The accrual basis of accounting entails the recording of revenue and expenditure on the date when a particular transaction occurs, even if the payment is yet to be completed. For instance, if company A has purchased goods on credit from company B on February 10, 2024, and the payment is to be made a month later, the transaction would be recorded in both companies’ books on February 10, 2024, rather than on the date when the payment is completed. Amongst the pivotal elements of accrual accounting is the accrued interest.
In this article, we shall discuss the meaning of accrued interest and how it is treated in accounting.
What is accrued interest?
Accrued interest refers to interest that builds up over time but has not yet been paid or received. It applies to both loans and investments.
For borrowers, accrued interest is the unpaid interest owed on a loan. For investors or deposit holders, it represents interest earned on an investment that has not yet been credited.
For example, if interest is payable on the 20th of every month and the month ends on the 30th, the interest earned from the 21st to the 30th is considered accrued interest because it has been earned but not yet received.
From an accounting perspective, accrued interest can be recorded as either income or an expense. If a business lends money, accrued interest is recognised as revenue. If it borrows funds, the accrued amount is treated as an expense.
Accrued interest is also reflected on the balance sheet. Outstanding amounts yet to be received are recorded as assets, while amounts due for payment are shown as liabilities. Since these are generally settled within a year, they are usually classified as current assets or current liabilities.
How is accrued interest treated in accounting?
The accrued interest for any particular period is recorded in the books of account, right from the journal to the statement of profit and loss and the balance sheet. Accrued interest due to be paid/ received by a company is recorded in the journal as an adjusting entry. For outstanding interest, there is a journal entry debiting the Interest Expense account and crediting the Accrued Interest Payable account. To record receivable interest, the Accrued Interest Receivable account is debited, and the Interest Revenue account is credited.
In the income statement of a company, accrued interest is recorded as an outstanding expense if it is to be paid and as an outstanding revenue if it is to be received. For the balance sheet, Accrued Interest Receivable is treated and recorded as a Current Asset (since accrued interest is usually for a period lower than one year), and Accrued Interest Payable is recorded as a Current Liability.
Additional read: What are Assets
Example of accrued interest
Let us understand how accrued interest is recorded in the account books through an example. Let us assume Company P has taken a loan of Rs. 12 lakh from Bank X at 10% per annum. The monthly instalments for the aforementioned loan is due on the 5th of each month. For the accounting period of any subsequent month (once the loan repayment begins), the total interest due shall be Rs. 10,000 and accrued interest shall be Rs. 8,333 (considering 30 days in a month).
What is accrued interest on bonds?
The concept of accrued interest is also applicable to investments. Therefore, when you purchase or sell a bond, the transaction amount shall be computed after taking into account the accrued interest on the investment. The interest on bonds is usually paid out on a yearly or bi-annual basis. If a bond is purchased within two interest payouts, the purchaser must add the accrued interest on the bond to the amount to be paid to the seller. This is done because the interest on the bond prior to the date of purchase is owed to the previous owner of the instrument.
Additional read: Capital Adequacy Ratio
Example of accrued interest on bonds
Let us understand how interest accrued on bonds is treated in the event of the sale of a bond. A purchases a bond with a face value of Rs. 1 lakh and 10% fixed annual interest from B on July 1, 2023. The interest for the bond is paid out on December 31. B is entitled to accrued interest from January 1, 2024, to June 30, 2024. The accrued interest for six months, that is, Rs. 5,000, shall be added to the purchase amount, and A will have to pay Rs. 1,05,000 to B for the purchase of the bond and the accrued interest. On December 31, 2024, B shall receive interest on the bond for the entire year (Rs. 10,000).
Conclusion
Accrued interest is an integral element of the accrual concept of accounting. Not only is it important from a transparency and full disclosure point of view, but it is also essential to comply with the revenue recognition concept and matching principle of accounting. By recording accrued interest in its books of accounts (both payable and receivable), a business can ensure that all transactions are being recorded as per the timeline of their occurrence, irrespective of when the payment is settled. Understanding the concept, workings, and accounting treatment of accrued interest is pivotal for modern-day businesses and their various stakeholders.
