What it means
Interest is earned or incurred continuously, but it is usually paid at intervals: monthly, quarterly, half-yearly or annually. Between payment dates the amount owed grows day by day.
Accrual accounting requires that growth to be recognised as it happens. A company with a loan that pays interest every 30 June and 31 December still owes, on 31 March, three months of interest that has not been billed.
Recording that accrued interest ensures the March accounts show the true cost of borrowing and the true liability. The same applies in reverse for money lent or invested.
A bank holding a loan, or an investor holding a bond, has earned interest since the last coupon date even though nothing has been received. Recording it as accrued interest income and an accrued asset keeps the income statement and balance sheet accurate.
In the bond market, accrued interest also determines what a buyer pays. Bonds are quoted at a "clean" price that excludes accrued interest, but the buyer must pay the seller the "dirty" price, which adds the interest accrued since the last coupon.
That is fair: the buyer will receive the whole next coupon, including the portion that was earned while the seller owned the bond. Bond markets use day-count conventions (such as actual/365, actual/actual or 30/360) to calculate the exact accrued amount, and the convention varies by bond type and country.
For individuals, accrued interest most commonly appears on savings accounts (interest shown as earned but not yet credited), on mortgages and loans when a payment is made partway through a period, and on the settlement statement when buying or selling a bond.
In practice
Real-world examples.
Example
A savings account shows interest earned of $42.10 for the month, which will be credited on the first of the following month; on the month-end statement it is accrued interest.
Example
A company that draws down a loan on 20 November and prepares December accounts records 41 days of accrued interest even though the first payment is not due until February.
Example
A pension fund selling a government bond between coupon dates receives the clean price plus accrued interest from the buyer.
Think of it
“Accrued interest is like a running tab at a restaurant. The interest meter keeps running even though you haven't received or paid the bill yet.
Formula
Calculation
Accrued Interest = Principal x Annual Interest Rate x (Days Accrued / Days in Year)
Worked example 1, a borrower. A company has a $500,000 loan at 8% a year with interest paid every six months on 30 June and 31 December. It prepares accounts on 31 March.
- Days accrued from 1 January to 31 March = 90
- Accrued interest = $500,000 x 8% x (90 / 365) = $9,863
The 31 March accounts show interest expense of $9,863 for the quarter and an accrued interest liability of $9,863. When the $20,000 half-year interest is paid on 30 June, the liability is cleared and the remaining $10,137 is charged as expense for April to June.
Worked example 2, a bond purchase. An investor buys a $10,000 bond with a 6% annual coupon paid twice a year. The last coupon was paid 60 days ago and the market uses a 30/360 convention with 180-day half-years.
- Accrued interest = $10,000 x 6% x (60 / 360) = $100
- If the clean price is 98.50% of face value, the buyer pays $9,850 + $100 = $9,950
Ninety days later the buyer receives the full $300 coupon, of which $100 simply returns the accrued interest paid at purchase.Case study
Seen in the real world.
A property developer had a $6 million construction loan on which interest was rolled up and paid at completion rather than monthly. The bookkeeper, seeing no interest payments, recorded no interest expense for eighteen months. The management accounts showed the project comfortably profitable.
When the development completed and the bank presented its statement, accrued interest of $780,000 arrived in a single month, wiping out the reported profit of the two prior years and prompting a difficult conversation with the investors who had been paid distributions on the strength of those figures. The developer adopted a monthly accrual for all rolled-up interest and now shows the growing liability on every project balance sheet, so that reported profit and the eventual cash bill move together.
Watch out
Common mistakes.
- Recording interest only when it is paid. Rolled-up or infrequently paid interest then arrives as a shock and prior periods are overstated.
- Using the wrong day-count convention on bonds. Actual/365 and 30/360 give different answers, and settlement systems expect the market's convention.
- Forgetting to reverse the accrual when the cash is paid, which double-counts the expense.
Questions
People also ask.
Is accrued interest an asset or a liability?
For the borrower it is a liability (interest owed). For the lender or investor it is an asset (interest receivable).
Do I pay tax on accrued interest I have not received?
Rules vary by country and taxpayer type. Businesses using accrual accounting generally recognise it as income when earned; individuals are often taxed when it is credited or received.
Why do bond prices exclude accrued interest?
Quoting a clean price lets investors compare bonds without the distortion of where each one is in its coupon cycle. The accrued interest is added at settlement.
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