Your business’s income statement offers an in-depth look at its financing. If any of this financing involves borrowing money, you’ll need to make interest payments as you repay the balance. How is this interest dealt with in business accounting, and what is an interest expense on the income statement? Here’s what you need to know.
What is interest expense?
The income statement shows a full list of all core expenses, one of which is the interest expense. Interest is usually incurred whenever a company finances its assets through debt, because it’s the cost of borrowing money. If your business leases assets from another company, this might also generate an interest expense.
Interest expense usually appears below the EBIT (Earnings Before Interest and Taxes) as a separate line on the income statement. However, some businesses choose to list this expense in the SG&A (Selling, General, & Administrative) section instead. Listing this as a line item below EBIT makes it easy to calculate EBT (Earnings Before Tax) because you can simply deduct interest expense from EBIT to arrive at EBT. Interest is usually the last item that’s deducted from operating profit before taxes are also taken out to calculate net profit.
How to calculate interest expense
You’ll need to know how to calculate interest expense to put together your business income statement. To arrive at this figure, you can follow these simple steps:
Find the outstanding principal (or remaining balance) for the loan during the accounting period in question.
Find the annualized interest rate, which should be listed in your loan paperwork.
Decide which period you’ll be calculating your interest expense for. This might be for the year, month, or a specific accounting period.
Plug the principal, interest rate, and period into the interest expense formula, which we’ll share below.
You can also find this information on the company debt schedule, which should outline all of the business’s debts along with their balances and interest rates. Capital leases are the exception because you’re leasing an asset rather than borrowing money.
Interest expense formula and example
Use the following interest expense formula to calculate interest:
Interest Expense = Principal x Period x Interest Rate
As a quick example, imagine that Company ABC has borrowed $75,000 at a 5% interest rate. An accountant for Company ABC is drawing up its financial statements for the first quarter of 2021 and wants to know the interest expense for this three-month period. To calculate this figure using the interest expense formula, it would look like:
$75,000 Principal x 0.25 Period x .05 Interest rate = $937.50
The period is written as 0.25 because it’s one quarter of the year in relation to the 5% annual interest rate. So, during the first quarter of 2021, the company paid $937.50 in interest expense and can list this on its income statement.
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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