In accounting, accrued interest is reported by both borrowers and lenders:
- Borrowers list accrued interest as an expense on the income statement and a current liability on the balance sheet.
- Lenders list accrued interest as revenue and current asset, respectively.
Entries to the general ledger for accrued interest, not received interest, usually take the form of adjusting entries offset by a receivable or payable account. Accrued interest is typically recorded at the end of an accounting period.
Accrued interest accumulates with the passage of time, and it is immaterial to a company's operational productivity during a given period.
Accrued interest is usually counted as a current asset, for a lender, or a current liability, for a borrower, since it is expected to be received or paid within one year.
- This process is based on the accrual method, which counts economic activity when it occurs, not when it is received.
- Accrued interest is listed as an expense on the borrower's income statement.
- It is listed as revenue and current asset by the lender.
The use of accrued interest is based on the accrual method of accounting, which counts economic activity when it occurs, regardless of the receipt of payment. This method follows the matching principle of accounting, which states that revenues and expenses are recorded when they happen, instead of when payment is received or made.
Accrued interest normally is recorded as of the last day of an accounting period.
(By contrast to the accrual principle, the cash accounting principle recognizes an event when cash or compensation is received for an event.)
Suppose a firm receives a bank loan to expand its business operations. Interest payments are due monthly, starting on Jan. 1. Even though no interest payments are made between mid-December and Dec. 31, the company's December income statement needs to reflect profitability by showing accrued interest as an expense. After all, those funds eventually leave the business.
How to Adjust
In this case, the company creates an adjusting entry by debiting interest expense and crediting interest payable. The size of the entry equals the accrued interest from the date of the loan until Dec. 31.
Typical adjusting entries include a balance sheet account for interest payable and an income statement account for interest expense.
Accurate and timely accrued interest accounting is important for lenders and for investors who are trying to predict the future liquidity, solvency, and profitability of a company.
Sometimes corporations prepare bonds on one date but delay their issue until a later date. Any investors who purchase the bonds at par are required to pay the issuer accrued interest for the time lapsed. The company assumed the risk until its issue, not the investor, so that portion of the risk premium is priced into the instrument.
Par Value Only
Keep in mind this only works if investors purchase the bonds at par. The company's journal entry credits bonds payable for the par value, credits interest payable for the accrued interest, and offsets those by debiting cash for the sum of par, plus accrued interest.