This blog and referenced guidance is not applicable to loans obtained under the Payroll Protection Program (PPP). See this blog for further guidance.
Nonprofit organizations often receive loans that are interest free. Because these are not normally obtainable through traditional financing options, the American Institute of Certified Public Accountants (AICPA) believes a restricted contribution element should be recognized to reflect the value of an interest-free loan. In addition, interest expense should be recognized over the life of the loan using an imputed interest rate. How should a nonprofit organization determine an appropriate imputed interest rate to recognize interest expense? In this blog article, we will answer this question and discuss the proper accounting treatment and journal entries for interest-free loans.
Determining an Imputed Interest Rate
Determining an imputed-interest rate requires the nonprofit’s management to estimate the organization’s incremental cost of capital. Simply put, this is the estimated market interest rate the organization could obtain if it otherwise obtained a loan. A nonprofit’s weighted average cost of capital on existing financing could be used to estimate this rate. If the nonprofit does not have any existing financing, a risk-adjusted externally published rate, such as the prime rate, could also be used as an estimate.
3 Steps for Accounting for Interest-Free Loans and Imputed Interest Expense
- Receipt of loan
Upon receipt of the interest-free loan, the nonprofit should record the loan at face value and the restricted contribution revenue at the fair value of the interest-free element received. Generally, the value of an interest-free element on the loan can be determined by the difference between the face amount of the loan and the present value of the loan’s future required payments at the imputed interest rate.
Note: The interest-free element is recorded as donor-restricted support, due to an implicit time restriction. The organization realizes the benefit of the contributed interest-free element over the life of the loan. See step two for recording releases of restrictions.
Example: ABC Charity receives an interest-free loan in the amount of $100,000 from Stice Corporation on January 1, 20X0. Five equal payments of $20,000 are due on the loan annually on December 31. ABC Charity’s management has determined an imputed interest rate of 5.00% appropriately reflects their organization’s incremental cost of capital. As of January 1, 20X0, the present value of five annual payments of $20,000 first due December 31, 20X0 discounted at 5.00% is $86,590. The journal entries are as follows:
Journal entry to record receipt of loan:
Journal entry to record restricted contribution revenue and discount on loan:
|Discount on note payable||13,410|
|Contribution revenue – restricted by donor||(13,410)|
- Recording interest expense, releases of restrictions, and cash payments
The nonprofit should recognize interest expense using the effective interest method, whether or not required cash payments are made according to loan arrangements. Additionally, the nonprofit should record unrestricted support revenue and the related release of donor restrictions to reflect the value of the interest-free loan used in the current period.
Example: ABC Charity makes its first required cash payment of $20,000 on December 31, 20X0. Using the effective interest rate method (see: Table A), it determines 20X0 interest expense to be $4,329 (5.00% * $86,590 net outstanding note payable).
|Table A: Effective Interest Method|
|Present value of payments at 5.00%:||$86,590|
|Payment Number||For Year
|Cash Payment||Imputed Interest||Reduction of Principal||Remaining Principal|
|1.||December 31, 20X0||20,000||4,329||15,671||70,919|
|2.||December 31, 20X1||20,000||3,546||16,454||54,465|
|3.||December 31, 20X2||20,000||2,723||17,277||37,188|
|4.||December 31, 20X3||20,000||1,859||18,141||19,048|
|5.||December 31, 20X4||20,000||952||19,048||–|
The journal entries are as follows:
Journal entry to record cash payment on loan:
Journal entry to record 20X0 interest expense using the effective interest method:
|Discount on note payable||(4,329)|
Journal entry to record 20X0 satisfaction of implicit time restriction:
|Net assets with donor restrictions – release of restrictions||4,329|
|Net assets without donor restrictions – release of restrictions||(4,329)|
- Presentation on financial statements – additional consideration for interest-free loans
Note: The requirements listed below are in addition to other U.S. GAAP financial statement requirements for loans and interest expense.
Statement of financial position (SFP)
The outstanding loan should be presented as a liability net of any unamortized discount on the statement of financial position (SFP). If a classified SFP is presented, the current portion of principal due (within one year of the SFP date) should be classified as a current liability.
Statement of activities and change in net assets (SOA)
Imputed interest expense on the loan should be presented with total expenses as a decrease in net assets without donor restrictions on the SOA. The restricted contribution element should be presented with total revenues as an increase in net assets with donor restrictions. The release of restrictions should be presented with total revenues as both an increase in net assets without donor restrictions and a decrease in net assets with donor restrictions on the SOA.
Statement of functional expenses (SFE)
If feasible, imputed interest expense should be directly allocated to programs and supporting services the loan’s proceeds benefited. Otherwise, imputed interest expense may be allocated across programs and supporting services using an appropriate allocation method determined by the nonprofit’s management.
Statement of cash flows (SCF)
The initial recording and amortization of the discount on the loan should be presented as a reconciling increase and decrease, respectively, from change in net assets on the SCF. Cash proceeds and principal payments related the loan should be presented as financing cash flows on the SCF. The portion of payments on the loan attributed to imputed interest should be presented in the SCF supplemental information as cash paid for interest.
Management’s accounting policy for determining imputed interest on interest-free loans should be disclosed. The nature and description of the interest-free loan arrangement should also be disclosed.
For more information on interest-free loans or related matters, contact Karl Spanbauer in Aronson’s nonprofit assurance group at email@example.com or 301.231.6200.
Sources: AICPA NFP Guide, paragraphs 5.172 through 5.174