Accrued Interest – Definition, Example & How to Calculate it?
What is Accrued Interest?
Accrued interest is the amount of interest that has accumulated on a loan or investment but has not yet been paid or received. In simpler words, accrued interest means the interest that is earned but not yet received or paid out. It’s important to keep track of accrued interest because it will eventually need to be paid or received.
How Does Accrued Interest Work?
Accrued interest is a part of the accrual-based accounting system. When interest becomes due, whether payable or receivable, it is recorded in the books of accounts, not on the date it is paid or received. This is to satisfy the matching concept and the revenue recognition principle of accounting. Accrued interest works by accumulating overtime on a loan or investment that has an interest rate attached to it.
Accrued interest works similarly to loans. For example, if you have a loan with a 5% annual interest rate, interest will accrue on the outstanding balance each day until the loan is paid off. If you make a payment on the loan, a portion of the payment will go towards paying off the accrued interest, and the rest will go towards reducing the principal balance of the loan.
Overall, accrued interest is a way to keep track of how much interest has been earned or owed over a certain period of time, even if it hasn’t been paid out or received yet.
To understand the concept of accrued interest better, check the accrued interest formula below and see how it is calculated.
Accrued Interest Formula
Accrued interest formula is calculated for a specified accrual period. For this, the following formula is used:
- Accrued interest = Principal amount * (rate of interest/365) * accrual period
How to Calculate Accrued Interest?
Here, the face value of the loan is the principal amount. In the case of a bond or security, it is the given face value. Further, dividing the interest rate by 365 gives you the daily interest rate. Multiply this by the number of days in the accrual period to calculate the figure of accrued interest.
For example, you have taken out a loan of Rs.10 lakh at an interest rate of 7.3% per annum, payable every month. The interest for the accrual period of April 1 to May 1 (30 days) will be calculated as:
Accrued interest = 10,00,000 * (0.073/365) * 30
= 10,00,000 * 0.0002 * 30
= Rs.6,000
This way, you can seamlessly calculate the accrued interest for any accrual period.
Types of Accrued Interest
1. Simple Interest
This is the most basic type of interest, where interest is calculated as a percentage of the original loan amount and accrues on a daily, weekly, or monthly basis. The interest is then added to the principal balance, and interest continues to accrue on the new, higher balance.
2. Compound Interest
This type of interest involves calculating interest not only on the original principal balance but also on any interest that has accrued since the last payment was made. This means that interest can grow more quickly over time, as the interest itself also earns interest.
3. Accrued Interest Bonds
These are bonds that have earned interest, but the interest payments have not yet been made to the bondholder. The bond issuer is responsible for paying the accrued interest at a later date.
4. Accrued Expenses
These are expenses that a company has incurred but has not yet paid for. For example, if a company hires a consultant to work on a project for a month, but does not pay the consultant until the end of the month, the cost of the consultant’s work would be considered an accrued expense.
Accrued Interest in Accounting
Accrued interest is recorded using the accrual accounting method, which recognises revenue and expenses when they are earned or incurred, rather than when they are paid or received. This means that if a company has earned interest but has not yet received payment, the interest income will still be recorded in the company’s financial statements.
Accrued interest is important in accounting because it represents income that has been earned but not yet received or expenses that have been incurred but not yet paid. It is important to accurately record accrued interest to ensure that financial statements reflect the true financial position of the company.
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Accrued Interest in Accounting – Example
Let’s say that a company has a $10,000 bond investment that pays an annual interest rate of 5%. The interest on the bond is paid annually, but the company’s financial statements are prepared on a quarterly basis. At the end of the first quarter, the company would have earned $250 in interest on the bond investment (i.e., $10,000 x 5% x 1/4).
However, because the interest is not paid until the end of the year, the company would need to record an accrued interest liability of $250 at the end of the first quarter. This is because the company has earned the interest, but has not yet received the payment.
