What is 'Accrued Interest'
Accrued interest is a term used in accrual accounting that disregards cash flows and reports interest that has been earned but not collected. At the end of a period, the projected future cash flows are calculated and reported on the company’s financial statements. The projected future cash flows are calculated based on the established interest rate or coupon payments.
BREAKING DOWN 'Accrued Interest'Accrued interest is calculated based on the last day of the accounting period. For example, if interest is payable on the 20th of each month and the accounting period is the end of each calendar month, the month of April will require an accrual of 10 days (21st to the 30th) of interest. Accrued interest is reported on the income statement as a revenue or expense. Alternatively, the portion of revenue or expense yet to the paid or collected is reported on the balance sheet as an asset or liability. Because accrued interest is expected to be received or paid within one year, it is often classified as a current asset or current liability.
The application of accrued interest is a result of the use of accrual accounting in which economic events are reported when the transaction has occurred. In the event of interest, the transaction is considered to have occurred upon the passage of time. Even if the investment or loan agreement does not accrue interest daily, the passage of time results in an accumulation in the legal obligation to pay the debt or collect the interest. Therefore, the accrual principle dictates that interest is accrued not when it is paid or received but when it has been accumulated.
Accrued interest revenue is reported on the financial statements through a debit to the interest receivable account and a credit to interest revenue. This entry accounts for revenue in the period it was actually earned as opposed to when it is later collected. In the subsequent period, the accrued interest revenue entry is reversed and when the cash is collected for the interest, an entry is made to debit the cash account and credit the entire interest revenue. The credit to the interest revenue account will be offset by the reversed debit to the revenue account to reflect the accurate total dollar amount of revenue in the current period.
Accrued interest expense is reported in a similar manner. The accrual entry results in a debit to interest expense and a credit to interest payable. Upon reversing the entry in a future period, an entry is made when the interest is paid by debiting the interest expense account and crediting the cash account.