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Accounting Principles: A Business Perspective, Financial Accounting (Chapters 9 – 18)
A Textbook Equity Open College Textbook
originally by
Hermanson, Edwards, and Maher
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Textbook Provenance (1998 - 2011) 1998 Edition Accounting: A Business Perspective (Irwin/Mcgraw-Hill Series in Principles of Accounting) [Hardcover] Roger H. Hermanson (Author), James Don Edwards (Author), Michael W. Maher (Author) Eighth Edition
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Publisher: Richard D Irwin; 7 Sub edition (April 1998)
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2010 Editions (http://globaltext.terry.uga.edu/books/) Global Text Project Conversion to Creative Commons License CC-BY “Accounting Principles: A Business Perspective First Global Text Edition, Volume 1 Financial Accounting”, Revision Editor: Donald J. McCubbrey, PhD.
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Table of Contents
9 Receivables and payables.............................................................................11
9.1 Learning objectives.......................................................................................................... 11
9.2 A career in litigation support...........................................................................................11
9.3 Accounts receivable......................................................................................................... 13
9.4 Current liabilities............................................................................................................26
9.5 Notes receivable and notes payable................................................................................35
9.6 Short-term financing through notes payable.................................................................42
9.7 Analyzing and using the financial results—Accounts receivable turnover....................45
9.8 Key terms........................................................................................................................ 50
9.9 Self test............................................................................................................................ 52
9.10 Questions....................................................................................................................... 54
9.11 Exercises........................................................................................................................ 56
9.12 Problems........................................................................................................................ 58
9.13 Alternate problems........................................................................................................61
9.14 Beyond the numbers—Critical thinking........................................................................63
9.15 Using the Internet—A view of the real world................................................................65
9.16 Answers to self test........................................................................................................66
10 Property, plant, and equipment.................................................................68
10.1 Learning objectives........................................................................................................68
10.2 A company accountant's role in managing plant assets...............................................68
10.3 Nature of plant assets...................................................................................................69
10.4 Initial recording of plant assets.....................................................................................71
10.5 Depreciation of plant assets..........................................................................................77
10.6 Subsequent expenditures (capital and revenue) on assets..........................................90
10.7 Subsidiary records used to control plant assets...........................................................94
10.8 Analyzing and using the financial results—Rate of return on operating assets...........97
10.9 Key terms..................................................................................................................... 101
10.10 Self-test...................................................................................................................... 102
10.11 Exercises..................................................................................................................... 106
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10.12 Problems.................................................................................................................... 109
10.13 Alternate problems..................................................................................................... 112
10.14 Beyond the numbers—Critical thinking.....................................................................115
10.15 Using the Internet—A view of the real world.............................................................118
10.16 Answers to self-test.................................................................................................... 118
11 Plant asset disposals, natural resources, and intangible assets.................120
11.1 Learning objectives....................................................................................................... 120
11.2 A company accountant's role in measuring intangibles..............................................120
11.3 Disposal of plant assets................................................................................................ 122
11.4 Sale of plant assets....................................................................................................... 122
11.5 Natural resources......................................................................................................... 133
11.6 Intangible assets........................................................................................................... 138
11.7 Analyzing and using the financial results—Total assets turnover...............................147
11.8 Key terms...................................................................................................................... 155
11.9 Self-test......................................................................................................................... 156
11.10 Problems..................................................................................................................... 162
11.11 Alternate problems..................................................................................................... 166
11.12 Beyond the numbers-Critical thinking.......................................................................170
11.13 Using the Internet—A view of the real world.............................................................173
11.14 Answers to self-test..................................................................................................... 173
12 Stockholders' equity: Classes of capital stock............................................175
12.1 Learning objectives....................................................................................................... 175
12.2 The accountant as a corporate treasurer.....................................................................175
12.3 The corporation............................................................................................................ 176
12.4 Analyzing and using the financial results—Return on average common stockholders' equity....................................................................................................................................... 202
12.5 Key Terms.................................................................................................................... 209
12.6 Self-test........................................................................................................................ 212
12.7 Exercises....................................................................................................................... 215
12.8 Problems......................................................................................................................216
12.9 Alternate problems.....................................................................................................220
12.10 Beyond the numbers—Critical thinking....................................................................225
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12.11 Using the Internet—A view of the real world.............................................................227
12.12 Answers to self-test....................................................................................................228
13 Corporations: Paid-in capital, retained earnings, dividends, and treasury stock................................................................................................................230
13.1 Learning objectives......................................................................................................230
13.2 The accountant as a financial analyst.........................................................................230
13.3 Paid-in (or contributed) capital...................................................................................231
13.4 Paid-in capital—Stock dividends................................................................................232
13.5 Paid-in capital—Treasury stock transactions.............................................................233
13.6 Paid-in capital—Donations.........................................................................................233
13.7 Retained earnings........................................................................................................233
13.8 Paid-in capital and retained earnings on the balance sheet.......................................234
13.9 Retained earnings appropriations..............................................................................244
13.10 Statement of retained earnings.................................................................................246
13.11 Statement of stockholders' equity..............................................................................247
13.12 Treasury stock...........................................................................................................248
13.13 Net income inclusions and exclusions.......................................................................253
13.14 Analyzing and using the financial results—Earnings per share and price-earnings ratio.......................................................................................................................................... 259
13.15 Key terms................................................................................................................... 265
13.16 Self-test...................................................................................................................... 267
13.17 Exercises..................................................................................................................... 271
13.18 Problems....................................................................................................................273
13.19 Alternate problems....................................................................................................278
13.20 Beyond the numbers—Critical thinking...................................................................282
13.21 Using the Internet—A view of the real world............................................................286
13.22 Answers to self-test...................................................................................................286
14 Stock investments....................................................................................288
14.1 Learning objectives......................................................................................................288
14.2 The role of accountants in business acquisitions.......................................................288
14.3 Cost and equity methods............................................................................................290
14.4 Accounting for short-term stock investments and for long-term stock investments of less than 20 percent ................................................................................................................291
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14.5 Cost method for short-term investments and for long-term investments of less than 20 percent ............................................................................................................................... 291
14.6 The equity method for long-term investments of between 20 percent and 50 percent ................................................................................................................................................. 297
14.7 Reporting for stock investments of more than 50 percent ........................................298
14.8 Consolidated balance sheet at time of acquisition.....................................................302
14.9 Accounting for income, losses, and dividends of a subsidiary...................................308
14.10 Consolidated financial statements at a date after acquisition..................................309
14.11 Uses and limitations of consolidated statements......................................................313
14.12 Analyzing and using the financial results—Dividend yield on common stock and payout ratios............................................................................................................................ 314
14.13 Key terms.................................................................................................................... 321
14.14 Self-test...................................................................................................................... 322
14.15 Exercises.................................................................................................................... 325
14.16 Problems....................................................................................................................327
14.17 Alternate problems.....................................................................................................331
14.18 Beyond the numbers—Critical thinking....................................................................334
14.19 Using the Internet—A view of the real world............................................................336
14.20 Answers to self-test...................................................................................................336
15 Long-term financing: Bonds.....................................................................337
15.1 Learning objectives......................................................................................................337
15.2 The accountant's role in financial institutions...........................................................338
15.3 Bonds payable.............................................................................................................339
15.4 Comparison with stock................................................................................................340
15.5 Selling (issuing) bonds................................................................................................340
15.6 Bond prices and interest rates....................................................................................348
15.7 Redeeming bonds payable...........................................................................................359
15.8 Analyzing and using the financial results—Times interest earned ratio....................365
15.9 Appendix: Future value and present value.................................................................370
15.10 Demonstration problem............................................................................................377
15.11 Solution to demonstration problem...........................................................................377
15.12 Key terms................................................................................................................... 378
15.13 Self-test......................................................................................................................380
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15.14 Exercises.................................................................................................................... 383
15.15 Problems.................................................................................................................... 385
15.16 Alternate problems....................................................................................................387
15.17 Beyond the numbers—Critical thinking....................................................................389
15.18 Using the Internet—A view of the real world............................................................392
15.19 Answers to self-test....................................................................................................393
16 Analysis using the statement of cash flows...............................................394
16.1 Learning objectives......................................................................................................394
16.2 A career in external auditing.......................................................................................394
16.3 Purposes of the statement of cash flows.....................................................................396
16.4 Uses of the statement of cash flows............................................................................397
16.5 Information in the statement of cash flows................................................................398
16.6 Cash flows from operating activities..........................................................................400
16.7 Steps in preparing statement of cash flows................................................................404
16.8 Analysis of the statement of cash flows.......................................................................412
16.9 Liquidity and capital resources...................................................................................412
16.10 Analyzing and using the financial results—Cash flow per share of common stock, cash flow margin, and cash flow liquidity ratios.....................................................................421
16.11 Appendix: Use of a working paper to prepare a statement of cash flows.................424
16.12 Key terms...................................................................................................................431
16.13 Self-test...................................................................................................................... 432
16.14 Questions...................................................................................................................434
16.15 Exercises.................................................................................................................... 435
16.16 Problems....................................................................................................................437
16.17 Alternate problems....................................................................................................446
16.18 Management's discussion and analysis - Capital......................................................449
16.19 Management's discussion and analysis - Financial*.................................................453
16.20 Beyond the numbers—Critical thinking....................................................................457
16.21 Using the Internet—A view of the real world............................................................461
16.22 Answers to self-test...................................................................................................462
17 Analysis and interpretation of financial statements..................................463
17.1 Learning objectives......................................................................................................463
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17.2 Accountants as investment analysts...........................................................................463
17.3 Objectives of financial statement analysis..................................................................464
17.4 Sources of information................................................................................................467
17.5 Horizontal analysis and vertical analysis: An illustration..........................................469
17.6 Trend percentages.......................................................................................................473
17.7 Ratio analysis............................................................................................................... 475
17.8 Understanding the learning objectives.......................................................................505
17.9 Demonstration problem .............................................................................................508
17.10 Solution to demonstration problem..........................................................................510
17.11 Key terms.....................................................................................................................511
17.12 Self-test....................................................................................................................... 513
17.13 Exercises..................................................................................................................... 517
17.14 Problems..................................................................................................................... 519
17.15 Alternate problems.....................................................................................................527
17.16 Beyond the numbers – Critical thinking...................................................................534
17.17 Using the Internet—A view of the real world.............................................................537
17.18 Answers to self-test....................................................................................................538
18 Managerial accounting concepts/job costing............................................540
18.1 Learning objectives......................................................................................................540
18.2 A manager's perspective.............................................................................................540
18.3 Compare managerial accounting with financial accounting......................................542
18.4 Merchandiser and manufacturer accounting: Differences in cost concepts..............543
18.5 Financial reporting by manufacturing companies.....................................................548
18.6 The general cost accumulation model........................................................................552
18.7 Job costing................................................................................................................... 555
18.8 Predetermined overhead rates....................................................................................563
18.9 Appendix: Variable versus absorption costing...........................................................567
18.10 Demonstration problem............................................................................................570
18.11 Solution to demonstration problem...........................................................................571
18.12 Key terms................................................................................................................... 573
18.13 Self-test...................................................................................................................... 574
18.14 Questions................................................................................................................... 577
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18.15 Exercises.................................................................................................................... 579
18.16 Problems.................................................................................................................... 581
18.17 Alternate problems....................................................................................................586
18.18 Beyond the numbers—Critical thinking....................................................................588
18.19 Using the Internet—A view of the real world............................................................592
18.20 Answers to self-test...................................................................................................594
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9 Receivables and payables
9.1 Learning objectives
After studying this chapter, you should be able to:
• Account for uncollectible accounts receivable under the allowance method.
