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CHAPTER 8

FINANCIAL REPORTING & ANALYSIS BY REVSINE – COLLINS – JOHNSON 2 nd Edition. CHAPTER 8. RECEIVABLES. Slides Authored by Brian Leventhal University of Illinois at Chicago. I. Assessing the Net Realizable Value of Accounts Receivable.

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CHAPTER 8

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  1. FINANCIAL REPORTING & ANALYSIS BY REVSINE – COLLINS – JOHNSON 2nd Edition CHAPTER 8 RECEIVABLES Slides Authored by Brian Leventhal University of Illinois at Chicago

  2. I. Assessing the Net Realizable Value of Accounts Receivable A. Estimating the net realizable value of receivables: 1. The full amount of receivablesmay not be collectible either because customers: a. Are unable to pay (referred to as uncollectibles), or b. Return the merchandise for credit or are allowed a reduction in the amount owed (referred to as returns and adjustments).

  3. I. Assessing the Net Realizable Value of Accounts Receivable A. Estimating the net realizable value of receivables: 2. These losses are an unavoidable consequence of the trade-off between increased costs and additional profits from credit sales.

  4. I. Assessing the Net Realizable Value of Accounts Receivable • Sales to customers who are ultimatelyunable to pay are treated as: • Expensesof the period in which the sales are made to follow the matching principle. • Most likely this will be an ESTIMATE! 1. The entry under GAAP is: DR Bad debt expense $30,000 CR Allowance for uncollectibles $30,000

  5. Contra-Asset Account to A/R I. Assessing the Net Realizable Value of Accounts Receivable How the Allowance Account Works Allowance For Uncollectibles Actual Uncollectibles When Known Estimate of Uncollectibles In the Period of Sale

  6. I. Assessing the Net Realizable Value of Accounts Receivable How the Allowance Account Works Allowance For Uncollectibles Beg. Balance XX Actual Customer Written Off Bad Debts Expense (Estimate) XX Ending Balance XX

  7. Allowance For Uncollectibles Bad Debt Expense I. Assessing the Net Realizable Value of Accounts Receivable 1. The entry under GAAP is: DR Bad debt expense $30,000 CR Allowance for uncollectibles $30,000 The allowance for uncollectibles is a contra-asset account that is subtracted from gross accounts receivable. Beg. Bal. $15,000 $30,000 $30,000 Goes On I/S End. Bal. $45,000

  8. Allowance For Uncollectibles Accounts Receivable Gross I. Assessing the Net Realizable Value of Accounts Receivable Balance Sheet Presentation Accounts Receivable Net = Less $1,500,000 = $45,000 $1,455,000 OR Accounts Receivable (gross) $1,500,000 Less: Allowance for uncollectibles (45,000) Accounts Receivable (net) $1,455,000

  9. How do we get this $$? I. Assessing the Net Realizable Value of Accounts Receivable C. Estimatinguncollectible receivables: Allowance For Uncollectibles Estimate of Uncollectibles In the Period of Sale Method #1 – The Sales Revenue Approach

  10. How do we get this $$? I. Assessing the Net Realizable Value of Accounts Receivable C. Estimatinguncollectible receivables: Method #1 – The Sales Revenue Approach Allowance For Uncollectibles • A specific loss percentage is multiplied by sales revenue to estimate bad debt expense. • The loss percentage is based on past experience of the firm. Est. of Uncoll. In the Period of Sale

  11. I. Assessing the Net Realizable Value of Accounts Receivable C. Estimatinguncollectible receivables: Method #1 – The Sales Revenue Approach Bad Debts Exp = Net Credit Sales * Loss % = $3,000,000 * .01 $30,000 This method directly provides the adjusting entry amount. DR Bad debt expense $30,000 CR Allowance for uncollectibles $30,000

  12. Allowance For Uncollectibles Bad Debt Expense I. Assessing the Net Realizable Value of Accounts Receivable C. Estimatinguncollectible receivables: Method #1 – The Sales Revenue Approach DR Bad debt expense $30,000 CR Allowance for uncollectibles $30,000 Beg. Bal. $15,000 $30,000 $30,000

  13. Allowance For Uncollectibles Est. of Uncoll. In the Period of Sale How do we get this $$? I. Assessing the Net Realizable Value of Accounts Receivable C. Estimatinguncollectible receivables: Method #2 – The gross receivables approach: • A specific loss percentage is multiplied by gross receivables to estimate the required allowance account balance. • The adjusting entry is the amount necessary to get the unadjusted allowance balance to the required amount. • The loss percentage is based on past experience.

  14. I. Assessing the Net Realizable Value of Accounts Receivable C. Estimatinguncollectible receivables: Method #2 – The gross receivables approach: Required Allowance = Gross Receivables * Loss % Balance +/- Bal. In Allowance Bad Debts Expense This method does notdirectly provide the adjusting entry amount.

