ACCT 351 - Ch. 7

Allowance method journal entries

*At the end of the fiscal period, record a bad debt expense* [Dr] Bad debt expense [Cr] Allowance for uncollectible accounts *Write off specific accounts when determined to be uncollectible* [Dr] Allowance for uncollectible accounts [Cr] Accounts receivable

QUIZ Assignment of accounts receivable where company collects money from customers BlueMoon Co. will continue to collect the receivables, and will record any discounts, sales returns, and bad debt write-offs, but will remit the cash to Finance Bank, usually on a monthly basis. Assume $400,000 of the receivables assigned are collected in December.

*Collecting $ from customer* [Dr] Cash = 400,000 [Cr] Accounts receivable = 400,000 *Paying money back for 1 month* [Dr] Interest exp = 5,000 (500,000 × 12% × 1/12) Liability = 400,000 [Cr] Cash = 405,000

QUIZ Five Dollar Stores (FDS) sells merchandise for cash. It began 2023 with a refund liability of $0, made sales of $1,000,000 during 2023 which cost FDS $600,000 (or 60%), estimates that 1% of all sales will be returned, and experiences $8,000 of returns during 2023. When accruing its estimate of remaining returns at the end of 2023, FDS would debit sales returns and credit the refund liability for:

*Estimated returns* 1,000,000 × 1% = 10,000 *Actual returns* 8,000 *Refund liability* 10,000 - 8,000 = 2,000

On December 31, 2023, the Matador Company sold land in exchange for a nine-month, 10% note. The note requires the payment of $200,000 plus interest on September 30, 2024. The company's fiscal year-end is December 31. The 10% rate properly reflects the time value of money for this type of note. On March 31, 2024, Matador discounted the note at the Bank of the East. The bank's discount rate is 12%.

*Find the interest amount prior to being discounted* $200,000 × 10% × 3/12 = $5,000 This is done because the company held the note receivable for 3 months *Find interest to maturity* $200,000 × 10% × 9/12 = $15,000 This is only related to the 9 months where the company discounted the note receivable *Add interest to maturity to calculate maturity value* $200,000 + $15,000 = $215,000 *Find the discount amount* $215,000 × 12% × 6/12 = $12,900 *Subtract the maturity value with the discount to find the cash proceeds* $215,000 - $12,900 = $202,100 *Journalize everything* [Dr] Cash = $202,100 Loss on sale of note receivable = $2,900 [Cr] Note receivable = $200,000 Interest receivable = $5,000

QUIZ On June 1, 2023, Carbot accepted a six-month note paying $100,000 plus 8% interest in exchange for services rendered. Carbot immediately discounted the note at NorthridgeBank, paying a 10% discount rate. On June 1, Carbot will receive how much cash from NorthridgeBank?

*Interest prior discount* $100,000 × 8% × 6/12 = $4,000 *Maturity value (maturity + interest)* $100,000 + $4,000 = $104,000 *Discount amount* $104,000 × 10% × 6/12 = $5,200 *Cash proceeds (maturity - discount)* $104,000 - $5,200 = $98,800

QUIZ The Matador Manufacturing Company offers credit customers a 2% sales 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 October 5, 2023, Matador sold merchandise at a price of $20,000. The customer paid $13,720 ($14,000 less the 2% cash discount) on October 14 and the remaining balance of $6,000 on November 4.

*Journal entries for Oct 5* *Gross Method* [Dr] Accounts Receivable = 20,000 [Cr] Sales Revenue = 20,000 *Net method* [Dr] Accounts receivable = (20,000 * 98%) = 19,600 [Cr] Sales Revenue = (20,000 * 98%) = 19,600 ------------------------------ *Journal entries for Oct 14* *Gross Method* [Dr] Cash = 13,720 Sales discounts = 280 [Cr] Accounts receivable = 14,000 *Net Method* [Dr] Cash = 13,720 [Cr] Accounts receivable = 13,720 ------------------------------ *Journal entries for Nov 4* *Gross Method* [Dr] Cash = 6,000 [Cr] Accounts receivable = 6,000 *Net Method* [Dr] Cash = 6,000 [Cr] Accounts receivable = 5,880 Sales discounts forfeited = 120 ------------------------------ *Gross Method* Sales revenue = *20,000* - Discount = *-280* + Discount forfeit = *0* = Net sales revenue = *19,720* *Net Method* Sales revenue = *19,600* - Discount = *0* + Discount forfeit = *120* = Net sales revenue = *19,720*

Sometimes, cash is restricted for a specific purpose

*Look at slide 5 ch. 7 pt. 1*

QUIZ Short-term noninterest bearing loans Matador Company sold shoes to Northridge Sporting Goods on May 1, 2023, accepting a six-month, $700,000 noninterest-bearing note in exchange for delivering goods that have a cash sales price of $658,000.

