Internet expense is an expense for the business which is incurred during a financial year. As it is with all the other expenses of the business, the interest expense as well needs to be recorded for the amount of the expense that has been incurred during the year, regardless of the fact if any payments have been made for it or not.
An interest expense is generally not recorded by the business during the course of the financial year. It is for this reason that companies then need to make a year-end adjusting entry to record interest expense for the year as it does for other accrued expenses such as rent or salaries.
This accrued expense is known as interest payable. This is essentially an interest that been occurred but has not been paid yet by the company. Like other accrued expenses, any outstanding interest payments must also be recorded by the company.
The adjusting entry made at the end of the financial year allows the company to recognize interest expense that has occurred during the year and also adjust the liability of the company according to the interest expense.
This is because any unpaid interest is a liability for the company and must be recorded in the books. Recording the interest expense and the corresponding interest liability in the income statement and the balance sheet of the company ensures that the expenses or liabilities of the company are not understated, and nor is the profit or equity overstated as a result of this. This article will discuss how to record the interest expense and provide an example for it.
Adjusting Journal Entry for Interest Expense
The year-end journal entry to record the interest expense is made by debiting the interest expense account while crediting the interest payable account. In this case, the interest payable account is a liability account.
Explanation for Journal Entry for Interest Expense
It is important to record both the interest expense and the interest liability to correctly represent the financial accounts of the company. An adjusting entry is made at the end of the year to record the expense and liabilities of the business in terms of the interest it owes and has accumulated during the year allow to ensure that the financial statements of the company are not understated in terms of expenses incurred and liabilities owed by the business.
When the interest expense is paid by the company, it must be recorded using the appropriate journal entries which include debiting the interest payable anoint by the amount of interest being paid by the company, debiting the interest expense account by the interest for the new period, and then crediting cash account with the amount of interest paid.
This journal entry allows the company to record that the liability which was owed from the previous year-end adjusting entry has been paid off so that it can be eliminated from the books now. Further, the recording of the interest expense for the new period ensures that the current expense which has been incurred is recorded as well.
Journal Entry for Interest Expense- An Example
The example below will explain how to write a year-ending adjusting entry for interest expense.
Company ABC Limited received a loan from Bank XYZ on 16th June 2020, for $100,000 payable in the next 2 years. The interest payable on the loan is 24% per annum. The company must pay monthly interest on the 15th of each month. The principal amount must be paid back at the end of the 2-year period.
To account for the interest expense that has been incurred from 16th June to the 30th June 2020, the company needs to calculate the interest expense for the period. This can be done by calculating the interest rate per month and dividing that by 2, to arrive at the half monthly interest expense.
Interest rate per month = 24%/12= 2%
Interest expense per month = 100,000*2% = $2,000
Interest expense for the period 16th June to 30th June = $2,000/2 = $1,000
To record the journal entry for this period on 30th June 2020, the company must make following journal entries:
This journal entry allows the company to recognize the interest expense incurred during the 15 days of the month of June as well as to recognize the liability associated with this expense as the interest is not paid yet and therefore is recorded as interest payable.
If the company fails to record these journal entries, the liabilities of the company and its expenses will both be understated by $1,000.
On 15th July 2020 when the company has to make its first interest payment, it must now pay a sum of $2,000 ($100,000*2%), as the monthly interest as per the loan agreement.
To record this, the company must make the following journal entry on 15th July 2020:
This journal entry allows the company to record the interest expense for the period from 1st July to 15th July by debiting the interest expense account. It will also record the payment of $2,000 by crediting the cash account and will be eliminating the liability of $1,000 previously recorded as interest payable as it is now paid.
To sum up, recording the interest expense through an adjusting entry allows the company to ensure that the company’s profits are not overstated due to understated expenses nor is the equity part of the balance sheet overstated because of understated liabilities and higher profits.
It is important to record both the interest expense and interest payable in the period in which they occur, whether the interest payments have been made for them or not. This is line with the accrual’s basis of accounting. The adjusting entry will allow the company to match the expenses and liabilities to the correct accounting period.