CSLB Law & Business ExamBusiness FinancesHard
A contractor makes a $2,000 monthly payment on an equipment loan. Of this payment, $450 is interest and $1,550 is principal. How should this payment be reflected in the contractor's financial records?
- AThe entire $2,000 is recorded as an interest expense
- BThe $1,550 principal portion is recorded as an expense; the $450 interest is added to the asset's value
- CThe entire $2,000 is recorded as a reduction of the loan liability
- DOnly the $450 interest portion is recorded as an expense; the $1,550 principal portion reduces the loan liability
Show answer & explanationAnswer & explanation
Correct answer: D. Only the $450 interest portion is recorded as an expense; the $1,550 principal portion reduces the loan liability
Loan payments must be split between interest expense and principal repayment. Only the interest portion ($450) is a deductible business expense on the income statement; the principal portion ($1,550) simply reduces the outstanding loan balance on the balance sheet.
Why the other options are wrong
- A. Incorrect: only the interest portion is an expense, not the full payment.
- B. Reverses the correct treatment of interest and principal.
- C. Incorrect: this ignores the interest expense component entirely.
Loan Payment Allocation
The division of a loan payment between interest expense (income statement) and principal reduction (balance sheet liability).
- Only interest is a deductible business expense
- Principal reduces the loan balance, not an expense
- Amortization schedules show this breakdown over time
Memory trick: Interest is the cost of borrowing; principal is paying back what you owe.