How to Record an Adjusting Entry for Interest Expense

An adjusting entry for interest expense is a procedure in accrual basis accounting, which requires that expenses are recognized when incurred, not necessarily when cash is paid. This entry is made at the end of an accounting period to account for any interest on a loan that has accumulated but has not yet been paid. By recording interest that is owed, a business presents a more complete picture of its expenses and liabilities for that specific period.

Calculating Accrued Interest Expense

Before an adjusting entry can be recorded, the amount of accrued interest must be calculated. This calculation requires the loan’s principal amount, the annual interest rate, and the time period the adjustment covers. The amount is determined using the simple interest formula: Principal × Rate × Time.

To illustrate, consider a business with a $10,000 loan that has a 6% annual interest rate. If the company is preparing financial statements for one month, the time component of the formula is 1/12 of a year. The calculation would be $10,000 (Principal) multiplied by 0.06 (Rate) multiplied by (1/12) (Time), resulting in $50 of accrued interest expense for that month.

The time period in the formula must align with the interest rate’s term. Since most interest rates are stated annually, the time factor should be expressed as a fraction of a year. For an adjustment covering a single month, the fraction is 1/12; for a quarter, it would be 3/12.

Recording the Adjusting Journal Entry

Once the accrued interest amount is calculated, it is recorded in the general journal. This process involves two accounts: Interest Expense and Interest Payable. Interest Expense is an income statement account that tracks the cost of borrowing money, while Interest Payable is a balance sheet account that represents the amount owed to a lender.

For an accrued interest entry, Interest Expense is debited, and Interest Payable is credited. A debit increases an expense account, reflecting that the company’s costs for the period have gone up. A credit increases a liability account, showing that the company’s obligations have risen.

Using the previously calculated amount of $50, the journal entry is dated on the last day of the accounting period. The first line shows a debit of $50 to Interest Expense. The second line shows a credit of $50 to Interest Payable, completing the entry.

Impact on Financial Statements

Posting the adjusting entry for accrued interest affects a company’s main financial statements. The entry ensures that the income statement and balance sheet adhere to the matching principle, which requires that expenses be recorded in the same period as the revenues they help generate. This provides a more accurate assessment of a company’s performance and financial position.

The debit to Interest Expense increases the total expenses reported on the income statement, which reduces the company’s reported net income for the period. For example, recording $50 in interest expense lowers the pre-tax profit by that same amount. This provides stakeholders with a clearer view of the company’s true profitability by including all costs of operation.

Simultaneously, the credit to Interest Payable increases the current liabilities on the balance sheet. This ensures the balance sheet gives a complete picture of the company’s obligations at the end of the period. Recognizing this liability is important for lenders and investors who use this statement to evaluate the company’s financial health.