Intermediate accounting 17e stice skousen cengage chapter 07

• Bad Debts—must be estimated in the period when credit sales are made or accounts receivable are outstanding.. Uncollectible Accounts Receivable—Direct Write-Off Method When a receiva

The Operating Cycle of a

Business

1 Purchase inventory with cash or credit

2 Sell the inventory, usually on account

3 Collect the receivable

4 Reinvest cash in the business

The Operating Cycle of a

Business

The entry for recognizing revenue and a

receivable from the sale of goods or services

is as follows:

Sales xx

When the amount is collected, Accounts

Receivable is credited and Cash is debited as follows:

The Operating Cycle of a

Business

Accounts Receivable xx

Types of Receivables

• Trade receivables —most significant category

resulting from everyday credit sales of

goods/services to customers

• Notes receivables —trade receivables with a

formal written promise to pay

Nontrade Receivables

receivables They arise from a variety of

transactions, such as:

1 The sale of securities or property other than

inventory

2 Deposits to guarantee contract performance or

expense payment

3 Claims for rebates and tax refunds

4 Dividends and interest receivable

Accounting for Sales Revenue

• Discounts—offered at the time of sale or the time of payment.

• Sales Returns and Allowances—occur subsequent to

the sale and can occur before or after payment has

been made.

• Bad Debts—must be estimated in the period when

credit sales are made or accounts receivable are

outstanding.

• Warranties for Service or Replacement—long after a

sale is made, the warranty period may still be in

• A trade discount reduces the list sales price to the net

sales price charged to the customer.

• A cash (sales) discount can only be taken if the

customer makes the payment within a specified time period There are two methods to account for this:

 Gross method

 Net method

Cash Discount—Gross Method

The gross method is illustrated as follows with credit terms of 2/10, n/30.

Cash Discount—Net Method

The net method records the sale and the receivable net of the discount.

Sales Returns and Allowances

Red sweaters costing $600 are sold to a customer for

$1,000 The customer calls and states that green sweaters were ordered and should have been shipped Rather than return the sweaters, the customer agrees to keep the

sweaters for a reduction in price—an allowance of $200 The return is recorded as follows:

Sales Returns and Allowances 200

Accounts Receivable 200

Suppose that instead of an allowance, the customer elects

to return the sweaters The return requires two entries.

Sales Returns and Allowances 1,000

Accounts Receivable 1,000

Sales Returns and Allowances

Accounting for Bad Debts

• Occurs when customers do not pay for items or

services purchased on credit.

• Bad debts are uncollectible accounts receivable.

• Bad Debt Expense is reported as a selling or general

and administrative expense.

• Accounts Receivable are reported on the balance

sheet at net realizable value; that is, the expected

cash value.

Uncollectible Accounts Receivable—Direct

Write-Off Method

When a receivable proves to be uncollectible,

the direct write-off method requires the

following entry:

Bad Debt Expense xxx

Accounts Receivable xxx

• The use of the direct write-off method is

not allowed under generally accepted

accounting principles

• While it does a poor job of matching

expenses with current revenues, the direct

write-off method is often used by small

businesses

Uncollectible Accounts Receivable—Direct

Write-Off Method

Using the allowance method, the amount of

receivables estimated to be uncollectible is recorded

by the following entry:

Bad Debt Expense xxx

Allowance for Bad Debts xxx

Bad Debt Expense is reported as a selling or

general and administrative expense.

Uncollectible Receivables (Allowance

Method)

When a particular account is determined to be uncollectible:

Accounts Receivable xxx

Note: Bad Debt Expense

Occasionally, an account that has been written off is unexpectedly collected Assume a $1,500 account previously written off is collected

Two entries are required as shown next: the

first to reverse the write-off entry; the second to record receipt of the cash

Uncollectible Receivables (Allowance

Method)

The first entry is to reverse the write-off entry:

The second entry is to record receipt of the cash:

Uncollectible Receivables (Allowance

Method)

Uncollectible Receivables (Allowance

Method)

• Allowance for Bad Debts is a

contra-asset account that is subtracted from

Accounts Receivable on the balance sheet.