  15. I. Assessing the Net Realizable Value of Accounts Receivable C. Estimatinguncollectible receivables: Method #2 – The gross receivables approach: Required Allowance = Gross Receivables * Loss % Balance +/- Bal. In Allowance Bad Debts Expense $1,500,000 $45,000 .03 - $15,000 Bad Debts Expense $30,000 The Adjusting entry is: DR Bad debt expense $30,000 CR Allowance for uncollectibles $30,000

  16. Allowance For Uncollectibles Bad Debt Expense I. Assessing the Net Realizable Value of Accounts Receivable C. Estimatinguncollectible receivables: Method #2 – The gross receivables approach: DR Bad debt expense $30,000 CR Allowance for uncollectibles $30,000 Beg. Bal. $15,000 $30,000 $30,000

  17. Allowance For Uncollectibles I. Assessing the Net Realizable Value of Accounts Receivable How the Allowance Account Works What happens when we know this $$? Actual Customer Written Off Actual information is updated when known! DR Allowance for uncollectibles $750 CR Accounts Receivable-Ralph Co. $750

  18. Allowance For Uncollectibles I. Assessing the Net Realizable Value of Accounts Receivable I. Assessing the Net Realizable Value of Accounts Receivable How the Allowance Account Works DR Allow. for uncoll. $750 CR A/R-Ralph Co. $750 Actual customer write-off It makes sense because bad debtsexpense is an estimate and already recorded. This is updating your estimate in theAllowance Account! Actual Customer Written Off Bad Debts Exp. (Estimate) Assets = Liabilities + Owner’s Equity Allow. For Uncoll Accts. ($750) A/R- Ralph Co. 750 Why does this make sense? Why is Bad Debts Exp. not affected? Overall effect $0

  19. Allowance For Uncollectibles Actual Customer Written Off Bad Debts Exp. (Estimate) I. Assessing the Net Realizable Value of Accounts Receivable I. Assessing the Net Realizable Value of Accounts Receivable How the Allowance Account Works • The loss % is based on historical averages. • Changes in credit terms, the credit policy, or economic changes may require use of a different %. • Actual write-offs that differ from expected levels in any year may not require a changeinestimate.

  20. Allowance For Uncollectibles Actual Customer Written Off Bad Debts Exp. (Estimate) I. Assessing the Net Realizable Value of Accounts Receivable I. Assessing the Net Realizable Value of Accounts Receivable How the Allowance Account Works A change in estimate is required only when there is fundamental change in underlying market conditions.

  21. I. Assessing the Net Realizable Value of Accounts Receivable D. Assessing the adequacy of the allow. for uncoll. accounts balance: 1. Management performs an aging of A/R. a. An aging of receivables is a determination of how long each receivable has been outstanding. b. The longer a receivable is outstanding, the more likely that it will be uncollectible.

  22. I. Assessing the Net Realizable Value of Accounts Receivable D. Assessing the adequacy of the allow. for uncoll. account balance: 2. Because of the judgment that is required, the temptation to “manage” earnings by using bad debt accruals can be strong.

  23. I. Assessing the Net Realizable Value of Accounts Receivable E. Estimatingsales returns & adjust.: • Sometimes the wrong goods are shipped to customers orthe correct goods arrive damaged • prompting customers to return the goods or request price adjustments.

  24. I. Assessing the Net Realizable Value of Accounts Receivable E. Estimatingsales returns & adjust.: 2. These returns & adjustmentsreduce both the accounts receivablebalance and income. Contra Revenue Account DR Sales Returns & Allowances $8,000 CR A/R-Bath Co. $8.000 3. Ignoringestimated future returns & adjustments has a trivial effect on income when the amount of actual returns & adjustmentsdoes not vary greatly from year to year.

  25. I. Assessing the Net Realizable Value of Accounts Receivable F. Do existing receivables represent real sales? • The growth ratesinsales and accounts receivable will be roughly equal when: • sales terms,customer credit standing, and accounting methods • do not change from period to period. 2. Any disparity between the two growth rates represents a potential “red flag.”

  26. II. Imputed Interest A. Sellers may extend long-term credit to buyers, who then sign notes payable. • An attempt is made to separate the operating income ( gross profit from sale) from: • the financing income (interest income).

  27. II. Imputed Interest C. The transaction is recorded at the fair value of the item(s) given up, if known. 1. This is the first option since managers have a better idea about the value of the items they routinely sell. • An imputed interest rate, that equates the value of the items given up to the future cash inflows from the note, is calculated. This is calculating the IRR.

