Accounting Principles - Interest

Financial Accounting > Interest

The commonly accepted definition of interest is “Money paid for the use of money.” The late Colonel Sprague, who perhaps gave more thought to the subject of interest than any other man who has written on the subject, took a somewhat different view. He defined interest in substance as “The increase in principal due to lapse of time.” For the purposes of this discussion, however, it does not seem to be necessary to attempt the reconciliation of these somewhat divergent definitions, since there is probably no question in any student’s mind as to what constitutes interest. The reason for interest is that some one has borrowed capital or funds, and for the use of these funds some one is obliged to pay interest. Without regard at present as to whether interest is to be regarded as an item of income or an item of expense, there are certain characteristics of interest which are common to both and which must be, for the purpose of discussion, first stated. These characteristics are, namely: principal, rate and time. The question of principal and rate require no particular discussion. The question of time is the one which vitally affects the computation of interest and, consequently, the bases or methods of calculation. Generally speaking, these methods, in so far as simple interest is concerned, are confined to three, namely: the 360-day basis, the 365-day basis and what is generally regarded as the legal method. The first-named consists in dividing the interest for a year by 360 and considering 1-360th as the amount applicable to each day. The second consists in dividing the interest for a year by 365 and considering 1-365^ as the amount applicable to each day. The legal method, which is the construction generally placed upon the statutes now in force, consists in dividing the interest for a year by 12 and considering I-12th as the amount applicable to each month. Odd days are treated as 365ths of a year.

The legal day begins and ends at midnight. Therefore, in computing interest for a given number of days the first day should be excluded and the last day included, or vice versa. Colonel Sprague advocated “counting the nights.” In applying the methods above described a concrete example may prove beneficial. Let the statement of facts be as follows: Principal, $1,000; rate, 6 per cent; period, February 21 to March 27. The year’s interest will amount to $60. Using the 360-day basis, the interest per day will be $.166. The number of days elapsed between February 21 and March 24 will be 34. The amount of interest will, therefore, be $5.64. Using the 365-day basis, the interest per day will be $.164. The number of days elapsed between February 21 and March 27 will be 34. The amount of interest will, therefore, be $5.57. Using the legal method the time will be 1 month, 6 days. The interest for the 1 month will be 1-12th of $60, or $5. The interest for the 6 days will be 6-365ths of $60, or $.98, making the interest for the time elapsed between February 21 and March 27 $5.98. The 360-day basis is probably the most general basis used, since it is easiest. Banks and brokers generally use it. However, it is said of some banks and trust companies that they charge interest on the 360-day basis and pay interest on the 365-day basis. The 365-day basis is used generally by accountants whose desire it is to be as accurate as possible. The legal rate is used in computing interest on judgments and wherever interest is involved in judicial actions and decisions.
To take up now interest as affecting the accounts of a given organization we find that interest may be related to the accounts either as income or expense. As an item of income, it may appear as interest on bonds owned, interest on bonds and mortgages receivable, interest on bank balances, interest on accounts receivable, and interest on notes receivable. As an expense it may appear in connection with bond and mortgage payable, debentures, income bonds, accounts payable, notes payable, or loans payable. In isolated cases it may appear as interest on capital, especially in the case of copartnerships. It accrues over a period of time, and in accordance with such accrual must be taken into the accounts at closing dates whether or not it has been actually paid or collected. As an earning or item of income we have it charged to some asset account and taken into the income for the period. As an item of expense we have it charged against the expenses of the period and credited to a liability account. Subsequent receipt or payment of the interest in cash will not affect in any way the income or expense items. The cash received subsequent to the accrual appears in the light of a realization of the asset, accrued interest. The payment of the cash for interest subsequent to the accrual of the interest appears in the light of a liquidation of the liability, interest accrued. It might be said here that for convenience many accountants have adopted a nomenclature which will distinguish between interest accrued as an asset and interest accrued as a liability. The distinction consists in using the word accrued before the word interest for the purpose of denoting an asset, whereas for the purpose of denoting a liability the word accrued follows the word interest.

To run through one or two sets of typical transactions for the purpose of illustrating the entries in connection with interest, we may take the following statement of facts:
«
Principal of a note received from customer $1,000
Rate of interest 6 per cent.
Date of note June 1
Period 3 months
Basis (for convenience in illustration) 360-day
Closing date June 30
Note paid September 1
The interest on the note will be $5 per month. In closing the books at June 30 the entry will be as follows:
Accrued interest $5.00
To Interest earned $5.00
Upon the settlement of the note on September 1, the following entry will appear:
Cash $1,015.00
To Notes receivable $1,000.00
Accrued interest 5.00
Interest earned 10.00
A variation of this procedure might, of course, take place if before making the final entry the interest transaction were com
pleted, namely: by charging accrued interest and crediting interest earned with $10. The entry corresponding to the above would then appear as:
Cash $1,015.00
To Notes receivable $1,000.00
Accrued interest 15.00
If the above statement of facts may be similarly used to illustrate the entries in the case of notes payable instead of notes receivable, the entry at June 30 would then appear:
Interest expense $5.00
To Interest accrued $5.00
At the time of paying the note the entry would appear:
Notes payable $1,000.00
Interest accrued 5.00
Interest expense 10.00
To Cash $1,015.00

