Definition: Accrued interest is an accrual accounting term that describes interest that is due but hasn’t been paid yet. It reflects the liability that a company has to pay an amount to someone else.
What Does Accrued Interest Mean?
The accrual basis of accounting requires that expenses must be recognized when incurred regardless of when they are actually paid. Thus, interest that is due on a certain date but goes unpaid is still recorded to reflect the expense.
A good example of this is the interest that accumulates between the last coupon payment or the initial investment and the settlement date of a fixed security.
Typically, a bondholder who sells a bond has a right over the accrued interest of the bond. At the time of sale, the buyer pays the bondholder the net value of the bond plus the accrued interest, which is the product of the coupon rate multiplied by the number of days that have elapsed since the last payment.
When a bond transaction takes place, the buyer buys the underlying asset plus the right to the next coupon payment, which includes the accrued interest since the date of the initial investment. Therefore, as compensation for the loss, the seller requires the buyer to pay the accrued interest that accumulates between the last coupon payment date and the day of the purchase.
Let’s look at an example.
Leonard owns a bond worth $1,000 with an interest rate of 14%. Leonard decides to sell the bond to Adrian. The last coupon payment that Leonard made was three months ago. Therefore, if Adrian wants to buy the bond, he needs to pay Leonard $1,000 plus the interest of the three months.
Since the bond has an interest rate of 14%, the interest rate per month is 1.17%.
Since the last coupon payment was made three months ago, the accrued amount is 1.17% x 3 = 3.51%.
Adrian needs to pay Leonard $1,000 + ($1,000 x 3.51%) = $1,035.1 to acquire the bond.
If the last coupon payment had been made eight months ago, the accrued amount would be 1.17% x 8 = 9.36% and Adrian would have to pay Leonard $1,000 + ($1,000 x 9.36%) = $1,093.6. This happens because closer to the settlement date, the accrued interest increases.