• Record credit card sales and collections.
• Define liabilities, current liabilities, and long-term liabilities.
• Define and account for clearly determinable, estimated, and contingent
liabilities.
• Account for notes receivable and payable, including calculation of interest.
• Account for borrowing money using an interest-bearing note versus a non
interest-bearing note.
• Analyze and use the financial results—accounts receivable turnover and the
number of days' sales in accounts receivable.
9.2 A career in litigation support
What is litigation support? It does not mean working in an attorney's office. It
involves assisting legal counsel in attempting to gain favorable verdicts in a court of
law. Persons involved in litigation support generally work for a public accounting firm,
a consulting firm, or as a sole proprietor or in partnership with others. An experienced
litigation support person can expect to earn an income well into six figures.
Litigation support in a broad sense encompasses fraud auditing, valuation analysis,
investigative accounting, and forensic accounting. The practice of litigation support
involves assisting legal counsel in such things as product liability disputes, shareholder
disputes, contract breaches, and major losses reported by entities. These investigations
require the accountant to gather and evaluate evidence to assess the integrity and
dollar amounts surrounding the aforementioned situations.
The accountant can be, and often is, requested to serve as an expert witness in a
court of law. This experience requires knowledge of accounting and auditing in
addition to possessing good communication skills, appropriate credentials, relevant
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experience, and critical information that could result in successful resolution of the
issue.
What kind of person pursues litigation support as a career? It takes a very special
individual. The person must be part accountant, part auditor, part lawyer, and part
skilled businessperson. An undergraduate accounting degree, an MBA, and a law
degree would be the perfect educational background needed for such a career. Many
universities offer a combined MBA/JD program. Such a program fulfills the graduate
needs of the litigation support person.
In addition to the degree, work experience in the business sector is essential. A
career in public accounting, industry, or with a government agency would serve as
valuable experience in pursuing a career in litigation support.
Much of the growth of business in recent years is due to the immense expansion of
credit. Managers of companies have learned that by granting customers the privilege of
charging their purchases, sales and profits increase. Using credit is not only a
convenient way to make purchases but also the only way many people can own high-
priced items such as automobiles.
This chapter discusses receivables and payables. For a company, a receivable is
any sum of money due to be paid to that company from any party for any reason.
Similarly, a payable describes any sum of money to be paid by that company to any
party for any reason.
Primarily, receivables arise from the sale of goods and services. The two types of
receivables are accounts receivable, which companies offer for short-term credit with
no interest charge; and notes receivable, which companies sometimes extend for both
short-and long-term credit with an interest charge. We pay particular attention to
accounting for uncollectible accounts receivable.
Like their customers, companies use credit, which they show as accounts payable or
notes payable. Accounts payable normally result from the purchase of goods or services
and do not carry an interest charge. Short-term notes payable carry an interest charge
and may arise from the same transactions as accounts payable, but they can also result
from borrowing money from a bank or other institution. Chapter 4 identified accounts
payable and short-term notes payable as current liabilities. A company also incurs
other current liabilities, including payables such as sales tax payable, estimated
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product warranty payable, and certain liabilities that are contingent on the occurrence
of future events. Long-term notes payable usually result from borrowing money from a
bank or other institution to finance the acquisition of plant assets. As you study this
chapter and learn how important credit is to our economy, you will realize that credit
in some form will probably always be with us.
9.3 Accounts receivable
In Chapter 3, you learned that most companies use the accrual basis of accounting
since it better reflects the actual results of the operations of a business. Under the
accrual basis, a merchandising company that extends credit records revenue when it
makes a sale because at this time it has earned and realized the revenue. The company
has earned the revenue because it has completed the seller's part of the sales contract
by delivering the goods. The company has realized the revenue because it has received
the customer's promise to pay in exchange for the goods. This promise to pay by the
customer is an account receivable to the seller. Accounts receivable are amounts that
customers owe a company for goods sold and services rendered on account.
Frequently, these receivables resulting from credit sales of goods and services are
called trade receivables.
When a company sells goods on account, customers do not sign formal, written
promises to pay, but they agree to abide by the company's customary credit terms.
However, customers may sign a sales invoice to acknowledge purchase of goods.
Payment terms for sales on account typically run from 30 to 60 days. Companies
usually do not charge interest on amounts owed, except on some past-due amounts.
Because customers do not always keep their promises to pay, companies must
provide for these uncollectible accounts in their records. Companies use two methods
for handling uncollectible accounts. The allowance method provides in advance for
uncollectible accounts. The direct write-off method recognizes bad accounts as an
expense at the point when judged to be uncollectible and is the required method for
federal income tax purposes. However, since the allowance method represents the
accrual basis of accounting and is the accepted method to record uncollectible accounts
for financial accounting purposes, we only discuss and illustrate the allowance method
in this text.
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Even though companies carefully screen credit customers, they cannot eliminate all
uncollectible accounts. Companies expect some of their accounts to become
uncollectible, but they do not know which ones. The matching principle requires
deducting expenses incurred in producing revenues from those revenues during the
accounting period. The allowance method of recording uncollectible accounts adheres
to this principle by recognizing the uncollectible accounts expense in advance of
identifying specific accounts as being uncollectible. The required entry has some
similarity to the depreciation entry in Chapter 3 because it debits an expense and
credits an allowance (contra asset). The purpose of the entry is to make the income
statement fairly present the proper expense and the balance sheet fairly present the
asset. Uncollectible accounts expense (also called doubtful accounts expense or
bad debts expense) is an operating expense that a business incurs when it sells on
credit. We classify uncollectible accounts expense as a selling expense because it results
from credit sales. Other accountants might classify it as an administrative expense
because the credit department has an important role in setting credit terms.
To adhere to the matching principle, companies must match the uncollectible
accounts expense against the revenues it generates. Thus, an uncollectible account
arising from a sale made in 2010 is a 2010 expense even though this treatment requires
the use of estimates. Estimates are necessary because the company sometimes cannot
determine until 2008 or later which 2010 customer accounts will become uncollectible.
Recording the uncollectible accounts adjustment A company that estimates
uncollectible accounts makes an adjusting entry at the end of each accounting period.
It debits Uncollectible Accounts Expense, thus recording the operating expense in the
proper period. The credit is to an account called Allowance for Uncollectible Accounts.
As a contra account to the Accounts Receivable account, the Allowance for
Uncollectible Accounts (also called Allowance for doubtful accounts or Allowance
for bad debts) reduces accounts receivable to their net realizable value. Net
realizable value is the amount the company expects to collect from accounts
receivable. When the firm makes the uncollectible accounts adjusting entry, it does not
know which specific accounts will become uncollectible. Thus, the company cannot
enter credits in either the Accounts Receivable control account or the customers'
accounts receivable subsidiary ledger accounts. If only one or the other were credited,
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the Accounts Receivable control account balance would not agree with the total of the
balances in the accounts receivable subsidiary ledger. Without crediting the Accounts
Receivable control account, the allowance account lets the company show that some of
its accounts receivable are probably uncollectible.
To illustrate the adjusting entry for uncollectible accounts, assume a company has
USD 100,000 of accounts receivable and estimates its uncollectible accounts expense
for a given year at USD 4,000. The required year-end adjusting entry is:
Dec. 31
Uncollectible Accounts Expense (-SE) 4,000
Allowance for Uncollectible Accounts (-A) 4,000 To record estimated uncollectible accounts.
The debit to Uncollectible Accounts Expense brings about a matching of expenses
and revenues on the income statement; uncollectible accounts expense is matched
against the revenues of the accounting period. The credit to Allowance for
Uncollectible Accounts reduces accounts receivable to their net realizable value on the
balance sheet. When the books are closed, the firm closes Uncollectible Accounts
Expense to Income Summary. It reports the allowance on the balance sheet as a
deduction from accounts receivable as follows:
Brice Company Balance Sheet 2010 December 31 Current assets Cash $21,200 Accounts receivable $ 100,000 Less: Allowance for uncollectible accounts 4,000 96,000
Estimating uncollectible accounts Accountants use two basic methods to
estimate uncollectible accounts for a period. The first method—percentage-of-sales
method—focuses on the income statement and the relationship of uncollectible
accounts to sales. The second method—percentage-of-receivables method—focuses on
the balance sheet and the relationship of the allowance for uncollectible accounts to
accounts receivable.
Percentage-of-sales method The percentage-of-sales method estimates
uncollectible accounts from the credit sales of a given period. In theory, the method is
based on a percentage of prior years' actual uncollectible accounts to prior years' credit
sales. When cash sales are small or make up a fairly constant percentage of total sales,
firms base the calculation on total net sales. Since at least one of these conditions is
15
usually met, companies commonly use total net sales rather than credit sales. The
formula to determine the amount of the entry is:
Amount of journal entry for uncollectible accounts – Net sales (total or credit) x
Percentage estimated as uncollectible
To illustrate, assume that Rankin Company's uncollectible accounts from 2008 sales
were 1.1 percent of total net sales. A similar calculation for 2009 showed an
uncollectible account percentage of 0.9 percent. The average for the two years is 1
percent [(1.1 +0.9)/2]. Rankin does not expect 2010 to differ from the previous two
years. Total net sales for 2010 were USD 500,000; receivables at year-end were USD
100,000; and the Allowance for Uncollectible Accounts had a zero balance. Rankin
would make the following adjusting entry for 2010:
Dec. 31 Uncollectible Accounts Expense (-SE) 5,000 Allowance for Uncollectible Accounts (-A) 5,000 To record estimated uncollectible accounts ($500,000 X 0.01).
