What Is an Accrual Rate?
An accrual rate is the interest rate applied to a financial obligation, such as bonds, mortgages, and credit cards. The accrual rate is the rate at which interest is accrued, which is often daily for credit cards. However, the accrual rate for paid vacation time and pensions is the rate at which vacation time or benefits are earned.
- An accrual rate is the percentage interest applied to the principal of a financial obligation.
- Accrual rates vary based on what type of financial obligation they are applied to.
- Accrual rates are often used to calculate the sum of paid sick time, vacation time, and pensions.
- Accrual rates play a vital role in calculating the true value of a financial obligation.
How an Accrual Rate Works
Knowing the rate at which a financial obligation accumulates interest is important for understanding its price and, ultimately, its value. For example, in the case of bonds, since a bond’s price is the sum of all its future cash flows—including principal and interest, the price at which it changes hands will include any interest accrued (but not yet paid.) Similarly, when calculating the payoff amount for a mortgage or other debt, accrued interest amounts must be added to the principal balance outstanding.
Properly calculating an accrual rate can often be quite complex.
The concept of accruals also applies in Generally Accepted Accounting Principles (GAAP) and plays a crucial role in accrual accounting. Under this method of accounting, earnings and expenses are recorded at the time of the transaction, regardless of whether or not cash flows have been received or dispensed. This method of accounting is often utilized for the purposes of determining the performance and position of a company by factoring in the totality of payments made (cash outflow) as well as the sum of expected future cash inflows. By doing this, a company can assess its financial position by factoring in the amount of money that it expects to take in rather than the money that it has received as of yet.
Accrual accounting is in contrast to cash accounting, which only considers money that has actually exchanged hands, rather than factoring in amounts of cash that a company expects to receive. Accrual accounting is almost always utilized for companies that hold large amounts of inventory or make sales based on credit. In such cases of accrual accounting, the accrual rate of expected incoming payments will be factored into a company’s overall worth.
Example of an Accrual Rate
You can calculate the daily accrual rate on a financial instrument by dividing the interest rate by the number of days in a year—365 or 360 (some lenders divide the year into 30 day months)—and then multiplying the result by the amount of the outstanding principal balance or face value.
Similarly, for obligations with monthly accrual rates, you would divide the annual interest rate by 12, and then multiply the result by the amount of the outstanding balance. Normally, accrual rates are positive values. But in extraordinary circumstances, such as during a period of negative interest rates, they might be negative.
Accrual rates are also used in non-financial contexts, such as for tracking vacation or sick days—as well as other paid time off and pension balances—and for the calculation of various payment plans.