What Is Accrued Interest?
In finance, the term "accrued interest" refers to the interest income earned on a debt that has yet to be collected. Accrued interest essentially comes in two forms:
- The interest on a loan or a bond that has accumulated from the time the principal investment was made
- The interest accumulated since the previous coupon was made
Understanding 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 accrual of 10 days of interest—in this case, from the 21st to the 30th.
Accrued interest is reported on the income statement as a revenue or expense. Alternatively, the portion of revenue or expense yet to be 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 Accrual Principle
The application of accrued interest is a result of accrual accounting which counts economic events when they occur regardless of receipt of payment. It is the method associated with the matching principle of accounting. The matching principle states that revenues and expenses are realized when they occur, rather than when payment is received or expended. The accrual principle differs from the cash accounting principle, which recognizes an event when cash or other forms of consideration are received.
To illustrate how the accrual principle works, consider a retailer who is selling a customer goods on credit, in the month of September. According to the accrual principle, the transaction is to be immediately recorded in the accounts receivable account. The transaction will also be labeled as income for September, although technically no payment was received for the transaction.
From an accounting perspective, the concept of accrued interest is generally used to compile the amount of unpaid interest that’s either payable or receivable, by a business operation, at the conclusion of an accounting period. The ultimate goal is to ensure that the transaction is accurately recorded in the right period.
Consider the following example. Let us assume there is a $20,000 loan receivable, with an interest rate of 15%, on which payment has been received for the period through the 20th day of the month. In this scenario, to record the extra amount of interest receivable that was earned from the 21st to the 30th days of the month, the calculation would be as follows:
- (15% x (10 / 365)) x $20,000 = $82.19
The amount of accrued interest for the party who is receiving payment is a credit to the interest revenue account and a debit to the interest receivable account. The debit amount is consequently rolled into the balance sheet—classified as a short-term asset. The amount is also classified as credit into the income statement. The accrued interest for the party who owes the payment is a credit to the accrued liabilities account and a debit to the interest expense account.
The credit is rolled into the balance sheet as a short-term liability, while the debit is rolled into an interest expense account. Both cases are tagged as reversing entries, meaning that they are subsequently reversed on the first day of the following month. The net effect of these events is thus that the revenue shifts to a future date.