Fundamental Financial Accounting Concepts Fourth Edition by Edmonds, McNair, Milam, Olds

1. Fundamental Financial Accounting ConceptsFourth EditionbyEdmonds, McNair, Milam, Olds PowerPoint® presentation by J. Lawrence Bergin

2. Chapter 7 Accounting for Accruals: Advanced Topics- Receivables and Payables

3. Advanced topics include: • Accounting for bad debts • Accounting for interest-bearing notes and noninterest bearing (discounted) notes • Warranties Want to learn some accounting?

4. Accounts and Notes Receivable • A/R are the expected future cash receipts of a company. They are typically small and are expected to be received within 30 days. • N/R are used when longer credit terms are necessary. The promissory note specifies the maturity date, the rate of interest, and other credit terms.

5. Value of Receivables • Receivables are reported at their face value less an allowance for accounts which are likely to be uncollectible. • The amount which is actually expected to be collectedis called the net realizable value (NRV).

6. Allowance Method vs. Direct Write-Off Method • GAAP requires that A/R be reported at NRV. (A/R minus Allowance) • This is done using a valuation allowance: An ALLOWANCE METHOD. • % of Sales (or “Income Statement”) approach. • Aging (or “Balance Sheet”) approach. • With the ALLOWANCE METHOD, an estimateof the amount that will NOT be collected is recorded in the same period that the sales revenue is recorded. Thus, the MATCHING PRINCIPLE is being followed.

7. Allowance Method vs. Direct Write-Off Method (continued) • The DIRECT WRITE-OFF method violates GAAP because it does NOT follow the MATCHING principle. • With the Direct Write-off method, no estimate of bad debts is recorded at the time of the sale. Rather, only after a specific account is deemed “uncollectible” is a Bad Debt Expense recorded. • Since GAAP is only required if the amounts are MATERIAL (significant), if the amount of uncollectible A/R is immaterial the Direct Write-off method may be used.

8. Transaction Analysis: • Assume the following selected events occurred at Cell-It. For each event: • Determine how the accounting equation was affected and fill in the horizontal model. (Assume GAAP must be followed.) • Determine the effect on the financial statements. • Record the event in t-accounts.

9. Transaction Analysis: The following selected events occurred at Cell-It during 2004. 1. Provided services to customers for $10,000 on account. 2. Collected $7,000 on account receivables. 3. At year-end it was estimated that 2% of year’s credit sales will never be collected. 4. Jane Doe’s $50 account was written-off as “uncollectible”. 5A&B. $50 cash is unexpectedly received from Jane Doe.

10. Record the five transactions in this horizontal statements model. Balance Sheet Inc. Statement Cashflow Assets = Liab.+ Stk. Equity Cash+ A/Rec .- Allow. = A/P+C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA 1 2 3 4 5A 5B Bal.

11. Provided services to customers for $10,000 on account. Balance Sheet Inc. Statement Cashflow Assets = Liab.+ Stk. Equity Cash+ A/Rec .- Allow. = A/P+C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA 1 2 3 4 5A 5B Bal.

12. Provided services to customers for $10,000 on account. Balance Sheet Inc. Statement Cashflow Assets = Liab.+ Stk. Equity Cash+ A/Rec .- Allow. = A/P+C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA 110000 10000 10000 10000 n.a. 2 3 4 5A 5B Bal.

13. 2. Collected $7,000 from account receivable. Balance Sheet Inc. Statement Cashflow Assets = Liab.+ Stk. Equity Cash+ A/Rec .- Allow. = A/P+C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA 110000 10000 10000 10000 n.a. 2 3 4 5A 5B Bal.

14. 2. Collected $7,000 from account receivable. Balance Sheet Inc. Statement Cashflow Assets = Liab.+ Stk. Equity Cash+ A/Rec .- Allow. = A/P+C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA 110000 10000 10000 10000 n.a. 27000 (7000) 7000 OA 3 4 5A 5B Bal.

