What is Interest Expense? Calculation Formula and Effective Accounting

Interest expense is a common expenditure for businesses when using borrowed capital for production and business activities, but not everyone fully understands how to calculate it, account for it, and the related tax regulations. If you want to quickly grasp what interest expense is and how to handle it correctly, this article will help you understand everything from the concept to practical application.

1. Concept of Interest Expense

Interest Expense is the cost a business must pay for funds borrowed for the purpose of production and business. Simply put, interest expense is the amount of money a business uses to pay interest on its loans, such as borrowing capital, borrowing to purchase assets, equipment, supplement inventory, pay invoices, etc.

Interest expense includes the following types:

• Long-term and short-term loan interest
• Interest on overdrafts
• Financial charges on financial lease assets;
• Interest on bonds and convertible debt
• Interest on other loans

Interest expense directly related to the investment in construction or production of a qualifying asset will be included in the value of that asset. Borrowing costs are capitalized when the enterprise is certain to obtain future economic benefits from that asset and the borrowing costs can be reliably determined.

2. Impact of Interest Expense

The impact of interest expense on a business’s operations can be analyzed from the following aspects:

• Impact on business results: Interest expense is a business cost, therefore it reduces the company’s profit. Specifically, when interest expense increases, the company’s after-tax profit will decrease.
• Impact on the cost of products, goods, and services: Interest expense is added to the cost of products, goods, and services. When interest expense increases, the cost of products, goods, and services will also increase accordingly.
• Impact on solvency: Interest expense is a fixed cost, so the business needs to have sufficient financial resources to pay this expense. If the business does not have enough financial resources to pay the interest expense, its solvency will be affected.

• Impact on financial risk: High interest expense can increase a company’s financial risk. Specifically, when interest expense is high, the company will have to allocate more resources to pay this cost, thus having fewer resources to invest in production and business activities. This can reduce the company’s profitability and increase financial risk.

• Impact on corporate income tax: Interest expense is deductible when calculating corporate income tax (CIT) according to legal regulations. Therefore, when interest expense increases, the amount of CIT payable will decrease. However, it should be noted that interest expense is only deductible if it meets the conditions stipulated by law.

3. Latest Regulations on Interest Expense

Interest Expense in Related-Party Transactions

Pursuant to Decree 68/2020/ND-CP amending Clause 3, Article 8 of Decree 20/2017/ND-CP dated February 24, 2017, it is clearly stated:

“The total interest expense (after deducting interest from deposits and loans) incurred during the period that is deductible when determining corporate income tax taxable income shall not exceed 30% of the total net profit from business activities in the period plus interest expense (after deducting interest from loans and deposits) incurred during the period plus depreciation expense incurred during the period.”

In other words, in cases where a business with related parties has a loan transaction with a related party, the interest expense is capped at no more than 30% of the total net profit from business activities in the period plus interest expense (after deducting interest from loans and deposits) incurred during the period plus depreciation expense incurred during the period.

Interest Expense in Corporate Income Tax Finalization

Interest expense in Corporate Income Tax (CIT) finalization is regulated in Article 4, Circular 96/2015/TT-BTC of the Ministry of Finance as follows:

• The portion of interest expense on loans for production and business from entities other than credit institutions or economic organizations that exceeds 150% of the base interest rate announced by the State Bank of Vietnam at the time of borrowing.
• Interest paid on loans corresponding to the portion of registered charter capital (or investment capital for private enterprises) that is still outstanding according to the capital contribution schedule stated in the company’s charter, even if the company has commenced production and business activities. Interest paid on loans during the investment process that has been recorded in the value of assets or investment projects.

Interest expense for investing in other enterprises during the course of business will be included in deductible expenses when determining taxable income if the enterprise has fully contributed its charter capital.