*May 1, 2023* [Dr] Note receivable = 700,000 [Cr] Discount on note receivable = 42,000 (700,000 × 12% × (6/12)) Sales revenue = 658,000 *Nov 1, 2023* [Dr] Discount on Note Receivable = 42,000 Cash = 700,000 [Cr] Interest Revenue = 42,000 Note receivable = 700,000 ------------------------------------------------------------------- What if the items were sold on Aug 1, 2023 and the company's fiscal year ends on Dec 1, 2023? Aug 1, 2023 [Dr] Discount on Notes Receivable = 35,000 [Cr] Interest Revenue = 35,000 Feb 1, 2023 [Dr] Discount on Notes Receivable = 7,000 Cash = 700,000 [Cr] Interest Revenue = 7,000 Note Receivable = 700,000

QUIZ During 2023, its first year of operations, the Matador Company sold merchandise for $2,000,000 cash. This merchandise cost Matador $1,200,000 (60% of the selling price). Industry experience indicates that 10% of all sales will be returned, which equals $200,000 ($2,000,000 ×10%) in this case. Customers returned $130,000 of sales during 2023. Matador uses a perpetual inventory system.

*Sales revenue* [Dr] Cash = 2,000,000 [Cr] Sales Rev = 2,000,000 [Dr] COGS = 1,200,000 [Cr] Inventory = 1,200,000 ----------------------------------------------------------- *Return* [Dr] Sales Returns = 130,000 [Cr] Cash = 130,000 [Dr] Inventory = 78,000 = (130K * 60%) [Cr] COGS = 78,000 = (130K * 60%) ----------------------------------------------------------- *Expected additional returns for the end of 2023* [Dr] Sales returns = 70,000 (200,000 - 130,000) [Cr] Return liability = 70,000 (200,000 - 130,000) [Dr] Inventory est. returns = 42,000 [Cr] COGS = 42,000 ----------------------------------------------------------- *The expected additional returns occurred in 2024* [Dr] Refund liability= 70,000 [Cr] Cash = 70,000 [Dr] Inventory = 42,000 [Cr] Inventory est. returns = 42,000

Factoring

*This is the main focus in this class* - A financial institution (factor) buys the AR and charges a fee for this service - The borrower sells AR EXAMPLE A customer used their credit card, to buy something for $100 at a retail company. 2 days later, the credit card company (factor) will give $100 to the retailer but will charge a fee of 3%. The retailer will only get $97.

Cash discounts (AKA sales discounts)

- A credit customer may get a discount if they pay their due within a period of time - Intended to provide incentives for a quick payment 2/10, n/30

Pledging

- A form of secured borrowing - Here, accounts receivable is a collateral - No special account treatments are needed - The company is responsible for collection of the receivables - No receivables are associated with the loan

Sale of receivable

- Can be sold at a gain or a loss like other assets - Accounting treatment is similar to that of the sale of other assets

Sale of receivables steps

- Company removes the receivables from the accounts - Recognizes at fair value any assets acquired or liabilities assumed by the seller in the transaction - Records the difference as a gain or loss

Sales of receivable types

- Factoring - Securitization

The 2 methods to record sales discounts

- Gross method Assumes the customer will pay within the 30 days, not within the discount period - Net method Assumes the customer will pay the liability within the discount period and receive the discount for it

The 2 cons of direct write-off method

- Overstates the balance in accounts receivable in the periods prior to the write-off - Distorts net income by postponing recognition of any bad debt expense until the period in which the customer actually fails to pay