The same variation as was above indicated in the case of notes receivable might occur here, namely: that the interest might be fully accrued at the time of payment before the entry for the cash transaction was made. The final entry under such circumstances would then be:
Notes payable $1,000.00
Interest accrued 15.00
To Cash $1,015.00

It would seem as though this were an appropriate place to discuss discount, on account of the close relation which it bears to interest, being considered, in fact, as interest paid before it is due. Discount is of two kinds: bank discount and true discount . Bank discount is simple interest collected in advance. True discount is compound interest collected in advance, or the difference between the amount of the principal and its present worth. The bank discount on $1,000 at 6 per cent. for one year would be $60. The true discount on the same amount for the same time and rate would be $56.61. The bank discount is obtained by multiplying $1,000 by 6 per cent., whereas the true discount is ascertained by dividing 1 by 1.06, the result of which will give the present worth of a dollar at 6 per cent. compound interest for one year. The present worth of $1 multiplied by $1,000 will give $943.39. This sum subtracted from the principal of $1,000 shows the discount of $56.61.

Mr. H. C. Bentley, C.P.A., in his book on the “Science of Accounts” makes a distinction between interest and discount which is logical if somewhat novel. Mr. Bentley holds that bank discount should never be called discount. He is of the opinion rather that where collected in advance it should be called simply interest paid in advance.

Such a distinction would help considerably to clarify matters since discount would then mean but one thing. In the case of the three months’ note previously referred to, the interest would be $15.00; the discount $14.78. The interest might be paid in advance or at maturity; discount would always be collected in advance. Under such circumstances it would be unnecessary to distinguish between bank discount and true discount. Why banks prefer the former is not difficult to see.

If we accept the suggestion that discount should mean but one thing, then the only question in so far as our accounting is concerned is the relation of this discount to the accounting periods. In treating with discount we must look at it from two points of view—one, that of the party who pays the discount; the other, the party who receives the discount. Taking up first the point of view of the. party paying the discount, it then appears that interest has been paid for the use of money covering a period which has not yet elapsed. The interest, or discount, is, therefore, appropriately and properly to be considered as a payment in advance. Consequently, it should be treated as a deferred charge to expense. As the time elapses over which this prepayment extends the deferred charge to expense should be gradually reduced by charges to expense. In the case of the note on which the discount was $14.78, the original discounting of the note, stated in terms of journal entries, would be as follows:

Cash
Discount
To Notes payable
$985.22
14.78

$1,000.00

The item of $14.78 will subsequently be charged to interest expense, or interest on notes payable, and credited to discount as the time elapses. At June 30, assuming that the note was discounted on June 1, $4.87 of this amount will be charged to the expense for the month, while the remaining $9.91 will appear in the balance sheet as a deferred charge.

The opposite of the above is true and applies especially to banks and banking institutions. If, in the first case, the man who stands the discount is entitled to defer the charge to his expenses in accordance with the extent to which the period covered has elapsed, then surely the recipient of the discount must not take into his earnings the entire amount. The bank or banker discounting notes should set up discount as a deferred credit to income under the head of discount unearned and take same into its earnings in accordance with the lapse of time. To use again the same illustration, the entry for the bank will be, upon discounting the note:
Notes receivable $ 1,000.00
To Discount unearned $ 14.78
Cash 985 22

At the end of the month an entry should be made charging discount unearned and crediting discount earned with $4.87 of the discount. There would then appear in the discount earned for the period $4.87 and as a deferred credit to income on the balance sheet $9.91.

The question of setting up the unearned discount is not, as a rule, important in a mercantile concern for the reason that, like so many other items, the results of taking it into consideration are not worth the energy and trouble expended in so doing. In the case of a bank or banker, a large part of whose business consists in discounting paper, the situation would be quite different. It is of utmost importance in such cases that careful attention be given to the matter of unearned discount. Banks which close their books annually or semi-annually will tell you that the discount will average up between periods and that it is not necessary to observe the rule with regard to taking the earnings on discount into income. Thus it might easily happen in the case of a bank closing its books monthly or quarterly that there would be a marked fluctuation in the income among the different quarters. The decrease in any given period would probably be attributed off-hand to a falling off of business. This might, of course, be true. On the other hand, it might also be true that the money value of the notes discounted had increased rather than decreased, but that the average term which the various notes had to run was so much shorter than the average term of notes discounted in the preceding period as to more than offset the increase in the discount resulting from the increase in the amount of the notes. If the discount were properly spread over the life of the notes a situation such as the above could not exist. An increase or decrease in the earnings from discount as among periods would then represent the true fluctuation in the volume of notes discounted.

