Non Interest Bearing Loans

Non Interest Bearing Loans

Note: This page is currently under construction and information may change as it is developed

Some financial systems for cultural and/or religious reasons, , , , , require loans to be handled in a way in which the payment of interest is not the means of earning revenue by the institution providing the loan profiting from the transaction. In these loan forms both the lender and the borrower usually share the risk of the loan rather than the risk being primarily on the borrower. Here our objective is identify the essential features of the accounting treatment as independently as possible from the legal framework in which they are conducted. This is never entirely possible of course. The accounting treatment in a particular jurisdiction will always be dependent on the specifics laws in that jurisdiction. Taxation, also generally dependent upon profit, is not treated in the following to simplify the explanations given and will have to be included as required by taxation legislation and regulation in the applicable jurisdiction. These type ofloans also cannot be treated simply as a zero interest loan.

In many cases this type is handled by a transfer of equity to the lender (or a trustee who holds the equity on behalf of the investor(s) and issues a document similar to a bond/promissary note). The investor (or trustee) then shares in the profit of the enterprise in an agreed manner and timing which is in accordance with the cultural and/or religious practices which apply. The arrangements regarding profit sharing can usually be varied by agreement between the parties during the course of the loan. On maturity of the loan as specified in the contract, the borrower can purchase the lender's equity on terms agreed in the contract and the proceeds are paid to the investor or renegotiate the loan arrangement. Variations in the contract can include additional payments above the profit sharing which reduce the equity of the investor over the period of the loan.

In another form of these loans often used to purchase domestic property, the arrangement is more like a purchase-lease. The lender purchases on behalf of the borrower and retains title over the property during the period of the loan. The lender makes regular agreed lease payments to the borrower for the period of the loan and at maturity pays back the principal of the loan to the lender and title is transferred to the borrower. Again a variation may allow for additional payments above those of the lease component which reduce the lenders equity in the loan.

The dependence of the payments to the lender on the profit of the enterprise make the calculation of a schedule of payments where the timing and amounts of the payments is specified in advance, as with interest bearing loans, impossible as no general formulae for the payments can be derived.

The examples given below are not intended to be proscriptive but are meant primarily to illustrate general features in the possible accounting treatment of non-interest bearing loans. Appropriate advice should be sought from accounting professionals in the applicable jurisdiction rather than relying on the examples here which should not be interpreted as specific accounting advice.

Zero Interest Loan

A zero interest loan is the trivial case of an interest bearing loan. Here there is no transfer of equity to the lender. It is included here primarily to highlight the difference to the loans described above. In this case the borrower agrees to borrow an amount or principal P and to pay back the principal, and depending upon the agreement, an additional fee amount F at regular intervals over N such intervals. In this case the payments will simply be Py =(P+F)/N. The initial loan establishment is recorded by the creation of a liability when the principal of the loan is transferred to the borrower. The payment of the fee F is deferred to and expensed at the time of the payment. An equity account has been used to record the deferremnt of the fees in this case (an asset account could also have been used but the choice of equity is more natural here as the liability to pay the fee reduces the equity in the entity/business):

Transactions to initially establish the loan

Account affected	Debit	Credit
Asset:Bank:CheckAccount	P
Equity:LoanFeesDeferred	F
Liability:Loan:		P + F

.

The transactions for recording each payment and the expensing of the loan feeare as follows:

Transaction to record each loan repayment

Account affected	Debit	Credit
Asset:Bank:CheckAccount		Py = (P+F)/N
Liability:Loan:	Py = (P+F)/N
Equity:LoanFeesDeferred		F/N
Expense:LoanFees	F/N

where P, F and Py are amounts in the currency in which the transaction is carried out.

Non Interest Bearing Loan - Repayment by Profit Sharing

In this type of loan, the lender and borrower enter into an effective partnership partnership, the lender effectively gaining equity in the enterprise for the period of the loan and sharing the profits of the enterprise. The extent to which this is an actual partnership in a legal sense may depend upon the effective control the lender can exert over the enterprise which will clearly depend on local legislation and the contract itself. The lenders equity and share of the profit may be fixed for the period of the loan and becomes zero when the borrower repays the principal at the end of the loan. Alternatively, the lender's equity may also reduce over the loan period where the borrower makes payments above the agreed share of profits, the additional payment reducing the lender's equity. If such additional payments do not completely reduce the outstanding amount of the principal to zero, any oustanding amount of the principal is payable to the lender at the end of the loan period again reducing the lender's share of equity to zero. In another variation, the profit share may vary over the loan period in an agreed manner.

