What are the effects on the accounting equation from the adjusting entry for interest expense accrued?

Accrual Interest in Accounting

Under accrual accounting, accrued interest is the amount of interest from a financial obligation that has been incurred in a reporting period, while the cash payment has not been made yet in that period.

Accrual-based accounting requires revenues and expenses to be recorded in the accounting period when they are incurred, regardless of when the cash payments are made. The accrual-based accounting method discloses a company’s financial health more accurately than the cash-based method.

The amount of accrued interest is posted as adjusting entries by both borrowers and lenders at the end of each month. The entry consists of interest income or interest expense on the income statement, and a receivable or payable account on the balance sheet. Since the payment of accrued interest is generally made within one year, it is classified as a current asset or current liability.

The borrower’s entry includes a debit in the interest expense account and a credit in the accrued interest payable account. The lender’s entry includes a debit in accrued interest receivable and a credit in the interest revenue.

Accrual Interest in Accounting – Example

For example, on March 21, a company borrows $100,000 from a bank at an annual interest rate of 6%, and its first interest payment is due in 30 days on April 20. The annual interest is $6,000 ($100,000 * 4%), and the monthly payment is $500 ($6,000 / 12).

Assuming the accounting period ends on March 31 for both the lender and the borrower, the interest payment incurred within the period of March covers ten days. Therefore, the accrued interest for the accounting period will be $166.67 ($500 * 10/30). The company and the bank’s adjusting entries are shown below:

Accrued Interest in Bonds

Under the bond perspective, accrued interest refers to the part of the interest that has been incurred but not paid since the last payment day of the bond interest. Bonds can be traded in the market every day, while their interests are usually paid annually or semi-annually.

Accrued interest occurs when a bond is not traded on its coupon payment date. It is the part of the interest that a bond buyer gives up from the last coupon payment date to the date the bond is bought. The amount of accrued interest can be calculated by the formula below:

Where:

• AI = Accrued interest
• t = Days from the last payment date to the settlement date
• T = Days in the coupon payment period
• PMT = Coupon payment of each period

There are two typical methods to count the number of days in a coupon payment period (T) and the days since the last coupon period (t).

One is the actual/actual convention, counting the actual number of days, which is generally used for U.S. Treasury bonds and notes. The other one is the 30/360 convention, assuming 30 days for a month and 360 days for a year, which is usually used for corporate bonds.

The amount of accrued interest should be earned by the bond seller. The quoted price in the bond market, known as the clean price or flat price, does not include any accrued interest. When a bond is traded between two coupon payment dates, its full price (also known as dirty price), which is the present value of its future cash flows, is the sum of two parts: the accrued interest and the flat price.

Accrued Interest in Bonds – Example

For example, a Treasury bond with a $1,000 par value has a coupon rate of 6% paid semi-annually. The bond matures in two years, and the market interest rate is 4%. The last coupon payment was made on March 31, and the next payment will be on September 30, which gives a period of 183 days.

The coupon payment for each period is $30 ([6%/2] * $1,000). If a trader buys the bond on May 31, the accrued interest will be $10 ($30 * [61/183]) with the actual/actual day-count convention.

The full price will be the present value of future cash flows calculated as below:

The flat price can be calculated by subtracting the accrued interest part from the full price, which gives a result of $1,028.08.

Additional Resources

Thank you for reading CFI’s guide on Accrued Interest. To keep advancing your career, the additional resources below will be useful:

If you’ve taken out a business loan or line of credit, you’re aware that interest accrues on the borrowed amount. But, do you know how to record accrued interest in your books?

Recording interest allocates interest expenses to the appropriate accounts in your books. That way, you can stay organized and better manage your accounting books. 

About accrued interest 

Loans and lines of credit accrue interest, which is a percentage on the principal amount of the loan or line of credit. The interest is a “fee” applied so that the lender can profit off extending the loan or credit. Whether you are the lender or the borrower, you must record accrued interest in your books.

Accrued interest is interest that’s accumulated but not yet been paid. Because it’s accrued and not yet paid, it can be a payable (if you’re the borrower) or receivable (if you’re the lender). 

When you accrue interest as a lender or borrower, you create a journal entry to reflect the interest amount that accrued during an accounting period. 

You also record it on your business income statement and balance sheet. So, how do you record accrued interest on these two financial statements? 

For borrowers, accrued interest is: 

• An expense on the income statement
• A current liability on the balance sheet

For lenders, accrued interest is:

• Revenue on the income statement
• A current asset on the balance sheet 

How to record accrued interest in your books 

How you create an accrued interest journal entry depends on whether you’re the borrower or lender. 

If you’re the borrower, you’ll work the following accounts:

• Interest Expense account
• Accrued Interest Payable account

If you’re the lender (e.g., extending credit), you’ll work with these accounts:

• Accrued Interest Receivable account
• Interest Revenue account

Read on to learn how to calculate the accrued interest during a period. Then, find out how to set up the journal entry for borrowers and lenders and see examples for both. 

Calculating accrued interest during a period 

To calculate accrued interest, you need to know three things:

1. Interest rate (percentage)
2. Time period (number of days the interest accrued over)
3. Loan or credit amount 

Once you know these three pieces of information, you can plug them into the accrued interest formula:

Accrued Interest = [Interest Rate X (Time Period / 365)] X Loan Amount

Example

Let’s look at a $10,000 loan with 5% interest. You want to find out the accrued interest over 20 days. 

[5% X (20 / 365)] X $10,000 = $27.40

The accrued interest during this time period is $27.40. This would be the amount you would record in your books.

Borrower’s guide on how to record interest payable

When you take out a loan or line of credit, you owe interest. You must record the expense and owed interest in your books. 

To record the accrued interest over an accounting period, debit your Interest Expense account and credit your Accrued Interest Payable account. This increases your expense and payable accounts. 

Take a look at how to record interest expense journal entry:

Example

Let’s say you are responsible for paying the $27.40 accrued interest from the previous example. Your journal entry would increase your Interest Expense account through a $27.40 debit and increase your Accrued Interest Payable account through a $27.40 credit. 

Take a look at how your journal entry would look:

Lender’s guide on how to record interest receivable 

If you extend credit to a customer or issue a loan, you receive interest payments. You must record the revenue you’re owed in your books. 

To record the accrued interest over an accounting period, debit your Accrued Interest Receivable account and credit your Interest Revenue account. This increases your receivable and revenue accounts. 

Here’s how the journal entry would look:

Example 

Now, let’s say your customer owes you $27.40 in accrued interest. Your journal entry should increase your Interest Expense account through a debit of $27.40 and increase your Accrued Interest Payable account through a credit of $27.40.

Looking for an easier way to manage your accounting books? Give Patriot’s accounting software a try! Our patented Dual-Ledger Accounting feature gives you the power to run reports using cash, modified cash, or accrual accounting. Try it for free today!