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ch06 fundamental of financial accounting by edmonds (4th edition)

ch06 fundamental of financial accounting by edmonds (4th edition)

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Fundamental Financial Accounting Concepts

Fourth Edition
by Edmonds, McNair, Milam, Olds
PowerPoint® presentation by J. Lawrence Bergin

7- 2

Chapter 7 Accounting for Accruals: Advanced TopicsReceivables and Payables

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

7- 3

Advanced topics include:
s

s

s

Accounting for bad debts Accounting for interest-bearing notes and noninterest bearing (discounted) notes Warranties

Want to learn some accounting?

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

7- 4

Accounts and Notes Receivable
s

s

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.
© The McGraw-Hill Companies, Inc., 2003

McGraw-Hill/Irwin

7- 5

Value of Receivables
s

s

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 collected is called the net realizable value (NRV).
© The McGraw-Hill Companies, Inc., 2003

McGraw-Hill/Irwin

7- 6

Allowance Method vs. Direct Write-Off Method
s

s

GAAP requires that A/R be reported at NRV. (A/R minus Allowance) This is done using a valuation allowance: An ALLOWANCE METHOD.
Ë Ë

% of Sales (or “Income Statement”) approach. Aging (or “Balance Sheet”) approach.

s

With the ALLOWANCE METHOD, an estimate of 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.
© The McGraw-Hill Companies, Inc., 2003

McGraw-Hill/Irwin

7- 7

Allowance Method vs. Direct Write-Off Method (continued)
s

s

s

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.
© The McGraw-Hill Companies, Inc., 2003

McGraw-Hill/Irwin

7- 8

Transaction Analysis:
s

Assume the following selected events occurred at Cell-It. For each event:
Ë

Ë

Ë

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.
© The McGraw-Hill Companies, Inc., 2003

McGraw-Hill/Irwin

7- 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.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003

7- 10

Record the five transactions in this horizontal statements model.
Balance Sheet Assets = Liab.+ Stk. Equity Cash+ A/Rec .- Allow. = A/P + C.Stk.+ R.E. 1 2 3 4 5A 5B
Bal.

Inc. Statement

Cashflow

Rev. - Exp. = N. I. OA,IA,FA

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

7- 11

1.

Provided services to customers for $10,000 on account.
Inc. Statement Cashflow

Balance Sheet Assets = Liab.+ Stk. Equity Cash+ A/Rec .- Allow. = A/P + C.Stk.+ R.E. 1 2 3 4 5A 5B
Bal.

Rev. - Exp. = N. I. OA,IA,FA

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

7- 12

1.

Provided services to customers for $10,000 on account.
Inc. Statement Cashflow

Balance Sheet Assets = Liab.+ Stk. Equity Cash+ A/Rec .- Allow. = A/P + C.Stk.+ R.E. 1 2 3 4 5A 5B
Bal.

Rev. - Exp. = N. I. OA,IA,FA 10000 n.a.

10000

10000 10000

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

7- 13

2. Collected $7,000 from account receivable.
Balance Sheet Assets = Liab.+ Stk. Equity Cash+ A/Rec .- Allow. = A/P + C.Stk.+ R.E. 1 2 3 4 5A 5B
Bal.

Inc. Statement

Cashflow

Rev. - Exp. = N. I. OA,IA,FA 10000 n.a.

10000

10000 10000

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

7- 14

2. Collected $7,000 from account receivable.
Balance Sheet Assets = Liab.+ Stk. Equity Cash+ A/Rec .- Allow. = A/P + C.Stk.+ R.E. 1 2 7000 3 4 5A 5B
Bal.

Inc. Statement

Cashflow

Rev. - Exp. = N. I. OA,IA,FA 10000 n.a. 7000 OA

10000 (7000)

10000 10000

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

7- 15

3. At year-end it was estimated that 2% of the year’s credit sales will not be collected.
Balance Sheet Assets = Liab.+ Stk. Equity Cash+ A/Rec .- Allow. = A/P + C.Stk.+ R.E. 1 2 7000 3 4 5A 5B
Bal.

Inc. Statement

Cashflow

Rev. - Exp. = N. I. OA,IA,FA 10000 200 (200) n.a. 7000 OA n.a.