While the matter of setting up the unearned discount is one of considerable trouble to banks which are particular about this point some of them have devised means of facilitating their work in this respect. Ordinarily it is probable that they would ascertain their unearned interest at the end of a given period in the same manner in which an accountant is obliged to ascertain such information when he goes in to make an audit or examination, namely: by listing the discounted notes and figuring on each note the unexpired discount collected in advance. This then would be charged to discount earned, or interest and discount, and credited to discount unearned, or interest received in advance. To avoid this laborious process some banks, as has just been suggested, keep what is known as a discount register. This book is somewhat similar to the ordinary notes payable or notes receivable books so common among mercantile concerns. In it the notes are listed and the particulars concerning them, including the amount of each and the discount on each. The discount is then spread over a series of columns corresponding to the months in accordance with the number of months the respective notes have to run. While this practice is comparatively rare, it would probably be still rarer to find a bank spreading its discount scientifically; that is, increasing gradually from month to month as the time elapsed. While admittedly not scientific, it is probably satisfactory to divide the discount by the number of months the note has to run and credit to each month its proportionate share. It will be seen that by the use of this method all discount will be credited immediately to an unearned account, but will be credited to earnings monthly by an entry charging discount unearned and crediting discount earned in an amount corresponding to the footing in the discount register for any given month.
Another expedient for facilitating the accruing of interest may also be mentioned at this time. Organizations holding numerous securities on which interest accrues find the computing of the interest a source of considerable trouble. Here again the interest must be computed either at the end of the period on the particular securities or investments owned individually or through the means of a register in which the interest on each security for the month is set up. As a variation from both of these methods it sometimes becomes possible to classify the par principal according to the various rates of interest, namely: 4 per cent., 414 per cent., 5 per cent, etc., and accrue the interest on the total amount of principal in each class at any time. For example: Assuming that a given concern had $100,000 4 per cent. bonds, $50,000 4^2 per cent. bonds, $200,000 5 per cent. bonds, another $200,000 of 4 per cent. bonds, another $50,000 4^ per cent. bonds, instead of accruing the interest of five separate items, the two lots of 4 per cent. bonds would be added and the accrued interest at 4 per cent. computed on the total. In the same way the 4^ per cent. bonds would be added and the interest accrued on the total. Then by accruing the interest on the 5 per cent. bonds there would be three calculations instead of five. If this illustration may now be applied to a large organization in which a great many different securities are held, the value of such a method will be apparent. In order to employ this method it is necessary to keep a register in which the securities are entered in accordance with the rate of interest which they bear. It is, of course, evident that broken periods, resulting from purchases or sales of securities, except at the end of the accrual periods, will upset the calculations unless the items in question are deducted from the totals and the interest accrued on these items separately.

In the matter of copartnerships interest of capital becomes an important factor. Ordinarily it seems that nothing is to be gained by charging the business with interest on capital and taking it in as an earning. This has too much the appearance of doing business with one’s self. It would seem hardly necessary to add that no money is ever made in this way. Some economists undertake to analyze the profit of a business organization and classify it with regard to the factors which produce it. In this way capital is shown to have earned interest. This would seem to be an unnecessary procedure and tend to confusion rather than otherwise. It is conceded that statistical information concerning the employment of capital and the return therefrom is at times of value to the administrative force. There would seem to be no reason, however, why the general books and accounts of the organization should be burdened with carrying and showing this information. It would seem rather to be a matter for independent calculation. In the case of a copartnership, however, where certain conditions exist, the situation becomes quite different. Here many times the amount which the respective partners are credited with will depend upon the matter of interest on capital. The following three rules may be given concerning when it is proper to charge and credit interest:

(1) When the capital is unequal and the profits are to be equally divided, charge interest on capital and credit the respective drawing accounts of the partners.
(2) When the capital is unequal and the profits are to be unequally divided, charge interest on capital and credit the respective drawing accounts of the partners.
(3) When the capital is equal and the profits are to be unequally divided, charge interest on capital and credit the respective drawing accounts of the partners.
Where the capital is equal and the profits are to be equally divided, nothing is gained by charging and crediting interest.

The following ledger accounts will, it is hoped, make clear the reasons for the above rule:
First proposition. Share profits and yi; capital unequal. Interest 6%.
Profit and Loss
P&L $3,000 $60,000 P&L $3,000
I. 3.600

$40,000 Int . $6,000 A $3,000 I. 2,400 B 3,000
Second proposition. Share profits 2/3 and 1/3; capital unequal. Interest 6%.
B Profit and Loss
P&L $4,000 $60,000 P&L $2,000
I. 3.600

$40,000 Int. $6,000
I. 2400

A $4,000
B 2,000

Third proposition. Share profits 2/3 and 1/3; capital equal. Interest 6%.

$50,000 P&L $2,000 $50,000 Int. $6,000 A $4,000 I. 3,000 I. 3,000 B 2,000
Fourth proposition. Share profits y2 and Y*; capital equal. Interest 6%.
A B Profit and Loss

$50,000 P&L $3,000 $50,000 Int. $6,000 A $3,000 I. 3,000 I. 3,000 B 3,000

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