Chapter 7 Comprehensive Review
What are the two methods to account for bad debts?
- Direct Write-Off Method: records bad debts when the company determines that a customer will not pay - Allowance Method: estimates the amount of A.R. that is uncollectible, called the Allowance for Uncollectible Accounts.
What are the two methods for accounting for sales discounts
-Gross Method: records revenue at the full invoice price(ignores the sales discounts). If a customer does pay within the discount period reduce net sales revenue using the contra-revenue account, Sales discounts -Net Method: records revenue at the invoice price less the sales discount. If a customer does not pay within the discount period and pays the full invoice price, the extra amount is recorded to an account called sales discounts forfeited which is an increase to net sales revenue.
What are the weaknesses of the Direct Write-Off Method?
1. Balance Sheet: Accounts Receivable are overstated because some won't be collected. Income Statement: Net income is overstated in the period of sale and understated in the period following the sale, if the company doesn't determine that a customer won't pay until the period following the sale.
What are the 4 aspects of Internal control:
1. Encourage adherence to company policies and procedures 2. promote operational efficiency 3. minimize errors and theft 4. enhance the reliability and accuracy of accounting data
49er Company would record the following entries on the date it receives payment of the note receivable.
11/1/2021 Cash 100 1,058,301 Discount on Note Receivable 126 58,301 Notes Receivable 125 1,058,301 Interest Revenue 410 58,301
Now record the receipt of the note and contractual interest on November 1, 2021. Interest = 1,000,000 × 12% × 6/12 = 60,000 Cash Received = 1,000,000 + 60,000 = 1,060,000
11/1/2021 Cash 100 1,060,000 (C) Note Receivable 125 1,000,000 (C) Interest Revenue 410 60,000
On August 1, 2021, 49er Company sold $1,000,000 of merchandise to a customer. It agreed to accept a $1,000,000, 6-month, 12% note from its customer. Interest is receivable at maturity. Assume that a 12% interest rate is the appropriate rate for this type of note. 49er Company's fiscal year end is December 31. 49er Company would record the following journal entries (ignore COGS and inventory): • What is the required entry at December 31?
12/31/2021 Accrued Interest = 1,000,000 × 6% × 5/12 = 50,000 12/31/2021 Interest Receivable 115 50,000 (C) Interest Revenue 410 50,000
At 12/31/21, 49er Company estimates it will only collect $2,800,000 of the accounts receivable and needs to create an allowance for uncollectible accounts of $250,000. (We will learn two methods of how to estimate the uncollectible amounts, but for now just assume this is the number.) The journal entry to recognize bad debt expense and establish the allowance is:
12/31/2021 Bad Debt Expense 550 250,000 (C) Allowance for Uncoll. Accounts 111 250,000
49er Company will continue to collect on the receivables. It will remit cash received from collecting its assigned receivables to Finance Bank on a monthly basis. If $800,000 of the receivables assigned are collected in December, 49er Company records the following entries.
12/31/2021 Cash 100 800,000 (C) A.R. 110 800,000 Interest Expense = $1,000,000 × 12% × 1/12 = $10,000 12/31/2021 Interest expense 550 10,000 Liability- Financing Arrangement 230 800,000 (C) Cash 100 810,000
During 2021, its first year of operations, 49er Company sold merchandise for $20,000,000 cash. This merchandise cost 49er Company $12,000,000 (60% of the selling price). Industry experience indicates that 10% of all sales will be returned, which equals $2,000,000 ($20,000,000 x 10%). Customers returned $1,300,000 of sales during 2021. 49er Company uses a perpetual inventory system. Record journal entries for the following: At the end of 2021, the company estimates an additional $700,000 of sales returns are expected (i.e., the returns will happen in 2022). The cost of the inventory expected to be returned is $420,000.
