4. Third illustration 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. \$1,000 cash distribution was made to the owner.
2. On April 30, 20X8 Mr. Candely received the principal and interest on the certificate of deposit when it matured.
3. The business borrowed \$2,400 from a local bank on March 1, 20X8. The note carried 10% annual interest and had a 1-year term.
4. 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.
5. At the end of the accounting period the company made an adjusting entry to record interest expense.

All 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 on a page.

For your convenience, we provide the balance sheet amounts at the beginning of 20X8:

Illustration 17: Balance sheet amounts at the beginning of 20X8

 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 analyze the events and their impacts on the basic accounting equation.

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 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

4.2. Maturity of certificate of deposit 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 the recognition of interest accrual for the last 4 months (in 20X8). Recall that we already recognized interest accrual for first 8 months (in 20X7). Therefore, 4 additional months remain to be accounted for in 20X8. The amount of accrued 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 (by increasing Interest Revenue). The transaction is an asset source one.

Illustration 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 the 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 the 12 months (\$60 = \$40 + \$20). The event acts to increase the Cash account and decrease the Interest Receivable account. Accordingly, this is an asset exchange transaction.

Illustration 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

The third entry related to the certificate of deposit maturity represents collection of the principal. Recall that on May 1, 20X7, Candely Services bought a CD with a 1-year term from a bank. Respectively, on April 30, 20X8 Mr. Candely's business should get the invested money back. This transaction increases the Cash account and decreases the Certificate of Deposit account. Both accounts involved are asset accounts, so this is an asset exchange transaction.

Illustration 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
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