Chapter 10

Debt Accounting

What Is Simple Interest?

Simple interest is the amount of principal multiplied by the interest rate, multiplied by the period. Principal is the amount of a debt that was originally borrowed, and that remains unpaid. The interest rate is a percentage of the principal amount of a loan, which is paid for the use of the loaned funds. The formula is:

Example

Pegasus Corporation borrows $100,000 for six months, at a 5 percent annual interest rate. At the end of the six months, the amount of interest that Pegasus owes is:

What Is Compound Interest?

Compound interest is based on both the principal and interest for the previous period, so compound interest results in a larger amount of interest than a simple interest calculation (see the preceding section). The formula is:

Year 1 | Principal × Interest percentage | = Interest for year 1 |

Year 2 | (Principal + Year 1 interest) × Interest percentage | = Interest for year 2 |

Year 3 | (Principal + Year 1 interest + Year 2 interest) × Interest percentage | = Interest for year 3 |

The compounding formula does not apply if you pay the interest at the end of each period, so that it does not roll into the principal balance that forms the basis for interest calculations in the next period.

Example

Pegasus Corporation borrows ...