Intermediate accounting 19th by stice stice chapter 07

Uncollectible Accounts Receivable—Direct Write-Off Method When a receivable proves to be uncollectible, the direct write-off method requires the following entry: Accounts Receivable xx

Intermediate

Accounting

James D Stice Earl K Stice

PowerPoint presented by Douglas Cloud Professor Emeritus of Accounting, Pepperdine

The Revenue/Receivable/ Cash Cycle

Chapter 7

19 th

Edition

The Operating Cycle of

a Business

• The normal operating cycle of a

business involves purchasing inventory (using either cash or credit), which is

then sold, often on account

• Once the receivable is collected, the

cycle begins again

• The normal operating cycle is the

lifeblood of any business enterprise

(continued)

• The recognition of revenue is generally

related to the recognition of accounts

When the amount is collected, Accounts Receivable is credited and Cash is

Types of Receivables

significant category of receivables, result

from the normal activities of a business

• Trade receivables may be evidenced by a formal written promise to pay and classified

In its broadest sense, the term receivable

is applicable to all claims against others

for money, goods, or services

In its broadest sense, the term receivable

is applicable to all claims against others

for money, goods, or services

Nontrade Receivables

of 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

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

(continued)

Suppose that instead of an allowance, the

customer elects to return the sweaters The

return requires two entries.

Sales Returns and Allowances 1,000

The first entry recognizes the return and the

reduction of the customer’s account The

second entry reports that the sweaters are now

in inventory.

Sales Returns and Allowances

Accounting for Bad Debts

• Bad debts occur when customers do not pay for items or services purchased on credit; thus, 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 and not the present value.

(continued)

Uncollectible Accounts Receivable—

Direct Write-Off Method

When a receivable proves to be

uncollectible, the direct write-off

method requires the following entry:

Accounts Receivable

xxx

(continued)

• The use of the direct write-off method is

not allowed under GAAP because it does not provide for the matching of expenses

with current revenues and does not report receivables at their net realizable value

• The direct write-off method is often used by small businesses because of its simplicity

Uncollectible Accounts Receivable—

Direct Write-Off Method

• Using the allowance method, which is

required by GAAP, the amount of

receivables that are not collectible has to

be estimated

Uncollectible Account Receivables

—Allowance Method

• A typical entry to recognize bad debt

expense, normally made as an period adjustment is as follows:

Allowance for Bad Debts

xx

To record estimated uncollectible

accounts receivable for the period.

• Bad Debt Expense is reported as a

selling or general and administrative

• When positive evidence is available

concerning the partial or complete

worthlessness of an account, the account is written off using the following entry:

Note: Bad Debt Expense

is not debited.

Note: Bad Debt Expense

is not debited.

Writing off an Uncollectible Accounting

Under the Allowance Method

Allowance for Bad Debts xx

Accounts Receivable xx

To record the write-off of an

uncollectible account.

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

Collecting a Written-off Account Under

the Allowance Method

(continued)

Accounts Receivable 1,500 Allowance for Bad Debts

1,500

To reverse the entry made to

write off the account.

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

The second entry is to record receipt of the

cash:

Collecting a Written-off Account Under

the Allowance Method

Allowance for Bad Debts

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:

Estimating Uncollectibles Based

on 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.

(continued)

• If 2% of sales is considered doubtful in terms of collection and sales for the period are

$100,000, the charge for Bad Debt Expense

would be 2% of the current period’s sales, or

$2,000.

• The existing balance in Allowance for Bad

Debts is ignored.

Allowance for Bad Debts

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:

Allowance for Bad Debts

900

To record estimated bad debt expense for the period ($1,500 required balance

− $600 current balance = $900 adjustment).

Estimating Uncollectibles Based

on A/R Balance

Aging Receivables

• The most commonly used method for

establishing an allowance based on

outstanding receivables involves aging receivables

• Individual accounts are analyzed to

determine those not yet due and those past due.

adjustment, the following entry is needed:

Allowance for Bad Debts

2,250

To record estimated bad debt expense

required balance

− $620 current balance = $2,250

adjustment)

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.

Helpfu l Reminder

• When bad debts are estimated based on a

computed and the balance of the allowance account is then determined

• When you are using the

allowance account is computed, and then the amount of bad debt expense for the

period is determined

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

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

(continued)

The number of systems sold in 2012 and

2013 was 5,000 and 6,000, respectively Actual repair costs were $12,500 in 2013 and $55,000 in 2014.

Warranties for Service or

Replacement

(continued)

To record estimated warranty expense:

2012

2012

Estimated Liability for Warranties

75,000 To record estimated warranty

expense based on systems sold

(5,000 × 0.30 × $50 = $75,000).

Warranties for Service or

Replacement

(continued)

To record the cost of actual repairs in 2012:

Estimated Liability for Warranties 12,500

To record estimated warranty expense:

Estimated Liability for Warranties

90,000To record estimated warranty

expense based on systems sold (6,000 × 0.30 × $50).

