Intermediate Accounting November 2nd, 2010

Intermediate Accounting November 2nd, 2010
General Course Questions Chapter 7 Cash and Receivables: A. Cash & Bank Reconciliations questions 2, 3, Ex 2 & 24 B. Trade Discounts and Sales Discounts ? 5, 6 BE 2 & 3 C. Estimating and Recording Bad Debts ?8,9,11, Ex 8 & 9 D. A/R journal entries, Analysis (turnover & liquidity Ex 20) E. Notes Receivable ex 6 & 7 3. Chapter 7 Assignments for Thursday, November 4th: A. Using Receivables to Raise Cash Questions 17, 19 & 20 BE 8,9,10, & 17, Exercise 18 B. Recording Bad Debt Expense Problems 2,4, and 6 Review Midterm Exam Review Project 1 Columbia Sportswear 10-K

Cash & Cash Equivalents
Cash: Currency and coins held, available funds on deposit at the bank, money orders received, certified checks, cashier’s checks, personal checks, bank drafts and savings accounts. Cash Equivalents are short-term, highly liquid investments that are both: Readily convertible into known amounts of cash So near maturity that there is no risk of change in valuation from fluctuating interest rates (original maturities of no longer than 3 months) Examples: T-bills, commercial paper, money market funds

Reporting Cash Cash Cash Equivalents Restricted Cash Bank Overdrafts
reported as the most liquid current asset on the balance sheet Cash Equivalents Grouped together with cash Restricted Cash Disclosed separately from regular cash Examples – restricted for 1) plant expansion, retirement of long-term debt and 3) compensating balances. Classify as current or long-term depending on expected use Bank Overdrafts US GAAP: Disclosed as a current liability unless there are other positive-balance cash accounts at the same bank that it can be netted against IFRS: Included in cash and cash equivalents if repayable on demand and form a part of an entity’s cash management Homework Questions 2, 3 ex 2

Summary of Cash-Related Items
Illustration 7-2

Control over Cash Why are internal controls over cash so important?
Three Key Controls 1) Management oversight and authorization Especially useful in small organizations where the owner can monitor activities (and where there are limited resources to have separation of duties) Separation of duties: Physical control, authorization and record keeping E.g., one employee prepare the deposit slip and make the entry, and another employee will actually make the deposit Physical Protection of cash Minimize the cash on hand; only petty cash fund and current day’s receipts Keep funds in a vault, safe, or locked cash drawer Transmit each day’s receipts to the bank as soon as practicable Periodically prove (reconcile) the balance shown in the general ledger to the bank statement.

Controls and Cash: Bank Reconciliation
Balance per bank $xxx,xxx Add: Deposits in Transit x,xxx Less: Outstanding Checks (x,xxx) +/- and Bank Errors (x,xxx) Adjusted Bank Balance $xxx,xxx* Should equal the current balance per books after adjusting entries on the books are made for bank charges or credits noted on bank statement corrections of any book errors found during reconciliation. Why is this an effective control? Exercise 24

Recording Trade & Cash Discounts
Trade Discounts – reduction in list price for differential volume. Sales & A/R are reduced by the discount (reflecting the amount the customer is billed) and no other accounts are affected. Cash discounts – reduction in amount owed if paid within a specified period (reward for prompt payment) Possible accounting methods : Gross method records discounts when taken by customers as “Sales Discounts” in contra Sales account (most commonly used). Net method records discounts not taken by customers as “Sales Discounts Forfeited” which is an “other revenue” item on the Income Statement. Questions 5 & 6, brief exercises 2 & 3

Cash Discounts - Net & Gross Methods
Sale of $1,000 of inventory, 2/10, n/30 on 1/1/09, for two scenarios: Payment is made on 1/10/09 b) Payment is made on 1/15/09: Net Method: Gross method: January 1, 2009: Dr. A/R (1,000 x .98) 980 Cr. Sales Revenue 1,000 If paid within discount period 1/10/09 Dr. Cash A/R inside discount period on 1/10/09 Dr. Sales Discounts 20 outside discount period on 1/15/09: C r. Sales Discounts Forfeited

