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Accrued Interest

Accrued interest is best described as the amount of interest that has been earned, but has not yet been paid out (or received). Put another way, it is interest that has “accrued” since the last payment of interest. It should be noted that accrued interest is not “owed” until a specified payment date.

It follows the idea that expenses should be matched against the revenues associated with them, both in terms of when they are incurred and when payment is made. As such, accrued interest is recognized in the financial reporting periods in which the related expenses are incurred, rather than when the actual payments are made.

Accrued interest is a common concept in the area of finance, particularly for debt instruments like mortgages, bonds, and loans, which are associated with an interest rate. As an example, if an individual has a mortgage at the rate of 4.5% that requires one payment each month, the interest would accrue during the month with the payment being made at the end of the period. In this scenario, the accrued interest would be the amount due at the end of the month.

The calculation of interest can be determined by multiplying the principal amount by the interest rate and then dividing that total by the number of days in a year (for example in the U.S., 365 days). Once the daily interest rate is known, the accrued interest for a particular period is calculated by multiplying the daily rate by the number of days in that period.

For example, a bond issuer may be required to pay $5,000 worth of interest per year on a bond with a principal value of $50,000 and an interest rate of 5%. The daily interest rate would thus be 0.05/365 = 0.000137, and the accrued interest for the 3 months (90 days) of the period would be calculated as 0.000137 x 90 = $12.33.

When dealing with accrued interest in the financial statement, it is essential that the adjusting journal entries be entered at the end of the accounting period, to ensure they are recorded as expenses in the same accounting period with which they are associated. This ensures that expenses are matched with the corresponding revenues, in accordance with the revenue recognition and matching principles of accounting.

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