91Ó°ÊÓ

Use the accounting equation to show the effects of each of the following transactions on the firm's balance sheet: 1\. Borrowed \(\$ 20,000\) cash from First Bank and signed an interest-bearing \(120-\) day note \((12 \% \text { annual interest rate })\) on October 1. 2\. On November 1 , borrowed cash from Interwest Bank. Signed a note with a face value of \(\$ 18,000\) and a maturity of 90 days. The bank discounted the note at a \(10 \%\) annual interest rate and issued the net proceeds to the firm. 3\. At December 31 (year-end), record the following adjustments: \(\cdot\)Accrued interest on the note in transaction 1 \(\cdot\)Interest incurred on the note in transaction 2. 4\. Paid the note in transaction 1 plus interest at maturity. 5\. Paid the note in transaction 2 at maturity.

Step by step solution

01

Calculate the accrued interest for Transaction 1

The total interest to be paid on Transaction 1 after 120 days can be calculated using the formula for simple interest, \( I = PRT \), where \( P = \$20000 \), \( R = 12 \% \), and \( T = 120/365 \). Therefore, \( I = \$20000 * 0.12 * 120/365 = \$787.67 \). The interest for 90 days (from October 1 to December 31) to be accrued at the end of the year is \( \$ 20000 * 0.12 * 90/365 = \$ 590.41 \) which increases the firm’s liabilities.

02

Calculate the discount and net proceeds for Transaction 2

The discount is the interest the bank takes upfront, calculated similarly to the interest in step 1. The discount is \( \$18000 * 0.10 * 90/365 = \$ 443.84 \) The net proceeds are the face value of the note minus the discount, therefore, the net proceeds are \( \$18000 - \$ 443.84 = \$ 17556.16 \) which is the cash borrowed by the firm.

03

Record the accrued interest for Transaction 2

The total interest for Transaction 2 is already considered as discount at the beginning of the note. Hence, there is no need for accrual at the end of the year.

04

Record the payment for Transaction 1

At maturity, the firm pays the principal plus the full interest, so the firm’s liabilities decreases by \( \$ 20000 + \$ 787.67 = \$ 20787.67\) and cash (asset) decreases by the same amount.

05

Record the payment for Transaction 2

For Transaction 2, at maturity, the firm pays the full face value of the note. This decrease liabilities by \$18000 and reduces cash (asset) by the same amount.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Balance Sheet

A balance sheet is an important financial statement that provides a snapshot of a company's financial position at a specific point in time. It consists of three main components:

• Assets: Everything the company owns that has value. This includes cash, inventory, equipment, and buildings.
• Liabilities: Obligations the company must pay to others, such as loans or accounts payable.
• Equity: The residual interest in the assets of the company after deducting liabilities, often referred to as the owners' equity.

Each transaction, like those in the exercise, affects the balance sheet by altering these components. For example, borrowing money increases both cash (asset) and the note payable (liability). This ensures the balance sheet continues to satisfy the accounting equation: \[\text{Assets} = \text{Liabilities} + \text{Equity}\] Any changes to assets or liabilities will also affect the firm's equity thus maintaining this balance.

Accrued Interest

Accrued interest is the interest that accumulates on a loan over time, rather than being paid as it accrues. This concept is significant for accounting purposes, especially at the end of a financial period.When a company takes a loan, like in Transaction 1, the interest accrues daily based on the terms of the loan. Even if the interest isn't paid until a later date, it is still recorded at year-end as a liability. This is because it represents an obligation the company will eventually need to fulfill.In the solution, the accrued interest for 90 days is calculated using the simple interest formula: \[ I = P imes R imes \frac{T}{365} \] Where:

• \( P \) is the principal amount of the loan.
• \( R \) is the annual interest rate.
• \( T \) is the time in days.

This helps students understand how to calculate the interest that is owed but not yet paid.

Simple Interest

Simple interest is a way to calculate the interest charge on a loan based on the original amount borrowed (the principal) and is calculated over a period.The formula for simple interest is:\[ I = P imes R imes T \]Where:

• \( I \) is the interest.
• \( P \) is the principal amount.
• \( R \) is the annual interest rate.
• \( T \) is the time period, often in years.

For Transaction 1, the simple interest formula helped determine how much total interest would accrue over 120 days, and more specifically, how much accrued by the fiscal year-end for accounting purposes. Students learn that simple interest is straightforward but essential for managing financial obligations, helping both lenders and borrowers understand costs associated with loans.

Liabilities

Liabilities are financial obligations a company owes to others, and they appear on the balance sheet. They represent the use of someone else's resources. Common liabilities include loans, accounts payable, and mortgages. In our exercise, when the company signs notes to borrow money, it incurs liabilities. For instance, with a bank note, the firm is obliged to repay both the principal and the interest at a later date. As observed in the transactions:

• Borrowing increases liabilities, as shown by the note payable entries.
• Payment reduces liabilities, which occurs when the company repays the borrowed amount and any accrued interest.

Understanding liabilities helps students learn how companies manage debt and obligations and shows how those affect the overall financial health as displayed in the balance sheet. Proper management ensures the company meets its obligations without straining its resources.