Why converting verbal loan to written agreement prevents audits

Imagine your business hits a rough patch. Your friend, bless their kind heart, offers you five thousand dollars to help out. You shake hands, thank them, and promise to pay them back “when things get better”. No papers, no lawyers, just trust. A few months later, your business picks up, and your friend suddenly needs their money back. But they remember you promised to pay six months earlier, and they think you owe them a bit extra for waiting. You have a different idea of what you owe. Now, not only is your friendship at risk, but your business records are a complete mess, and the tax office has no idea where that five thousand dollars came from or went!

This is a common, heartbreaking problem for many small business owners. Borrowing money from friends and family feels easy, but a “verbal agreement” is like building a house on sand. When there are no written rules, memories fade, misunderstandings grow, and friendships can shatter. For students and teachers, this scenario highlights a critical lesson in accounting: if it is not written down, it almost does not exist. This article will show you exactly how to turn a shaky verbal promise into a solid, recorded business loan, protecting both your friendship and your financial future.

12 Simple steps to record a verbal business loan from a friend

1. Write down everything you can remember immediately

The very first thing you must do is write down every single detail you can recall about the verbal agreement. Do not wait. Your memory is strongest right after the event. Grab a piece of paper or open a document on your computer. This is about creating a history of the loan as best you can.

Write down the exact date you received the money. Note the exact amount of money. Who gave you the money? Was it a friend, a family member, or both? What was the original purpose of the loan? Was it for new equipment, to pay staff, or just to help you through a tough time? All these details are crucial for building a clear record.

2. Prepare a simple loan agreement document

Even if you started with a verbal agreement, it is never too late to put it in writing. This does not have to be a complicated, lawyer-written document. A simple “Loan Agreement” signed by both you and your friend will make a huge difference. This turns a shaky promise into a solid business record.

On the document, include the date the money was given, the full amount, the name of the lender (your friend), and your business name. State clearly if there is any interest (extra money) to be paid, and if so, how much. Most importantly, write down the agreed-upon repayment plan. For example, “$100 per month starting next month”. This protects both sides.

3. Classify the loan as a “loan payable” in your books

When your business receives a loan, it is not “income” because you have to pay it back. Instead, it is a “liability” in your accounting books. This means it is money that your business owes to someone else. You must record it as a “Loan Payable” or “Loan from Friend” on your balance sheet.

This is very important for students to understand. If you record a loan as sales income, your profits will look much higher than they really are, and you will pay too much tax. A loan increases your assets (you have more cash) and increases your liabilities (you owe more money). It does not directly affect your profit in the year you receive it.

4. Record the loan in your business bank account

The money from your friend should have gone straight into your business bank account. If it went into your personal account first, you need to be very clear about transferring it to the business account and labelling it correctly. Your bank statement is your official record of money moving in and out of your business.

When the money arrives in your business account, you should make a note in your accounting software or on your spreadsheet. Label it clearly as “Loan from [Friend’s Name]”. This provides a clear, official trail that the money came from your friend and was for the business, not personal use.

5. Document every repayment you make to your friend

As you pay back your friend, each payment must be recorded. Do not just send money and forget about it. Every time money leaves your business bank account to go back to your friend, it reduces your “Loan Payable” liability. This shows that your debt is getting smaller.

Make sure your bank transfer has a clear reference, such as “Loan Repayment” or “Loan to [Friend’s Name].” In your accounting records, note the date and the amount of each payment. This builds a complete picture of the loan and ensures both you and your friend agree on how much is left to pay.

6. If there’s interest, record it separately as an expense

Sometimes, a friend might charge a small amount of “interest” on the loan. This is like paying a fee for borrowing money. If you agreed to pay interest, this part of the payment is treated differently from the main loan amount. The interest is a “finance expense” for your business.

For example, if you pay your friend $100 per month and $5 of that is interest, you record $95 as reducing the loan and $5 as an interest expense. This expense helps to lower your taxable profit. Make sure the loan agreement clearly states the interest amount so there are no arguments later.

7. Keep a running balance of the loan in your records

It is a good idea to have a simple spreadsheet or a specific section in your accounting software that tracks this loan. You can start with the full amount you borrowed. Every time you make a repayment, you subtract it from the total. This gives you a clear “outstanding balance” at all times.

Knowing the exact amount you still owe helps prevent misunderstandings with your friend. It also makes it easy for your financial advisor to check your books at the end of the year. This running balance acts as a mini-statement for the loan, making it transparent for everyone involved.

8. Get written confirmation from your friend for the agreement

Once you have drafted a simple loan agreement document, ask your friend to sign it. This is the most important step in turning a verbal promise into a formal, binding agreement. A signature shows that both parties understand and agree to the terms.

Even if your friend says, “Oh, don’t worry about it, we’re friends!”, insist on a signature. Explain that it is for your business records and for tax purposes. This protects both of you. It avoids future arguments and ensures that both of your memories of the agreement are the same.

9. Explain to your friend what you are doing and why

Honesty and clear communication are key to keeping your friendship strong. Sit down with your friend and explain that you are putting the loan into your business accounts properly. Tell them why it is important for tax reasons and for good business practice.

This conversation helps your friend understand that you are taking their generosity seriously. It shows respect and transparency. They will appreciate that you are being professional, even though you are friends. This talk can clear up any worries or misunderstandings before they even begin.

10. Consult a financial advisor or accountant for guidance

If the loan amount is very large, or if you are still unsure about how to record it, always speak to a professional. A financial advisor or accountant can review your simple loan agreement and your records. They can make sure everything is compliant with tax laws.

They can also give you advice on the best way to structure repayments or handle interest. Think of them as a referee who can make sure both you and your friend are playing by the same rules. Their guidance is an investment in both your business and your friendship.

11. Store all loan documents safely and securely

Once you have written and signed the loan agreement, and you have copies of all the bank transfers, you must store these documents safely. If the tax office ever asks about a large sum of money entering your business, these papers are your proof.

Keep a physical copy in a locked cabinet and a digital copy saved on your computer and backed up in a cloud service. Label the folder clearly, for example, “Loan from [Friend’s Name] 2023”. This ensures that you can find the documents quickly if they are ever needed.

12. Reconcile loan balances regularly with your friend

Just as you reconcile your bank statement, you should also reconcile the loan balance with your friend. Every few months, send them a quick message or email showing them the current amount you believe is still owed. Ask them to confirm if they agree.

This simple check keeps everyone on the same page. If there is a difference, you can sort it out immediately. It stops small misunderstandings from growing into big arguments. This practice builds trust and ensures your records are always a true reflection of the money owed.

Conclusion

Borrowing money from a friend with a verbal agreement can feel like a kindness, but it is actually a hidden danger for both your business and your relationship. By taking these twelve simple steps, you can turn a risky handshake into a clear, professional business loan. This protects your business from tax problems, keeps your accounting records accurate, and most importantly, safeguards your friendship. Remember, good business means good records, and good records mean clear communication. Do not let a lack of paperwork turn a helpful gesture into a stressful nightmare. Take control today and put that verbal agreement into writing.

See also:

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How to decode worded transactions using ALICE accounts: A beginner’s guide to debits and credits

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Master the Accounting Cycle steps: Your guide to tracking business finances like a pro

What is an account? A beginner’s guide

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