Chapter 6 Receivables and Inventory

Learning Objectives After studying this chapter, you should be able to…  Describe the common classifications of receivables  Describe the nature of and the accounting for uncollectible receivables  Describe the direct write-off method of accounting for uncollectible receivables  Describe the allowance method of accounting for uncollectible receivables

Learning Objectives (continued) After studying this chapter, you should be able to…  Describe the common classifications of inventories  Describe three inventory cost flow assumptions and how they impact the financial statements  Compare and contrast the use of the three inventory costing methods  Describe how receivables and inventory are reported on the financial statements

Learning Objective 1 Describe the common classifications of receivables

Classifying Receivables Accounts Receivable ─ Credit terms extended to customers ─ Less formal, usually no interest is charged because it’s very short-term ─ Considered a current asset Notes Receivable ─ More formal agreement ─ Includes a maker and payee and a stated interest and due date ─ Can be current or an investment category depending on length of loan ─ Vendors sometimes request that their account receivable be turned into a note if they can’t pay back within the 30 days or so Other Receivables ─ Can include interest receivable, taxes receivable, and receivables from employees or officers

Accounting for Notes Receivable (like on E6-2 for homework) A promissory note is a written promise to pay the face amount, usually with interest, on demand or at a date in the future. The makee is the party making the promise to pay, the payee is the party to whom the note is payable. Interest on a note is computed as follows: Interest Amount= Face Amount * Interest Rate * (Term/360 days) Face is the amount of the loan Interest rate is usually stated annually (Term/360) means that you need to break the interest rate down for the period of the loan…..if you had a loan outstanding for 2 months this year than you would do 60 days/360 days The maturity value of a note is the amount that must be paid at the due date of the note. Maturity value equals the face amount of the note plus the interest accrued over the life of the note.

Learning Objective 2 Describe the nature of and the accounting for uncollectible receivables

Uncollectible Receivables Q.What if a customer does not pay the balance owed to the company? A.Companies must recognize an operating expense for accounts that are not collectible. It is called Bad Debt Expense. Some customers will not pay their accounts receivable balances, that is, some accounts receivables will become uncollectible. Companies can mitigate this risk in a variety of ways: Not accept credit sales except for credit cards – this shifts the risk of non-payment to the credit card company Sell receivables to another company for collection – this shifts the risk on non-payment to another company. This is common in organizations like Home Depot or JC Penney, who issue their own credit cards. Regardless of how careful a company is in granting credit, some credit sales will become uncollectible. Some warning signs are: Receivable is past due Customers do not respond to the company’s attempts to collect Customer files for bankruptcy Customer closes its business Customer can not be located

Bad Debt Expense Two Methods If a customer does not pay, a company may turn the account over to a collection agency. After the collection agency attempts to collect payment are complete, any balance remaining will need to be written off. There are two methods to account for uncollectible accounts, the direct write-off method and the allowance method. The direct write-off method is only used by small companies or companies with a small amount of receivables. Generally accepted accounting principles (GAAP) require large companies or companies with a material amount of receivables to use the allowance method. DirectWrite-OffMethod AllowanceMethod

Learning Objective 3 Describe the direct write-off method of accounting for uncollectible receivables

Direct Write-Off Method Bad Debt Expense is recorded and the receivable written off when the account is determined to be worthless. Under the direct write-off method, the bad debt expense is not recorded until the time the account is determined to be worthless. At that time, the accounts receivable account is reduced and the bad debt is recorded as an expense, reducing Retained Earnings.

If payment is collected after the write-off, the write-off entry is reversed and the cash collection is recorded

Learning Objective 4 Describe the allowance method of accounting for uncollectible receivables

Allowance Method- MUCH better method, records bad debt expense in the period in which the revenue was recorded instead of waiting for the accounts to go bad Required by GAAP for companies with large accounts receivable Estimates the accounts receivable that will not be collected and records bad debt expense for this estimate at the end of each period using an allowance account

Estimate of Uncollectible Accounts Receivable: $30,000 If the total accounts receivable balance is $200,000, the new net realizable value is $170,000 Based on industry averages, a company estimates that of the $200,000 accounts receivable balance, $30,000 is estimated to be uncollectible. However, the company will not know which customers will be uncollectible so specific customer accounts can not be adjusted. Instead, a contra asset account, Allowance for Doubtful Accounts, is used. This adjustment affects both the income statement and balance sheet. On the Income Statement, the $30,000 of Bad Debts Expense will be matched against the related sales revenues of the period. On the Balance Sheet, the value of Accounts Receivable is reduced to then amount that is expected to be collected or realized. This amount, $170,000, is the net realizable value of Accounts Receivable.