10000 (7000) 200

10000 10000 (200)

2% x $10,000 = $200

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

7- 16

Allowance for Doubtful Accounts is 3. At year-end it was estimated that 2% of a CONTRA- ASSET account. This the year’s credit sales will notINCREASING by account balance is be collected.
Assets = Liab.+ Stk. Equity Cash+ A/Rec .- Allow. = A/P + C.Stk.+ R.E. 1 2 7000 3 4 5A 5B
Bal.

$200 causing TOTAL assets to Balance Sheet Inc. Statement Cashflow decrease.
Rev. - Exp. = N. I. OA,IA,FA 10000 200 (200) n.a. 7000 OA 200 (200) n.a. 10000 10000

10000 (7000)

2% x $10,000 = $200

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

7- 17

4. Jane Doe’s $50 account was written-off as uncollectible.

Balance Sheet Assets = Liab.+ Stk. Equity Cash+ A/Rec .- Allow. = A/P + C.Stk.+ R.E. 1 2 7000 3 4 5A 5B
Bal.

Inc. Statement

Cashflow

Rev. - Exp. = N. I. OA,IA,FA 10000 200 (200) n.a. 7000 OA n.a.

10000 (7000) 200

10000 10000 (200)

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

7- 18

4. Jane Doe’s $50 account was written-off as uncollectible.

Balance Sheet Assets = Liab.+ Stk. Equity Cash+ A/Rec .- Allow. = A/P + C.Stk.+ R.E. 1 2 7000 3 4 5A 5B
Bal.

Inc. Statement

Cashflow

Rev. - Exp. = N. I. OA,IA,FA 10000 n.a. 7000 OA n.a.

10000 (7000) (50) 200 (50)

10000 10000 (200)

200 (200) NO EXPENSE!

Note: This is NOT the Direct Write-off method. Rather, it is a write-off under the ALLOWANCE Method.
© The McGraw-Hill Companies, Inc., 2003

McGraw-Hill/Irwin

7- 19

Effect of Transaction 4 on Acct. Rec. Net Realizable Value

Before Event 4 A/R $ Allow. N.R.V. $

After Event 4 A/R $ Allow. N.R.V. $
Acme Collection Agency

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

7- 20

Effect of Transaction 4 on Acct. Rec. Net Realizable Value

Before Event 4 A/R $3,000 Allow. (200) N.R.V. $2,800
The check is in the mail.

After Event 4

Acme Collection Agency

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

7- 21

Effect of Transaction 4 on Acct. Rec. Net Realizable Value

Before Event 4 A/R $3,000 Allow. (200) N.R.V. $2,800

After Event 4 A/R $2,950 (150) Allow. N.R.V. $2,800

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

7- 22

Effect of Transaction 4 on Acct. Rec. Net Realizable Value

Before Event 4 A/R $3,000 Allow. (200) N.R.V. $2,800

After Event 4 A/R $2,950 Allow. (150) N.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.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003

7- 23

Before recording Transaction #5: What happens when an account that has been written off later pays off his/her account?
x

y

Reinstate the account by recording an entry that undoes (reverses) the write-off: Ë increase (debit) Accounts Receivable Ë increase (credit) Allowance for Doubtful Accounts (a contra-asset) Record the entry to show the cash collection and A/Rec. reduction: Ë increase (debit) Cash Ë decrease (credit) Accounts Receivable
© The McGraw-Hill Companies, Inc., 2003

McGraw-Hill/Irwin

7- 24

5. $50 cash was unexpectedly received from Jane Doe. (5A=Reinstate, 5B=Collect)
Balance Sheet Assets = Liab.+ Stk. Equity Cash+ A/Rec .- Allow. = A/P + C.Stk.+ R.E. 1 2 7000 3 4 5A 5B
Bal.

Inc. Statement

Cashflow

Rev. - Exp. = N. I. OA,IA,FA 10000 n.a. 7000 OA n.a.

10000 (7000) (50) 50 200 (50) 50

10000 10000 (200)

200 (200) NO EXPENSE!

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

7- 25

5. $50 cash was unexpectedly received from Jane Doe. (5A=Reinstate, 5B=Collect)
Balance Sheet Assets = Liab.+ Stk. Equity Cash+ A/Rec .- Allow. = A/P + C.Stk.+ R.E. 1 2 7000 3 4 5A 5B
Bal.

Inc. Statement

Cashflow

Rev. - Exp. = N. I. OA,IA,FA 10000 n.a. 7000 OA n.a.