Using T-accounts, Rankin would show:
Uncollectible Accounts Expense Allowance for Uncollectible Accounts Dec. 31 Bal. before Adjustment 5,000 adjustment -0-
Dec. 31 Adjustment 5,000 Bal. after adjustment 5,000
Rankin reports Uncollectible Accounts Expense on the income statement. It reports
the accounts receivable less the allowance among current assets in the balance sheet as
follows:
Accounts receivable $ 100,000 Less: Allowance for uncollectible accounts 5,000 $ 95,000 Or Rankin's balance sheet could show: Accounts receivable (less estimated uncollectible accounts, $5,000) $95,000
On the income statement, Rankin would match the uncollectible accounts expense
against sales revenues in the period. We would classify this expense as a selling expense
since it is a normal consequence of selling on credit.
The Allowance for Uncollectible Accounts account usually has either a debit or
credit balance before the year-end adjustment. Under the percentage-of-sales method,
the company ignores any existing balance in the allowance when calculating the
16
amount of the year-end adjustment (except that the allowance account must have a
credit balance after adjustment).
For example, assume Rankin's allowance account had a USD 300 credit balance
before adjustment. The adjusting entry would still be for USD 5,000. However, the
balance sheet would show USD 100,000 accounts receivable less a USD 5,300
allowance for uncollectible accounts, resulting in net receivables of USD 94,700. On
the income statement, Uncollectible Accounts Expense would still be 1 percent of total
net sales, or USD 5,000.
In applying the percentage-of-sales method, companies annually review the
percentage of uncollectible accounts that resulted from the previous year's sales. If the
percentage rate is still valid, the company makes no change. However, if the situation
has changed significantly, the company increases or decreases the percentage rate to
reflect the changed condition. For example, in periods of recession and high
unemployment, a firm may increase the percentage rate to reflect the customers'
decreased ability to pay. However, if the company adopts a more stringent credit
policy, it may have to decrease the percentage rate because the company would expect
fewer uncollectible accounts.
Percentage-of-receivables method The percentage-of-receivables
method estimates uncollectible accounts by determining the desired size of the
Allowance for Uncollectible Accounts. Rankin would multiply the ending balance in
Accounts Receivable by a rate (or rates) based on its uncollectible accounts experience.
In the percentage-of-receivables method, the company may use either an overall rate or
a different rate for each age category of receivables.
To calculate the amount of the entry for uncollectible accounts under the
percentage-of-receivables method using an overall rate, Rankin would use:
Amount of entry for uncollectible accounts – (Accounts receivable ending balance x
percentage estimated as uncollectible) – Existing credit balance in allowance for
uncollectible accounts or existing debit balance in allowance for uncollectible accounts
Using the same information as before, Rankin makes an estimate of uncollectible
accounts at the end of 2010. The balance of accounts receivable is USD 100,000, and
the allowance account has no balance. If Rankin estimates that 6 percent of the
receivables will be uncollectible, the adjusting entry would be:
Dec. 31 Uncollectible Accounts Expense (-SE) 6,000
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Using T-accounts, Rankin would show:
Uncollectible Accounts Expense Allowance for Uncollectible Accounts Dec. 31 Bal. before Adjustment 6,000 Adjustment -0-
Dec. 31 Adjustment 6,000 Bal. after Adjustment 6,000
If Rankin had a USD 300 credit balance in the allowance account before
adjustment, the entry would be the same, except that the amount of the entry would be
USD 5,700. The difference in amounts arises because management wants the
allowance account to contain a credit balance equal to 6 percent of the outstanding
receivables when presenting the two accounts on the balance sheet. The calculation of
the necessary adjustment is [(USD 100,000 X 0.06)-USD 300] = USD 5,700. Thus,
under the percentage-of-receivables method, firms consider any existing balance in the
allowance account when adjusting for uncollectible accounts. Using T-accounts,
Rankin would show:
Uncollectible Accounts Expense Allowance for Uncollectible Accounts Dec. 31 Bal. before Adjustment 5,700 Adjustment 300
Dec. 31 Adjustment 5,700 Bal. after Adjustment 6,000
ALLEN COMPANY Accounts Receivable Aging Schedule
2010 December 31
Customer
Accounts Receivable Balance
Not Yet Due
Days Past Due
1-30 31-60 61-90 Over 90
X $ 5,000 $ 5,000 Y 14,000 $ 12,000 $2,000 Z 400 $200 200 All others 808,600 $ 560,000 240,000 2,000 600 6,000
$ 828,000 $ 560,000 $252,000 $4,000 $800 $11,200
Percentage estimated as uncollectible Estimated amount uncollectible
1% 5% 10% 25% 50%
$ 24,400 $ 5,600 $ 12,600 $ 400 $200 $ 5,600
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Exhibit 1: Accounts receivable aging schedule
As another example, suppose that Rankin had a USD 300 debit balance in the
allowance account before adjustment. Then, a credit of USD 6,300 would be necessary
to get the balance to the required USD 6,000 credit balance. The calculation of the
necessary adjustment is [(USD 100,000 X 0.06) + USD 300] = USD 6,300. Using T-
accounts, Rankin would show:
Uncollectible Accounts Expense Allowance for Uncollectible Accounts Dec. 31 Bal. before Dec. 31 Adjustment 6,300 Adjustment 300 Adjustment 6,300
Bal. after Adjustment 6,000
No matter what the pre-adjustment allowance account balance is, when using the
percentage-of-receivables method, Rankin adjusts the Allowance for Uncollectible
Accounts so that it has a credit balance of USD 6,000—equal to 6 percent of its USD
100,000 in Accounts Receivable. The desired USD 6,000 ending credit balance in the
Allowance for Uncollectible Accounts serves as a "target" in making the adjustment.
So far, we have used one uncollectibility rate for all accounts receivable, regardless
of their age. However, some companies use a different percentage for each age category
of accounts receivable. When accountants decide to use a different rate for each age
category of receivables, they prepare an aging schedule. An aging schedule classifies
accounts receivable according to how long they have been outstanding and uses a
different uncollectibility percentage rate for each age category. Companies base these
percentages on experience. In Exhibit 1, the aging schedule shows that the older the
receivable, the less likely the company is to collect it.
Classifying accounts receivable according to age often gives the company a better
basis for estimating the total amount of uncollectible accounts. For example, based on
experience, a company can expect only 1 percent of the accounts not yet due (sales
made less than 30 days before the end of the accounting period) to be uncollectible. At
the other extreme, a company can expect 50 percent of all accounts over 90 days past
due to be uncollectible. For each age category, the firm multiplies the accounts
receivable by the percentage estimated as uncollectible to find the estimated amount
uncollectible.
19
The sum of the estimated amounts for all categories yields the total estimated
amount uncollectible and is the desired credit balance (the target) in the Allowance for
Uncollectible Accounts.
Since the aging schedule approach is an alternative under the percentage-of-
receivables method, the balance in the allowance account before adjustment affects the
year-end adjusting entry amount recorded for uncollectible accounts. For example, the
schedule in Exhibit 1 shows that USD 24,400 is needed as the ending credit balance in
the allowance account. If the allowance account has a USD 5,000 credit balance before
adjustment, the adjustment would be for USD 19,400.
The information in an aging schedule also is useful to management for other
purposes. Analysis of collection patterns of accounts receivable may suggest the need
for changes in credit policies or for added financing. For example, if the age of many
customer balances has increased to 61-90 days past due, collection efforts may have to
be strengthened. Or, the company may have to find other sources of cash to pay its
debts within the discount period. Preparation of an aging schedule may also help
identify certain accounts that should be written off as uncollectible.
An accounting perspective:
Business insight
According to the Fair Debt Collection Practices Act, collection agencies
can call persons only between 8 am and 9 pm, and cannot use foul
language. Agencies can call employers only if the employers allow such
calls. And, they can threaten to sue only if they really intend to do so.
Write-off of receivables As time passes and a firm considers a specific
customer's account to be uncollectible, it writes that account off. It debits the
Allowance for Uncollectible Accounts. The credit is to the Accounts Receivable control
account in the general ledger and to the customer's account in the accounts receivable
subsidiary ledger. For example, assume Smith's USD 750 account has been determined
to be uncollectible. The entry to write off this account is:
Allowance for Uncollectible Accounts (-SE) 750 Accounts Receivable—Smith (-A) 750 To write off Smith's account as uncollectible.
20
The credit balance in Allowance for Uncollectible Accounts before making this entry
represented potential uncollectible accounts not yet specifically identified. Debiting the
allowance account and crediting Accounts Receivable shows that the firm has
identified Smith's account as uncollectible. Notice that the debit in the entry to write
off an account receivable does not involve recording an expense. The company
recognized the uncollectible accounts expense in the same accounting period as the
sale. If Smith's USD 750 uncollectible account were recorded in Uncollectible Accounts
Expense again, it would be counted as an expense twice.
A write-off does not affect the net realizable value of accounts receivable. For
example, suppose that Amos Company has total accounts receivable of USD 50,000
and an allowance of USD 3,000 before the previous entry; the net realizable value of
the accounts receivable is USD 47,000. After posting that entry, accounts receivable
are USD 49,250, and the allowance is USD 2,250; net realizable value is still USD
47,000, as shown here:
Before Entry for After Write-Off Write-Off Write-Off
Accounts receivable $ 50,000 Dr. $750 Cr. $ 49,250 Dr. Allowance for uncollectible accounts 3,000 Cr. 750 Dr. 2,250 Cr. Net realizable value $47,000 $ 47,000
You might wonder how the allowance account can develop a debit balance before
adjustment. To explain this, assume that Jenkins Company began business on 2009
January 1, and decided to use the allowance method and make the adjusting entry for
uncollectible accounts only at year-end. Thus, the allowance account would not have
any balance at the beginning of 2009. If the company wrote off any uncollectible
accounts during 2009, it would debit Allowance for Uncollectible Accounts and cause a
debit balance in that account. At the end of 2009, the company would debit
Uncollectible Accounts Expense and credit Allowance for Uncollectible Accounts. This
adjusting entry would cause the allowance account to have a credit balance. During
2010, the company would again begin debiting the allowance account for any write-offs
of uncollectible accounts. Even if the adjustment at the end of 2009 was adequate to
cover all accounts receivable existing at that time that would later become
uncollectible, some accounts receivable from 2010 sales may be written off before the
end of 2010. If so, the allowance account would again develop a debit balance before
the end-of-year 2010 adjustment.
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Uncollectible accounts recovered Sometimes companies collect accounts
previously considered to be uncollectible after the accounts have been written off. A
company usually learns that an account has been written off erroneously when it
receives payment. Then the company reverses the original write-off entry and
reinstates the account by debiting Accounts Receivable and crediting Allowance for
Uncollectible Accounts for the amount received. It posts the debit to both the general
ledger account and to the customer's accounts receivable subsidiary ledger account.
