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Intermediate Accounting November 4 th , 2010

Intermediate Accounting November 4 th , 2010. General Course Questions Chapter 7 Cash and Receivables (using assigned homework) A. Recording Bad Debt Expense Problems 2,4, and 6 B. Using Receivables to Raise Cash ?17 & 19 BE 8 , 9, & 10

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Intermediate Accounting November 4 th , 2010

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  1. Intermediate AccountingNovember 4th, 2010 • General Course Questions • Chapter 7 Cash and Receivables(using assigned homework) A. Recording Bad Debt Expense Problems 2,4, and 6 B. Using Receivables to Raise Cash ?17 & 19 BE 8, 9, & 10 C. A/R journal entries, turnover and liquidity Ex 20 D. Long-term Notes Receivable ?16, BE 17, ex 6, 7 & 18 3. Chapter 7 Assignments for Tuesday, November 9th: A. Using Receivables to Raise Cash (Ex 14, 16, 17, Pr 7 & 11) B. Loan Impairments (Ex 27 and problem 15) 4. Review Project 1 Columbia Sportswear 10-K 5. Additional Questions and Review of Midterm Exam

  2. Estimating Uncollectible Receivables Methods of Accounting for Uncollectible Accounts • Direct Write-Off • Theoretically undesirable: • A/R are written off when determined uncollectible • No matching (Expense and Revenue not likely recorded in the same period) • Receivables not stated at net realizable value (no Balance Sheet account for “allowance for bad debts”) • Not GAAP, unless bad debt expense in immaterial Allowance Method Losses are Estimated using an contra account (Allowance for Bad Debts): • Percentage-of-sales • Meets GAAP Matching requirement - Bad Debt expense estimated in same period as Sale. • Percentage-of-receivables • Meets GAAP - Receivables are carried at net realizable value

  3. Uncollectible Accounts Receivable Income Statement Approach (ignore Balance Sheet Accounts – A/R & Allowance Account) Use “Sales” to estimate the “Bad debt expense” for the period. Balance Sheet Approach (ignore Income Statement accounts – Sales and Bad Debt Expense) Use A/R to determine what the ending Balance in the Allowance Account should be (adjust it). Entry: Debit: Bad Debt Expense (temporary account, 0 before adj.) Credit: Allowance for Doubtful Accounts (permanent account)

  4. AR Allowance Methods: Determining the Amount of the Adjustment Percent of Receivables Allowance method • Balance-sheet oriented • Uses one B/S account (AR) to estimate another B/S account (Allowance) • Estimates the ENDING balance in the allowance account • Bad debt expense is the “plug” Percent of Sales Allowance method • Income-statement oriented • Uses one I/S account (revenue) to estimate another I/S account (bad debt expense) • Estimates the TOTAL bad debt expense • The allowance is the “running total” Entry: Debit: Bad Debt Expense (temporary account, 0 before adj.) Credit: Allowance for Doubtful Accounts (permanent account)

  5. Balance Sheet Representation Short-term accounts receivable are shown at their net realizable value as follows: Accounts Receivable (gross): $ XXX less: Allowance: ($ XX) Net Realizable Value: $ XX Or present in line item as: “AR net of $xxx allowance for doubtful accounts”

  6. Disposition of Accounts and Notes Receivable Owner may transfer accounts or notes receivables to another company for cash. Reasons: • Competition. • Sell receivables because money is tight. • Billing / collection are time-consuming and costly. Transfer accomplished by: • Secured borrowing (Holder retains ownership of receivables in a secured borrowing transaction) • Sale of receivables (Holder transfers ownership of receivables in a sale)

  7. Secured Borrowing Sale With Recourse Without Recourse Accounting for Transfers of Receivables Transfers • Seller guarantees payment if debtor does not pay • Factored receivables are written off, loss on sale recognized and includes estimate of a recourse liability of future payment firm will have to make for uncollectible receivables sold • Seller has no future obligation • Write-off factored receivables (and recognize any gain / loss)

  8. Secured Borrowing – the Basics • Overall - Receivables remain on the books of the company borrowing money (i.e. – no sale) (and continue to treat A/R as usual (collections, write-off, etc.) • Also called “pledged” receivables • Transferor: • Records liability • Records a finance charge. • Collects accounts receivable. • Records sales returns and sales discounts. • Absorbs bad debts expense. • Records interest expense on notes payable. • Pays on the note periodically from collections.

