Accrued interest refers to interest expense that been incurred by a business but has yet to be paid.
It is a key feature of accrual account systems that many companies practice around the world.
This is a common expense as the majority of companies uses credit facilities or term loans that has been issued by lenders.
This also means that for lenders, accrued interest can refer to interest revenue generated but has yet to be collected from borrowers.
It must be noted that accrued interest is not exclusively accounted for by lenders such as banks as interest revenue. This is because lenders also borrow funds from other financial institutions that charges interest. Accrued interest therefore, can be both an expense and revenue.
Business accounting
Accrued items play a prominent role in the accounting of business financial statements.
For example accrued income indicates sales that has been generated but the funds has yet to be collected. This can occur when customers purchase with credit cards or when sales has been processed by third party merchants who would pay the business at a later date.
It can also be accrued expense such as for the purchase of inventory where vendors provide credit terms allowing a business to have stocks delivered and pay at a later date.
Depending on the nature of items accrued, they can either be recorded in the balance sheet as an asset or liability.
Accrued interest is often found recorded in profit and loss statements where senior management is able to see the expense and offset it from gross profits.
If a working capital term loan for example, has a payment date on the 5th of the month, then 25 days (assuming a 30 day month) worth of accrued interest expense would be booked as a journal entry adjustment at the end of the month accounts.
This is because interest expense from the 6th day to 30th day has already been incurred even though payment for it would only be on the 5th of the following month.
Should the monthly payment on the debt obligation is $300, then the accrued interest in this case, would be $250 at the end of the 30-day month.
If a balance sheet is prepared at this point, then the accrued interest would appear as a current liability in the statement.
When financial statements are prepared for the end of a financial period, accrued interest appears as an accumulated interest.
Should a business not practice accrual accounting, then a person who is assessing the finances of the company, maybe for an acquisition, might observe strong revenue and net profits… but operation profits might go into the red when accrued interest and other accrued expenses are taken into account.
This is why accrued items are such a critical aspect of analysing the financial strength and position a company is in.
On the other hand, a business that has high sales but a high amount of accrued earnings can mean that they are having a hard time collecting revenue that has been earned. It can also mean a potential of bad debt.
In the financial markets, accrued interest can also refer to interest earned from the yield of bonds but has not been paid out.
