Accrued Interest: Definition
Accrued interest refers to the payment made for the use of money. Many loans or notes are interest-bearing and have the following characteristics:
- Principal or face amount: The amount lent or borrowed
- Maturity date: The date the loan must be repaid
- Maturity value: The total of the principal and interest at the maturity date
- Interest rate: The percentage rate of interest, which is usually stated in annual terms and must be prorated for periods shorter than a year
Formula to Calculate Accrued Interest
In general, the correct amount of accrued interest can be calculated using the following formula:
i = p x r x t
- i = interest
- p = principal of the loan
- r = annual interest rate
- t = applicable time period (in fractions of a year)
To illustrate the use of the above formula, assume that Ozark Company borrows $100,000 at 12% for 9 months.
In this example, the principal of the loan is $100,000, the annual interest rate is 12%, and the maturity value is $109,000, which is calculated as follows:
To illustrate how interest accruals are calculated and recorded, assume that on 1 June 2019, the Smith Company lent $10,000 to one of its suppliers at 9% interest.
The loan’s maturity date is in 9 months (i.e., 28 February 2020), at which time both the principal and the total interest are due.
In this situation, 9% represents the interest for 1 year. This must be prorated in order to determine the interest income for 9 months. In this example, as well as others, interest is based on 12 30-day months.
It would not be correct to wait until the due date of 28 February to recognize the interest revenue earned through 31 December 2019.
This would violate the matching convention because no revenue would be recognized in 2019 and too much would be recognized in 2020.
Although it is possible to record the interest on a daily basis, this involves excess record keeping. For this reason, a single adjusting entry is made at the end of the accounting period.
In this example, the $10,000 9% note earns interest from 1 June 2019 to 31 December 2019 (7 months lasting 30 days each), which amounts to $525 and is calculated as follows:
i = $10,000 x .9 x 7/12
The total accrued interest for the 9-month term of the loan is $675, or $10,000 x .09 x 9/12. Thus, the interest revenue recognized in 2019 is $525, and the interest earned for 2020 is $150 (total interest for 9 months of $675 less $525 earned in 2019).
These relationships are illustrated in the timeline below.
Total interest revenue $675
The appropriate journal entries for the following dates are shown in the table below:
- 1 June 2019, the date of the loan
- 31 December 2019, the end of the accounting period
- 28 February 2020, the maturity date of the loan
At the maturity date, the cash account is debited for the entire value of the loan. Interest receivable of $525 is credited for the interest recognized in the prior period. Also, interest revenue is credited $150 for the interest earned during the current period.
Finally, the principal of the loan of $10,000 is credited.
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About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True contributes to his own finance dictionary, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.