Valuation of Accounts Receivable
Short term receivables are reported at their net realizable value (NRV) What is NRV? less estimated non-collectible accounts less allowance for returns. Classification of Accounts Receivable US GAAP: Must separately disclose material related party receivables (i.e., trade receivables separate from non-trade) IFRS: Classified on balance sheet as a financial asset May separately disclose material related party receivables

Estimating Uncollectible Receivables
Methods of Accounting for Uncollectible Accounts Direct Write-Off Theoretically undesirable: A/R are written off when determined uncollectible No matching (Expense and Revenue not likely recorded in the same period) Receivables not stated at net realizable value (no Balance Sheet account for “allowance for bad debts”) Not GAAP, unless bad debt expense in immaterial Allowance Method Losses are Estimated using an contra account (Allowance for Bad Debts): Percentage-of-sales Meets GAAP Matching requirement - Bad Debt expense estimated in same period as Sale. Percentage-of-receivables Meets GAAP - Receivables are carried at net realizable value

Accounts Receivable Direct write-off (used only if low & infrequent bad debts) Bad debt expense (I/S) XXX AR (B/S - Asset) XXX Indirect (allowance method) In year of the sale: Allowance for bad debts (B/S – Asset) XXX When found to be uncollectible: AR (B/S – Asset) XXX If payment received after account written off: Cash (B/S – Asset) XXX

Uncollectible Accounts Receivable
Income Statement Approach (ignore Balance Sheet Accounts – A/R & Allowance Account) Use “Sales” to estimate the “Bad debt expense” for the period. Balance Sheet Approach (ignore Income Statement accounts – Sales and Bad Debt Expense) Use A/R to determine what the ending Balance in the Allowance Account should be (adjust it). Entry: Debit: Bad Debt Expense (temporary account, 0 before adj.) Credit: Allowance for Doubtful Accounts (permanent account)

Computing the Adjusting Entry for Bad Debt Expense
Instructions: Prepare the journal entry to record bad debt expense assuming Tuyet-Mai Company estimates bad debts at 1% of net sales and (b) 5% of accounts receivable.

Instructions: Prepare the journal entry to record bad debt expense assuming Tuyet-Mai Company estimates bad debts at 1% of net sales and (b) 5% of accounts receivable. Bad Debt Expense 7,500 Allowance for Doubtful Accounts 7,500 ($800,000 – $50,000) x 1% = $7,500

Instructions: Prepare the journal entry to record bad debt expense assuming Tuyet-Mai Company estimates bad debts at 1% of net sales and (b) 5% of accounts receivable. Bad Debt Expense 7,500 Allowance for Doubtful Accounts 7,500 ($800,000 – $50,000) x 1% = $7,500 Bad Debt Expense 6,000 Allowance for Doubtful Accounts 6,000 ($160,000 x 5%) – $2,000) = $6,000

AR Allowance Methods: Determining the Amount of the Adjustment
Percent of Receivables Allowance method Balance-sheet oriented Uses one B/S account (AR) to estimate another B/S account (Allowance) Estimates the ENDING balance in the allowance account Bad debt expense is the “plug” Percent of Sales Allowance method Income-statement oriented Uses one I/S account (revenue) to estimate another I/S account (bad debt expense) Estimates the TOTAL bad debt expense The allowance is the “running total” Entry: Debit: Bad Debt Expense (temporary account, 0 before adj.) Credit: Allowance for Doubtful Accounts (permanent account)

Allowance Example “Percent of Receivables” method (B/S-oriented) Irwin Co. has $60,000 in sales in AR at 12/31/10 is $24,000. Allowance for doubtful accounts at 12/31/10 is $ What adjusting entry should be made at year end? The company estimates allowance based on 1% of AR < 31 days, 2% days, 5% days and 20% > 90 days: Amount $24, ,000 8,000 4,000 2,000 Uncollectible % 1% 2% 5% 20% Allow. Est. $860 = Entry:

Allowance Example 1. “Percent of Receivables” method (B/S-oriented) Irwin Co. has $60,000 in sales in AR at 12/31/10 is $24,000. Allowance for doubtful accounts at 12/31/10 is $ What adjusting entry should be made at year end? The company estimates allowance based on 1% of AR < 31 days, 2% days, 5% days and 20% > 90 days: Amount $24, ,000 8,000 4,000 2,000 Uncollectible % 1% 2% 5% 20% Allow. Est. $860 = Bad Debt Expense 660 Allowance for Doubtful Accounts 660 ($860 – $200) = $660

