For both public and private sectors, bonds are the foundation of conventional debt financing. They open doors to great opportunities for a moderately protected and consistent income. At any instance, a potential bond buyer may ask, “For what reason do I have to pay this accrued interest?” The appropriate response is, on the grounds that only the bondholder of record can get interest payments on the coupon date, else it unjustifiably inconveniences a previous bondholder who sold the bond in the middle of coupon payment. But the previous bondholder should be made up for their time of ownership, whether or not they sold it. To battle this issue, in addition to the price of the bond during the sale the party buying a bond will pay the accrued interest to the seller of the bond. The bond buyer is then repaid at the following coupon date as they will get a full interest payment despite the fact that they just held the bond for a period of time since the last coupon payment.
So, as you can see one needs to know the answer to what is accrued interest before stepping a foot in the bond markets. This article explores accrued interest formula, accrued interest accounting, accrued interest calculator and much more to form a firm grip on this concept.
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What is accrued interest?
In bookkeeping, accrued interest alludes to the measure of interest that has been incurred, starting at a particular date, on a loan or other financial commitment has not yet been paid out. Accrued revenue can either be in a form of accrued interest revenue, for the lender, or accrued interest expense, for the borrower.
The term accrued interest can likewise refer to the amount of bond interest that has aggregated since the last time a bond interest payment was made.
Accrued Interest Formula
The accrued interest formula is not that difficult to understand. Below is given a step-by-step formula guide to calculate the accrued interest of a potential bond buy or sale.
- Step 1: Calculate the Amount of Time of Accrued Interest
Factor = Time Held After the Last Coupon Payment / Time Between Coupon Payments
- Step 2: Calculate the Proper Interest Rate
Interest Rate per Payment = Annual Interest Rate (Coupon) / Number of Payments per Year
- Step 3: Calculate the Accrued Interest
Accrued Interest = Face Value of the Bonds x Rate (Step 2) x Factor (Step 1)
Accrued Interest Example
For example, let’s assume that you are planning to buy a bond with a $20,000 face value and a 7.0% coupon that pays semi-annually on March 1 and September 1. You are buying the bond on November 30, right before the three-month anniversary of the last interest payment made on September 1. Let’s insert these numbers into the formula mentioned above to find the accrued interest that must be paid to the seller.
Note: It is standard practice in the bond market to assume that all months have 30 days regardless of the actual amount of days in a given month; therefore, a year would be 360 days. For this example, the time held after the last coupon payment would be 90 days [3 months x 30 days] and the time between coupon payments would be 180 days [6 months x 30 days].
Step 1: Factor = 90 days / 180 days = 0.5
Step 2: Interest Rate = 7.0%, Interest Rate per Payment = 0.07 / 2 payments per year = 0.035
Step 3: Accrued Interest = $20,000 × 0.035 × 0.5 = $350
So, the buyer will pay the seller an extra $350 in addition to the price of the bond during the transaction of the bond sale. However, the buyer would also receive a coupon payment of $700 in three months on March 1; this makes up for the previously accrued interest payment when they bought the bond three months earlier.
So, the above question clearly explains what is accrued interest with example. Do not be too surprised if the formulas are too much for you because neither the dealer, seller, nor buyer has any judgement on how accrued interest is calculated in the exchange process; it is an objective calculation that follows securities industry rules.
What is the difference between interest paid and interest accrued?
In accrued interest accounting the amount of interest that has been incurred at a specific date but has not yet been paid is called accrued interest. Accrued interest has two forms, i.e., it can be in the form of accrued interest expense owed by the borrower or accrued interest income on customer deposits that are owed by the bank.
Payment made as charges for borrowing a loan is referred to as regular interest. When a person borrows money from a bank, a credit union, or an individual, they are supposed to pay some interest on the loan extended to them. Interest can also be in the form of income, where an individual earns interest income on money deposited in an interest-bearing account.
Accrued Interest Accounting
In accrued interest accounting, accrued, interest is recorded as a revenue or expense on the income statement, based on whether the company is lending or borrowing. Moreover, the part of revenue or expense yet to be paid or received is reported on the balance sheet, as an asset or liability. Since accrued interest is expected to be received or paid within one year, it is often referred as current asset or current liability.
Accrual accounting results in accrued interest and it requires that accounting transactions must be recognized and recorded when they occur, despite the fact whether payment has been received or made at that time. The ultimate goal when accruing interest is to ensure that the transaction is accurately recorded in the right period. Accrual accounting differs from cash accounting, which records a transaction when cash or other forms of consideration trade hands.
Two extremely important aspects of accrual accounting are the revenue recognition principle and matching principle, and both are highly relevant in the concept of accrued interest. The revenue recognition principle states that revenue should be recognized in the period in which it was earned, rather than when payment is received. The matching principle states that expenses should be recorded in the same accounting period as they occur..
To show how these principles affect accrued interest, consider a business that purchases a company vehicle on loan. The company owes the bank accrued interest on loan for the vehicle on the 1st day of the following month. The company has use of the vehicle for the entire prior month, and is, therefore, able to utilize the vehicle to carry out business and produce revenue.
At the end of each month, the business will need to record interest that it expects to pay out on the following day. Moreover, the bank will be recording accrued interest income for the same one month period because it expects that the borrower will be paying it the following day.
Accrued Interest Calculator
Even if you’re not currently making loan payments, interest continues to accrue. Paying a little more toward your loan may decrease your total loan cost. To see how accrued interest could affect your loan balance you can calculate accrued interest through the accrued interest calculator instantly.
The bottom line is that accrued interest is an interest that is recognized but not yet paid or received due to the difference in timing of cash flows. To compensate the former bondholder for their period of ownership, it is added on to the face value of bonds. Keep accrued interest in mind next time you think about buying or selling a bond.