Accrued Interest Definition & Example

Accrued Interest: Introduction

One of the key ideas in banking and business is accrued interest. It refers to the interest that builds up over time on a debt or other financial asset but has not yet been paid out. Because it affects borrowing costs and can have a big effect on someone's expenses, accrued interest is essential to comprehend. An in-depth explanation of accumulated interest, including what it is, how it is determined, and how it can affect an individual's wealth, is provided in this article.

What is Accrued Interest?

The interest that builds up over time on a loan or other financial instrument that is yet to be paid is known as accrued interest. It represents the total interest that has accrued since the last payment. Due to the fact that accrued interest has not yet been paid, it is frequently referred to as "unearned interest".

According to whether the business is lending or borrowing, accrued interest is shown on the income statement as a revenue or expense. Additionally, an asset or liability is shown on the balance statement for the part of income or expenditure that has not yet been paid or collected. Accrued interest is frequently categorized as a current asset or current liability because it is anticipated to be received or paid within a year.

How does Accrued Interest work?

The accrual-based bookkeeping method includes the entries related to accrued interest. Interest is not noted in the books of accounts on the day it is paid or received but rather on the date it becomes due (or incurred), whether outstanding or receivable. The matching idea and the income recognition principle of bookkeeping are satisfied in this way. On a debt or investment with an interest rate affixed, accrued interest builds up over time.

Loans and accrued interest function similarly. For example, until the loan is repaid, interest will be charged on the outstanding amount as per the defined annual interest rate. In the event that you make a loan payment, a portion will be treated to the principal amount of the loan, and the remaining portion will be treated to the accrued interest.

In general, accrued interest is a method to keep track of how much interest has been gained over time, even if it hasn't been paid out or received yet.

Types of Accrued Interest

1. Basic Interest

The simplest kind of interest is this one, which is determined as a percentage of the principal debt amount and is accumulated daily, weekly, or monthly. Later, when the interest is applied to the principal amount, interest is then calculated on the larger, new balance.

2. Compound Interest

In this form of interest, interest is computed on both the original principal amount and any interest that has accumulated since the last payment, in addition to the original principal balance. As a result, interest can compound more rapidly over time because interest itself generates interest.

3. Accrued Interest Bonds

These bonds have accrued interest, but the interest payments to the bondholder have not yet been paid. The accumulated interest shall be paid by the Bond Issuer at a later period.

4. Accrued Expenses

These are costs that an organization has incurred but has not yet made payments. A business would incur an accrued expenditure, for instance, if it hired an expert for a month to work on a project but did not pay the consultant until the end of the month.

Accrued Interest Formula

A specific accrual time is used to compute accrued interest. The method or formula used for this is as follows:

Accrued interest = Principal amount * (rate of interest/365) × accrual period

How is Accumulated Interest determined?

Accrued interest is typically calculated on a daily basis. Based on the principal sum of the debt and the interest rate levied by the lender, interest is calculated daily. The loan's principal sum is multiplied by the interest rate, which is subsequently divided by 365 (the number of days in a year) to determine the amount of interest that will be charged on a specific day.

For instance, if a loan has a principal sum of $10,000 and an interest rate of 5%, the daily interest accrued would be $1.37 ($10,000 x 5% / 365).

Accrued Interest in Accounting

The accrual accounting technique is used to record accrued interest because it notes revenue and expenditures as they are incurred, as opposed to when they are paid or received. Accordingly, interest revenue will still be recorded in a company's financial records even if it has been earned but has not yet been paid.

Accounting considers accrued interest to be significant because it reflects revenue that has been made but not yet received or expenses that have been incurred but not yet paid. Accrued interest must be recorded correctly for the financial statements to represent the company's financial situation accurately.

Example of Accrued Interest in Accounting

Take the example of a business that owns a $10,000 bond with a 5% yearly interest rate. Although the company's financial statements are produced on a quarterly basis, the interest on the bond is paid yearly. However, the business would have made $250 (i.e., $10,000 x 5% x 1/4) in income on the bond investment at the end of the first quarter.