  28. II. Imputed Interest D. If not recorded at fair value of items given up, then the transaction is recorded at the present value of the note accepted in return for the item(s). • If the stated rate is equal to the prevailing market rate for a note of that risk level, • then the sales priceequals the face value of the note.

  29. II. Imputed Interest Stated Rate = Prevailing Rate NO NEED TO IMPUTE INTEREST Example: Michelle Corp. sells a machine to Texas Products Co. accepting a $50,000 three-year note with interest of 10% per annum to be paid in quarterly installments each year. Assume that 10% approximates prevailing borrowing rates for like companies. DR Notes Receivable-Texas Products $50,000 CR Sales Revenues $50,000

  30. II. Imputed Interest Stated Rate = Prevailing Rate NO NEED TO IMPUTE INTEREST Example: Michelle Corp. sells a machine to Texas Products Co. accepting a $50,000 three-year note with interest of 10% per annum to be paid in quarterly installments each year. Assume that 10% approximates prevailing borrowing rates for like companies. Interest Incomeaccrues each quarter: DR Accrued Interest Receivable $1,250 CR Interest Income $1,250 3 months interest = [$50,000 x .10] /4 = $1,250

  31. II. Imputed Interest Stated Rate = Prevailing Rate NO NEED TO IMPUTE INTEREST Example: Michelle Corp. sells a machine to Texas Products Co. accepting a $50,000 three-year note with interest of 10% per annum to be paid in quarterly installments each year. Assume that 10% approximates prevailing borrowing rates for like companies. When cash payment is received, the accrued interest receivable would be reduced: DR Cash $1,250 CR Accrued Interest Receivable $1,250

  32. II. Imputed Interest D. If not recorded at fair value of items given up, then the transaction is recorded at the present value of the note accepted in return for the item(s). • If the stated ratedeviates from the prevailing market rate, or • if there is no stated interest rate, • then the seller must calculate the present value of the future cash inflows. a. An estimated discount rate must be selected. b. The rate selecteddirectly affects the allocation of income between operating and financingactivities.

  33. Stated Rate = Prevailing Rate NEED TO IMPUTE INTEREST II. Imputed Interest Example: Monson Corp. sells a machine to Davenport Products Co. accepting a $50,000 three-year note with no interest to be paidoff at end of three years. Monson’s cash selling price for equipment is $37,566. Assume that 10% approximates prevailing borrowing rates for like companies. The Present Value factor for 3 years at 10% is .75132 PV of note = Future Value x Present Value interest factor (Sale Price) = x $37,566 $50,000 .75132

  34. Stated Rate = Prevailing Rate NEED TO IMPUTE INTEREST II. Imputed Interest Example: Monson Corp. sells a machine to Davenport Products Co. accepting a $50,000 three-year note with no interest to be paid at end of three years. Monson’s cash selling price for equipment is $37,566. Assume that 10% approximates prevailing borrowing rates for like companies. The Present Value factor for 3 years at 10% is .75132 DR Notes Receivable-Davenport Products $37,566 CR Sales Revenues $37,566

  35. Stated Rate = Prevailing Rate NEED TO IMPUTE INTEREST II. Imputed Interest Example: Monson Corp. sells a machine to Davenport Products Co. accepting a $50,000 three-year note with no interest to be paid at end of three years. Monson’s cash selling price for equipment is $37,566. Assume that 10% approximates prevailing borrowing rates for like companies. Over the next 3 years, interest incomerecognized is: Let’s see How to split this up over the 3 yrs. Notes Receivable-Davenport Products $50,000 Less: Sales Revenues $37,566 Total Interest on N/R all 3 years $12,434

  36. Stated Rate = Prevailing Rate NEED TO IMPUTE INTEREST II. Imputed Interest Example: Monson Corp. sells a machine to Davenport Products Co. accepting a $50,000 three-year note with no interest to be paid at end of three years. Monson’s cash selling price for equipment is $37,566. Assume that 10% approximates prevailing borrowing rates for like companies. Year 1- N/R is increased and interest incomerecognized. Interest Income = CV of N/R x Prevailing Rate = $3,756.60 $37,566 .10 x

  37. Stated Rate = Prevailing Rate NEED TO IMPUTE INTEREST II. Imputed Interest Example: Monson Corp. sells a machine to Davenport Products Co. accepting a $50,000 three-year note with no interest to be paid at end of three years. Monson’s cash selling price for equipment is $37,566. Assume that 10% approximates prevailing borrowing rates for like companies. The Present Value factor for 3 years at 10% is .75132 DR Notes Receivable-Davenport Products $3,756.60 CR Interest Income $3,756.60

  38. Stated Rate = Prevailing Rate NEED TO IMPUTE INTEREST II. Imputed Interest Notes Receivable Interest Income Beg yr.1 $37,566.00 Year 1 $3,756.60 $3,756.60 $41,322.60 End yr.1