Secured borrowing

- Pledge accounts receivable as collateral for a loan - Entire receivables balance serves as collareral - Responsibility for collection of the receivables remains solely with the company - The arrangement should be described in a disclosure note - No special accounting treatment is needed

Cash equivalents

- Short-term highly liquid investments that can be easily converted to cash with little risk or loss - They have a maturity date no longer than 3 months from the date of purchase EXAMPLE: - Money market funds - Treasury bills - Commercial paper

Trade discounts

- This is a percentage reduction from the list price - Quantity discounts to large customers

Assigning

- This is when a company is required to assign particular receivables to serve as collateral for loans - The lender will lend an amount of money that is less than the amount of receivables assigned by the borrower - The lender usually charges the borrower an up-front finance charge in addition to stated interest on the loan - Receivables may be collected by either the lender or the borrower. The borrower can collect it because the accounts receivable is considered as an asset to the borrower. They need to collect the accounts receivable from their own customers to finance the amount they owe to the lender. EXAMPLE: Mortgage on a home

QUIZ Merch was sold to a customer for $10,000 in Dec 2023. The COGS is $6,000. In 2024, 30% of the merch was returned within the return window

2023 *Ignore returns* Rev = 10,000 Exp = 6,000 Inc = 4,000 *Est returns* Rev = 7,000 Exp = 4,200 Inc = 2,800 2024 *Ignore returns* Rev = -3,000 Exp = -1,800 Inc = -1,200 This is -3,000 because of the 30% of merch being returned.

How long are accounts receivable usually due?

30 to 60 days

QUIZ RedValley Co. borrows $100,000 on January 1 from Northridge Bank at a 12% interest rate. RedValley assigned $140,000 of its accounts receivable as collateral, and agreed to pay a financing fee of 2% of accounts receivable assigned. On January 1, RedValley'saccounting for this transaction will include:

Cash = 97,200 Finance exp = 2,800 Liability = 100,000

Transfer of notes receivable

Company gives note to financial institution They receive cash, which is the maturity value of the note - discount The discount is the financing fee, which is maturity value × discount rate

What a bank's asset section looks like

December 31, 2021 Loans = *$956,770* Allowance for loan losses = *(11,004)* Net loans = *$945,766*

What is the major liability of banks?

Deposits Which are notes payable

Example of compensating balance

EXAMPLE A company borrows $10,000,000 from a bank at an interest rate of 12%. The bank requires a compensating balance of $2,000,000 to be held in a noninterest-bearing checking account Total borrowing from bank = $10,000,000 Interest (10,000,000 * 12%) = $1,200,000 Actual borrowing (10,000,000 - 2,000,000) = $8,000,000 Effective rate of interest (1,200,000 / 8,000,000) = 15% The 15% represents how much interest you will actually be paying for borrowing $8,000,000 instead of $10,000,000. 15% > 12%

Maturity value

Face amount + interest to maturity = maturity value

Direct write-off method

Here, a bad-debt is recorded when an account is deemed uncollectible Is not accepted by GAAP

Allowance method (indirect method)

Here, companies use a contra-asset account called "the allowance for doubtful accounts", to decrease accounts receivable Is required by GAAP

Expense matching principle

Here, companies will have a certain amount of accounts receivable due next year. So, they'll take a portion of that amount as an estimate of receivables that they won't receive, AKA, a "bad debt". They will record this bad debt within the current year

What does it mean when the borrower "collects" the accounts receivable?

It means the borrower will collect money from their customer to fund the money they need to pay back to the lender EXAMPLE: Target owes Bank $300. Target doesn't have $300, so they collect that amount from their customers to pay the amount they owe to Bank

What does the discount on note receivable represent?

It represents future interest revenue that will be recognized over time. It is a contra account to the 'Notes Receivable' account

*REVIEW THIS* QUIZ Long-term Noninterest-bearing notes Matador Company sold shoes to Northridge Sporting Goods on January 1, 2023, accepting a $700,000, two-year note in payment for the shoes, assuming a 12% effective interest rate.

