What is Accrued Interest in Accounting? Examples & Calculation

Introduction

Let us consider a company that has borrowed money or made an investment. Even though no payments have been exchanged, the interest starts accumulating immediately. Each day, interest increases, creating a liability if the company is the borrower or an asset if it’s the lender. By the end of the accounting period, this growing interest must be accounted for, even if cash hasn’t yet changed hands. This interest is called accrued interest in accounting, which basically means interest has been earned or incurred but has not yet been paid or received by the end of an accounting period.

Accrued interest ensures that financial statements reflect the full reality of ongoing financial obligations or earnings. In this blog, we will explore the concept of accrued interest, diving into its role in accounting and why it’s important for financial accuracy. We’ll also walk through practical examples and calculations of accrued interest, helping you understand how it applies to everyday business transactions. 

What is Accrued Interest? 

Accrued interest refers to the interest that has been earned or incurred on a financial obligation or investment but has not yet been paid or received by the end of an accounting period. It is an essential component for understanding an entity’s cash flow and financial health. 

This concept ensures financial statements reflect the entity’s actual financial position by recognizing interest as it accumulates, rather than waiting for the cash transaction to occur.

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Accrued Interest Formula 

The formula for calculating accrued interest depends on the principal amount, interest rate, and the time period for which the interest has accrued. Here’s the general formula:

Where:

Principal is the loan or investment amount.

Annual interest rate is the percentage rate applied to the principal annually.

Time Period is expressed as a fraction of a year (for example, for 6 months, the time period would be 6/12, for 90 days, it would be 90/365). 

Example of Accrual Interest in Accounting

Let us consider a company that has taken a $10,000 loan with a 5% annual interest rate, and you’re calculating interest over 90 days:

Accrued Interest=10,000 × 0.05 × 365/90 =123.29

So, the accrued interest for 90 days would be $123.29

What is Accrued Interest in Bonds?

Accrued interest in bonds refers to the interest that has accumulated on a bond since the last interest payment but has not yet been paid to the bondholder. Bonds typically pay interest periodically (e.g., semi-annually), but if a bond is sold between interest payment dates, the buyer must compensate the seller for the interest earned up to that point.

Example of Accrual Interest in Bonds 

Let us consider you own a $1,000 bond with a 6% annual interest rate. The bond pays interest every 6 months, which means you get $30 twice a year (because 6% of $1,000 is $60 annually, divided into two $30 payments).

Now, if you sell the bond 3 months after the last interest payment, the new buyer will owe you for the interest that’s been building up during those 3 months. 

To calculate the accrued interest:

• Semi-annual interest = $30 (half of the annual interest)
• Accrued interest for 3 months = Since 3 months is half of the 6-month period, the buyer will pay you half of the $30, which is $15.

So, the buyer will give you $15 in accrued interest to cover the time you owned the bond, and the buyer will receive the full $30 at the next payment.

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FAQs

1. What does accrued interest mean?

Accrued interest refers to the interest that has been earned or incurred but not yet paid or received by the end of an accounting period. It ensures that financial statements accurately reflect the true interest obligations or earnings, even if the cash transaction hasn’t occurred yet.

2. Is the accrued interest taxable?

Yes, accrued interest is taxable. It is considered income for the lender or investor and is subject to taxation even if the payment hasn’t been received yet. Tax authorities require that accrued interest be reported in the period it is earned, following the accrual method of accounting.

3. How to report accrued interest paid on purchases?

Accrued interest paid on purchases, such as bonds, should be reported as part of the purchase price but recorded separately in accounting. This amount is considered an interest expense and can be deducted from the total interest income when filing taxes, as it’s paid to the seller for earned interest.

4. How to calculate interest accrued on a loan?

To calculate interest accrued on a loan, use the formula:

Accrued Interest = Principal × Annual Interest Rate × Time Period

The principal is the amount borrowed, the interest rate is the percentage charged on that amount annually, and the time period is expressed as a fraction of the year. 

5. How to report accrued interest paid on bond purchases?

Accrued interest paid on bond purchases should be reported as part of the bond’s purchase price but listed separately in accounting records. This amount is recognized as an interest expense, which can be deducted when calculating taxable income, reflecting the interest earned up to the purchase date.

6. Is accrued interest an asset?

Yes, accrued interest can be considered an asset when it represents interest that has been earned but not yet received, such as in the case of loans or investments. It is recorded as an interest receivable on the balance sheet, reflecting the expectation of future cash inflow when the interest is eventually paid.