12/31/2021 Sales Returns 410 700,000 (C) Refund Liability 230 700,000 Inventory-Est. Returns 131 420,000 (C) Cost of Goods Sold 505 420,000
What if 49er Company had written off so many accounts in 2022 that the pre-adjusted balance of the allowance account at 12/31/2022 was a debit balance of $100,000: What would the journal entry look like
12/31/2022 Bad Debt Expense 550 370,000 (C) Allowance for Uncollectible Accts. 111 370,000
The journal entry to record bad debt expense and adjust the ending allowance to $270,000 is:
12/31/22 Bad Debt Expense 550 50,000 (C) Allowance for Uncollectible Accounts 111 50,000
During 2021, its first year of operations, 49er Company sold merchandise for $20,000,000 cash. This merchandise cost 49er Company $12,000,000 (60% of the selling price). Industry experience indicates that 10% of all sales will be returned, which equals $2,000,000 ($20,000,000 x 10%). Customers returned $1,300,000 of sales during 2021. 49er Company uses a perpetual inventory system. Record journal entries for the following: 1. Sales of $20,000,000 for cash in 2021 where the cost of the inventory sold was 12,000,000
2021 Cash 100 20,000,000 (C) Sales Revenue 400 20,000,000 Cost of Goods Sold 505 12,000,000 (C) Inventory 130 12,000,000
During 2021, its first year of operations, 49er Company sold merchandise for $20,000,000 cash. This merchandise cost 49er Company $12,000,000 (60% of the selling price). Industry experience indicates that 10% of all sales will be returned, which equals $2,000,000 ($20,000,000 x 10%). Customers returned $1,300,000 of sales during 2021. 49er Company uses a perpetual inventory system. Record journal entries for the following: 2. Sales returns of $1,300,000 occurred during 2021. The cost of the inventory returned is 780,000
2021 Sales Returns 410 1,300,000 (C) Cash 100 1,300,000 Inventory 130 780,000 (C) Cost of Goods Sold 505 780,000
During 2021, its first year of operations, 49er Company sold merchandise for $20,000,000 cash. This merchandise cost 49er Company $12,000,000 (60% of the selling price). Industry experience indicates that 10% of all sales will be returned, which equals $2,000,000 ($20,000,000 x 10%). Customers returned $1,300,000 of sales during 2021. 49er Company uses a perpetual inventory system. Record journal entries for the following: Sales returns of $700,000 occurred during 2022. The cost of returned inventory is $420,000.
2022 Refund Liability 230 700,000 (C) Cash 100 700,000 Inventory 130 420,000 (C) Inventory-Est. Returns 420,000
investments of less than ___ months are considered cash
3 months
When accounts are deemed uncollectible: On April 24, 2022, 49er Company concludes that it will not collect a $30,000 account receivable from a customer that has recently gone bankrupt. 49er Company writes off the receivable by recording the following journal entry:
4/24/2022 Allowance for uncoll. accounts 111 30,000 (C) Accounts Receivable 110 30,000
49er Company sold $30,000 of goods to a customer on November 1, 2021. On April 24, 2022, 49er Company learned that the customer went bankrupt and will not be able to pay. Using the Direct Write-Off Method, on April 24, 2022, 49er Company will record the following journal entry:
4/24/2022 Bad Debt Expense 550 30,000 (C) Accounts Rec 110 30,000
If a customer pays on an account that was previously written off, then you reverse the write-off entry and then record the cash receipt. Let's look at what happens for the April 24th transaction For example, if on 5/31/2022, 49er Company gets paid by the customer above whose account was written off, 49er Company would record the following entries:
5/31/2022 Accounts Receivable 110 30,000 (C) Allowance for Uncollectible Accounts 111 30,000 5/31/2022 Cash 100 30,000 (C) Accounts Receivable 110 30,000
For example, if 49er borrowed 2,000,000 on June 1, 2021 and pledged its receivables as collateral, it would record the entry as what?
6/1/2021 Cash 100 2,000,000 (C) Note Payable 225 2,000,000
Allowance for Uncollectible accounts is what type of account?
A contra-asset
What does COSO define internal control as?
A process, undertaken by an entity's board of directors, management, and other personnel, designed to provide reasonable assurance regarding the achievement of objectives in the following categories: • Effectiveness and efficiency of operations • Reliability of financial reporting • Compliance with applicable laws and regulations.
What do banks typically call the allowance account for uncollectible notes receivable?
