Any company’s capital structure has two most important parts. Equity and debt collectively make the capital structure of the firm. A company can get capital through equity financing or debt financing.
The ratio of equity and debt in the overall capital represents the information about the firm’s capital structure.
In the case of equity financing, the money is owned by the company owners, who are shareholders. They are entitled to a profit in the company’s earnings up to the percentage of their investment.
However, in debt financing, the company involves third parties to finance its capital. Therefore, it creates a lender and borrower relationship.
The company has to pay the cost of borrowing money or what we generally call interest on the loan. The loan can be taken from financial institutions like banks or borrowed from the public through bonds.
According to the International Standards Of Financial Reporting, any business entity must do accounting for the interest paid on the funds borrowed. We will do an in-depth analysis of interest expense, its accounting nature, and accounting treatment.
What Is Interest Expense?
Interest expense is the cost an entity has to pay for the borrowed funds. The interest expense is recorded in the income statement as a non-operating expense. We cannot attribute all kinds of borrowing costs under the head of interest expense.
The formal definition of Interest Expense as of IFRS 23 is,
Any borrowing cost except those attributable to the acquisition, installation, or production of the qualifying asset is treated as the interest expense.
There are two important terms in the definition: qualifying asset and interest expense. We will break down the definition to get a better understanding.
Breaking Down Interest Expense
According to the IFRS, an interest expense is defined and calculated under IAS 39. It is a subset of the borrowing costs any entity bears. The interest expense is calculated under the effective interest method under IAS 39.
The second term discussed in the definition is a qualifying asset. According to IFRS 23.5, a qualifying asset is an asset that requires a substantial amount of time to become completely operational.
The assets measured at a fair value like biological assets, are excluded from the scope of IFRS 23. Besides, the inventories manufactured repetitively are also excluded from its scope.
Example
The interest expense is calculated on the borrowed funds of an entity. The interest is payable on the bonds, convertible bonds, bank loans, and lines of credit. The total interest expense of the company is calculated on the net borrowings.
The effective interest rate is also calculated for the net amount under IFRS 39.
For example, a company has borrowed $1,000,000 from ABC bank at the interest rate of 10% p.a. The interest is paid after every year. So the company’s interest expense for a financial year will be 10% of the amount borrowed. It will be around $100,000 per annum.
We will closely look at the calculations for the interest expense in the following sections.
Accounting Treatment Of Interest Expense
Interest expense is a non-operating expense for any entity. Therefore, it is recorded in the income statement as an expense. Most commonly, the interest expense is subtracted from EBIT (Earnings before Interest and Tax).
EBIT is also called pre-tax and pre-interest income and operating profit for any entity.
Formula
The interest expense is the interest that the company has paid or is due on the date of financial statement preparation. The main principle is that interest expense is added once the interest is due, either paid or unpaid.
The formula for the calculation of interest expense is as follows:
Interest Expense = Principle Amount Of Loan X Interest Rate X (Days for which fund was borrowed÷ 365)
How To Calculate Interest?
Let’s see how to calculate the interest expense. We need to follow the following steps to calculate the interest expense for any entity.
- You need to ascertain the principal amount of borrowed money for the measurement period of interest expense.
- In the documents of any entity, the annualized interest rate is mentioned. We need that interest rate for calculation.
- The period of the interest expense measurement is determined. It can be annual, monthly, semi-annual, or quarterly.
- Finally, we will put the values in the interest expense formula.
Let’s look at this example.
Suppose that the company has a total outstanding loan of 2,500,000 on December 31st. The company follows the normal financial year from January 1st to December 31st. As mentioned in the documents, the company’s annualized interest rate is 8%. We need to calculate the interest expense for the last year.
We have the formula,
Interest Expense = Principle Amount Of Loan X Interest Rate X (Days for which fund was borrowed÷ 365)
Interest Expense= 2,500,000 X 8% X 365/365
Interest Expense = $200,000
For the same example, let’s suppose the company calculates the interest quarterly.
We have the formula
Interest Expense = Principle Amount Of Loan X Interest Rate X (Days for which fund was borrowed÷ 365)
Interest Expense= 2,500,000 X 0.08 X 91/365
Interest Expense = $2,500,000 X 0.08 X 0.25
Interest Expense= $50,000
Similarly, you can calculate the interest expense monthly and semi-annually.
Cash Interest Vs. Interest Expense
While going through any entity’s income statements, you will know two terms cash interest and interest expense.
There is often a query why interest expense is sometimes greater than cash interest.
Or if the cash interest is the same as the interest expense?
Let’s answer this question.
An expense should be recorded in the company’s financial statement in the accrual-based accounting system once it’s realized. This recording should be irrespective of whether cash has been paid or not.
The same concept applies to the cash interest vs. interest expense. Cash interest is the interest expense that the entity has paid to the creditors. Or we can say it is the proportion of interest expense that has been settled.
Whereas the interest expense is the total interest expense of the company. It is the total amount due for a particular financial period.
Let’s understand with a small example. We can take the data from the above-solved example. The total interest expense of the company was $200,000 for one year.
On December 31st, when the financial statements were prepared, $150,000 for the first three quarters had already been settled. However, $50,000 was due on December 31st, but it was still to be paid.
So the total interest expense was $200,000, but cash interest accounted for $150,000.
Interest Payable Vs. Interest Expense
The interest payable vs. interest expense concept is similar to the cash interest vs. interest expense.
Interest expense is the total interest expense due for a certain financial period. Interest payable is the proportion of the total interest expense due and payable.
The interest expense is recorded in the income statement of the business. However, the interest payable is recorded in the liabilities section of the balance sheet.
Suppose a company has a total interest expense of $149000 for a financial year; however, they have only paid $100000 by the time of financial statement preparation. Following the accrual accounting system, the interest expense of $149000 will be recorded in the income statement, and $49000 will be added to the liabilities as interest payable.
Is Interest Expense Debit Or Credit?
We all know that all the expenses are of a debit nature. The interest on the outstanding debt is an expense for the business entity. Therefore, it will be treated as an expense and debited in the financial records.
Let’s explain it with an example. A company has a total interest expense of $150000 for a financial period. A journal entry for the interest expense is made at the time of interest payment. The interest expense is debited expense, whereas cash is going out, so it is credited.
Is Interest Expense Financing Activity?
Interest is a non-operating expense because it is unrelated to an entity’s day-to-day business activities. All the expenses that do not relate to daily operations are regarded as non-operating expenses.
However, there is a lot of confusion about the recording of interest in the cash flow statement. There is an argument about recording interest as operating activity or financing activity in cash flows.
There is a difference between International Financial Reporting Standards and the US Generally Accepted Accounting Principles. The latter is more strict in the standards of reporting.
According to the IFRS, the interest paid as an expense can be recorded under financing or operating activities. Whereas the US GAAP restricts the recording of interest expense under the head of operating cash flow.
Therefore, we can say that interest expense is more like an operating cash flow than financing.
Conclusion
In this blog, we have tried to explain the concept of interest expense in detail. The accounting nature of interest, treatment, calculation and general rules regarding the recording of interest expense has been discussed.