  9. Sale of Receivables – the Basics • Factor records the (transferred) accounts as assets in its books. • Transferor: • Transfers ownership of receivables to factor. • Records any amount retained by transferee as “due from factor.” • This is an amount held back to allow customer adjustments for sales returns and allowances • Records loss on sale of receivables. • Records any component liability IF with recourse • i.e., any estimated future liability that the transferor will need to pay if customers do not pay

  10. Secured Borrowing Example To help overcome a cash shortage, H Software took out a $1,000 loan with T Bank. H Software used $3,000 of A/R as collateral for the loan. T Bank withheld $30 as a finance charge, and forwarded $970 to H Software on July 1. H Software collected the on the accounts on July 31 ($120 were written off), and repaid T Bank on August 2nd with interest of $50. July 1: July 31: August 2:

  11. Secured Borrowing Example To help overcome a cash shortage, H Software took out a $1,000 loan with T Bank. H Software used $3,000 of A/R as collateral for the loan. T Bank withheld $30 as a finance charge, and forwarded $970 to H Software on July 1. H Software collected the on the accounts on July 31 ($120 were written off), and repaid T Bank on August 2nd with interest of $50. July 1: Dr. Cash 970 Dr. Finance charge 30 Cr. Note Payable 1,000 July 31: Dr. Cash 2,880 Dr. Allowance for doubtful accounts 120 Cr. A/R 3,000 August 2: Dr. Interest Expense 50 Dr. Note Payable 1,000 Cr. Cash 1,050

  12. Sales of Receivables Factorsare finance companies or banks that buy receivables from businesses for a fee.

  13. Sales of Receivables Sale Without Recourse • Purchaser assumes risk of collection • Transfer is outright sale of receivable • Seller records loss on sale • Seller use Due from Factor (receivable) account to cover discounts, returns, and allowances Sale With Recourse • Seller guarantees payment to purchaser • Financial components approach used to record transfer

  14. Sales of Receivables Illustration:Crest Textiles, Inc. factors $500,000 of accounts receivable with Commercial Factors, Inc., on a without recourse basis. Commercial Factors assesses a finance charge of 3 percent of the amount of accounts receivable and retains an amount equal to 5 percent of the accounts receivable (for probable adjustments). Journal entry by Crest Textiles: Journal entry by Commercial Factors:

  15. Sales of Receivables Illustration:Crest Textiles, Inc. factors $500,000 of accounts receivable with Commercial Factors, Inc., on a without recourse basis. Commercial Factors assesses a finance charge of 3 percent of the amount of accounts receivable and retains an amount equal to 5 percent of the accounts receivable (for probable adjustments). Journal entry by Crest Textiles: Cash $ 460,000 Due from Factor 25,000 Loss on Sale of Receivables 15,000 Accounts Receivable $500,000 Journal entry by Commercial Factors: Accounts Receivable $500,000 Due to Crest Textiles $25,000 Financing Revenues 15,000 Cash 460,000

  16. Sales of Receivables Illustration: Assume Crest Textiles sold the receivables on a with recourse basis. Crest Textiles determines that this recourse obligation has a fair value of $6,000. Journal entry by Crest Textiles: Journal entry by Commercial Factors:

