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Chapter 7: Accounts Receivable and Notes Receivable

Chapter 7: Accounts Receivable and Notes Receivable. Accounts receivable arise from selling goods or services to customers on account. Recorded at face amount to be collected. However, we must also reflect the fact that a portion of A/R may not be collected.

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Chapter 7: Accounts Receivable and Notes Receivable

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  1. Chapter 7:Accounts Receivableand Notes Receivable

  2. Accounts receivable arise from selling goods or services to customers on account. Recorded at face amount to be collected. However, we must also reflect the fact that a portion of A/R may not be collected. Two ways to account for the uncollectibles: Direct Write-Off method Allowance method Accounts Receivable

  3. Assume $100,000 is recorded in sales on account in 2006; one of the customers defaults on collection in 2007. Record sale in 2006: A/R 100,000 Sales Revenue 100,000 Record default in 2007: Bad Debt Expense 1,000 A/R 1,000 Note: this is called the direct method, and is not the preferred method for most companies for several reasons. Direct Write-Off Method

  4. Problem: the direct method, on the previous slide, does not achieve matching (revenues recognized in 2006, but a related expense was recognized in 2007). Problem: the direct method does not correctly value the asset, A/R. The assets are overvalued until 2007, when the receivable is finally written off. Solution: create a contra to A/R, called Allowance for Doubtful Accounts (ADA) and estimate the A/R that will not be collected. Problems with Direct Method

  5. In the year of sale, the AJE to record estimate for all future uncollectibles in 2006 (ex: 4% of sales): Bad Debt Expense 4,000 ADA 4,000 The General JEduring 2007, when a specific A/R is deemed uncollectible (this is called the write-off of a specific A/R): ADA 1,000 A/R 1,000 (Other uncollectible accounts would also be written off against the allowance account.) When are the income statement and balance sheet affected? Solution: the Allowance Method At adjusting journal entry.

  6. Note that, in Slide 5, we do not know in 2006 which A/Rs will not be collected in 2007. Therefore, we must estimate uncollectibles. There are two methods: 1. Percentage of sales 2. Percentage of accounts receivable Both methods are used to estimate uncollectibles for the AJE. The percentage of sales method is simpler, but the percentage of A/R method is more comprehensive. Estimation of Uncollectibles

  7. Usually based on credit sales, but may use total sales or net sales as basis. Calculation: Sales x % = Bad Debt Expense (focus on the debit side of the AJE) Called the Income Statement approach, because: revenues x % = expense. 1. Percentage of Sales Method

  8. Based on ending A/R and ending Allowance account. Calculation: Ending A/R x % = Ending Allowance (focus on the credit side of the AJE) Called Balance Sheet approach, because: ending asset x % = ending contra asset. Requires the analysis of the Allowance account before preparing the AJE. May be based on one percentage or multiple percentages - see the aging schedule. An aging schedule of A/R is the most accurate way to estimate uncollectibles (see pp. 288-89). 2. Percentage of A/R Method

  9. Based on the analysis of the Allowance account. Calculate the “desired ending balance” based on an aging of A/R. Now, given the Beginning, Ending and Write-off amounts, calculate the amount of the current estimate that must be added to the Allowance account to achieve the “desired ending balance.” T-Account Approach for Percentage of A/R Method

  10. Allowance for Doubtful Accts. (T-account) Allowance for Doubtful Accts. 1. Beginning Balance 1. The allowance established in the prior period carries forward for current period write-offs.

  11. Allowance for Doubtful Accts. (T-account) Allowance for Doubtful Accts. Beginning Balance 2. Write-off of specific accounts receivable 2. As specific accounts are determined uncollectible during the year, they are written-off to the allowance account as shown. These write-offs may cause the allowance account to have a debit balance before the AJE if the prior year’s expense was underestimated. Accounts Receivable 2. Write-off of specific accounts receivable

  12. Allowance for Doubtful Accts.(T-account) Allowance for Doubtful Accts. Beginning Balance Write-off of accounts receivable 3. Ending Balance 3. The “desired ending balance” in the allowance account is estimated using the percentage calculation or the aging schedule. Accounts Receivable Write-off of accounts receivable

  13. Allowance for Doubtful Accts. (T-account) Allowance for Doubtful Accts. Bad Debts Expense Beginning Balance 4. Recognition of bad debt expense Write-off of accounts receivable 4. Recognition of bad debt expense Ending Balance 4. The AJE to record the estimate of uncollectibles is calculated based on the amount necessary to achieve the “desired ending balance” in the allowance account. The focus is on the Allowance account. Accounts Receivable Write-off of accounts receivable

  14. Given the following information: At December 31, 2007, Company Z prepared an aging schedule to determine that the uncollectible accounts receivable at that date were $18,000. The balance in the Allowance for Doubtful Accounts at 1/1/07 was a $3,000 credit. During 2007, the company wrote off $5,000 of specific accounts receivable that were deemed to be uncollectible. Required: prepare the AJE to record the estimated uncollectibles at 12/31/07. Class Problem 1