Allowance Example (cntd.)
2. “Percent of Sales” method (I/S-oriented) Assume instead that Irwin estimates bad debt expense based on 1.5% of sales. Sales $60,000 Uncollectible % 1.5% Bad debt expense $900

Allowance Example (cntd.)
2. “Percent of Sales” method (I/S-oriented) Assume instead that Irwin estimates bad debt expense based on 1.5% of sales. Sales $60,000 Uncollectible % 1.5% Bad debt expense $900 Bad Debt Expense 900 Allowance for Doubtful Accounts 900

Allowance Examples (cntd.)
3. % of Sales Method is based on Keele’s credit sales: Keele Total sales, 2010: $20,000,000 Keele Credit sales, 2010: $15,000,000 Keele A/R Balance, Dec 31, 2010: $1,900,000 Allow. for bad debt balance (before adjustment) 12/31/10: $62,000 Prior history: 1% of credit sales are uncollectible What is the journal entry to record bad debt expense for 2010

3. % of Sales Method is based on Keele’s credit sales: Keele Total sales, 2010: $20,000,000 Keele Credit sales, 2010: $15,000,000 Keele A/R Balance, Dec 31, 2010: $1,900,000 Allow. for bad debt balance (before adjustment) 12/31/10: $62,000 Prior history: 1% of credit sales are uncollectible What is the journal entry to record bad debt expense for 2010 Bad Debt Expense $150,000 Allowance for Doubtful Accounts $150,000 ($15,000,000 x 1% = $150,000)

4. Percent of Receivables Now assume Keele estimates their Allowance using an A/R aging. Prior collections history is used to estimate the percentage of each category that is uncollectible. Age Balance % bad 0-30 days 1,200, x % = 9,000 31-60 days , x % = 40,000 days , x % = 40,000 $1,900, ,000 Total sales, 2010: $20,000,000, Credit sales, 2010: $15,000,000 Allow. for bad debt balance (before adjustment) 12/31/10: $62,000 What is the adjusting journal entry at year end?

4. Percent of Receivables Now assume Keele estimates their Allowance using an A/R aging. Prior collections history is used to estimate the percentage of each category that is uncollectible. Age Balance % bad 0-30 days 1,200, x % = 9,000 31-60 days , x % = 40,000 days , x % = 40,000 $1,900, ,000 Total sales, 2010: $20,000,000, Credit sales, 2010: $15,000,000 Allow. for bad debt balance (before adjustment) 12/31/10: $62,000 What is the adjusting journal entry at year end? Bad Debt Expense $27,000 Allowance for Doubtful Accounts $27,000 ($89,000 – $62,000) = $27,000

A/R Write offs Affect on the Allowance & Adj Entry
Percent of Receivables – Write off’s and recovery. At the beginning of 2009, the balance in the Allowance account was $11,000 (CR). During the year, $8,000 of delinquent accounts were written off. Then, $2,000 of these delinquent accounts was surprisingly collected. What Entries would be made to record the Write off: The Subsequent Collection of $2,000: No other entries have been made for bad debts during the year, what is the Current balance in the Allowance Account, before the Year End Adjusting entry to record Bad Debt Expense? $______

Percent of Receivables – Write off’s and recovery. At the beginning of 2009, the balance in the Allowance account was $11,000 (CR). During the year, $8,000 of delinquent accounts were written off. Then, $2,000 of these delinquent accounts was surprisingly collected. What Entries would be made to record the Write off: The Subsequent Collection of $2,000: No other entries have been made for bad debts during the year, what is the Current balance in the Allowance Account, before the Year End Adjusting entry to record Bad Debt Expense? $______ Allowance for Doubtful Accounts $8,000 Accounts Receivable $8,000 Accounts Receivable $ 2,000 Allowance for Doubtful Accounts $ 2,000 Cash $ 2,000 Accounts Receivable $ 2,000

