Accounting for Advanced Accruals

Illustration 6-23: T-accounts for illustration of warranties accounting

Assets		=	Liabilities and Equity
Cash			Warranties Payable		Retained Earnings
Beg. 400				Beg. 0		Beg. 500
(1a) 700	(3) 80		(3) 80	(2) 100		(cl.) 400
Bal. 1,020				Bal. 20		Bal. 900

Inventory					Sales Revenue
Beg. 600			Contributed Capital			Beg. 0
	(1b) 200			Beg. 500	(cl.) 700	(1a) 700
Bal. 400				Bal. 500		Bal. 0

					Warranties Expense
					Beg. 0
					(2) 100	(cl.) 100
					Bal. 0

					Cost of Goods Sold
					Beg. 0
					(1b) 200	(cl.) 200
					Bal. 0

We will not show financial statements for this accounting period because they are similar to those from the previous period. Note that Warranties Payable are included in the liabilities sector on the balance sheet.

6.7 Definition and explanation of discount bonds

So far we have been dealing with interest-bearing notes. When such a note is matured, face value plus accrued interest are to be paid.

Interest-bearing notes require an interest to be paid in addition to the face value. In other words, such notes require the borrower to pay the face value and interest at the maturity date.

In contrast, there is another type of notes called Discount Notes that have the interest included in the face value.

Discount bonds are bonds that have interest included in the face value. When the note matures, the borrow only pays the face value, which includes interest in it.

For example, a $3,000 face value discount note is repaid with $3,000 cash that contains both the face value and the accrued interest. The illustration below provide a good example of accounting for discount notes.

6.7.1 Illustration #1 of accounting for discount bonds

Assume that Safe Life is a business specializing in security services. In 20X7 the company management decided to expand operations and hire more employees. To cover extra expenses, Safe Life issued a $5,000 face value discount note to the Companies Bank on May 1, 20X7. The note carried 7% discount rate and a 1-year term to maturity. In order to determine the amount of cash borrowed, we need to divide the face value into the principal and discount. The discount is computed by multiplying the face value by the interest rate by the time period. So, the discount equals: $350 = $5,000 x 7% x 1 period (year). The amount borrowed (principal) is determined by subtracting the discount from the face value. In our case, this amount is $4,650 (i.e., $5,000 - $350). We have come up with the principal of $4,650 and the discount of $350:

Illustration 6-24: Principal and discount amounts of a discount bond

Face value	$5,000
Discount	$350	= $5,000 x 7% x 1
Principal	$4,650	= $5,000 - $350

To record the book value (also called carrying value) of the borrowing, assets (Cash) and liabilities (Notes Payable) are increased by $4,650. This is an asset source transaction:

Illustration 6-25: Effect of issuing a discount note in the horizontal model

Event No.

Assets

Liabilities

Equity

Rev.

Exp.

Net Inc.

Cash Flow

4,650

n/a