Allowance for Credit Losses
What is a pledge?
An arrangement where a company pledges all its receivables as collateral in exchange for a loan.
How is bad debt recorded on the income statement?
As an operating expense
In 2022, 49er Company made credit sales of $16,000,000. Based on industry experience and experience from 2021, it estimates that 2% of credit sales will not be collectible. What would the journal entry look like?
Bad Debt Expense 550 320,000 (C) Allowance for Uncoll. Accts. 111 320,000
What is included in cash?
Cash includes currency and coins, balances in checking accounts, and items acceptable for deposit in these accounts, such as check and money orders received from customers
What is Restricted Cash?
Cash restricted for a particular purpose and not available for general use.
The framework for designing internal control systems used by publicly traded companies is known as?
Committee of Sponsoring Organizations (COSO)
Sales returns is what type of account
Contra-revenue
The T-Account to record bad debt expense and adjust the ending allowance to $270,000 is:
Credit Side: 220,000 12/31/22 Pre-Adjustment balance 50,000 GJ1 12/31/22 Bad Debt expense (Plug) 270,000 Bal. 12/31/22
In 2022, 49er Company made credit sales of $16,000,000. Based on industry experience and experience from 2021, it estimates that 2% of credit sales will not be collectible. What would the t-account look like?
Credit: 220,000 12/31/22 320,000 GJ1 12/31/22 Bad Debt Expense- est. directly 540,000 Bal. 12/31/22 Post-adjustment balance
What if 49er Company had written off so many accounts in 2022 that the pre-adjusted balance of the allowance account at 12/31/2022 was a debit balance of $100,000: What would the T-Account look like
Debit: 12/31/22 100,000 Pre-adjustment balance Credit: 370,000 GJ1 12/31/22 Bad Debt expense (plug) 270,000 Bal. 12/31/22 Post-adjustment balance
What are the two most common types of selling arrangements
Factoring: In a factoring arrangement, the company sells its accounts receivable to a financial institution. The financial institution typically buys the receivables for cash, and handles the billing and collection of the receivables, and charges a fee for this service. Securitization: Securitization is a more complicated transaction where accounts receivable are sold to a "special purpose entity" specifically set up to own and collect on the receivables. We will not cover the accounting for securitizations, but any of you who are going into the banking industry should read more about accounting for these transactions in the book.
What is an assignment?
Financing arrangement involve the company assigning specific receivables as collateral against the loan.
49er Company offers customers who purchase on account a 2% sales discount if they pay their invoices within 10 days. Amounts not paid within 10 days are due in 30 days. That is, the payment terms are 2/10, n/30. The follow events occurred: Scenario 1 On April 5, 2022, 49er Company sold merchandise at a price of $40,000. The customer paid $39,200 ($40,000 less the 2% sales discount) on April 14, 2022.
Gross Method: 4/5/2022: Accounts Rec 110 40,000 (C) Sales Revenue 400 40,000 4/14/22 Cash 110 39,200 Sales Discount 401 800 (C) Accounts Rec 110 40,000 Sales Revenue: 40,000 Less: Sales discounts (800) Add: Discounts forfeited 0 Net sales revenue: 39,200 Net Method: 4/5/2022 Accounts Rec 110 39,200 (C) Sales Rev 400 39,200 4/14/2022 Cash 100 39,200 (C) Accounts Rec 110 39,200 Sales revenue: 39,200 Less: Sales discounts 0 Add: Discounts forfeited 0 Net sales revenue: 39,200
49er Company offers customers who purchase on account a 2% sales discount if they pay their invoices within 10 days. Amounts not paid within 10 days are due in 30 days. That is, the payment terms are 2/10, n/30. The follow events occurred: Scenario 2 On April 5, 2022, 49er Company sold merchandise at a price of $40,000. The customer paid $40,000 on May 4, 2022.
