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Interest grows on a daily basis, but most businesses don’t make daily payments. If you use the accrual accounting system, you’ll need to record accrued interest for each accounting period. Keep reading to find out how this works.
Accrued interest explained
Accrued interest is used in accrual accounting, following the matching principle. It offers a way to account for interest that has accrued over time without yet being paid. In accrual accounting, transactions must be recognized when they occur whether or not the payment has been received. Recording accrued interest on your income statement keeps your books in line with this revenue recognition principle.
This type of interest can be applied to any loan or other financial obligation. It’s applicable to both the lender, as accrued interest revenue, and the borrower, as accrued interest expense. The term can also apply to bond interest, referring to the quantity of interest that has built up since the most recent payment.
Imagine that a business takes out a loan to purchase company equipment. It pays interest on this loan on the first day of the month. There could be some time that the company uses this equipment to generate revenue throughout the month before making its first interest payment. The business would record interest it expects to pay on the first of the following month in its current monthly records. The bank would also record this interest as income for the current monthly accounting period, despite not physically receiving the payment yet.
Accrued interest formula
You can calculate how much interest should be recorded using the following accrued interest formula:
This basic formula lists the interest rate as a percentage and works best with accounting periods based on the calendar month or year. You can adjust it to fit your business’s financial terms or obligations as needed.
How to calculate accrued interest
When looking at how to calculate accrued interest, you’ll need to plug a few variables into the formula above. For example, a $15,000 loan receivable with a 10% interest rate receives a payment on the 20th day of the month. To record the extra interest revenue earned between the 21st and 30th days of the month, you’d calculate it using the formula:
This value of $41.10 would be the amount of accrued interest covering the final ten days of the calendar month for this accounting period.
How to record accrued interest
You can record accrued interest at the end of any accounting period as an adjusting journal entry. When the next accounting period begins, this adjusting entry is reversed. To determine how to record accrued interest, you must add up any accumulated interest that hasn’t yet been paid by the accounting period’s ending date.
Suppose that interest for a business loan is payable on the 15th of each month, but your accounting period ends on the 30th of this calendar month. In this case, you will accrue 15 days of interest, from the 16th to the 30th. This figure would be added up and posted as part of your adjusting journal entries, and then reversed on the first day of the next month when the cash transaction is received.
You will also record accrued interest on the income statement. If your company is the lender, it would be listed as a revenue. For borrowers, it’s recorded as an expense. This figure should also be reported on the balance sheet as either an asset or liability. Accrued interest is usually classed as a current asset or current liability due to its short-term nature; in most cases the payment will be made within one year.
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