Interest represent the payment for using money. It can be described as the difference between the amount of money repaid and the money originally borrowed. The interest is usually represented as a rate over a certain period of time (Nikolai, Bazley & Jones, 2010).
Simple interest is the kind of interest on the original amount paid/received (principal), which does not take into consideration the interest accrued and paid before, as well as the time passed. Interest rate for simple interest is usually expressed as an annual rate, which is further adjusted for other periods. Therefore, Simple interest can be expressed as the product of the principal, the annual rate and the time, that the principal is borrowed for. If the interest is calculated for several years, only the principal amount is considered. Simple interest is most used only for short-term investment. The interest for simple interest calculations is constant over time (Kimmel, Kieso & Weygandt, 2010).
Compound interest, unlike simple interest, accrues on the principal as well as on the past interest. Compound interest is usually calculated quarterly and considers the accumulated amount at the end of the quarter as a principal for the next quarter. Therefore, it is usually more profitable to choose compound interest, other things being equal, since it yields the most revenue. Compound interest can be used in various settings, and should be used for calculating future value of a single firm and an annuity and present value of a single sum and an annuity (Kimmel, Kieso & Weygandt, 2010).
Interest calculations are used in the preparation of many financial reports and indicators in a company. Moreover, they are involved in the evaluation of the time-value of money both paid and received. Therefore, careful attention should be paid both to the choice of the interest and to the understanding of the two interest methods, and their implications for the company.
Kimmel, P. D., Kieso, D. E., & Weygandt, J. J. (2010). Financial accounting: tools for business
decision making. (6th ed.). Hoboken, the United States of America: John Wiley and Sons.
Nikolai, L. A., Bazley, J. D., & Jones, J. P. (2010). Intermediate accounting. (11th ed.). Mason,
OH: Cengage Learning.