15. 3. At year-end it was estimated that 2% of the year’s credit sales will not be collected. Balance Sheet Inc. Statement Cashflow Assets = Liab.+ Stk. Equity Cash+ A/Rec .- Allow. = A/P+C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA 110000 10000 10000 10000 n.a. 2 7000 (7000) 7000 OA 3 4 5A 5B Bal. 200 (200) 200 (200) n.a. 2% x $10,000 = $200

16. Allowance for Doubtful Accounts is a CONTRA- ASSET account. This account balance is INCREASING by $200 causing TOTAL assets to decrease. 3. At year-end it was estimated that 2% of the year’s credit sales will not be collected. Balance Sheet Inc. Statement Cashflow Assets = Liab.+ Stk. Equity Cash+ A/Rec .- Allow. = A/P+C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA 110000 10000 10000 10000 n.a. 2 7000 (7000) 7000 OA 3 4 5A 5B Bal. 200 (200) 200 (200) n.a. 2% x $10,000 = $200

17. 4. Jane Doe’s $50 account was written-off as uncollectible. Balance Sheet Inc. Statement Cashflow Assets = Liab.+ Stk. Equity Cash+ A/Rec .- Allow. = A/P+C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA 1 10000 10000 10000 10000 n.a. 2 7000 (7000) 7000 OA 3 4 5A 5B Bal. 200 (200) 200 (200) n.a.

18. 4. Jane Doe’s $50 account was written-off as uncollectible. Balance Sheet Inc. Statement Cashflow Assets = Liab.+ Stk. Equity Cash+ A/Rec .- Allow. = A/P+C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA 1 10000 10000 10000 10000 n.a. 2 7000 (7000) 7000 OA 3 4 5A 5B Bal. 200 (200) 200 (200) n.a. (50) (50) NO EXPENSE! Note: This is NOT the Direct Write-off method. Rather, it is a write-off under the ALLOWANCE Method.

19. Effect of Transaction 4 on Acct. Rec. Net Realizable Value Before Event 4 After Event 4 A/R $ A/R $ Allow. Allow. N.R.V. $ N.R.V. $ Acme Collection Agency

20. Effect of Transaction 4 on Acct. Rec. Net Realizable Value Before Event 4 After Event 4 A/R $3,000 Allow. (200) N.R.V. $2,800 The check is in the mail. Acme Collection Agency

21. Effect of Transaction 4 on Acct. Rec. Net Realizable Value Before Event 4 After Event 4 A/R $3,000 A/R $ Allow. (200) Allow. N.R.V. $2,800 N.R.V. $ 2,950 (150) 2,800

22. Effect of Transaction 4 on Acct. Rec. Net Realizable Value Before Event 4 After Event 4 A/R $3,000 A/R $2,950 Allow. (200) Allow. (150) N.R.V. $2,800N.R.V. $2,800 When using an ALLOWANCE method, the Net Realizable Value of accounts receivable does not change as a result of the write-off.

23. Before recording Transaction #5: What happens when an account that has been written off later pays off his/her account? • Reinstate the account by recording an entry that undoes (reverses) the write-off: • increase (debit) Accounts Receivable • increase (credit) Allowance for Doubtful Accounts (a contra-asset) • Record the entry to show the cash collection and A/Rec. reduction: • increase (debit)Cash • decrease (credit) Accounts Receivable

24. 5. $50 cash was unexpectedly received from Jane Doe. (5A=Reinstate, 5B=Collect) Balance Sheet Inc. Statement Cashflow Assets = Liab.+ Stk. Equity Cash+ A/Rec .- Allow. = A/P+C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA 1 10000 10000 10000 10000 n.a. 2 7000 (7000) 7000 OA 3 4 5A 5B Bal. 200 (200) 200 (200) n.a. (50) (50) NO EXPENSE! 50 50

25. 5. $50 cash was unexpectedly received from Jane Doe. (5A=Reinstate, 5B=Collect) Balance Sheet Inc. Statement Cashflow Assets = Liab.+ Stk. Equity Cash+ A/Rec .- Allow. = A/P+C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA 1 10000 10000 10000 10000 n.a. 2 7000 (7000) 7000 OA 3 4 5A 5B Bal. 200 (200) 200 (200) n.a. (50) (50) NO EXPENSE! 50 50 50 (50) 50 OA

26. Calculate all ending balances. Balance Sheet Inc. Statement Cashflow Assets = Liab.+ Stk. Equity Cash+ A/Rec .- Allow. = A/P+C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA 1 10000 10000 10000 10000 n.a. 2 7000 (7000) 7000 OA 3 4 5A 5B Bal. 200 (200) 200 (200) n.a. (50) (50) NO EXPENSE! 50 50 50 (50) 50 OA 7050 2950 200 9800 10000 200 9800 7050 bal.

