Chapter 7

Receivables and Investments

Accounts Receivable

Receivable arising from the sale of goods or services with a verbal promise to pay

Stated on the balance sheet at net realizable, which takes into account and estimate of the uncollectible amount (bad debts)

Two methods used in estimating bad debts: Percentage of sales approach Percentage of receivables approach

LO 1

The Use of a Subsidiary Ledger Assume that Apple sells $25,000 of hardware to a

school. The sale results in the recognition of an asset and revenue

The Use of a Subsidiary Ledger

Contains the necessary detail on items that collectively make up a single general ledger account, called the control account

Two Methods to Account for Bad Debts

Direct write-off method: recognition of bad debts expense at the point an account is written off as uncollectible

Allowance method: estimating bad debts on the basis of either net credit sales or accounts receivable Allowance for doubtful accounts: a contra-asset

account—reduce accounts receivable to its net realizable value

Example 7.1—Using the Direct Write-Off Method for Bad Debts

Assume that Roberts Corp. makes a $500 sale to Dexter Inc. on November 10, 2014, with credit terms of 2/10, n/60

Example 7.1—Using the Direct Write-Off Method for Bad Debts (continued)

Assume further that Dexter is unable to pay within 60 days. After pursuing the account for four months into 2015, the credit department of Roberts informs the accounting department that it has given up on collecting the $500 from Dexter and advises that the account be written off. To do so, the accounting department makes an adjustment

Example 7.2—Using the Allowance Method for Bad Debts

Assume that Roberts’ total sales during 2014 amount to $600,000 and that at the end of the year, the outstanding accounts receivable total $250,000. Also, assume that Roberts estimates that 1% of the sales of the period, or $6,000, will prove to be uncollectible. Under the allowance method, Roberts makes an adjustment at the end of 2014

Example 7.2—Using the Allowance Method for Bad Debts (continued)

Balance sheet presentation of accounts receivable

Dexter’s $500 account is written off on May 1, 2015

Accounts receivable $250,000 Less: Allowance for doubtful accounts (6,000) Net accounts receivable $244,000

Approaches to the Allowance Method of Accounting for Bad Debts

Percentage of Net Credit Sales Approach Uses the past relationship between bad debts and

net credit sales to predict bad debt amounts Percentage of Accounts Receivable Approach

Estimate bad debts by relating them to the balance in the Accounts Receivable

Example 7.3—Using the Percentage of Net Credit Sales Approach

Assume that the accounting records for Bosco Corp. reveal the following:

Average percentage = 2% ($153,700/$7,560,000 = 0.02033)

Example 7.3—Using the Percentage of Net Credit Sales Approach (continued)

Assume the company uses the 2% rate and that its net credit sales during 2014 are $2,340,000, Bosco makes an adjustment of 0.02 × $2,340,000

Example 7.4—Using the Percentage of Accounts Receivable Approach

Assume that the records for Cougar Corp. reveal the following:

Average percentage = 0.8% ($32,330/$4,038,000 = 0.008)

Example 7.4—Using the Percentage of Accounts Receivable Approach (continued)

Assume balances in Accounts Receivable and Allowance for Doubtful Accounts on December 31, 2014 is $865,000 and $2,100, respectively

Example 7.4—Using the Percentage of Accounts Receivable Approach (continued)

The net realizable value of Accounts Receivable is determined as follows:

Exhibit 7.1—Aging Schedule

Aging schedule: categorizes the various accounts according to their length of time outstanding

Example 7.5—Using an Aging Schedule to Estimate Bad Debts

The totals on the aging schedule are used as the basis for estimating bad debts, as shown below

Example 7.5—Using an Aging Schedule to Estimate Bad Debts (continued)

Assume that Allowance for Doubtful Accounts has a balance of $1,230 before adjustment, the adjusting entry is as follows:

Accounts Receivable Turnover Ratio

Measures the number of times accounts receivable is collected during the period

LO 2

Net Credit SalesAverage Accounts Receivable

Accounts Receivable Turnover Ratio =

Number of Days’ Sales in Receivables

Measures how long it takes to collect receivables

Number of Days in the PeriodAccounts Receivable Turnover Ratio

Number of Days’ Sales in Receivables =

The Ratio Analysis Model

1. How many times a year does a company turn over its accounts receivable?

2. Gather the information about net credit sales and average accounts receivable

3. Calculate accounts receivable turnover ratio4. Compare the ratio with prior years and with

competitors5. Interpret the ratios—measures how long it

takes to collect receivables

The Business Decision Model

1. If you were a banker, would you loan money to a company?

2. Gather information from the financial statements and other sources

3. Compare the company's accounts receivable turnover ratio with industry averages and look at trends

4. Lend money or find an alternative use for the money

5. Monitor the loan periodically

Notes Receivable

Asset resulting from the acceptance of a promissory note from another entity

Promissory note: a written promise to repay a definite sum of money on demand or at a fixed or determinable date in the future

Maker: party that agrees to repay the money Payee: party that will receive the money Note payable: a liability resulting from the

signing of a promissory noteLO 3

Summary of Relationship Between Maker and Payee

Important Terms Connected with Promissory Notes

Principal—the cash received, or the fair value of the products or services received, by the maker when a promissory note is issued

