What are Interests?
Bought a piece of equipment under installments and wondered why it costs more than paying for it in one go? That right there is what we call interests. No, we’re not talking about preferences. In accounting, interests are compensations that a person will incur from choosing an installment plan. Additionally, it could also be considered as a fee for borrowing money from banks or lenders; interests can serve as additional income for lenders.
According to Investopedia, interests are monetary charges from borrowing money. Additionally, they could also be used as an expression to show a person’s ownership of a particular company. We could also categorize interests into two main types: simple and compound.
Simple interests are, as the name implies, are quick and easy to calculate. We can calculate simple interest by multiplying the daily interest rate by the principle and the number of days between payments.
Most of the time, interests can be found as a separate line item below Earnings Before Interests and Taxes (EBIT) or in the Selling, general, and administrative expenses (SG&A) section depending on the company’s accounting practices.
What are Interest Expenses?
In the world of Accounting, interest expenses are no stranger to a company’s financial statements. Interest expenses are one of the core expenses which accountants or employees could find in an income statement. From bonds, loans, convertible debts, or lines of credit, interest expenses are a representation of interest that is payable on any borrowings.
Interest expenses are considered as a “non-operating expense”, meaning to say that it is unrelated to the core operations of a company. Accountants could calculate interest expenses as the interest rate multiplied by the outstanding principal amount of debt.
Interest expenses are accounting items that a company incurs due to servicing debt. Additionally, interest expenses are given favorable tax treatment, and the greater the interest expense, the greater the potential impact on profitability.
How do Interest Expenses work?
If an interest has been accrued and has not been paid for yet, it would appear in the “Current Liabilities” section of a company’s balance sheet. Conversely, if a company has paid for an interest in advance, instead of appearing in the “Current Liabilities”, it would appear in the “Current Assets” section as a prepaid item.
Mortgage interest is the most significant category expense for an average person over their lifetime.
Interest expenses have a direct impact on a company’s profitability, especially for companies that have a high amount of debt load. During an economic downturn, companies that are heavily indebted would have a more challenging time serving their debt loads.
During periods of rampant inflation, companies that have incurred debts during this period will have an interest expense because the debts that they have incurred will have a much higher interest rate than usual.
Let’s say, for example, that a company used a loan purely for investment purposes only. If that were the case, most jurisdictions would allow the total interest expense for this loan to be deducted from taxes, albeit having some sort of restriction.
Understanding how interests work can benefit you in many ways especially when you are planning to invest, take out a loan, use your credit card, and many more. It is for the best that you stay updated about your finances so you can make more informed decisions.