What are Interest Expenses?
Long-term financing is highly common across almost all businesses in the modern-day and age. The greatest advantage of companies taking on long-term loans is the fact that they are able to generate funds and finance without having to worry much regarding ownership dilution.
In the same manner, they are not liable to be paid a share of profits in the form of dividends. However, against the debt that the firm draws, there is a financial cost that needs to be integrated. This finance cost is referred to as interest, and it is treated as a cost of financing the particular debt.
Interest Expense, can simply be defined as the cost that is incurred by the company against the long-term liability (the debt) that exists on the Balance Sheet.
This is considered to be a charge against the lender lending that money for the company, and hence, it is treated as a finance cost for the company.
Since interest is drawn on all long-term debt instruments, it is imperative for companies to classify them separately in the Income Statement, under the Finance Cost heading.
What are Operating Expenses?
Operating Expenses are expenses that are incurred by the company as a result of their regular operations. Therefore, operating expenses can be defined as the expenses that the company has to pay as a result of their sustenance.
They include a number of costs, like rent, marketing, salaries, insurance, as well as funds. These can also be categorized as fixed expenses, which are inconsistent with the amount of level of production within the company.
Operating Expenses are categorized in the Income Statement as because they give an idea regarding the expenses that the company has incurred over the course of time.
Hence, this tends to directly influence the volume of profits that the company generates over the course of time. Companies strive to keep operating costs low, because of the exact same reason.
Even though these costs are often unavoidable, yet they can be effectively managed in order to increase the profitability of the company.
How is Interest Expense presented in the Financial Statements?
Interest Expense is classified as a financial expense. Therefore, it is supposed to be reflected in the financial statements of the company, because of the fact that it is a significant expense, and cost of financing should be made public in order for transparency, and proper disclosure of financial transactions.
However, interest expense is not classified as an operating expense. This means that interest expense is treated as a financial expense, and hence, it is classified after all the operating expenses have been subsequently listed.
It is important to disclose interest expense under operating expense, in a separate heading, because it helps to identify the exact amount that has been paid in the form of finance charges for the respective year.
In the same manner, Interest Expense, if accrued, is also mentioned on the balance sheet as a current liability, in the case where interest expense for the current year is not paid.
In that case, interest expense is carried forward to the next year, as a Current Liability, and is mentioned as such in the disclosure to the financial statements.
Is Interest Expense classified as an Operating Expense?
Interest Expense is not classified as an operating expense because of the fact that it does not have to day with day to day operations of the company.
In fact, interest expense is incurred as a result of the company sourcing finance from external sources, and hence, it is separately classified as a financial charge.
Interest expense on the Income Statement is representative of the financial charge for the period for which the income statement has been prepared.
Regardless of the interest charge for the particular year being settled or not, it is important for accountants to ensure that the amount of interest charge for the particular year is disclosed.
In case of non-payment, it will be represented as a Current Liability in the Balance Sheet. Since this amount is representative of the cost that is incurred to service debt, it is rudimentary for financial analysts to have a clear idea regarding the costs associated with debt servicing versus other means of external financing (for example, equity financing).
Therefore, if interest expense is not separately shown in the financial statements as a financial cost for the relevant year, it might be difficult for decision-makers to make a strategy regarding sources of financing in the upcoming years.