The loan interest corresponding to the charter capital deficit according to the capital contribution schedule specified in the company’s charter is not deductible when finalizing CIT and is determined as follows:

• If the loan amount is less than or equal to the charter capital deficit, the entire loan interest is a non-deductible expense.
• If the loan amount is greater than the charter capital deficit according to the capital contribution schedule:
  • If the enterprise has multiple loans, the non-deductible interest expense is calculated by the percentage of the charter capital deficit over the total loan amount, multiplied by the total interest.
  • If the enterprise has only one loan, the non-deductible interest expense is calculated as the charter capital deficit multiplied by the loan’s interest rate, multiplied by the period of the charter capital deficit.”

Thus, if the enterprise has contributed its full charter capital, the entire interest expense is considered a deductible expense. However, if the enterprise has a large cash balance on its books but cannot prove it has projects or contracts requiring significant capital mobilization, the interest expense may be disallowed as a deductible expense by the tax authorities.

4. How is loan interest expense calculated?

Calculating bank loan interest expense

The formula for calculating bank loan interest rates is standardized for all borrowing customers. Therefore, you need to understand the bank’s lending interest rates to make appropriate choices regarding the loan amount and repayment term that align with your company’s financial situation.

The most common loan interest calculation formula currently used by banks is based on a declining balance, with the formula as follows:

Calculate loan interest costs for individuals, businesses, and other organizations

The method for calculating loan interest may differ for individuals, businesses, and other organizations. However, loan interest is fundamentally calculated based on the outstanding balance, the loan interest rate (monthly/annually), and the actual duration of the loan.

The general formula for calculating loan interest for individuals, businesses, and organizations is as follows:

Including:

5. How to Account for Deductible Loan Interest Expense

What is deductible loan interest expense?

Deductible loan interest expense is the loan interest expense incurred during the tax period, accounted for in accordance with legal regulations, and meeting all the following conditions:

• The funds are used for the enterprise’s production and business activities.
• The loan interest rate does not exceed 150% of the basic interest rate announced by the State Bank of Vietnam at the time of borrowing.
• The enterprise has fully contributed its registered charter capital (or investment capital for a private enterprise) that was still outstanding according to the capital contribution schedule stated in the enterprise’s charter, even if the enterprise has already commenced production and business operations.

How to account for deductible loan interest expense

Commonly occurring cases include:

Case 1: Periodic loan interest expense:

• Debit Acct 635 – Financial expenses
• Credit Acct 111 – Cash on hand, Acct 112 – Bank account

If other costs directly related to the borrowing activity arise, record:

• Debit Acct 635 – Financial expenses
• Credit Acct 111, 112,…

Case 2: If interest is paid in advance for multiple periods:

When paying interest, record:

• Debit Acct 242 – Prepaid expenses (According to Circular 200/2014/TT-BTC and 133/2016/TT-BTC)
• Credit Acct 111, 112

When gradually allocating interest to expenses, record:

• Debit Acct 635 – Financial expenses
• Credit Acct 242 – Prepaid expenses

Case 3: If interest is paid after the loan contract or agreement ends:

Periodically accrue interest expense, record:

• Debit Acct 635 – Financial expenses
• Credit Acct 335 – Accrued expenses

When paying interest at the end of the loan contract, record:

• Debit Acct 335 – Accrued expenses
• Credit Acct 111, 112

Case 4: If the enterprise has a financial lease, the financial lease interest payable:

When receiving an invoice for financial lease payment ⇒ The enterprise pays immediately, record:

• Debit Acct 635 – Financial expenses
• Credit Acct 111 – Cash on hand, Acct 112 – Cash in bank

When receiving an invoice for financial lease payment, but the enterprise has not yet paid, record:

• Debit Acct 635 – Financial expenses
• Credit Acct 315 – Long-term liabilities due for payment

Case 5: If the enterprise pays deferred interest on assets purchased on a deferred or installment basis:

Interest payable to the seller when purchasing assets, record:

• Debit Acct 242 – Prepaid expenses
• Credit Acct 111, 112

Periodically allocate deferred interest to expenses, record:

• Debit Acct 635 – Financial expenses
• Credit Acct 242 – Prepaid expenses

Capitalization of loan interest expense

Capitalization of loan interest expense is the act of recording loan interest expense into the value of the invested asset, instead of directly expensing it in the period. The capitalization of loan interest expense is only performed when the interest expense arises directly from capital construction investment or the production of work-in-progress assets.

