What is interest expense? The simplest definition of interest expense is the cost that a bank charges a borrower for using the bank’s cash. However, on a more detailed level interest expense refers to the actual cost that a bank charges for the use of its cash. In its simplest form, this means the amount by which the actual principal is greater than the interest paid on an outstanding loan. The expense must be recorded in the statement of accounts as an itemized deduction.
When a bank charges an individual for the right to borrow funds the bank accounts the transaction as a sale or purchase of an item. The sale price is a lump sum equal to the amount of the loan plus the accrued interest. In order to record the sale, the bank charges the individual a pre-determined fee equal to one percent of the total amount of the loan plus the accrued interest. This fee is documented in the financial statement as an itemized deduction.
When a bank lends funds to an individual, it is required by law to charge interest on the loan. The interest charged is reported on an individual income statement. It represents the portion of the loan that is interest income. Because interest represents an intangible asset and because the financial statements are prepared based on the accounting records of the individual rather than on the performance of the business, interest represents a non-financial item in the accounting process.
One way to understand how a bank charge is recorded on an individual income statement is to imagine looking back on your own income tax return. If you look back at your tax return from virtually any period during the previous ten years, you would see numerous transactions in which the bank or the government made a profit. You would see the check register at the grocery store, the utility bill in the local apartment complex, the rent at your house or even the monthly car payment. Each of these examples involves a transaction in which the bank earned a profit and paid you a dividend.
When the bank pays you a dividend each year, what is being reported is not what is interest income to the bank but what is interest expense to you. What is interest expense to you is a part of your income that you must report to the IRS. This is commonly referred to as the “self-employed” or “enterprise” income tax. Many small businesses operate through their accountants and pay the individual with whom they maintain accounts.
An individual business is usually run by a corporation and has many different account holders. The corporation reports its income in its financial statements like any other business. The corporation reports what it costs to operate each of its accounts including its loan and lease repayments. The corporation also reports what it pays in interest to each of its account holders including itself.
The individual with whom the bank maintains an account reports its own accounting information including its own income, its expenses and its dividends and the bank statement. The individual may have included interest earned on its own loans or purchases and reported that gain in its income statement. The bank statement is used to calculate what is the interest expense to the individual for that year. The individual may have deducted interest or other fees from its loan or purchase and still be able to deduct its interest.
Because the tax law requires individuals to report the total income of all of their income sources, what is the interest expense to one person may be a much higher amount than what is reported to another. The tax code is very complicated and the forms and instructions that accompany it are not readily available to the average taxpayer. A CPA or a tax accountant can help an individual understand the complex tax laws and regulations that apply to them. These professionals are also knowledgeable about how to interpret bank statements so that they can help an individual properly report their interest and other tax related expenses.