U.S. accounting standards require most businesses to record transactions as they affect the business, rather than when money changes hands. This method of accounting, known as accrual basis, requires reporting all accrued liabilities so potential investors can assess the health of the company. However, because many transactions are then recorded twice -- once when incurred and once when paid -- trying to follow a company’s journal can be confusing for non-accountants.
Generally accepted accounting principles split debts into two general categories: accounts payable and notes payable. Accounts payable are considered current liabilities, typically invoices from suppliers, which must be paid within 12 months. Notes payable, on the other hand, are long-term debts such as mortgages or bonds that have repayment periods longer than 12 months.
Lenders can charge interest on a note payable under a variety of terms, but typically the interest compounds on a regular basis. Under the accrual method, the company must recognize the interest expense as it accrues. If the company does not immediately pay the interest as it is charged to its note, the company must record it as accrued interest. The journal entry to record accrued interest on a note payable would include a debit to interest expense and a credit to accrued interest.
When the company makes a payment on a note payable, part of the payment is made on the interest and part on the principal. The portion applied to the interest must be recorded accordingly by the company’s bookkeepers. A journal entry to record the payment of accrued interest would debit the accrued interest account and credit the cash account. It may also include a debit to the note payable account to account for any paid principal.
Accrued interest is reported as a liability and appears on corporate balance sheets. When the company records the interest separate from the note payable and differentiates between long-term and current liabilities, investors are better able to analyze the company’s cost of capital and long-term financial health. Recording accrued interest also impacts the income statement, and its inclusion changes a profit into a loss under some circumstances.