Interest Payable vs Interest Expense

CFA Level I FRA
#1

I understand that Interest expense = intereest incurred and Interest payable = Amount overdue.

Let’s say here’s the income statement entry for interest expense: Interest expense $50 Also, assume that Interest payable = 0 Now, what would happen to the Cash flow statement? Even though no interest is overdue, doesn’t this mean that the interest has been paid off by using Cash? Hence, there should be outgoing cash flow worth $50, used to pay this interest. I understand that at the time of preparing balance sheet, the amount may not be overdue, but it is certainly possible that the amount must have been paid before?

I am reading a book by Carl Warren, and it says because ‘interest payable’ equal to 0, cash flow won’t be affected. How is this possible? Please help.

#2

I am not sure whether the interest payable in your question is beginning of period or ending of period.

There are two interest payable accounts, one for the beginning of period and other for the end of period. The beginning interest payable is the cumulative amount of interest which is overdue but you have not paid them in cash. The ending interest payable is the beginning interest payable (of all previous years) + interest expense not paid as cash (of current year only)

In equation form, this goes like this

Beg. interest payble (BS item) + Interest expense (IS item) - Interest paid (CF item) = End. Interest payable (BS item)

If both beg. and ending interest payable are same, then the current year interest expense has been fully paid in cash, otherwise the current year interest expense which has not been paid in cash, would increase the cumulative amount of interest payable. In this case, end. interest payable would be higher than Beg. interest payable.

#3

This is not quite true. The problem is that Interest expense (on the income statement) includes interest incurred (coupon payments due) plus amortization of bond premia/discounts. Thus, in place of

Interest expense (IS item)

you want

Interest expense (IS item) + amortized bond premium – amortized bond discount

#4

The God has spoken. :slight_smile:

I have a query. Why is amortized premium added and amortized discount deducted from the interest expense? Should not it be the other way round? As far as I understand, a premium bond would decrease your interest expense and a discount bond would increase your interest expense.

Thanks

#5

Remember what we’re trying to do here: get from interest payable at the beginning of the year to interest payable at the end of the year. Thus, we need to know how much interest was paid during the year. The amortization of a bond premium decreases the interest expense shown on the income statement; thus, to get from the income statement number (interest expense) to the actual interest paid (coupon payment), we have to undo that decrease: we add the amortization that was part of the interest expense number.

My pleasure.

#6

Finkid and S2000Magician, I am new to this forum and CFA world. Can you please let me know the section that covers Bond Amortilzation? I have started reading Financial Reporting because I heard it’s the toughest section. Thanks

#7

Welcome aboard!

Study Session 9. For 2013 it was LOS 32.b; I haven’t gotten the 2014 curriculum, so I don’t know if that’s changed. Look for the words “effective interest method.”

Many candidates think so.

You’re welcome.

#8

The original question asked is the relation between Interest Payable (B/S item) and Interest Expense (I/S item), therefore, it shall be true that :

Beginning Interest Payble + Interest Expense - Interest paid = Ending Interest Payable

On the other hand,

Interest Expense + Amortized Bond Premium - Amortized Bond Discount = Cash Out Flow (for interest)

Am I right ? Please confirm. Thanks !

#9

No. That’s what I was saying above. The proper formula is:

Beginning Interest Payable + Interest Incurred – Interest paid = Ending Interest Payable

The relationship between interest incurred and interest expense is:

Interest Expense = Interest Incurred – Amortized Bond Premium + Amortized Bond Discount

or

Interest Incurred = Interest Expense + Amortized Bond Premium – Amortized Bond Discount

Not quite. If you solve the equation:

Beginning Interest Payable + Interest Incurred – Interest paid = Ending Interest Payable

for interest paid (which is the cash flow), you get:

Interest Paid = Interest Incurred + Beginning Interest Payable – Ending Interest Payable

= Interest Incurred – ΔInterest Payable

= Interest Expense + Amortized Bond Premium – Amortized Bond Discount – ΔInterest Payable

It’s really late now, but in the morning I’ll add an example with numbers to show all of this.

#10

S2000magician：

Would you please advise what are the definitions of “Interest Expense” and “Interest Incurred” clearly ? What is the difference between them ? I am really confused !

