Accrued interest

Accrued interest is interest that has been earned but not yet paid or received. It builds up day by day between payment dates, and it exists in the accounts of both parties: as income and a receivable for the lender, and as an expense and a liability for the borrower.

The concept exists because interest accumulates continuously while payments arrive periodically. A loan repaid monthly earns interest on every day of the month, but cash moves only once. Accrued interest is the amount earned in the gap.

Under accrual accounting, interest is recognised in the period it is earned, regardless of when it is paid. Under cash accounting, it is recognised only when received. Almost all lending institutions report on an accrual basis, because cash-basis accounts of a loan portfolio understate income in growing periods and give no signal of deteriorating collection.

Where accrued interest appears

Accrued interest receivable is the lender's position: interest earned on outstanding loans but not yet collected. It sits on the balance sheet as an asset, separate from loan principal, and it is one of the balances most likely to be overstated in a portfolio with hidden arrears.

Accrued interest payable is the borrower's or deposit-taker's position: interest owed on borrowings or on customer deposits, incurred but not yet paid. It sits on the balance sheet as a liability.

An institution that both lends and takes deposits carries both, and the difference between what accrues in and what accrues out is the basis of net interest income.

How accrued interest is calculated

The general formula is:

Accrued interest = Principal × Annual interest rate × (Days elapsed ÷ Days in year)

Three inputs determine the answer, and each is a policy choice rather than a fact.

Principal. On a declining balance loan this is the outstanding principal at the start of the accrual period, which falls with each repayment. On a flat rate loan interest is computed on the original principal throughout, so the accrual base does not fall.

Rate. The contractual annual rate. Where the rate is variable, the accrual must switch on the effective date of the change, which means splitting the period.

Day count convention. How days are counted and what a year is assumed to contain.

Day count conventions

• Actual/365 — Actual calendar days ÷ 365 days. Used in retail and microfinance lending in many markets.
• Actual/360 — Actual calendar days ÷ 360 days. Used in money market and commercial lending.
• 30/360 — Every month treated as 30 days ÷ 360 days. Used in bonds, some mortgages, and legacy core systems.
• Actual/actual — Actual calendar days ÷ 365 or 366 days. Used primarily in government bonds.

The choice is not cosmetic. Actual/360 counts real days against a 360-day year, so it produces slightly more interest than actual/365 on the same loan — around 1.4 percent more over a year.

Worked example

A loan with 10,000 outstanding at 18 percent per annum, accruing from 1 January to 1 February:

• Actual/365: 10,000 × 18% × (31 ÷ 365) = 152.88
• Actual/360: 10,000 × 18% × (31 ÷ 360) = 155.00
• 30/360: 10,000 × 18% × (30 ÷ 360) = 150.00

Same loan, same rate, same month, three different answers. The convention must be stated in the loan agreement and configured consistently in the system that computes it.

Accounting entries

Recognising accrual at period end:

• Debit: Accrued interest receivable — 152.88
• Credit: Interest income — 152.88

Receiving the cash:

• Debit: Cash or bank — 152.88
• Credit: Accrued interest receivable — 152.88

The second entry touches no income account. The income was already recognised when it accrued; receipt only converts a receivable into cash. Recognising income again on receipt is a common and material error — it double-counts.

Where the institution runs branch-level reporting, both entries carry branch attribution so interest income is reported where the loan sits.

Accrued interest and payment allocation

When a repayment arrives, it is applied against outstanding balances in a defined order, commonly penalties, then fees, then accrued interest, then principal, with any surplus treated as an overpayment. This ordering is the allocation waterfall.

Accrued interest sits above principal in that order for a reason: interest that has already been earned is settled before the balance that generates future interest is reduced. Reversing the order — applying to principal first — reduces the lender's income and leaves an interest receivable that continues to sit unpaid.

Two consequences follow for loan servicing:

Early repayment. A borrower paying before the due date owes less accrued interest than the schedule shows, because fewer days have elapsed. On a declining balance loan the correct treatment is to recompute interest to the actual payment date, not to apply the scheduled figure.

