3. Second illustration of accrual accounting

Let us expand the example with Candely Services to the next accounting period. We will introduce a few more transactions that apply to 20X7. The transactions are listed below:

1. During 20X7 revenue of $2,700 was recognized on account.
2. $3,000 of accounts receivable was collected in cash from customers.
3. Salary expense of $1,400 was incurred.
4. $1,200 cash was paid to settle salaries payable.
5. $500 cash was distributed to the owner.
6. On May 1, 20X7 Mr. Candely's business invested into a $1,000 certificate of deposit (CD). The CD carries a 6% annual interest and 1-year maturity term.
7. On December 31, 20X7 the company adjusted the books to recognize interest revenue earned on the CD.

The table below summaries the effects of the 20X7 transactions on the accounting equation.

3.1. Summary of transactions for the second illustration of accrual accounting

Illustration 2-12: Effects of transactions for Candely Services for 20X7

The first five transactions are familiar to us (see explanations of 20X6 transactions earlier), so we will go straight to Event No. 6 and No. 7.

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 the 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 April 30, 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 at 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 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 a certificate of deposit. Interest revenue is an income statement account that increases equity.

Later, at the certificate of deposit maturity date, the bank will pay interest to the creditor and the creditor (our company) will decrease the Interest Receivable account and increase the Cash account.

We do not recognize interest revenue until the date of financial statements on December 31, 20X7. At that time, a single entry can 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 account receivable (i.e., interest receivable) on the balance sheet and interest revenue in the income statement.

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