Percent of Receivables – Write off’s and recovery. At the beginning of 2009, the balance in the Allowance account was $11,000 (CR). During the year, $8,000 of delinquent accounts were written off. Then, $2,000 of these delinquent accounts was surprisingly collected. What Entries would be made to record the Write off: The Subsequent Collection of $2,000: No other entries have been made for bad debts during the year, what is the Current balance in the Allowance Account, before the Year End Adjusting entry to record Bad Debt Expense? $__5,000_____ Allowance for Doubtful Accounts $8,000 Accounts Receivable $8,000 Accounts Receivable $ 2,000 Allowance for Doubtful Accounts $ 2,000 Cash $ 2,000 Accounts Receivable $ 2,000

Percent of Receivables – Write off’s and recovery. At the beginning of 2009, the balance in the Allowance account was $11,000 (CR). During the year, $8,000 of delinquent accounts were written off. Then, $2,000 of these delinquent accounts was surprisingly collected. What is the year end entry to estimate Bad Debt Expense if the n ending balance in A/R is $150,000 and the company estimates that 5 % % of A/R is uncollectible? What would be the ending balance in the Allowance for Doubtful Accounts account?

Percent of Receivables – Write off’s and recovery. At the beginning of 2009, the balance in the Allowance account was $11,000 (CR). During the year, $8,000 of delinquent accounts were written off. Then, $2,000 of these delinquent accounts was surprisingly collected. What is the year end entry to estimate Bad Debt Expense if the n ending balance in A/R is $150,000 and the company estimates that 5 % % of A/R is uncollectible? What would be the ending balance in the Allowance for Doubtful Accounts account? Bad Debt Expense $2,500 Allowance for Doubtful Accounts $2,500 ($150,000 x 5%) – $5,000) = $2,500

Percent of Receivables – Write off’s and recovery. At the beginning of 2009, the balance in the Allowance account was $11,000 (CR). During the year, $8,000 of delinquent accounts were written off. Then, $2,000 of these delinquent accounts was surprisingly collected. What is the year end entry to estimate Bad Debt Expense if the n ending balance in A/R is $150,000 and the company estimates that 5 % % of A/R is uncollectible? What would be the ending balance in the Allowance for Doubtful Accounts account? $5,000 Bad Debt Expense $2,500 Allowance for Doubtful Accounts $2,500 ($150,000 x 5%) – $5,000) = $2,500

Balance Sheet Representation
Short-term accounts receivable are shown at their net realizable value as follows: Accounts Receivable (gross): $ XXX less: Allowance: ($ XX) Net Realizable Value: $ XX Or present in line item as: “AR net of $xxx allowance for doubtful accounts”

Analysis of Receivables
What is purpose of analysis? Ratios used AR Turnover = Net Sales/Average net Trade AR Days AR or Average Collection Period = 365 days/AR turnover Impairment occurs when the loss is deemed to be “probable”

Disposition of Accounts and Notes Receivable
The holder of accounts or notes receivable may use them (transfer them) to raise cash. The transfer may be either: A secured borrowing (A/R is used as s collateral for a loan; transferor is borrowing from the transferee) No transfer of ownership, A/R stays on transferor’s books A sale of receivables Transferor sells A/R and transfers ownership of receivables in a sale

Accounting for Transfers of Receivables
Secured Borrowing Sale Without Recourse With Recourse Seller guarantees payment if debtor does not pay Factored receivables are written off, but a recourse liability is recognized based on estimate of future payment firm will have to make Seller has no future obligation Write-off factored receivables (and recognize any gain / loss)

Secured Borrowing – the Basics
Overall - Receivables remain on the books of the company borrowing money (i.e. – no sale) (and continue to treat A/R as usual (collections, write-off, etc.) Also called “pledged” receivables Transferor: Records liability – amount borrowed, using A/R as collateral Records a finance charge. Collects accounts receivable. Records sales returns and sales discounts. Absorbs bad debts expense. Records interest expense on notes payable. Pays on the note periodically from collections.

