Interest accumulated on loans or any other financial instrument but not yet collected is called Accrued Interest. Interest is accumulated from the date of loan issuance or since the last payment date of a bond sold on the secondary market. Accrued interest is calculated from the last day of the accounting period and is reported on the income statement.
Read on to understand the concept of accrued interest with an example, its formula, calculation and importance.
What is Accrued Interest?
Accrued interest is the interest that is generated in a financial year but has not been paid yet. This stems from accrual-based accounting, where any revenue earned or expense incurred is recorded in the period it is generated, irrespective of whether the monetary settlement for the same has been done.
If you are a borrower, you may owe interest payments. Whereas in the opposite scenario, if you are a lender, you might be due to receive interest payments. Until the time the interest is paid (or received), it is classified as accrued interest.
The amount of interest income or expense is recorded in the organisation’s profit and loss account, also known as the income statement. Accrued interest is expected to be written off within the short term and thus is treated as a current asset (if receivable) or a current liability (if payable). Therefore, accrued interest in the balance sheet is shown as accounts receivable (on the asset side) or accounts payable (on the liabilities side).
Let’s assume you have taken a loan of Rs.1,00,000 at a 12% per annum interest rate, payable on the 25th of every month. The amount of annual interest will be Rs.12,000. This means monthly interest payments are Rs.1,000. The first interest payment is due on April 25th. Since the accounting year ends on March 31st, expenses due for that period must be reconciled. Here, this includes five days in March. The accrued interest for that period will thus be included in the accounting year.
How does Accrued Interest Work?
Accrued interest, as mentioned above, 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.
You can find instances of accrued interest in various scenarios. A common example is an interest accrued on investments, such as bonds or other fixed-income securities. Since interest payments are usually made annually or semi-annually, the amount of interest that becomes due is accrued until the date when it is paid to the bondholders. Apart from the investment point of view, accrued interest is a typical instance in loan interest calculations. To understand the concept of accrued interest better, let us learn the formula and see how it is calculated.
Accrued Interest Formula
Accrued interest is calculated for a specified accrual period. For this, the following formula is used:
Accrued interest = Principal amount * (rate of interest/365) * accrual period
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
This way, you can seamlessly calculate the accrued interest for any accrual period.
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
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.
Why is Accrued Interest Important?
Accrued interest is an important concept from the accounting point of view. As most organisations follow the accrual basis of accounting, interest is recorded when it is recognised as an expense or income, irrespective of whether it has been paid. Accrued income is in line with this principle.
Apart from this, it is important to understand how much you can earn on a bond you purchase. By adding up the interest as it accrues, you can check the accrued interest bonds earned, reconcile the amount when you receive it, and check if you have been paid the entire amount.
You can see how much interest will accrue in future on a loan you have taken out. You can do the same with your credit card interest, which is added until the bill is paid. Moreover, with this, you can assess your financial health.
Knowing how much interest can accrue over a given period helps you plan your financial decisions accordingly. The longer the duration, the more the interest will accrue. Most advisors will tell you to repay your debts as soon as possible to minimise your interest burden.
Accrued interest is an important concept not just for those who need to maintain the books of accounts, but also for anyone who is to receive or pay interest on a later date from when the interest is generated. It is useful if you have invested in bonds, as you can calculate the interest that has accrued on your investment based on the period over which you hold the bond. Moreover, with this, you can always reconcile your statement and check if you have received or paid the correct amount.
Q1. What is accrued interest?
Ans. Accrued interest is the interest that has been accumulated since the investment of the principal amount. It is the due interest amount that the borrower is liable to pay to the lender.
Q2. How is accrued interest recorded in the books of accounts?
Ans. 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.
Q3. How can you calculate accrued interest?
Ans. Accrued interest is calculated for a specified accrual period. For this, the following formula is used: Accrued interest = Principal amount * (rate of interest/365) * accrual period
Q4. How can I calculate the interest I have earned on my bonds?
Ans. Bond interest is calculated on an accrual basis. Hence, we should use the formula for accrued interest to calculate bond interest.
Q5. Accrued interest is based on which accounting principle?
Ans. Accrued interest is an accounting concept based on the revenue recognition principle and matching concept in accounting.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information, and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
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