Accrued interest – Definition
Accrued interest is the payment 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 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 by 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 the 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, calculated as follows:
To illustrate how interest accruals are calculated and recorded, assume that on June 1, 2019, the Smith Company lent $10,000 to one of its suppliers, at 9% interest. The loan’s maturity date is in nine months, February 28, 2020, at which time both the principal and the total interest are due. In this situation, 9% represents the interest for one year and must be prorated in order to determine the interest income for nine months. (In this example, as well as others, interest is based on 12 30-day months.)
Once the loan is made, the Smith Company immediately starts earning interest revenue. However, the revenue is not recorded until the end of the accounting period, in this case December 31. It would not be correct to wait until the due date of February 28 to recognize the interest revenue earned through December 31, 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 daily, this involves excess record keeping, and so an adjusting entry is made at the end of the accounting period.
In this example, the $10,000, 9% note earns interest from June 1 to December 31, 2019 (7 months, each assumed to be 30 days), 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 on June 1, 2019, the date of the loan; December 31, 2019, the end of the accounting period; and February 28, 2020, the maturity date of the loan, are:
At the maturity date, Cash is debited for the entire value of the loan. Interest Receivable of $525 is credited for the interest recognized in the prior period. Interest Revenue is credited $150 for the interest earned during the current period. Finally, the principal of the loan of $10.000 is credited.