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The entrepreneurial journey often begins with a leap of faith and a modest injection of capital. For many small business owners, that first influx of cash does not come from a high-street bank or a venture capital firm but from the kitchen table. You have a brilliant idea, a solid plan, and a friend who believes in your vision enough to hand over a cheque or initiate a bank transfer.
At the time, it feels like a win-win scenario. There are no lengthy applications, no credit checks, and no stiff suits across a mahogany desk. However, this simplicity hides a looming accounting nightmare. Without a formal paper trail, what started as a friendly gesture can quickly morph into a financial muddle that confuses your tax returns, complicates your balance sheet, and potentially sours a lifelong friendship.
The core problem lies in the “verbal agreement” trap. In the eyes of a tax inspector or a professional auditor, a verbal agreement is a ghost. It exists in your memory and your friend’s memory, but it does not exist in the ledger. When money enters your business bank account without a clear label, it can be mistaken for taxable income, a personal gift, or even an illegal contribution.
If you do not record it correctly from day one, you risk paying taxes on money you actually owe back, or worse, losing the ability to deduct interest payments as a legitimate business expense. For students of accounting, this is a classic lesson in why “substance over form” matters, and for financial advisors, it is a frequent point of friction that requires a delicate touch to resolve.
We offer the necessary steps to ensure that your informal business loan is recorded with the precision and professionalism required to satisfy both the tax authorities and your peace of mind.
Identify the transaction as a liability
The very first step in your accounting software or physical ledger is to ensure the funds are not classified as revenue. When you receive money from a friend to grow your business, it is easy to feel like the business has simply become “richer”, but in reality, the business has gained a debt. In accounting terms, this is a liability because it represents an obligation to pay someone back in the future.
You should create a specific account in your Chart of Accounts titled “Loan Payable – [Friend’s Name]”. By naming the account specifically, you avoid grouping it with general trade creditors or bank loans. This distinction is vital for clear reporting and ensures that when you look at your balance sheet, you see exactly who is owed what. It also helps in keeping your personal and professional finances strictly separated, which is a hallmark of a well-run enterprise.
Determine the principal amount immediately
Before the memory of the conversation fades, you must record the exact amount of the principal. This is the total sum of money that actually hit your bank account. Even if you and your friend had a casual conversation mentioning “about ten thousand dollars”, the ledger must reflect the precise figure down to the last cent. This figure serves as the foundation for all future interest calculations and repayment schedules.
If the money was provided in multiple small tranches rather than one lump sum, each instance must be recorded as a separate entry under the same liability account. Keeping a precise record of the principal ensures there is no dispute later regarding how much was originally borrowed. This clarity is the best way to protect the friendship while maintaining the integrity of your financial statements for any future investors or lenders.
Memorialise the verbal terms in writing
Even though the agreement started as a verbal one, you must convert it into a written document as soon as possible. This does not necessarily require a high-priced lawyer, but it does require a clear statement of intent. Write a simple letter or memorandum that outlines what was discussed during your meeting. Include the date the money was received, the total amount, and the agreed-upon purpose of the funds.
Once you have written this summary, send it to your friend via email and ask them to reply with a simple confirmation that they agree with the details. This creates a digital paper trail that acts as a bridge between the informal handshake and a formal accounting entry. It provides the “evidence” that an auditor would look for to prove that the cash injection was indeed a loan and not an undeclared sale or a gift.
Establish an interest rate for tax validity
In many jurisdictions, the tax authorities may look suspiciously at interest-free loans between friends. They might view it as a gift or an attempt to shift income to avoid taxes. To make the loan look professional and “at arm’s length”, it is wise to agree on a modest interest rate. This rate should be documented clearly in your records so that the interest you pay can be correctly categorised as a business expense.
Calculating interest also provides a benefit to your friend, as they are being compensated for the risk of lending to a small business. From an accounting perspective, the interest you pay will be recorded in your Profit and Loss statement as a finance cost. This reduces your taxable profit, which is a legitimate way to manage your tax burden while ensuring your friend receives a fair return on their support.
Create a formal repayment schedule
A verbal agreement often lacks a specific timeline, with phrases like “pay me back when you can” being common. For a business, this ambiguity is dangerous. You need to create a structured repayment schedule that details when payments are due and how much each payment will be. This could be a monthly, quarterly, or annual arrangement depending on your business cash flow.