Jan 1, 2023 [Dr] Notes receivable = 700,000 (revenue for 2 years later) [Cr] Discount on note receivable = 141,964 Sales revenue = 558,036 (700,000 × 0.79719 *this is found on the present value table of $1, n=2, i=12%*)(This represents the CURRENT YEAR's sales revenue) Dec 31, 2024 [Dr] Discount on note receivable = 66,964 [Cr] Interest revenue = 66,964 (558,036 × 12%)(this is the interest revenue for the first year) Dec 31, 2024 [Dr] Cash = 700,000 Discount on note receivable = 75,000 (625,000 × 12%)(The 625,000 was found by subtracting 700,000 - 75,000. The 75,000 is found by 141,964 - 66,964) [Cr] Interest revenue = 75,000 Note receivable = 700,000

QUIZ Interest-bearing notes Matador Company manufactures shoes that it sells to retailers. On May 1, 2023, the company sold shoes to Northridge Sporting Goods. Matador agreed to accept a $700,000, 6-month, 12% note in payment for the shoes. Interest is receivable at maturity. Assume that an interest rate of 12% is appropriate for a note of this type.

Journal entries *May 1, 2023* [Dr] Notes receivable = 700,000 [Cr] Sales revenue = 700,000 *Nov 1, 2023* [Dr] Cash = 742,000 [Cr] Interest revenue = 42,000 Note receivable = 700,000 ------------------------------------------------------------------- What if the sale occurs on Aug 1, 2023, and the company's fiscal year ends on Dec 31? A year-end adjusting entry accrues interest earned: *Dec 31, 2023* [Dr] Interest receivable = 35,000 (700,000 × 12% × (6/12)) [Cr] Interest revenue = 35,000 *Feb 1, 2024* [Dr] Cash = 742,000 [Cr] Interest revenue = 7,000 Interest receivable = 35,000 Note receivable = 700,000

What is the major asset of banks?

Loans Which are notes receivable

When are revenues recorded for accounts receivable?

Revenue of accounts receivable are recorded at the time of delivery

Financing with receivables

Secured borrowing Sale of receivables

Securitization

The company creates a special purpose entity (SPE) They can either: Sell the SPE to a 3rd party. The SPEs here are related securities, typically debt like bonds or commercial paper - or - Buy these things: - Trade receivables - Credit card receivables - Lona *They buy these things to sell. They essentially get a bunch of customers who have mixed credit scores and will make a security out of this to sell it*

What is the "annual rate"?

The interest rate

Which is better, the gross or the net method?

The net method is better because the discount is money that customers do not want to miss out saving. EXAMPLE There is a $100 sale with a 2/10, n/30 To save $2, the customer needs to pay $98 20 days earlier than the due date (basically within 10 days). We can think of this scenario as investing $98 to earn $2 2 / 98 = 2.04% This is the rate of return, but only for 20 days 2.04%/20 × 365 = 37.23% This is the annual rate of return You divide 2.04% with 20 days to see how much you earn per day

What is the "face amount"?

The principal

Cash

These are amounts that are readily available to pay off debt or to use in operations EXAMPLE: - Currency and coins - Balances in checking accounts

When restrictions are imposed contractually

These are debt instruments that require the borrower to set aside funds If the debt is noncurrent, then the restricted cash is noncurrent If the debt is current, then the restricted cash is current

Allowance for loan losses

These are loans that will not be paid back from the people that borrowed money from you. Bank regulators do a lot of estimations when it comes to this account.

Noninterest-bearing notes

These notes have interest associated with them despite their name The interest is discounted from the face amount to determine the cash proceeds made available to the borrower

Sale of receivables

This happens if the company cannot pay their debt, so they sell their receivable

Notes receivable

This is a formal written contract between the lender and borrower It specifies the - Amount of money (principal) - Maturity date - Interest rate

Compensating balance

This is an amount that compensates the bank for granting the loan or extending the line of credit The bank requires the borrower to maintain a certain amount of balance in a low interest or noninterest-bearing account at the bank.

