Accrued Interest: Meaning, Calculation, Examples, and Accounting Treatment

 

Definition of Accrued Interest

Accrued interest refers to the amount of interest that has been earned or incurred on a financial instrument—such as loans, bonds, or deposits—but has not yet been paid or received by the parties involved. It represents interest accumulated over time but not yet settled in cash.

Meaning of Accrued Interest in Detail

In finance and accounting, transactions often occur on credit or over a period of time. When an entity borrows or lends money, interest accrues daily but is usually settled on a specific payment date (monthly, quarterly, semi-annually, or annually).

For example:

• A company issuing bonds must record the interest expense that has accumulated, even if it has not yet paid bondholders.

• Similarly, an investor holding a bond records accrued interest as income even before receiving the actual interest payment.

This ensures accurate representation of financial position and complies with the accrual basis of accounting, where expenses and incomes are recognized when incurred, not when cash is exchanged.

Sub-Sections for Clarity

In Finance

Accrued interest shows the true interest cost or income over time.

In Accounting

It is recorded through adjusting journal entries at the end of an accounting period to match expenses with revenues.

In Bonds

Bond investors often buy or sell bonds between coupon dates. The buyer compensates the seller for the accrued interest earned till the sale date.

Formula for Accrued Interest

The general formula is:

$$\text{Accrued Interest} = \text{Principal} \times \text{Rate of Interest} \times \frac{\text{Number of Days Accrued}}{\text{Total Days in Period}}$$

Where:

• Principal = Loan amount or face value of bond

• Rate of Interest = Annual interest rate

• Number of Days Accrued = Days passed since the last payment

• Total Days in Period = Days in the full interest period (e.g., 180 days for semi-annual coupon)

Example Calculation

A bond with a face value of ₹100,000 carries a 12% annual interest rate, payable semi-annually (every 180 days).

• Annual Interest = 100,000 × 12% = ₹12,000

• Semi-annual Interest = ₹12,000 ÷ 2 = ₹6,000

• Accrued Days = 45 (bond sold 45 days after coupon date)

$$\text{Accrued Interest} = 100,000 \times 12\% \times \frac{45}{180}$$ $$= 100,000 \times 0.12 \times 0.25 = ₹3,000$$

So, the buyer of the bond pays ₹3,000 accrued interest to the seller.

Journal Entry for Accrued Interest

When recording accrued interest in accounting books:

For Borrower (Expense side):

• Debit: Interest Expense

• Credit: Interest Payable

For Lender (Income side):

• Debit: Interest Receivable

• Credit: Interest Income

Example:

Company A borrowed ₹500,000 at 10% annual interest. At year-end, 3 months of interest (₹12,500) is accrued but not paid.

Journal Entry:

• Debit Interest Expense ₹12,500

• Credit Interest Payable ₹12,500

Detailed Illustration Calculation

Loan: ₹1,200,000
Rate: 8% annually
Interest Payable: Semi-annually (June 30 & Dec 31)

By March 31 (year-end), 3 months’ interest has accrued:

$$\text{Accrued Interest} = 1,200,000 \times 8\% \times \frac{3}{12}$$ $$= 1,200,000 \times 0.08 \times 0.25 = ₹24,000$$

Journal Entry at March 31:

• Debit Interest Expense ₹24,000

• Credit Interest Payable ₹24,000

Key Features / Components of Accrued Interest

• Based on accrual accounting principle

• Recognized even when not paid/received

• Occurs in loans, deposits, and bonds

• Affects both lenders and borrowers

• Needs precise day-count conventions (Actual/360, Actual/365, 30/360)

Importance of Accrued Interest in Business

• Ensures accurate matching of income and expenses

• Helps investors calculate the true cost of bonds

• Provides transparency in financial reporting

• Essential for valuation and taxation

• Prevents understatement or overstatement of profits

Advantages and Disadvantages

Advantages

• Accurate financial reporting

• Reflects true economic position

• Helps in fair valuation of securities

Disadvantages

• Complex calculations in bonds with irregular dates

• Requires consistent accounting treatment

• May cause confusion for beginners

Usage of Accrued Interest

• Banking and lending transactions

• Bond trading (settlement between buyer and seller)

• Corporate accounting (financial reporting)

• Tax calculations (interest income recognition)

Case Study: Accrued Interest in Bonds

In 2020, Indian Railway Finance Corporation (IRFC) issued bonds with semi-annual coupons. Many investors traded bonds before coupon dates. Buyers compensated sellers for accrued interest to ensure fair distribution of income. This case highlights the critical role of accrued interest in bond markets.

Practical Example

A student takes a car loan of ₹600,000 at 10% interest, repayable monthly. If the installment date is the 5th but the financial year closes on 31st March, the accrued interest for March is recorded as liability, even though it will be paid on 5th April.

Common Mistakes or Misunderstandings

• Treating accrued interest as cash paid instead of a liability/asset

• Ignoring day-count conventions

• Recording only on payment date (cash basis) instead of accrual basis

• Overlooking adjustments at financial year-end

Real-Life Applications and Legal Implications

• Banking: Recognizing loan interest receivable/payable

• Bond Market: Determining settlement price in bond transactions

• Corporate Finance: Accurate P&L reporting

• Taxation: Interest income taxed on accrual basis in many countries

• Legal Requirement: IFRS & GAAP mandate accrual accounting, making accrued interest reporting compulsory

FAQs

What is accrued interest?
It is the interest earned or incurred but not yet paid or received.

Is accrued interest an asset or liability?
For lenders, it is an asset (receivable); for borrowers, it is a liability (payable).

How is accrued interest calculated in bonds?
By multiplying face value, coupon rate, and fraction of days passed since last payment.

Does accrued interest affect profit?
Yes, it increases interest expense or income, directly impacting profit.

Expert Tip from Learn with Manika

👉 Always adjust accrued interest at the end of reporting periods. Ignoring it can misstate profits, affect tax liability, and mislead investors.

Related Terms

• Interest Payable
• Interest Receivable
• Coupon Rate
• Effective Interest Rate
• Accrual Accounting
• Bond Settlement Price