The overall accumulated interest earned over time by an investor on an investment or bond the institution or borrow has yet to pay.
Accrued Interest Details
Business is a term that people mostly use to justify their idea of making legitimate money, and anyone who’s starting up a venture must be profit inclined in some way. But no matter how much we think this through, you still discover that some truths are being learned in MBAs that you may not easily understand until you attend one. Everyone was once enthusiastic about their enterprise until they came in contact with the calculations involved in accounting for interest on loans.
Accrued interest can be seen from various angles based on the field of accounting, and it is the interest that has been earned over a long period on a bond, loan, or annuity but hasn’t been collected yet or paid. It is a term used in accrual accounting which deals with calculating accumulated interests on a particular principal investment over a given time.
While regular interest deals with the interest earned by the banks when they issue out loans to you, it is simply the money paid to a lender. These two can sometimes be confused for each other, but it is imperative to know the difference as entrepreneurs.
When you enter into an investment, the interest earned on that investment over a long time but remains unpaid is accrued interest. It is consistently recognized and recorded over time, pending on the date of maturity.
Real-World Example of Accrued Interest
One of the significant challenges of young business owners today is how to know what they owe the banks that have been granting them these loans over the years and how these institutions account for the debts from the first day it was incurred till the date of payment. Funny enough, the banks will not teach you these things as they also have their own business to manage.
Now you are in a business, you have no other option but to deal with the banks, insurance, licensing, and so on, and these things matter to institutions when you get loans or buy bonds from them.
However, accrued interest can be a form of profit to the banks, known as accrued interest expense, or interest to a customer known as accrued interest income. When a borrower collects loans, the banks will receive some interest on those loans over the period given (accrued interest expense to the borrower). But when a customer deposits a principal investment or buys a bond in a financial institution, he’ll be paid accrued interest income on the said date of maturity.
For instance, when you open a savings account with your banks, they pay interest at the end of each month, which is being accrued daily on your account. However, you cannot spend or see the credited value until at the end of the month when you get credited.
The general formula for how to calculate accrued interest is the following:
Interest Rate × (Days/365) × Value on Loan
Each term in the equation is a variable inserted according to the terms of investment.
For instance, if you acquired a loan value of $15,000 on a 10% interest rate with payment expected on the 20th day of the month, to calculate your interest after paying the loan on the said day, there’ll be ten more days to complete the month from the 21st to the 30th.
Use the formula:
(10% × (10/365)) × $15,000 = $41.10
This value is the accrued interest for the ten days remaining after paying the interest on the loan received. The total accrued interest is consistently recognized and recorded in the income statement even before the payment is received.
There are some other terms with close disparity as accrued interest and include the following:
- Earned interest—While accrued interest is uncollected interest, earned interest is the particular amount of money that your investment is gaining for you. For instance, if you have an investment of $10,000 at a 10% annual interest rate. It means that you’ll earn $1000 every year on that particular investment. It becomes your earned interest.
- Paid interest—This is an interest that you have received as a credit on an investment. When interest is paid, it is no longer an accrued interest.
- Return on investment (ROI)—Return on investment (ROI) is a financial ratio used to calculate the benefit an investor will receive in relation to their investment cost. For example, If an investor purchased a landed property for $1,000,000 and sold it after two years for $2,000,000, the return on investment is calculated thus:
- ROI = ($2,000,000 - $1,000,000)/(1,000,000) = 1 or 100%
So the earned interest is the value to be paid, the accrued interest is the daily invisible multiplications, while the paid interest is the amount paid at the end of the month. It is just a simple analogy to differentiate these concepts.
Every business comes with its ethics, and the primary aim should be to make profits at the end of the day. These simple definitions and calculations may be the knowledge you need to stop losing money on investments, bonds, or loans.