Interest Expense

Definition

Interest expense is the cost incurred by an entity for borrowing money. It represents the amount paid to lenders or creditors for the use of their funds. Interest expense is a critical component in accounting as it directly impacts a company's profitability and cash flow, and must be properly recorded and reported in the financial statements.

5 Must Know Facts For Your Next Test

1. Interest expense must be recorded as an adjusting entry at the end of each accounting period to ensure the proper matching of revenues and expenses.
2. When a company takes out a short-term note payable, the interest expense associated with that loan must be recorded in the journal entries.
3. The effective-interest method is used to compute the amortization of long-term liabilities, such as bonds, and the associated interest expense.
4. Interest expense is a key component in the life cycle of bonds, as it must be recorded in the journal entries for bond issuance, interest payments, and bond retirement.
5. Proper recording and reporting of interest expense is crucial for accurately assessing a company's financial performance and making informed decisions.

Review Questions

• Explain how interest expense should be recorded as an adjusting entry at the end of an accounting period.
  • Interest expense must be recorded as an adjusting entry at the end of each accounting period to ensure the proper matching of revenues and expenses. This is necessary because interest often accrues over time, meaning that some interest has been incurred but not yet paid or recorded. The adjusting entry involves debiting Interest Expense and crediting Accrued Interest Payable, which represents the liability for the interest that has been incurred but not yet paid.
• Describe the journal entries required to record a short-term note payable and the associated interest expense.
  • When a company takes out a short-term note payable, the initial journal entry would involve debiting Cash and crediting Notes Payable for the amount of the loan. As the company incurs interest expense on the loan, it must record this expense by debiting Interest Expense and crediting Cash or Accrued Interest Payable, depending on whether the interest has been paid or not. These journal entries ensure that the interest expense is properly recorded and matched with the corresponding period.
• Analyze how the effective-interest method is used to compute the amortization of long-term liabilities and the associated interest expense.
  • The effective-interest method is used to compute the amortization of long-term liabilities, such as bonds, and the associated interest expense. This method takes into account the actual interest rate paid on the liability, which may differ from the stated or nominal interest rate due to factors such as fees and compounding. By using the effective-interest method, the company can accurately record the interest expense and the amortization of the liability over the life of the instrument, ensuring that the financial statements reflect the true cost of borrowing.

Related terms

Effective Interest Rate: The actual interest rate paid on a loan or debt, which may differ from the stated or nominal interest rate due to factors such as fees and compounding.

Accrued Interest: Interest that has been incurred but not yet paid, which must be recorded as a liability on the balance sheet.

Amortization: The systematic allocation of the cost of a long-term liability, such as a bond, over the life of the instrument.