Secured Borrowing Example
To help overcome a cash shortage, H Software took out a loan with T Bank. H Software used $1000 of A/R as collateral for the loan. T Bank withheld $30 as a finance charge, and forwarded $970 to H Software on July 1. H Software collected the on the accounts on July 31 ($120 were written off), and repaid T Bank on August 2nd with interest of $50. July 1: Dr. Cash Dr. Finance charge Cr. Note Payable 1,000 July 31: Dr. Cash Dr. Allowance for doubtful accounts 120 Cr. A/R 1,000 August 2: Dr. Interest Expense Dr. Note Payable 1,000 Cr. Cash 1,050

Sale of Receivables – the Basics
Factor records the (transferred) accounts as assets in its books. Transferor: Transfers ownership of receivables to factor. Records any amount retained by transferee as “due from factor.” This is an amount held back to protect the transferee in case of non-payment by customer Records loss on sale of receivables. Records any component liability IF with recourse i.e., any estimated future liability that the transferor will need to pay if customers do not pay (and if the amount held back by the factor is insufficient)

Transfer of Receivables: Sale Without Recourse
To help overcome a cash shortage, H Software factored $1,000 of receivables to W Factor on July 1, W Factor withheld $100 pending collectability, and charged H Software $40. The remaining $860 was forwarded to H Software on July 1. W Factor collected on the A/R, without recourse. On August 2nd, W Factor informed H Software that $75 of the accounts were uncollectible, and W Factor returned to H Software the appropriate payment. Dr. Cash Dr. Due from Factor Dr. Loss on sale of A/R Cr. A/R Dr. Loss Cr. Due from Factor What if instead, W Factor informed H Software on Aug 2 that it was able to collect all of the AR? What would be the journal entry?

Transfer of Receivables: Sale With Recourse
To help overcome a cash shortage, H Software factored $1,000 of receivables to W Factor on July 1, W Factor withheld $100 pending collectability, and charged H Software $40. The remaining $860 was forwarded to H Software on July 1. W Factor collected on the A/R, but had recourse in case of bad debts. H Software estimated that $150 of the receivables would ultimately be uncollectible. On August 2nd, W Factor informed H Software that $120 of the accounts were uncollectible, and H Software sent W Factor the appropriate recourse payment. Dr. Cash Dr. Due from Factor Dr. Loss on Sale of A/R (plug) Cr. A/R Cr. Recourse Liability Dr. Recourse Liability Cr. Cash Cr. Due from Factor Cr. Recovery of loss sale What if W Factor informed H Software that $220 of the accounts were uncollectible?

Transfer of Receivables: Dawson Example
On January 1, 2006, Dawson Associates is considering outsourcing the collection of its accounts receivable. The following factoring options are available to Dawson. Speedy Finance, Inc. Under the terms of the agreement, Speedy Finance would pay Dawson 98% of the gross amount of the transferred receivables and Dawson would be responsible to pay Speedy Finance for any uncollectible accounts. Dawson estimates its recourse liability would be $60,000. Speedy Finance will collect the receivables and will have the right to pledge or sell the receivables to another party. Strapped Solutions, Inc. Under the terms of the agreement, Strapped Solutions would pay Dawson 96.5% of the gross amount of Dawson’s receivables without recourse. Strapped Solutions will collect the receivables and will have the right to pledge or sell the receivables to another party. The following information is available from Dawson’s Balance Sheet at Dec. 31, 2005: Accounts Receivable $5,000,000 Allowance for doubtful accounts ,000

Prepare the journal entry that Dawson would record on January 1, 2006 if it decides to enter into the agreement with Speedy Finance.

Prepare the journal entry that Dawson would record on January 1, 2006 if it decides to enter into the agreement with Strapped Solutions.

Which alternative should Dawson select if it wants to maximize reported income in 2006?

Recognition of Notes Receivable
Short term N/R Long term N/R Record at present value of cash expected to be collected Record at face value less allowance

Long-Term Notes Receivable: The Basics
Why does a company issue a notes receivable? NR provides a stream of cash to the issuer Principle Interest Present value cash inflow = fair value transaction Interest rates: Stated vs. market Stated rate = effective (market rate)  note issued at face value Stated rate < market rate  note issued at a discount. Stated rate > market rate  note issued at a premium. The discount or premium is amortized to interest revenue by the effective interest method. Record interest revenue each period using the effective interest method

