What is Accrued Interest?
Accrued interest refers to the part of the interest that has occurred, but the payment has not been made or received by the borrower or the lender yet. It has different meanings under the accounting perspective and the bond perspective.
- As a feature of accrual-based accounting, accrued interest is the amount of interest that has been incurred in a reporting period, while the cash payment has not been made yet in that period.
- The adjusting entry for accrued interest consists of an interest income and a receivable account from the lender’s side, or an interest expense and a payable account from the borrower’s side.
- Accrued interest in bonds refers to the interest that has been incurred but not paid since the last payment day of the bond interest.
Accrual Interest in Accounting
Under the accounting perspective, accrued interest is the amount of interest of a financial obligation that has been incurred in a reporting period, while the cash payment has not been made yet in that period.
It is a feature of accrual-based accounting, which requires revenues and expenses to be recorded in the accounting period when they are incurred, regardless of when the cash payments are made. The accrual-based accounting method can reveal a company’s financial health more accurately than the cash-based method.
The amount of accrued interest is posted as accrual adjusting entries by both borrowers and lenders at the end of each month. The entry consists of an interest income or expense account from the income statement, and a receivable or payable account from the balance sheet. Since the payment of accrued interest is generally made within one year, it is classified as a current asset or current liability.
The borrower’s entry includes a debit in the interest expense account and a credit in the accrued interest payable account. The lender’s entry includes a debit in accrued interest receivable and a credit in the interest revenue.
Accrual Interest in Accounting – Example
For example, on March 21, a company borrows $100,000 from a bank at an annual interest rate of 6%, and its first interest payment is due in 30 days on April 20. The annual interest is $6,000 ($100,000 * 4%), and the monthly payment is $500 ($6,000 / 12).
Assuming the accounting period ends on March 31 for both the lender and the borrower, the interest payment incurred within the period of March covers ten days. Therefore, the accrued interest for the accounting period will be $166.67 ($500 * 10/30). The company and the bank’s adjusting entries are shown below:
Accrued Interest in Bonds
Under the bond perspective, accrued interest refers to the part of the interest that has been incurred but not paid since the last payment day of the bond interest. Bonds can be traded in the market every day, while their interests are usually paid annually or semi-annually.
Accrued interest occurs when a bond is not traded on its coupon payment date. It is the part of the interest that a bond buyer gives up from the last coupon payment date to the date the bond is bought. The amount of accrued interest can be calculated by the formula below:
- AI = Accrued interest
- t = Days from the last payment date to the settlement date
- T = Days in the coupon payment period
- PMT = Coupon payment of each period
There are two typical methods to count the number of days in a coupon payment period (T) and the days since the last coupon period (t).
One is the actual/actual convention, counting the actual number of days, which is generally used for U.S. Treasury bonds and notes. The other one is the 30/360 convention, assuming 30 days for a month and 360 days for a year, which is usually used for corporate bonds.
The amount of accrued interest should be earned by the bond seller. The quoted price in the bond market, known as the clean price or flat price, does not include any accrued interest. When a bond is traded between two coupon payment dates, its full price (also known as dirty price), which is the present value of its future cash flows, is the sum of two parts: the accrued interest and the flat price.
Accrued Interest in Bonds – Example
For example, a Treasury bond with a $1,000 par value has a coupon rate of 6% paid semi-annually. The bond matures in two years, and the market interest rate is 4%. The last coupon payment was made on March 31, and the next payment will be on September 30, which gives a period of 183 days.
The coupon payment for each period is $30 ([6%/2] * $1,000). If a trader buys the bond on May 31, the accrued interest will be $10 ($30 * [61/183]) with the actual/actual day-count convention.
The full price will be the present value of future cash flows calculated as below:
The flat price can be calculated by subtracting the accrued interest part from the full price, which gives a result of $1,028.08.
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