Definition: Interest expense is the cost incurred by an company for the use of another firm’s resources typically in the form of a loan. Loan agreements outline the interest rate, terms associated with the debt, and payment structure.
What Does Interest Expense Mean?
What is the definition of interest expense? You can think of this like a rental fee for borrowing another company’s cash. A company that needs money to finance its operations can borrow cash from a bank and pay the bank a small fee based on the amount borrowed until it is all repaid. This expense is typically recorded below the operating expense section of the income statement. The amount of expense recorded is typically based on the accrual method of accounting. Thus, the amount recorded can differ from the amount actually paid during the year due to timing differences between interest payment date and interest accrual date. These differences also appear on the balance sheet as a current asset (prepaid interest) or a current liability (interest payable).
Example
It’s a common practice for organizations to borrow funds to finance operations. Let’s assume a small grocery store chain requires a loan to expand the business, and they attain a $500,000 loan on November 15, 2015, with a 0.5% monthly interest rate. The terms of the loan state that interest is due starting on December 15, 2015, and there is no requirement to pay down the principal balance for the twelve months of the loan. Let’s take a look at how we’d account for the interest paid within fiscal year of the grocery store.
The most crucial factor in determining the amount of expense to recognize, is the period of time the principal balance was outstanding. In this case, the $500,000 borrowing occurred on November 15, 2015 and remained in effect through the end of 2015. Using the 0.5% monthly interest rate applied to the $500,000 principal, the first interest payment due on December 15, 2015 would have been $2,500 ($500,000 × .005). This amount would have been recognized as expense during 2015.
The next payment of $2,500 is due on January 15, 2016, but a portion of that payment actually relates to a period of time in 2015. In this case, half of the $2,500 interest paid on January 15, 2016 actually relates to December 2015; therefore, the company would debit interest expense $1,250 to recognize the 2015 expense and credit interest payable $1,250 to recognize the grocery store owed the interest payment at the end of the year.
This entry ensures the grocery store appropriately accounts for the payment that will be made after the year-end close of December 31, 2015.
Summary Definition
Define Interest Expense: Interest expense means the cost incurred by an organization to maintain debt.