10000 (7000) (50) 50 (50) 200 (50) 50

10000 10000 (200)

200 (200) NO EXPENSE!

OA

50

50

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

7- 26

Calculate all ending balances.
Balance Sheet Assets = Liab.+ Stk. Equity Cash+ A/Rec .- Allow. = A/P + C.Stk.+ R.E. 1 2 7000 3 4 5A 5B
Bal. 7050

Inc. Statement

Cashflow

Rev. - Exp. = N. I. OA,IA,FA 10000 n.a. 7000 OA n.a.

10000 (7000) (50) 50 (50) 2950 200 (50) 50

10000 10000 (200)

200 (200) NO EXPENSE!

OA

50

50 200 9800 10000 200 9800 7050 bal.

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

7- 27

After completing the horizontal model fill in below.

What’s the result?

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?………………………….
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003

7- 28

Final Account Balances
Remember, the Bad Debt EXPENSE is accrued in the year of sale, NOT when the account is written off!

Balance Sheet Assets = Liab.+ Stk. Equity Cash+ A/Rec .- Allow. = A/P + C.Stk.+ R.E. 1 2 7000 3 4 5A 5B
Bal. 7050

Inc. Statement

Cashflow

Rev. - Exp. = N. I. OA,IA,FA 10000 n.a. 7000 OA n.a.

10000 (7000) (50) 50 (50) 2950 200 (50) 50

10000 10000 (200)

200 (200) NO EXPENSE!

OA

50

50 200 9800 10000 200 9800 7050 bal.

MATCHING PRINCIPLE
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003

7- 29

After completing the horizontal model fill in below.

What’s the result?

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?………………………….
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003

$

200

7- 30

Final Account Balances
Net Realizable Value (NRV) = Acct.Rec. - Allowance
Balance Sheet Assets = Liab.+ Stk. Equity Cash+ A/Rec .- Allow. = A/P + C.Stk.+ R.E. 1 2 7000 3 4 5A 5B
Bal. 7050

Inc. Statement

Cashflow

Rev. - Exp. = N. I. OA,IA,FA 10000 n.a. 7000 OA n.a.

10000 (7000) (50) 50 (50) 2950 200 (50) 50

10000 10000 (200)

200 (200) NO EXPENSE!

OA

50

50 200 9800 10000 200 9800 7050 bal.

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

7- 31

After completing the horizontal model fill in below.

What’s the result?

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?………………………….
McGraw-Hill/Irwin

$

200

$ 2,750

$ 2,750

© The McGraw-Hill Companies, Inc., 2003

7- 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.

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

7- 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.

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

7- 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.
(1) 10,000

Allow. for D.A.

Service Revenue Bad Debt Exp.
10,000 (1)

Retain. Earn.

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

7- 35

Transaction Posted to T-accounts
2. Collected $7,000 of the Accounts Receivables. Cash Acct. Rec.
(1) 10,000

Allow. for D.A.

Service Revenue Bad Debt Exp.
10,000 (1)

Retain. Earn.

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

7- 36

Transaction Posted to T-accounts
2. Collected $7,000 of the Accounts Receivables. Cash Acct. Rec.
(1) 10,000 7,000 (2)

Allow. for D.A.

(2) 7,000

Service Revenue Bad Debt Exp.
10,000 (1)

Retain. Earn.

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

7- 37

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.
(2) 7,000 (1) 10,000 7,000 (2)

Transaction Posted to T-accounts

Service Revenue Bad Debt Exp.
10,000 (1)

Retain. Earn.

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

7- 38

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.
(2) 7,000 (1) 10,000 7,000 (2) 200 (3)

Transaction Posted to T-accounts

Service Revenue Bad Debt Exp.
10,000 (1) (3) 200

Retain. Earn.

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

7- 39

Transaction Posted to T-accounts
4. Jane Doe’s $50 account was written-off as uncollectible. Cash Acct. Rec.
(1) 10,000 7,000 (2)

Allow. for D.A.
200 (3)

(2) 7,000

Service Revenue Bad Debt Exp.
10,000 (1) (3) 200

Retain. Earn.

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

7- 40

Transaction Posted to T-accounts
4. Jane Doe’s $50 account was written-off as uncollectible. Cash Acct. Rec.
(1) 10,000 7,000 (2) 50 (4)

Allow. for D.A.
(4) 50 200 (3)

(2) 7,000

Service Revenue Bad Debt Exp.
10,000 (1) (3) 200

Retain. Earn.

