Overdraft or an ordinary short-term loan: which is cheaper and how is it recorded in the accounts?
A bakery needs uneven amounts of cash for flour during the month. We compare the interest on a one-month loan and an overdraft by days, record the overdraft on accounts 6810, 9610 and 6920 and show where it sits on the balance sheet.
The "Sahro Non" bakery takes a large batch of flour at the beginning of every month, while the money comes back from shops gradually, by the middle of the month. Manager Otabek went to the bank and received two offers: a 60 million soum loan for one month or an overdraft limit of up to 60 million soum on the account. Both are "short-term debt", but the way the money works is completely different.
How does an overdraft differ from an ordinary short-term loan?
With an ordinary loan the bank transfers the whole amount to the account on one day, and interest is charged on the full amount from the first day. With an overdraft nothing is credited to the account: when the company makes payments exceeding its own money, the bank covers the difference itself, and subsequent receipts usually close this debt automatically.
| Feature | Ordinary short-term loan | Overdraft |
|---|---|---|
| When the money is provided | At once, the full amount | Only when payments exceed the money in the account |
| What interest is charged on | The whole amount, for the whole term | The debt actually used each day |
| Repayment | According to the schedule in the contract | Usually partly closed with each receipt |
| What need it suits | A specific purpose: a batch purchase, an equipment advance | A short gap between daily payments and receipts |
| Main risk | Interest is paid even on unused money | Constant use of the limit becomes a habit |
The specific terms, including the limit, the rate and the repayment procedure, differ for each bank and contract.
Which one is cheaper?
The bank rates are hypothetical: the loan at 22% per year, the overdraft at 26% per year. Even though the overdraft rate is higher, the days decide the result. In the calculation the year is taken as 365 days; in practice the procedure in the contract applies.
The bakery's debt to the bank during the month (with an overdraft):
| Days | Debt | Number of days | Debt × days |
|---|---|---|---|
| 1–4 | 40 million | 4 | 160 million |
| 5–9 | 60 million | 5 | 300 million |
| 10–14 | 25 million | 5 | 125 million |
| 15–30 | 0 | 16 | 0 |
| Total | 30 | 585 million |
- Overdraft interest: 585 000 000 × 26% ÷ 365 = 416 712 soum.
- Loan interest: 60 000 000 × 22% × 30 ÷ 365 = 1 084 932 soum.
The overdraft turned out 2.6 times cheaper, because there was no debt at all for half the month. If the bakery used the full limit throughout the month, the overdraft would be more expensive because of the higher rate: 60 000 000 × 26% × 30 ÷ 365 = 1 282 192 soum. The rule is simple: if money is needed briefly and unevenly, an overdraft; if it is needed for long and in full, a loan.
How is it recorded in the accounts?
NAS No. 21 does not name the overdraft separately. Since an overdraft is a short-term bank loan, it is logical to keep it on 6810 "Short-term bank loans" (paragraph 292: short-term loans received by the organisation are accounted for on this account); record the chosen procedure in your accounting policy. Entries are made on the basis of the bank statement (paragraph 225).
An important point: 5110 "Settlement account" is an asset account, it shows money received into and paid out of the account (paragraph 225). Bank overdrafts, however, are a liability (NAS No. 1, paragraph 75), so it is logical to show the part paid in excess of own money not as a negative balance on 5110 but as a debt to the bank on 6810.
On day 1 the account held 15 million soum, and the bakery paid its flour supplier 55 million soum:
| Day | Transaction | Debit | Credit | Amount | Basis (NAS No. 21) |
|---|---|---|---|---|---|
| 1 | Paid from own money in the account | 6010 | 5110 | 15 000 000 | Paragraph 226, line 15 |
| 1 | The bank paid the rest from the overdraft | 6010 | 6810 | 40 000 000 | Paragraph 296, line 3 |
| 5 | Another payment to the supplier from the overdraft | 6010 | 6810 | 20 000 000 | Paragraph 296, line 3 |
| 10 | Receipts from buyers | 5110 | 4010 | 35 000 000 | Paragraph 226, line 3 |
| 10 | Overdraft partly closed from receipts | 6810 | 5110 | 35 000 000 | Paragraph 296, line 4 |
| 15 | Receipts from buyers | 5110 | 4010 | 25 000 000 | Paragraph 226, line 3 |
| 15 | Overdraft fully closed | 6810 | 5110 | 25 000 000 | Paragraph 296, line 4 |
| 30 | Monthly interest accrued | 9610 | 6920 | 416 712 | Paragraph 427, line 1 |
| 30 | Interest paid to the bank | 6920 | 5110 | 416 712 | Paragraph 309, line 5 |
In the financial statements the overdraft balance is included in current liabilities as bank overdrafts (NAS No. 1, paragraph 75). In the statement of cash flows bank loans belong to financing activities, but an overdraft that is repayable on demand and forms an integral part of cash management is shown within cash and cash equivalents (NAS No. 9, paragraph 7). An overdraft that is opened and closed every month, as at the bakery, is close to exactly this situation; justify which interpretation applies in your accounting policy.
Test yourself
5 questions on this topic: pick an option or reveal the answer.
Money had been deposited in a checkbook from a short-term loan. The bank returned the amount of unused checks to repay the short-term loan. What journal entry is made?
A company lent 24 000 000 soums short-term to a partner organization, with 15% annual simple interest agreed in the contract. What is one month's interest, and how is it recorded under NAS No. 21?
A bank granted the company a short-term loan, and the loan amount was transferred directly to a letter of credit opened in favor of a supplier. What journal entry is made?
A short-term loan received from a bank was repaid on time from the settlement account. What journal entry is made?
"Jizzax tekstil" LLC took a 5-year bank loan for a new workshop, and the loan money arrived in the company's settlement account. Which journal entry is made under NAS No. 21?
Answered: 0 / 50 of 5 correct
All tests →See also
Sources
- NAS No. 21 "Chart of Accounts", paragraphs 292 and 296 (lines 1, 3 and 4) · 6810 short-term bank loans; 5110–5530 / 6810–6820; 6010 / 6810–6820; 6810–6820 / 5110–5530
- NAS No. 21, paragraphs 225 and 226 (lines 3 and 15) · entries on the settlement account are based on bank statements; 5110 / 4010; 6010 / 5110
- NAS No. 21, paragraphs 423 and 427 (line 1), paragraph 309 (line 5) · interest on loans 9610 / 6920; payment of accrued interest 6920 / 5110–5530
- NAS No. 1 "Presentation of Financial Statements and Accounting Policies", paragraph 75 · bank overdrafts are included in current liabilities
- NAS No. 9 "Statement of Cash Flows", paragraph 7 · bank loans belong to financing activities; overdrafts repayable on demand are a component of cash and cash equivalents if they form an integral part of cash management
- Example, interest rates and calculations · compiled by the author, hypothetical; the real rate and terms are set in the contract with the bank