The firm also records the amount received as a debit to Cash and a credit to Accounts
Receivable. And it posts the credit to both the general ledger and to the customer's
accounts receivable subsidiary ledger account.
To illustrate, assume that on May 17 a company received a USD 750 check from
Smith in payment of the account previously written off. The two required journal
entries are:
May 17 Accounts Receivable—Smith (+A) Allowance for Uncollectible Accounts (-A) To reverse original write-off of Smith account.
750
750
May 17 Cash (+A) Accounts Receivable—Smith (-A) To record collection of account.
750
750
The debit and credit to Accounts Receivable—Smith on the same date is to show in
Smith's subsidiary ledger account that he did eventually pay the amount due. As a
result, the company may decide to sell to him in the future.
When a company collects part of a previously written off account, the usual
procedure is to reinstate only that portion actually collected, unless evidence indicates
the amount will be collected in full. If a company expects full payment, it reinstates the
entire amount of the account.
Because of the problems companies have with uncollectible accounts when they
offer customers credit, many now allow customers to use bank or external credit cards.
This policy relieves the company of the headaches of collecting overdue accounts.
22
A broader perspective:
GECS allowance for losses on financing receivables
Recognition of losses on financing receivables. The allowance
for losses on small-balance receivables reflects management's best
estimate of probable losses inherent in the portfolio determined
principally on the basis of historical experience. For other receivables,
principally the larger loans and leases, the allowance for losses is
determined primarily on the basis of management's best estimate of
probable losses, including specific allowances for known troubled
accounts.
All accounts or portions thereof deemed to be uncollectible or to require
an excessive collection cost are written off to the allowance for losses.
Small-balance accounts generally are written off when 6 to 12 months
delinquent, although any such balance judged to be uncollectible, such
as an account in bankruptcy, is written down immediately to estimated
realizable value. Large-balance accounts are reviewed at least quarterly,
and those accounts with amounts that are judged to be uncollectible are
written down to estimated realizable value.
When collateral is repossessed in satisfaction of a loan, the receivable is
written down against the allowance for losses to estimated fair value of
the asset less costs to sell, transferred to other assets and subsequently
carried at the lower of cost or estimated fair value less costs to sell. This
accounting method has been employed principally for specialized
financing transactions.
(In millions) 2000 1999 1998 Balance at January 1 $3,708 $3,223 $2,745 Provisions charged To operations 2,045 1,671 1,603 Net transfers related to companies acquired or sold 22 271 386 Amounts written off-net (1,741) (1,457) (1,511)
Balance at December 31 $4,034 $3,708 $3,223 Source: General Electric Company, 2000 Annual Report.
23
An accounting perspective:
Uses of technology
Auditors use expert systems to review a client's internal control
structure and to test the reasonableness of a client's Allowance for
Uncollectible Accounts balance. The expert system reaches conclusions
based on rules and information programmed into the expert system
software. The rules are modeled on the mental processes that a human
expert would use in addressing the situation. In the medical field, for
instance, the rules constituting the expert system are derived from
modeling the diagnostic decision processes of the foremost experts in a
given area of medicine. A physician can input information from a
remote location regarding the symptoms of a certain patient, and the
expert system will provide a probable diagnosis based on the expert
model. In a similar fashion, an accountant can feed client information
into the expert system and receive an evaluation as to the
appropriateness of the account balance or internal control structure.
Credit cards are either nonbank (e.g. American Express) or bank (e.g. VISA and
MasterCard) charge cards that customers use to purchase goods and services. For
some businesses, uncollectible account losses and other costs of extending credit are a
burden. By paying a service charge of 2 percent to 6 percent, businesses pass these
costs on to banks and agencies issuing national credit cards. The banks and credit card
agencies then absorb the uncollectible accounts and costs of extending credit and
maintaining records.
Usually, banks and agencies issue credit cards to approved credit applicants for an
annual fee. When a business agrees to honor these credit cards, it also agrees to pay the
percentage fee charged by the bank or credit agency.
When making a credit card sale, the seller checks to see if the customer's card has
been canceled and requests approval if the sale exceeds a prescribed amount, such as
USD 50. This procedure allows the seller to avoid accepting lost, stolen, or canceled
24
cards. Also, this policy protects the credit agency from sales causing customers to
exceed their established credit limits.
The seller's accounting procedures for credit card sales differ depending on whether
the business accepts a nonbank or a bank credit card. To illustrate the entries for the
use of nonbank credit cards (such as American Express), assume that a restaurant
American Express invoices amounting to USD 1,400 at the end of a day. American
Express charges the restaurant a 5 percent service charge. The restaurant uses the
Credit Card Expense account to record the credit card agency's service charge and
makes the following entry:
Accounts Receivable—American Express (+A) 1,330 Credit Card Expense (-SE) 70 Sales (+SE) 1,400 To record credit card sales.
The restaurant mails the invoices to American Express. Sometime later, the
restaurant receives payment from American Express and makes the following entry:
Cash (+A) 1,330 Accounts Receivable – American Express (-A) 1,330 To record remittance from American Express.
To illustrate the accounting entries for the use of bank credit cards (such as VISA or
MasterCard), assume that a retailer has made sales of USD 1,000 for which VISA cards
were accepted and the service charge is USD 30 (which is 3 percent of sales). VISA
sales are treated as cash sales because the receipt of cash is certain. The retailer
deposits the credit card sales invoices in its VISA checking account at a bank just as it
deposits checks in its regular checking account. The entry to record this deposit is:
Cash (+A) 970 Credit Card Expense (-SE) 30 Sales (+SE) 1,000 To record credit Visa card sales.
An accounting perspective:
Business insight
Recent innovations in credit cards include picture IDs on cards to
reduce theft, credits toward purchases of new automobiles (e.g. General
25
Motors cards), credit toward free trips on airlines, and cash rebates on
all purchases. Discover Card, for example, remits a percentage of all
charges back to credit card holders. Also, some credit card companies
have reduced interest rates on unpaid balances and have eliminated the
annual fee.
Just as every company must have current assets such as cash and accounts
receivable to operate, every company incurs current liabilities in conducting its
operations. Corporations (IBM and General Motors), partnerships (CPA firms), and
single proprietorships (corner grocery stores) all have one thing in common—they have
liabilities. The next section discusses some of the current liabilities companies incur.
9.4 Current liabilities
Liabilities result from some past transaction and are obligations to pay cash,
provide services, or deliver goods at some future time. This definition includes each of
the liabilities discussed in previous chapters and the new liabilities presented in this
chapter. The balance sheet divides liabilities into current liabilities and long-term
liabilities. Current liabilities are obligations that (1) are payable within one year or
one operating cycle, whichever is longer, or (2) will be paid out of current assets or
create other current liabilities. Long-term liabilities are obligations that do not
qualify as current liabilities. This chapter focuses on current liabilities and Chapter 15
describes long-term liabilities.
Note the definition of a current liability uses the term operating cycle. An
operating cycle (or cash cycle) is the time it takes to begin with cash, buy necessary
items to produce revenues (such as materials, supplies, labor, and/or finished goods),
sell goods or services, and receive cash by collecting the resulting receivables. For most
companies, this period is no longer than a few months. Service companies generally
have the shortest operating cycle, since they have no cash tied up in inventory.
Manufacturing companies generally have the longest cycle because their cash is tied up
in inventory accounts and in accounts receivable before coming back. Even for
manufacturing companies, the cycle is generally less than one year. Thus, as a practical
26
matter, current liabilities are due in one year or less, and long-term liabilities are due
after one year from the balance sheet date.
The operating cycles for various businesses follow:
Type of Business Operating Cycle Service company selling for cash only Instantaneous Service company selling on credit Cash -> Accounts Receivable -> Cash Merchandising company selling for cash Cash -> Inventory -> Cash Merchandising company selling on credit Cash -> Inventory -> Accounts receivable -> Cash Manufacturing company selling for cash Cash -> Materials inventory -> Work in process
inventory -> Finished goods inventory -> Accounts Receivable -> Cash
Current liabilities fall into these three groups:
• Clearly determinable liabilities. The existence of the liability and its
amount are certain. Examples include most of the liabilities discussed previously,
such as accounts payable, notes payable, interest payable, unearned delivery fees,
and wages payable. Sales tax payable, federal excise tax payable, current portions
of long-term debt, and payroll liabilities are other examples.
• Estimated liabilities. The existence of the liability is certain, but its amount
only can be estimated. An example is estimated product warranty payable.
• Contingent liabilities. The existence of the liability is uncertain and usually
the amount is uncertain because contingent liabilities depend (or are contingent)
on some future event occurring or not occurring. Examples include liabilities
arising from lawsuits, discounted notes receivable, income tax disputes, penalties
that may be assessed because of some past action, and failure of another party to
pay a debt that a company has guaranteed.
The following table summarizes the characteristics of current liabilities:
Is the Is the Existence Amount
Type of Liability Certain? Certain? Clearly determinable liabilities Yes Yes Estimated liabilities Yes No Contingent liabilities No No
Clearly determinable liabilities have clearly determinable amounts. In this section,
we describe liabilities not previously discussed that are clearly determinable—sales tax
payable, federal excise tax payable, current portions of long-term debt, and payroll
liabilities. Later in this chapter, we discuss clearly determinable liabilities such as notes
payable.
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Sales tax payable Many states have a state sales tax on items purchased by
consumers. The company selling the product is responsible for collecting the sales tax
from customers. When the company collects the taxes, the debit is to Cash and the
credit is to Sales Tax Payable. Periodically, the company pays the sales taxes collected
to the state. At that time, the debit is to Sales Tax Payable and the credit is to Cash.
To illustrate, assume that a company sells merchandise in a state that has a 6
percent sales tax. If it sells goods with a sales price of USD 1,000 on credit, the
company makes this entry:
Accounts Receivable (+A) 1,060 Sales (+SE) 1,000 Sales Tax Payable (+L) 60 To record sales and sales tax payable.
Now assume that sales for the entire period are USD 100,000 and that USD 6,000 is
in the Sales Tax Payable account when the company remits the funds to the state taxing
agency. The following entry shows the payment to the state:
Sales Tax Payable (-L) 6,000 Cash (-A) 6,000
An alternative method of recording sales taxes payable is to include these taxes in
the credit to Sales. For instance, the previous company could record sales as follows:
Accounts Receivable (+A) 1,060 Sales (+SE) 1,060
When recording sales taxes in the same account as sales revenue, the firm must
separate the sales tax from sales revenue at the end of the accounting period. To make
this separation, it adds the sales tax rate to 100 percent and divides this percentage
into recorded sales revenue. For instance, assume that total recorded sales revenues for
an accounting period are USD 10,600, and the sales tax rate is 6 percent. To find the
sales revenue, use the following formula:
Sales= Amount recorded for sales account 100 per centsales tax rate
= USD10,600106 per cent =USD10,000
The sales revenue is USD 10,000 for the period. Sales tax is equal to the recorded
sales revenue of USD 10,600 less actual sales revenue of USD 10,000, or USD 600.
