A company using accrual accounting must record revenues and expenses in the same period they are earned and incurred, respectively. The accrued interest receivable refers to interest income a company has earned but has not received in cash. This happens when the cash interest payment falls outside an accounting period. Accrued interest receivable is an asset account on the investor's books and a current liability on the issuer's books.
Sources of interest income include bonds, notes and other interest-bearing products. Some of these products may pay interest on maturity, while others may pay interest semiannually. This means the company may not receive the interest payment before it prepares the financial statements for an accounting period, which is why it must prepare adjusting entries to record the earned interest in accrued interest receivable.
The interest receivable amount is a function of the interest rate, the principal (or par value) and the period over which the interest has accrued. For example, if a company owns a $1,000 corporate bond that pays interest semiannually at an annual 6 percent rate, the annual interest payment is $60 ($1,000 x 0.06), and the interest accrues at $5 per month ($60 / 12). For the first-quarter financial statements at the end of March, the company has accrued three months of interest, or $15 ($5 x 3).
The company must prepare adjusting entries for the accrued interest receivable when it prepares its quarterly financial statements. These entries are to debit accrued interest receivable and credit interest revenue, thus increasing both accounts. In the example, the amounts for these entries are $15 each. When the company receives the cash interest payment, it debits cash, credits accrued interest receivable and credits interest revenue. To conclude the example, at the end of the second quarter when the company receives the first semiannual interest payment, it debits cash by $30 ($5 x 6), credits accrued interest receivable by $15 ($5 x 3) and credits interest revenue by $15 ($5 x 3). Note that it only has to credit three months of revenue at that point because the company has included the first quarter's interest revenues in the first quarter's income statement.
Accrued interest receivable increases the current asset account on a company's balance sheet, while interest revenue increases net income. Accrued revenues are noncash transactions, meaning the company must deduct these amounts from net income to calculate net cash flow. When the company receives the cash, the accounting entries move the balance in accrued interest receivable to cash, which increases net cash flow for the period but has no impact on the net income calculation.
Some issuers may not make interest payments on time or may not be able to repay the principal amount. The accounting entries in this case would be to write off and transfer the interest and principal receivable amounts into allowance for doubtful accounts, which is a contra account that reduces the value of receivables on the balance sheet.