  17. Sales of Receivables Illustration: Assume Crest Textiles sold the receivables on a with recourse basis. Crest Textiles determines that this recourse obligation has a fair value of $6,000. Journal entry by Crest Textiles: (recourse Liab. increases loss) Cash $ 460,000 Due from Factor 25,000 Loss on Sale of Receivables 21,000 Accounts Receivable $500,000 Recourse Liability 6,000 Journal entry by Commercial Factors: (no change) Accounts Receivable $500,000 Due to Crest Textiles $25,000 Financing Revenues 15,000 Cash 460,000

  18. Presentation & Disclosure of Receivables Rules: • Segregate different types of receivables if material • Offset valuation accounts against gross balance • Ensure all current receivables will really be converted to cash within a year or operating cycle, whichever is longer • Disclose any loss contingencies on the receivables • Disclose amounts pledged as collateral • Disclose significant concentrations of credit risk

  19. Analysis of Receivables What is purpose of analysis? Ratios used AR Turnover = Net Sales/Average net Trade AR Days AR or Average Collection Period = 365 days/AR turnover Exercise 20

  20. Recognition of Notes Receivable • Supported by a formal promissory note (negotiable instrument) • Maker signs in favor of a Payee • Interest-bearing (has a stated rate of interest) OR • Zero-interest-bearing (interest included in face amount) Generally originate from: • Customers who need to extend payment period of an outstanding receivable • High-risk or new customers • Loans to employees and subsidiaries • Sales of property, plant, and equipment • Lending transactions (the majority of notes)

  21. Recognition of Notes Receivable Short-Term Long-Term Record at Face Value, less allowance Record at Present Value of cash expected to be collected Note Issued at Interest Rates Stated rate = Market rate Stated rate > Market rate Stated rate < Market rate Face Value Premium Discount

  22. Notes Issued at Face ValueStated Rate = Market Rate On December 31, 2007, Nemo, Inc. finished consultation services and accepted in exchange a promissory note with a face value of $600,000, a due date of December 31, 2010, and a stated rate of 6%, with interest receivable at the end of each year. The note is considered to have a market rate of interest of 6%. How much should the Note Receivable be recorded for? What is the fair value of the transaction? • PV of cash interest payments • PV of principle payment

  23. Notes Issued at Face ValueStated Rate = Market Rate On December 31, 2007, Nemo, Inc. finished consultation services and accepted in exchange a promissory note with a face value of $600,000, a due date of December 31, 2010, and a stated rate of 6%, with interest receivable at the end of each year. The note is considered to have a market rate of interest of 6%. How much should the Note Receivable be recorded for? i = 6% $600,000 Principal $36,000 36,000 36,000 Interest 0 1 2 3 4 n = 3 • What is the fair value of the transaction? • PV of cash interest payments 3 n 6% I/Y 36,000 pmt; cpt PV_______ • PV of principle payment

  24. Notes Issued at Face ValueStated Rate = Market Rate On December 31, 2007, Nemo, Inc. finished consultation services and accepted in exchange a promissory note with a face value of $600,000, a due date of December 31, 2010, and a stated rate of 6%, with interest receivable at the end of each year. The note is considered to have a market rate of interest of 6%. How much should the Note Receivable be recorded for? i = 6% $600,000 Principal $36,000 36,000 36,000 Interest 0 1 2 3 4 n = 3 • What is the fair value of the transaction? • PV of cash interest payments 3 n 6% I/Y 36,000 pmt; cpt PV $ 96,228,43 • PV of principle payment 3 n 6% I/Y 600,000 FV; cpt PV $503,771.57

  25. Notes Receivable:Stated Rate = Market Rate

  26. Notes Issued at Face ValueStated Rate = Market Rate Summary • Present value of interest $ 96,228,43 • Present value of principal $503,771.57 • Note current market value $600,000.00 Notes receivable 600,000 Consulting Revenue 600,000 Cash 36,000 Interest revenue 36,000

