What Is The Interest Expense In Accounting?
The cost of borrowing money is called an interest expense. Interest is considered a non-operating expense, meaning that it is not part of a company’s regular key expenditures such as rent, salaries, or equipment. This also means that it can be tax deductible.
Interest expense is an important part of invoicing for small business operations and freelancers, especially if you are running the business on your own.
The following article will teach you everything you need to know about this term in the context of accounting.
Where Do You Find It?
Whether you use a cloud based invoicing software or traditional accounting methods, the interest expense is typically a one-line item at the bottom of any income statement.
There are two ways it can be presented; on its own, or combined with interest income. This inverse definition refers to the interest made by the company, for example in a savings account. When the interest expense and income are combined, it is called one of the following:
- “Interest Income - Net” - This is used when there is more interest income than expense overall
- “Interest Expense - Net” - This is used when there are more expenses than income overall
For example, if a company pays $250 every month for a $5000 loan it took, but is making $100 interest from a savings account, it would be seen on the income statement as “Interest Expense - Net = $150).
The best way to figure out your interest expenses is by understanding the following equation.
Interest Expense Average = Debt Balance x Interest Rate
For example, imagine that someone named Bill took a loan of $50,000 for his business at 5% interest rate in July.
Bill’s interest expense will be as follows:
- $50,000 x 5% = $2,500 for July.
In August, if Bill Pays $25,000 back, the interest expense for August will be as follows:
- $25,000 x 5% = $1,250 for August.
In addition to the calculation above, interests are treated favorably when it comes to tax audits and calculations for business owners. This is why it is also a tax deduction that self-employed business owners can use.
For example; if Tom has an annual income of $170,000 and the taxable rate is 20%, Bill has to pay $34,000 per year. Suppose he has an average interest expense of $1,200 per year at $120 per month, he will pay the reduced amount of $32,800 in taxes for that year.
Is Interest Expense a Debit or Credit?
Did you know the interest of expenses can be both an asset and a liability? For example, if you have paid interest already, it is counted as an asset while unpaid interest expenses are counted as a liability.
This is the same reason why accrued interest of expenses is considered debit.
For example, consider that Bill paid $500 in interest for a loan in July. It will show up in the journal as shown below:
- Debit on interest expense: $2,500
- Credit to cash: $2,500
Besides indicating that he cashed out 2,500 in June, another account reflects the debit of that 2,500 too.
Is Interest Expense an Operating Expense?
The truth is that your interest expense is not in the same category as operating expenses. These expenses include payables such as mortgage, rent, employee pay, marketing expenses, equipment, and so on.
Consider that Mike runs an advertising firm called The Noun. He has to pay his staff as well as the adverts he runs for the business. He also needs to cover software payments and use outsourced design services. Any loans he needs to pay are not considered to be an operating expense, seeing as a loan is not directly related to his work. In other words, a bank - a business that makes its money directly from interest - could consider it an operating expense. Mike cannot.
An operating expense only relates to activities that are responsible for directly generating revenue for a company, within its scope of activity.
Interest expense is a crucial term to understand when it comes to invoicing for freelancers and small enterprises. Knowing how to manage the payment of interest is a key part of successfully running a business, especially when it is tax deductible.
Fortunately, you can manage these expenses and your entire income statement effortlessly with the help of invoicing software such as QuickBooks.