What is accrued interest (short definition)
– Accrued interest is interest that a lender has earned or a borrower has incurred but that has not yet been paid or received. Under accrual accounting, you record that interest in the period it is earned or incurred, not only when cash changes hands.
Key concepts and definitions
– Accrual accounting: an accounting method that recognizes income and expenses when they are earned or incurred, regardless of when cash is exchanged.
– Accounting period: the reporting period (month, quarter, year) for which financial statements are prepared. Accrued interest is measured as of the last day of that period.
– Revenue recognition principle: revenue is reported when earned, not when cash is collected.
– Matching principle: expenses are recorded in the same period as the related revenues they help generate.
– Clean (or flat) bond quote: a bond price quoted without accrued interest included. A buyer normally pays the clean price plus accrued interest owed to the seller.
How accrued interest is used in accounting (high level)
– For the lender (or investor): record accrued interest as Interest Receivable (asset) and Interest Revenue (income).
– For the borrower (or issuer): record accrued interest as Interest Expense (expense) and Accrued Liabilities or Interest Payable (liability).
– Classification: because accrued interest is normally expected to be settled within one year, it’s commonly shown as a current asset or current liability on the balance sheet.
– Adjusting and reversing entries: you typically record an adjusting entry at period end to capture accrued interest, then reverse that entry when the cash payment is made so the cash receipt/payment is recorded in the period when it occurs.
Checklist — steps to handle accrued interest
1. Identify the accounting period end and the last interest payment date.
2. Determine the day-count convention to use (e.g., ACT/365, ACT/360, 30/360); this affects the days calculation.
3. Count the number of days interest has accumulated since the last payment date up to the period end (or settlement date for bond trades).
4. Compute accrued interest: Interest = Principal × Annual rate × (Days accrued ÷ Day-count denominator).
5. Post adjusting journal entry at period end:
– Lender: Debit Interest Receivable; Credit Interest Revenue.
– Borrower: Debit Interest Expense; Credit Accrued Liabilities (Interest Payable).
6. When cash is paid/received, reverse the accrual (if using reversing entries) and record the cash transaction.
7. For bond trades, add accrued interest to the purchase price paid to the seller; the buyer will receive the full next coupon.
Worked numeric example — loan accrual and subsequent payment
Assumptions
– Loan principal: $20,000
– Annual interest rate: 7.5% (0.075)
– Accounting month: April with interest payable on the 20th of each month
– Use actual/365 day-count for illustration
Step A — Accrual at month end (April 30)
– Interest days accrued from April 21–30 = 10 days.
– Accrued interest = 20,000 × 0.075 × (10/365)
= 20,000 × 0.075 × 0.027397 ≈ $41.10
Adjusting entry on April 30
– Lender (to record revenue earned but not yet received):
– Debit Interest Receivable $41.10
– Credit Interest Revenue $41.10
– Borrower (to record expense incurred but not yet paid):
– Debit Interest Expense $41.10
– Credit Accrued Liabilities (Interest Payable) $41.10
Step B — Cash payment on the 20th of the next month (covers 30 days)
– Total interest for the 30-day period (1–30 of month) = 20,000 × 0.075 × (30/365) ≈ $123.29
– Of that total, $41.10 was already recorded for the prior month (the reversing entry will cancel the accrual), so the remaining $82.19 is recognized as interest income/expense in the second month.
– Journal when cash arrives (after reversing the accrual):
– Cash received: Debit Cash $123.29
– Reverse receivable: Credit Interest Receivable $41.10
– Recognize remaining interest revenue: Credit Interest Revenue $82.19
(Analogous entries apply for the borrower, using Interest Payable and Interest Expense.)
Worked numeric example — basic bond accrued-interest illustration
Assumptions
– Bond face value: $1,000
– Annual coupon rate: 5% (paid semiannually)
– Coupon dates: June 1 and Dec 1
– Purchase date: Sept 1
– Use actual/365 day-count for illustration
Step 1 — Semiannual coupon amount = 1,000 × 0.05 / 2 = $25
Step 2 — Days from last coupon (June 1) to purchase (Sept 1) = 92 days (June 1 → Sept 1)
Step 3 — Accrued interest = 1,000 × 0.05 × (92/365) ≈ $12.60
Practical implication: when you buy the bond on Sept 1 you pay the seller the clean price plus about $12.60 of accrued interest. You will receive the full $25 coupon on the next coupon date (Dec 1), so your net cash return accounts for that interim compensation to the seller.
Common pitfalls and choices to check
– Day-count convention matters: ACT/365 vs ACT/360 vs 30/360 produce different accrued interest amounts.
– Reversing entries: beneficial when you want the cash receipt/payment recorded cleanly in the next period; confirm your accounting system’s approach.
– Bond trades: broker conventions and settlement rules (trade date vs. settlement date) affect the precise days counted and the accrued interest amount.
– Classification: confirm whether accrued interest is short-term (current) or, in rare cases, long-term, given anticipated settlement timing.
References (further reading)
– Investopedia — “Accrued Interest” (explains accrual accounting application to interest)
https://www.investopedia.com/terms/a/accruedinterest.asp
– FINRA — “Bonds” (investor guide to bond basics, coupons, and settlement)
https://www.finra.org/investors/learn-to-invest/types-investments/bonds
– U.S. Securities and Exchange Commission (SEC) — “Investor Bulletin: Fixed Income Securities”
https://www.sec.gov/reportspubs/investor-publications/investorpubsfixedincomehtm.html
Educational disclaimer
This explainer is for educational purposes only and does not constitute individualized investment or accounting advice. For decisions affecting your finances or formal financial statements, consult a qualified accountant or licensed financial professional.