1 Long-Term Notes Receivables Long-term notes are valued at the present value of cash expected in the future. The relationship between the face value and the present value of the notes is dependent on the relationship between the stated (or contractual) interest rate and the market (or effective) interest rate. Stated rate = Market rate means Face value = Present value –Interest-bearing –Zero-interest-bearing

2 Long-term Note for Cash (Stated rate = Market rate): Jeremiah Co. receives a $10,000, 3-year, 10% note. The market rate for a note of similar risk is also 10%. What is the present value? What are the appropriate journal entries? How does the effective interest method of interest revenue recognition work? $10,000Face (Contractual) value of the note Present value of the note: Present value of the annual interest receipts: Present value of the principal amount of the note: $10,000 (PVF 3, 10%) = $10,000 X $1,000 (PVF-OA3,10%) = 1,000 X Present value of the annual interest receipts: $10,000 $ 0Difference $7, $2,487 Receipt of the Note: 10,000Cash 10,000Notes Receivable ($10,000 X 10% X 12/12) 1,000Interest Revenue 1,000Cash Interest earned for the next two years: 1,000Interest Revenue 10,000Notes Receivable Payment of Note and Interest in year three: 11,000Cash

3 Face (Contractual) value of the note$10,000 Present value of the principal amount of the note: Present value of the annual interest receipts: Present value of the note: $10,000 (PVF 3, 12%) = $10,000 X Present value of the annual interest receipts: $1,000 (PVF-OA3,12%) = 1,000 X $ 9,520 Difference$ $7, $2,402 Receipt of the Note: Notes Receivable10,000 Discount on Notes Receivable480 Cash9,520 Interest earned for the next year: Cash1,000 Discount on Notes Receivable142 Interest Revenue1,142 ($9,520 X 12% X 12/12) Payment of Note and Interest in year three: Cash11,000 Discount on Notes Receivable179 Notes Receivable10,000 Interest Revenue1,179 1 Stated Interest = 10,000 X 10% 2 Market Interest = Present Value X 12% 3 Difference = Stated Interest – Market Interest 9,5209, ,1421,000 9, ,1591,0009,662 10, ,1791,0009,821 End. Balance, Note - PV Difference: Discount 3 Market Interest: Interest Revenue 2 Stated Interest: Cash 1 Beg. Balance, Note - PV Effective Interest Method of Note Discount Amortization Long-term Note for Cash (Stated rate = Market rate): Jeremiah Co. receives a $10,000, 3-year, 10% note. The market rate for a note of similar risk is 12%.

4 Face (Contractual) value of the note$10,000 Present value of the principal amount of the note: Present value of the annual interest receipts: Present value of the note: $10,000 (PVF 3, ? ) = $10,000 X $1,000 (PVF-OA3, ? ) = 0 X $ 7, Difference$ 2, $7, $ 0 Receipt of the Note: Notes Receivable10, Discount on Notes Receivable2, Cash7, Interest earned for the next year: Discount on Notes Receivable Interest Revenue Payment of Note in year three: Cash10, Discount on Notes Receivable Notes Receivable10, Interest Revenue Stated Interest = $10,000 X 0% 2 Market Interest = Present Value X 9% 3 Difference = Stated Interest – Market Interest 7, , , , , , Long-term Note for Cash (Stated rate = Market rate): In exchange for $7,721.80, Jeremiah Co. receives a $10,000, 3-year, zero-interest-bearing note. 7, , What is the Market Rate? PVF (3, ) = 9% End. Balance, Note - PV Difference: Discount 3 Market Interest: Interest Revenue 2 Stated Interest: Cash 1 Beg. Balance, Note - PV Effective Interest Method of Note Discount Amortization

5 Notes Receivables For materiality purposes, short-term notes are generally recorded at face value (less an allowance account). Notes issued for property, goods, or services are assumed to be fairly stated at the contractual rate, unless: –There is no interest rate stated. –The rate stated is unreasonable. –The contractual value is different from the fair value of either the goods purchased or the debt instrument employed.

