What Is the Ratable Accrual Method?
The ratable accrual method is a formula for determining how much interest income was earned on an investment over a period of time and when within the period it was earned. It counts income as it's accrued rather than paid and is mainly used for determining taxes owed on interest income.
- The ratable accrual method is a formula for determining income on investments as it's accrued rather than paid.
- It is primarily used for determining taxes owed on interest income.
- The ratable accrual method can be utilized to find the accrued market discount of a bond traded in the secondary bond market or to determine the property taxes owed on real estate.
Understanding the Ratable Accrual Method
In this sense, "ratable" means proportional. The investor is determining how much they received of the total interest earned on the investment, and how much is owed in taxes on that profit.
The ratable accrual method can be used, for example, to find the accrued market discount of a bond traded in the secondary bond market, or to determine the property taxes owed on real estate that is held over several tax periods.
It uses a simple calculation. In the case of bonds, the market discount is divided by the number of days from the bond's maturity date minus the purchase date, multiplied by the number of days the investor actually held the bond.
The ratable accrual method usually results in a greater accrual of a discount than the alternative method for determining accrued market discount, the constant yield method.
This method is approved by the Internal Revenue Service (IRS) for use in determining interest earned on taxable bonds. IRS Publication 538 outlines all of the allowable accounting methods.
Examples of the Ratable Accrual Method
Example 1: Say you bought a $20,000 bond at a discount for $18,000 with 400 days until its expiration date. Then, you sold the bond 300 days later for $19,500. To compute the interest income, you would multiply the portion of the days you held the bond by the increase in its value.
- Days bond held [300/400] = 0.75
- Bond value at sale [$19,500-$18,000] = $1,500
- Taxable interest income [0.75 x $1,500] = $1,125
Example 2: Say you are paid $1,500 in interest income every quarter with the next payment due on February 28. That translates to $500 per month for December, January, and February.
Under the ratable accrual method, the interest income accrued for December, $500, would have to be included in the taxes for that year, and the remaining $1,000 would be counted in next year's taxes. In this example, the income is counted as it accrues as opposed to when it's paid.