• The actual write-off entry for $1,500 does not reduce

net receivables, as shown below:

Percentage of Sales

When basing estimated uncollectibles on

sales for the period, it is preferable to apply

the percentage to credit sales However, the

percentage is frequently applied to total sales

to avoid having to maintain separate records for cash and credit sales

During 2011, a company had credit sales of $100,000 The current accounts receivable balance is $30,500

The allowance for bad debts balance is $350

Historically, 2 percent of the credit sales are not

collected The following adjusting entry is made at the end of the fiscal period:

Bad Debt Expense 2,000

Allowance for Bad Debts

Allowance for Bad Debts Balance

350

Adjusting 2,000

Dec 31, Bal 2,350

After the adjusting entry is posted, Allowance for Bad Debts will have a balance of $2,350

Percentage of Credit Sales

If total accounts receivable for Lamberson Company are

$50,000 and it is estimated that 3% of those accounts will

be uncollectible, the allowance account needs to have a

balance of $1,500 ($50,000 × 0.03) If the allowance

account already has a $600 credit balance, the

current-period adjusting entry is as follows:

Bad Debt Expense 900

Allowance for Bad Debts 900

To record estimated bad debt expense for the period ($1,500 required balance − $600Percentage of Accounts Receivable

• The ending balance must be forced to achieve the

desired balance

• For instance, in the previous example if the allowance

account had already had a debit balance of $200, the adjustment required would be for $1,700 to bring the allowance account to the desired ending balance of

$15,00.

Adjusting 1,700 Dec 31, Bal 1,500

Allowance for Bad Debts Balance 200

Percentage of Accounts Receivable

Aging Receivables

establishing an allowance based on

outstanding receivables involves aging

receivables

• Individual accounts are analyzed to

determining those not yet due and those past due

Corrections to Allowance for

Bad Debts

• If the allowance provisions are too large or small,

a correction in the allowance as well as a change

in the rate or in the method employed will be needed (if the amount is material).

• The effect of this change in accounting estimate

would be reported in the current and future periods as an ordinary item on the income statement, usually as an addition or subtraction from Bad Debt Expense.

Warranties for Service or Replacement

Many companies agree to provide free services on units failing to perform

satisfactorily or to replace defective goods These agreements are referred to

as a warranties

MJW Video & Sound sells DVD players

with a 2-year warranty Past experience

indicates that 10% of all systems sold will

need repairs in the first year, and 20% will

need repairs in the second year The average repair cost is $50 per system

Warranties for Service or Replacement

The number of systems sold in 2010 and 2011 was 5,000 and 6,000, respectively Actual

repair costs were $12,500 in 2010 and $55,000

in 2011

Warranties for Service or Replacement

To record estimated warranty expense:

Warranties for Service or Replacement

To record the cost of actual repairs in 2010:

To record estimated warranty expense:

Warranties for Service or Replacement

To record cost of actual repairs in 2011:

Monitoring Accounts Receivable

• Average collection period is the average

number of days that lapse between the time

that a sale is made and the time that cash is

collected

• It is calculated by dividing the average daily

sales by the average receivables outstanding

In 2010, WS Corporation had average receivables

of $354,250 and net sales of $1,650,000 The

average collection period can be calculated as

follows:

Average collection period = 78 days

Average daily sales = ($1,650,000/365)

Monitoring Accounts Receivable

Monitoring Accounts Receivable

Accounts receivable turnover = 4.7 days

by dividing net sales by the average trade

accounts receivable outstanding during the

year

Net sales $1,650,000 Average net receivables $354,250=

Monitoring Accounts Receivable

Monitoring Accounts Receivable

In some cases, it may be more useful to

report the average collection period for the

receivables existing at the end of the period

Monitoring Accounts Receivable

Compensating Balances

common practice for a company to agree to

maintain a minimum or average balance on

deposit with a bank

SEC as “that portion of any demand deposit

maintained by a corporation which constitutes support for borrowing arrangements ”

Management and Control of Cash

1 Specifically assigned responsibilities for handling

cash receipts

2 Separation of handling and recording cash receipts

3 Daily deposits of all cash received

4 Voucher system to control cash payments

5 Internal audits at irregular intervals

6 Double record of cash—bank and books, with

reconciliations performed by someone outside the

Basic characteristics of a cash control system are:

Book balance

Common causes for differences between the two

• Bank credits for items such as the bank

collecting a note for the depositor

• Errors

Bank Reconciliation

Bank Reconciliation

The following entries would be required on the books of Svendsen, Inc., as a result of the November 30

18.00 To record correction of advertising

recorded as $64 instead of the

Bank Reconciliation

Accounts Receivable 118.94 Miscellaneous General Expense 3.16

Cash

122.10To record customer’s uncollectible

check and bank charges for November.

