Interest Expense in Income Statement - Formula, Calculation, Journal entry

What is Interest Expense?

Interest expense represents an amount of interest payable on any borrowings which includes loans, bonds or other lines of credit. Every firm needs money for financing its operations from a bank and pay a small fee based on the amount borrowed until is repaid. These are costs incurred by the entity for borrowed funds shown on the income statement.

Interest expense in the Income statement is usually calculated as the interest rate times the outstanding debt balance. These expenses on the income statement highlight interest accrued during the period covered by the financial statements and not the interest amount paid over the time period. While such expenses are tax-deductible for firms, with respect to an individual, the purpose and jurisdiction of the loan are applicable.

Interest Expense Formula

Below is the formula to calculate interest expense.

Interest Expense Formula = Average Balance of Debt Obligation x Interest Rate

How is Interest Expense Recorded in the Income Statement?

It is reported after the Operating income or EBIT as shown in the income statement below.

source: Apple SEC filings

Example of Interest Expense

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 15^th 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 expense 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 payable in the future)

How is Interest Expense Recorded in Balance Sheet?

Interest accrued but not paid would be recorded under Current Liabilities of the Balance Sheet (as interest payable)
Interest paid in advance will be recorded within the section of Current Assets as a Prepaid item.

Where is Interest Expense Recorded in Cash Flow Statements?

As the net profit or loss reported by the firm’s cash flow statement includes this 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 this expense will appear under the income statement.
The interest amount paid on loans (short term and long term debt) is recorded under Operating activities in the cash flow. However, the principal amounts borrowed and that repaid are separately included under financing activities. 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 statement but not the income statement.

Interest and Tax Shield

Interest reduces the overall taxes in the income statement and thus can be used as a way to reduce tax liabilities (also called as tax shield).

For example, a firm with no Debt 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 received on Investments. On a financial statement, the income can be listed separately from expenses or provide a net interest number which is either positive or negative.

Interest Expense