How Interest Expense Affects the Income Statement
- Graziano Stefanelli
- Sep 22
- 3 min read
Interest expense represents the cost of borrowing funds and is reported in the income statement as part of financing activities. It arises from loans, bonds, leases, and other debt arrangements, reflecting the compensation lenders receive for the use of their capital. While it does not relate to core operations, interest expense significantly affects net income, cash flow, and measures of financial performance. Its recognition and disclosure are governed by both IFRS and US GAAP to ensure comparability and transparency across entities.
Interest expense is the cost of financing business activities.
Companies often require external financing to fund operations, acquire assets, or expand. Borrowed funds create obligations that carry an interest charge. Interest expense is the periodic recognition of this cost, representing the time value of money.
For example, if a company issues a 1,000,000 loan at 6 percent annual interest, it incurs interest expense of 60,000 each year, payable in installments or at maturity depending on the terms of the loan. This expense reduces profitability and must be carefully distinguished from principal repayments, which affect the balance sheet but not the income statement.
Presentation in the income statement emphasizes its financing nature.
Interest expense is usually presented below operating income, within the section for non-operating items, along with interest income and other financing gains or losses. This placement separates operating performance from financing structure, allowing users to distinguish between core profitability and the cost of capital.
For example:
This presentation highlights how interest expense reduces pre-tax income.
Journal entries illustrate recognition of interest.
At the end of an accounting period, accrued interest must be recognized, even if not yet paid. For example, for 5,000 of interest accrued:
Debit: Interest Expense 5,000
Credit: Interest Payable 5,000
When the interest is paid:
Debit: Interest Payable 5,000
Credit: Cash 5,000
These entries ensure that expenses are recorded in the correct period, aligning with the accrual principle.
Standards guide recognition and measurement.
Under IFRS 9 and US GAAP (ASC 835: Interest), interest expense is measured using the effective interest method, which allocates interest over the life of the debt based on its carrying amount and yield. This method ensures that interest expense reflects the true cost of borrowing, including fees, premiums, or discounts.
For example, if bonds are issued at a discount, the effective interest method records higher interest expense than the nominal coupon rate, reflecting the economic reality of the borrowing arrangement.
Interest expense influences profitability and leverage ratios.
High interest expense reduces net income and affects ratios such as:
Interest coverage ratio (EBIT ÷ Interest Expense): Measures a company’s ability to meet interest obligations. A low ratio may indicate financial strain.
Debt-to-equity ratio: While not directly impacted by interest, this ratio contextualizes the level of interest expense relative to capital structure.
For example, a company with EBIT of 200,000 and interest expense of 40,000 has an interest coverage ratio of 5, signaling adequate ability to service debt. If the ratio falls below 2, creditors may question solvency.
Disclosures provide clarity about financing costs.
Both IFRS and US GAAP require companies to disclose the total amount of interest expense recognized during the period, along with significant terms of borrowing. IFRS also requires disclosure of borrowing costs capitalized under IAS 23, which mandates capitalization of interest incurred on funds used to construct qualifying assets, such as large buildings or infrastructure.
For instance, interest incurred during the construction of a factory may be capitalized as part of the asset’s cost rather than expensed immediately, reducing short-term interest expense but increasing future depreciation.
Interest expense connects financing activities with profit reporting.
While interest expense does not affect operating performance, it plays a decisive role in overall profitability and financial stability. Its accurate reporting ensures that stakeholders can evaluate the cost of a company’s capital structure and assess its ability to sustain debt obligations. By presenting interest expense transparently in the income statement and disclosing key borrowing terms, companies provide a reliable view of how financing decisions shape earnings and long-term financial health.
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