Accounting for Accruals

The third entry related to the certificate of deposit maturity represents collection of the principal. Recall that on April 31, 20X7, Candely Services bought a CD with a 1-year term from a bank. Respectively, on May 1, 20X8 Mr. Candely's business should get the invested money back. This transaction increases Cash and decreases Certificate of Deposit account. Both accounts involved are asset accounts, so this is an asset exchange transaction.

Illustration 2-21: Effect of certificate of deposit principal collection

	Assets	...	Assets
	Cash	...	Certificate of Deposit
Beginning Balances	$3,860		$1,000
2.3) Redeemed CD	+1,000		-1,000
Ending Balances	4,860		0

2.4.3 Borrowing from a bank transaction analysis

3) Event No. 3 is borrowing money from a local bank. This is an asset source transaction. The asset account (Cash) and liability account (Note Payable) increase by a like amount.

Note payable is an obligation in the form of a written promissory note signed by the borrower. The note includes the information on the rate of interest, the term of maturity, and collateral pledged to secure the loan.

Illustration 2-22: Effect of borrowing funds from a bank

	Assets	...	Liabilities
	Cash	...	Note Payable
Beginning Balances	$4,860		$ 0
3) Borrowed Funds	+2,400		2,400
Ending Balances	7,260		2,400

2.4.4 Land purchase transaction analysis

4) Event No. 4 describes a land purchase by Mr. Candely's business. This is an asset exchange transaction because one asset account (Land) increases and the other asset account (Cash) decreases. Note that the land is recorded at its historical cost of $5,000 (see below). According to the historical cost principle, the increase in the market value of the land does not change its recorded value in the financial statements. So, the increase in land market value to $5,600 does not have any impact on the financial statements

Historical cost is based on the dollar amount originally exchanged to acquire an asset. A historical cost also refers to an accounting principle requiring financial statements to be based on original costs.

Illustration 2-23: Effect of land purchase

	Assets	...	Assets
	Cash	...	Land
Beginning Balances	$7,260		$ 0
4) Purchased Land	-5,000		+5,000
Ending Balances	2,260		5,000

2.4.5 Interest expense accrual transaction analysis

5) Finally, Event No. 5 represents an adjusting entry at the end of accounting period. When Candely Services borrowed money from a bank, the company agreed to pay interest on it. Therefore, the company should record the accrued interest for the period up to the accounting period end (December 31, 20X8), or, in other words, to incur interest expense for 10 months (from March to December). In our situation, the amount of interest will be calculated like this:

$2,400 x 10% x (10/12) = $200

A liability account (Interest Payable) increases, and equity (Retained Earnings) decreases.

Interest payable is a liability account that shows future interest payments for using somebody's money. For example, taking a long in a bank usually means that the borrower will pay the principal and interest. Such interest is show in the interest payable account until paid.

Retained earnings decrease through an increase in the interest expense.

Interest expense is the charge that a business needs to take and record when using somebody's money. Interest expense is an income statement account which decreases equity.

Recording the interest expense is a claim exchange transaction. Note that the company did not pay off the amount of interest payable in 20X8, so there were no cash outflows. The company just recorded the interest in the books.

Illustration 2-24: Effect of Interest Accrual

	Liabilities	...	Equity
	Interest Payable	...	Retained Earnings
Beginning Balances	$0		$1,160
5) Accrued Interest	+200		-200
Ending Balances	200		960

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