Maturity date—the due date of promissory note Term—the length of time a note is outstanding Maturity value—the amount to be paid by the

maker on the maturity date Interest—the difference between the principal

amount and the maturity value

Example 7.7—Accounting for a Note Receivable

Assume that on December 13, 2014, High Tec sells a computer to Baker Corp. at an invoice price of $15,000. Because Baker is short of cash, it gives High Tec a 90-day, 12% promissory note. The total amount of interest due on the maturity date is determined as follows:

$15,000 × 0.12 × 90/360 = $450 The effect of the receipt of the note by High Tec can be identified and

analyzed as follows:

Example 7.7—Accounting for a Note Receivable (continued)

Assume that on December 31, an adjustment is needed to recognize interest earned but not yet received. In computing interest, it is normal practice to count the day a note matures but not the day it is signed. Interest would be earned for 18 days (December 14 to December 31) during 2014 and for 72 days in 2015:

Interest earned during 2014 = $15,000 × 0.12 × (18/360), or $90

Example 7.7—Accounting for a Note Receivable (continued)

Adjustment made on December 31 to record interest earned during 2014:

Example 7.7—Accounting for a Note Receivable (continued)

On March 13, 2015, High Tec collects the principal amount of the note and interest from Baker

Interest earned during 2015 = $15,000 × 0.12 × (72/360) = $360

Accelerating the Inflow of Cashfrom Sales

Credit card sales Accelerate collection of cash from a customer Pass the risk of nonpayment to credit card company

Discounting notes receivable Allows a company to accelerate the inflow of cash

LO 4

Exhibit 7.2—Basic Relationships Among Parties with Credit Card Sales

Example 7.8—Accounting for Credit Card Sales

Assume that Joe Smith buys an iPad in an Apple store and charges the $500 cost to his VISA card. Collection fee is 5%. Assume that total credit card sales on June 5 amount to $8,000. The entry on Apple’s books is as follows:

Example 7.8—Accounting for Credit Card Sales (continued)

Assume that Apple remits the credit card receipts to VISA once a week and that the total sales for the week ending June 11 amount to $50,000. Further assume that on June 13, VISA pays the amount due to Apple after deducting a 5% collection fee

Example 7.8—Accounting for Credit Card Sales (continued)

Assume that on July 9, Apple presents VISA credit card receipts to its bank for payment in the amount of $20,000 and that the collection charge is 4%

Discounting Notes Receivable

Discounting: the process of selling a promissory note

Sell note prior to maturity date for cash It is normally done ‘‘with recourse”

If the customer fails to pay the bank, the company that transferred the note to the bank is liable for the full amount

Accounting for Investments

Certificate of deposit (CD): highly liquid financial instrument

Equity securities: issued by corporations as a form of ownership in the business

Debt securities: issued by corporations and governmental bodies as a form of borrowing

LO 5

Example 7.9—Accounting for an Investment in a Certificate of Deposit

On October 2, 2014, Creston Corp. invests $100,000 of excess cash in a 120-day CD. The CD matures on January 30, 2015, at which time Creston receives the $100,000 and interest at an annual rate of 6%

Example 7.9—Accounting for an Investment in a Certificate of Deposit

December 31 is the end of Creston’s fiscal year, so an entry is needed on this date to record interest earned during 2014 even though no cash will be received until the CD matures in 2015

The basic formula to compute interest is as follows: Interest (I) = Principal (P) × Interest Rate (R) × Time (T)

Example 7.9—Accounting for an Investment in a Certificate of Deposit (continued)

The entry on January 30 to record the receipt of the principal amount of the CD of $100,000 and interest for 120 days is as follows

Exhibit 7.3—Interest Calculation

Investments in Stocks and Bonds

Example 7.10—Accounting for an Investment in Bonds

On January 1, 2014, ABC issues $10,000,000 of bonds that will mature in ten years. Assume that Atlantic buys $100,000 of these bonds at face value, which is the amount that will be repaid to the investor when the bonds mature. The bonds pay 10% interest semiannually on June 30 and December 31.

Example 7.10—Accounting for an Investment in Bonds

Atlantic will receive 5% of $100,000, or $5,000, on June 30 and December 31. On June 30, Atlantic must record the receipt of semiannual interest.

Example 7.10—Accounting for an Investment in Bonds

On July 1, 2014, Atlantic sells all of its ABC bonds at 99. The amount of cash received is 0.99 × $100,000, or $99,000.

Example 7.11—Accounting for an Investment in Stock

On February 1, 2014, Dexter Corp. pays $50,000 for shares of Stuart common stock and another $1,000 in commissions.

Example 7.11—Accounting for an Investment in Stock

On March 31, 2014, Dexter received dividends of $500 from Stuart.

Example 7.11—Accounting for an Investment in Stock

Dexter sells the Stuart stock on May 20, 2014, for $53,000. In this case, Dexter recognizes a gain for the excess of the cash proceeds, $53,000, over the amount recorded on the books, $51,000

Exhibit 7.4—How Investments and Receivables Affect the Statement of Cash Flows

LO 6

End of Chapter 7