Bank Reconciliation

Presentation of Receivables in the

Financial Statements

• Current receivables may be grouped in the balance

sheet in the following classes:

1 Notes receivable—trade debtors

2 Accounts receivable—trade debtors

3 Other receivables

• It is possible to combine trade notes and accounts

receivable into a single amount.

• Restrictions on any receivables should be disclosed.

Receivables as a Source

of Cash

Receivables may be converted to cash:

• As a sale (either with or without

recourse)

• As a secured borrowing

FASB Statement No 140 specified the conditions for receivables to be accounted for as a sale:

1 The transferred assets have been isolated

from the transferor and its creditors cannot access the assets.

2 The transferee has the right to pledge or

exchange the transferred assets.

Receivables as a Source of

Cash

Receivables as a Source of

Cash

3 The transferor does not maintain effective

control over the assets through either (a) an agreement to repurchase them before their maturity or (b) the ability to cause the

transferee to return specific assets.

Sale of Receivables Without

Recourse

1 Close the receivables accounts.

2 Close the accompanying allowance for bad debts

account.

3 Any loss from a factoring charge is found by

comparing the book value of the receivables to the proceeds.

A sale of receivables without recourse is commonly

Sale of Receivables Without

Recourse

4 Establish a receivable for any portion of sales

price withheld until final settlement.

5 Debit Cash for net proceeds of the sale.

6 Recognize a gain or loss from factoring.

Selling receivables with recourse means that a purchaser (bank or finance company)

advances cash in return for receivables but

retains the right to collect from the seller if

debtors (seller’s customers) fail to make

payments when due

Sale of Receivables

With Recourse

Secured Borrowing

• With an assignment of receivables:

 There are no special accounting problems involved.

 Simply record the loan.

• With specific assignment:

 Specified accounts receivable pledged

 Accounts Receivable reclassified on balance sheet

 Footnote disclosure of loan provisions required

Derecognition of Receivables: IAS 39

The purpose of the three conditions in SFAS

No 140 is to identify receivable transfers in

which economic ownership of the receivables has been transferred IAS 39 contains the same

concept but applied slightly differently

IAS 39 contains a 2-step test for derecognition.

1 Determine whether the receivable transfer

involves a transfer of “substantially all of the

risks and rewards of ownership of the

[receivable].” If so, the transfer is accounted

for as a sale of the receivable.

Derecognition of Receivables: IAS 39

2 If the receivable transfer does not involve the

transfer of substantially all the risks and

rewards of ownership, determine whether

control of the receivable has been transferred

If so, account for the receivable transfer as a

sale If not, the transfer is treated as a secured loan.

Derecognition of Receivables: IAS 39

Notes Receivable

promise to pay a certain sum of money at a

specified time

• The note is signed by the maker and is

payable to the order of a specified payee

or bearer

• Notes usually involve interest stated at an

annual rate

Special Valuation Problems

• When a note is exchanged for cash:

• It should be recorded at its face amount.

• Any difference between face and cash proceeds―record

as premium or discount on the note.

• When a note is exchanged for property, goods, or

services:

• The present value of the note is found in the terms of the note or supporting documents.

• If there is no current market price for the property, goods,

or services or the note, then use an imputed interest rate.

Note Exchanged for Property

Illustration

On July 1, 2011, Timberline Corporation sells

a tract of land purchased three years ago at a cost of $250,000 The buyer gives Timberline

a 1-year note with a face amount of

$310,000, bearing interest at a stated rate of

8% The market value of the land is

$300,000

July 1 Notes Receivable 310,000

Land 250,000

Gain on Sale of Land 50,000

2011

The unamortized discount balance would be subtracted from Notes Receivable on the

December 31, 2011, balance sheet

Note Exchanged for Property

Illustration

Imputing an Interest Rate

If there is no current market price for either

the property, good, or service or the note, then the present value of the note must be

determined by selecting an appropriate interest rate The imputed interest rate is determined at the date of the exchange and not altered

thereafter

Horrocks & Associates accepted a $45,000

note as payment for services The note is interest-bearing and comes due in three yearly installments of $15,000 each, beginning

non-December 31, 2012 Assume there is no market value for the note and no objective way to

determine the value of the service

(continues)

Imputing an Interest Rate

The computation is based on the present value

The entry to record the receipt of the note would be:

Imputing an Interest Rate