Accounting for Interest Income: Methods and Entries

Interest income is the revenue generated from lending money or allowing another entity to use your funds. For example, when you deposit money into a bank savings account, the bank pays you interest. Other examples include earnings from certificates of deposit (CDs), loans made to other individuals or businesses, and investments in corporate or government bonds. The core concept is that you are being compensated for the use of your capital. This income can be distributed through monthly, quarterly, or yearly payments depending on the specific arrangement.

Methods for Recognizing Interest Income

The timing of when interest income is recorded in accounting records depends on the method used. The two primary methods are the cash basis and the accrual basis. Each approach has a distinct rule for when income is recognized.

Under the cash basis of accounting, interest income is recognized only when the cash is received. For instance, if a loan payment that includes interest is due in December but not received until January, a cash-basis taxpayer would record that interest income in January. This method is straightforward and often used by small businesses because it directly tracks cash flow. The IRS allows certain small businesses, with average annual gross receipts of $31 million or less for the preceding three years, to use this method.

Conversely, the accrual basis of accounting requires that income be recognized when it is earned, regardless of when the payment is received. Using the same example, if interest was earned throughout December, it would be recorded as income in December, even if the cash arrives in January. This method provides a more accurate picture of a company’s financial health. Generally Accepted Accounting Principles (GAAP) mandates the use of the accrual method for most businesses to ensure consistency and comparability.

Calculating and Recording Interest Income

The fundamental formula for calculating interest is straightforward: Principal x Interest Rate x Time. The principal is the amount of money lent, the rate is the percentage charged, and time represents the period over which the interest has been earned.

The journal entry to record this income differs depending on the accounting method. Under the cash basis, when payment is received, the entry is made. For example, if a company receives $100 in interest, it would debit (increase) the Cash account by $100 and credit (increase) the Interest Income account by $100.

Under the accrual method, when interest is earned but not yet received, an adjusting journal entry is made. If a company earned $500 of interest in a month, it would debit an asset account called Interest Receivable for $500 and credit Interest Income for $500. This entry recognizes the income in the period it was earned and establishes a record of the amount owed to the company. When the cash is later collected, a second entry is made: Cash is debited for $500, and Interest Receivable is credited for $500.

Accounting for Bond Investments

Accounting for interest from bond investments has additional complexity when a bond is purchased for a price that differs from its face value, also known as par value. When a bond is bought for more than its face value, it is purchased at a premium. When it is bought for less, it is purchased at a discount. These premiums or discounts are not treated as immediate losses or gains but must be spread out over the life of the bond in a process called amortization.

The purpose of amortization is to adjust the amount of interest income recognized each period so that it reflects the bond’s true yield, or effective interest rate. The effective interest method is the prescribed approach under GAAP for this process. It calculates interest income by multiplying the bond’s current carrying value by the effective interest rate. The difference between this calculated interest income and the actual cash interest payment received represents the amortization of the premium or discount for that period.

For example, the amortization of a discount increases the amount of interest income reported each period above the cash received, while the amortization of a premium reduces it. This causes the bond’s carrying value to gradually move toward its face value over its life.

Financial Statement Presentation

Financial statements provide a structured overview of a company’s financial health and performance for external stakeholders like investors and lenders. The classification of interest income depends on the company’s primary operations.

Interest income is reported on the income statement. For most non-financial companies, interest earned is not part of their core business activities and is typically classified in a section called “Other Income” or “Non-operating Income.” For financial institutions like banks, whose main business is lending, interest income is a primary revenue source and is reported in the main operating income section of the income statement.

Assets related to interest also appear on the balance sheet. Any interest that has been earned but not yet collected is reported as a current asset under the line item “Interest Receivable.” The carrying value of the investments themselves, such as loans made to others or bond investments, are also listed as assets on the balance sheet, reflecting their value after any premium or discount amortization.