What is Interest Expense?

Formula

Interest expense is usually calculated as the interest rate times the outstanding debt balance.

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How is Interest Expense Recorded in the Income Statement?

It is reported after the Operating income vs. EBITOperating Income Vs. EBITEBIT refers to the business’s earnings during a period without considering the interest expense and the tax expense. In contrast, operating income is the income earned by a business organization from its principal revenue-generating activities, not considering non-operating income and expenses.read more, as shown in the income statement below.

source: Apple SEC filings

Example

Let us look at the below instance for a clear understanding of such an expense under the accrual method:

Assume a company borrows $125,000 on January 15 and agrees to pay the interest on the 15th of every month from February 20. The loan indicates interest is 2% per month on the loan balance. The interest expense for month of January shall be [125,000 * 2%* 0.5 month] = $1,250.

Interest for month of February = $125,000 *2% * 1 = $2,500

  • It should be noted that interest on the debt is not paid daily, and a firm must record an adjusting entry to accrue this expenseAccrue This ExpenseAn accrued expense is the expenses which is incurred by the company over one accounting period but not paid in the same accounting period. In the books of accounts it is recorded in a way that the expense account is debited and the accrued expense account is credited.read more and report interest payable.Extending the above example, the loan commenced on January 15, so only interest for the remaining days (0.5 months) would be considered for that month.An accrued expense is the expenses which is incurred by the company over one accounting period but not paid in the same accounting period. In the books of accounts it is recorded in a way that the expense account is debited and the accrued expense account is credited.read more

Interest Expense Journal Entries

Let us look at the below examples of journal entries of interest expense:

Monthly Journal Entry –

(This signifies cash amount paid out against interest recording)

Postpaid Journal Entry –

(Interest payment is recorded as a liability, and the amount is to be paid)

Prepaid Journal Entry –

(Cash paid in advance for interest payableInterest PayableInterest Payable is the amount of expense that has been incurred but not yet paid. It is a liability that appears on the company’s balance sheet.read more in the future)

How to record in the Balance Sheet?

  • Interest accrued but not paid would be recorded under Current Liabilities of the Balance SheetCurrent Liabilities Of The Balance SheetCurrent Liabilities are the payables which are likely to settled within twelve months of reporting. They’re usually salaries payable, expense payable, short term loans etc.read more (as interest payable)Interest paid in advance will be recorded within theCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc.read more Current AssetsCurrent AssetsCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc.read more section as a Prepaid item.

Where to record in Cash Flow Statements?

  • As the net profit or loss reported by the firm’s cash flow statement includes these expenses the business has paid during a given period, the amount paid appears as a separate line item on the company’s cash flow statement, and the appropriate expense will appear under the income statement.The interest amount paid on loans (short-term andLong-term debt is the debt taken by the company that gets due or is payable after one year on the date of the balance sheet. It is recorded on the liabilities side of the company’s balance sheet as the non-current liability.read more long-term debtLong Term DebtLong-term debt is the debt taken by the company that gets due or is payable after one year on the date of the balance sheet. It is recorded on the liabilities side of the company’s balance sheet as the non-current liability.read more) is recorded under Operating activities in the cash flowOperating Activities In The Cash FlowCash flow from Operations is the first of the three parts of the cash flow statement that shows the cash inflows and outflows from core operating business in an accounting year. Operating Activities includes cash received from Sales, cash expenses paid for direct costs as well as payment is done for funding working capital.read more. However, the principal amounts borrowed and repaid are separately included under The various transactions that involve the movement of funds between the company and its investors, owners, or creditors in order to achieve long-term growth are referred to as financing activities. Such activities can be analyzed in the financial section of the company’s cash flow statement.read morefinancing activitiesFinancing ActivitiesThe various transactions that involve the movement of funds between the company and its investors, owners, or creditors in order to achieve long-term growth are referred to as financing activities. Such activities can be analyzed in the financial section of the company’s cash flow statement.read more. Since loan amounts are borrowed money and not an income from the sale of goods or services, they are a part of the cash flow statementCash Flow StatementA Statement of Cash Flow is an accounting document that tracks the incoming and outgoing cash and cash equivalents from a business.read more but not the income statement.

Interest and Tax Shield

The interest reduces the overall taxes in the income statement and thus can be used as a way to reduce tax liabilities (also called a tax shieldTax ShieldTax shield is the reduction in the taxable income by way of claiming the deduction allowed for the certain expense such as depreciation on the assets, interest on the debts etc. It is calculated by multiplying the deductible expense for the current year with the rate of taxation as applicable to the concerned person.read more).

For example, for a firm with noPretax income is a company’s net earnings calculated after deducting all the expenses, including cash expenses like salary expense, interest expense, and non-cash expenses like depreciation and other charges from the total revenue generated before deducting the income tax expense.read more DebtDebtPretax income is a company’s net earnings calculated after deducting all the expenses, including cash expenses like salary expense, interest expense, and non-cash expenses like depreciation and other charges from the total revenue generated before deducting the income tax expense.read more and EBT [Earnings Before Tax] of $2 million (tax rate @30%), the tax payable will be $600,000.

If the same firm assumes a debt and has an interest of, say, $500,000, the new Earnings before Profit would be $1.5 million [$2million – $500,000]. This will make their taxes payable $500,000 [$1.5mm*30%].

Thus, there is a tax shield of $600,000 – $500,000 = $100,000.

Net Interest Expense

source: Colgate SEC filings

Net interest expense is the Total Interest net of any interest income that a company receives on Investments. On a financial statementA Financial StatementFinancial statements are written reports prepared by a company’s management to present the company’s financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more, the income can be listed separately from expenses or provide a net interest number, either positive or negative.

This has been a guide to what interest expense is in the Income Statement and its meaning. Here we discuss how to record interest expenses in the income statement & balance sheet along with its journal entries. You may learn more about accounting from the following articles –

  • Formula of Interest ExpenseExplain Income Summary AccountCapitalized InterestImputed Interest