Accounting for Accruals
2.4 Illustration #3 of accrual accounting
Finally, there is the third accounting period (20X8) that we will discuss using the Candely Services example. During this period Mr. Candely's company experienced the following events:
- $1,000 cash distribution was made to the owner.
- On May 1, 20X8 Mr. Candely received the principal and interest on the certificate of deposit when it matured.
- The business borrowed $2,400 from a local bank on March 1, 20X8. The note carried 10% of annual interest and had a 1-year term.
- On November 1, 20X8, Candely Services purchased a plot of land that cost $5,000. Due to changes in the land market, the value of the land had risen to $5,600 by December 31, 20X8.
- At the end of the accounting period the company made an adjusting entry to record interest expense.
All the transactions are presented below. When reviewing the transactions, keep in mind that only affected accounts are presented. All other accounts are not shown due to space limitations.
For your convenience, we provide the balance sheet amounts at beginning of 20X8:
Illustration 2-17: Balance sheet amounts at 20X8 beginning
Cash |
4,800 |
Accounts Receivable |
500 |
Interest Receivable |
40 |
Certificate of Deposit |
1,000 |
Land |
0 |
Salary Payable |
700 |
Interest Payable |
0 |
Note Payable |
0 |
Contributed Capital |
3,500 |
Retained Earnings |
2,140 |
Let's move to the events and their impacts on the basic accounting equation.
2.4.1 Cash distribution transaction analysis
1) Event No. 1 is already familiar to us. Cash distribution is an asset use transaction. Both assets (Cash) and equity (Retained Earnings) decrease.
Illustration 2-18: Effect of cash distribution
|
Assets |
... |
Equity |
|
Cash |
... |
Retained Earnings |
Beginning Balances |
$4,800 |
|
$2,140 |
1) Cash Distribution |
-1,000 |
|
-1,000 |
Ending Balances |
3,800 |
|
1,140 |
2.4.2 Maturity of CD transaction analysis
2) Event No. 2 relates to the maturity of the certificate of deposit. The transaction falls into three parts. The first (2.1 in the table below) is related to recognition of interest accrual for the last 4 months (in 20X8). Recall that we have already recognized interest accrual for first 8 months (in 20X7). Therefore, 4 additional months remain to be accounted for in 20X8. The amount of accrual interest to be recognized is calculated as follows:
$1,000 x 6% x (4 / 12) = $20
The entry will increase assets (Interest Receivable) and equity (Interest Revenue). The transaction is an asset source one.
Illustration 2-19: Effect of interest revenue recognition
|
Assets |
... |
Equity |
|
Interest Receivable |
... |
Retained Earnings |
Beginning Balances |
$40 |
|
$1,140 |
2.1) Interest Revenue |
+20 |
|
+20 |
Ending Balances |
60 |
|
1,160 |
The second effect (2.2 in the table below) the transaction has on the accounting equation is collection of the interest receivable. Remember that even though $40 of accrued interest was recognized in 20X7, no cash was collected at that time. Thus, the collection of cash in 20X8 covers the entire interest amount for 12 months ($60 = $40 + $20). The event acts to increase Cash account and decrease Interest Receivable. Accordingly, this is an asset exchange transaction.
Illustration 2-20: Effect of cash collection
|
Assets |
... |
Assets |
|
Cash |
... |
Interest Receivable |
Beginning Balances |
$3,800 |
|
$60 |
2.2) Collected Cash for Interest |
+60 |
|
-60 |
Ending Balances |
3,860 |
|
0 |
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