Loans and interest accruals

Borrowing money creates a financial liability. When the loan is received, cash and the liability rise by the same amount; nothing is income. The cost of borrowing is interest, an expense of each period the money is outstanding — whether or not it has been paid.

Simple interest for part of a year is principal × annual rate × days ÷ 365 (or the day-count basis in the loan agreement). It's how short-term notes and overdrafts are usually charged.

Most term loans are repaid in level instalments (an annuity). Each payment is the same, but its make-up changes: - interest = opening balance × periodic rate — high at first, falling as the balance falls; - principal = payment − interest — rising over time; - closing balance = opening − principal.

Laying this out for every period gives the amortisation schedule. Only the interest part of a payment is an expense; the principal part simply reduces the liability.

Interest accruals. Payment dates rarely match the year end. If a loan's annual payment falls on 30 September and the year ends on 31 December, three months of interest have been incurred but not paid at the year end: debit Interest expense, credit Interest payable. When the payment is made, the interest is split between the amount already accrued (which clears Interest payable) and the current year's share (expense). Forgetting the accrual understates both liabilities and expenses; charging the whole payment's interest to expense in the year it's paid double-counts the accrued part. (Some businesses reverse accruals on the first day of the new period instead; the total expense per year is the same.)

Presentation. Under IAS 1, the principal repayable within 12 months is a current liability and the rest is non-current; accrued interest is current. Loans are financial liabilities measured at amortised cost under IFRS 9; for a loan with no fees taken at a market rate, amortised cost is simply the schedule's balance. Fees and transaction costs change the effective rate — see the next lesson on bonds.