©The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin Chapter Eight Accounting for Accruals – Advanced Topics: Receivables and Payables

©The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin

Chapter Eight

Accounting for Accruals – Advanced Topics:Receivables and Payables

Credit Terms and Bad Debts

Some customers may be unwilling or unable to pay their accounts receivable. Because we do not want to overstate assets, we must show accounts

receivable at its net realizable value on the balance sheet. The net realizable value is the

gross amount of the receivables less some estimated allowance for doubtful accounts.

Let’s look at the revenue and doubtful account Let’s look at the revenue and doubtful account process.process.

Revenue Recognition

Event 1 Revenue Recognition

During 2006, Matrix, Inc. a service During 2006, Matrix, Inc. a service company, renders services on account company, renders services on account

for customers in the amount of for customers in the amount of $375,000.$375,000.

Event No. Assets = Liab. + Equity Rev. – Exp. = Net Inc. Cash Flow

1 375,000 = NA + 375,000 375,000 – NA = 375,000 NA

Collection for Receivables

Event 2 Collection of Receivables

During the year, Matrix, Inc. collects During the year, Matrix, Inc. collects cash of $325,000 on its accounts cash of $325,000 on its accounts

receivable.receivable.Event No. Assets = Liab. + Equity Rev. – Exp. = Net Inc. Cash Flow

2 Cash + Accts. Rec.325,000 (325,000) = NA + NA NA – NA = NA 325,000 OA

Recognizing Bad Debts Expense

Event 3 Recognizing Bad Debts Expense

Based upon past experience, Matrix, Based upon past experience, Matrix, Inc. estimates that $200 of its current Inc. estimates that $200 of its current

accounts receivable balance will accounts receivable balance will eventually prove to be uncollectible.eventually prove to be uncollectible.


3 (200) = NA + (200) NA – 200 = (200) NA

Total accounts receivable 375,000$ Cash collected on accounts receivable 325,000 Balance in accounts receivable 50,000$

Accounts receivable 50,000$ Less: Allowance for Doubtful Accounts 200 Net Realizable Value of Receivables 49,800$

Real-World Reporting Practices

General Ledger AccountsCash

Accounts Receivable

Allowance for Doubtful Accounts

Retained Earnings

Service Revenue

Bad Debts Expense

325,000

325,000375,00050,000

200 200 200

374,800

375,000 375,000

0 Bal.

Bal. 0

Financial Statements

Service Revenue 375,000$ Bad Debts Expense 200 Net income 374,800$

Income Statement

Assets Cash 325,000$ Accounts receivable 50,000$ Less: Allowance (200) Net Realizable Value 49,800 Total Assets 374,800$

Stockholders' Equity Retained Earnings 374,800$

Balance Sheet

Operating Activities Inflow from Customers 325,000$ Investing Activities - Financing Activities - Net Change in Cash 325,000 Beginning Cash Balance -

Ending Cash Balance 325,000$

Statement of Cash Flows

Subsequent PeriodEvent 1 Write-Off of an Uncollectible

Account Receivable

During 2007, Matrix, Inc. determines During 2007, Matrix, Inc. determines that an account receivable of $75 will that an account receivable of $75 will

not be collected. The company elects to not be collected. The company elects to write-off the account.write-off the account.


1 Accts. Rec. + Allow.(75) (70) = NA + NA NA – NA = NA NA

Before Write-Off

After Write-Off

Accounts Receivable 50,000$ 49,925$ Allowance for Doubtful Accounts (200) (125) Net Realizable Value 49,800$ 49,800$

Notes ReceivableEvent 2 Investment in Note Receivable

During 2007, Matrix, Inc. decides to invest During 2007, Matrix, Inc. decides to invest some idle cash. On November 1, 2007, the some idle cash. On November 1, 2007, the

company loans $50,000 to another company. company loans $50,000 to another company. The note is due in one year and bears interest The note is due in one year and bears interest

at an annual rate of 9%. at an annual rate of 9%. Event No. Assets = Liab. + Equity Rev. – Exp. = Net Inc. Cash Flow

2 Cash + Notes Rec.(50,000) 50,000 = NA + NA NA – NA = NA (50,000) IA

Revenue RecognitionEvent 3 Revenue Recognition

During 2007, Matrix, Inc. renders services on During 2007, Matrix, Inc. renders services on account in the amount of $65,000. account in the amount of $65,000.


