See Also:
What is Compound Interest
Effective Rate of Interest Calculation
Nominal Interest Rate
When is Interest Rate Not as Important in Selecting a Loan?
Capitalized InterestInterest Expense Definition
Interest expense, defined as a non-operating expense on the
income statement, occurs anywhere money is borrowed. Interest expenses are considered part of a company’s financing activities. The interest expense represents the company’s cost of borrowing money. It is calculated as the
interest rate multiplied by the principal amount of the
loan or debt. Interest expense can be interest payments on loans, bonds, or other debt instruments.
Interest Expense Explanation
Interest expenses may be recorded on the
balance sheet as
current liabilities before they are expensed. If the interest expense is accrued prior to being paid, it can be recorded in a liabilities account called interest payable. This represents borrowing costs that the company has incurred but not yet paid.
Also, interest expenses can be recorded on the balance sheet as
current assets if they are prepaid. This means they are paid for before they are incurred. They will not be recognized as expenses until they are due according to the loan agreement, so prior to being expensed these payments are recorded as an asset on the balance sheet called prepaid interest.
Interest Expense Formula
Interest expense calculations involve 4 parts: Principal, Rate, Time, and Compunding.
Simple interest formula (which excludes compounding)
:
Interest Expense = Principal X Rate X Time
Compound interest rate formula:
Principal X (1+ (R / N))
(N X T)
Where:
R = Interest rate
N = Number of times interest is compounded in a year
T = Time in years
Interest Expense Calculation
Principal = $50,000
Interest Rate = 7%
Time = 3 years
$50,000 X .07 X 3 = $10,500 in interest expense
Interest Expense Journal Entry
When recording an interest expense journal entry, the interest expense account is debited and the cash account or the interest payable account is credited. This represents money coming out of the cash or interest payable account and going into the interest expense account.
If the interest payment has already been recorded as a liability, it may show up on the balance sheet as interest payable. If it has not already been recorded as a liability on the balance sheet, the amount used to pay for the interest expense will come out of the cash account or the prepaid interest account on the balance sheet. This journal entry is made when the interest expense is recognized. Depending on the circumstances, the journal entry may look like one of the following:
Debit Credit
Interest Expense $1,000
Cash $1,000
Interest Expense $1,000
Interest Payable $1,000
Interest Expense $1,000
Prepaid Interest $1,000
Interest Expense Example
Dwayne has started a company which rents party equipment. Dwayne is considering financing some equipment, mainly the additional trucks he needs to move supplies, so that he could provide a high level of service. Dwayne wonders what his interest expenses would be. He looks on the web to find an "interest expense calculator". Dwayne calculates these results:
Principal: $50,000
Interest: 7%
Time: 3 years
Compounding: None
So:
$50,000 X .07 X 3 = $10,500 in interest expense