USA Interest expense...confused

[ncs22]

Hello,

I had a question regarding the definition of interest expense. The site Accountingcoach.com defines it, in part, as follows: "The amount of interest expense appearing on the income statement is the cost of the money that was used during the time interval shown in the heading of the income statement..." On the surface, that looks pretty easy, but if you read it closely it could be interpreted 2 ways. The first way would be to think of the COST as being used in the time period...the second way would be to think of the BORROWED MONEY as being used in the time period. Which is right? For example, let's say a firm borrows 20,000 dollars, and agrees to pay the lender 6% interest per year (so 1200 dollars per year). Let's say this interest is paid as a lump sum on one particular day of each year. Let's also say the firm prepares monthly income statements. The interest expense on a given month's income statement would be 1200/12, or 100 dollars. Let's say that in a certain month, the firm used $2000 of the total $20000 of borrowed money. Would we say that the cost of that $2000 was $100? Or do we say that $100 of the $1200 annual cost was used up in that month? Or are these 2 ways of saying the same thing? Would appreciate anyone's help on this, thank you very much.

 

[Counterofbeans]

I'm pretty tired as I'm reading this, so bear with me if I'm missing something, but what does it mean, "the firm used $2000 of the total $20000 of borrowed money?"

That they purchased goods/services with it?

Does that change the amount owed to the lender for interest?

I'd just make it easy on yourself...

First question to ask yourself is, "What are the cash outflows?"

$1,200 per annum, yes?

As such, when preparing your monthly financial statements, you must devise a systematic and rational method of applying that $1,200 to interest expense over the course of the year. In my mind, I'd just be simple and straight line the expense, as you suggested ($100/month), and call it a day.

It appears, however, that you might want to establish a different method of applying the interest expense based on how it's used/spent. I suppose one could get creative and make that work, but it would make me raise an eyebrow, as what debit would you record if the borrowings were never spent for the entire year (silly example, but just illustrating the point)? The lender will need to get paid, so cash is ultimately going to go out the door, but the debit would need to go somewhere...

Further, I also think that it would be tough to go through months without recognizing any interest expense. It seems to me that you are getting a benefit from the borrowings regardless of whether they are spent or not.

NOTE: This might be an example of where the matching principle completely falls apart. You will have a tough time justifying that an asset has been created (i.e. "Deferred costs" is not an asset in and of itself), but it would propertly "match" the expenses with revenues/usage. As accountants, we really need to move away from this dated concept, but that is another story...

 

[ncs22]

Hi, thanks so much for your quick reply My example was not the best...but I think the crux of my question revolves around this definition of Interest Expense: "The amount of interest expense appearing on the income statement is the cost of the money that was used during the time interval shown in the heading of the income statement..." Can you explain that a bit for me? I'm a little confused by the "cost of the money that was used" part...what does that mean? Does the verb "used" in that phrase apply to the word "money" or the word "cost"? If it applies to the word "money", it makes it look like interest expense in a given month is the cost of the amount of borrowed funds that were used in that month (so, in my previous example, the cost of the $2000 that were used in the month). If it applies to the word "cost", it makes it look like interest expense in a given month is the portion of the total annual cost ($1200) of the borrowed funds that was used in that month (which must be $1200/12=$100). I just want to make sure I'm thinking about Interest Expense in the correct manner, conceptually..

 

[Counterofbeans]

I'm not a fan of that definition. I did a quick search and I like the definition from Investopedia better:

"The cost incurred by an entity for borrowed funds."

Interest Expense Definition | Investopedia

I wouldn't get tripped up over the usage of the word, "used" here. I don't really think it makes any difference in the cash outflows.

You know you're going to have to pay $1,200 in your example & the bank will likely invoice you for it. Further, it's likely going to be calculated by multiplying the outstanding balance times the appropriate interest rate. I don't see how the cash being, "used" has anything to do with it.

As such, I'd say your disconnect is simply between the definition you are reading and how your lender/bank would actually invoice you for the service of borrowing money from them. That then would dictate how you account for it, but 99 out of a 100 times the expense is simply going to be the cash paid for interest during the fiscal year, adjusting for proper accruals (i.e.plus any amounts paid in the following year that related to the current year, less amounts paid in the current year that related to the prior year).

Hope that helps

 

[ncs22]

Thanks very much for the clarification As I like to do, instead of just assuming I understand a concept, I will throw out my current understanding of the topic and see if it is right or not:

Let's say that on the Income Statement for February 2014, the Interest Expense was shown as $100. That does NOT mean that $100 of interest was paid out in February, but it does mean that $100 of interest "accrued" (ie. amassed/accumulated) during that month (in other words, the firm incurred a cost of $100 for the borrowed funds in February), REGARDLESS of whether any of the borrowed money was actually USED in that month. Basically, in my previous example, the borrowed money cost the firm $1200 for the year...or $100 each month...and that $100 each month cost is reflected in each month's Interest Expense. Does that seem ok? Thanks again so much..

 

[Counterofbeans]

Let's say that on the Income Statement for February 2014, the Interest Expense was shown as $100. That does NOT mean that $100 of interest was paid out in February,

Correct. This is why, in accounting speak, we have "accruals," which are really nothing more than unsettled/unpaid liabilities (most of the time).

but it does mean that $100 of interest "accrued" (ie. amassed/accumulated) during that month (in other words, the firm incurred a cost of $100 for the borrowed funds in February), REGARDLESS of whether any of the borrowed money was actually USED in that month.

Be careful here. As stated above, "accrual," in general, has a pretty specific meaning in accounting. It means that you've received goods/services and have a legal liability to pay a vendor. Once it's paid, it's no longer accrued, as the liability is now settled.

Basically, in my previous example, the borrowed money cost the firm $1200 for the year...or $100 each month...and that $100 each month cost is reflected in each month's Interest Expense. Does that seem ok? Thanks again so much..

Correct. You'll want to record $100 of interest expense, REGARDLESS of the actual cash flows (e.g. when you pay it is irrelevant). Basically, you'll want to Debit Interest Expense and Credit Accrued Expenses/Liabilities each month. Then, when it's paid, you simply Debit Accrued Liabilities and Credit Cash.

 

[ncs22]

Thank you very much I understand the concept now. For some reason, expenses are a little hard to get my head around (unlike revenues). Like, a very common definition of expenses I see is "the costs necessary to earn revenues." But then, on AccountingCoach.com, when it was discussing the Matching Principle (for Accrual Basis accounting), it said that, ideally, there would be a cause-and-effect relationship between Revenues and Expenses. It then gave an example that said "Sales causes Cost of Goods Sold Expense, and it causes Sales Commissions Expense." I mean, I understand this (after all, how could you have a value for Cost of Goods Sold Expense if nothing was sold? Similarly, how could you have incurred a Sales Commissions Expense if nothing was sold?)...HOWEVER, the wording of this example seems a little at-odds with the formal definition of Expenses I listed above. If Expenses are "necessary to earn Revenues", it makes me think that the expense COMES BEFORE the associated revenue.....but the example I listed above has the REVENUE being the causal factor for the expense (ie. it seems like the REVENUE comes first). In reality, is it feasible to view each one as coming first (even though that seems contradictory)? Thanks again..