Why labels matter in modelling – Interest on a loan



Kenny Whitelaw-Jones


20 Jan 2014




Once you have been working with the FAST standard for a while, you begin to realise that one of the most difficult things to get right are labels.

Labels – often in column E – should be: descriptive (yes), concise (yes, yes), short, punchy and accurate (yes, yes, yes).  And in order to make the single source calculation structure work, they should be unique.  We work with unique labels as a matter of course: avoid naming identical things with different labels; avoid calling different things by the same label.

Unique labels can also help to bust jargon.  And here is an example of where things get full of jargon: interest on a loan.

Capitalised interest

Imagine that you are modelling a project where the first two years are spent building an asset.  It is known as a construction period.  The thing about a construction period is that – more often than not – there is no revenue.  So costs cannot be written off to the income statement because there is no revenue.  An income statement relies on revenue since it is a basic accounting principle that costs should be matched with revenue.  If you have no revenue, then you have no income statement.  You can show no costs.

So costs that are awaiting revenue (against which they may be matched) are capitalised.  They appear on the balance sheet as an asset.  So interest that is charged during construction by a lender is capitalised.  It sits on the balance sheet as an asset and is subject to depreciation once the revenue starts to come in.

If you model interest during construction as an asset, then what you have determined is a particular accounting treatment for interest.  When should this treatment be adopted?  Answer: interest should be capitalised when there is no revenue against which to match it.

Interest expense

Now let us assume that there is plenty of revenue.  There is no requirement for capitalised interest and so interest is taken to the income statement in the period to which it relates.  We call this “interest expense due” or “interest payable”.

Most of the time our model period ends are aligned with interest setting dates.  It is one of the facts of modelling that the lender’s terms will often determine whether the model is monthly, semi-annual or annual.  It makes sense for the modeller to get those dates aligned since interest charged for a particular period can then be slotted into its equivalent model period.

One exception would be where the lender has offered zero coupon debt.  Zero coupon debt requires no payment of interest until the final redemption period.  At this point, all the debt is paid back in one single sum covering principal and interest.  Even though no interest is charged until the end, accountants would still accrue for interest in every period.  And so should modellers.

Interest paid

So what is the difference between interest expense due and interest paid?  Often we assume no difference: interest is calculated for a particular period and immediately paid.  The same calculation appears in both the income statement and the cash flow statement.  And the label reflects this assumption: “interest expense due & paid” or “interest payable & paid”.

And if there is a lag in payment then a cork screw for an “interest payable” balance would be deployed.  What makes the balance go up: interest payable (as charged to the income statement).  What makes the balance go down: interest paid (as shown in the cash flow statement).

What is important here is that the interest must be paid.  There is a contractual obligation that – if ignored – could lead to default and the lender’s right to insist on immediate repayment of the loan.

Rolled up interest

But what if there is insufficient cash to pay the interest?  One option is for the borrower to draw down more principal on the loan facility to cover the additional interest.  The interest is still paid but the amount required to repay the loan increases by the extra amount borrowed to pay the interest.  We call this “rolled up interest”.

Rolled up interest describes a particular funding solution for the interest paid.  It does not describe an accounting treatment.  The interest is paid by drawing down further on the loan facility that generates the interest in the first place.

Accounting treatment vs. financing solution

What this boils down to is clear thinking about interest.  There are two questions to be answered:

(a) How should I account for interest?  In the income statement (cost) or in the balance sheet (asset); and

(b) How is my interest paid financed?

Once you have these two questions clear, you begin to realise that there might be various combinations to model.  And each combination has a different risk profile.  Understanding the different risk profiles is key to understanding a lender’s negotiating position.

And it all starts with good labels.

Download “The Devil’s Guide to Spreadsheet Creation” for a light hearted look at how not to create models.

The Devil's Guide to Spreadsheet Creation

Kenny Whitelaw-Jones
Kenny Whitelaw-Jones is no longer with F1F9 but we really like this blog so we've kept it.