6 Note in a Sale: SWSH manufactures athletic shoes that it sells to retailers. On , the company sold shoes to HSG Sports. SWSH agreed to accept a $700,000, 6-month, 12% note for the shoes. Interest is payable at maturity. This transactions should be accounted for as follows: 5/1/04Notes Receivable700,000 Sales700,000 8/1/04Notes Receivable700,000 Sales700,000 11/1/05 Notes Receivable700,000 11/1/05 Interest Revenue42,000 ($700,000 X 12% X 6/12) 11/1/05Cash742,000 Note in a Sale: SWSH manufactures athletic shoes that it sells to retailers. On , the company sold shoes to HSG Sports. SWSH agreed to accept a $700,000, 6-month, 12% note for the shoes. Interest is payable at maturity. This transactions should be accounted for as follows: 12/31/04Interest Receivable35,000 Interest Revenue35,000 ($700,000 X 12% X 5/12) 2/1/05Cash742,000 Notes Receivable700,000 Interest Receivable35,000 Interest Revenue7,000 ($700,000 X 12% X 1/12)

7 Zero-interest-bearing Note for Sale: Oasis Co. sold a lot to Rusty Pelican as a restaurant site and accepted a 5-year note with a maturity value of $35,247 and no stated interest rate. The land originally cost Oasis $14,000 and at the date of sale had an appraisal value of $20,000: 15,247 Discount on Notes Receivable (35,247 – 20,000) 6,000 Gain on Sale of Land (20,000-14,000) 14,000 Land Notes Receivable $35,247 20,00022,4002, ,0882, ,400 28,0993, ,088 End. Balance, Note - PV Difference: Discount 3 Market Interest: Interest Revenue 2 Stated Interest: Cash 1 Beg. Balance, Note - PV Effective Interest Method of Note Discount Amortization 1 Stated Interest = 35,247 X 0% 2 Market Interest = Present Value X 12% 3 Difference = Stated Interest – Market Interest 31,4713, ,099 35,2473, ,471

8 Accounts Receivables Adjustments: –Sales Returns & Allowances –Sales Discounts Valuation –Net Realizable Value Percentage of Sales Percentage of Receivables Disposition –Secured Borrowing –Factoring/Securitization Without Recourse With Recourse

9 Sales (Cash) Discounts: Company A offers credit customers a 2% cash discount if the sales price is paid within 10 days. Any amounts not paid within 10 days are due in 30 days. These repayment terms are stated as 2/10, n/30. On , Co. A sold merchandise at a price of $20,000. The customer paid $13,720 ($14,000 less the 2% cash discount) on and the remaining balance of $6,000 on Gross Method: October 5 Accounts Receivable20,000 Sales20,000 October 14 Cash13,720 Sales Discount280 Accounts Receivable14,000 November 4 Cash6,000 Accounts Receivable6,000 October 14 13,720Accounts Receivable 13,720Cash Net Method: October 5 19,600 Accounts Receivable 19,600Sales 5,880Accounts Receivable 6,000Cash November 4 120Sales Discount Forfeited Accounts Receivable Adjustments: Sales Discounts

10 Sales Returns: In 2003, Company A sold merchandise on account for $2,000,000. This merchandise cost $1,200,000 (60% of the selling price). Industry experience indicates that 10% of all sales will be returned. Customers returned $130,000 in sales during 2003, prior to making payment. Return 130,000Accounts Receivable 130,000Sales Returns (actual) Sale: 2,000,000 Accounts Receivable 2,000,000Sales 1,200,000 Cost of goods sold (60% X $130,000) 1,200,000Inventory 78,000Cost of goods sold (60%) 78,000Inventory 70,000Allowance for sales returns 70,000Sales Returns ([10% X $2,000,000] – 130,000) Adjusting entries 42,000Cost of goods sold (60%) 42,000Inventory Accounts Receivable Adjustments: Sales Returns & Allowances

11 BRIEF EXERCISE 7-4 Battle Tank had net sales in 2004 of $1,200,000. At December 31, 2004, before adjusting entries, the balances in selected accounts were: Accounts Receivable $250,000 debit, and Allowance for Doubtful Accounts $2,100 credit. If battle Tank estimates that 2% of net sales will prove to be uncollectible, prepare the December 31, 2004, journal entry to record bad debt expense. ($1,200,000 X 2% = $24,000) 24,000Allowance for Doubtful Accounts 24,000Bad Debt Expense Accounts Receivable Valuation: Percentage of Sales