Having a schedule allows you to forecast your future cash outflows accurately. It ensures that you do not overspend on inventory or marketing because you have already “earmarked” a portion of your cash for loan servicing. When you present your books to a financial advisor or a bank for a future loan, seeing a disciplined repayment schedule for a private loan demonstrates high levels of fiscal responsibility and professional maturity.
Record the initial cash inflow entry
The actual bookkeeping entry for receiving the loan is a two-sided transaction. You will debit your “Cash” or “Bank” account, which increases your assets. At the same time, you will credit the “Loan Payable” account, which increases your liabilities. This maintains the fundamental accounting equation where assets must always equal the sum of liabilities and equity.
It is helpful to include a detailed memo in this specific transaction entry within your software. Mention the date of the verbal agreement and the date the funds were actually received. This “memo” field is your best friend during an audit, as it provides context to the numbers. It explains to anyone reading the books exactly where the money came from without them having to search through external emails or physical folders.
Separate interest and principal in payments
When you begin making repayments, you must not simply record the entire payment as a “loan repayment”. Each payment usually consists of two parts: a portion that reduces the principal balance and a portion that covers the interest. In your accounting system, the principal portion reduces the liability on your balance sheet, while the interest portion is recorded as an expense on your income statement.
Failing to split these can lead to a balance sheet that shows you owe more or less than you actually do. It also means you might miss out on tax deductions for the interest paid. Keeping these two elements separate requires a bit more work during the monthly book-closing process, but it ensures that your financial health is represented accurately. This is a key concept for students to grasp when learning about debt servicing.
Issue monthly or quarterly statements
To keep the relationship professional and transparent, you should provide your friend with a regular statement of the loan. This can be a simple document exported from your accounting software that shows the original balance, the payments made to date, the interest accrued, and the remaining balance. This practice prevents any “surprises” or disagreements regarding how much is still owed.
Providing these statements shows your friend that you take their investment seriously and that you are treating the verbal agreement with the same rigour as a bank loan. It builds trust and can even make the friend more likely to help again in the future if the business needs more capital. For the business owner, it serves as a regular reminder of the debt obligation, helping to keep growth plans grounded in reality.
Document the purpose of the loan
In the eyes of tax collectors, the “why” of a loan is almost as important as the “how much”. You should keep a record of what the borrowed funds were used for, such as purchasing equipment, hiring a specific staff member, or covering a temporary cash flow gap. This documentation helps prove that the loan was for a genuine business purpose rather than a personal expense.
If you use the loan to buy a specific asset, like a delivery van or a new oven, link the loan entry to the asset purchase in your mind and your records. If the loan is ever audited, being able to point to a specific piece of machinery and say “that loan bought this machine” makes the transaction much more credible. This level of detail is exactly what financial advisors recommend to protect their clients from “piercing the corporate veil”.
Address the potential for debt forgiveness
Sometimes, a friend might decide they no longer want the money back, effectively “forgiving” the debt. While this sounds like great news, it creates a complex accounting situation. Forgiven debt is often treated as taxable income by the government. If your friend tells you not to worry about the verbal agreement anymore, you cannot simply delete the liability from your books.
Instead, you must record the forgiven amount as “Other Income” or as a “Capital Contribution” depending on your business structure and local tax laws. This ensures your balance sheet stays balanced. Moving the amount from the liability section to the equity section reflects that the business no longer owes the money but has instead gained value. Consult with a professional to ensure this transition is handled without triggering an unexpected tax bill.
Use a promissory note for added security
If the verbal agreement involves a significant sum of money, it is highly recommended to create a retroactive promissory note. This is a legal document where you, as the borrower, promise to pay the lender a specific amount under specific terms. Even if the money has already been spent, signing a note that reflects the original verbal terms adds a layer of legal and financial protection for both parties.
The promissory note should be signed and dated by both you and your friend. Keep a scanned copy in your accounting software attached to the initial loan entry. This makes the loan “official” in a way that a simple bank transfer description like “loan for business” cannot. It serves as the ultimate piece of evidence for anyone questioning the legitimacy of the debt or the source of the business’s capital.
Account for foreign exchange fluctuations
If your friend lives in a different country and sent the money in a currency other than US$, you have the added challenge of exchange rate fluctuations. The verbal agreement might have been for a specific amount in their currency, but your books must reflect the value in your local currency at the time of receipt. Over time, the value of that debt may change as exchange rates shift.
