How to Properly Record Interest Expense

Interest expense is the cost incurred by an individual or business for borrowing money. It arises from various forms of debt, such as loans, lines of credit, and credit card balances. Properly recording this expense is important for maintaining accurate financial records and assessing an entity’s financial health. This article provides guidance on the accounting treatment of interest expense, covering both immediate payments and accrued amounts.

Fundamentals of Recording Interest Expense

Recording interest expense involves specific accounts. The “Interest Expense” account, an expense account, is debited when interest is incurred or paid, increasing its balance and reducing profitability. The “Cash” account is credited when interest is paid, indicating a decrease in cash. For interest incurred but not yet paid, the “Accrued Interest Payable” liability account is used, increasing with credits.

The timing of recording interest expense depends on the accounting method. Under cash basis accounting, transactions are recorded only when cash changes hands; revenue is recognized when received, and expenses when paid. This method is simpler and often used by very small businesses.

Accrual basis accounting, adopted by most businesses, records revenues when earned and expenses when incurred, irrespective of when cash is exchanged. For interest expense, this means recording it as it accumulates over time, not just when payment is made. Accrual accounting provides a comprehensive view of financial performance by matching expenses to the period they relate.

Recording Interest When Paid

When interest is paid, the transaction decreases cash and increases interest expense. The journal entry involves a debit to the “Interest Expense” account and a credit to the “Cash” account. For example, if a business makes a $500 loan payment that includes $100 of interest, the “Interest Expense” account is debited for $100, and the “Cash” account credited for $100, representing the interest portion.

Identifying the interest portion of a payment is important for accurate recording. For loans, this information is typically found on an amortization schedule provided by the lender. An amortization schedule breaks down each payment into its principal and interest components, showing how the allocation changes over the loan’s term. In a loan’s early stages, a larger portion of each payment usually goes towards interest, while later payments allocate more to principal.

For credit cards, interest charges appear on monthly statements, applying when an unpaid balance is carried from one billing cycle to the next. Paying the full statement balance by the due date can help avoid these interest charges.

Recording Accrued Interest

Accrued interest refers to interest that has accumulated over a period but has not yet been paid. Recording accrued interest is necessary under the accrual basis of accounting to align expenses with the period in which they are incurred, rather than when cash is disbursed. This practice ensures financial statements accurately reflect the true cost of borrowing for a given accounting period.

To record accrued interest, an adjusting journal entry is made at the end of an accounting period, such as month-end or year-end. This entry involves a debit to the “Interest Expense” account and a credit to the “Accrued Interest Payable” account.

For instance, if a loan’s interest is paid quarterly but financial statements are prepared monthly, interest incurred during the month must be recognized. If $400 of interest accrues monthly on a loan, a debit of $400 to “Interest Expense” and a credit of $400 to “Accrued Interest Payable” is recorded. When the actual payment is made, the “Accrued Interest Payable” account is debited to reduce the liability, and the “Cash” account is credited for the payment, clearing the accrued amount.