Interest expense is the cost of the funds that have been loaned to a borrower. To calculate interest expense, follow these steps:
- Determine the amount of principal outstanding on the loan during the measurement period.
- Determine the annualized interest rate, which is listed in the loan documents.
- Determine the time period over which the interest expense is being calculated.
- Use the interest formula to arrive at the interest expense. The formula is:
Principal x Interest rate x Time period = Interest expense
For example, a company has borrowed $85,000 at a 6.5% interest rate. The controller issues financial statements each quarter, and wants to know the amount of the interest expense for the past three months. The calculation is:
$85,000 Principal x .065 Interest rate x .25 Time period
= $1,381.25 Interest expense
Once calculated, interest expense is usually recorded by the borrower as an accrued liability. The entry is a debit to interest expense (expense account) and a credit to accrued liabilities (liability account). When the lender eventually sends an invoice for the expense, the credit is shifted to the accounts payable account, which is another liability account. When the interest is paid, the accounts payable account is debited to flush out the amount, and the cash account is credited to show that funds were expended.