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.
The ratable accrual method is used primarily for determining taxes owed on interest income. It 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.
Understanding the Ratable Accrual Method
In this sense, "ratable" means proportional. The investor is determining how much he or she received of the total interest earned on the investment, and how much is owed in taxes on that profit.
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.
- The ratable accrual method can be used to determine the interest owed on a bond that is bought and sold on the secondary market.
- It is approved by the IRS for use in calculating taxes owed on taxable bonds.
- The formula for the ratable accrual method is simpler than the alternative.
The method is approved by the Internal Revenue Service (IRS) for use in determining interest earned on taxable bonds. It is also easier to use than the alternative.
The formula is as follows: market discount divided by the number of days from the bond's maturity date minus the purchase date, multiplied by the number of days the bond was held.
The ratable accrual method uses a simple calculation. In the case of bonds, for example, 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.
IRS Publication 538 outlines all of the allowable accounting methods.
Example of the Ratable Accrual Method
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, or 300/400 = 0.75. And $19,500-$18,000 = $1,500. So, 0.75 x $1,500 = $1,125 in taxable interest income.