Financial Glossary
Accrued Interest
Accrued interest is interest that has been earned by a lender or incurred by a borrower since the most recent contractual payment date but has not yet been paid or received in cash. It accumulates daily based on the outstanding principal balance and the stated interest rate. On a bond, the buyer compensates the seller for accrued interest from the last coupon date to the settlement date so the seller receives full compensation for time elapsed since the last payment. On a loan, accrued interest appears as a liability on the borrower's balance sheet and an asset on the lender's until the next payment date. Under accrual-basis accounting, interest is recognized as revenue or expense when earned or incurred, regardless of when cash changes hands.
Problem & Application
A commercial real estate borrower carries a $1.2 million loan at 6% annual interest, paid monthly. Monthly interest expense is $1.2 million multiplied by 6% divided by 12, or $6,000. If the lender's books are closed on the 20th and the interest payment is due on the 1st, 20 days of accrued interest is outstanding: ($1.2 million multiplied by 6% divided by 365) multiplied by 20, or approximately $3,945. This amount appears as accrued interest payable on the borrower's balance sheet and accrued interest receivable on the lender's. In bond markets, accrued interest matters when a security is sold between coupon dates: the buyer pays the clean price plus accrued interest (the full or dirty price), ensuring the seller receives compensation for the fraction of the coupon period during which the seller held the bond. Misstating accrued interest understates liabilities and overstates net income in the period, creating a reporting error that compounds over time.
In Short
Accrued interest plays a pivotal role in maintaining transparency and accuracy in financial dealings. It ensures fair compensation for lenders or investors and is an integral part of financial accounting and investment strategies.