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

7- 41

Effect of Transaction 4 on Acct. Rec. Net Realizable Value

Before Event 4 A/R $3,000 Allow. (200) N.R.V. $2,800

After Event 4 A/R $2,950 Allow. (150) N.R.V. $2,800

Net realizable value of accounts receivable did not change as a result of the write-off.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003

7- 42

Transaction Posted to T-accounts
5a. Jane Doe’s account is reinstated. Cash Acct. Rec.
(1) 10,000 7,000 (2) 50 (4)

Allow. for D.A.
(4) 50 200 (3)

(2) 7,000

Service Revenue Bad Debt Exp.
10,000 (1) (3) 200

Retain. Earn.

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

7- 43

Transaction Posted to T-accounts
5a. Jane Doe’s account is reinstated. Cash Acct. Rec.
(1) 10,000 7,000 (2) 50 (4) 5a 50

Allow. for D.A.
(4) 50 200 (3) 50 (5a)

(2) 7,000

Service Revenue Bad Debt Exp.
10,000 (1) (3) 200

Retain. Earn.

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

7- 44

Transaction Posted to T-accounts
5b. Jane Doe’s account is collected. Cash Acct. Rec.
(1) 10,000 7,000 (2) 50 (4) 5a 50

Allow. for D.A.
(4) 50 200 (3) 50 (5a)

(2) 7,000

Service Revenue Bad Debt Exp.
10,000 (1) (3) 200

Retain. Earn.

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

7- 45

Transaction Posted to T-accounts
5b. Jane Doe’s account is collected. Cash Acct. Rec. Allow. for D.A.
200 (3) 50 (5a)

(2) 7,000 5b 50

(1) 10,000 7,000 (2) (4) 50 50 (4) 50 (5b) 5a 50

Service Revenue Bad Debt Exp.
10,000 (1) (3) 200

Retain. Earn.

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

7- 46

Transaction Posted to T-accounts
Closing entries at the end of Year 1. Cash Acct. Rec. Allow. for D.A.
200 (3) 50 (5a)

(2) 7,000 5b 50

(1) 10,000 7,000 (2) (4) 50 50 (4) 50 (5b) 5a 50

Service Revenue Bad Debt Exp.
10,000 (1) (3) 200

Retain. Earn.

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

7- 47

Transaction Posted to T-accounts
Closing entries at the end of Year 1. Cash Acct. Rec. Allow. for D.A.
200 (3) 50 (5a)

(2) 7,000 5b 50

(1) 10,000 7,000 (2) (4) 50 50 (4) 50 (5b) 5a 50

Service Revenue Bad Debt Exp.
(c) 10,000
McGraw-Hill/Irwin

10,000 (1) (3) 200

Retain. Earn.
(c) 200 10,000 (c)

200 (c)

© The McGraw-Hill Companies, Inc., 2003

7- 48

Transaction Posted to T-accounts
Balances of all accounts after Year 1 closings. Cash Acct. Rec. Allow. for D.A.
200 (3) 50 (5a) 200 bal.

(2) 7,000 5b 50 bal. 7,050

(1) 10,000 7,000 (2) (4) 50 50 (4) 50 (5b) 5a 50 bal 2,950

Service Revenue Bad Debt Exp.
(c) 10,000
McGraw-Hill/Irwin

10,000 (1) (3) 200 0 bal bal. 0

Retain. Earn.
(c) 200 10,000 (c) 9,800 bal.

200 (c)

© The McGraw-Hill Companies, Inc., 2003

7- 49

Summary: Accounting for Bad Debts
s

Allowance method
Ë Ë

Ë

Ë

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.
© The McGraw-Hill Companies, Inc., 2003

McGraw-Hill/Irwin

7- 50

Summary: Accounting for Bad Debts
s

Direct Write-off method
Ë Ë

Ë

Ë

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).