Referring to CFAI 2013 text Vol 3, P494

For 2010 : Interest Expense was ￡57,473, Interest Payment (actual cash outflow) was ￡50,000 and amortization was ￡7,473.

Is it that the Interest Incurred was same as the Interest Expense (￡57,473) ?

#11

Suppose that you issue $1,000,000 par of 10-year, 6% coupon, annual-pay (to make it easier) bonds for $1,050,000 (i.e., at a premium). The effective interest rate (YTM) is 5.3417%, and you use the effective interest rate method to amortize the premium. Your fiscal year is a calendar year: 1/1 to 12/31; coupons are paid on 12/31 each year.

Every year, your interest incurred is $60,000 (= 6% × $1,000,000).

The first year your interest expense will be $56,088 (= 5.3417% × $1,050,000), and the bond premium amortization will be -$3,912 (= $56,088 – $60,000). Bonds payable at the end of the year will be $1,046,088 (= $1,050,000 – $3,912).

The second year, your interest expense will be $55,879 (= 5.3417% × $1,046,088), and the bond premium amortization will be -$4,121 (= $55,879 – $60,000). Bonds payable at the end of the year will be $1,041,966 (= $1,046,088 – $4,121, with slight rounding error).

And so on.

Suppose that, at the beginning of the second year, you have interest payable of $10,000. In the second year, you pay only $55,000 in coupon (maybe you have a cash flow problem). Then at the end of the second year your interest payable is $15,000 (= $10,000 + $60,000 – $55,000).

Here are some examples of the calculations (for year 2) that you might have to do on the exam:

  1. Given:
  • Coupon of $60,000
  • Premium amortization of $4,121

What is interest expense?

Answer:

$60,000 – $4,121 = $55,879

  1. Given:
  • Interest expense of $55,879
  • Premium amortization of $4,121
  • Beginning interest payable of $10,000
  • Ending interest payable of $15,000

What is interest paid (i.e., cash flow)?

Answer:

$15,000 – $10,000 – $55,879 – $4,121 = -$55,000

(Note: this is interest paid, so the cash flow is negative (an outflow).)

  1. Given:
  • Interest expense of $55,879
  • Premium amortization of $4,121
  • Beginning interest payable of $10,000
  • Interest paid of $55,000

What is ending interest payable?

Answer:

$10,000 + $55,879 + $4,121 – $55,000 = $15,000

And so on.

#12

These two scenarios will happen only if there was a default by the bond issuer, right ? That is, the coupon payment was $60,000 but only $55,000 was paid. In any other cases, shall following equation hold ?

Begining interest payble + Interest Expense (Interest Incurred) - Interest payment (paid) = Ending interest payable

Please confirm again. Thanks !

#13

That’s correct. I simply wanted to illustrate how the numbers work together. You should work out the numbers if they paid $65,000 instead of $60,000.

Once again, don’t confuse interest expense (which includes amortization) with interest incurred (which is just the coupon).

You’re quite welcome.

#14

Do you mean : Interest Incurred = Interest Payment (interest paid, actual cash outflow) ?

#15

Usually, interest incurred will equal the interest payment. However, if the company defaults, or if they prepay some of the interest, then they won’t be equal. It’s better to write that:

Interest incurred = coupon rate × par value

That way, it’s correct whether the company pays the interest that is incurred, or pays too little (default), or pays too much (prepaid interest).

#16

S2000magician ：

Thank you so much !

#17

You’re quite welcome.

#18

Hello S2000magician,

I am sorry to open this old thread. I am curious – what would be used for tax purpose? Interest expense or interest incurred? Please let me know.

Thanks in advance.

#19

No need to apologize; that’s why they stick around: so people can revisit them.

Remember that accounting for taxes is generally cash-based (depreciation being the primary exception). Thus, you would show the interest paid (i.e., the cash flow), which can be different from interest expense (if you have amortization of a premium or discount, for example) and may be different from interest incurred (if you prepaid interest, or fell behind in your payments).

You’re quite welcome.

#20

Thanks S2000magician. I believe that the gist of this is that “cash paid” (in your equation above) will be used for tax purposes. Neither interest incurred nor interest expense will be used. Right?

Thanks