Balance b/d | 300,000 Cr | ||
| 31 Aug | Cash at bank | 30,000 | 270,000 Cr | |
| 20X8 | ||||
| 1 Jan | Balance b/d | 270,000 Cr |
| Date | Particulars | Dr ($) | Cr ($) | Balance ($) |
|---|---|---|---|---|
| 20X7 | ||||
| 31 Dec | Interest expense payable | 2,000 | 2,000 Dr | |
| 31 Dec | Income summary | 2,000 | − | |
| 20X8 | ||||
| 1 Jan | Interest expense payable | 2,000 | 2,000 Cr | |
| 31 Aug | Cash at bank | 6,000 | 4,000 Dr | |
| 31 Dec | Interest expense payable | 1,800 | 5,800 Dr | |
| 31 Dec | Income summary | 5,800 | − |
- 1 September 20X6: the business obtained a bank loan of $300,000, paid into its bank account.
- 31 August 20X7: the business repaid $30,000 of the loan by cheque.
- 31 December 20X7: the business incurred and owed interest expense of $2,000 for the year (recorded as interest expense payable).
- 1 January 20X8: the business reversed last year's $2,000 interest expense payable adjustment, so it is not counted again this year.
- 31 August 20X8: the business paid $6,000 interest by cheque. This covers the $2,000 owed from 20X7 plus $4,000 of 20X8's own interest.
- 31 December 20X8: a year-end adjustment records $1,800 of interest incurred but still unpaid at the new year-end.
Length = $300,000 ÷ $30,000 = 10 years.
Interest expense for 20X8 = $4,000 (the part of the 31 August payment belonging to 20X8) + $1,800 (still owed at year-end) = $5,800. The account closes to the Income summary at $5,800, shown under Less: Other expenses in the Statement of Financial Performance.
Reading a debit in the Bank loan account as a new loan. The Bank loan account is a liability (credit balance). A credit with particulars "Cash at bank" is a loan taken; a debit with particulars "Cash at bank" is a repayment.
Mistaking the first entry of the new year for a new expense. The first entry of the new financial year in the Interest expense account is the reversal of last year's year-end adjustment — not interest for the new year.
Getting the effect of a missing adjustment backwards. Leaving out interest expense payable understates the current liability and overstates profit.