3 65,000 = NA + 65,000 65,000 – NA = 65,000 NA

Collections on Account Receivable

Event 4 Collection on Accounts Receivable

During 2007, Matrix, Inc. collects $80,000 on During 2007, Matrix, Inc. collects $80,000 on its accounts receivable. its accounts receivable.


4 Cash + Accts. Rec.80,000 (80,000) = NA + NA NA – NA = NA 80,000 OA

Reinstatement of AccountEvent 5 Reinstatement of Account Written-Off

Of the $75 of accounts receivable previously Of the $75 of accounts receivable previously written-off, it turns out that Matrix will be able written-off, it turns out that Matrix will be able

to collect the full $75 amount owed. to collect the full $75 amount owed.


5 Acct. Rec. + Allow.75 75 = NA + NA NA – NA = NA NA

Recovery on Account


6 Cash + Acct. Rec.75 (75) = NA + NA NA – NA = NA 75 OA

Event 6 Collection of Recovered Amount

Of the $75 of accounts receivable previously Of the $75 of accounts receivable previously written-off, it turns out that Matrix will be able written-off, it turns out that Matrix will be able

to collect the full $75 amount owed. to collect the full $75 amount owed.

Year-End Adjusting EntriesEvent 7 Adjustment for Bad Debts Expense

At the end of 2007, Matrix estimates that its At the end of 2007, Matrix estimates that its bad debts will amount to 1% of its gross sales. bad debts will amount to 1% of its gross sales.

Sales for 2007 65,000$ Uncollectible percent 1%Uncollectible amount 650$


7 Acct. Rec. + Allow.NA 650 = NA + (650) NA – 650 = (650) NA

Interest RevenueEvent 8 Recognition of Interest Revenue

At the end of 2007, Matrix must accrue At the end of 2007, Matrix must accrue interest on its note receivable. interest on its note receivable.

$50,000 $50,000 × 9% × 2/12 = $750 interest revenue× 9% × 2/12 = $750 interest revenue$50,000 $50,000 × 9% × 2/12 = $750 interest revenue× 9% × 2/12 = $750 interest revenue


8 750 = NA + 750 750 – NA = 750 NA

General Ledger T-Accounts

Cash

Accounts Receivable

Allowance for Doubtful Accounts

Bal. 325,000

80,000Bal. 49,92565,000

Bal. 125

80,00075

75

75

75

Notes Receivable50,000

50,000

Interest Receivable750

650

Service Revenue

Bad Debts Expense650 650

65,000 65,000

0 Bal.

Bal. 0

Interest Revenue750

Retained Earnings374,800 Bal.

65,100

Bal. 355,075

34,925

850

750

Bal. 0

439,900 Bal.


Service Revenue 65,000$ Bad Debts Expense 650 Net Operating Income 64,350 Interest Revenue 750 Net Income 65,100$

Income Statement

Assets Cash 355,075$ Accounts receivable 34,925$ Less: Allowance (850) Net Realizable Value 34,075 Notes Receivable 50,000 Interest Receivable 750 Total Assets 439,900$

Stockholders' Equity Retained Earnings 439,900$

Balance Sheet

Operating Activities Inflow from Customers 80,075$ Investing Activities Loan to other company (50,000) Financing Activities - Net Change in Cash 30,075 Beginning Cash Balance 325,000



Direct Write-Off MethodEvent 1 Recognition of Revenue on

Account

During 2008, Matrix, Inc. provides During 2008, Matrix, Inc. provides services to clients on account in the services to clients on account in the

amount of $400,000.amount of $400,000.Event No. Assets = Liab. + Equity Rev. – Exp. = Net Inc. Cash Flow

1 Accts. Rec.400,000 = NA + 400,000 400,000 – NA = 400,000 NA

Account Title Debit CreditAccounts Receivable 400,000 Service Revenue 400,000

Direct Write-Off MethodEvent 2 Recognition of Bad Debt

During 2008, Matrix, Inc. determines that a During 2008, Matrix, Inc. determines that a customer who owes us $500 is unable to customer who owes us $500 is unable to

pay the amount due.pay the amount due.