According to the regulations of the Ministry of Finance, capitalized loan interest expense must meet the following conditions:

• The loan interest expense arises directly from capital construction investment or the production of work-in-progress assets.
• The invested asset must be capable of generating future income.
• The capitalization rate of loan interest expense does not exceed the ratio between the investment value and the value of the invested asset.
• Capitalizing loan interest expense will increase the value of the invested asset, thereby reducing the loan interest expense payable in the period. This will help the enterprise improve its business results and shareholder income.

For example, an enterprise borrows from a bank to invest in building a new factory. The loan interest expense incurred during the factory’s construction is capitalized into the factory’s value. When the factory becomes operational, the enterprise will have to pay interest to the bank, but the amount of interest payable will be lower than if the loan interest expense had not been capitalized.

6. How to Account for Non-Deductible Loan Interest Expense

What is non-deductible loan interest expense?

Non-deductible loan interest expense refers to loan interest expenses that are not deductible when calculating corporate income tax (CIT). According to Vietnamese law, non-deductible loan interest expense includes the following:

• Loan interest expense exceeding 150% of the basic interest rate announced by the State Bank of Vietnam at the time of borrowing.
• Loan interest expense corresponding to the shortfall in charter capital according to the capital contribution schedule stated in the enterprise’s charter.
• Loan interest expense arising from illegal loans.
• Loan interest expense arising from loans not used for their intended purpose.
• Loan interest expense arising from loans with unreasonable interest rates.

For example, an enterprise borrows from a bank at an interest rate of 20%/year. The basic interest rate of the State Bank of Vietnam at the time of borrowing is 5%/year. Thus, the enterprise’s loan interest expense exceeds 150% of the basic rate, making it a non-deductible loan interest expense. The portion of interest expense corresponding to the 5%/year excess will be excluded from deductible expenses when determining CIT.

Enterprises need to be aware of the regulations on non-deductible loan interest expense to ensure they account for loan interest expense properly and avoid administrative penalties related to taxes.

How to account for non-deductible loan interest expense

Based on the amount of non-deductible interest expense, the accountant records:

• Debit Account 811 – Other expenses
• Credit Account 111 – Cash on hand, Account 112 – Cash in bank

At the end of the period, the closing entry is recorded as:

• Debit Account 911 – Determination of business results
• Credit Account 811 – Other expenses

Example: Company A has a total interest expense incurred during the period of 1 billion VND. Of this, the deductible interest expense is 800 million VND. Thus, the non-deductible interest expense is 200 million VND.

The accountant records the non-deductible interest expense as follows:

• Debit Account 881 – Other expenses: 200 million VND
• Credit Account 112 – Cash in bank: 200 million VND

How to handle non-deductible interest expenses

The enterprise needs to determine the additional Corporate Income Tax (CIT) payable using the formula:

The business is responsible for declaring and paying the additional corporate income tax (CIT) owed to the state budget. At the end of the year, when preparing the CIT finalization return, this non-deductible expense must be excluded (Enter it in section B4 on the 03/TNDN CIT finalization form).

Deductible and non-deductible interest expenses are crucial factors in a company’s financial planning. 1Office hopes that through this article, you will gain a clearer understanding of the regulations on interest expenses, thereby using capital loans effectively and leveraging their role as financial leverage and a tax shield for the business.

7. How do interest expenses impact business valuation?

In business valuation, interest expense is not just a regular financial cost but also a factor that directly affects cash flow value, profitability, and attractiveness to investors. If interest expenses are not calculated correctly and fully, the business’s value can be “inflated,” leading to flawed decisions in investment or mergers and acquisitions (M&A).