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Federal excise tax payable Consumers pay federal excise tax on some goods,
such as alcoholic beverages, tobacco, gasoline, cosmetics, tires, and luxury
automobiles. The entries a company makes when selling goods subject to the federal
excise tax are similar to those made for sales taxes payable. For example, assume that
the Dixon Jewelry Store sells a diamond ring to a young couple for USD 2,000. The
sale is subject to a 6 percent sales tax and a 10 percent federal excise tax. The entry to
record the sale is:
Accounts Receivable (+A) 2,320 Sales (+L) 2,000 Sales Tax Payable (+L) 120 Federal Excise Tax Payable 200 To record the sale of a diamond ring.
The company records the remittance of the taxes to the federal taxing agency by
debiting Federal Excise Tax Payable and crediting Cash.
Current portions of long-term debt Accountants move any portion of long-
term debt that becomes due within the next year to the current liability section of the
balance sheet. For instance, assume a company signed a series of 10 individual notes
payable for USD 10,000 each; beginning in the 6th year, one comes due each year
through the 15th year. Beginning in the 5th year, an accountant would move a USD
10,000 note from the long-term liability category to the current liability category on
the balance sheet. The current portion would then be paid within one year.
An accounting perspective:
Uses of technology
Many companies use service bureaus to process their payrolls because
these bureaus keep up to date on rates, bases, and changes in the laws
affecting payroll. Companies can either send their data over the Internet
or have the service bureaus pick up time sheets and other data.
Managers instruct service bureaus either to print the payroll checks or
to transfer data back to the company over the Internet so it can print the
checks.
29
Payroll liabilities In most business organizations, accounting for payroll is
particularly important because (1) payrolls often are the largest expense that a
company incurs, (2) both federal and state governments require maintaining detailed
payroll records, and (3) companies must file regular payroll reports with state and
federal governments and remit amounts withheld or otherwise due. Payroll liabilities
include taxes and other amounts withheld from employees' paychecks and taxes paid
by employers.
Employers normally withhold amounts from employees' paychecks for federal
income taxes; state income taxes; FICA (social security) taxes; and other items such as
union dues, medical insurance premiums, life insurance premiums, pension plans, and
pledges to charities. Assume that a company had a payroll of USD 35,000 for the
month of April 2010. The company withheld the following amounts from the
employees' pay: federal income taxes, USD 4,100; state income taxes, USD 360; FICA
taxes, USD 2,678; and medical insurance premiums, USD 940. This entry records the
payroll:
2010 April 30 Salaries Expense (-SE) 35,000
Employees' Federal Income Taxes Payable (+L) 4,100 Employees' State Income Taxes Payable (+L) 360 FICA Taxes Payable (+L) 2,678 Employees' Medical Insurance Premiums Payable (+L)
940
Salaries Payable (+L) 26,922 To record the payroll for the month ending April 30.
All accounts credited in the entry are current liabilities and will be reported on the
balance sheet if not paid prior to the preparation of financial statements. When these
liabilities are paid, the employer debits each one and credits Cash.
Employers normally record payroll taxes at the same time as the payroll to which
they relate. Assume the payroll taxes an employer pays for April are FICA taxes, USD
2,678; state unemployment taxes, USD 1,890; and federal unemployment taxes, USD
280. The entry to record these payroll taxes would be:
2010 April 30 Payroll Taxes Expense (-SE)
FICA Taxes Payable (+L) State Unemployment Taxes Payable (+L) Federal Unemployment Taxes Payable (+L) To record employer's payroll taxes.
4,848 2,678 1,890 280
30
These amounts are in addition to the amounts withheld from employees' paychecks.
The credit to FICA Taxes Payable is equal to the amount withheld from the employees'
paychecks. The company can credit both its own and the employees' FICA taxes to the
same liability account, since both are payable at the same time to the same agency.
When these liabilities are paid, the employer debits each of the liability accounts and
credits Cash.
An accounting perspective:
Uses of technology
One of the basic components in accounting software packages is the
payroll module. As long as companies update this module each time
rates, bases, or laws change, they can calculate withholdings, print
payroll checks, and complete reporting forms for taxing agencies. In
addition to calculating the employer's payroll taxes, this software
maintains all accounting payroll records.
Managers of companies that have estimated liabilities know these liabilities exist but
can only estimate the amount. The primary accounting problem is to estimate a
reasonable liability as of the balance sheet date. An example of an estimated liability is
product warranty payable.
Estimated product warranty payable When companies sell products such as
computers, often they must guarantee against defects by placing a warranty on their
products. When defects occur, the company is obligated to reimburse the customer or
repair the product. For many products, companies can predict the number of defects
based on experience. To provide for a proper matching of revenues and expenses, the
accountant estimates the warranty expense resulting from an accounting period's sales.
The debit is to Product Warranty Expense and the credit to Estimated Product
Warranty Payable.
To illustrate, assume that a company sells personal computers and warrants all
parts for one year. The average price per computer is USD 1,500, and the company
sells 1,000 computers in 2010. The company expects 10 percent of the computers to
31
develop defective parts within one year. By the end of 2010, customers have returned
40 computers sold that year for repairs, and the repairs on those 40 computers have
been recorded. The estimated average cost of warranty repairs per defective computer
is USD 150. To arrive at a reasonable estimate of product warranty expense, the
accountant makes the following calculation:
Number of computers sold 1,000 Percent estimated to develop defects X 10% Total estimated defective computers 100 Deduct computers returned as defective to date 40 Estimated additional number to become defective during warranty period 60 Estimated average warranty repair cost per compute: X $ 150 Estimated product warranty payable $9,000
The entry made at the end of the accounting period is:
Product Warranty Expense (-SE) 9,000 Estimated Product Warranty Payable (+L) 9,000 To record estimated product warranty expense.
When a customer returns one of the computers purchased in 2010 for repair work in
2008 (during the warranty period), the company debits the cost of the repairs to
Estimated Product Warranty Payable. For instance, assume that Evan Holman returns
his computer for repairs within the warranty period. The repair cost includes parts,
USD 40, and labor, USD 160. The company makes the following entry:
Estimated Product Warranty Payable (-L) 200 Repair Parts Inventory (-A) 40 Wages Payable (+L) 160 To record replacement of parts under warranty.
An accounting perspective:
Business insight
Another estimated liability that is quite common relates to clean-up
costs for industrial pollution. One company had the following note in its
recent financial statements:
In the past, the Company treated hazardous waste at its chemical
facilities. Testing of the ground waters in the areas of the treatment
impoundments at these facilities disclosed the presence of certain
32
contaminants. In compliance with environmental regulations, the
Company developed a plan that will prevent further contamination,
provide for remedial action to remove the present contaminants, and
establish a monitoring program to monitor ground water conditions
in the future. A similar plan has been developed for a site previously
used as a metal pickling facility. Estimated future costs of USD
2,860,000 have been accrued in the accompanying financial
statements...to complete the procedures required under these plans.
When liabilities are contingent, the company usually is not sure that the liability
exists and is uncertain about the amount. FASB Statement No. 5 defines a contingency
as "an existing condition, situation, or set of circumstances involving uncertainty as to
possible gain or loss to an enterprise that will ultimately be resolved when one or more
future events occur or fail to occur".1
According to FASB Statement No. 5, if the liability is probable and the amount can
be reasonably estimated, companies should record contingent liabilities in the
accounts. However, since most contingent liabilities may not occur and the amount
often cannot be reasonably estimated, the accountant usually does not record them in
the accounts. Instead, firms typically disclose these contingent liabilities in notes to
their financial statements.
Many contingent liabilities arise as the result of lawsuits. In fact, 469 of the 957
companies contacted in the AICPA's annual survey of accounting practices reported
contingent liabilities resulting from litigation.2
The following two examples from annual reports are typical of the disclosures made
in notes to the financial statements. Be aware that just because a suit is brought, the
company being sued is not necessarily guilty. One company included the following note
in its annual report to describe its contingent liability regarding various lawsuits
against the company:
1 FASB, Statement of Financial Accounting Standards No. 5, "Accounting for Contingencies"
(Stamford, Conn., 1975). Copyright © by Financial Accounting Standards Board, High Ridge
Park, Stamford, Connecticut 06905, USA.
2 AICPA, Accounting Trends & Techniques (New York, 2000), p. 100.
33
Contingent liabilities:
Various lawsuits and claims, including those involving ordinary routine litigation
incidental to its business, to which the Company is a party, are pending, or have been
asserted, against the Company. In addition, the Company was advised...that the United
States Environmental Protection Agency had determined the existence of PCBs in a
river and harbor near Sheboygan, Wisconsin,USA, and that the Company, as well as
others, allegedly contributed to that contamination. It is not presently possible to
determine with certainty what corrective action, if any, will be required, what portion
of any costs thereof will be attributable to the Company, or whether all or any portion
of such costs will be covered by insurance or will be recoverable from others. Although
the outcome of these matters cannot be predicted with certainty, and some of them
may be disposed of unfavorably to the Company, management has no reason to believe
that their disposition will have a materially adverse effect on the consolidated financial
position of the Company.
Another company dismissed an employee and included the following note to
disclose the contingent liability resulting from the ensuing litigation:
Contingencies:
...A jury awarded USD 5.2 million to a former employee of the Company for an
alleged breach of contract and wrongful termination of employment. The Company has
appealed the judgment on the basis of errors in the judge's instructions to the jury and
insufficiency of evidence to support the amount of the jury's award. The Company is
vigorously pursuing the appeal.
The Company and its subsidiaries are also involved in various other litigation
arising in the ordinary course of business.
Since it presently is not possible to determine the outcome of these matters, no
provision has been made in the financial statements for their ultimate resolution. The
resolution of the appeal of the jury award could have a significant effect on the
Company's earnings in the year that a determination is made; however, in
management's opinion, the final resolution of all legal matters will not have a material
adverse effect on the Company's financial position.
34
Contingent liabilities may also arise from discounted notes receivable, income tax
disputes, penalties that may be assessed because of some past action, and failure of
another party to pay a debt that a company has guaranteed.
The remainder of this chapter discusses notes receivable and notes payable.
Business transactions often involve one party giving another party a note.
