4.3. Borrowing from bank transaction analysis

3) Event No. 3 is borrowing $2,400 from a local bank. This is an asset source transaction. Assets (Cash) and liabilities (Note Payable) increase by $2,400.

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 22: Effect of borrowing funds from a bank

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:

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 23: Effect of land purchase

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 the land market value to $5,600 does not have any impact on the financial statements.

4.5. Interest expense accrual transaction analysis

5) Finally, Event No. 5 represents an adjusting entry at the end of 20X8 accounting period. When Candely Services borrowed money from a bank, the company agreed to pay interest on it. Therefore, in 20X8 the company should record the accrued interest for the period from March 1, 2008 to December 31, 20X8, or, in other words, to incur interest expense for 10 months. In our situation, the amount of interest can be calculated like this:

$2,400 x 10% x (10 ÷ 12) = $200

A liability account (Interest Payable) increases, and equity (Retained Earnings) decreases. The Retained Earnings account decreases through an increase in the interest expense.

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

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 expense in the books.

Illustration 24: Effect of Interest Accrual

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