what is a Interest Expense ?

what is a Interest Expense ?

Interest expense is one of the core expenses found in the income statement. A company must finance its assets either through debt or equity. With the former, the company will incur an expense related to the cost of borrowing. Understanding a company’s interest expense helps to understand its capital structure and financial performance.

Interest is often found as a separate line item below EBIT (Earnings Before Interest and Taxes). Alternatively, some companies may list interest in the SG&A section, depending on their accounting practices.

Most commonly, interest expense arises out of company borrowing money. However, another transaction that generates interest expense is the use of capital leases. When a firm leases an asset from another company, the lease balance generates an interest expense that appears on the income statement.

How Interest Expenses Work

Interest expense often appears as a line item on a company’s balance sheet, since there are usually differences in timing between interest accrued and interest paid. If interest has been accrued but has not yet been paid, it would appear in the “current liabilities” section of the balance sheet. Conversely, if interest has been paid in advance, it would appear in the “current assets” section as a prepaid item.

While mortgage interest is tax-deductible in the United States, it is not tax-deductible in Canada. The loan’s purpose is also critical in determining tax-deductibility of interest expense. For example, if a loan is used for bona fide investment purposes, most jurisdictions would allow the interest expense for this loan to be deducted from taxes. However, there are restrictions even on such tax-deductibility.

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 In Canada, for instance, if the loan is taken out for an investment that is held in a registered account – such as a Registered Retirement Savings Plan (RRSP), Registered Education Savings Plan (RESP) or Tax-Free Savings Account – interest expense is not permitted to be tax-deductible.

The amount of interest expense for companies that have debt depends on the broad level of interest rates in the economy. Interest expense will be on the higher side during periods of rampant inflation since most companies will have incurred debt that carries a higher interest rate. On the other hand, during periods of muted inflation, interest expense will be on the lower side.

The amount of interest expense has a direct bearing on profitability, especially for companies with a huge debt load. Heavily indebted companies may have a hard time serving their debt loads during economic downturns. At such times, investors and analysts pay particularly close attention to solvency ratios such as debt to equity and interest coverage.

Interest Expense Formula

Here is the formula to calculate interest on the income statement:

Interest Expense = Average Balance of Debt Obligation x Interest Rate

Accounting for Interest Expense

The lender usually bills the borrower for the amount of interest due. When the borrower receives this invoice, the usual accounting entry is a debit to interest expense and a credit to accounts payable. If a bill has not yet arrived from the lender as of month-end and the borrower wants to close its books promptly, it can instead accrue the expense with a debit to interest expense and a credit to interest payable or accrued interest.

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The borrower should set up this journal entry as a reversing entry, so that the entry automatically reverses at the beginning of the next accounting period. Then, when the lender’s invoice eventually arrives, the borrower can record it in the manner just noted for an invoice.

If the period covered by a lender’s invoice does not exactly match the dates of a borrower’s accounting period, the borrower should accrue the incremental amount of interest expense not included in the invoice. For example, if a lender’s invoice only runs through the 25th of the month, the borrower should accrue the additional interest expense associated with any debt outstanding from the 26th to the last day of the month.

Interest expense in accounting

How is interest expense handled in accounting journal entries? Once you’ve calculated the expense, you can record it as an accrued liability.

For the journal entry, you would list it as a debit to the expense account under “interest expense”. For double-entry bookkeeping, it would also be listed as a credit to accrued liabilities, a liability account. When an invoice is received from the creditor for this expense, the expense is credited to the accounts payable account. After you’ve paid your interest, debit the accounts payable account accordingly and credit the cash account.

Interest expense on tax returns

Like other expenses, you can list interest expense deductions on your tax return. Because interest payments are a reduction to your business’s net income, this makes it tax-deductible. The interest expense deduction is something to keep in mind as a strategic way to reduce your tax burden if you need to finance assets for your business. Be sure to consult with a financial advisor to find the most advantageous rate and repayment schedule.

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Example of Interest Expense

ABC International borrows $1,000,000 from a bank on June 1 and repays the loan on July 15. The interest rate on the loan is 8%. The interest expense during the month of June is calculated as:

(30 days ÷ 365 days) x 8% x $1,000,000 = $6,575.34

The interest expense during the month of July is calculated as:

(15 days ÷ 365 days) x 8% x $1,000,000 = $3,287.67