9.5 Notes receivable and notes payable
A note (also called a promissory note) is an unconditional written promise by a
borrower (maker) to pay a definite sum of money to the lender (payee) on demand or
on a specific date. On the balance sheet of the lender (payee), a note is a receivable; on
the balance sheet of the borrower (maker), a note is a payable. Since the note is usually
negotiable, the payee may transfer it to another party, who then receives payment from
the maker. Look at the promissory note in Exhibit 2.
A customer may give a note to a business for an amount due on an account
receivable or for the sale of a large item such as a refrigerator. Also, a business may give
a note to a supplier in exchange for merchandise to sell or to a bank or an individual for
a loan. Thus, a company may have notes receivable or notes payable arising from
transactions with customers, suppliers, banks, or individuals.
Companies usually do not establish a subsidiary ledger for notes. Instead, they
maintain a file of the actual notes receivable and copies of notes payable.
Most promissory notes have an explicit interest charge. Interest is the fee charged
for use of money over a period. To the maker of the note, or borrower, interest is an
expense; to the payee of the note, or lender, interest is a revenue. A borrower incurs
interest expense; a lender earns interest revenue. For convenience, bankers sometimes
calculate interest on a 360-day year; we calculate it on that basis in this text. (Some
companies use a 365-day year.)
35
Exhibit 2: Promissory note
The basic formula for computing interest is:
Interest=Principal×Rate×Time , or I=P×R×T
Principal is the face value of the note. The rate is the stated interest rate on the
note; interest rates are generally stated on an annual basis. Time, which is the amount
of time the note is to run, can be either days or months.
To show how to calculate interest, assume a company borrowed USD 20,000 from a
bank. The note has a principal (face value) of USD 20,000, an annual interest rate of 10
percent, and a life of 90 days. The interest calculation is:
Interest=USD20,000×0.10× 90 360
Interest = USD 500
Note that in this calculation we expressed the time period as a fraction of a 360-day
year because the interest rate is an annual rate.
The maturity date is the date on which a note becomes due and must be paid.
Sometimes notes require monthly installments (or payments) but usually all of the
principal and interest must be paid at the same time as in Exhibit 2. The wording in the
note expresses the maturity date and determines when the note is to be paid. A note
falling due on a Sunday or a holiday is due on the next business day. Examples of the
maturity date wording are:
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• On demand. "On demand, I promise to pay..." When the maturity date is on
demand, it is at the option of the holder and cannot be computed. The holder is the
payee, or another person who legally acquired the note from the payee.
• On a stated date. "On 2010 July 18, I promise to pay..." When the maturity date
is designated, computing the maturity date is not necessary.
• At the end of a stated period.
(a)"One year after date, I promise to pay..." When the maturity is expressed
in years, the note matures on the same day of the same month as the date of
the note in the year of maturity.
(b)"Four months after date, I promise to pay..." When the maturity is
expressed in months, the note matures on the same date in the month of
maturity. For example, one month from 2010 July 18, is 2010 August 18, and
two months from 2010 July 18, is 2010 September 18. If a note is issued on
the last day of a month and the month of maturity has fewer days than the
month of issuance, the note matures on the last day of the month of
maturity. A one-month note dated 2010 January 31, matures on 2010
February 28.
(c)“Ninety days after date, I promise to pay..." When the maturity is
expressed in days, the exact number of days must be counted. The first day
(date of origin) is omitted, and the last day (maturity date) is included in the
count. For example, a 90-day note dated 2010 October 19, matures on 2008
January 17, as shown here:
Life of note (days) 90 days Days remaining in October not counting date of origin of note: Days to count in October (31 - 19) 12 Total days in November 30 Total Days in December 31 73 Maturity date in January 17 days
Sometimes a company receives a note when it sells high-priced merchandise; more
often, a note results from the conversion of an overdue account receivable. When a
customer does not pay an account receivable that is due, the company (creditor) may
insist that the customer (debtor) gives a note in place of the account receivable. This
action allows the customer more time to pay the balance due, and the company earns
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interest on the balance until paid. Also, the company may be able to sell the note to a
bank or other financial institution.
To illustrate the conversion of an account receivable to a note, assume that Price
Company (maker) had purchased USD 18,000 of merchandise on August 1 from
Cooper Company (payee) on account. The normal credit period has elapsed, and Price
cannot pay the invoice. Cooper agrees to accept Price's USD 18,000, 15 percent, 90-day
note dated September 1 to settle Price's open account. Assuming Price paid the note at
maturity and both Cooper and Price have a December 31 year-end, the entries on the
books of the payee and the maker are:
Aug. 1
Cooper Company, Payee Accounts Receivable—Price Company (+A) Sales (+SE) To record sale of merchandise on account.
18,000
18,000 Sept. 1 Notes Receivable (+A)
Accounts Receivable—Price Company (-A) To record exchange of a note from Price Company for open account.
18,000
18,000
Nov. 30 Cash (+A) Notes Receivable (-A) Interest Revenue ($18,000 X 0.15 X 90/
360 ). (+SE)
To record receipt of Price Company note principal and interest.
18,675
18,000 675
Aug. 1
Price Company, Maker Purchase (+A) Accounts Payable—Cooper Company (+L) To record purchase of merchandise on account.
18,000
18,000 Sept. 1 Accounts Payable—Cooper Company (-L)
Notes Payable (+L) To record exchange of a note to Cooper Company for open account.
18,000
18,000
Nov. 30 Notes Payable (-L) Interest Expense ($18,000 X 0.15 X 90/360). (-SE) Cash (-A) To record payment of note principal and interest.
18,000 675
18,675
The USD 18,675 paid by Price to Cooper is called the maturity value of the note.
Maturity value is the amount that the maker must pay on a note on its maturity date;
typically, it includes principal and accrued interest, if any.
Sometimes the maker of a note does not pay the note when it becomes due. The next
section describes how to record a note not paid at maturity.
A dishonored note is a note that the maker failed to pay at maturity. Since the
note has matured, the holder or payee removes the note from Notes Receivable and
records the amount due in Accounts Receivable (or Dishonored Notes Receivable).
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At the maturity date of a note, the maker should pay the principal plus interest. If
the interest has not been accrued in the accounting records, the maker of a dishonored
note should record interest expense for the life of the note by debiting Interest Expense
and crediting Interest Payable. The payee should record the interest earned and
remove the note from its Notes Receivable account. Thus, the payee of the note should
debit Accounts Receivable for the maturity value of the note and credit Notes
Receivable for the note's face value and Interest Revenue for the interest. After these
entries have been posted, the full liability on the note—principal plus interest—is
included in the records of both parties. Interest continues to accrue on the note until it
is paid, replaced by a new note, or written off as uncollectible. To illustrate, assume
that Price did not pay the note at maturity. The entries on each party's books are: Cooper Company, Payee
Nov. 30 Accounts Receivable—Price Company (+A) 18,675 Notes Receivable (-A) 18,000 Interest Revenue (+SE) 675 To record dishonor of Price Company note.
Price Company, Maker Nov. 30 Interest Expense (-SE) 675
Interest Payable (+L) 675 To record interest on note payable.
When unable to pay a note at maturity, sometimes the maker pays the interest on
the original note or includes the interest in the face value of a new note that replaces
the old note. Both parties account for the new note in the same manner as the old note.
However, if it later becomes clear that the maker of a dishonored note will never pay,
the payee writes off the account with a debit to Uncollectible Accounts Expense (or to
an account with a title such as Loss on Dishonored Notes) and a credit to Accounts
Receivable. The debit should be to the Allowance for Uncollectible Accounts if the
payee made an annual provision for uncollectible notes receivable.
Assume that Price Company pays the interest at the maturity date and issues a new
15 percent, 90-day note for USD 18,000. The entries on both sets of books would be:
39
Cooper Company, Payee Price Company, Maker Cash (+A) Interest Revenue (+SE) To record the receipt of interest on Price Company note.
675
675
Interest Expense (-SE) Cash (-A) To record the payment of interest on note to Cooper Company.
675
675
(Optional entry) Notes Receivable (+A) Notes Receivable (-A) To replace old 15%, 90-day note from Price Company with new 15%, 90-day note.
18,000
18,000
(Optional entry) Notes Payable (-L) Notes Payable (+L) To replace old 15%, 90-day note to Cooper Company with new 15%, 90-day note.
18,000
18,000
Although the second entry on each set of books has no effect on the existing account
balances, it indicates that the old note was renewed (or replaced). Both parties
substitute the new note, or a copy, for the old note in a file of notes.
Now assume that Price Company does not pay the interest at the maturity date but
instead includes the interest in the face value of the new note. The entries on both sets
of books would be:
Cooper Company, Payee Price Company, Maker Notes Receivable (+A) 18,675 Interest Expense (-SE) 675 Interest Revenue (+SE) 675 Notes Payable (-L) 18,000 Notes Receivable (-A) 18,000 Notes Payable (+L) 18,675 To record the To record the replacement of the replacement of the old Price Company old $18,000, 15%, $18,000, 15%, 90- 90-day note to day note with a Cooper Company with new $18,675, 15%, a new $18,675, 15%, 90-day note. 90-day note.
On an interest-bearing note, even though interest accrues, or accumulates, on a day-
to-day basis, usually both parties record it only at the note's maturity date. If the note
is outstanding at the end of an accounting period, however, the time period of the
interest overlaps the end of the accounting period and requires an adjusting entry at
the end of the accounting period. Both the payee and maker of the note must make an
adjusting entry to record the accrued interest and report the proper assets and
revenues for the payee and the proper liabilities and expenses for the maker. Failure to
record accrued interest understates the payee's assets and revenues by the amount of
the interest earned but not collected and understates the maker's expenses and
liabilities by the interest expense incurred but not yet paid.
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Payee's books To illustrate how to record accrued interest on the payee's books,
assume that the payee, Cooper Company, has a fiscal year ending on October 31 instead
of December 31. On October 31, Cooper would make the following adjusting entry
relating to the Price Company note:
Oct. 31 Interest Receivable (+A) 450 Interest Revenue ($18,000 X 0.15 X 60/360) (+SE) 450 To record interest earned on Price Company note for the period September 1 through October 31.
The Interest Receivable account shows the interest earned but not yet collected.
Interest receivable is a current asset in the balance sheet because the interest will be
collected in 30 days. The interest revenue appears in the income statement. When Price
pays the note on November 30, Cooper makes the following entry to record the
collection of the note's principal and interest:
Nov. 30 Cash (+A) 18,675 Notes Receivable (-A) 18,000 Interest Receivable (-A) 450 Interest Revenue (+SE) 225 To record collection of Price Company note and interest.
Note that the entry credits the Interest Receivable account for the USD 450 interest
accrued from September 1 through October 31, which was debited to the account in the
previous entry, and credits Interest Revenue for the USD 225 interest earned in
November.
