Interest expense is the cost a borrower incurs for the use of borrowed money over a period of time. It is recognized as the debt is outstanding rather than when the cash moves, so an accrual-basis borrower reports it for the days the money was owed rather than for the payment dates. For a business that is not a financial institution it is a non-operating charge, and on the caption list the SEC prescribes for commercial and industrial registrants it is stated under caption 8, interest and amortization of debt discount and expense, rather than inside caption 9, non-operating expenses (17 CFR 210.5-03).
What Counts as Interest Expense
For purposes of the business interest limitation in section 163(j), interest is an amount paid, received, or accrued as compensation for the use or forbearance of money under the terms of an instrument or contractual arrangement, including a series of transactions, that is treated as a debt instrument for purposes of section 1275(a) and not treated as stock under Treasury Regulation 1.385-3, or an amount that is treated as interest under other provisions of the Code or the Income Tax Regulations (Treasury Regulation 1.163(j)-1(b)(22)(i)).
In a firm’s client work the charge shows up on the obvious borrowings first. A term loan carries interest on the principal still outstanding, a line of credit only on the drawn balance, and a carried credit card balance at the rate the cardholder agreement states. Bonds the client issued carry it at the effective rate on the carrying amount, which equals the coupon rate only when the proceeds equal the face amount, a split covered in coupon rate, and a finance lease carries it on the lease liability under the standard in lease accounting.
The regulation’s list also reaches amounts a loan statement never prints. Original issue discount is interest, covered in accrued interest, and so is forgone interest on a below-market loan, covered in imputed interest.
What Type of Account Interest Expense Is
It is an expense account, which makes it neither an asset nor a liability, and it carries a normal debit balance. Expense accounts are temporary, meaning the closing entries reduce them to zero at period end and move the balance into equity, a class set out in temporary accounts. Interest expense therefore measures one period and starts the next at nothing.
The liability people have in mind is interest payable, the amount incurred and still unpaid at the reporting date. It is permanent in the ledger sense, carried forward until settled, and the distance between the period’s charge and that unpaid balance is worked through in accrued interest.
How Interest Expense Is Recorded
On a plain interest-bearing loan the period’s charge is the principal outstanding, multiplied by the rate, multiplied by the fraction of the rate period the principal was outstanding, and the day-count convention that fixes that fraction is set out in accrued interest.
Debit interest expense and credit cash for interest paid during the period, the interest portion of a scheduled loan payment included (loan payable). Where the period ends with interest incurred and not yet paid, the credit goes to interest payable instead, in a period-end adjusting entry for the interest already incurred.
Interest on an asset being readied for its intended use is added to that asset’s cost instead of being charged to the period, so it reaches income later with the rest of that cost, a treatment set out in capitalized interest.
Where the Deduction Sits on the Return
The statute allows it broadly and narrows it afterwards. There shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness, and for a taxpayer other than a corporation no deduction is allowed for personal interest, a term that excludes interest on indebtedness properly allocable to a trade or business other than performing services as an employee (26 U.S.C. 163(a) and (h)).
The cap comes after that. For a taxpayer the business interest limitation reaches, the deduction is limited and the disallowed part carries forward, and the arithmetic behind that cap is in cost of capital. Firms compute it on Form 8990, used to calculate the amount of business interest expense you can deduct and the amount to carry forward to the next year (IRS, About Form 8990).
What Interest Expense Is Not
The lender’s side of the same arrangement is interest income. It is not the stated rate on the note either, since the rate printed there and the rate the expense follows can differ, a split covered in nominal interest rate and effective interest rate formula. How far a period’s earnings cover the charge is a separate test, the times interest earned ratio, and for a bank the charge is core rather than incidental, because interest income less interest expense is net interest income.
Accountably places trained offshore accountants and tax preparers inside US CPA and EA firms, so debt schedules and period-end interest accruals are prepared and reviewed before they reach the partner who signs.
