The accrued interest definition can be explained through the interest collected by a set date on financial obligations that were not paid out. As interest can be of two types, so does accrued interest split into two kinds, accrued interest revenue for the party experiencing gain (the borrower) and accrued interest expense for the party experiencing cost (the lender).
Used in the accrual method of accounting, the accrued interest also follows the matching principles and the recognition principle. For each expense, there is a directly proportional revenue. When booking accrued interest in the income statement, they are included through adjusting journal entries at the end of the accounting period. The first day of the month of the following accounting period reverses these accrued interests: expenses become revenues and vice-versa.
Following the accrual accounting method, accrued interest accounts for expenses and revenues that are registered as an outgoing or incoming financial transaction, but cash was not recorded at the transaction time. The accrual method was developed as a way to account for any kind of transaction that was not reimbursed instantly. Accrued interest is a result of it and an evolution for the increasingly complex business transactions of today.
As mentioned above, accrued interests are recorded through adjusting journal entries at the end of every month in the income statement. Accrued interests can be revenues or expenses, and the amount of revenue or expense that was not yet paid is also recorded in the balance sheet. Expenses are liabilities, and revenues are assets. As accrued interests are expected to be paid over a year, they are also referred to as current liabilities and current assets.
These principles govern the accrual method of accounting together with others under generally accepted accounting principles (GAAP).
The matching principle, as stated above, demands a match for every expense and revenue, underlining the need to record in the same accounting period both related expenses and revenues. In other words, an expense sustained during July is recorded in the same period in which the revenue related to it is earned.
If a rental owner pays 10% of the monthly rent earned on utilities, with a monthly rent of $1,000, using the matching principle of the accrual method, they will report the $100 utility expense during the same month as the month when they incurred the profit for that month.
The revenue recognition principle demands that the revenue be recorded when earned, even if it isn’t received. This means that business owners don’t have to wait to receive cash to record the revenue gained.
A rental owner that rents all the units in a property will recognize the fees from the rented units as earned even before the payments come from the renters.