Gross Method: 4/5/2022: Accounts Rec 110 40,000 (C) Sales Revenue 400 40,000 5/4/2022 Cash 100 40,000 (C) Accounts Receivable 110 40,000 Sales Revenue: 40,000 Less: Sales discounts 0 Add: Discounts forfeited 0 Net sales revenue: 40,000 Net Method: 4/5/2022: Accounts Rec 110 39,200 (C) Sales Revenue 400 39,200 5/4/2022 Cash 100 40,000 (C) Accounts Rec 110 39,200 (C) Sales Discount Forfeited 800 Sales Revenue: 39,200 Less: Sales discounts 0 Add: Discounts forfeited 800 Net sales revenue: 40,000
Do you believe the presentation of Sales Discounts Forfeited as an addition to Net Sales Revenue represents the economics of the transaction? Asked differently, why is the customer paying $800 and not $39,200?
In substance, the $800 represents interest revenue earned by 49er Company. The customer is paying $800 because it chose to take 49er Company on its offer to finance the transaction for 30 days rather than paying cash within the first 10 days of purchase.
Record the 12/31/2021 accrued interest revenue and amortization of the discount on the note.
Interest = 996,492 × 12% × 12/12 = $119,579 12/31 Discount on Notes Receivable 126 119,579 (C) Interest Revenue 410 119,579
What is a compensating balance?
Is the minimum cash balance required by a lender to be maintained at the financial institution of the lender, which may be legally restricted for use
How is bad debt expense impact the balance sheets?
It becomes Accounts Receivable, net of allowance for uncollectible accts.
What account is Discount on Notes Receivable
It is a contra-notes receivable
When is the Bad Debt Expense recorded using the Allowance Method?
It is helpful to first understand when it is not recognized. It is not recognized when specific receivables are written off. Instead, bad debts are estimated and recognized in the same period as the credit sales were made. This approach matches the cost of extending credit, recognized as Bad Debt Expense, with the related revenues.
What is included in Cash Equivalents?
Money market funds, treasury bills, and commercial paper
On May 1, 2021, 49er Company sold merchandise to a customer. It agreed to accept a $1,058,301, 6-month, 0% note from its customer. Interest is receivable at maturity. Assume that a 12% interest rate is the appropriate rate for this type of note. If 49er Company determined that the effect of time value of money was material even though the note was for a period of less than a year, 49er Company would record the following journal entries (ignore COGS and inventory):
N: 0.5 I/Y 12 (PV) 1,000,000 PMT 0 FV 1,058,301 5/1/2021 Note Receivable 125 1,058,301 (C) Sales Revenue 400 1,000,000 (C) Discount on Notes Receivable 121 58,301
On January 1, 2021, 49er Company sold merchandise to a customer. It agreed to accept a $1,250,000, 2-year, 0% note (noninterest-bearing) from its customer. Interest is receivable at maturity (December 31, 2022). Assume that a 12% interest rate is the appropriate rate for this type of note.
N: 2 I/Y: 12 (PV) -996,491 PMT 0 FV 1,250,000 1/1/21 Note Receivable 125 1,250,000 (C) Sales revenue 400 996,492 (C) Discount on Notes Receivable 126 253,508
Do we typically incorporate TVM in accounting and accounts receivable?
No. The financing component is typically immaterial. You will recall from chapter 6 that typically we ignore TVM if the period between delivery of a product or service is less than a year.
When can companies use the Direct Write-Off Method?
Not compliant with GAAP can only used if bad debts are immaterial
When a receivable is accompanies by a formal promissory note (or in essence has terms) it is known as?
Note receivable
On May 1, 2021, 49er Company sold $1,000,000 of merchandise to a customer. It agreed to accept a $1,000,000, 6-month, 12% note from its customer. Interest is receivable at maturity. Assume that a 12% interest rate is the appropriate rate for this type of note. 49er Company would record the following journal entries (ignore COGS and inventory):
Note: Notes receivable and sales revenue will be equal as note rate = market rate 5/1/2021 Note receivable 125 1,000,000 (C) Sales Revenue 400 1,000,000
What are notes receivable?
Notes receivables are formal credit arrangements between a creditor (lender) and a a debtor (borrower) that specify payment terms
When an account is written off on the allowance method what happens?
Notice that under the allowance method, when an account is written off, there is no effect on net income, or net assets. Accounts Receivable, net continues to be reported at $2.8M.