  15. Solution to Class Problem 1 (1) Post the beginning balance and write-off. (2) Post the desired ending balance. (3) Post the adjusting journal entry. Allowance for Doubtful Accounts 3,000 Beginning (1) (1) W/O 5,000 20,000 AJE (3) 18,000 End. Balance (2) AJE: Bad debt expense 20,000 Allowance for D.A. 20,000

  16. Notes Receivable (N/R) are similar to A/R, except they usually have a longer collection period, and also may include interest. Activity to record N/R includes the following entries: To record N/R N/R xx Sales Revenue xx To record interest at the end of the period: Int. Receivable xx Interest Revenue xx Calculation of the interest at the end of the period is based on the following formula: Principal x rate per year x time period P x R x T Notes Receivable

  17. On November 1, 2008, Pistol Pete’s Western Gear sold merchandise totaling $10,000 to the Orange Cow Company. Pete’s accepted a note containing a 6 % annual interest rate, where interest and principal were to be repaid in 3 months, on January 31, 2009. Prepare the journal entries for Pistol Pete’s on the following dates: 1. Sale on November 1, 2008 (ignore COGS). 2. Interest accrual at December 31, 2008. 3. Collection of note and interest at January 31, 2009. Class Problem 2

  18. 1. Sale on November 1, 2008: 2. Interest accrual at December 31, 2008: 3. Collection of loan and interest at 1/31/09: Class Problem 2 Notes Receivable 10,000 Sales Revenue 10,000 Interest Receivable 100 Interest Revenue 100 Cash 10,150 Notes Receivable 10,000 Interest Receivable 100 Interest Revenue 50

  19. 1. a. Percent of sales 2% of 834,000 = 16,680 Bad Debt Expense 16,680 Allowance 16,680 (balance in Allow. not relevant to current JE) Exercise 7-2

  20. Exercise 7-2 1.b Analyze Allowance: Allowance for Doubtful Accounts 2,600 Before AJE (1) 16,606 AJE (3) 19,206 End. Balance (2) AJE: Bad debt expense 16,606 Allowance for D.A. 16,606

  21. Exercise 7-2 2.a. No difference 2.b. Analyze Allowance: Allowance for Doubtful Accounts (1) Before AJE 2,600 21,806 AJE (3) 19,206 End. Balance (2) AJE: Bad debt expense 21,806 Allowance for D.A. 21,806

  22. 1. Aging Schedule: % Uncoll. Current 200,000 x .10 = 20,000 < 1 mo. 60,300 x .25 = 15,075 1-2 mos. 35,000 x .35 = 12,250 > 2 mos. 45,000 x .75 = 33,750 Total 340,300 81,075 End Allow 2. Show higher uncoll. for that customer (don’t write off until bankruptcy court settles assets) Problem 7-2A

  23. 3. Balance sheet Accts. Receivable $340,300 Less: Allowance for DA 81,075 A/R Net $259,225 Problem 7-2A

  24. Part 1 (1)Sales: A/R (80%) 630,000 Cash (20%) 157,500 Sales 787,500 (2)Collection on A/R: Cash 502,500 A/R 502,500 (3) Write-off of specific A/R: Allow. for Doubt. Acct 3,000 A/R 3,000 Problem 7-1A

  25. Part 2a: % of Sales Bad Debt Expense is % of credit sales Sales x % = Bad Debt Expense (no analysis of Allowance necessary) Sales on account (credit sales) = 630,000 x .03 = 18,900 BD Exp. AJE(2a): Bad Debt Expense 18,900 Allow. for D.A. 18,900 Problem 7-1A

  26. Problem 7-1A (% of Sales) Post A/R: Then post Allowance: (ending balance last) Accts. Receivable Allowance for D A B 105,000 1,950 B (JE1) 630,000 502,500 (JE2) 3,000 (JE3) 18,900 (AJE) (JE3) 3,000 E 229,500 17,850 E Part 3: Net A/R = 229,500- 17,850 = 211,650

  27. Problem 7-1A (2b, % of A/R) Post A/R (same): Then post Allow: (AJE Last) Accts. Receivable Allowance for D A B 105,000 1,950 B (JE1) 630,000 502,500 (JE2) 3,000 (JE3) (3) 3,000 14,820 (AJE) E 229,500 13,770 E Calc. 6% before AJE AJE: Bad debt expense 14,820 Allowance for D.A. 14,820 Part 3: Net A/R = 229,500 - 13,770 = $215,730

  28. Recognition of Bad Debt Expense (AJE): BDExp xx (+Exp, -NI) Decr. SE Allow xx (+Allow) Decr. Assets Write-off: Allow xx (-Allow) Incr. Assets A/R xx (-A/R) Decr. Assets No effect on total assets No effect on I/S No effect on Net A/R Problem 7-1A, Part 4

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