To record cost of actual repairs in 2013:

Estimated Liability under Warranties 55,000 Cash

55,000To record cost of actual repairs

Periodically, the warranty liability account should be analyzed to see whether the

actual repairs approximate the estimate.

Warranties for Service or

Assume that warranty costs incurred in 2013 were only $35,000 Then the ending balance in the allowance account of $117,500 would be considered much higher than the $100,000

estimate The following adjustment would be made in 2013

Warranties for Service or

Replacement

Estimated Liability under Warranties 17,500

Warranty Expense.

17,500 To record adjustment for

estimate for warranty repair.

Monitoring Accounts Receivable

• The 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

receivables outstanding by the average daily sales

(continued)

In 2012, 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 receivable $354,250 Average daily sales = ($1,650,000/365)

(continued)

Monitoring Accounts Receivable

Accounts receivable turnover = 4.7 times

Accounts receivable turnover is determined

by dividing net sales by the average trade

accounts receivable outstanding during the year The calculation for 2012 is as follows:

Average net receivables = $354,250

Monitoring Accounts Receivable

• Revenues and receivables have value

because they will eventually be converted

to cash.

• Cash is important because it provides the basis for measurement and accounting for all other items.

• The FASB identified the need to report

information on cash and liquidity as one of the key objectives of financial reporting.

Cash Management and Control

(continued)

cash equivalents

(continued)

Composition of Cash

• Deposits that are not immediately available for withdrawal or have other restrictions are sometimes referred to as time deposits

• Time deposits are sometimes separately

classified as temporary investments

• Deposits in foreign banks that are subject

to immediate and unrestricted withdrawal generally qualify as cash

(continued)

Composition of Cash

• Cash balances specifically designated by

management for special purposes should be reported separately, e.g a bond sinking

fund.

• A credit balance in the cash account resulting from the issuance of checks in excess of the amount on deposit is known as a cash

overdraft.

Compensating Balances

• In connection with financing arrangements,

it is common practice for a company to

agree to maintain a minimum or average

balance on deposit with a bank

• These compensating balances are

defined by the SEC as “that portion of any demand deposit maintained by a

corporation which constitutes support

for borrowing arrangements ”

(continued)

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

Basic characteristics of a cash control

system are:

(continued)

5 Internal audits at irregular intervals

6 Double record of cash—bank and books,

with reconciliations performed by someone outside the accounting function

These controls are more likely to be found in large companies with many employees.

These controls are more likely to be found in large companies with many employees.

Management and Control of Cash

Bank Reconciliation

A comparison of the bank balance

with the book balance is usually made monthly by means of a summary

known as a bank reconciliation.

Bank

balance

Book balance

(continued)

If, after considering these items, the

bank statement and the book balances

cannot be reconciled, a detailed

analysis of both the bank’s records and the depositor’s books may be necessary

to determine whether errors or

irregularities exist on the records of

either party.

(continued)

Bank Reconciliation

The following entries would be required on the

books of Svendsen, Inc., as a result of the

18.00 To record correction for check

payment of advertising recorded as

$64 instead of the actual amount,

$46.

Preparing a Bank Reconciliation

Miscellaneous General Expense 3.16

Cash

122.10To record customer’s

uncollectible check and bank

charges for November.

Preparing a Bank Reconciliation

Presentation of Receivables in the

Financial Statements

• Current receivables may be grouped in the

balance sheet in the following classes:

 Notes receivable—trade debtors

 Accounts receivable—trade debtors

 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 quickly in one of two ways:

• As a sale (either with or without

recourse)

• As a secured borrowing

(continued)

FASB specified in Topic 860 the conditions for receivables to be accounted for as a

sale:

1 The transferred assets have been

isolated from the transferor That is, 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

(continued)

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

Receivables as a Source of Cash

Sale of Receivables Without Recourse

• When banks, dealers, and finance companies purchase receivables from companies, in

many cases, these purchases are done

without recourse.

• Without recourse means the purchaser

assumes the risks associated with the

collectibility of the receivables.

• A sale of receivables without recourse is

commonly referred to as accounts

receivable factoring, and the buyer is the

factor

(continued)

a) failure of the debtors to pay when due,

b) the effects of prepayments, or

c) adjustments resulting from defects in the

eligibility of the transferred receivables.”

of a transferee of receivables to receive

payment from the transferor of those receivable for any of the following reasons:

(continued)

Sale of Receivables Without Recourse

• Assume that $10,000 of receivables are

factored, that is, sold without recourse, to a finance company for $8,500.

• An allowance for bad debts equal to $300

was previously established for these

accounts.

• The finance company withheld 5% of the

purchase price as protection against sales

returns and allowances

(continued)

Sale of Receivables Without Recourse