Interest Expense

Interest expense represents an interest payable on any borrowings, including 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, not the interest amount paid.

Thus, the amount shows how much cost the business has to incur for taking loans or borrowing funds to meet its expenses and invest for expansion and growth.  It is a very important part of the financial statement that provides information regarding the position of debt and tax benefits.

Interest expense is the cost that the company has to pay if they borrow funds for the purpose of growth, expansion, and meet the operational cost of the business. It is recorded in the profit and loss statement as a non-operating expense. The borrowings may be in the form of loans, debt or bonds.

It is important to understand that this interest expense equation does not show the interest that has already been paid. It is the accrued interest only for that period, on the money that has been taken as a loan and is yet to be paid to the lender.

This amount helps the business reduce taxable income but in case of personal loans, the rule may depend on the tax rules followed in the region or country. Typically interest on mortgage loan amounts are huge which spreads over the lifetime of the borrower. In countries like Canada, the borrower does not get tax benefit, but people in the US get it, subject to certain restrictions.

The economic condition of a country also influences the value of this expense to some extent for big corporations. They usually take loans which are of huge amount and pay a lot of interest. But if the country in general is undergoing inflationary situation where the interest rates set by the policymakers is very high, then the expense incurred by the company will be high.

Investment interest expense is a good metric to understand the financial condition of the business because high interest expense denotes high debt which is a pressure on the financial resources of the company. It affects profitability and may affect the business during downturns in the economy. Therefore companies should try to maintain a balance in the financial structure.

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

Let us understand how to record the calculation in the financial statement.

In Income Statement

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

source: Apple SEC filings

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 Current Assets section as a Prepaid item.

In Cash Flow Statement

• 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 and long-term debt) is recorded under Operating activities in the cash flow. However, the principal amounts borrowed and 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.

Let us look at the below instance for a clear understanding of how to calculate interest expense under the accrual method:

Assume a company borrows $125,000 on January 15 and agrees to pay the interest on the 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 = $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 expense 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.

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 payable in the future).

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

For example, for a firm with no Debt and EBT 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 . This will make their taxes payable $500,000 .

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

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 statement, the income can be listed separately from expenses or provide a net interest number, either positive or negative.

Some limitations of the financial concept of investment interest expense are as follows:

• It is a value that does not account for the principal amount of loan, which leads to the fact that the proper financial position of the business is not reflected.
• Profitability is impacted because there may be interest rate fluctuations, especially if the economy is undergoing turbulent times.
• The amount of debt influences the interest expense, so if debt is high, this figure will also be high.
• Sometimes, companies may take loans in the form of operating lease, which is kept hidden from the balance sheet. But there are interest expenses on them. This leads to misrepresentation of financial statements.
• Sometimes the expense on interest may be offset by the income from interest. Thus, the financial statement is not providing a clear view in this case because the expense is accounted for separately.
• Reporting may vary from company to company and may also depend on the jurisdiction. This affects the reporting of financial statements because there is no consistency.

Thus, the above are some limitations of the concept of mortgage interest expense.

Both the above are two financial and accounting terms that are used to record transactions that are related to interest on borrowings. But let us understand the differences between them in details.

• The former is a part of the income or the profit and loss statement, but the latter is a liability in the balance sheet of the business.
• The main purpose of the former is to identify the cost that the business pays for taking borrowed money, which is an operating expense, but for the latter, we identify it as an amount that the business owes to lender.
• For the former, the expense is recorded in the financial statements for the period when they are incurred not when the amount is paid out. For the latter, the payable amount arises when the interest is incurred even though the company has not yet paid it.
• In case of reporting the mortgage interest expense is reported in income statement but the latter is reported in the balance sheet.

Thus, the above are some important differences between the two items. It is necessary to understand that if the interest is not paid on time, then the interest payable will increase. However, the interest expense will continue to be recorded in the profit and loss statement as and when they are incurred.  However, both are equally important for the view of financial reporting and calculation of tax.

This has been a guide to what is Interest Expense. We explain its formula and journal entry with net expense, example & differences with interest payable. You may learn more about accounting from the following articles –

• Formula of Interest Expense
• Explain Income Summary Account
• Capitalized Interest
• Imputed Interest