Interest in the lifeblood of the modern financial system. In most cases, we earn interest when we put our money in a savings account or a fixed deposit with a bank.
Customers need to pay interest when they take any type of loan, like a personal loan, mortgage, or auto loan. On the other hand, we receive interest when we lend money or invest in an interest-bearing instrument - for, say, a corporate bond or simply save our money in a bank account.
When we pay interest, we call it an interest expense. On the other hand, when when we earn interest, we call it interest revenue.
So, what all incomes constitute interest revenue? How is interest revenue calculated? How do we record interest revenue, and why is it important? Or why is interest income considered revenue in the first place?
Read on to get all answers to all these questions.
What is interest revenue?
Interest revenue is the interest that an entity earns from the money it has lent or the investments it has made.
So, what is interest in the first place?
In the simplest words, interest is the cost of using money we do not own. We pay interest when we borrow cash from a bank or take a loan to purchase a house or a car, etc. Businesses pay interest on business loans or commercial real estate loans from banks or other financial institutions.
We earn interest revenue when we have lent money to an entity or invested in an interest-bearing financial asset like a fixed deposit.
Businesses also earn interest revenue primarily from the following sources:
- The loans it has extended to other individuals or entities
- Investing in interest-earning financial assets like bonds, certificates of deposits, or a marketable security
- Depositing money within a savings bank account
Now, another important question is why interest income is treated as revenue.
Revenue is any income earned by a company in the normal course of its business. Therefore, the source of business revenue can be multiple. A company can earn interest income in due course of its business. Thus, interest income can be rightfully treated as business revenue.
We can know about the interest revenue earned by a company in a given period by looking at the income statement.
What is an example of interest revenue?
Interest revenue is a common source of income for most companies.
Let’s take an example to understand it.
Suppose ABC Ltd. is an automobile company with a substantial cash surplus. The company has invested $100,000 in an interest-bearing financial asset, for, say, a certificate of deposits that pays an annual interest rate of 5%. So, after one year, ABC Ltd. would earn $5,000 as interest income.
This interest income earned by the company in the given time period is called interest revenue for the company.
Here, we must discuss an important concept - how interest revenue is different from interest receivables. Many often confuse these two slightly different terms.
Difference between interest revenue and interest receivable
Both interest revenue and interest receivables are the interest earnings of a company in a given period. However, there is a slight difference:
- Interest revenue is the income the company has earned, whether the interest payment has been received or not.
- Interest receivable is the interest income the company has earned and expects to receive.
How is interest revenue calculated?
In order to calculate interest revenue, we need to know three pieces of information: the principal amount lent or invested the rate of interest, and the period.
The formula of interest revenue
Interest revenue is calculated using the following formula:
Using this formula, we can calculate interest revenue in the previous example.
Putting the values from the previous example, we get:
Interests revenue = $100,000X 5% X 1= $100,000 * 0.05 = $5,000.
Net interest income
Most companies earn interest on investments, extended loans, etc., while paying interest on the credits. In such a case, we need to calculate net interest income.
Net interest income is the difference between the interest income earned and the interest expenses of the company in a given period and is reported in the company's income statement.
Net Interest Income = Interest Income - Interest Expenses
A bank’s main goal is to increase the net interest income it receives. For example, banks earn interest income from the loans they extend. Also, banks need to pay interest to the deposit holders.
Is interest revenue an expense?
Interest revenue is an earning for the company which is receiving the interest income. However, since one party must pay the interest, the payer's interest amount is an expense.
We can simplify it as follows:
Interest income is revenue for the payee and an expense for the payer. Interest revenue increases the payee's tax liability and reduces the payee's tax liability because interest expense is tax deductible.
Both interest revenue and interest expense are recorded in the income statement.
How do companies record and report interest revenue and interest receivables?
Businesses record their financial transactions in the books of accounts on the basis o the generally accepted accounting principles (GAAP). A company following GAAP would record both interest revenue and interest receivables in the designated sections of the income statement. A company will either follow an accrual basis of accounting or a cash basis of accounting.
If a company follows an accrual basis of accounting, the interest revenue will be recorded in the income statement even if the interest income has not been received.
On the other hand, companies following thecash basis of accounting would record the interest revenue only when it has been received.
Recording interest revenue
The recording of interest revenue in the income statement depends on the nature of the business. Not all businesses rely in earning interest revenue as their primary source of income.
Most companies earn interest income; however, not all of these companies treat interest income as their primary source of income. For example, interest income is the primary income for a bank. Therefore, a bank would record interest revenue in the revenue section at the top of the income statement.
On the other hand, interest revenue may not be the primary source of income for different companies, such as automobile companies or electronics companies. In such cases, the interest income is generated for these companies from ancillary activities. These companies record interest income in the ‘Other Revenue and Expense’ section of the income statement.
As long as the interest is not received, it is included in the interest receivable account, any changes in the balance marked by the receipt or issuance of interest revenue, will reflect in this account.
Why is interest revenue important?
The primary goal of any company is to maximize its profits. Both financial and non-financial companies can increase their profitability by increasing interest income and cutting interest expenses.
Interest revenue is essential because:
- It is the primary source of revenue for companies that are lending money or selling mortgages, such as banks and financial institutions.
- It can be a significant source of revenue and profitability for non-financial companies.
- Interest income adds to the tax liability of a company.
- Interest expenses lower tax liability.
- Knowledge of interest income can help managers make efficient financial decisions and maximize returns on the surplus cash.