Accrued interest is a term used to describe the interest that has been incurred on a loan or other financial obligation but has not yet been paid out. It applies to various financial instruments, including bonds and loans, and is an important concept to grasp for both lenders and borrowers. In this article, we will explore the definition of accrued interest and provide an example to illustrate how it works.
Definition of Accrued Interest
Accrued interest is the amount of interest that has "built up" between the last payment and the present. When a bond or loan is involved, accrued interest accounts for the interest that is calculated on a per diem basis for the time between payments. It represents the interest that has accumulated since the last interest payment.
Accrued Interest in Bond Transactions
When a bond is sold from one person to another, the buyer needs to compensate the seller for the accrued interest since the last interest payment. This is because the corporation or municipality that issued the bond will make regular interest payments to the bondholders. The sale price of the bond must factor in the accrued interest to ensure a fair transaction for both parties.
After the bond is sold, the new owner receives the interest payment for the period they held the bond. The accrued interest is included in the calculation of the payment, allowing the new owner to receive the appropriate interest amount based on the duration of their ownership.
Accrued Interest in Debt and Loans
In the context of debt and loans, accrued interest refers to the total amount of interest payments due to the lender since the last payment was made. It represents the interest that has accumulated during that period and is added to the outstanding balance.
Accrued Interest and Accrual Accounting
Accrued interest is a fundamental concept in accrual accounting. Accrual accounting is a method that records transactions when they occur, rather than when the cash is exchanged. It follows the revenue recognition and matching principles of accounting.
At the end of an accounting period, accrued interest is booked as an adjusting journal entry. This entry ensures that the interest expense or revenue is properly recognized in the financial statements. The accrued interest is then reversed on the first day of the following accounting period.
Calculating Accrued Interest
The calculation of accrued interest depends on the specific terms of the financial instrument and the accounting period. For example, if interest is payable on the 20th of each month, and the accounting period ends on the last day of each calendar month, the calculation of accrued interest for the month of April would involve considering the 10 days of interest from the 21st to the 30th. This accrued interest would be posted as part of the adjusting journal entries at the end of the month.
Accrued interest is an essential concept in the world of finance and accounting. It represents the interest that has accumulated on a loan or financial obligation but has not yet been paid out. Whether it is applied to bonds or loans, accrued interest plays a vital role in ensuring fair transactions and accurate financial reporting. Understanding accrued interest is crucial for both lenders and borrowers as it helps them account for and manage the interest obligations associated with their financial instruments.
Summary
Accrued Interest applies to a bond or loan, accounting for the interest that is calculated per diem for the time between payments.
Accrued Interest is the amount of interest that has "built up" between the last payment and the present, with regards to bonds and loans. If a bond is sold from one person to another, and the corporation or municipality that issued the bond pays out an interest payment at regular intervals, the sale price will have to factor-in the "accrued interest" since the last distribution, and the buyer will have to pay the seller for the accrued interest due while the latter held the bond.
When the next interest payment comes in, the new owner of the bond nets the interest from the time since he acquired it. In terms of debt and loans, of course, accrued interest can mean the total amount of interest payments due to the lender since the last payment.
Accrual accounting is used by corporations for their balance sheets. It also plays a role in investments such as CMOs, where debts are pooled in tranches.