Maker's books Assume Price Company's accounting year also ends on October 31
instead of December 31. Price's accounting records would be incomplete unless the
company makes an adjusting entry to record the liability owed for the accrued interest
on the note it gave to Cooper Company. The required entry is:
Oct. 31 Interest Expense ($18,000 X 0.15 X 60/360) (-SE) 450 Interest Payable (+L) 450 To record accrued interest on note to Cooper Company for the period September 1 through October 31.
The Interest Payable account, which shows the interest expense incurred but
not yet paid, is a current liability in the balance sheet because the interest will be paid
in 30 days. Interest expense appears in the income statement. When the note is paid,
Price makes the following entry:
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Nov. 30 Notes Payable (-L) 18,000 Interest Payable (-L) 450 Interest Expense (-SE) 225 Cash (-A) 18,675 To record payment of principal and interest on note to Cooper Company.
In this illustration, Cooper's financial position made it possible for the company to
carry the Price note to the maturity date. Alternatively, Cooper could have sold, or
discounted, the note to receive the proceeds before the maturity date. This topic is
reserved for a more advanced text.
9.6 Short-term financing through notes payable
A company sometimes needs short-term financing. This situation may occur when
(1) the company's cash receipts are delayed because of lenient credit terms granted
customers, or (2) the company needs cash to finance the buildup of seasonal
inventories, such as before Christmas. To secure short-term financing, companies issue
interest-bearing or non interest-bearing notes.
Interest-bearing notes To receive short-term financing, a company may issue an
interest-bearing note to a bank. An interest-bearing note specifies the interest rate
charged on the principal borrowed. The company receives from the bank the principal
borrowed; when the note matures, the company pays the bank the principal plus the
interest.
Accounting for an interest-bearing note is simple. For example, assume the
company's accounting year ends on December 31. Needham Company issued a USD
10,000, 90-day, 9 percent note on 2009 December 1. The following entries would
record the loan, the accrual of interest on 2009 December 31 and its payment on 2010
March 1:
2009 Dec.
1 Cash (+A) Notes Payable (+L) To record 90-day bank loan.
10,000
10,000
31 Interest Expense (-SE) Interest Payable (+L) To record accrued interest on a note payable at year-end ($10,000 X 0.09 X 30/360).
75
75
2010 Mar.
1 Notes Payable (-L) Interest Expense ($10,000 X 0.09 X 60/360) (-SE) Interest Payable (-L) Cash (-A) To record principal and interest paid on bank loan.
10,000 150 75
10,225
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Non interest-bearing notes (discounting notes payable) A company may
also issue a non interest-bearing note to receive short-term financing from a bank. A
non interest-bearing note does not have a stated interest rate applied to the face value
of the note. Instead, the note is drawn for a maturity amount less a bank discount; the
borrower receives the proceeds. A bank discount is the difference between the
maturity value of the note and the cash proceeds given to the borrower. The cash
proceeds are equal to the maturity amount of a note less the bank discount. This
entire process is called discounting a note payable. The purpose of this process is
to introduce interest into what appears to be a non interest-bearing note. The meaning
of discounting here is to deduct interest in advance.
Because interest is related to time, the bank discount is not interest on the date the
loan is made; however, it becomes interest expense to the company and interest
revenue to the bank as time passes. To illustrate, assume that on 2009 December 1,
Needham Company presented its USD 10,000, 90-day, non interest-bearing note to
the bank, which discounted the note at 9 percent. The discount is USD 225 (USD
10,000 X 0.09 X 90/360), and the proceeds to Needham are USD 9,775. The entry
required on the date of the note's issue is:
2009 Dec. 1 Cash (+A)
Discount on Notes Payable (-L) Notes Payable (+L) Issued a 90-day note to bank.
9,775 225
10,000
Needham credits Notes Payable for the face value of the note. Discount on notes
payable is a contra account used to reduce Notes Payable from face value to the net
amount of the debt. The balance in the Discount on Notes Payable account appears on
the balance sheet as a deduction from the balance in the Notes Payable account.
Over time, the discount becomes interest expense. If Needham paid the note before
the end of the fiscal year, it would charge the entire USD 225 discount to Interest
Expense and credit Discount on Notes Payable. However, if Needham's fiscal year
ended on December 31, an adjusting entry would be required as follows:
2009 Dec. 31 Interest Expense (-SE)
Discount on Notes Payable (+L) To record accrued interest on note payable at year-end.
75
75
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This entry records the interest expense incurred by Needham for the 30 days the
note has been outstanding. The expense can be calculated as USD 10,000 X 0.09 X
30/360, or 30/90 X USD 225. Notice that for entries involving discounted notes
payable, no separate Interest Payable account is needed. The Notes Payable account
already contains the total liability that will be paid at maturity, USD 10,000. From the
date the proceeds are given to the borrower to the maturity date, the liability grows by
reducing the balance in the Discount on Notes Payable contra account. Thus, the
current liability section of the 2009 December 31, balance sheet would show:
Current Liabilities: Notes payable $ 10,000 Less: Discount on notes payable 150 $ 9,850
When the note is paid at maturity, the entry is:
2010 Mar. 1 Notes Payable (-L) 10,000
Interest Expense (-SE) 150 Cash (-A) 10,000 Discount on Notes Payable (+L) 150 To record note payment and interest expense.
The T-accounts for Discount on Notes Payable and for Interest Expense appear as
follows:
Discount on Notes Payable Interest Expense 2009 Dec. 1 225
2009 Dec. 31 75
2009 Dec. 31 75
2009 Dec. 31 To close 75
Dec. 31 Balance 150 2010 2010 Mar. 1 150 Mar. 1 150
In Exhibit 3, we compare the journal entries for interest-bearing notes and non-
interest-bearing notes used by Needham Company.
Interest-Bearing Notes Non interest-Bearing Notes 2009 2009 Dec. 1 Cash (+A) 10,000 Dec. 1 Cash (+A) 9,775
Notes Payable (+L) 10,000 Discount on Notes Payable (-L) 225 To record 90-day bank loan, Notes Payable (+L)
To record 90-day bank loan. 10,000
31 Interest Expense (-SE) 75 31 Interest Expense (-SE) 75 Interest Payable (+L) 75 Discount on Notes Payable (+L) 75 To record accrued interest on a note payable at year-end.
To record accrued interest on a note payable at year-end.
2010 2010 Mar. 1 Notes Payable (-L) 10,000 Mar. 1 Notes Payable (-L) 10,000
Interest Expense (-SE) 150 Interest Expense (-SE) 150 Interest Payable (-L) 75 Cash (-A) 10,000 Cash (-A) To record note principal and
10,225 Discount on Notes Payable (+L) To record note payment and
150
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Exhibit 3: Comparison between interest-bearing notes and noninterest-bearing
notes
9.7 Analyzing and using the financial results—Accounts receivable turnover
Accounts receivable turnover is the number of times per year that the average
amount of accounts receivable is collected. To calculate this ratio divide net credit
sales, or net sales, by the average net accounts receivable (accounts receivable after
deducting the allowance for uncollectible accounts):
Accounts receivable turnover= Net credit sales net sales Average net accounts receivable
Ideally, average net accounts receivable should represent weekly or monthly
averages; often, however, beginning and end-of-year averages are the only amounts
available to users outside the company. Although analysts should use net credit sales,
frequently net credit sales are not known to those outside the company. Instead, they
use net sales in the numerator.
Generally, the faster firms collect accounts receivable, the better. A company with a
high accounts receivable turnover ties up a smaller proportion of its funds in accounts
receivable than a company with a low turnover. Both the company's credit terms and
collection policies affect turnover. For instance, a company with credit terms of 2/10,
n/30 would expect a higher turnover than a company with terms of n/60. Also, a
company that aggressively pursues overdue accounts receivable has a higher turnover
of accounts receivable than one that does not.
For example, we calculated these accounts receivable turnovers for the following
hypothetical companies:
Accounts Receivable Net Sales Average (millions) Net Turnover
Abercrombie & Fitch $ 1,238 $ 14 88.43 The Limited, Inc. 10,105 1,012 10.00
We calculate the number of days' sales in accounts receivable (also called the
average collection period for accounts receivable) as follows:
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Numberof days ' sales per accounts receivable=Number of days per a year 365 Accounts receivable turnover
This ratio measures the average liquidity of accounts receivable and gives an
indication of their quality. The faster a firm collects receivables, the more liquid (the
closer to being cash) they are and the higher their quality. The longer accounts
receivable remain outstanding, the greater the probability they never will be collected.
As the time period increases, so does the probability that customers will declare
bankruptcy or go out of business.
Based on 365 days, we calculated the number of days' sales for each of these
hypothetical companies:
Accounts Receivable Company Turnover Number of
Day's Sales in Abercrombie & Fitch 88.43 4.1 The Limited, Inc. 10.00 36.5
These companies have collection periods ranging from 4.1 to 36.5 days. Assuming
credit terms of 2/10, n/30, one would expect the average collection period to be under
30 days. If customers do not pay within 10 days and take the discount offered, they
incur an annual interest rate of 36.5 percent on these funds. (They lose a 2 percent
discount and get to use the funds another 20 days, which is equivalent to an annual
rate of 36.5 percent.)
Having studied receivables and payables in this chapter, you will study plant assets
in the next chapter. These long-term assets include land and depreciable assets such as
buildings, machinery, and equipment.
9.7.1 Understanding the learning objectives
• Companies use two methods to account for uncollectible accounts receivable:
the allowance method, which provides in advance for uncollectible accounts; and
the direct write-off method, which recognizes uncollectible accounts as an expense
when judged uncollectible. The allowance method is the preferred method and is
the only method discussed and illustrated in this text.
• The two basic methods for estimating uncollectible accounts under the
allowance method are the percentage-of-sales method and the percentage-of-
receivables method.
46
• The percentage-of-sales method focuses attention on the income statement and
the relationship of uncollectible accounts to sales. The debit to Uncollectible
Accounts Expense is a certain percent of credit sales or total net sales.
• The percentage-of-receivables method focuses attention on the balance sheet
and the relationship of the allowance for uncollectible accounts to accounts
receivable. The credit to the Allowance for Uncollectible Accounts is the amount
necessary to bring that account up to a certain percentage of the Accounts
Receivable balance. Either one overall percentage or an aging schedule may be
used.
• Credit cards are charge cards used by customers to charge purchases of goods
and services. These cards are of two types—nonbank credit cards (such as
American Express) and bank credit cards (such as VISA).
• The sale is recorded at the gross amount of the sale, and the cash or receivable
is recorded at the net amount the company will receive.
• Liabilities result from some past transaction and are obligations to pay cash,
provide services, or deliver goods at some time in the future.