12 BRIEF EXERCISE 7-5 Battle Tank had net sales in 2004 of $1,200,000. At December 31, 2004, before adjusting entries, the balances in selected accounts were: Accounts Receivable $250,000 debit, and Allowance for Doubtful Accounts $2,100 credit. If battle Tank estimates that 10% of accounts receivable will prove to be uncollectible, prepare the December 31, 2004, journal entry to record bad debt expense. Accounts Receivable Valuation: Percentage of A/R [(10% X $250,000) – $2,100] 22,900Allowance for Doubtful Accounts 22,900Bad Debt Expense (a) Battle Tank had net sales in 2004 of $1,200,000. At December 31, 2004, before adjusting entries, the balances in selected accounts were: Accounts Receivable $250,000 debit, and Allowance for Doubtful Accounts $2,100 credit. If battle Tank estimates, based on an aging of accounts receivable, that $24,600 of accounts will prove to be uncollectible, prepare the December 31, 2004, journal entry to record bad debt expense. ($24,600 – $2,100) 22,500Allowance for Doubtful Accounts 22,500Bad Debt Expense(b)

13 Writing off an account: Battle Tank receives notice from Client Company A, who owes Battle $1,500, that it has declared bankruptcy and does not have the means to pay Ace the amount owed. Accounts Receivable Valuation: Additional Issues 1,500Accounts Receivable 1,500Allowance for Doubtful Accounts Subsequent payment for a written off account: Several months later, Battle Tank receives $750 from a bankruptcy settlement relating to Client Company A. 750Allowance for Doubtful Accounts 750Accounts Receivable 750Accounts Receivable 750Cash Note that this transaction does not change the net realizable value of accounts receivable.

14 Akira, Inc. 680,000 Cash 20,000 Finance Charge 700,000 Notes Payable Alisia National Bank 700,000 Notes Receivable 680,000 Cash 20,000 Financing Revenue Secured Borrowing (BE 7-8) On , Akira assigns $1,000,000 of its accounts receivable to Alisia Bank as collateral for a $700,000 note. The bank assesses a finance charge of 2% of the receivable assigned and interest on the note of 13%. Prepare the 10-1 journal entries for both Akira and Alisia. Accounts Receivable Disposal: Secured Borrowing & Factoring

15 Fredrick 100,000 Accounts Receivable 92,000 Cash 2,000 Financing Revenue 6,000 Due to CRC **2% X $100,000 = $2,000 *6% X $100,000 = $6,000 CRC 92,000 Cash 100,000 Accounts Receivable 2,000** Loss on Sale of Receivables 6,000* Due from Factor Factoring Without Recourse (BE 7-9) CRC factored $100,000 of accounts receivable with FF on a WITHOUT RECOURSE basis. FF assesses a 2% finance charge of the amount of accounts receivable and retains an amount equal to 6% of accounts receivable for possible adjustments. Prepare the journal entry for CRC and FF to record the factoring of the accounts receivable to FF. Factoring With Recourse (BE 7-10) CRC factored $100,000 of accounts receivable with FF on a WITH RECOURSE basis. FF assesses a 2% finance charge of the amount of accounts receivable and retains an amount equal to 6% of accounts receivable for possible adjustments. The recourse obligation has a fair value of $7,500. Prepare the journal entry for CRC and FF to record the factoring of the accounts receivable to FF. Fredrick 100,000 Accounts Receivable 92,000 Cash 2,000 Financing Revenue 6,000 Due to CRC **2% X $100,000 = $2,000 + $7,500 *6% X $100,000 = $6,000 CRC 92,000 Cash 100,000 Accounts Receivable 9,500** Loss on Sale of Receivables 6,000* Due from Factor 7,500 Recourse Obligation

16 Classify as current or noncurrent in the balance sheet. Disclose separately in notes details of the arrangement. Cash separately classified as a deposit maintained as a compensating balance Compensating balances If right of offset exists, reduce cash Current liabilityBank overdrafts May also be classified as office supplies. Prepaid expensePostage on hand Assumed to be collected from employees or deducted from their salaries. ReceivablesTravel Advances Assumed to be collectible.ReceivablesPostdated Checks and IOU's Investments with maturity of 3 to 12 months. Temporary InvestmentsShort-term paper Investments with maturity of less than 3 months. Cash equivalentsShort-term paper CashPetty cash and change funds If restricted, identify and classify as current or noncurrent asset. If unrestricted, report as cash. Cash CommentClassificationItem Classification of Cash, Cash Equivalents, and Noncash Items