Write-Offs to the Allowance Account When a customer’s account is identified as uncollectible, it is written off against the allowance account. The expense for that worthless account had already been estimated and recorded in a prior period that related to when the original sale was made. This transaction removes the specific accounts receivable and an equal amount from the allowance account.

If payment is collected after the write-off, the write-off entry is reversed and the cash collection is recorded. Assume a $5,000 account had been previously written off.

Estimating Uncollectible Accounts Based on past experiences and forecasts of the future Two common methods: The allowance method require an estimate of uncollectible accounts at the end of the period. The estimate can be made using two different methods, both based on past experience. The estimate based on percent of sales determines the uncollectible amount as a percentage of credit sales. Since credit sales create the account receivable, if the portion of credit sales to total sales is relatively constant, this estimate can be a reliable forecast of the future. The analysis of receivables method is based on the experience that the longer a receivable is outstanding, the more likely that receivable will become uncollectible. Percent of SalesAnalysis of the Receivables

Sample Aging Schedule- refer to this for E6-7

Estimate Based on Percent of Sales Assume that on December 31, 2009, the Allowance for Doubtful Accounts for ExTone Company has a negative balance of $3,250. In addition, ExTone estimates that 3/4% of 2009 credit sales will be uncollectible. Credit sales for the year are $3,000,000.

Estimate Based on Analysis of Receivables Comparing the $26,490 estimate with the unadjusted balance in the allowance account determines the needed adjustment for bad debt expense. Assume the unadjusted balance in the allowance account is a negative $3,250. $23,240 more is needed in the allowance account.

Learning Objective 5 Describe the common classifications of inventory

Inventory Classification for Merchandisers In Chapter 4, we learned that merchandise on hand is called merchandise inventory. Inventory sold becomes the cost of merchandise sold Cost of inventory includes all costs of ownership (e.g., purchase price, transportation costs, insurance costs, etc.)

Manufacturing Inventories Materials Inventory Raw material used to make the product Work In Process Inventory Cost of partially completed products Finished Goods Inventory Total cost of completed goods: material, labor, manufacturing overhead

Manufacturing Inventories

Footnote Disclosure of Manufacturing Inventories

Learning Objective 6 Describe three inventory cost flow assumptions and how they impact the financial statements

Inventory Cost Flow Identical units purchased at different unit costs during a period When units are sold, it is necessary to determine the cost of units sold Cost of units sold can be determined using a cost flow assumption Units Purchased Units Sold

Specific Identification If the merchandise can be identified with a specific purchase, the specific identification method can be used Each unit of merchandise can be identified with a specific purchase price Only practical if each unit has a unique identification number (e.g., VIN for an automobile)

Three Inventory Methods

First-In, First-Out (FIFO) One unit is sold on May 30 for $20

Last-In, First-Out (LIFO) One unit is sold on May 30 for $20

Average Cost One unit is sold on May 30 for $20

Learning Objective 7 Compare and contrast the use of the three inventory costing methods

Comparing Methods - Rising Prices METHODI/S EFFECTB/S EFFECTRESULT FIFO Lower COGS Higher gross profit Inventory shows replacement cost Benefit lost in higher future costs LIFO Higher COGS Lower gross profit Lower inventory valuesMatches current cost with current revenue AVERAGE Average (middle) gross profit Average inventory valueCompromise between LIFO & FIFO

Learning Objective 8 Describe how receivables and inventory are reported on the financial statements

Balance Sheet Presentation

Lower of Cost or Market- refer to this for E6-18

Reporting Receivables and Inventory Accounts Receivable Classified as a current asset if collection is expected within 1 year. Reported at net realizable value: A/R – Allowance for Doubtful Accounts Inventory Reported at the net realizable value Net realizable value = selling price – direct costs of disposal Reported at Lower of Cost or Market (LCM)

End of Chapter 6