Late repayment. Interest continues to accrue past the due date, so a payment made two weeks late covers more interest and less principal than scheduled. If the system applies the scheduled split rather than the actual accrual, principal is understated and the loan silently falls behind its amortisation.

Non-accrual status and interest in suspense

Accruing interest on a loan that will not be repaid inflates both income and assets. Every prudential framework addresses this, and the mechanism is broadly consistent.

Non-accrual status. Once a loan passes a defined threshold of arrears — commonly ninety days past due, though thresholds vary by regulator and by loan category — the lender stops recognising further interest as income. The loan is placed on non-accrual.

Treatment of interest already accrued. Interest recognised as income before the loan went non-accrual is either reversed against current-period income, or transferred to an interest in suspense account. Interest in suspense is not income. It is a memorandum balance recording what the borrower owes, held outside the income statement until it is actually collected.

Recognition on recovery. If the borrower later pays, suspended interest is recognised as income at that point. If the loan is written off, the suspended interest is written off alongside it and never touches income.

Return to accrual. A loan that is brought fully current, and stays current for a defined observation period, may return to accrual status. Restructuring alone is generally not sufficient — repeatedly rescheduling a distressed loan to keep it accruing is one of the clearest signs of a portfolio being managed for appearance.

This mechanism connects directly to loan loss provisioning and to the arrears classification driven by aging buckets. Specific thresholds are set by prudential guidelines and differ by jurisdiction.

Accrued interest on flat rate loans

On a flat rate loan, total interest is fixed at origination — principal multiplied by the flat rate multiplied by the tenor — and each instalment carries an equal portion of it.

This creates a recognition question. Spreading the total interest evenly across instalments is simple but overstates income early in the loan, because the outstanding balance is falling while the recognised interest is not. The more defensible treatment recognises interest on an effective interest basis, so income tracks the declining balance even though the borrower's instalments are equal.

The practical implication: on flat rate portfolios, the accrued interest recognised in the accounts will not equal the interest portion shown on the borrower's repayment schedule. Both figures are correct for their own purpose, and the difference must be reconcilable.

Accrued interest in bond markets

Outside lending, the term most often appears in fixed income trading.

A bond pays coupons periodically, but trades on any day. The buyer compensates the seller for interest earned since the last coupon date. This produces two prices:

• Clean price — the quoted price, excluding accrued interest
• Dirty price — the amount actually settled, being the clean price plus accrued interest

The accrual is computed on the bond's stated day count convention, commonly 30/360 for corporate issues and actual/actual for government bonds. On the coupon date accrued interest resets to zero and the two prices converge.

Common errors

• Recognising income twice — once on accrual and again on receipt.
• Convention mismatch — the agreement states one day count, the system computes another. The gap compounds silently across the portfolio.
• Accruing on non-performing loans — inflating income until an eventual write-off reveals the overstatement in one period.
• Failing to reverse on downgrade — moving a loan to non-accrual but leaving previously accrued interest in income.
• Ignoring accrual on early settlement — charging the scheduled interest rather than interest to the actual settlement date, which overcharges the borrower and creates a consumer protection exposure.
• Applying payments to principal before interest — understating income and leaving a stale receivable.
• Month-end only accrual — computing interest once a month rather than daily, which misstates any account that transacts mid-month.
• No reconciliation between the loan ledger and the general ledger — accrued interest receivable in the accounts should reconcile to the sum of accrued interest across open loans, and rarely does when the two are maintained separately.

Frequently asked questions

What is the difference between accrued interest and interest receivable? In lending they usually describe the same balance. Where a distinction is drawn, accrued interest is interest earned but not yet billed, while interest receivable is interest billed but not yet paid.

Is accrued interest taxable? Under accrual-basis taxation, interest income is generally taxable when it accrues rather than when it is received, though most jurisdictions provide relief for interest on non-performing loans. Treatment varies, and the position should be confirmed with a local tax adviser.