What is Interest Income?
Interest Income is the revenue earned by lending money to other entities and the term is usually found in the company’s income statement to report the interest earned on the cash held in the savings account, certificates of deposits or other investments.
Since this interest is not a part of the original investment, it is separately recorded. It is obtained by multiplying the principal amount by the interest rate for the period the money was lent.
Let us take an example of Bank of America. Revenue for a bank is different from the revenue of a non-financial company. Revenue for a bank comprises of net interest incomeNet Interest IncomeNet Interest Margin is a popular profitability ratio used by banks which helps them determine the success of firms in investing in comparison to the expenses on the same investments. It is calculated as Investment income minus interest expenses (this step is referred to as netting) divided by the average earning assets. and net non-interest incomeNon-interest IncomeNon-Interest Income is the amount of revenue generated by a bank or other financial institution through non-core activities such as late payment fees, loan processing charges, and penalties, among others..
- For Bank of America, the total interest earned for the period was $57.5 billion.
- And the net interest income (total interest minus total interest expense) was $ 44.6 billion.
Types of Interest Income
There are two types – – Income from Operations and Other Income
#1 – Income from Operations
source: Bank of America SEC Filings
In cases where the company’s income statement shows Income from Operations and Other Income separately, then the types of InterestThe Types Of InterestFixed interest, variable interest, annual percentage rate, prime interest rate, discounted interest rate, simple interest, and compound interest are the most common types of interest. Income depends upon the primary operations of the business. If the business is primarily making income from the interests like for lending companies and financial institutions, then this is taken as Income from Operations. As we note from the example above, Bank of America’s core income is from “Interest.”
#2 – Non-Operating Income (Other Income)
source: Starbucks SEC Filings
If the core income does not come from interest, then it is non-operating interest income and comes under other income.
All individuals, as well as organizations, have financial assetsFinancial AssetsFinancial assets are investment assets whose value derives from a contractual claim on what they represent. These are liquid assets because the economic resources or ownership can be converted into a valuable asset such as cash. from which they earn a variety of interests. The interest earned on these investments over a period of time is taken as an income for the organization.
In most cases, the interest earned by the individual or the organization is reported in the income statement under Income from Operations or Other Income. The Internal Revenue System (IRS) has made it mandatory that this interest must be reported as taxable income.
Interest Income Accounting
- With reference to the accrual method of accountingAccrual Method Of AccountingAccrual Accounting is an accounting method that instantly records revenues & expenditures after a transaction occurs, irrespective of when the payment is received or made. , the interest is recorded as it is earned and not necessarily as it is paid by assuming that the risk of receiving payment is low. For keeping a proper record of accounting for interest, a detailed understanding of investment terms and conditions is required. The calculation of this accrued interest Accrued Interest Accrued Interest is the unsettled interest amount which is either earned by the company or which is payable by the company within the same accounting period.is dependent on the interest rate, the compounding period, and the investment balance.
- It is amount can be either paid in cash, or it may have been accrued as having been earned but not yet paid. In the latter circumstances, this can only be reported if there is a probability of receiving cash, and the amount of payment which is to be received can be ascertained. It is obtained from the investments of the entity that pay interests such as savings account or certificate of depositCertificate Of DepositA certificate of deposit (CD) is an investment instrument mostly issued by banks, requiring investors to lock in funds for a fixed term to earn high returns. CDs essentially require investors to set aside their savings and leave them untouched for a fixed period..
- It should not be confused or mixed up with dividends, as both are different. The dividend is paid to the holders of a company’s common or preferred stock, and it signifies the distribution of the issuing company’s retained earnings Retained EarningsRetained Earnings are defined as the cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company. It is shown as the part of owner’s equity in the liability side of the balance sheet of the company..
- The penalties paid by the customers on overdue accounts receivable are also treated as income because these payments are related to the use of the company’s funds like accounts receivable by the customerAccounts Receivable By The CustomerAccounts receivables is the money owed to a business by clients for which the business has given services or delivered a product but has not yet collected payment. They are categorized as current assets on the balance sheet as the payments expected within a year. . Some companies prefer to mention this type of income as penalty income. It is reported within the interest income account in the general ledger. It is a line item and is generally recorded separately from interest expense in the income statement. This income is taxable as per IRS, and the ordinary tax rate is applicable for this income.
- The types of assets which help in earning interest for the bank are varied like mortgages: auto loans, personal loans, and commercial real estate loans.
How does Interest Income Works? (Individuals vs. Banks)
- Suppose a person runs a big sized capital goods business and he has a balance of $10, 50,000 in the company’s savings account. Now it must be understood that this $10, 50,000 is not going to be lying idle in the account until the owner decides to withdraw the entire amount.
- The bank in which the savings account is maintained loans this money to the other people and, in return, gets interested in this loan amount. This system is also known as fractional banking. The bank in this situation keeps a small percentage of the actual amount of $10, 50, 000 deposits in its hand.
- Now, these loans given by the bank can be of a long term or short term. The short-term loans are the overnight loans that are given to other banks. Since the bank is getting money on the person’s deposit, the bank then pays an amount as interest to the owner of the deposit so that the owner is motivated to keep the money in the account. So, for the entire year, the cash balance is the earning interestEarning InterestSimple interest (SI) refers to the percentage of interest charged or yielded on the principal sum for a specific period. paid by the bank at the end of each month.
- The bank is required to send out the details giving how much interest it has paid the owner of the deposit in the bank account. Based on this statement, the owner of the deposit gets a clear idea of how much taxable interest income he has earned on the financial assets. So the owner’s business gets the interest payment, which is recorded in his income statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements. as income.
Interest Income Video
This article has been a guide to Interest Income. Here we discuss types of interest income – operating and non operating (other income). Also, we discuss interest income accounting along with practical examples. You may learn more about basic accounting from the following articles –