Non Interest Bearing Loans
Non Interest Bearing Loans
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 loans 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
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):
| 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:
| 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 |
