What is Interest Expense?
Interest expense represents an amount of interest payable on any borrowings which includes loans, bonds or other lines of credit and its associated costs are shown on the income statement. These expenses highlight interest accrued during the period and not the interest amount paid over the time period.
Interest expense is usually calculated as the interest rate times the outstanding debt balance.
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., as shown in the income statement below.
source: Apple SEC filings
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 interest amount 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 on a daily basis, 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. and to report interest payable.
- Extending the above example, the loan was commenced from January 15, so for that month, only interest for remaining days (0.5 months) would be considered.
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 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. 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. (as interest payable)
- Interest paid in advance will be recorded within the section of 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. 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 time 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 and 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.) 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.. However, the principal amounts borrowed and that repaid are separately included under financing 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.. 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 StatementStatement of Cash flow is a statement in financial accounting which reports the details about the cash generated and the cash outflow of the company during a particular accounting period under consideration from the different activities i.e., operating activities, investing activities and financing activities. 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.).
For example, a firm with no 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. 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., the income can be listed separately from expenses or provide a net interest number, which is either positive or negative.
This has been a guide to what is Interest Expense in the Income Statement and its meaning. Here we discuss how to record interest expense in income statement & balance sheet along with its journal entries. You may learn more about accounting from the following articles –