  27. Notes Issued at Face ValueStated Rate < Market Rate On December 31, 2007, Nemo, Inc. finished consultation services and accepted in exchange a promissory note with a face value of $600,000, a due date of December 31, 2010, and a stated rate of 3%, with interest receivable at the end of each year. The note is considered to have a market rate of interest of 6%. How much should the Note Receivable be recorded for? i = 3% $600,000 Principal $18,000 18,000 18,000 Interest 0 1 2 3 4 n = 3 • What is the fair value of the transaction? • PV of cash interest payments 3 n 6% I/Y 18,000 pmt; cpt PV _________ • PV of principle payment 3 n 6% I/Y 600,000 FV; cpt PV $503,771.57

  28. Notes Issued at Face ValueStated Rate < Market Rate On December 31, 2007, Nemo, Inc. finished consultation services and accepted in exchange a promissory note with a face value of $600,000, a due date of December 31, 2010, and a stated rate of 3%, with interest receivable at the end of each year. The note is considered to have a market rate of interest of 6%. How much should the Note Receivable be recorded for? i = 3% $600,000 Principal $18,000 18,000 18,000 Interest 0 1 2 3 4 n = 3 • What is the fair value of the transaction? • PV of cash interest payments 3 n 6% I/Y 18,000 pmt; cpt PV $ 48,114.22 • PV of principle payment 3 n 6% I/Y 600,000 FV; cpt PV $503,771.57

  29. Notes Receivable:Stated Rate < Market Rate On December 31, 2007, Nemo, Inc. finished consultation services and accepted in exchange a promissory note with a face value of $600,000, a due date of December 31, 2010, and a stated rate of 3%, with interest receivable at the end of each year. The note is considered to have a market rate of interest of 6%. Is this a discount or a premium? How much should the Note Receivable be recorded for?

  30. Notes Receivable:Stated Rate < Market Rate Fair value of transaction: Interest: $ 48,114.22 Principle:` $503,771.57 $551,885.79 Journal entry at 12/31/07: Note Receivable $600,0000 Discount on Note Rec. $48,114.21 Consulting Revenue 551,885.79

  31. N/R: Stated Rate < Market RateEffective Interest Amortization

  32. N/R: Stated Rate < Market RateEffective Interest Amortization

  33. Notes Receivable:Stated Rate < Market Rate Journal Entries:

  34. Notes Receivable:Stated Rate < Market Rate Journal Entries: Cash $18,000 Discount on Note Receivable $15,113 Interest Revenue $ 33,113 Cash $18,000 Discount on Note Receivable $16,020 Interest Revenue $ 34,020 Cash $18,000 Discount on Note Receivable $16,981 Interest Revenue $ 34,981

  35. Notes Issued at Face ValueStated Rate > Market Rate On December 31, 2007, Nemo, Inc. finished consultation services and accepted in exchange a promissory note with a face value of $600,000, a due date of December 31, 2010, and a stated rate of 9%, with interest receivable at the end of each year. The note is considered to have a market rate of interest of 6%. How much should the Note Receivable be recorded for? i =9% $600,000 Principal $54,000 54,000 54,000 Interest 0 1 2 3 4 n = 3 • What is the fair value of the transaction? • PV of cash interest payments 3 n 6% I/Y 54,000 pmt; cpt PV $ • PV of principle payment 3 n 6% I/Y 600,000 FV; cpt PV $503,771.57

  36. Notes Issued at Face ValueStated Rate > Market Rate On December 31, 2007, Nemo, Inc. finished consultation services and accepted in exchange a promissory note with a face value of $600,000, a due date of December 31, 2010, and a stated rate of 9%, with interest receivable at the end of each year. The note is considered to have a market rate of interest of 6%. How much should the Note Receivable be recorded for? i =9% $600,000 Principal $54,000 54,000 54,000 Interest 0 1 2 3 4 n = 3 • What is the fair value of the transaction? • PV of cash interest payments 3 n 6% I/Y 54,000 pmt; cpt PV $144,342.65 • PV of principle payment 3 n 6% I/Y 600,000 FV; cpt PV $503,771.57

  37. Notes Receivable:Stated Rate > Market Rate On December 31, 2007, Nemo, Inc. finished consultation services and accepted in exchange a promissory note with a face value of $600,000, a due date of December 31, 2010, and a stated rate of 9%, with interest receivable at the end of each year. The note is considered to have a market rate of interest of 6%. Is this a discount or a premium? How much should the Note Receivable be recorded for?

