Short-term and long-term debts are an important part of the capital structure of a business. Capital structure refers to the make up of a business’s assets and obligations. Short-term liabilities refer to any obligations owed by a company within one year. One of the most common forms of short-term debt is the amount due on a long-term loan within the current year. Long-term debts are obligations of over one year. These include notes and mortgages payable which can run as long as thirty years.
Short-term debts are obligations that must be paid by the company within one year. In the case of a mortgage loan, the amount of the loan that must be paid in the current year is shown by making an accounting entry to reduce the long-term debts by the total anticipated mortgage payments that are during the current year. For example, if the total mortgage debt is $200,000 and $12,000 in payments will be due during the first year, an adjusting entry would be made as follows: debit (reduce) long term mortgages payable by $12,000 and credit (increase) short-term liabilities $12,000. Another example of a short-term debt is accounts payable. This includes purchases of merchandise from suppliers who require payment within 30 days. The accounting entry would be: debit (increase) purchases expense on the profit and loss statement, and debit (increase) accounts payable on the balance sheet.
Long-term debts are important because they provide the capitalization or addition of large assets such as real estate which normally require long-term finance. Long-term debts are gradually reduced by the periodic payments made by the company to pay-off, or retire, the debt. When a substantial capital asset such as real estate is acquired using a mortgage, the accounting entry would be: debit (increase) real estate on the balance sheet, and credit (increase) long-term mortgages payable, also on the balance sheet.
Reasons to Separate Long-Term and Short-Term Debts
Cash flow is one of the most important factors a business must be prepared for in its daily operation. The ability of a business to meet its short-term obligations such as ordinary operating expenses and short term debt obligations from the available cash flow generated through sales is crucial to a business’s survival. Management must be sure that its gross receipts can cover these obligations in the short run. This is why it is important to break out the current or short-term obligations that must be paid, even as they relate to long-term liabilities of the company.
When allocating the division of short-term and long-term debts, you should consult a CPA or accounting professional when setting up accounting entries. This is so the company can have a clear picture of its current obligations as well as its long-term obligations. A company’s need to borrow funds in times of cash flow shortages is usually predicated by its need to fulfill its most current obligations first, such as payments to its current product suppliers and its current payments on long-term debts, so the company doesn’t go into foreclosure on its real estate holdings.