You will need to record “unrealised gains or losses” on the loan if the exchange rate changes significantly before you pay it back. This is a more advanced accounting topic, but it is crucial for businesses operating internationally. Students should note that the amount you eventually pay back might be more or less than what you originally received in your local currency, and this difference must be accounted for in your profit and loss statements.
Maintain a dedicated “loan folder”
Organisation is the enemy of confusion. You should maintain a physical or digital folder specifically for this loan. Inside, you should keep the confirmation emails, the bank transfer receipts, the repayment schedule, and any promissory notes. Having all this information in one place makes it incredibly easy to answer questions during tax season or when preparing your annual accounts.
For a teacher explaining this to students, this is a lesson in “audit readiness”. A business that can produce a complete folder of documentation for an informal loan is a business that is less likely to face penalties or delays. It reflects a culture of transparency and meticulousness that investors and creditors highly value. It also ensures that if you ever sell the business, the buyer can see exactly what debts they are assuming.
Treat the friend as a formal creditor
Psychologically and practically, you should treat your friend exactly like you would treat a bank. This means making payments on time, every time. If you are going to be late with a payment, communicate this in writing before the deadline, just as you would with a professional lender. This professionalises the relationship and ensures that the verbal agreement does not lead to casual or sloppy financial habits.
In your accounting software, you can even set up your friend as a “Vendor” or “Supplier”. This allows you to use the standard “Accounts Payable” workflows, making it easier to track when the next payment is due. This systematic approach reduces the emotional weight of the debt because it becomes just another line item in your business operations rather than a personal favour hanging over your head.
Consult an accountant for year-end adjustments
At the end of the financial year, your accountant will need to review the loan to ensure it is correctly classified as a “current liability” (due within one year) or a “long-term liability” (due after one year). This distinction is important for calculating your business’s liquidity ratios, which tell you how easily you can cover your short-term debts.
An accountant can also help you determine if any interest needs to be “accrued”. This means recording interest that you owe but haven’t actually paid yet by the end of the year. This ensures that your annual expenses are accurate and that you are not understating your liabilities. Getting professional eyes on an informal loan once a year is a small investment that prevents much larger, more expensive problems down the road.
Understand the impact on business valuation
If you ever decide to sell your business or bring in a new partner, every liability on your books will be scrutinised. A loan from a friend based on a verbal agreement can look like a “red flag” to a potential buyer if it is not properly documented. They might worry that the friend could suddenly demand the money back or claim they own a piece of the company instead of just being a creditor.
By following the steps to record the loan formally, you protect the value of your business. You can show a buyer that the debt is clearly defined, the terms are set, and there is no ambiguity regarding ownership. This clarity makes your business much more attractive and easier to value accurately. It proves that you are a sophisticated owner who knows how to handle complex financial arrangements.
Use the loan to build a credit history
While a loan from a friend usually doesn’t report to credit bureaus, you can still use the documented history of the loan to help secure future bank financing. If you can show a bank manager a three-year history of regular, documented repayments on a private loan, it serves as powerful evidence of your character and your business’s ability to service debt.
This is where the “simple written explanation” from a financial advisor becomes so valuable. By teaching clients to document these informal arrangements, advisors are helping them build a “track record” that can be used as a springboard to more formal capital markets. It turns a “friendly favour” into a strategic building block for the company’s long-term financial infrastructure.
18. Close the loan account properly
Once the final payment has been made, you must officially “close” the loan in your books. This involves one last entry to bring the liability balance to zero. You should also send a final “Thank You” note to your friend, confirming that the loan has been paid in full and the agreement is concluded. This provides a satisfying and clear end to the financial transaction.
Keep the records for this loan for at least seven years, or whatever the legal requirement is in your region. Even though the debt is gone, you may still need to prove where that initial cash came from years later during a tax audit. Closing the loop with a final document and a clean ledger ensures that the “handshake headache” is permanently cured and the friendship remains intact.
Conclusion
Managing a business loan from a friend requires a delicate balance of personal gratitude and professional rigour. By following these eighteen steps, you transform a casual verbal agreement into a transparent, legally sound, and accounting-compliant financial instrument. This not only protects your business from tax and legal risks but also honours the trust your friend placed in you. Remember that in the world of business, clarity is the highest form of respect you can show to those who support your dreams. Whether you are a student, a small business owner, or an advisor, these principles of documentation and systematic recording are the foundation of financial success.
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