So, through what mechanisms do interest expenses affect business valuation? Below are the key aspects to analyze:

1. Impact on WACC (Weighted Average Cost of Capital):
   • Interest expense is a component of the Cost of Debt.
   • When interest expense increases, WACC increases → the company’s net present value (NPV) decreases.
   • Conversely, low interest expense helps the business utilize the “tax shield,” reducing WACC and increasing its value.
2. Impact on EV/EBITDA and other valuation multiples:
   • EV (Enterprise Value) reflects the company’s value, including debt.
   • High interest expense → EBITDA decreases, causing an abnormal increase in EV/EBITDA, making the company look “expensive” to investors.
   • Conversely, well-controlled interest expense helps the business maintain a reasonable valuation ratio.
3. Impact on Free Cash Flow:
   • Interest expense reduces the free cash flow to equity (FCFE).
   • Cash flow “eroded” by interest expense causes the business’s value to decline in DCF valuation models.
4. A risk signal for investors:

• • A high ratio of interest expense to total financial costs indicates the business is using significant leverage.
  • Investors perceive a risk of default → they discount the business’s value at a lower rate.

8. How to optimize interest expenses during a period of high interest rates

When market interest rates escalate, interest expense becomes a significant burden for businesses. Especially for companies with high financial leverage, the additional interest can “erode” profits and strain cash flow. Managing interest expense is therefore no longer an option, but a vital element of financial strategy.

So, in a rising interest rate environment, what should businesses do to optimize interest expenses while maintaining liquidity and protecting profits?

Renegotiate loan terms with the bank:

• • Negotiate to switch from a floating to a fixed interest rate to reduce volatility risk.
  • Extend the loan term to reduce short-term repayment pressure.
  • Leverage a good credit relationship to get preferential interest rates.

Restructure debt reasonably:

• • • Consolidate multiple small loans into one large loan with a more favorable interest rate.
    • Refinance by taking out a new, cheaper loan to pay off old debt.
    • Prioritize prepaying high-interest loans.

Manage cash flow tightly:

• • Strengthen revenue and expenditure management to ensure timely debt repayment.
  • Cut non-essential costs and allocate funds for interest payments.
  • Create a 3–6 month cash flow plan to be proactive with liquidity.

Utilize financial derivatives:

• • Use interest rate swaps to fix borrowing costs.
  • Use futures or options for foreign currency loans to hedge against exchange rate risk.

Diversify capital sources:

• • Reduce reliance on banks, find additional fundraising channels: issue corporate bonds, raise equity capital.
  • Increase owner’s equity to reduce the debt-to-equity ratio, thereby easing interest pressure.

Increase the efficiency of loan capital use:

• • Only borrow when the project’s cash flow is strong enough to cover the interest expense.
  • Channel loan capital into high-return activities instead of spreading it thin.

9. Frequently Asked Questions

Are interest expenses considered reasonable expenses?

Yes, but only if the loan serves production and business activities and the interest rate does not exceed 150% of the basic interest rate (for loans from non-credit institutions).

When are interest expenses not tax-deductible?

Common cases include: interest corresponding to the portion of charter capital that has not been fully contributed on schedule; interest on loans from non-credit or non-economic organizations that exceeds 150% of the basic interest rate; and for related-party transactions, the portion of net interest expense exceeding 30% of EBITDA as regulated is not deductible in the period.

Can interest expense be included in the product cost?

How does interest expense affect profit?

Interest expense increases financial costs, which reduces profit if revenue and other factors remain unchanged. Therefore, revenue may increase, but profit can still decrease if the interest burden is large.

Can a business that borrows from an individual record the interest expense?

Yes, but not all of it is considered a tax-deductible expense. If borrowing from an individual or an entity that is not a credit institution or economic organization, the portion of interest exceeding 150% of the basic interest rate will not be deductible.