Interest Expense refers to the cost of borrowing money that is used or to be used by a business. It is paid or to be paid to the lender. Sometimes known as: Finance Cost
Interest Expense is an expense account and is presented as a deduction from revenues in the income statement. In a condensed income statement, is normally included under "Other Expenses" or "Finance Costs".
Interest expense may be paid monthly, annually, or upon payment of the principal. It may also be paid in advance (deducted from the amount borrowed). Nonetheless, interest expense for the period must be properly recognized. Interest arises as the period lapses, regardless of when it is paid.
For interest that is paid monthly, the journal entry would be:
For interest that has accrued but is yet to be paid, the journal entry would be:
The above is an adjusting entry and is made at the end of every period – annually, quarterly, or monthly, depending on the need of the company.
1. On October 1, 2020, INDIGO Company borrowed $600,000 at 10% interest from a bank. As per agreement, the principal is to be paid after 1 year while interest is payable monthly. On October 31, 2020, the company paid the first interest payment. The journal entry to record the interest would be:
The interest is computed as: $600,000 x 10% x 1/12 = $5,000.
2. On December 1, 2020, GRADE Corp. acquired a $100,000 short-term loan from a bank at 12% p.a. compounded monthly. The principal and interest are to be paid at the end of 6 months. On December 31, the end of the accounting period, an adjusting entry to record the interest that has accrued must be prepared. The entry would be:
The interest expense is computed as: $100,000 x 12% x 1/12 = $1,000.
"Compounded monthly" means that interest accumulated will be added to the principal in computing for the interest expense. Hence, the interest for January 2021 shall be computed as: ($100,000 + 1,000) x 12% x 1/12 = $1,010.
It is easy to calculate for the interest expense of interest-bearing debts. A problem arises when the debt is non-interest bearing or has been discounted (interest is deducted in advance from the principal). In such case, the accountant must compute for the "implicit" interest using the effective interest rate. Nonetheless interest expense, like any other expense, should be recognized in the period it has been incurred regardless of when it is paid.