  38. Notes Receivable:Stated Rate > Market Rate Fair value of transaction: Interest: $144,342.65 Principle:` $503,771.57 $648,114.22 Journal entry at 12/31/07: Note Receivable $600,0000 Premium on Note Rec $48,114.21 Consulting Revenue 648,114.21

  39. N/R: Stated Rate > Market RateEffective Interest Amortization

  40. N/R: Stated Rate > Market RateEffective Interest Amortization

  41. Notes Receivable:Stated Rate > Market Rate Journal Entries

  42. Notes Receivable:Stated Rate < Market Rate Journal Entries: Cash $54,000 Premium on Note Receivable $15,113 Interest Revenue $ 38,887 Cash $54,000 Premium on Note Receivable $16,020 Interest Revenue $ 37,980 Cash $54,000 Premium on Note Receivable $16,981 Interest Revenue $ 37,019

  43. Non-interest Bearing Notes This is a special case of a discount. Steps: 1. Determine issue price on notes receivable at implicit rate of interest 2. The discount is amortized to interest revenue by the effective interest method

  44. Notes Receivable – Non-Interest Bearing On 1/1/06 Mickey Co. purchases a machine from Mouse. Co. with a list price of $10,000. Mickey signs a non-interest bearing note promising to pay Mouse Co. $10,000 on December 31, 2007. The fair value of the machine on 1/1/06 is $7,972. Implicitly, how much interest revenue will Mouse receive over the 2 year period of the note? What is the implicit interest rate on this note receivable? • It is the rate that equates the fair value of the machine today $7972 to the $10,000 that will be received in two years $7,972 PV, 2 N, 10,000 FV CPT I/Y = ___________%

  45. Notes Receivable – Non-Interest Bearing On 1/1/06 Mickey Co. purchases a machine from Mouse. Co. with a list price of $10,000. Mickey signs a non-interest bearing note promising to pay Mouse Co. $10,000 on December 31, 2007. The fair value of the machine on 1/1/06 is $7,972. Implicitly, how much interest revenue will Mouse receive over the 2 year period of the note? What is the implicit interest rate on this note receivable? • It is the rate that equates the fair value of the machine today $7972 to the $10,000 that will be received in two years $7,972 PV, 2 N, 10,000 FV CPT I/Y = 11.99995 or 12%

  46. Notes Receivable – Non-Interest Bearing On 1/1/06 Mickey Co. purchases a machine from Mouse. Co. with a list price of $10,000. Mickey signs a non-interest bearing note promising to pay Mouse Co. $10,000 on December 31, 2007. The fair value of the machine on 1/1/06 is $7,972. Implicitly, how much interest revenue will Mouse receive over the 2 year period of the note? What is the implicit interest rate on this note receivable? • It is the rate that equates $7972 at t=0 to $10,000 at t=2 • 7,972F = 10,000; or F=10,000/7,972 = 1.2544 • In table 6.1, Future Value of 1 (p. 303), the rate is 12% (F=1.2544, n = 2)-

  47. Note Rec.: Non-Interest Bearing Effective Interest Amortization

  48. Note Rec.: Non-Interest Bearing Effective Interest Amortization

  49. Notes Receivable – Non-Interest Bearing January 1, 2006: December 31, 2006: December 31, 2007:

  50. Notes Receivable – Non-Interest Bearing January 1, 2006: Notes Receivable $7,972 Sales $7,972 December 31, 2006: Notes Receivable $956.64 Interest Income $956.64 December 31, 2007: Notes Receivable $1071.44 Interest Income $1071.44 Cash $10,000 Notes Receivable $10,000

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