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

7- 51

Direct Write-off Method for Accounting for Bad Debts
s

Direct Write-off method

Entry to write off J. Jones’ $100 account:

Cash+Acct.Rec. = A/P +C. Stk.+Ret.E. Rev.- Exp. = N.I. Cashflow

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

7- 52

Direct Write-off Method for Accounting for Bad Debts
s

Direct Write-off method

Entry to write off J. Jones’ $100 account: Bad Debt Expense Acct. Rec.-Jones 100 100

Cash+Acct.Rec. = A/P +C. Stk.+Ret.E. Rev.- Exp. = N.I. Cashflow

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

7- 53

Direct Write-off Method for Accounting for Bad Debts
s

Direct Write-off method

Entry to write off J. Jones’ $100 account: Bad Debt Expense Acct. Rec.-Jones 100 100

Cash+Acct.Rec. = A/P +C. Stk.+Ret.E. Rev.- Exp. = N.I. Cashflow (100)
McGraw-Hill/Irwin

(100)

+100 (100)

n.a.

© The McGraw-Hill Companies, Inc., 2003

7- 54

Accrued Liabilities: Warranty Costs
s s

Why give warranties? When should expense be recognized?
We will repair or replace this item... Warranty

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

7- 55

Warranties…When to “expense”? General Principle
According to GAAP, the entire estimated warranty expense must be recorded in the period the sale is made, NOT in the period when the actual warranty cost is paid. (Matching principle is being followed.) s A warranty liability is recorded along with the expense. This liability is REDUCED whenever cash is paid to service a product still under warranty.
s

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

7- 56

Transaction Analysis
s

The following selected warranty related events occurred at Cell-It. For each event:
Ë

Ë

Determine how the financial statements are affected and fill in the horizontal model. Record each event directly in LEDGER accounts.

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

7- 57

Transaction Analysis
The following selected events occurred at Cell-It. (Perpetual inventory method is used.) 1. On 1/1/04 sold merchandise for $5,000 cash that had originally cost $4,000. These goods were sold with a two-year warranty. 2. Estimated that $100 of warranty cost will be incurred over the next two years on the goods sold in #1. 3. During 2005 a customer returned for repair, goods still under warranty. The cost of the repair was $30 cash.
s
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003

7- 58

Horizontal Model Transaction Analysis
C=CofGS,W=War.exp. Balance Sheet Assets = Liab.+ Stk. Equity Inc. State. Cashflow Cash+ A/R + M.Inv. = W/P+C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA

1a

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

7- 59

1a. Sold (on 1/1/04 with 2 yr. warranty) for $5,000 cash, 1b. merchandise that originally cost $4,000. (perpetual inventory method is used.)

C=CofGS,W=War.exp. Balance Sheet Assets = Liab.+ Stk. Equity Inc. State. Cashflow Cash+ A/R + M.Inv. = W/P+C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA 5000 5000 5000 5000 5000 OA 1a (4000) (4000) C 4000 (4000) n.a. 1b

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

7- 60

Before recording Transaction #2: Warranties…When to “expense”
According to GAAP, the entire estimated warranty expense must be recorded in the period the sale is made, NOT in the period when the actual warranty cost is paid. (Matching principle is being followed.) s A warranty liability is recorded along with the expense. This liability is REDUCED whenever cash is paid to service a product still under warranty.
s

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

7- 61

2. Estimated that $100 of warranty cost will be incurred over the next two years on the goods sold in #1.

C=CofGS,W=War.exp. Balance Sheet Assets = Liab.+ Stk. Equity Inc. State. Cashflow Cash+ A/R + M.Inv. = W/P+C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA 5000 5000 5000 5000 5000 OA 1a (4000) (4000) C 4000 (4000) n.a. 1b 2 100 (100) w 100 (100) n.a.

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003

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3. During 2005 a customer returned for repair goods still under warranty. The cost of the repair was $30 cash.

C=CofGS,W=War.exp. Balance Sheet Assets = Liab.+ Stk. Equity Inc. State. Cashflow Cash+ A/R + M.Inv. = W/P+C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA 5000 5000 5000 5000 5000 OA 1a (4000) (4000) C 4000 (4000) n.a. 1b 2 100 (100) w 100 (100) n.a. 3 (30) (30) n.a. n.a. n.a. n.a. (30) OA

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SUMMARY QUESTIONS
C=CofGS,W=War.exp. Balance Sheet Assets = Liab.+ Stk. Equity Inc. State. Cashflow Cash+ A/R + M.Inv. = W/P+C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA 5000 5000 5000 5000 5000 OA 1a (4000) (4000) C 4000 (4000) n.a. 1b 2 100 (100) w 100 (100) n.a. 3. (30) (30) n.a. n.a. n.a. n.a. (30) OA