27. What’s the result?After completing the horizontal model fill in below. How did the previous transactions affect the financial statements? 20X1 How much Bad Debt Expense should appear on the income statement?…. What is the A/R: NRV at year end?…… How much A/R should be added to the other current assets on the year-end balance sheet?………………………….

28. Final Account BalancesRemember, the Bad Debt EXPENSE is accrued in the year of sale, NOT when the account is written off! Balance Sheet Inc. Statement Cashflow Assets = Liab.+ Stk. Equity Cash+ A/Rec .- Allow. = A/P+C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA 1 10000 10000 10000 10000 n.a. 2 7000 (7000) 7000 OA 3 4 5A 5B Bal. 200 (200) 200 (200) n.a. (50) (50) NO EXPENSE! 50 50 50 (50) 50 OA 7050 2950 200 9800 10000 200 9800 7050 bal. MATCHING PRINCIPLE

29. What’s the result?After completing the horizontal model fill in below. How did the previous transactions affect the financial statements? 20X1 How much Bad Debt Expense should appear on the income statement?…. What is the A/R: NRV at year end?…… How much A/R should be added to the other current assets on the year-end balance sheet?…………………………. $ 200

30. Final Account BalancesNet Realizable Value (NRV) = Acct.Rec. - Allowance Balance Sheet Inc. Statement Cashflow Assets = Liab.+ Stk. Equity Cash+ A/Rec .- Allow. = A/P+C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA 1 10000 10000 10000 10000 n.a. 2 7000 (7000) 7000 OA 3 4 5A 5B Bal. 200 (200) 200 (200) n.a. (50) (50) NO EXPENSE! 50 50 50 (50) 50 OA 7050 2950200 9800 10000 200 9800 7050 bal.

31. What’s the result?After completing the horizontal model fill in below. How did the previous transactions affect the financial statements? 20X1 How much Bad Debt Expense should appear on the income statement?…. What is the A/R: NRV at year end?…… How much A/R should be added to the other current assets on the year-end balance sheet?…………………………. $ 200 $ 2,750 $ 2,750

32. Transactions Posted to T-accounts Post the five transactions to these Ledger accounts. Cash Acct. Rec. Allow. for D.A. Service Revenue Bad Debt Exp. Retain. Earn.

33. Transaction Posted to T-accounts 1. Provided services to customers for $10,000 which will be collected at a later date. Cash Acct. Rec. Allow. for D.A. Service Revenue Bad Debt Exp. Retain. Earn.

34. Transaction Posted to T-accounts 1. Provided services to customers for $10,000 which will be collected at a later date. Cash Acct. Rec. Allow. for D.A. (1) 10,000 Service Revenue Bad Debt Exp. Retain. Earn. 10,000 (1)

35. Transaction Posted to T-accounts 2. Collected $7,000 of the Accounts Receivables. Cash Acct. Rec. Allow. for D.A. (1) 10,000 Service Revenue Bad Debt Exp. Retain. Earn. 10,000 (1)

36. Transaction Posted to T-accounts 2. Collected $7,000 of the Accounts Receivables. Cash Acct. Rec. Allow. for D.A. (1) 10,000 7,000 (2) (2) 7,000 Service Revenue Bad Debt Exp. Retain. Earn. 10,000 (1)

37. Transaction Posted to T-accounts 3. At Yr. end it was estimated that 2% of the year’s credit sales will never be collected. Cash Acct. Rec. Allow. for D.A. (1) 10,000 7,000 (2) (2) 7,000 Service Revenue Bad Debt Exp. Retain. Earn. 10,000 (1)

38. Transaction Posted to T-accounts 3. At Yr. end it was estimated that 2% of the year’s credit sales will never be collected. Cash Acct. Rec. Allow. for D.A. (1) 10,000 7,000 (2) (2) 7,000 200 (3) Service Revenue Bad Debt Exp. Retain. Earn. 10,000 (1) (3) 200

