Accounting for Accruals
2.3.2 Purchase of certificate of deposit transaction analysis
The purchase of a certificate of deposit represents an investment. The event acts to decrease the cash account and to increase the certificate of deposit (CD) account. As both accounts involved in the transaction are asset accounts, it is an asset exchange transaction.
When Mr. Candely invested into a CD, he effectively loaned money to the bank. In return for using his money, the bank agreed to pay back an amount greater than the amount borrowed.
The amount initially invested (or borrowed) is called the principal.
Excess of money over the initial invested amount (principal) is called interest and is usually set as a percentage to the principal.
In our situation, the interest on the CD is 6%. That means that on May 1, 20X8 Mr. Candely will get back the principal ($1,000) and the interest in the amount of $60 ($1,000 x 6%), or $1,060 in total.
It is important to note that the interest is earned on a continuous basis even though the payment of investment return is made on the maturity date. In other words, the amount of interest due increases proportionally with the passage of time. When a portion of interest is earned, the interest receivable account (i.e., amount due from the bank) increases along with an increase in the interest revenue account.
Interest receivable represents future cash receipts of interest by a company. Interest receivable account is shown on the asset side of the balance sheet.
Interest revenue is the amount of interest earned. Interest revenue (or just interest) may be earned on an investment such as a savings account or certificate of deposit. Interest revenue is an income statement account that increases equity.
Later, at the accounting period end, the bank will pay interest to the creditor and the creditor (our company) will decrease interest revenue account and increase cash account.
We do not recognize interest revenue until the date of financial statements on December 31, 20X7. At that time, a single entry could be made to recognize the accrual of 8 months of interest (from May 1 to December 31). This entry is called an adjusting entry.
Adjusting entries adjust the account balances before the final financial statements are prepared. Each adjusting entry affects one balance sheet account and one income statement account.
The amount of interest to be recognized at period end represents accrued revenue.
Accrued revenue is revenue earned but not yet received. When recorded, such amounts are usually shown as interest receivable in the balance sheet and interest revenue in the income statement.
2.3.3 Interest revenue accrual transaction analysis
Event No. 7 in the table above is the adjusting entry to recognize accrual of interest. The amount is computed by multiplying the face value of the CD by the interest rate by the length of time for which the loan was outstanding:
$1,000 x 6% x (8 / 12) = $40
It is time to look at the financial statements for Candely Services for the accounting period 20X7.
2.3.4 Financial statements for illustration #2 of accrual accounting
Illustration 2-13: Income statement for Candely Services for 20X7
Candely
Services |
|
|
|
Consulting Revenue |
$ 2,700 |
Interest Revenue |
40 |
Total Revenue |
2,740 |
|
|
Salary Expenses |
(1,400) |
|
|
Net Income |
1,340 |
There is a new element called interest revenue in the income statement. The interest revenue is the amount we recognized by posting the adjusting entry on December 31, 20X7.
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