What is Accrued Interest?
Accrued interest is an accounting concept that represents the interest incurred on a financial obligation at a specific date. However, it is the interest that has not been paid or received at the time of reporting. Accrued interest is a concept that comes as a result of the accruals concept of accounting. In accounting, the term accruals refer to expense or income incurred but for which no payments or receipts have occurred.
At the end of each accounting period, companies and other organizations have to report their obligations. Accounting standards require these entities to account for all their liabilities. Therefore, it also requires them to calculate the accrued interest on their existing debts. Similarly, for their interest-generating assets, they need to calculate the interest income receivable.
How does Accrued Interest work?
When a company prepares its financial statements at the end of an accounting period, it must calculate and report all its obligations. If a company has any debt obligations with interest payments, companies need to calculate accrued interest. Accrued interest is the amount that companies are liable to pay but haven’t exchanged cash for yet.
Accrued interest is only relevant for debts that do not occur on the same dates or periods as its accounting period. For example, when a company pays interest after its Balance Sheet date, it must calculate and report the accrued interest. It is because it has incurred some part of the obligation on that date.
Companies usually settle their accrued interest within the next accounting period. Therefore, accrued interest is a short-term obligation for companies. They report their accrued interest under the current liabilities portion of their Balance Sheet. Similarly, they charge the relevant accrued interest in the Income Statement for the same period.
What is the formula for Accrued Interest?
The formula for accrued interest is straightforward. Entities need to calculate their interest expense for the upcoming period. Once they do so, they must divide it into two portions. The first portion is the interest amount that is relevant to the current reporting period. It is the interest that they must record as accrued interest for the current period.
The second portion is the interest payment that is not relevant to the current period. Therefore, companies can disregard this portion until it becomes payable or the entity incurs it. Accounting standards do not require them to report this portion of their interest incurred.
The accrued interest formula is as below.
Accrued Interest = t / T x Interest Payment
In the above formula, ‘t’ represents the time from the last payment date to the settlement date. On the other hand, ‘T’ denotes the total period of coupon payments.
Example
A company, Red Co., has a debt obligation amounting to $100,000. The coupon rate on it is 10%. The interest is payable each year. However, the company must record accrued interest for the current period. Of the total interest payment, only three months relate to the current period. Therefore, Red Co.’s accrued interest will be as follows.
Accrued Interest = t / T x Interest Payment
Accrued Interest = 3 months / 12 months x ($100,000 x 10%)
Accrued Interest = $2,500
Conclusion
Accrued interest refers to an amount that represents interest incurred on a financial obligation on a specific date. It is only the amount that a company has incurred but has not made a payment for yet. Companies with financial obligations must record their accrued interest at each reporting date.
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