When a company borrows money, they must pay interest and record the interest payable or expense accurately to reflect borrowing costs. Calculating interest expense can be straightforward if the note payable has a stated interest rate or coupon. However, the process can become difficult to account for, given the nature of the debt instrument and related parties.
What is Interest Expense?
When a company borrows money, they typically enter into a repayment agreement that stipulates regular principal and interest payments. Lenders charge interest to make money off the transaction, but the amount of interest is a function of market conditions and the type of financing provided. The type of loan, collateral, loan term, and other variables impact interest. Most companies record the amount of interest expense on a monthly basis and note the accruing interest when interest expense should be recognized.
Interest Expense Formula
Calculating simple interest expense is a function of multiplying the stated annual interest rate, principal amount, and time. This type of calculation can be used every accounting period before financial statements are published to ensure the income statement accurately reflects interest expense. If it doesn’t, or an accrual hasn’t been posted, an adjusting entry can be posted to the general ledger. Compound interest is calculated using a similar method. The formula, however, calculates interest earned on interest. Many accounting departments keep amortization tables illustrating interest expense for the current accounting period.
Examples of Interest Expense Journal Entries
If a company borrows money from a bank via a short-term lending conduit, the loan amount would be recognized as a liability on the balance sheet, with a corresponding debit to cash. As principal and interest payments are made monthly and are usually considered current liabilities, journal entries would be made to credit cash, debit loans payable, and debit interest expense. Interest expense can be charged on all sorts of loans, payables, and bonds. However, it is important to distinguish interest expense from late charges, penalties, and fines. Categorizing expenses accurately will make it easier for management to gauge operations.
Understanding the interest expense account is important from a bookkeeping and managerial perspective. The expense must be recorded monthly, including the accrual method for expenses incurred but not yet paid. Management must know the annual interest expense amounts for the year-end and percentages to adequately plan for cash flow and capital structure.