Interest –A practical guide on its accounting treatment

Introduction            

Interest recorded in the books can be an item of income or an item of expense. The accounting treatment of interest income is prescribed in AS 9 Revenue Recognition and that of interest expense depends on the nature of interest incurred. If the interest expense directly relates to the acquisition, construction or production of a qualifying asset it shall be governed by the principles contained in AS 16 Borrowing Costs otherwise, general accounting principles shall be applied.

1. Meaning of Interest Expense 

Interest expense is the cost incurred by an entity in connection with the borrowing of funds which may include loans, bonds or other forms of credit for business purpose or for the acquisition of asset. It is a non-operating expense shown on the income statement representing interest accrued during the period covered by the financial statements and not by the amount of interest paid during the period.

Interest expense is usually charged to the statement of profit and loss. However, if certain conditions specified for capitalization as per AS 16 Borrowing Costs are met then such interest expense (borrowing cost) should be capitalized to cost of the related asset.

1.1 Accounting treatment

1.1-1 In General 

The interest expense generally accrues over a period of time and it is irrespective of company’s operational productivity during a given period of time. The interest accrued during a period is shown in the statement of profit and loss unless an alternative accounting treatment is provided in any other accounting standard.  Thus, an entity needs to account for interest expense by making a journal entry for such expense that has occurred during the period regardless of whether or not the entity has paid it.

Journal entry on accrual of Interest

Journal entry on Payment of Interest

1.1-2 Capitalization of interest expense

If the amount borrowed directly relates to the acquisition, construction or production of a qualifying asset then interest incurred on such borrowings needs to be capitalized as a part of cost of that asset provided conditions stated in the AS 16 are complied with. The amount of interest to be capitalized as cost of asset depends on the nature of borrowings acquired by the entity i.e. specific borrowings or general borrowings.

The conditions stated in the standard are as follows:-

1. 1. Expenditure for the acquisition, construction or production of qualifying asset is being incurred;
   2. Borrowing costs are being incurred; and
   3. Activities necessary to prepare the asset for its intended use or sale are in progress.

Journal entry on capitalization of borrowing costs

 Further, the capitalization should be suspended during the periods which involve interruption in active development and interest incurred during that period should be charged to the statement of profit and loss. Also, the capitalization should close down when all the substantial activities, essential for preparing the asset for its intended use have been accomplished.

2. Meaning of Interest Income 

Interest income is the amount of interest earned during a specific period of time by lending money to other entities or consideration received from the use by others of entity’s resources. Interest income can be earned from investments that pay interest such as certificates of deposits, cash held in savings accounts and other forms of investments. This line item is separate from interest expense and as per general accounting principles both these items of interest expense and interest income should be presented separately in the books of accounts.

2.1 Accounting treatment

An entity may earn interest income from various avenues and thus its presentation in the financial statements will largely depend on the nature of business’ primary operations. If the entity’s primary business is earning income from interest (like lending institutions and financial institutions), then the interest income shall be recorded in the books as ‘Income from Operations’. However, if the core earnings of the entity do not include interest income, then it is treated as non-operating income in nature and recorded as ‘Other Income’. However, the presentation of interest income depends on the accounting treatment followed.

Journal entry on accounting interest income

 2.2 Recognition Principle

The basic principles for recognition of interest income are prescribed in AS 9 Revenue Recognition; which includes that revenue from interest income should be recognized when no significant uncertainty as to measurability or collectability exists. It further states that interest income is to be recognized on a time proportion basis taking into account the amount outstanding and rate applicable. Thus, interest income is to be recognized in the books as it is earned and not necessarily at the time it is received, provided the provisions stated in the standard are complied with.

3. Conclusion

Interest expense is a line item on a company’s income statement indicating the amount that has been incurred by an entity on the funds borrowed. Interest recorded in the Income Statement represents the interest accrued during the period covered by the financial statements; not the amount of interest paid over that period. Interest income, on the other hand, is the revenue earned by an entity for lending their funds or letting others to use entity’s resources. Both these items are separate line item in company’s financial statement and therefore, should be disclosed separately for each period.