Interest accumulated on loans or any debt instrument, such as bond, but not yet collected is called accrued interest. Interest is accrued or accumulated from the date of loan issuance or since the last payment date of a bond sold on the secondary market.
Let us understand the concept of accrued interest in terms of accounting in detail.
To simply put, accrued interest is the interest that is generated in a financial year but which 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).
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. For example, 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 25th April. Since the accounting year ends on 31st March, expenses due for that period must be reconciled. Here, this includes five days of March. The accrued interest for that period will thus be included in the accounting year.
To understand the concept of accrued interest better, let us see how it is calculated.
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.
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.
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.
The difference between accrued interest and regular interest is that accrued interest is the interest that becomes due within a period but is not paid and may be variable, whereas regular interest remains fixed.
For instance, you take out a loan of Rs. 10 lakh, on which interest of Rs. 10,000 is payable every year. This is paid with the loan instalment and remains fixed throughout repayment. It is calculated based on simple interest and remains the same.
On the other hand, accrued interest is accumulated between the payment dates. It is an accounting term used to maintain the books per the accounting standards.
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.
Ans. Accrued interest is the interest that is generated in a particular period but which has not yet been paid.
Ans. Accrued interest is recorded in the profit and loss account, also known as the income statement. It is also treated as a current asset (if receivable) or a current liability (if payable), thus comes in the balance sheet as accounts receivable/payable.
Ans. Accrued interest is calculated using the following formula:
Accrued interest = Principal amount * (rate of interest/365) * accrual period
Here, the principal amount is the amount of your loan or the face value of securities you hold. Accrual period is the time frame after which the interest is paid or received.
Ans. Bonds come with a coupon rate, which is the rate of interest. Interest is paid annually or semi-annually and accrues constantly till the date it is paid. As a bond holder, you can calculate the interest accrued to you based on the time period from the last payout date till the date you sell the security (if it is before the next payout date) using the formula:
Accrued interest = Face value of bond * (rate of interest/365) * accrual period
Ans. The concept of accrued interest is based on the revenue recognition principle of account as well as the matching concept. Based on this, revenue is recognised when it is realised. That is, it must be recorded in the accounting period when it becomes due, irrespective of whether it is paid/received or not.
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