Accrued Interest

What is Accrued Interest?

Definition: Accrued interest is an accrual accounting term that describes interest that is due but hasn’t been paid yet. It reflects the liability that a company has to pay an amount to someone else.

In accounting, accrued interest refers to the amount of interest that has been incurred, as of a specific date, on a loan or other financial obligation 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.

In finance, accrued interest is the interest on a bond or loan that has accumulated since the principal investment, or since the previous coupon payment if there has been one already.

For a financial instrument such as a bond, interest is calculated and paid in set intervals (for instance annually or semi-annually). Ownership of bonds/loans can be transferred between different investors not just when coupons are paid, but at any time in-between coupons. Accrued interest addresses the problem regarding the ownership of the next coupon if the bond is sold in the period between coupons: Only the current owner can receive the coupon payment, but the investor who sold the bond must be compensated for the period of time for which he or she owned the bond. In other words, the previous owner must be paid the interest that accrued before the sale.

Under the accrual basis of accounting, the amount of accrued interest is to be recorded with accrual adjusting entries by the borrower and the lender before issuing their financial statements.

The borrower’s adjusting entry will debit Interest Expense and credit Accrued Interest Payable (a current liability). The lender’s adjusting entry will debit Accrued Interest Receivable (a current asset) and credit Interest Revenue (or Income).

Accrued interest is the interest that has accumulated between the most recent payment and the sale of a bond or other fixed-income security. At the time of sale, the buyer pays the seller the bond’s price plus “accrued interest,” calculated by multiplying the coupon rate by the fraction of the coupon period that has elapsed since the last payment. (If a bondholder receives $40 in coupon payments per bond semiannually and sells the bond one-quarter of the way into the coupon period, the buyer pays the seller $10 as the latter’s proportion of interest earned.)

What Does Accrued Interest Mean?

The accrual basis of accounting requires that expenses must be recognized when incurred regardless of when they are actually paid. Thus, interest that is due on a certain date but goes unpaid is still recorded to reflect the expense.

A good example of this is the interest that accumulates between the last coupon payment or the initial investment and the settlement date of a fixed security.

Typically, a bondholder who sells a bond has a right over the accrued interest of the bond. At the time of sale, the buyer pays the bondholder the net value of the bond plus the accrued interest, which is the product of the coupon rate multiplied by the number of days that have elapsed since the last payment.

When a bond transaction takes place, the buyer buys the underlying asset plus the right to the next coupon payment, which includes the accrued interest since the date of the initial investment. Therefore, as compensation for the loss, the seller requires the buyer to pay the accrued interest that accumulates between the last coupon payment date and the day of the purchase.

What is Accrued Interest Formula?

Accrued interest is that amount of interest which is due for a debt or bond but not paid to the lender of the bond. Interest is accrued in case of a bond because, interest starts accumulating from the time the bond is issued but the interests are generally paid in the form of a coupon in periodical interval like quarterly, semi-annually or annually. So for the period, the interest is accumulated but not paid becomes an accrued interest. The formula of accrued interest calculation is to find out how much is the daily interest and then multiply it by the period for which it is accrued.

Accrued interest formula is represented as follows

Accrued Interest Formula = Loan Amount  * (Yearly Interest / 365) * Period for which the Interest is Accrued

Interest becomes accrued when the interest is payable but not yet paid, because the timing for interest payable and interest paid is different. Interest is accrued in case of a bond because, interest starts accumulating from the time the bond is issued but the interests are generally paid in the form of a coupon in periodical interval like quarterly, semi-annually or annually. So for the period, the interest is accumulated but not paid becomes an accrued interest.

Example

Consider the following example. Let us assume there is a $20,000 loan receivable, with an interest rate of 15%, 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 days of the month, the calculation would be as follows:

$20,000 x (15% x (10 / 365)) = $82.19

The amount of accrued interest for the party who is 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 same 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, meaning that they 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, $246.58 (15% x (30/365) x $20,000) is received by the lending company on the 20th day of the second month. Of that, $82.19 related to the prior month and was booked as an adjusting journal entry at the prior month 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 $164.39 ($246.58 – $82.19) of the payment is recognized in the second month. That is equivalent to the 20 days worth of interest in the second month.

Special Consideration

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.

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 reason being, 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 prior to the sale.

For example, Leonard owns a bond worth $1,000 with an interest rate of 14%. Leonard decides to sell the bond to Adrian. The last coupon payment that Leonard made was three months ago. Therefore, if Adrian wants to buy the bond, he needs to pay Leonard $1,000 plus the interest of the three months.

Since the bond has an interest rate of 14%, the interest rate per month is 1.17%.

Since the last coupon payment was made three months ago, the accrued amount is 1.17% x 3 = 3.51%.

Adrian needs to pay Leonard $1,000 + ($1,000 x 3.51%) = $1,035.1 to acquire the bond.

If the last coupon payment had been made eight months ago, the accrued amount would be 1.17% x 8 = 9.36% and Adrian would have to pay Leonard $1,000 + ($1,000 x 9.36%) = $1,093.6. This happens because closer to the settlement date, the accrued interest increases.

Summary

  • 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 at the end of an accounting period as an adjusting journal entry, which reverses the first day of the following period.
  • 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.