How to Make Entries for Accrued Interest in Accounting

Reviewed by Michael J BoyleFact checked by Yarilet Perez

In accounting, accrued interest is the amount of interest that has been incurred but not yet paid as of a specific date. This applies to loans or other debt obligations. Accrued interest occurs in the following ways, reported by both borrowers and lenders:

• Borrowers list accrued interest as an expense on the income statement and a current liability on the balance sheet.
• Lenders list accrued interest as revenue and a current asset, respectively.

Read on to learn how to correctly account for accrued interest.

Key Takeaways

• Accrued interest is the interest earned on a loan over a specific period of time but has not yet been paid.
• Mortgages, credit cards, auto loans, and personal loans all incur accrued interest.
• Accrued interest has to be accounted for on financial statements and differs for borrowers and lenders.
• Accrued interest is listed as an expense and a liability on the borrower’s income statement and balance sheet, respectively.
• It is listed as revenue and a current asset by the lender.
• This process is based on the accrual method, which counts economic activity when it occurs, not when it is received.

Accrued Interest in Accounting

Entries to the general ledger for accrued interest, not received interest, usually take the form of adjusting entries offset by a receivable or payable account. Accrued interest is typically recorded at the end of an accounting period.

Accrued interest accumulates with the passage of time, and it is immaterial to a company’s operational productivity during a given period. 

Accrued interest is usually counted as a current asset, for a lender, or a current liability, for a borrower, since it is expected to be received or paid within one year.

Important

Accrued interest normally is recorded as of the last day of an accounting period.

The use of accrued interest is based on the accrual method of accounting, which counts economic activity when it occurs, regardless of the receipt of payment. This method follows the matching principle of accounting, which states that revenues and expenses are recorded when they happen, instead of when payment is received or made.

By contrast to the accrual principle, the cash accounting principle recognizes an event when cash or compensation is received for an event.

Adjusting Entries

Suppose a firm receives a bank loan to expand its business operations. Interest payments are due monthly, starting on Jan. 1. Even though no interest payments are made between mid-December and Dec. 31, the company’s December income statement needs to reflect profitability by showing accrued interest as an expense. After all, those funds eventually leave the business.

How to Adjust

In this case, the company creates an adjusting entry by debiting interest expense and crediting interest payable. The size of the entry equals the accrued interest from the date of the loan until Dec. 31.

Typical adjusting entries include a balance sheet account for interest payable and an income statement account for interest expense.

Accurate and timely accrued interest accounting is important for lenders and for investors who are trying to predict the future liquidity, solvency, and profitability of a company.

Issued Bonds

Sometimes corporations prepare bonds on one date but delay their issue until a later date. Any investors who purchase the bonds at par are required to pay the issuer accrued interest for the time lapsed. The company assumes the risk until its issue, not the investor, so that portion of the risk premium is priced into the instrument.

Par Value Only

Keep in mind this only works if investors purchase the bonds at par. The company’s journal entry credits bonds payable for the par value, credits interest payable for the accrued interest, and offsets those by debiting cash for the sum of par, plus accrued interest.

Why Do You Pay Accrued Interest?

You pay accrued interest because most debt obligations have an interest rate for borrowing money. When you borrow money for a house or car, you will pay interest on that amount. The interest that accrues is the amount you owe, usually at the end of the month, which is included in your loan payment.

What Is the Difference Between Earned, Accrued, and Paid Interest on an Investment?

For an investment, earned interest is the interest earned over a specific time frame, accrued interest is the amount of interest your investment is earning but that has not been paid to you, and paid interest is the amount of interest that you have already received.

How Do You Record Accrued Interest?

As a borrower, you would debit your interest expense account and credit your accrued interest payable account. It is an expense on your income statement and a liability on your balance sheet.

The Bottom Line

Accounting is a precise science and needs to be done correctly to ensure books balance and accounting principles are met for legal purposes. If you don’t have extensive accounting experience, particularly when it comes to debt obligations, seek out professional help to ensure your numbers are correct.

Read the original article on Investopedia.