Notes Receivable: Stated Rate = Market Rate
On December 31, 2007, Nemo, Inc. finished consultation services and accepted in exchange a promissory note with a face value of $600,000, a due date of December 31, 2010, and a stated rate of 6%, with interest receivable at the end of each year. The note is considered to have a market rate of interest of 6%. How much should the Note Receivable be recorded for? What is the fair value of the transaction? PV of cash interest payments PV of principle payment

Table 6-2 (PV of single sum) Periods (n) 3% 6% 9% 3 Table 6-4 (PV of an ordinary annuity)

Fair value of transaction: Interest: Principle: Journal entries

Notes Receivable: Stated Rate < Market Rate
On December 31, 2007, Nemo, Inc. finished consultation services and accepted in exchange a promissory note with a face value of $600,000, a due date of December 31, 2010, and a stated rate of 3%, with interest receivable at the end of each year. The note is considered to have a market rate of interest of 6%. Is this a discount or a premium? How much should the Note Receivable be recorded for?

Fair value of transaction: Interest: Principle: Journal entry at 12/31/07

N/R: Stated Rate < Market Rate Effective Interest Amortization
Date Cash Interest Effective Int Rev Discount Amortized Carrying Amt N/R

Journal Entries

Notes Receivable: Stated Rate > Market Rate
On December 31, 2007, Nemo, Inc. finished consultation services and accepted in exchange a promissory note with a face value of $600,000, a due date of December 31, 2010, and a stated rate of 9%, with interest receivable at the end of each year. The note is considered to have a market rate of interest of 6%. Is this a discount or a premium? How much should the Note Receivable be recorded for?

Fair value of transaction: Interest: Principle: Journal entry at 12/31/07

N/R: Stated Rate > Market Rate Effective Interest Amortization
Date Cash Interest Effective Int Rev Premium Amortized Carrying Amt N/R

Journal Entries

Non-interest Bearing Notes
This is a special case of a discount. Steps: 1. Determine issue price on notes receivable at implicit rate of interest 2. The discount is amortized to interest revenue by the effective interest method

Notes Receivable – Non-Interest Bearing
On 1/1/06 Mickey Co. purchases a machine from Mouse. Co. with a list price of $10,000. Mickey signs a non-interest bearing note promising to pay Mouse Co. $10,000 on December 31, The fair value of the machine on 1/1/06 is $7,972. Implicitly, how much interest revenue will Mouse receive over the 2 year period of the note? What is the implicit interest rate on this note receivable? It is the rate that equates $7972 at t=0 to $10,000 at t=2 7,972F = 10,000; or F=10,000/7,972 = In table 6.1, Future Value of 1 (p. 303), the rate is 12% (F=1.2544, n = 2)-

January 1, 2006: December 31, 2006: December 31, 2007:

Impairment of Long-Term Receivables
The “Crisis of Credit” When does impairment occur? How is the impairment measured? Book value less PV future cash flows Impairment occurs when the loss is deemed to be “probable”

Example: Brillard Properties owes First Prudent Bank $30million under a 10% note with two years remaining until maturity. Due to financial difficulties of the developer, the previous year’s interest of $3million was not paid. First Prudent agrees to 1. Suspend the interest payment from last year until the following year 2. Reduce the remaining two interest payments to $2 million each 3. Reduce the principal to $25 million 4. Later decides to forgive the interest payment from last year. How much impairment loss should be recorded?

Book value of asset: Accrued interest (10% x $30million) $ 3,000,000 Principal ,000,000 Carrying amount of the receivable $33,000,000 New Value: PV of future interest ($2million x ) $3,471,080 PV of principal ($25million x ) 20,661,250 PV of receivable (24,132,330) Loss $8,867,670 Journal Entry Loss on troubled debt restructuring 8,867,670 Accrued interest receivable 3,000,000 Note receivable ($30,000,000-24,132,330) 5,867,670

Presentation & Disclosure of Receivables
Rules: Segregate different types of receivables if material Offset valuation accounts against gross balance Ensure all receivables are really current Disclose any loss contingencies on the receivables Disclose amounts pledged as collateral Disclose significant concentrations of credit risk Impairment occurs when the loss is deemed to be “probable”

Intermediate Accounting November 2nd, 2010

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