Key Concepts
Interest is the cost of borrowing — the lender's charge for letting the business use its money. Interest is an expense of running the business.
Two accounting theories explain why and when we record it:
- Matching theory — a business borrows in order to earn income. The interest is the cost of borrowing, so it belongs in the same accounting period as the income earned from using the loan. Matching the expense to that income in the same accounting period gives the profit for the period.
- Accrual basis of accounting — an expense is recorded in the period it is incurred (used up), whether or not it has been paid. So interest used up this year belongs to this year, even if the cash is paid later.
Interest expense payable. If, by the year-end, the business has used the loan but has not yet paid all the interest for the year, the unpaid portion is interest expense payable — a current liability (money still owed for interest already incurred).
The year-end adjustment and the closing entry. At the financial year-end, you record the interest still owed, then close the interest expense off to the Income summary — a temporary account that gathers all income and expenses at year-end to work out the profit:
| Step | Debit | Credit | Why |
|---|---|---|---|
| Year-end adjustment | Interest expense (+expense) | Interest expense payable (+liability) | Record the interest incurred this year that is still owed |
| Closing entry | Income summary | Interest expense | Transfer the interest expense to the Income summary to work out profit |
Interest expenseG3Interest expense incurred = Interest rate per annum (%) × Outstanding loan balance × (Months used ÷ 12)Per annum means per year. The outstanding loan balance is the amount of the loan still owed — it decreases after each repayment, so a later year uses a smaller balance.
G2 students do not calculate this — the interest amount for the year is given in the question. Both tiers then record and present it in exactly the same way.
Why the "Months used ÷ 12" part matters. A loan is often taken partway through the year, so the business has used it for only part of the year. Interest is charged only for the months the loan was actually used. For example, a loan taken on 1 April has been used for 9 months by a 31 December year-end, so only 9 months' interest is incurred that year.
At the start of the next year — the reversal. On the first day of the next year, reverse the interest expense payable (Dr Interest expense payable / Cr Interest expense). This clears the liability. It also stops last year's interest from being counted a second time when the cash is paid this year. Step 4 of the worked example below shows this reversal.
Interest is used up over time, not when paid. By accrual basis, record the interest incurred this year as an expense, even if unpaid — the unpaid part becomes Interest expense payable (a current liability). Year-end: Dr Interest expense / Cr Interest expense payable. Then close it off: Dr Income summary / Cr Interest expense.
The loan was used from 1 April to 31 December — that is 9 months.
G3 calculation: $120,000 × 8% × (9 ÷ 12) = $7,200.
G2: the question would simply tell you the interest incurred for the year is $7,200.
Because none of it has been paid yet, the full $7,200 is interest expense payable.
| Date | Particulars | Dr ($) | Cr ($) |
|---|---|---|---|
| 20X4 | |||
| 31 Dec | Interest expense | 7,200 | |
| Interest expense payable | 7,200 |
Transfer the interest expense to the Income summary so it reduces this year's profit.
| Date | Particulars | Dr ($) | Cr ($) |
|---|---|---|---|
| 20X4 | |||
| 31 Dec | Income summary | 7,200 | |
| Interest expense | 7,200 |
On the first day of the new year, reverse last year's interest expense payable so the $7,200 is not counted again when the interest is paid in 20X5.
| Date | Particulars | Dr ($) | Cr ($) |
|---|---|---|---|
| 20X5 | |||
| 1 Jan | Interest expense payable | 7,200 | |
| Interest expense | 7,200 |
What this means for the financial statements: the $7,200 interest expense reduces this year's profit, and the $7,200 interest expense payable is a current liability at 31 December 20X4. (How these appear in the statements is covered in the next section.)
Charging a whole year's interest when the loan was taken partway through the year. Interest is only for the months the loan was used. A loan taken on 1 April, with a 31 December year-end, incurs 9 months' interest that year — not 12.
Not recording interest because it has not been paid. By the accrual basis, interest incurred must be recorded even if unpaid — the unpaid portion is Interest expense payable.
Calling interest expense payable a non-current liability. It is expected to be settled within the next financial year — typically paid together with the next loan instalment — so it is a current liability.