Accrued interest refers to the interest that has accumulated on a debt or financial instrument but has not yet been paid or received by the borrower or lender. It is an important concept in both accounting and bonds, and understanding how it works is crucial for financial analysis and decision-making.
What is accrued interest?
Accrued interest is the interest that has been earned or incurred over time but has not yet been paid or received. It applies to both borrowing and investing.
For borrowers, accrued interest is the amount they owe on a loan but haven’t paid yet. For investors or savers, accrued interest is the amount they have earned on an investment, but haven’t received yet.
Imagine this: Let’s say you have an interest payment due on the 20th of each month, and the month ends on the 30th. From the 21st to the 30th, you’ve actually earned interest, but you haven’t received it yet. This unpaid interest is what we call “accrued interest.”
Now, where it gets interesting (pun intended) is how it’s recorded. If your company lends money, accrued interest is counted as revenue on the income statement. But if you’re borrowing, it’s an expense. So, it can either be money you’re making or money you owe.
Accrued interest also shows up on your balance sheet. The part of the revenue or expense that’s still waiting to be paid or collected is listed as an asset or liability. And because it’s usually expected to be settled within a year, we often label it as a current asset or current liability.
Types of accrued interest
Accrued interest can be divided into two types concerning personal finance-
1. Accrued interest when borrowing
For loans or credit cards, interest is the cost of borrowing the money. So, when you take a loan or use a credit card, accrued interest represents the amount of interest accumulated on your outstanding loan balance since your last payment. This amount will be added to the loan amount.
This accrued interest is an expense and must be paid at regular intervals, such as monthly or quarterly, depending on the loan terms, to reduce the burden of interest payments on the loan.
2. Accrued interest when investing or saving
When you invest in interest-bearing instruments such as savings accounts, bonds, or certificates of deposit (CDs), accrued interest represents the interest accumulated since the last interest payment or compounding date. This interest is earned but not yet received or credited to your account.
How to Calculate Accrued Interest?
To calculate the accrued interest, you can use the following formula:
Accrued Interest = (t / T) * PMT
Where:
t = Days from the last payment date to the settlement date
T = Days in the coupon payment period
PMT = Coupon payment of each period
Accrued interest formula
The formula for calculating accrued interest is given below-
Accrued interest = (t/T) * PMT,
Where t = number of days from the last payment date to the settlement date
T = Number of days in the coupon payment period
PMT = Coupon payment of each period
Difference between interest & accrued interest
Understanding the difference between interest and accrued interest is crucial to manage your income and expenses better. Here’s a brief overview of their differences-
Features
Interest
Accrued Interest
Definition
Interest is the percentage charged for borrowing money or the return on investment for lending money.
Accrued interest is the amount of interest that has accumulated on a loan or investment up to a specific point in time but has not yet been paid or received.
Payment duration
Interest is paid or received according to a fixed schedule, such as at the end of a loan term or periodically in case of investments.
Accrued interest accumulates over a period of time and represents the interest earned or owed from the last payment date to the present.
Application
Applies to various financial products, including loans, bonds, savings accounts, and investments, where payments are made on a scheduled basis.
Mostly relevant for loans, bonds, and other interest-bearing financial instruments where interest accrues before the payment date.
Accounting treatment
Interest is recognized as an expense (for borrowers) or income (for lenders) when it is actually paid or received.
Accrued interest is recorded as an expense (for borrowers) or as income (for lenders) before the actual cash transaction occurs, ensuring accurate financial reporting.
Accrued interest in accounting: Explanation with examples
Accrued interest in accounting requires the use of adjusting entries to record the interest income or expense and the corresponding receivable or payable account. These entries are made at the end of the accounting period to ensure accurate financial reporting.
Let’s consider a practical example to understand the accounting treatment of accrued interest. Suppose a company has borrowed $100,000 from a bank at an annual interest rate of 8%, and the interest is payable annually. The accounting period ends on December 31, and the interest payment is due on January 15 of the following year.
To accurately reflect the interest incurred in the current accounting period, the company needs to record the accrued interest as an adjusting entry. This entry would involve debiting the interest expense account and crediting the accrued interest payable account.
The journal entry would look like this:
Interest Expense $8,000
Accrued Interest Payable $8,000
This entry recognizes the interest expense of $8,000 for the current period and establishes a liability of $8,000 for the accrued interest payable
How accrued interest affects bond trading and financial reporting?
To provide a practical understanding of accrued interest, let’s explore some real-world examples and applications.
Corporate Bonds: When trading corporate bonds in the secondary market, the buyer needs to compensate the seller for the accrued interest. This ensures that the seller receives the interest earned since the last payment date, while the buyer will receive the full interest payment on the next coupon payment date.
Fixed Income Securities: Accrued interest is an important consideration when buying or selling fixed income securities such as Treasury bonds, municipal bonds, or corporate bonds. The buyer needs to account for the accrued interest to ensure a fair transaction.
Accounting for Interest Expense: Accrued interest plays a crucial role in accurately reflecting the interest expense in a company’s financial statements. It allows for a more accurate representation of the company’s financial health and performance.
Conclusion
Accrued interest is a fundamental concept in both accounting and bonds. It represents the interest that has been incurred or earned but not yet paid or received. Understanding how accrued interest is calculated and accounted for is crucial for financial analysis and decision-making.
By properly recording accrued interest through adjusting entries, companies can ensure accurate financial reporting and reflect the interest expenses or income for the relevant accounting period.
As you navigate the world of finance, consider exploring business loan to meet your financial needs. Tata Capital offers business loan solutions that can help you achieve your goals.
What is the difference between earned, accrued & paid interest on an investment?
Earned interest is the total interest accumulated, accrued interest is the portion earned but not yet received, and paid interest is the amount already disbursed to the investor.
What is the difference between interest payable and accrued interest?
Interest payable refers to the total interest due for payment, while accrued interest is the interest accumulated but not yet paid, recorded in financial statements before the payment date.
What is an example of accrued interest?
If a bond pays interest every six months and is sold before the next payment date, the seller receives compensation for the accrued interest earned since the last payout.
How to record accrued interest?
Accrued interest is recorded as an adjusting journal entry, debiting the interest expense (for borrowers) or interest income (for lenders) and crediting the accrued interest liability or asset account.
What is the difference between interest and accrued interest?
Interest is the total amount charged for borrowing money. Accrued interest is the portion that builds up each day but isn't paid yet.
Is accrued interest a good thing?
It benefits lenders by tracking income not yet received. For borrowers, it means interest keeps adding even before repayment starts.
Is accrued interest debit or credit?
For a borrower, accrued interest is treated as a credit because it increases liabilities. For a lender, it is recorded as a debit since it reflects expected income.
03 April 2025
6 mins read
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