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Companies can choose between various forms of finance. The two most common ones include equity and debt. However, each source comes with its costs. While equity is more expensive, it is easier to obtain. The primary expense associated with equity finance is dividends paid to shareholders. In contrast, debt finance comes with interest expense.
What is Interest Expense?
Interest expense is an item on the income statement often reported as a part of financial expense. It is the cost of using debt finance. In some cases, interest expense may also relate to services received from financial institutions like banks. Usually, the more debt finance a company obtains, the higher its interest expense will be.
Interest expense is a prevalent item on the income statement for all companies. For most companies, it is a non-operating expense as it does not relate to operations. It differs from interest paid, which refers to the monetary amount paid to lenders. Companies calculate interest expenses on an accrual basis. Consequently, it requires recording that expense when accrued rather than when the settlement occurs.
How to calculate Interest Expenses?
Calculating interest expense is not as straightforward for every loan. This calculation may differ based on the terms and features associated with debt. However, companies can measure it for most loans using the same formula for interest expense. It requires multiplying the principal amount by the interest rate and apportioning the amount to a specific time.
Companies can use the following interest expense formula to calculate the amount.
Interest expense = Principal debt amount x Interest rate x Days/Months for which the interest is calculated / 365 days or 12 months
Most financial institutions provide a schedule of the interest expense already calculated on loans. Companies can also use that schedule to record interest expenses on the relevant loans.
What are the journal entries for Interest Expense?
As stated above, companies must record interest expense when it occurs rather than when settled. It is a requirement under the accrual principle in accounting. Later, when a company pays the lender, it can record the amount as paid. When recording interest expenses initially, companies can use the following journal entry.
| Dr | Interest expense |
| Cr | Interest payable |
Once a company settles the payment, it can record the transaction as below.
| Dr | Interest payable |
| Cr | Cash or bank |
Example
A company, Red Co., obtains a loan amounting to $100,000 from a financial institution. The lender set a 5% annual interest rate, payable quarterly. At the end of the last quarter, Red Co. calculated the interest expense on the loan as follows.
Interest expense = Principal debt amount x Interest rate x Days/Months for which the interest is calculated / 365 days or 12 months
Interest expense = $100,000 x 5% x 3 months / 12 months
Interest expense = $1,250
At the time, Red Co. recorded the interest expense using the following journal entry.
| Dr | Interest expense | $1,250 |
| Cr | Interest payable | $1,250 |
Later, Red Co. paid the lender the interest expense calculated above through its bank account. The company used the following journal entry to record the transaction.
| Dr | Interest payable | $1,250 |
| Cr | Bank | $1,250 |
Conclusion
Interest expense is the cost of borrowing funds or debt finance. It is a prevalent item on the income statement, often reported as a part of financial expenses. Although companies can use a common formula for interest expense, its calculation may differ in some cases. Companies must record this expense while conforming to the accrual principle in accounting.
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