Interest income refers to revenue earned for lending money. It is computed by multiplying the principal amount by the interest rate for the period the money was lent.
Interest Income is an income account and is presented in the income statement.
If the company's income statement presents "Income from Operations" and "Other Income" separately, the classification of Interest Income will depend upon the primary operations of the business.
If the business primarily makes income from interests (such as for lending companies and financial institutions), then Interest Income is considered "Income from Operations". Otherwise, interest income is to be presented as other income.
When the business earns and receives interest income, the journal entry is:
Cash is debited for the receipt of the amount. An asset account is debited to increase it. Interest income is credited to recognize the income. It is an income amount, hence credited when recognized.
In some cases, interests are not received until the end of the term of the contract. In such cases, interest income is still recorded but is debited to a receivable account instead of cash.
The journal entry to record interest earned but are still to be collected is:
Accrued Interest Receivable (or simply Interest Receivable) is debited to recognize the interest payment to be collected in the future. The entry is made monthly (if more accurate monthly balances are needed) or at the end of the year before the financial statements are prepared.
1. On December 31, 2020, GAMELI Company received the monthly interest on its bank account. The interest amounted to $200 for the month of December. The journal entry to record the receipt of the interest would be:
2. On December 1, 2020, GRACE Company purchased a $100,000 1-year bond that pays 12% interest. The principal and interest are to be collected at the end of the term of the bond.
On December 31, 2020, the end of the accounting period, interest has already accrued for 1 month. Even if the interest has not yet been collected, it should be properly recognized in the books of the business. The journal entry would be:
Interest is computed as I = Prt; where I=interest, P=principal, r=interest rate, and t=time. In the above example, interest is computed as 100,000x12%x(1/12). Time used is 1/12 since the interest is computed for December only (1 month only which is 1/12th of a year).
The above is an adjusting journal entry that is required at the end of every period. If the company wants updated monthly balances and more accurate monthly financial statements, then the entry should be made every month.