When is the income statement approach allowed to estimate bad debt expense?
Only when the ending balance of allowance for doubtful accounts is accurate.
What are receivables?
Receivables represent a company's claims to future collection of cash, other assets, or services
What does with recourse and without recourse mean?
Recourse: a right to collection Without recourse: don't have right to collection (risk non-payment)
What does the income statement look like for the Sales Returns Example if we didn't estimate sales returns?
Sales Revenue 21 20,000,000 22 (0) Total 20,000,000 Less: Sales Returns 21 (1,300,000) 22 (300,000) Total (2,000,000) Net Sales Revenue 21 18,700,000 22 (700,000) Total 18,000,000 C.G.S 21 11,220,000 22 (420,000) Total 10,800,000 Gross Profit 21 7,480,000 22 (280,000) Total 7,200,000
What does the income statement look like for the Sales Returns Example?
Sales Revenue 21 20,000,000 22 (0) Total 20,000,000 Less: Sales Returns 21 (2,000,000) 22 (0) Total (2,000,000) Net Sales Revenue 21 18,000,000 22 (0) Total 18,000,000 C.G.S 21 10,800,000 22 0 Total 10,800,000 Gross Profit 21 7,200,000 22 0 Total 7,200,000
What are the two categories of approaches to receivables-financing arrangements?
Secured Borrowing: Pledge (or assign) accounts receivable as collateral for a loan • Entire receivables balance serves as collateral• 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 Sale of Receivables: Can be sold at a gain or a loss like other assets • Responsibility for collection of the receivables transfers to the financial institution • Accounting treatment is similar to that of the sale of other assets • The accounting varies with whether the sale is with recourse or without recourse.
What is the most critical control for cash?
Separation of duties- Individuals who have physical responsibility for assets should not also have access to accounting records. In the context of cash, separation of duties means that the employees who handle the cash should not be in or have access to accounting records, not be involved in the reconciliation of cash book balances to bank balances
What is the main problem with allowing customers to pay for goods and services 30-60 days after the date of sale?
Some customers won't pay. These are called bad debts (or credit losses). The amount that is never collected from customers and recorded to an account called Bad Debt Expense. It is not recorded as a reduction to revenues
On December 1, 2021, 49er Company borrowed $1,000,000 from Finance Bank and signed a promissory note. Interest at 12% is payable monthly. 49er Company assigned $1,200,000 of its receivables as collateral for the loan. Finance Bank charges a finance fee equal to 1.5% of the accounts receivable assigned (note that the finance fee is based on the accounts receivable amount assigned, not the amount borrowed). Record the borrowing on December 1, 2021:
The 12/1/2021 journal entry includes: • Liability for gross amount borrowed = $1,000,000 • Finance Charge Expense = $18,000 • Net Cash Received (after bank finance charge) = $982,000 12/1/2021 Cash 100 982,000 Finance Charge (expense) 520 18,000 (C) Liability-Financing arrangement
How do companies estimate the allowance?
The allowance for uncollectible accounts is estimated under CECL ("Current Expected Credit Loss") model. CECL does not specify a particular method for estimating bad debts. It allows a company to apply any method that reasonably captures its expectation of credit losses so that the reported carrying value of net accounts receivable is the amount the company expects to collect. The estimate needs to consider all receivables and be based on all relevant information, including historical experience, current conditions, and reasonable and supportable forecasts.
What is the allowance method?
The allowance method estimates the amount of Accounts Receivable that is uncollectible, which is called the Allowance for Uncollectible Accounts.
What does a zero interest loan mean?
The loans will bear interest at the market rate of interest for the type of transaction
n February 1, 2022, 49er Company factors $500,000 of accounts receivable with Factor Bank, on a without recourse basis. Factor Bank assesses a finance charge of 3 percent of the amount of accounts receivable and retains an amount equal to 5 percent of the accounts receivable (for probable adjustments). 49er Company makes the following journal entry to record the sale of its accounts receivable:
The sale of the accounts receivable = $500,000 • The finance charge (loss on sale) = 3% × $500,000 = $15,000 • Receivables from Factor = 5% × $500,000 = $25,000 • Cash Received (net) = $500,000 - $15,000 - $25,000 = $460,000 2/1/2021 Cash 100 460,000 Loss on Sale of Receivables 525 15,000 Receivables from Factor 115 25,000 (C) Accounts Receivable 110 500,000
Accounts receivable are what type of credit arrangements?