39. Transaction Posted to T-accounts 4. Jane Doe’s $50 account was written-off as uncollectible. Cash Acct. Rec. Allow. for D.A. (1) 10,000 7,000 (2) 200 (3) (2) 7,000 Service Revenue Bad Debt Exp. Retain. Earn. 10,000 (1) (3) 200

40. Transaction Posted to T-accounts 4. Jane Doe’s $50 account was written-off as uncollectible. Cash Acct. Rec. Allow. for D.A. (1) 10,000 7,000 (2) 50 (4) (4) 50 200 (3) (2) 7,000 Service Revenue Bad Debt Exp. Retain. Earn. 10,000 (1) (3) 200

41. Effect of Transaction 4 on Acct. Rec. Net Realizable Value Before Event 4 After Event 4 A/R $3,000 A/R $2,950 Allow. (200) Allow. (150) N.R.V. $2,800N.R.V. $2,800 Net realizable value of accounts receivable did not change as a result of the write-off.

42. Transaction Posted to T-accounts 5a.Jane Doe’s account isreinstated. Cash Acct. Rec. Allow. for D.A. (1) 10,000 7,000 (2) 50 (4) (4) 50 200 (3) (2) 7,000 Service Revenue Bad Debt Exp. Retain. Earn. 10,000 (1) (3) 200

43. Transaction Posted to T-accounts 5a. Jane Doe’s account is reinstated. Cash Acct. Rec. Allow. for D.A. (1) 10,000 5a 50 7,000 (2) 50 (4) (4) 50 200 (3) 50 (5a) (2) 7,000 Service Revenue Bad Debt Exp. Retain. Earn. 10,000 (1) (3) 200

44. Transaction Posted to T-accounts 5b. Jane Doe’s account is collected. Cash Acct. Rec. Allow. for D.A. (1) 10,000 5a 50 7,000 (2) 50 (4) (4) 50 200 (3) 50 (5a) (2) 7,000 Service Revenue Bad Debt Exp. Retain. Earn. 10,000 (1) (3) 200

45. Transaction Posted to T-accounts 5b. Jane Doe’s account is collected. Cash Acct. Rec. Allow. for D.A. (1) 10,000 5a 50 7,000 (2) 50 (4) 50 (5b) (4) 50 200 (3) 50 (5a) (2) 7,000 5b 50 Service Revenue Bad Debt Exp. Retain. Earn. 10,000 (1) (3) 200

46. Transaction Posted to T-accounts Closing entriesat the end of Year 1. Cash Acct. Rec. Allow. for D.A. (1) 10,000 5a 50 7,000 (2) 50 (4) 50 (5b) (4) 50 200 (3) 50 (5a) (2) 7,000 5b 50 Service Revenue Bad Debt Exp. Retain. Earn. 10,000 (1) (3) 200

47. Transaction Posted to T-accounts Closing entries at the end of Year 1. Cash Acct. Rec. Allow. for D.A. (1) 10,000 5a 50 7,000 (2) 50 (4) 50 (5b) (4) 50 200 (3) 50 (5a) (2) 7,000 5b 50 Service Revenue Bad Debt Exp. Retain. Earn. 10,000 (1) (c) 10,000 (3) 200 200 (c) (c) 20010,000 (c)

48. Transaction Posted to T-accounts Balances of all accounts after Year 1 closings. Cash Acct. Rec. Allow. for D.A. (1) 10,000 5a 50 bal 2,950 7,000 (2) 50 (4) 50 (5b) (4) 50 200 (3) 50 (5a) 200 bal. (2) 7,000 5b 50 bal. 7,050 Service Revenue Bad Debt Exp. Retain. Earn. 10,000 (1) (c) 10,000 0 bal (3) 200 200 (c) bal. 0 (c) 200 10,000 (c) 9,800 bal.

49. Summary: Accounting for Bad Debts • Allowance method • GAAP • Required if company has a significant amount of bad debts. • Matches bad debt expense (on the income statement) with the sale. • Requires an adjusting journal entry before closing the books.

50. Summary: Accounting for Bad Debts • Direct Write-off method • Violates GAAP (Matching) • No estimates of bad debts are made, so no allowance account is used. • Used by small businesses with few account receivables or large business with few collection problems. • No entry until time specific account is deemed “bad” (uncollectible).