Interest expense is the cost of funds loaned to a business by a lender, and recognized within an accounting period. The amount of interest is typically expressed as a percentage of the outstanding amount of principal. The interest expense formula is:
(Days during which funds were borrowed ÷ 365 Days) x Interest rate x Principal = Interest expense
For example, ABC International borrows $1,000,000 from a bank on June 1 and repays the loan on July 15. The interest rate on the loan is 8%. The interest expense during the month of June is calculated as:
(30 days ÷ 365 days) x 8% x $1,000,000 = $6,575.34
The interest expense during the month of July is calculated as:
(15 days ÷ 365 days) x 8% x $1,000,000 = $3,287.67
The lender usually bills the borrower for the amount of interest due. When the borrower receives this invoice, the usual accounting entry is a debit to interest expense and a credit to accounts payable. If a bill has not yet arrived from the lender as of month-end, and the borrower wants to close its books promptly, it can instead accrue the expense with a debit to interest expense and a credit to interest payable or accrued interest. The borrower should set up this journal entry as a reversing entry, so that the entry automatically reverses at the beginning of the next accounting period. Then, when the lender's invoice eventually arrives, the borrower can record it in the manner just noted for an invoice.
If the period covered by a lender's invoice does not exactly match the dates of a borrower's accounting period, the borrower should accrue the incremental amount of interest expense not included in the invoice. For example, if a lender's invoice only runs through the 25th of the month, the borrower should accrue the additional interest expense associated with any debt outstanding from the 26th to the last day of the month.
Interest expense is usually a tax-deductible expense, which makes debt a lower-cost form of funding than equity. However, an excessive amount of debt also presents the risk of corporate failure if the borrower cannot meet its debt obligations. Thus, a prudent management team only incurs a modest amount of interest expense in relation to the asset base and earning power of a business.