Restricted cash

This is cash that is restricted and is not available for use. Is usually recorded as investment like a building

Sales without recourse

This means the buyer cannot ask the seller for more money if the receivables are uncollectible

Sales with recourse

This means the seller retains all of the risk of bad debts, and they may not got money out of the receivable - To compensate the seller for retaining the risk of bad debts, the buyer will charge a lower factoring fee when receivables are sold with recourse

2/10, n/30

This means you get a 2% discount if you pay your debt within 10 days. If you don't, you still need to pay your liability within 30 days

Interest-bearing notes

This represents funds loaned by a lender to a borrower where interest is accrued in accordance with the agreement It requires a specified principal and maturity date

Balance sheet approach

This states that as accounts receivable gets older, it is less likely to be collected

QUIZ Alpha company started operations in 2023. It had sales of $1,200,000 on credit and collected $895,000, leaving $305,000 at the end of the year Alpha believes it will collect $280,000 of its accounts receivable

What is the estimated amount of money that will not be collected? 305,000 - 208,000 = 25,000 [Dr] Bad debt expense = 25,000 [Cr] Allowance for uncollectible accounts = 25,000 ----------------------------------------------------------- On Apr 24, Alpha company concludes they will not collect $15,000 from a customer who became bankrupt [Dr] Allowance for uncollectible accounts = 15,000 [Cr] Accounts receivable = 15,000 ----------------------------------------------------------- However, the customer's financial situation got better and can pay back some of their debt back [Dr] Accounts receivable = 1,200 [Cr] Allowance for uncollectible accounts = 1,200 [Dr] Cash = 1,200 [Cr] Accounts receivable = 1,200

QUIZ Accounts receivable factored without recourse In December 2023, the BlueMoon Company entered into the following factoring arrangement with Factor Bank: • BlueMoon transferred accounts receivable that had a book value of $600,000. • The transfer was made without recourse. • Factor immediately remitted to BlueMoon cash equal to 90% of the factored amount (90% × $600,000 = $540,000). • Factor retains the remaining 10% to cover its factoring fee (equal to 4% of the total factored amount; 4% ×$600,000 = $24,000) and to provide a cushion against potential sales returns and allowances. • After Factor has collected cash equal to the amount advanced to BlueMoon plus the factoring fee, Factor will remit the excess to BlueMoon. Therefore, BlueMoon has a "beneficial interest" in the transferred receivables equal to the fair value of the last 10% of the receivables to be collected (which management estimates to equal $50,000), less the 4% factoring fee.

[Dr] *Cash = 540,000* (90% × 600,000) *Loss on sale of receivables = 34,000* (This is found by using the other numbers in this journal entry: 540,000 + 26,000 - 600,000) *Receivable from factor = 26,000* (50,000 - 24,000) (The $26,000 is used to cover uncertanties in the future. The $24,000 is the fee) [Cr] *Accounts receivable = 600,000*

QUIZ Accounts receivable factored without recourse Assume the same facts as in the previous illustration, except that BlueMoon sold the receivables to Factor with recourse and estimates the fair value of the recourse obligation to be $5,000.

[Dr] *Cash = 540,000* (90% × 600,000) *Loss on sale of receivables = 39,000* (This is found by using the other numbers in this journal entry: 540,000 + 26,000 - 600,000) *Receivable from factor = 26,000* (50,000 - 24,000) (The $26,000 is used to cover uncertanties in the future. The $24,000 is the fee) [Cr] *Recourse liability* = 5,000 *Accounts receivable = 600,000*

What is the journal entry when you conclude that you won't get a receivable?

[Dr] Allowance for uncollectible accounts [Cr] Accounts receivable

What is the journal entry when you expect to not get a receivable?

[Dr] Bad Debt [Cr] Uncollectible accounts

QUIZ Assignment of accounts receivable On December 1, 2023, the BlueMoon Company borrowed $500,000 from Finance Bank and signed a promissory note. Interest at 12% is payable monthly. The company assigned $620,000 of its receivables as collateral for the loan. Finance Bank charges a finance fee equal to 1.5% of the accounts receivable assigned.

[Dr] Cash (difference) = 490,700 Finance charge expense = 9,300 (620,000 ×1.5%) [Cr] Liability - financing arrangement = 500,000

Which of the following is not true about factoring receivables? a.) Cash received upon transfer is less than the amount of receivables transferred b.) A transfer without recourse means that the transferor bears the risk of the receivables not being collected c.) A larger loss is recorded by the transferor when receivables are transferred with recourse d.) The transferor removes the factored accounts receivable from its balance sheet

b. A transfer without recourse means that the transferor bears the risk of the receivables not being collected *Remember, in a situation without recourse, the transferor does NOT bear any risk*