They are informal credit arrangements supported by an invoice
What is the required entry at Feb 1?
Total Payment (unchanged) = $1,060,000 • Additional Interest Revenue (1 mo.) = 10,000 • Removal of Note Receivable = 1,000,000 • Removal of prior accrued Interest Receivable = 50,000 2/1/2022 Cash 100 1,060,000 (C) Interest Revenue 410 10,000 (C) Note Receivable 125 1,000,000 (C) Interest Receivable 115 50,000
What are the two types of discounts companies commonly offer?
Trade discounts: are a percentage reduction from the list price. •For example, if you buy a pair of pants with a list price of $100 from 49er Company on a Memorial Day Weekend Sale where all clothes are 25% off, the price you pay is $75. 49er Company records revenue of $75. Sales discounts: often called cash discounts, are reductions in the amount to be received if a customer pays within a specified period of time. •The amount of sales discount and the time period within which it's available to pay are conveyed by terms like 2/10, n/30, which mean the customer gets a 2% discount if they pay within 10 days, otherwise full payment is due in 30 days.
What are trade and non-trade receivables?
Trade receivables: are receivables resulting from the sale of goods or services on account and are called Accounts Receivable Non-Trade Receivables: are those other than trade receivables and include tax refund claims, interest receivables, and advances to employees
What is the key concern with cash disbursements?
Unauthorized payments
Thinking back to Chapter 6 on revenue recognition, what accounting issue do returns create?
Uncertainty about the transaction price. Specifically, returns represent variable consideration as the products might be returned or or the prices might be adjusted, there is uncertainty about the final amount the seller will be entitled to receive.
What is the balance sheet approach?
at the end of the period, a company estimates the ending allowance for uncollectible accounts. The company then records whatever amount of bad debt expense is needed to get the allowance account to the estimated balance.
What is the transferor?
the company was the original holder of the receivable
What is the transferee?
the new holder, the financial institution
Record the payment of the note at maturity. This will include: • Cash payment for the note face amount = $1,250,000 • 2022 accrued interest revenue and remaining discount amortization.
the remaining discount balance... 253,508 - 119,579 = 133,929 12/31/2022 Cash 100 1,250,000 Discount on Notes Receivable 126 133,929 (C) Notes Receivable 125 1,250,000 (C) Interest Revenue 410 133,929
On February 1, 2022, 49er Company factors $500,000 of accounts receivable with Factor Bank, on a with recourse basis. Factor Bank assesses a finance charge of 3 percent of the amount of accounts receivable and retains an amount equal to 5 percent of the accounts receivable (for probable adjustments). The fair value of the recourse obligation is estimated to be $6,000. 49er Company makes the following journal entry to record the sale of its accounts receivable:
• The sale of the accounts receivable = $500,000 • The recourse liability = $6,000 • The finance charge (loss on sale) = 3% × $500,000 + $6,000 = $21,000 • Receivables from Factor = 5% × $500,000 = $25,000 • Cash Received (net) = $500,000 - $15,000 - $25,000 = $460,000 2/1/2021 Cash 100 460,000 Loss on Sale of Receivables 525 21,000 Receivables from Factor 115 25,000 (C) Accounts Receivable 110 500,000 (C) Recourse Liability 260 6,000
How does legally binding affect the classification and disclosure of a compensating balance?
•If the restriction is legally binding, the cash is classified as either current or noncurrent (investments or other assets) depending on the classification of the related debt. •If the restriction is informal and not contractual, the compensating balance can be included with cash and cash equivalents with note disclosure of the arrangement.
In B2B transactions, it is customary to allow customers to pay 30 to 60 days after the date of the sale. Why is this helpful for businesses and customers?
•This is to help customers facilitate internal controls over disbursements discussed earlier and also encourages customers to purchase the company's product or service.
