Updated July 11, 2023
Definition of Interest Income
Interest Income (II) is the income earned or return generated on the amount of money invested, like the return earned from fixed deposits, savings accounts and other kinds of investments, or in the case of finance companies, the (II) is generated by lending money to the customers.
For them, it is a significant source of income as they charge interest at a specific rate on the amount of loan given.
Explanation
Interest income is the income generated on the funds invested by the business or an individual. The primary sources of (II) are return on fixed deposits, certificate of deposits, purchase of debentures, lending of money, etc. In the case of the companies that are non-finance, i.e., the companies that are not involved primarily in the lending of money, interest income is considered as the income from other sources. Still, for the finance companies like banks, NBFC, etc., the (II) is the primary source of revenue, so they are reported as the income from operations. As per the accrual basis of accounting, the (II) accrued should also be recognized in the books of accounts of the business.
For example, in case a company has deposited $10,000 in the bank for five years for a fixed deposit at a simple interest rate of 10% p.a. on April 1st, 2012. Each year at the end of the accounting year, $1,000 should be booked as (II) even though the amount of interest will be redeemed (received) along with the principal at the end of maturity of the fixed deposit.
How to Calculate Interest Income?
To calculate the (II) following steps will be followed:
- To calculate the Interest income, the first step is to determine the amount of the investment made by the company on which (II) will be earned
- After determining the interest income, in the next step rate of interest is to be determined, i.e., the rate at which the (II) will be received on the investment.
- Calculate the number of years the investment is made and the (II) is earned.
- Lastly, multiply the Investment amount by the interest percentage and the years for which the investment is made.
Formula
Examples of Interest Income
Let’s take an example of a company, ABC Ltd., which manufactures clothes and sells them to a wholesale distributor. At the beginning of the current financial year, the company invested in the bonds of another company for five years with a 7% interest rate per annum. The total investment amount by the company is $100,000. Calculate the total (II) that the company will earn during the whole investment period and the I(II) to be recognized in the income statement of the current financial year.
Solution:
- The first step is to determine the amount of investment made by the company. In the present case, it is $100,000
- The next step is to determine the interest rate, which is 7% in the present case.
- After that number of years for which the investment is made is to be calculated, which in the present case is five years.
- Lastly, (II) will be calculated using the below formula:
Interest Income is calculated using the formula given below
Interest Income= Investment Amount * Rate of Interest * Number of Years for Which Investment Is Made
- Interest Income= $100,000 * 7% * 5
- Interest Income= $35,000
Thus total (II) earned by the company during the whole investment period is $35,000
Now, (II) to be recognized in the income statement of the current financial year = Investment amount * Rate of Interest per annum
- =$100,000 *7%
- = $7,000
As the company is a manufacturing company and the primary purpose of the business is not to earn (II). So, this income will be shown under the ‘Other Income’ head of the company’s income statement.
Where is Interest Income Displayed?
(II) is the company’s income, so it is reflected under the income statement for that period. Further in the income statement, the income is divided into two areas, i.e., income from operations and other income from interest income. Most companies come under the category of ‘other income’ except for those whose primary income is (II); in that case, the (II) will come under the category of income from operations.
Advantages
The advantages of interest income are as follows:
- In the case of investments like fixed deposits, the interest payments are selected, assuring organizations that even if there is any fluctuation in the income from operations, they will get a fixed amount each year.
- Due to the concept of (II), the income can be generated from the money earned from normal operations. The concept of earning (II) doesn’t let the person or organizations remain idle and maintains the flow of money in the economy.
- If there is no (II), then there will be no finance company, as the primary source of income is the (II) for the finance company.
- Interest income motivates a person to deposit money into bank accounts because depositing money even in the savings account provides (II).
Disadvantages
The disadvantages of interest income are as follows:
- The amount earned on (II) may fluctuate in case the return depends upon the growth of the investment. So the earning of (II) may be significantly less if the investment’s value decreases over time.
- The income from the interest is taxable by the tax authorities at the applicable tax rate for most investments. So, net (II) earned gets reduced by the amount of tax paid on the same.
Conclusion
Therefore, (II) is the income earned on the investments made in fixed deposits, debentures, certificates of deposits, etc., even the money in the savings bank account fetches some interest. For all entities not in the finance business, the (II) is the income from other sources. For a finance company, interest income is the primary income generated by lending money to customers and is reported as income from operations.
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