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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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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

11

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

12

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.

13

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,

14

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

17

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

18

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:

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