• Current liabilities are obligations that (1) are payable within one year or one
operating cycle, whichever is longer, or (2) will be paid out of current assets or
create other current liabilities.
• Long-term liabilities are obligations that do not qualify as current liabilities.
• Clearly determinable liabilities are those for which the existence of the liability
and its amount are certain. An example is accounts payable.
• Estimated liabilities are those for which the existence of the liability is certain,
but its amount can only be estimated. An example is estimated product warranty
payable.
• Contingent liabilities are those for which the existence, and usually the amount,
are uncertain because these liabilities depend (or are contingent) on some future
event occurring or not occurring. An example is a liability arising from a lawsuit.
• A promissory note is an unconditional written promise by a borrower (maker)
to pay the lender (payee) or someone else who legally acquired the note a certain
sum of money on demand or at a definite time.
• Interest is the fee charged for the use of money through time. Interest=Principal×Rate of interest×Time.
47
• Companies sometimes need short-term financing. Short-term financing may be
secured by issuing interest-bearing notes or by issuing non interest-bearing notes.
• An interest-bearing note specifies the interest rate that will be charged on the
principal borrowed.
• A non interest-bearing note does not have a stated interest rate applied to the
face value of the note.
• Calculate accounts receivable turnover by dividing net credit sales, or net sales,
by average net accounts receivable.
• Calculate the number of days' sales in accounts receivable (or average collection
period) by dividing the number of days in the year by the accounts receivable
turnover.
• Together, these ratios show the liquidity of accounts receivable and give some
indication of their quality. Generally, the higher the accounts receivable turnover,
the better; and the shorter the average collection period, the better.
9.7.2 Demonstration problem
Demonstration problem A a. Prepare the journal entries for the following
transactions:
As of the end of 2010, Post Company estimates its uncollectible accounts expense to
be 1 percent of sales. Sales in 2010 were USD 1,125,000.
On 2011 January 15, the company decided that the account for John Nunn in the
amount of USD 750 was uncollectible.
On 2011 February 12, John Nunn's check for USD 750 arrived.
b. Prepare the journal entries in the records of Lyle Company for the following:
On 2010 June 15, Lyle Company received a USD 22,500, 90-day, 12 percent note
dated 2010 June 15, from Stone Company in payment of its account.
Assume that Stone Company did not pay the note at maturity. Lyle Company
decided that the note was uncollectible.
Demonstration problem B a. Prepare the entries on the books of Cromwell
Company assuming the company borrowed USD 10,000 at 7 percent from First
National Bank and signed a 60-day non interest-bearing note payable on 2009
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December 1, accrued interest on 2009 December 31, and paid the debt on the maturity
date.
b. Prepare the entries on the books of Cromwell Company assuming it purchased
equipment from Jones Company for USD 5,000 and signed a 30-day, 9 percent
interest-bearing note payable on 2010 February 24. Cromwell paid the note on its
maturity date.
9.7.3 Solution to demonstration problem
Solution to demonstration problem A
a.
1. 2010 Dec.
31 Uncollectible Accounts Expense (-SE) Allowance for Uncollectible Accounts (-A) To record estimated Uncollectible accounts for the year.
11,250
11,250
2. 2011 Jan.
15 Allowance for Uncollectible Accounts (+A) Accounts Receivable—John Nunn (-A) To write off the account of John Nunn as Uncollectible.
750
750
3. Feb. 12 Accounts Receivable—John Nunn (+A) Allowance for Uncollectible Accounts (-A) To correct the write-off of John Nunn's account on January 15.
750
750
12 Cash (+A) Accounts Receivable—John Nunn (-A) To record the collection of John Nunn's account receivable.
750
750
b.
1. 2010 June
15 Notes Receivable (+A) Accounts Receivable—Stone Company (-A) To record receipt of a note from Stone Company.
22,500
22,500
2. Sept 13 Accounts Receivable—Stone Company (+A) Notes Receivable (-A) Interest Revenue(+SE) To record the default of the Stone Company note of $22,500. Interest revenue was $675.
23,175
22,500 675
13 Allowance for Uncollectible Accounts* (+A) Accounts Receivable—Stone Company (-A) To write off the Stone Company as uncollectible.
23,175
23,175
*This debt assumes that Notes Receivable were taken into consideration when an
allowance was established. If not, the debit should be to Loss from Dishonored Notes
Receivable.
Solution to demonstration problem B
a.
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2009 Dec.
1 Cash (+A) Bank Discount ($10,000 X 0.07 X '0'/36)) (+A) Notes Payable (+L)
9,883.33 116.67
10,000.00 31 Interest Expense (-SE)
Bank Discount (-A) ($10,000 X 0.07 X ^/36))
58.33
58.33
2010 Jan.
30 Notes Payable (-L) Interest Expense (-SE) Bank Discount (-A) Cash (-A)
10,000.00 58.33
58.33 10,000.00
b. 2010 Feb
2 4
Equipment (+A) Notes Payable (+L)
5,000.00
5,000.00 Mar 2
6 Notes Payable (-L) Interest Expense (-SE) Cash (-A) ($5,000 X 0.09 X 30/360) = $37.50
5,000.00 37.50
5,037.50 675
9.8 Key terms Accounts receivable turnover Net credit sales (or net sales) divided by average net accounts receivable. Aging schedule A means of classifying accounts receivable according to their age; used to determine the necessary balance in an Allowance for Uncollectible Accounts. A different uncollectibility percentage rate is used for each age category. Allowance for Uncollectible Accounts A contra-asset account to the Accounts Receivable account; it reduces accounts receivable to their net realizable value. Also called Allowance for Doubtful Accounts or Allowance for Bad Debts. Bad debts expense See Uncollectible accounts expense. Bank discount The difference between the maturity value of a note and the actual amount—the note's proceeds—given to the borrower. Cash proceeds The maturity amount of a note less the bank discount. Clearly determinable liabilities Liabilities whose existence and amount are certain. Examples include accounts payable, notes payable, interest payable, unearned delivery fees, wages payable, sales tax payable, federal excise tax payable, current portions of long-term debt, and various payroll liabilities. Contingent liabilities Liabilities whose existence is uncertain. Their amount is also usually uncertain. Both their existence and amount depend on some future event that may or may not occur. Examples include liabilities arising from lawsuits, discounted notes receivable, income tax disputes, penalties that may be assessed because of some past action, and failure of another party to pay a debt that a company has guaranteed. Credit Card Expense account Used to record credit card agency's service charges for services rendered in processing credit card sales.
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Credit cards Nonbank charge cards (e.g. American Express) and bank charge cards (e.g. VISA and MasterCard) that customers use to charge their purchases of goods and services. Current liabilities Obligations that (1) are payable within one year or one operating cycle, whichever is longer, or (2) will be paid out of current assets or result in the creation of other current liabilities. Discount on Notes Payable A contra account used to reduce Notes Payable from face value to the net amount of the debt. Discounting a note payable The act of borrowing on a non interest-bearing note drawn for a maturity amount, from which a bank discount is deducted, and the proceeds are given to the borrower. Dishonored note A note that the maker failed to pay at maturity. Estimated liabilities Liabilities whose existence is certain, but whose amount can only be estimated. An example is estimated product warranty payable. Interest The fee charged for use of money over a period of time (I = P X R X T). Interest Payable account An account showing the interest expense incurred but not yet paid; reported as a current liability in the balance sheet. Interest Receivable account An account showing the interest earned but not yet collected; reported as a current asset in the balance sheet. Liabilities Obligations that result from some past transaction and are obligations to pay cash, perform services, or deliver goods at some time in the future. Long-term liabilities Obligations that do not qualify as current liabilities. Maker (of a note) The party who prepares a note and is responsible for paying the note at maturity. Maturity date The date on which a note becomes due and must be paid. Maturity value The amount that the maker must pay on the note on its maturity date. Net realizable value The amount the company expects to collect from accounts receivable. Number of days' sales in accounts receivable The number of days in a year (365) divided by the accounts receivable turnover. Operating cycle The time it takes to start with cash, buy necessary items to produce revenues (such as materials, supplies, labor, and/or finished goods), sell goods or services, and receive cash by collecting the resulting receivables. Payable Any sum of money due to be paid by a company to any party for any reason. Payee (of a note) The party who receives a note and will be paid cash at maturity. Percentage-of-receivables method A method for determining the desired size of the Allowance for Uncollectible Accounts by basing the calculation on the Accounts Receivable balance at the end of the period.
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Percentage-of-sales method A method of estimating the uncollectible accounts from the sales of a given period's total net credit sales or net sales. Principal (of a note) The face value of a note. Promissory note An unconditional written promise by a borrower (maker) to pay a definite sum of money to the lender (payee) on demand or at a specific date. Rate (of a note) The stated interest rate on the note. Receivable Any sum of money due to be paid to a company from any party for any reason. Time (of a note) The amount of time the note is to run; can be expressed in days, months, or years. Trade receivables Amounts customers owe a company for goods sold or services rendered on account. Also called accounts receivable or trade accounts receivable. Uncollectible accounts expense An operating expense that a business incurs when it sells on credit; also called doubtful accounts expense or bad debts expense.
9.9 Self test
9.9.1 True-false
Indicate whether each of the following statements is true or false.
The percentage-of-sales method estimates the uncollectible accounts from the
ending balance in Accounts Receivable.
Under the allowance method, uncollectible accounts expense is recognized when a
specific customer's account is written off.
Bank credit card sales are treated as cash sales because the receipt of cash is certain.
Liabilities result from some future transaction.
Current liabilities are classified as clearly determinable, estimated, and contingent.
A dishonored note is removed from Notes Receivable, and the total amount due is
recorded in Accounts Receivable.
When an interest-bearing note is given to a bank when taking out a loan, the
difference between the cash proceeds and the maturity amount is debited to Discount
on Notes Payable.
9.9.2 Multiple-choice
Select the best answer for each of the following questions.
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Which of the following statements is false?
a. Any existing balance in the Allowance for Uncollectible Accounts is ignored in
calculating the uncollectible accounts expense under the percentage-of-sales method
except that the allowance account must have a credit balance after adjustment.
b. The percentage-of-receivables method may use either an overall rate or a different
rate for each age category.
c. The Allowance for Uncollectible Accounts reduces accounts receivable to their net
realizable value.
d. A write-off of an account reduces the net amount shown for accounts receivable
on the balance sheet.
e. None of the above.
Hunt Company estimates uncollectible accounts using the percentage-of-receivables
method and expects that 5 percent of outstanding receivables will be uncollectible for
2010. The balance in Accounts Receivable is USD 200,000, and the allowance account
has a USD 3,000 credit balance before adjustment at year-end. The uncollectible
accounts expense for 2010 will be:
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