Accrued Interest

Definition

Accrued interest is interest that has been earned or incurred but not yet paid. Under accrual accounting, it must be recorded in the period in which it is earned or incurred—even if cash changes hands later. For lenders this appears as accrued interest revenue (an asset); for borrowers it appears as accrued interest expense (a liability).

Key takeaways

• Accrued interest arises from accrual accounting and follows the revenue recognition and matching principles.
• It is recorded as an adjusting entry at the end of an accounting period and typically reversed at the start of the next period.
• On financial statements, accrued interest appears on the income statement (revenue or expense) and on the balance sheet as a current asset or current liability.

How accrued interest is recorded

1. Determine the interest that has accumulated through the end of the accounting period.
2. Make an adjusting journal entry:
3. Lender (receivable): Debit Interest Receivable, Credit Interest Revenue.
4. Borrower (payable): Debit Interest Expense, Credit Accrued Liabilities (or Interest Payable).
5. Classify the receivable or payable as current if it is expected to be settled within one year.
6. On the first day of the next period, post a reversing entry so the cash receipt/payment when made flows to the proper period without double-counting.

Why accrual accounting matters

Accrual accounting records transactions when they occur, not when cash is exchanged. Two guiding principles:
* Revenue recognition: recognize revenue when earned.
* Matching principle: record expenses in the same period as the revenues they help generate.

Example: If a company uses a loan-financed asset for a month but interest is payable the next month, the company must accrue the interest expense for that month to match the expense with the period in which the asset generated revenue.

Numerical example (loan receivable)

Loan: $20,000 at 7.5% annual interest. Payment received through the 20th of the month; accounting period ends on the 30th. Accrued interest for 10 days (21st–30th):

Interest = 7.5% × (10 / 365) × $20,000 = $41.10

Journal entries:
* Lender: Debit Interest Receivable $41.10; Credit Interest Revenue $41.10.
* Borrower: Debit Interest Expense $41.10; Credit Accrued Liabilities $41.10.

When the cash payment is received the next month (example: $123.29 covering 30 days), the prior period’s $41.10 reversing entry ensures only the current-period portion is recognized in the current month.

Accrued interest and bonds

When bonds trade between coupon dates, accrued interest must be paid by the buyer to the seller because the upcoming coupon will be paid to the bondholder of record on the coupon date.

Terms:
* Clean (flat) quote: bond price excluding accrued interest.
* Dirty price: clean price plus accrued interest.

Bond example:
* Face value: $1,000; annual coupon: 5% paid semiannually ($25 per payment on June 1 and Dec. 1).
* Purchase date: Sept. 30. Using the 30/360 day-count convention, days since last coupon (June 1) = 120.
* Accrued interest = 120 × (5% / 360) × $1,000 = $16.67.
* Purchase price = $1,000 + $16.67 = $1,016.67.

At the next coupon payment (Dec. 1), you receive $25. Net interest for your holding period equals $25 − $16.67 = $8.33, which corresponds to the interest for the days you owned the bond.

Day-count conventions (e.g., 30/360, actual/365) vary by market and affect the precise accrued interest calculation.

Accounting period

An accounting period is the interval (month, quarter, year, etc.) over which financial activity is measured and reported. Accrued interest is calculated as of the end of the chosen accounting period to ensure revenues and expenses are recognized in the correct period.

Bottom line

Accrued interest ensures interest income and expense are recognized when earned or incurred, not when cash is exchanged. It affects income statements and balance sheets, is recorded via adjusting journal entries, and is particularly important when buying or selling interest-bearing instruments such as bonds.