3.3 Accrued Interest, Depreciation Adjustments & Other Estimates

Prepaids reclassify costs already paid. Bad-debt entries estimate uncollectible receivables. Two other adjusting estimates show up constantly on bookkeeper exams: accrued interest on notes and depreciation of property and equipment. AIPB's adjusting-entries training is about computing end-of-period adjustments so the trial balance can be updated. This independent OpenExamPrep section shows how to measure elapsed interest with Principal × Rate × Time, why the depreciation adjusting entry exists, and how a contra-asset presents accumulated usage. Detailed depreciation methods (units-of-production, declining-balance, sum-of-the-years'-digits, MACRS) belong in later chapters; here you need the why of the month-end entry and one straight-line illustration so the worksheet numbers make sense.

Accrued interest on notes

Interest is the cost of borrowing (or the earnings from lending) that builds as time passes, even if cash interest is paid only at maturity. If a note is outstanding across a statement date, the books must pick up the interest that belongs to the period just ended.

Interest = Principal × Annual interest rate × Time

Time is the fraction of a year that has elapsed since the note was issued or since interest was last recorded. Bookkeeping problems often use a 360-day banker's year and 30-day months. Some facts use 365 days or exact calendar days. Read the problem. Do not mix 360 and 365 in the same calculation.

Note receivable (you are the lender)

On November 1, Harbor Lane accepts a $12,000, 6%, 90-day note from a client who needed extra time to pay. Using 30-day months, November and December are 60 days through December 31.

Accrued interest = $12,000 × 0.06 × 60/360 = $12,000 × 0.06 × 1/6 = $120.

December 31 adjusting entry (lender):

• Debit Interest Receivable $120
• Credit Interest Revenue $120

Interest Receivable is an asset. Interest Revenue belongs on the income statement for November–December. When the note is collected at maturity (about January 30), Harbor Lane will debit Cash for principal plus total 90-day interest of $180 ($12,000 × 0.06 × 90/360) and will credit Interest Receivable $120, Interest Revenue $60 for January, and Notes Receivable $12,000. The December adjusting entry is what keeps January from claiming all $180.

If someone wrongly accrues the full 90-day interest of $180 on December 31, January revenue is understated and December revenue is overstated by $60.

Note payable (you are the borrower)

On October 1, Harbor Lane borrows $20,000 on a 6-month, 8% note. At December 31, three months have elapsed.

Accrued interest = $20,000 × 0.08 × 3/12 = $400.

December 31 adjusting entry (borrower):

• Debit Interest Expense $400
• Credit Interest Payable $400

Do not credit Notes Payable for the interest. The note is still $20,000 of principal. Interest Payable is a separate current liability. When the note is paid on April 1, six months of interest will total $800; $400 was already accrued at year-end, so the maturity entry expenses (or pays) the remaining $400 plus principal.

Cash is not in either adjusting entry. Cash interest, if any, was recorded when a payment was actually made.

Why depreciation needs an adjusting entry

Equipment, furniture, and vehicles are not expenses on the purchase date (beyond any immediately consumed supplies). They are plant assets used up over several periods. Depreciation allocates the asset's depreciable cost to the periods that use it. The matching idea is the same as prepaid insurance, but the remaining benefit is measured in years of service rather than months of a policy, and the credit does not go to the asset account.

The purchase already credited Cash (or Accounts Payable or Notes Payable). The adjusting entry is noncash. If you skip it, expenses are too low, assets are too high, and net income is overstated.

The entry and the contra-asset

Every routine depreciation adjusting entry looks like this:

• Debit Depreciation Expense
• Credit Accumulated Depreciation (a contra-asset)

Accumulated Depreciation has a credit balance and is reported as a deduction from the related asset. You keep the asset at historical cost so readers can see original investment and usage to date separately.

Net book value (also called carrying amount) = Cost − Accumulated Depreciation.

Net book value is not the same thing as fair market value. Depreciation is cost allocation, not an appraisal.

Crediting Equipment directly would hide cost and make it harder to track fully depreciated assets that are still in use. Crediting Cash would pretend cash left the bank again. Neither is the adjusting entry.

One straight-line illustration

Harbor Lane buys equipment on January 1 for $18,000 cash. Estimated salvage (residual) value at the end of a four-year useful life is $2,000. Straight-line depreciation assigns an equal amount of the depreciable base to each year:

Depreciable base = $18,000 − $2,000 = $16,000
Annual depreciation = $16,000 ÷ 4 = $4,000

December 31 adjusting entry:

• Debit Depreciation Expense $4,000
• Credit Accumulated Depreciation—Equipment $4,000

Balance-sheet presentation after year one:

If the firm issues monthly statements, one-twelfth of $4,000 is $333.33 (often rounded to $333, with a year-end true-up, or recorded as $333.33). Partial-year conventions and accelerated methods are later-chapter topics. For adjusting-entry questions, recognize that some depreciation must be accrued because the asset was used, and that the credit belongs in Accumulated Depreciation.

After four years, Accumulated Depreciation is $16,000 and net book value equals salvage of $2,000. You stop depreciating (unless a later change in estimate is made). The $2,000 is not expensed through depreciation; it remains in the asset until disposal.

Other estimates at the same close

The same worksheet often includes other estimated or accrued items that follow the same logic: pick up costs or revenues that belong to the period even though the source document arrives later.

Accrued wages (if not already posted) debit Wages Expense and credit Wages Payable for days worked but not yet paid. Accrued utilities debit Utilities Expense and credit Utilities Payable for service received before the bill arrives. Property taxes levied on a calendar that overlaps the books may need a monthly accrual. Bad-debt expense, covered in the previous section, is itself an estimate posted to a contra-asset. Prepaid insurance and supplies, covered earlier in this chapter, are deferrals rather than accruals, but they share the worksheet with these estimates.

What these items share: the adjusting entry does not wait for the cash movement, the amounts may be calculated rather than copied from an invoice, and reversing entries in the next period are optional bookkeeping policy, not a substitute for getting the December 31 balances right.

Traps

Using the full note term instead of elapsed time overstates accrued interest. Putting interest in Notes Payable or Notes Receivable mixes principal with cost of funds. For depreciation, crediting the asset, using cost without subtracting salvage in a straight-line problem that gives salvage, or treating book value as what the asset could sell for, all produce wrong statements. Keep interest and depreciation on the estimates list at every close until the worksheet's adjusted trial balance includes them.