What Is Accrued Interest?
In accounting, accrued interest refers to the amount of interest that has been incurred, as of a specific date, on a loan or other financial obligation but has not yet been paid out. Accrued interest can either be in the form of accrued interest revenue, for the lender, or accrued interest expense, for the borrower.
The term accrued interest can also refer to the amount of bond interest that has accumulated since the last time a bond interest payment was made.
- Accrued interest is a feature of accrual accounting, and it follows the guidelines of the revenue recognition and matching principles of accounting.
- Accrued interest is booked at the end of an accounting period as an adjusting journal entry, which reverses the first day of the following period.
- The amount of accrued interest to be recorded is the accumulated interest that has yet to be paid as of the end date of an accounting period.
Understanding Accrued Interest
Accrued interest is calculated as of the last day of the accounting period. For example, assume 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 of interest, from the 21st to the 30th. It is posted as part of the adjusting journal entries at month end.
Accrued interest is reported on the income statement as a revenue or expense, depending on whether the company is lending or borrowing. In addition, 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.
Accrual Accounting and Accrued Interest
Accrued interest is a result of accrual accounting which requires that accounting transactions be recognized and recorded when they occur, regardless of whether payment has been received or expended at that time. The ultimate goal when accruing interest is to ensure that the transaction is accurately recorded in the right period. Accrual accounting differs from cash accounting, which recognizes an event when cash or other forms of consideration trade hands.
The revenue recognition principle and matching principle are both important aspects of accrual accounting, and both are relevant in the concept of accrued interest. The revenue recognition principle states that revenue should be recognized in the period in which it was earned, rather than when payment is received. The matching principle states that expenses should be recorded in the same accounting period as the related revenues.
To illustrate how these principles impact accrued interest, consider a business that takes out a loan to purchase a company vehicle. The company owes the bank interest on the vehicle on the 1st day of the following month. The company has use of the vehicle for the entire prior month, and is therefore able to use the vehicle to conduct business and generate revenue.
At the end of each month, the business will need to record interest that it expects to pay out on the following day. In addition, the bank will be recording accrued interest income for the same one month period because it anticipates the borrower will be paying it the following day.
Example of Accrued Interest
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 revenue 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 receivable is consequently rolled onto the balance sheet and classified as a short-term asset. The same amount is also classified as revenue on 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 liability is rolled onto the balance sheet as a short-term liability, while the interest expense is presented on the income statement.
Both cases are posted as reversing entries, meaning that they are subsequently reversed on the first day of the following month. This ensures that when the cash transaction occurs in the following month, the net effect is only the portion of the revenue or expense that was earned or incurred in the current period stays in the current period.
Using the example above, $246.58 (15% x (30/365) x $20,000) is received by the lending company on the 20th day of the second month. Of that, $82.19 related to the prior month and was booked as an adjusting journal entry at the prior month end to recognize the revenue in the month it was earned. Because the adjusting journal entry reverses in the second month, the net effect is that $164.39 ($246.58 - $82.19) of the payment is recognized in the second month. That is equivalent to the 20 days worth of interest in the second month.
Accrued interest is an important consideration when purchasing or selling a bond. Bonds offer the owner compensation for the money they have lent, in the form of regular interest payments. These interest payments, also referred to as coupons, are generally paid semiannually.
If a bond is bought or sold at a time other than those two dates each year, the purchaser will have to tack onto the sales amount any interest accrued since the previous interest payment. The reason being, the new owner will receive a full 1/2 year interest payment at the next payment date. Therefore, the previous owner must be paid the interest that accrued prior to the sale.