What Is Accrued Interest?
In accounting, accrued interest refers to the amount of interest that has been incurred on a loan or other financial obligation as of a specific date 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 also refers to the amount of bond interest that has accumulated since the last time a bond interest payment was made.
KEY TAKEAWAYS
- 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 as an adjusting journal entry at the end of an accounting period, reversing the following period’s first day.
- 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 and matching principles are both important aspects of accrual accounting and are relevant to 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 first day of the following month. The company has used 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 must record the interest it expects to pay out 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 pay it the following day.
Accrued Interest Example – Accounting
Consider the following example. Let us assume there is a $20,000 loan receivable with an interest rate of 7.5%, 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 of the month, the calculation would be as follows:
- (7.5% x (10 / 365)) x $20,000 = $41.10
The accrued interest amount for the party 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 exact 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, which 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, the lending company receives $123.29 (7.5% x (30/365) x $20,000) on the 20th day of the second month. Of that, $41.10 was related to the prior month and was booked as an adjusting journal entry at the prior month’s 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 $82.19 ($123.29 – $41.10) of the payment is recognized in the second month. That is equivalent to 20 days’ worth of interest in the second month.
Accrued Interest Example – Bonds
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.1
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 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 before the sale.
Let’s assume you are interested in buying a bond with a face value of $1,000 and a 5% semiannual coupon. The interest payment is made twice a year, on June 1 and December 1, and you plan to buy the bond on September 30. How much-accrued interest would you have to pay?
Bond markets use several slightly differing day-count conventions to calculate the exact amount of accrued interest. Since most U.S. corporate and municipal bonds use the 30/360 convention, which assumes that each month has 30 days (regardless of the actual number of days in a particular month),2 we will use that day-count convention in this example.
Step 1: Calculate the exact number of days between the date of the last coupon payment (June 1) and your purchase date (September 30). In this example, the number of days (based on the 30/360 convention) is 120 days.
Step 2: Calculate accrued interest by multiplying the day count by the daily interest rate and the face value of the bond.
Thus, accrued interest = 120 x (5% / 360) * $1,000 = $16.67
Step 3: Add the accrued interest to the face value of the bond to get your purchase price.
Purchase price of bond = $1,000 + $16.67 = $1,016.67
On the next coupon payment date (December 1), you will receive $25 in interest. But since you paid $16.67 in accrued interest when you purchased the bond, the net interest received by you is $8.33 ($25 – $16.67), which is precisely the amount of interest you should have received for the 60 days that you owned the bond until the next coupon payment (September 30 to December 1).
- Financial Industry Regulatory Authority. “Bond Basics.”
- Nasdaq. “Thirty/Three Sixty (30/360).”
Note: ZPEnterprises is not a licensed investor/financial advisor, but we are trying to share awareness of financial topics. Please do further research and work with a licensed financial advisor.