  39. Stated Rate = Prevailing Rate NEED TO IMPUTE INTEREST II. Imputed Interest Example: Monson Corp. sells a machine to Davenport Products Co. accepting a $50,000 three-year note with no interest to be paid at end of three years. Monson’s cash selling price for equipment is $37,566. Assume that 10% approximates prevailing borrowing rates for like companies. Year 2- N/R is increased and interest incomerecognized. Interest Income = CV of N/R x Prevailing Rate = $4,132.26 $41,322.60 .10 x

  40. Stated Rate = Prevailing Rate NEED TO IMPUTE INTEREST II. Imputed Interest Example: Monson Corp. sells a machine to Davenport Products Co. accepting a $50,000 three-year note with no interest to be paid at end of three years. Monson’s cash selling price for equipment is $37,566. Assume that 10% approximates prevailing borrowing rates for like companies. The Present Value factor for 3 years at 10% is .75132 DR Notes Receivable-Davenport Products $4,132.26 CR Interest Income $4,132.26

  41. Stated Rate = Prevailing Rate NEED TO IMPUTE INTEREST Beg yr.1 $37,566.00 $3,756.60 $41,322.60 End yr.1 II. Imputed Interest Notes Receivable Interest Income Year 1 $3,756.60 Year 2 $4,132.26 $4,132.26 End yr. 2 $45,454.86

  42. Stated Rate = Prevailing Rate NEED TO IMPUTE INTEREST II. Imputed Interest Example: Monson Corp. sells a machine to Davenport Products Co. accepting a $50,000 three-year note with no interest to be paid at end of three years. Monson’s cash selling price for equipment is $37,566. Assume that 10% approximates prevailing borrowing rates for like companies. Year 3- N/R is increased and interest incomerecognized. Interest Income = CV of N/R x Prevailing Rate = $4,545.14 r $45,454.86 .10 x

  43. Stated Rate = Prevailing Rate NEED TO IMPUTE INTEREST II. Imputed Interest Example: Monson Corp. sells a machine to Davenport Products Co. accepting a $50,000 three-year note with no interest to be paid at end of three years. Monson’s cash selling price for equipment is $37,566. Assume that 10% approximates prevailing borrowing rates for like companies. The Present Value factor for 3 years at 10% is .75132 DR Notes Receivable-Davenport Products $4,545.14 CR Interest Income $4,545.14

  44. Stated Rate = Prevailing Rate NEED TO IMPUTE INTEREST II. Imputed Interest Notes Receivable Interest Income $37,566.00 Beg yr.1 Year 1 $3,756.60 $3,756.60 $41,322.60 Year 2 End yr.1 $4,132.26 $4,132.26 Year 3 $4,545.14 $45,454.86 Total 3 years $12,434.00 End yr. 2 $4,545.14 End yr. 3 $50,000.00

  45. Stated Rate = Prevailing Rate NEED TO IMPUTE INTEREST II. Imputed Interest Notes Receivable Interest Income $50,000.00 End yr. 3 $50,000.00 Year 1 $3,756.60 0 Year 2 $4,132.26 Year 3 DR Cash $50,000 CR N/R $50,000 To record payment of N/R $4,545.14 Total 3 years $12,434.00

  46. Accelerating Cash Collections: Transfers and Dispositions of Receivables A. There are two traditional ways to acceleratecash collections of accounts receivable:   • Factoring, where the company sells its receivablesoutright in exchange for cash and • The receivables are removed from the company’s books.

  47. Accelerating Cash Collections: Transfers and Dispositions of Receivables • Factoring, where the company sells its receivablesoutright in exchange for cash and the receivables removed from books. • Factoring can be without recourse, • The factor (buyer)cannot turn to the company for payment if customer receivables prove uncollectible.

  48. Accelerating Cash Collections: Transfers and Dispositions of Receivables • Factoring can be without recourse, the factor (buyer)cannot turn to the company for payment if customer receivables prove uncollectible. • The fee charged by the factor is charged to interest expense. • This fee is not only as a charge to cover the administrative cost of the factor, • but also as the difference between the present value and the NRV of the receivables.

  49. Accelerating Cash Collections: Transfers and Dispositions of Receivables • Factoring can be without recourse, the factor (buyer)cannot turn to the company for payment if customer receivables prove uncollectible. ii. The factor will charge a higher fee in a nonrecourse arrangement than a with recourse arrangement, because of the higher riskassumed.

  50. Accelerating Cash Collections: Transfers and Dispositions of Receivables • Factoring, where the company sells its receivablesoutright in exchange for cash and the receivables are removed from the company’s books. • Factoring can be with recourse, • The company is willing to buy back any bad customer receivables from the buyer of the A/R.

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