Computation of Interest
Interest is usually calculated on the basis of number of days. Thus, computation of interest involves.
(1) Calculation of days.
(2) Calculation of the amount of interest..
(3) Calculation of days. Following points should be kept in mind while calculating the number of days.
(i) There are three methods for calculating the number of days:
(a) Forward method. The method is most common. The number of days are calculated from the du date of the transaction to the date of settlement. –
(b) Backward or epoque method. In case of this method the number of days are counted from the opening date (i.e., the date of commencement of the account current) of the account current to the due date of the transaction.
(c) Daily balance method. The method is used by banks. Days are calculated from the due date of a transaction to th due date of the next transaction.
(ii) The effective date of the transaction should be considered for calculating the number of days irrespective of the method followed. For example if as per terms of trade, some credit period is allowed, interest is to be charged only with effect from the date after the expiry of such a period. Similarly when bills of exchange are received or issued, the due date of the bill (including 3 days of grace) will be the effective date for this purpose.
(iii) The date of the transaction should be excluded for calculating the number of days. For example if days are to be calculated from 5th January, 1989 (the date of transaction) to 31st January 1989 (settlement date) the number of days will be taken as 26, the day of 5th January will be excluded.
(iv) In case, some balance has been brought forward from the previous period, the first day of the new period will also be considered. For example if the opening balance is on 1St March and the settlement date is 30th June, the number of days will be Counted as follows:
March 31 + April 30 + May31 + June30 122
However, if a new transaction takes place on 1st March, the day of 1st March will not be counted for calculating the number of days.
(2) Calculation of amount of Interest. There are three methods for charging interest:
(i) Calculating interest on each item
In case of this method interest is calculated on each item separately. The days are calculated from the date of the transaction to the settlement date and interest is charged for the number oldays so calculated at agreed rate of interest.
(ii) Product Method
This is a modification of the first method. In place of makipg separate calculations, the amount involved in each transaction is multiplied by the number of days (or months) from its date to the date of settlement. Interest is calculated on the balance of the products for one thy (or month) and is put on the side the sum of the products is more. However, if the rates of interest are different for debits and credits, interest for debits and credits will have to be calculated separately.