What it means
Interest accumulates every day that money is borrowed or lent, but payment usually happens monthly, quarterly or twice a year. At a reporting date falling between payments, part of the interest cost has been incurred without being paid.
Accrued interest records that part, so the expense matches the time the money was actually borrowed. For a borrower, accrued interest is an expense and a liability.
For a lender or investor, it is revenue and an asset, often called interest receivable. The same amount appears on both sides of the deal, with opposite effects, which makes it a handy cross-check between a borrower and its lender.
The calculation depends on the principal (the amount borrowed), the annual rate and the time elapsed. Lenders often use a day count convention, such as counting actual days over 365 or assuming 30-day months over 360, so the loan agreement should be read carefully.
Small differences in convention can change the figure by a noticeable amount on large loans. Accrued interest also matters when bonds are bought and sold between coupon dates.
The buyer pays the seller the interest that has built up since the last payment, on top of the bond's price. This is why bond quotes often distinguish between the clean price, which excludes accrued interest, and the dirty price, which includes it.
Ignoring accrued interest understates costs and overstates profit. Lenders reviewing a company's accounts also look at it, since a growing balance of unpaid interest can indicate cash pressure.
Regular accruals, posted at every period end, avoid distortions. Spreadsheet and loan systems usually calculate accrued interest automatically, but the accountant should still check the result.
A common error is using the wrong start date or forgetting that a repayment changed the principal part-way through the period. Checking the figure against the lender's statement catches most problems.
In practice
Real-world examples
Example 1
A manufacturer has a bank loan that charges interest on the last day of every quarter. Its year ends one month after the last payment, so it accrues one month of interest. This ensures the annual accounts show a full year of borrowing cost, not just the payments that happened to fall inside the year.
Example 2
An investor holds corporate bonds that pay interest twice a year. At the end of the reporting period, four months of interest have built up. She records it as interest receivable and includes it in her income for the year.
Example 3
A buyer purchases a government bond halfway between coupon dates. The seller is entitled to half of the coupon, so the buyer pays the quoted price plus the accrued interest. At the next coupon date, the buyer receives the full payment and keeps the half that belongs to the period of ownership.
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 (Time elapsed / Time in a year)
A company borrows $240,000 at 5% a year, with interest paid every six months. At the end of the third month after the last payment, three months of interest have accrued. Accrued interest = $240,000 x 0.05 x 3/12 = $3,000. The company records a $3,000 interest expense and a $3,000 accrued liability, which it clears when it pays the full six-month interest of $6,000.Case study
Seen in the real world
Oakhaven Farms is a fictional agricultural business that, in this illustrative story, borrowed $600,000 to buy equipment at 6% a year, with interest due every six months. Ten months later the owner prepared the first set of year-end accounts, which fell four months after the first interest payment.
The owner included only the interest actually paid, so the accounts showed an interest cost of $18,000. The lender, reviewing the accounts for a renewal, noticed that four further months of interest, or $12,000, had built up since that payment and were missing.
After the correction, interest expense was $30,000, which matches 6% on $600,000 for ten months. The profit fell, but the revised accounts were accepted, and the owner learned to book accrued interest at every period end.
Watch out
Common mistakes
- Recording interest only when it is paid. This leaves a gap between the cost incurred and the cost shown.
- Using the wrong day count convention. The loan agreement specifies how interest is calculated, and it should be followed exactly.
- Forgetting that investors also accrue interest. Interest earned but not yet received is income for the period.
Questions
People also ask
Is accrued interest an asset or a liability?
It depends on which side you are on. For the borrower it is a liability, whereas for the lender it is an asset known as interest receivable.
What is the difference between accrued interest and interest expense?
Interest expense is the total cost for the period, while accrued interest is the portion that is unpaid at the reporting date. The accrued part forms a section of the expense, and the rest has already been paid in cash.
Does accrued interest apply to bonds?
Yes, and it is especially important when bonds trade between coupon dates. The buyer compensates the seller for interest earned up to the settlement date.
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