In general accounting, the difference between accruals and cash is not crucial. In most cases, accounting principles prefer companies to record transactions based on the accruals concept.
Consequently, they must account for transactions when they occur. The cash settlement involved in those transactions does not contribute to the matter. However, this treatment only covers the balance sheet and the income statement.
The cash flow statement disregards the accruals concept in accounting. This statement only presents the cash activity for a company during a period. Usually, companies prepare the cash flow statement using the indirect method. While it includes items falling under the accruals concept, it focuses on the cash aspects. However, it may require complex treatments for some areas.
The cash flow statement also involves separating cash flows into three headings. These include cash flows from operating, investing and financing activities. However, this process is not as straightforward. Some items may fall under two or more categories, which can be confusing. One such item that affects two areas within the cash flow statement includes interest.
What is an Interest Expense?
An interest expense refers to the cost incurred by companies for debt finance. It includes any spending toward repaying lenders. Usually, interest expense is a part of the income statement for all companies. It appears at the end of this statement to calculate net profits.
Interest expense does not form a part of a company’s operations. Instead, it relates to the capital structure and financing strategy.
Interest expense is a non-operating expense that appears at the bottom of the income statement. Usually, it represents the interest paid or payable on debt finance. Some companies may also term it as finance expenses in the income statement. Interest expense relates to all debt finance sources. Usually, these include loans, bonds, convertible debt, preferred shares, lines of credit, etc.
Companies record interest expense under the accruals concept in accounting. This concept requires them to account for the interest on debt when it occurs. In contrast, the cash concept may entail a treatment only when it involves a cash settlement. However, the income statement follows the former concept. Therefore, companies record interest expense as soon as it becomes payable to the lender.
Apart from companies, interest expense is also prevalent for other entities. For example, individuals incur this expense on personal or credit card loans. Nonetheless, they are more prevalent for companies since they acquire large sums in debt finance. The higher this finance is, the more interest expense a company will have. However, the treatment of interest expense in the cash flow statement is complex.
How to Treat Interest Expenses on the Cash Flow Statement?
The treatment of interest expense on the cash flow statement requires two steps. Before that, it is crucial to understand that the cash flow statement starts with a company’s net profits. These profits already include adjustments for interest expenses. However, this expense does not constitute cash payments only. In most cases, interest expense in the income statement also consists of payable amounts.
Therefore, including interest expense in the net profits is not accurate. However, that is not the only issue with interest expense on the statement of cash flows. As mentioned above, this expense does not relate to a company’s operations. Interest expense is a finance cost, which falls under non-operating expenses. Therefore, including interest expense in net profits will make it a part of cash flow from operating activities.
When reporting interest expense on the statement of cash flows, companies must tackle those issues. For the first problem, companies must add interest expense to net profits. The initial treatment subtracted it to reach net profits. Therefore, this adjustment is necessary. This way, companies can report a more accurate figure and remove its impact from operating activities. Alternatively, companies can include net profits before interest.
Companies can resolve the second issue by reporting interest expenses under financing activities. However, this expense does not include all items paid in cash. Consequently, companies must adjust this amount to reach the actual interest paid rather than the expense. This treatment covers the proper presentation of interest expense while removing accrued amounts. Practically, this process is more complex.
Overall, interest expense involves two treatments in the cash flow statement. The first requires companies to remove their impact from the net profits. Alternatively, companies can bring forward the net income before interest. In this case, the first treatment will not apply. The second treatment involves including interest expense under financing activities. However, companies must adjust it to include cash flows only.
How do Interest Expenses Report on the Statement of Cash Flow?
Companies report interest expenses on the statement of cash flows as financing activities. Usually, these items are outflows from financing activities. If companies also have interest income, they can net them off with interest expenses. Consequently, they can present a single figure under this section. However, companies may also report both separately.
Either way, companies include interest expenses under cash flows from financing activities. However, these items also appear under cash flows from operating activities. The latte treatment occurs first since this section also comes first. Companies adjust interest expenses under operating activities as follows.
| Cash flows from operating activities | |
| Net profits / (losses) | XXXX / (XXXX) |
| Add: Interest expense | XXXX |
| Add: Other non-cash expenses | XXXX |
| Additions / subtractions from cash | XXXX / (XXXX) |
| Net cash flows from operating activities | XXXX / (XXXX) |
The above treatment for interest expenses removes its impact from net profits. Similarly, it excludes those expenses from operating activities. Once companies fulfill this requirement, they can transfer interest expenses to cash flow from financing activities. Before that, however, they must ensure the item includes cash flows only. Consequently, they will remove any payable amounts from the adjustment.
Similarly, companies will rename interest expense to interest paid to reflect the item better. This item will appear on the cash flow statement as follows.
| Cash flows from financing activities | |
| Interest paid | (XXXX) |
| Other financing activities | XXXX / (XXXX) |
| Net cash flows from financing activities | XXXX / (XXXX) |
How to Calculate Interest Paid From Interest Expense?
As mentioned above, companies must include interest expenses under financing activities. However, this process also requires converting the amount to reflect the interest paid in cash. Usually, companies can remove any closing payable amounts to reach interest paid. This treatment assumes there are no opening balances in the interest payable account.
Practically, however, companies will also have opening interest payable balances. Consequently, companies must also adjust these to reach the interest paid figure. While it is complex, the calculations are straightforward. Companies can calculate interest paid from interest expense using the formula below.
Interest paid = Opening interest payables + Interest expense – Closing interest payables
In most cases, these are the only adjustments to reach interest paid. Usually, the opening and closing interest payables come from the balance sheet. Interest expense, on the other hand, is an income statement item. Once companies extract these items from the relevant financial statement, they can calculate interest paid. Companies can also use T-Accounts to make these calculations.
A company, ABC Co., has an interest expense of $200,000 on its income statement. Its balance sheet reports opening and closing interest payables as $150,000 and $100,000, respectively. ABC Co. must report its interest paid in the cash flow statement. Therefore, it must calculate the amount based on the above data. ABC Co. uses the following formula for interest paid to do so.
Interest paid = Opening interest payables + Interest expense – Closing interest payables
Interest paid = $150,000 + $200,000 – $100,000
Interest paid = $250,000
ABC Co. will add $200,000 back to its net profits under cash flows from operating activities. On the other hand, it will include cash outflows of $250,000 under interest paid. The latter figure will go under cash flows from financing activities.
Conclusion:
Interest expense refers to the cost of funding debt finance. It includes any cost incurred on bonds, loans, or other similar debt finance items. Usually, interest expense is available in the income statement. However, it also impacts the cash flow statement. This process involves two treatments, as stated above. Companies must also calculate the interest paid to report in the cash flow statement.
