Investeens

Definition: The build-up of money that a company owes or, on the flip side, is entitled to receive.

Example: Schmitt Corp. has 10 employees who each have an annual salary of $52,000, which equates to $1,000 per week. To cut down on paperwork, the company pays the employees $2,000 every other Friday. On the Friday between paydays, the company is asked to produce financial statements showing the state of its business. Before it can produce accurate statements, it must make a bookkeeping entry to record the fact that all the employees are owed one week of salary. It has accrued to them.

Investeens explains: Continuing with the above, if the $10,000 in salaries owed was not recorded, the profits of the company would be overstated by that amount. This demonstrates that businesses can have expenses before it pays for them. On the other hand, businesses can also achieve sales after providing goods and services to their customers. For example, an electronics store has a right to record a sale after it delivers and installs a TV at a customer's home even if the customer does not pay at the time of delivery.

Note that accrual accounting is time consuming and costly to do properly. For this reason, the Internal Revenue Service (the government's tax collection department) allows small companies the option of only recording business activities when cash moves and out of the business. See Cash basis accounting.

Riddle me this:

1. A tire company takes a full page advertisement in the December issue of Motor Trend magazine. It receives the bill from Motor Trend in December but pays it the following January. Identify in which month an advertising expense should be recorded, and why.
2. Explain why accrual accounting results in more accurate financial reporting than cash basis accounting.
3. Explain why the Internal Revenue Service nevertheless allows small companies to use cash basis accounting.

See opposite: Cash basis accounting, IRS (Internal Revenue Service).

Definition: The amount of interest that is built up between periodic (ie: regularly scheduled) bond interest payments. The seller of a bond wants to be paid this interest when he or she sells a bond any time between interest payments.

Example: A bond has an interest rate of 6%, meaning that it earns the holder 6% of its $1,000 face value, or $60 in interest per year. Companies typically pay interest twice per year, so the holder of a 6% bond will actually receive interest payments of $30 every six months. Notice that the interest in our example is $5 per month.

Let's say that a month before the next interest payment is going to be made, the owner of the bond can't wait for the payment and must sell the bond now. She realizes that whoever she sells the bond to will receive the next $30 interest payment in just a month. This seems unfair because she's held the bond for five of the six months between interest payments. To be treated fairly, she ensures that in addition to a fair price for the bond, the buyer pays her the $25 (ie: $5 per month x 5 months) interest that has accrued. The buyer agrees to this because in just a month, he, as the new owner, will receive the $30 interest payment. This makes up for the $25 paid he paid to the seller, with the $5 difference representing interest for the one month he's owned the bond.

Investeens explains: A bond that does not trade with accrued interest is known to trade "flat". The primary reason for a bond to trade flat is that the company has been unable to pay the interest it has promised to pay, so investors don't have much confidence that any future interest will be paid to them by the company.

Riddle me this:

1. What occurs between periodic bond interest payments?
2. Over what period of time will it take for a company to pay the interest stated on the bond?
3. How frequently do companies actually pay interest on their bonds?
4. When a person buys a bond from another person in between bond payments, besides paying for the bond itself, what else will the person pay?
5. How do we compute the amount of accrued interest the buyer should pay?

See related: Bond, Interest.