Loan classification and the capital section at the year end
Ashfield Garden Services is a sole trader with a year end of 31 March 20X5. Among the balances in the draft statement of financial position are a 6% bank loan of £60,000, taken out on 1 April 20X2 and repayable in ten equal annual instalments of £6,000, the first falling due on 1 April 20X5; loan interest paid during the year of £3,300; a bank overdraft of £4,200; trade payables of £31,700 and accruals of £2,150. Capital at 1 April 20X4 was £124,000. During the year the owner introduced £15,000 of capital and withdrew £28,600. Draft profit for the year, before any adjustment for loan interest, is £41,250. The owner intends to show the whole £60,000 loan as a non-current liability and the overdraft as non-current because he does not expect to clear it within a year.
1. Determine the correct treatment of the loan, the loan interest and the overdraft, with reasons.
Read the worked answer
Interest: 60,000 × 6% = £3,600 for the year. Only £3,300 has been paid, so an accrual of £300 is required: Dr Loan interest £300 / Cr Accruals £300.
Loan: the first instalment of £6,000 falls due on 1 April 20X5, within twelve months of the year end.
- Current liability: £6,000
- Non-current liability: £54,000
Overdraft: current liability. A bank overdraft is repayable on demand and forms part of cash and cash equivalents. The owner's intention to keep it long term is irrelevant - classification follows the lender's contractual right to demand repayment, not the borrower's plans.
Same logic for the loan: it is split by when the cash is contractually due, not by when the owner hopes to pay it.
2. Prepare the capital section of the statement of financial position at 31 March 20X5.
Read the worked answer
| Capital | £ |
|---|---|
| Balance at 1 April 20X4 | 124,000 |
| Add: capital introduced | 15,000 |
| Add: profit for the year (41,250 − 300) | 40,950 |
| Less: drawings | (28,600) |
| Balance at 31 March 20X5 | 151,350 |
Points to watch:
- The £300 interest accrual is an expense of this period, so it must reduce profit before the profit is transferred to capital.
- The same £300 appears in current liabilities as an accrual, so the statement of financial position stays in balance.
- Capital introduced is added; it is not income, and it is not a liability to the owner.
- Drawings are deducted from capital; they are never an expense in the income statement.
3. Explain how the presentation would change if the whole loan were repayable on 31 March 20Y0 instead, and why the classification must be reviewed every year.
Read the worked answer
If the whole £60,000 were repayable in one amount on 31 March 20Y0, nothing would be contractually due within twelve months of 31 March 20X5. The entire £60,000 would then be a non-current liability and the current portion would be nil; the only loan-related current item would be the £300 interest accrual.
Why annual review matters:
- The split is driven by the twelve months following each reporting date, so it changes every year. On 31 March 20X6, £6,000 of the £54,000 becomes current.
- If the repayment schedule is renegotiated, or a covenant is breached so that the loan becomes repayable on demand, the whole balance is reclassified as current immediately - the contractual position overrides the original terms.
- Misclassifying the loan distorts working capital and the current ratio, which users of the accounts rely on to judge liquidity.