Accrued interest is the interest that has been earned but not yet received or paid on an investment, loan, or other financial instruments over a specific period of time. Under the accrual basis of accounting, financial events are recognized when they occur, regardless of when the cash is exchanged. Accrued interest is an important concept in accounting and finance as it ensures that interest income or expense is recognized in the appropriate accounting period, adhering to the matching principle and the revenue recognition principle.
For the party earning interest (such as an investor, bondholder, or lender), accrued interest is considered an asset, representing the right to receive the interest payment in the future. For the party owing interest (such as a borrower or bond issuer), accrued interest is considered a liability, representing the obligation to make the interest payment in the future.
To account for accrued interest, a company would record a journal entry that:
- Debits an interest receivable account and credits an interest income account (for the party earning interest).
- Debits an interest expense account and credits an interest payable account (for the party owing interest).
These journal entries ensure that interest income or expense is recognized in the same accounting period in which it was earned or incurred, in accordance with the matching principle and the revenue recognition principle.
Examples of common situations where accrued interest may arise include:
- bonds: Interest accrues on bonds between interest payment dates, and bondholders are entitled to receive the accrued interest when they sell the bond or when the bond matures.
- Loans: Interest accrues on loans, such as mortgages or business loans, between interest payment dates, and the borrower is obligated to pay the accrued interest on the next payment date.
- Bank accounts: Interest accrues on savings or checking accounts between interest payment dates, and the account holder is entitled to receive the accrued interest on the next interest payment date.
By recognizing accrued interest in the financial statements, companies and individuals can more accurately reflect their financial performance and obligations during a given accounting period, providing a clearer picture of their financial health for management, investors, and other stakeholders.
Example of an Accrued Interest
Let’s consider a hypothetical example to illustrate accrued interest.
Imagine a company called “ABC Manufacturing” that took out a $100,000 loan from a bank on July 1st, with an annual interest rate of 6%. The interest on the loan is to be paid quarterly, with the first payment due on October 1st. ABC Manufacturing follows the accrual basis of accounting, and its accounting period ends on September 30th.
To calculate the accrued interest, we need to determine the interest expense for the three months from July 1st to September 30th:
Principal amount: $100,000 Annual interest rate: 6% (0.06) Months: 3 (out of 12)
Accrued interest = Principal amount x Annual interest rate x (Months / 12) Accrued interest = $100,000 x 0.06 x (3 / 12) = $1,500
As the interest accrues but is not yet paid, ABC Manufacturing must record this accrued interest as a liability on its financial statements at the end of the accounting period on September 30th. The company would record the following journal entry:
Debit: Interest Expense – $1,500 Credit: Interest Payable – $1,500
This journal entry recognizes the interest expense incurred during the accounting period and records the obligation to pay the accrued interest on the next interest payment date, October 1st.
By recording the accrued interest, ABC Manufacturing ensures that its financial statements accurately reflect its financial performance and obligations for the accounting period, providing a clearer picture of its financial position for management, investors, and other stakeholders.