17 EXERCISE 7-18 (10-15 minutes) $178,836.32Discount 221, and interest Present value of the note and 59, X at 12% annually—$12,000 payable annually for 8 years Present value of $12,000 $161, X in 8 years at 12%—$400,000 Present value of $400,000 due 400,000.00Maturity value the note: Computation of the present value of 221,163.68Service Revenue 178,836.32Discount on Notes Receivable 400,000.00Notes Receivable Discount on note receivable$ 401,460 Face value of note 1,101,460 Present value of note$ 700,000 Present value of 1 for 4 periods at 12%X Face value of note$1,101,460 [($700,000 – $590,000) 110,000.00Gain on Sale of Land 590,000.00Land 401,460.00Discount on Notes Receivable 1,101,460.00Notes Receivable 1.7/1/04 2.7/1/04

18 EXERCISE 7-19 (20-25 minutes) 200,000Notes Receivable 200,000Cash *$48, – $22, ,087.80Interest Revenue 26,087.80*Discount on Notes Receivable(c) *$151,228 X 15% = $22, ,684.20*Interest Revenue 22,684.20Discount on Notes Receivable (b) *Computation of present value of note: PV of $200,000 due in 2 years at 15% $200,000 X = $151, ,228*Consulting Revenue 48,772Discount on Notes Receivable 200,000Notes Receivable(a)

19 PROBLEM 7-9 $91, Capitalized value of services 36, Down payment $55, PV of $18,000 11% for 4 years ($18,000 X ) To record revenue at the present value of the note plus the immediate cash payment: 91,844.10Revenue from Services 16,155.90Discount on Notes Receivable 72,000.00Notes Receivable 36,000.00Cash December 31, 2004 (a)

20 6,142.85Interest Revenue 6,142.85Discount on Notes Receivable 18,000.00Notes Receivable 18,000.00Cash — 18, , c 12/31/08 16, , , /31/07 30, , , /31/06 43, b $18,000.00$6, a 12/31/05 $55,844.10——12/31/04 Present Value of Note Installment Paid Debit, Discount on Notes Receivable/ Credit, Interest Revenue Date a $6, = $55, X 11% b $43, = $55, $6, – $18, c Rounded by $.12 PROBLEM 7-9 (Cont.) (b) December 31, 2005 Schedule of Note Discount Amortization Totals 16, ,000.00

21 1, Interest Revenue 1, Discount on Notes Receivable 18, Notes Receivable 18,000.00Cash 3, Interest Revenue 3, Discount on Notes Receivable 18, Notes Receivable 18, Cash 4,838.56Interest Revenue 4, Discount on Notes Receivable 18, Notes Receivable 18, Cash (e) (d) (c) December 31, 2006 December 31, 2007 December 31, 2008

22 $ 26,300Bad debt expense, as adjusted 14,000Allowance for doubtful accounts (debit balance) 12,300Bad debt expense, before adjustment 3%3%Percentage $410,000Accounts receivable5. $1,010,000Accounts receivable, before deducting allowance for doubtful accounts 60,000Allowance for doubtful accounts balance 12/31/03 $950,000Accounts receivable, net of allowance for doubtful accounts $60,000Allowance for doubtful accounts balance 12/31/03 (24,000)Customer accounts written off as uncollectible during 2003 $84,000Bad debt expense for $58,000Allowance for doubtful accounts 12/31/03 63,000Bad debt expense for 2003 ($2,100,000 X 3%) (30,000)Customer accounts written off in ,000Establishment of accounts written off in prior years $17,000Allowance for doubtful accounts 1/1/033. $1,570,000Net realizable value (180,000)Amounts estimated to be uncollectible $1,750,000Accounts receivable2. $22,500Bad debt expense 1 1/2%Percentage $1,500,000Net Sales1. PROBLEM 7-2

23 PROBLEM 7-3 (a)The Allowance for Doubtful Accounts should have a balance of $50,000 at year-end. The supporting calculations are shown below: Days Account Outstanding Amount Expected Percentage Uncollectible Estimated Uncollectible 0-15 days$300,000.02$ 6, days 100, , days 80, , days 40, , days 20, ,000 Balance for Allowance for Doubtful Accounts$50,000 The accounts which have been outstanding over 75 days ($15,000) and have zero probability of collection would be written off immediately and not be considered when determining the proper amount for the Allowance for Doubtful Accounts. (b)Accounts receivable$540,000 Less: Allowance for doubtful accounts50,000 Accounts receivable (net)$490,000 (c) The year-end bad debt adjustment would decrease before-tax income $30,000 as computed below: Estimated amount required in the Allowance for Doubtful Accounts$50,000 Balance in the account after write-off of uncollectible accounts but before adjustment ($35,000 – $15,000) 20,000 Required charge to expense$30,000