The journal entry to record the accrued interest liability would be as follows:
- Debit Interest Receivable: $250
- Credit Accrued Interest Payable: $250
Accrued Interest in Bonds
Bonds are debt instruments actively traded by investors and are a great addition to your investment portfolio. Bonds come with a coupon rate at which interest is paid to the bondholder. In most cases, interest is paid out annually or semi-annually. You may not hold the bond when the interest is paid out as a bondholder. However, this does not mean that you will not earn the interest.
Bond interest is calculated on an accrual basis. For example, you purchased bonds that have a face value of Rs.100 per bond. The coupon rate is 4.38% per annum, which is paid annually. The interest on bonds accrues as follows:
Accrued interest = 100 x (0.065/365) x 72
= 100 x 0.00012 x 72
= 0.864
Thus, the interest accrued on each bond will be Rs.0.864. As we can see, calculating accrued interest is a vital thing for any investor.
Accrued Interest in Bonds – Example
Let’s say that on January 1st, a company purchases a bond with a face value of $10,000 and a coupon rate of 6%. The bond has a maturity date of December 31st and pays interest semi-annually on June 30th and December 31st. The company’s financial statements are prepared on a quarterly basis.
At the end of the first quarter, March 31st, the company had held the bond for three months and earned interest for one quarter. The interest earned during the first quarter would be calculated as follows:
$10,000 x 6% x 1/4 = $150
Why is Accrued Interest Important?
Accrued interest is important for the following reasons:
- Accrued interest is used to calculate the actual interest payment due at the end of the payment period. Failing to account for accrued interest can lead to incorrect interest payments and financial discrepancies.
- Accrued interest is used to determine the value of financial instruments such as bonds and other fixed-income securities. This is important for investors who may buy or sell these securities in the market.
- Accrued interest is important for accounting and financial reporting purposes. Companies must accurately report the interest income or expense on their financial statements, and accrued interest plays a role in these calculations.
Accrued interest vs. Regular interest
| Accrued Interest | Regular Interest |
| It refers to the interest that has been earned but has not yet been paid or received. It is a cumulative amount that grows over time as interest continues to accrue on the principal balance. | It is a basic interest calculation that is based only on the original principal amount and the interest rate. Interest is calculated on a daily, weekly, or monthly basis and is added to the principal balance. |
| Accrued interest is important to keep track of for accounting and tax purposes, and it is usually paid or received at a later date. | Regular interest does not take into account any interest that has already accrued, so the interest amount remains constant over time. |
Final Word
Accrued interest is important for both lenders and borrowers. For lenders, it represents the interest that they are owed but have not yet received. For borrowers, it represents the interest that they owe but have not yet paid.
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FAQs
Accrued interest is recorded by borrowers as an expense on their income statement at the end of the accounting period as an adjusting journal entry. This gets reversed on the first day of the following period.
Bond interest is calculated on an accrual basis. Hence, we should use the formula for accrued interest to calculate bond interest.
Accrued interest is an accounting concept based on the revenue recognition principle and matching concept in accounting.
Accrued interest is mostly considered a current asset, for a lender, or a current liability, for a borrower, since it is expected to be received or paid within one year.
Yes, when you purchase bonds in between interest payment periods and provide the seller any accrued interest, the seller must pay taxes on this interest.
Accrued interest can either be in the form of accrued interest revenue, for the lender, or accrued interest expense, for the borrower.
The buyer will have to pay accrued interest to the seller as part of the total purchase price when purchasing bonds in the secondary market.
Accrued interest is recorded in the profit and loss account as interest income or expense, depending on the context. When a company earns interest on its investments, loans, or other financial assets, this interest income is recognised in the profit and loss account. This interest income is recorded as revenue in the profit and loss account and contributes to the company’s net income.
On the other hand, when a company incurs interest expense on its borrowings or other financial obligations, this expense is recognized in the profit and loss account as an operating expense. This interest expense is recorded as an expense in the profit and loss account and reduces the company’s net income.
Accrued interest is recorded in the balance sheet as a current asset or liability, depending on the context.
Disclaimer
This article is solely for educational purposes. Navi doesn't take any responsibility for the information or claims made in the blog.