In this case, the business would have to report a $250 accrued interest obligation at the end of the first quarter, though, because the interest is not paid until the end of the year. This is because although the business has made the interest, it has not yet been paid.

The journal entry to record the accrued interest liability would be as follows:

Debit Interest Receivable: $250

Credit Accrued Interest Payable: $250

Bond Accrued Interest

Bonds are excellent additions to your investment portfolio because they are debt securities that are frequently exchanged by investors. Bonds have a coupon rate at which interest is given to the bondholder. Interest is typically given out yearly or semi-annually. When interest is paid as a bondholder, you may not hold the bond. However, you will still continue to earn interest.

When buying or selling bonds, you should take the accrued interest into account. In the form of consistent interest payments, bonds provide the owner with repayment for the money they have lent. Generally speaking, these interest payments-also known as coupons-are made every two years.

Accrued Interest in Bonds - Example

Bond interest is computed on an accrual basis. Let us understand this with the help of the following example:

Let's pretend for a second that you wish to buy a $1,000 bond with a 5% semiannual coupon. On September 30, you intend to acquire the bond. On June 1 and December 1, each year, there is a double interest payment. How much interest would have accumulated in the case?

Bond markets determine the precise amount of accrued interest using a variety of slightly different day-count systems. We are going to use that day-count convention in this example since most corporate and municipal bonds issued in the US follow the same 30/360 norm, which presumes that each month has 30 days (independent of the actual number of days in a given month). So, we calculate the accrued interest using the below steps:

Step 1: Determine the precise number of days that have passed between the last coupon payment date (June 1) and the date of your transaction (September 30). The number of days in this illustration is 120 (based on the 30/360 norm).

Step 2: Multiply the day count by the daily interest rate, as well as the bond's face value, to determine the accrued interest.

As a result, the accumulated interest is $16.67 or 120 × (5% / 360) * $1,000.

Step 3: To get your purchase price, add the accumulated interest to the bond's face value.

The bond purchase price is $1,000. We add $16.67 to this, making a total value of $1,016.67.

You will earn $25 in interest on the next coupon payment date (December 1). The net interest you get is $8.33 ($25 - $16.67), which is exactly the amount of interest you should have earned for the 60 days you possessed the bond before the next coupon payment (September 30 to December 1), but since you paid $16.67 in accumulated interest when you bought the bond, you should have received that amount of interest.

What are the implications of Accrued Interest?

Understanding the effects of accrued interest is crucial for both borrowers and lenders. The accrued interest for lenders can assist in ensuring that they receive the entire quantity of interest that is owed. Borrowers should be conscious that as interest accrues, the overall amount of their debt will increase with higher interest rates and lengthier loan terms.

Understanding the effects of accrued interest is crucial for borrowers because it helps with budgeting. If a borrower does not anticipate the additional interest, they may not be able to afford the full repayment amount when it is due. Borrowers should also be conscious that interest is cumulative, which means that interest will also be assessed on interest that has already accrued. This may cause the overall debt to rise considerably.

A person's financial situation may be significantly impacted by accrued interest. For instance, when paying off a debt, the borrower must also pay the accrued interest in addition to the initial amount. As a result of the accumulated interest, the overall cost of the loan will be greater than the principal amount. The overall cost of a loan can also be significantly impacted by the interest that accumulates over time, particularly if the loan has a longer term.

Accrued interest can also have an impact on a person's taxes. In some cases, a person may be able to deduct the amount of accrued interest they have paid on their taxes. However, this is only applicable in certain circumstances and should be discussed with a tax professional.

The Bottom Line

Since it can significantly affect a person's money, accrued interest is a crucial idea to comprehend. It is the interest that builds up over time on a loan or other financial instrument and is usually paid at the end of the loan period or when the loan or instrument is sold or refinanced. Daily accrued interest computations can significantly affect the overall cost of a debt or other financial asset. In addition, a person's taxes may be impacted by accumulated interest based on the situation.