Questions: 1. Warranty Expense for the year: 2. Warranty liability on year-end bal. sheet: 3. Cash outflow related to warranty work:
McGraw-Hill/Irwin

2004 $100

2005

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SUMMARY QUESTIONS
C=CofGS,W=War.exp. Balance Sheet Assets = Liab.+ Stk. Equity Inc. State. Cashflow Cash+ A/R + M.Inv. = W/P+C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA 5000 5000 5000 5000 5000 OA 1a (4000) (4000) C 4000 (4000) n.a. 1b 2 100 (100) w 100 (100) n.a. 3. (30) (30) n.a. n.a. n.a. n.a. (30) OA

Questions: 1. Warranty Expense for the year: 2. Warranty liability on year-end bal. sheet: 3. Cash outflow related to warranty work:
McGraw-Hill/Irwin

2004 $100 $100

2005

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SUMMARY QUESTIONS
C=CofGS,W=War.exp. Balance Sheet Assets = Liab.+ Stk. Equity Inc. State. Cashflow Cash+ A/R + M.Inv. = W/P+C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA 5000 5000 5000 5000 5000 OA 1a (4000) (4000) C 4000 (4000) n.a. 1b 2 100 (100) w 100 (100) n.a. 3. (30) (30) n.a. n.a. n.a. n.a. (30) OA

Questions: 1. Warranty Expense for the year: 2. Warranty liability on year-end bal. sheet: 3. Cash outflow related to warranty work:
McGraw-Hill/Irwin

2004 $100 $100 $ 0

2005

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SUMMARY QUESTIONS
C=CofGS,W=War.exp. Balance Sheet Assets = Liab.+ Stk. Equity Inc. State. Cashflow Cash+ A/R + M.Inv. = W/P+C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA 5000 5000 5000 5000 5000 OA 1a (4000) (4000) C 4000 (4000) n.a. 1b 2 100 (100) w 100 (100) n.a. 3. (30) (30) n.a. n.a. n.a. n.a. (30) OA

Questions: 1. Warranty Expense for the year: 2. Warranty liability on year-end bal. sheet: 3. Cash outflow related to warranty work:
McGraw-Hill/Irwin

2004 $100 $100 $ 0

2005 $ 0

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SUMMARY QUESTIONS
C=CofGS,W=War.exp. Balance Sheet Assets = Liab.+ Stk. Equity Inc. State. Cashflow Cash+ A/R + M.Inv. = W/P+C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA 5000 5000 5000 5000 5000 OA 1a (4000) (4000) C 4000 (4000) n.a. 1b 2 100 (100) w 100 (100) n.a. 3. (30) (30) n.a. n.a. n.a. n.a. (30) OA 70 balance

Questions:

2004

2005

1. Warranty Expense for the year: 2. Warranty liability on year-end bal. sheet: 3. Cash outflow related to warranty work:
McGraw-Hill/Irwin

$100 $100 $ 0

$ 0 $ 70

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SUMMARY QUESTIONS
C=CofGS,W=War.exp. Balance Sheet Assets = Liab.+ Stk. Equity Inc. State. Cashflow Cash+ A/R + M.Inv. = W/P+C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA 5000 5000 5000 5000 5000 OA 1a (4000) (4000) C 4000 (4000) n.a. 1b 2 100 (100) w 100 (100) n.a. 3. (30) (30) n.a. n.a. n.a. n.a. (30) OA 70 balance

Questions:

2004

2005

1. Warranty Expense for the year: 2. Warranty liability on year-end bal. sheet: 3. Cash outflow related to warranty work:
McGraw-Hill/Irwin

$100 $100 $ 0

$ 0 $ 70 ($30)OA

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Transactions Posted to T-accounts 1. In 2004, sold for $5000 cash (1A), units costing $4000 (1B). 2. During 2004, estimated $100 warranty cost over two years. 3. During 2005, paid $30 cash to repair units sold in 2004.
Cash Warranty Payable 30 (3) (3) 30 100 (2) Sales 5,000 (1A)

Bal. X (1A) 5,000

Inventory Bal. X 4,000 (1B)

Cost of Goods Sold (1B) 4,000

Entries (not shown here) to close Sales, Cost of Goods Sold, and Warranty Expense to Retained Earnings would have been made at the end of 2004.
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Warranty Expense (2) 100

