Investeens

Definition: The expense a company records under accrual accounting to recognize that the interest on money it has borrowed has built up but not yet been paid.

Example: BRW Corporation has borrowed $1 million from ML Bank. The loan calls for BRW to pay 6% interest on the loan at the end of each year that the money remains borrowed. BRW produces financial statements at the end of each quarter (ie: three months) of the year.

It would improper to ignore the interest on the loan that has been building up (ie: accruing) just because it won't be paid until the end of the 4th quarter. The amount of interest that accrues each quarter is $1,000,000 * 6% * 1/4 year, or $15,000. The company should make an entry which debits Accrued Interest Expense for $15,000 and credits Accrued Interest Payable for $15,000.

Investeens explains: The matching principle of accounting calls for companies to "match up" revenues with the expenses that are incurred to generate those revenues. BRW is able to put $ 1 million to use, perhaps by purchasing manufacturing equipment, to generate sales throughout the year. It is only proper to match the loan interest that is building up throughout the year with those sales.

Riddle me this:

1. How do we compute the amount of accrued interest on a loan?
2. What do you suppose will happen to the balance in the Accrued Interest Expense account when the company writes a check to the bank to pay the accrued interest?
3. What can a company to do generate sales with money that it borrows?

See related: Accrual accounting, Matching principle.

Definition: How many times over a company's Cash and Accounts Receivable are able to pay the company's Current Liabilities. The formula: (Cash + Accounts Receivable) / Current Liabilities.

Example: NKL Corp. has Cash of $1,000,000, Accounts Receivable of $500,000 and Current Liabilities of $750,000. Its Acid Test Ratio is ($1,000,000 + $500,000) / $750,000, or 2. It can pay off its Current Liabilities two times over with its existing cash and the cash it will receive when customers pay that they owe (which is kept track of by the Accounts Receivable account).

Investeens explains: Common Current Assets include Cash, Accounts Receivable, Inventory and Prepaid Expenses. Notice that this ratio excludes Inventory and Prepaid Expenses. By subtracting Inventory, we are assuming a "worst case" scenario where our Inventory is of little value now or in the future because has become obsolete or it is very specialized, resulting in our having a hard time finding a buyer for it. We exclude Prepaid Expenses because these may not be refundable, meaning that we cannot get our money back if we want to cancel the remainder of the service we paid for but haven't yet used.

This ratio is more stringent (ie: tougher) than the Current Ratio, which includes all Current Assets in the numerator!

Riddle me this:

1. How do we calculate the acid test ratio?
2. What is it designed to measure?
3. What is the difference between the acid test ratio and the current ratio?
4. Why might a company's inventory not be worth the amount that its accounting records show it is?

See related: Cash ratio, Current ratio, Liquidity ratios, Quick ratio.