We first need to define some terminology for dealing with this type of loan.

• Vb₀ - Nominal value of borrower's equity in the enterprise prior to taking out the loan;
• Vl₀ - Value of the lender's equity in the enterprise when the loan is established;
• P - Principal of the loan - Amount lent to borrower by the lender;
• N - Number of repayment periods the loan extends over;
• _n - the repayment period being evaluated where _n runs from 1 to N;
• f_n - The fraction of the profit evaluated over period _n payable to the lender;
  • f_n may be:
    • fixed for the period of the loan, i.e. f is independent of _n
    • variable over the loan period in an agreed manner, e.g. a schedule;
    • may be dependent on the lenders share of equity the outstanding loan balance represents.
• Pr_n - the profit of the enterprise evaluated over the period _n;
• Py_n - the amount payable to the lender at the end of period N;
• Pe_n - an additional payment made by the borrower for period _n above the share of profit which reduces the lenders equity;
  • May be zero if there is no reduction in equity of the lender over the loan period.
• Vb_n - The borrower's equity in the business after repayment period _n;
• Vl_n - The lender's equity in the business after repayment period _n.

We will make an assumption here that the property is shared in the same proportion as the lender's and borrowers equity (this may not necessarily be the case but the borrower can be assigned a nominal equity not equal to the actual value of the business where the sharing ratio f is not based on this assumption). The following assumes that the sharing ratio is dependent upon the ratio of the lender's equity to the total equity at the start of any payment period and is recalculated for each period. In either case immediately after the loan is established, we have:
Vl₀ = P;
Vb₀ + P is now total equity in the enterprise; and
f₀ = Vl₀/(Vb₀ + P); or alternatively
Vb₀ = P(1 + 1/f₀).

We can then define the following equations to define the state of the loan for period _n:

Py_n = f_n-1 * Pr_n + Pe_n;
Vl_n = P - sum k =1 to n of Pe_k;
Vb_n = Vb_n-1 + Pr_n * (1 -f_n-1);
f_n = Vl_n/(Vb_n + Vl_n).

Variations:

• If all Pe_n are zero, the lender's equity is the loan principal and the value of the final repayment;
• If f_n is a constant value f, i.e. f is independent of equity values, then only the first two equations would be used.

These calculations cannot be performed within GnuCash (they would require features not currently in GnuCash and not planned for GnuCash in the forseeable future - never say never). They can however be maintained quite easily in a spreadsheet external to GnuCash. The entries required to record a loan of this form in GnuCash would be as follows:

Transactions to initially establish the loan

Account affected	Debit	Credit
Asset:Bank:CheckAccount	P
Liability:Loan:Principal		P

.

and payment _n could be recorded as follows:

Transactions to record payment _n

Account affected	Debit	Credit
Asset:Bank:CheckAccount		Pyn
Expenses:Loan	fn-1*Prn
Liability:Loan:Repayment	Pen

.

Here the Liability:Loan account is a placeholder and the Liability:Loan:Principal accountand Liability:Loan:Repayments contra-account sum into the placeholder. This sort of structure is used when you are required or need to keep record the initial purchase cost of the property. E.g. if you need to track improvements to the property.

The final transaction would record repayment of any outstanding balance of the loan after the last payment:

Transactions to repay oustanding balance after last payment

Account affected	Debit	Credit
Asset:Bank:CheckAccount		P - sum k=1 to N of Pek
Liability:Loan:Repayment	P - sum k=1 to N of Pek

.

Purchase-Lease Arrangements

This a a common form of finance for existing homes where interest is not charged on loans. The borrower identifies the property they wish to purchase. The bank or financier purchases the property on behalf of the borrower. The borrower then leases the property from the financier ofr the period of the loan making payments on an agreed schedule which consist of a lease payment, which is a payment for service and a component for repayment of the principal. At the end of the agreed term and comp[letion of the repayments, title for the property is transferred to the borrower. The simplest form of this is where the principal is divided by the number of payment periods P/N and a lease fee P_L is charged for each period. Here we could expect the loan principal to be recorded as a liability, the lease fees as an expense with the paydown of the principal being recorded against the liability.

Transactions to initially establish the loan

Account affected	Debit	Credit
Asset:Bank:CheckAccount	P
Liability:Loan:Principal		P

.

with each payment recorded as follows:

Transactions to record payment _n

Account affected	Debit	Credit
Asset:Bank:CheckAccount		Pyn
Expenses:Lease	PL
Liability:Loan:Repayment	P/N

.

Variations can include lease payments P_L decreasing as the borrowers equity increases.