1 Accts. Rec.(500) = NA + (500) NA – 500 = (500) NA

Account Title Debit CreditBad Debts Expense 500 Accounts Receivable 500

Credit Card Sales

Rather than maintaining a credit granting department, many companies find it cost

beneficial to accept credit cards. The credit card company deducts a fee, usually between

2% and 8%, from the gross amount of the sales, and pays the merchant the net balance

(gross sales less credit card fee).

Credit Card Sales


1 9,800 = NA + 9,800 10,000 – 200 = 9,800 NA

Event 1 Recording a Credit Card Sale

Matrix, Inc. accepts a credit card in payment for servicesof $10,000. The credit card company charges a fee of 2%

of the gross sale.

Account Title Debit CreditAccounts Receivable 9,800 Credit Card Expense 200 Service Revenue 10,000

Credit Card Sales


2 Cash + Acct. Rec.9,800 (9,800) = NA + NA NA – NA = NA 9,800 OA

Event 2 Collection of a Credit Card Receivable

Matrix, Inc. collects the full amount due from thecredit card company.

Account Title Debit CreditCash 9,800 Accounts Receivable 9,800

Warranty ObligationsGenerally within the warranty period,

the seller promises to replace or repair defective products without charge to

the customer.Event 1 Sale of Merchandise

Matrix, Inc. sells $100,000 of merchandise for cash. The merchandise has a cost to Matrix of

$60,000.Event No. = Liab. + Equity Rev. – CofGS = Net Inc. Cash Flow

Cash + Inv.1a 100,000 NA = NA + 100,000 100,000 – NA = 100,000 100,000 OA1b NA (60,000) NA (60,000) NA – 60,000 (60,000) NA

Assets

Warranty ObligationsEvent 2 Recognition of Warranty Expense

Matrix, Inc. estimates that warranty expense associated with the current sale will be $5,000.


2 NA = 5,000 + (5,000) NA – 5,000 = (5,000) NA

Warranty ObligationsEvent 3 Settlement of Warranty Obligation

Matrix, Inc. pays $1,000 cash to repair defective merchandise returned by several customers.


2 (1,000) = (1,000) + NA NA – NA = NA (1,000) OA

General Ledger T-Accounts

Cash

Inventory

Warranties Payable

Bal. 355,075

60,000160,000

5,000

100,000

1,000

1,000Service Revenue

Cost of Goods Sold60,000 60,000

100,000 100,000

0 Bal.

Bal. 0

Warranty Expense5,000

Retained Earnings439,900 Bal.

35,000

Bal. 454,075

Bal. 100,000

5,000

Bal. 0

474,900 Bal.

4,000 Bal.

Common Stock75,175


Service Revenue 100,000$ Cost of Goods Sold (60,000) Gross Margin 40,000 Warranty Expense (5,000) Net Income 35,000$

Income StatementAssets Cash 454,075$ Inventory 100,000 Total Assets 554,075$

Liabilities Warranties Payable 4,000 Stockholders' Equity Common Stock 75,175 Retained Earnings 474,900 Total Liab. & Stockholders' Equity 554,075$

Balance Sheet

Operating Activities Inflow from Customers 100,000$ Outflows for Warranty (1,000) Net Inflows From Oper. 99,000 Investing Activities - Financing Activities - Beginning Cash Balance 355,075



Accounts Receivable Turnover

Accounts ReceivableAccounts ReceivableTurnover RatioTurnover Ratio

SalesSalesAccounts Accounts

ReceivableReceivable

==

The longer it takes to collect accounts The longer it takes to collect accounts receivable, the greater the opportunity receivable, the greater the opportunity

cost of lost income.cost of lost income.

Days to Collect Receivable

This ratio often helps simplify the This ratio often helps simplify the issues surrounding the collections of issues surrounding the collections of

accounts receivable.accounts receivable.

Average Number of Days to Collect Accounts Receivable

= 365Accounts Receivable Turnover

Ratio

Operating Cycle

The operating cycle is the average time it takes a business to convert inventory to

accounts receivable plus the time it takes to convert accounts receivable back into cash.

End of Chapter Eight

Documents

©The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin Chapter Eight Accounting for Accruals – Advanced Topics: Receivables and Payables