Accrued interest is interest that has been earned or incurred with the passage of time and has not yet been paid or received. It runs in two directions at once. For the lender or the holder of a debt instrument it is interest receivable, an asset. For the borrower or the issuer it is interest payable, a liability, and on accrual-basis books the same amount sits on both sides until the cash moves.
How Accrued Interest Is Calculated
Accrued interest is the principal multiplied by the stated annual rate, multiplied by the fraction of the period that has elapsed since the last payment date. Principal is the amount outstanding that interest is charged on. The stated rate is the annual rate the instrument itself names, which is not the yield a buyer earns when the price differs from face, a distinction set out in face amount of a bond. The fraction is where the answer is decided.
Both halves of that fraction come from a day-count convention, the rule the instrument states for how many days the elapsed period holds and how many days the year holds. That convention is a term of the deal rather than a property of the calendar, so a calculation that assumes one has already guessed. For dealers in municipal securities, computations under the rule shall be made on the basis of a thirty-day month and a three-hundred-sixty-day year, or, for securities paying interest solely at redemption, on the day count basis selected by the issuer of the securities (MSRB Rule G-33(e)). MSRB is the Municipal Securities Rulemaking Board, the self-regulatory body whose rules govern those dealers. The market shorthand for that count is 30/360.
The window being counted is a stated rule too. The number of days runs from the previous interest payment date, or from the dated date in the case of first coupons, up to but not including the settlement date (the same rule, section (a)). The dated date is the day interest starts to run, which is not always the day the security is issued. Treasury, defining the term for its own notes and bonds, says the dated date and issue date are usually the same, and that in those cases where interest begins accruing prior to the issue date the dated date will be prior to the issue date (31 CFR 356.2).
A different instrument states a different count, and the denominator moves with it. For a Treasury note or bond that is not inflation-indexed, where accrued interest covers a fractional portion of a full half-year period, the number of days in that full half-year period and the stated interest rate determine the daily interest decimal used to compute the accrued interest, and Treasury bases that decimal on the actual number of calendar days in the half-year or half-years involved (31 CFR part 356, appendix B).
Say a client’s note carries a fixed principal and a stated annual rate, the last interest payment fell on the last day of November, and the books close at the end of December. One calendar interval, three counts, three different balances.
Principal 600,000
Stated annual rate 7%
Annual interest 600,000 x 7% = 42,000
Thirty-day month, 360-day year
Days counted 30
Accrued interest 42,000 x 30/360 = 3,500.00
Actual days, 365-day year
Days counted 31
Accrued interest 42,000 x 31/365 = 3,567.12
Actual days, 360-day year
Days counted 31
Accrued interest 42,000 x 31/360 = 3,616.67Nothing about the loan changed between those three lines. Only the count did.
Where the Balance Shows Up in a Firm’s Work
The Adjusting Entry at Close
Accrued interest reaches the ledger as an adjusting entry at period end. A borrower debits interest expense and credits interest payable. A lender debits interest receivable and credits interest income. Either way the balance exists only on books kept on the accrual basis, because a cash-basis ledger records the payment and has nothing left to carry between dates. How the balance is presented, and the wording Regulation S-X uses for it, is set out in accruals.
The entry does not settle the tax answer. The deduction side of an accrual method adds an economic performance test on top of the all events test, so an entry can be correct on the ledger and premature on the return, and both timing tests are set out in accrual accounting.
Buying a Bond Between Interest Payment Dates
A buyer who settles between coupon dates pays the seller the interest built up since the last payment, because the issuer pays the whole coupon to the holder of record rather than a day’s worth to each owner. Treasury states the same mechanic in its own auction rules, where accrued interest is an amount bidders must pay as part of the settlement amount, compensating Treasury up front for interest that bidders will be paid but did not earn because it is attributable to a period of time prior to the issue date (31 CFR 356.2).
Tax then splits that payment between the two parties. On the seller’s side, when bonds are sold between interest dates, part of the sales price represents interest accrued to the date of the sale and must be reported as interest income (26 CFR 1.61-7(d)).
On the buyer’s side the same money is not income at all. If you buy a bond between interest payment dates, part of the purchase price represents interest accrued before the date of purchase, and when that interest is paid to you, you treat it as a return of your capital investment rather than interest income, by reducing your basis in the bond (IRS Publication 550).
The Form 1099-INT the buyer receives does not make that split. Report the full figure shown on the form on Schedule B, Part I, line 1, then enter the accrued interest paid to the seller below the subtotal, identify it as “Accrued Interest”, and subtract it, because that interest is taxable to the seller (IRS, Instructions for Schedule B (Form 1040)). Having accrued interest from a bond is itself one of the conditions that requires the schedule. What the instrument is, and which box on which form carries the rest of it, is in face amount of a bond.
What Accrued Interest Is Not
The Period’s Interest Expense
Accrued interest is a balance sheet amount and interest expense is an income statement amount. A filer following Regulation S-X reports interest and amortization of debt discount and expense as its own line in the statement of comprehensive income (17 CFR 210.5-03). The expense carries the whole period’s charge, including everything already settled in cash. The accrued balance carries only the part still unpaid at the reporting date. The expense equals the change in the accrued balance plus the interest paid in cash, so the two are equal only when the cash paid during the period exactly clears the balance carried in at the start of it.
It is not the amortization of a discount or premium either. That moves the carrying amount of the debt rather than the amount owed for the passage of time, and the method behind it is in bonds payable.
Original Issue Discount
Original issue discount is not interest the instrument states. It is the discount built into the instrument at issue, and it accrues into income by statute whether or not any interest is stated. Gross income of the holder of any debt instrument having original issue discount includes an amount equal to the sum of the daily portions of the original issue discount for each day during the taxable year on which the holder held the instrument (26 U.S.C. 1272(a)(1)). The rule has exceptions. It does not apply to a tax-exempt obligation, to a United States savings bond, to a debt instrument which has a fixed maturity date not more than 1 year from the date of issue, or to certain loans between natural persons (26 U.S.C. 1272(a)(2)). Accrued interest builds on a stated rate. Original issue discount builds without one.
A Deferral
A deferral runs the other way, holding recognition back on cash that has already moved, and both of its directions are in deferral. The interest version of it is prepaid interest, and the deduction rule sets the timing directly. If the taxable income of the taxpayer is computed under the cash receipts and disbursements method of accounting, interest paid by the taxpayer which is properly allocable to any period with respect to which the interest represents a charge for the use or forbearance of money, and which is after the close of the taxable year in which paid, shall be charged to capital account and shall be treated as paid in the period to which so allocable (26 U.S.C. 461(g)). The same subsection excepts points paid on debt incurred in connection with the purchase or improvement of, and secured by, the taxpayer’s principal residence, on the further conditions it states. Accrued interest recognizes a charge before the cash moves. Prepaid interest moves the cash before the deduction may follow.
Common Questions
Interest is the charge for the use of money. Accrued interest is the part of that charge which the passage of time has already earned or incurred and which nobody has paid or received yet. The difference is timing rather than amount. At a payment date the accrued balance settles in cash and drops to zero, then starts building again the next day.
Both, and which one depends on the side of the loan you are reading. The lender or holder carries interest receivable, an asset. The borrower or issuer carries interest payable, a liability. A business that both lends and borrows carries the two at the same time, on opposite sides of its own balance sheet, and where each of them sits there is set out in accruals.
Accountably places trained offshore accountants and tax preparers inside US CPA and EA firms, and a firm can put a block of its own interest schedules and period-end accrual work through a trial task before anything client facing depends on it.