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Notes Payable: Transaction Analysis
sAssume

the following selected events occurred at Cell-It. For each event:
ËDetermine

how the financial statements are affected and fill in the horizontal statements model.
ËRecord

the event in the Journal and Post to the Ledger.
© The McGraw-Hill Companies, Inc., 2003

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Notes Payable: Transaction Analysis

Assume the following events occurred at Cell-It. 1. On Oct. 1, 2004 Cell-It borrowed $8,000 cash by issuing a note payable with a one-year term and an 8% stated interest rate. All interest will be paid at maturity. This is an “interest bearing” note. 2. On Oct. 1, 2004 Cell-It issued an $8,000 face value, discounted note payable with a one-year term and an 8% stated discount rate. This is called a “Discounted” or “Non-interest bearing” note. 3. On Dec. 31, 2004 recorded interest related to the 8% interestbearing note issued on Oct. 1st (see #1). 4. On Dec. 31, 2004 recorded interest related to the 8% discounted (non-interest bearing) note issued on Oct. 1st (see #2). 5. On Sept. 30, 2005 repaid the 8% non-discounted note payable (#1), plus all interest. 6. On Sept. 30, 2005 repaid the 8% discounted note payable (#2).
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Horizontal Model Transaction Analysis
Balance Sheet Assets = Liabilities + Equity Inc. State. Cashflow Cash = I/P + N/P(1) + N/P(2) - Disc.+C.Stk+R.E. Rev.- Exp.= N. I. OA,IA,FA 1

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T1: On Oct. 1, 2004 Cell-it borrowed $8,000 at 8% for 1 year on an interest bearing note. All interest to be paid at maturity.
Balance Sheet Assets = Liabilities + Equity Inc. State. Cashflow Cash = I/P + N/P(1) + N/P(2) - Disc.+C.Stk+R.E. Rev.- Exp.= N. I. OA,IA,FA 1 8000 8000 8000 FA

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T2: On Oct. 1, 2004 Cell-it issued an $8,000 face value, one year note payable discounted at 8%. (A noninterest bearing note.)

Balance Sheet Assets = Liabilities + Equity Inc. State. Cashflow Cash = I/P + N/P(1) + N/P(2) - Disc.+C.Stk+R.E. Rev.- Exp.= N. I. OA,IA,FA 1 8000 2 7360 8000 8000 640 8000 FA 7360 FA

The interest is INCLUDED in the Note Payable. The interest must be subtracted to calculate the amount of cash the borrower receives on the issue date. Note Payable $8000 Since no time Interest ($8000 x .08 x 12/12) (640) has past, the Cash to borrower $7360 $640 is NOT an
EXPENSE yet.
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T2: On Oct. 1, 2004 Cell-it issued an $8,000 face value, one year note payable discounted at 8%. (A noninterest bearing note.)

Balance Sheet Assets = Liabilities + Equity Inc. State. Cashflow Cash = I/P + N/P(1) + N/P(2) - Disc.+C.Stk+R.E. Rev.- Exp.= N. I. OA,IA,FA 1 8000 2 7360 8000 8000 640 8000 FA 7360 FA

Discount on Note Payable is a contra liability account. Its balance is SUBTRACTED from the Note Payable account to obtain the total liability for the Note. Note Payable 8000 Less: Discount on N/P (640) Total Note Liability 7360
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T3: On Dec. 31, 2004 recorded interest related to the note in #1. Oct. 1-Dec. 31 = 3 mo. (8000 x .08 x 3/12=160)

Balance Sheet Assets = Liabilities + Equity Inc. State. Cashflow Cash = I/P + N/P(1) + N/P(2) - Disc.+C.Stk+R.E. Rev.- Exp.= N. I. OA,IA,FA 1 8000 2 7360 3 160 8000 8000 640 (160) 8000 FA 7360 FA 160 (160) n.a.

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T4: On Dec. 31, 2004 recorded interest related to the discounted (noninterest bearing) note in #2.
Balance Sheet Assets = Liabilities + Equity Inc. State. Cashflow Cash = I/P + N/P(1) + N/P(2) - Disc.+C.Stk+R.E. Rev.- Exp.= N. I. OA,IA,FA 1 8000 2 7360 3 160 4 8000 8000 640 (160) (160) (160) 8000 FA 7360 FA 160 (160) n.a. 160 (160) n.a.

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T5: On Sept. 30, 2005 repaid the 8% note from Transaction #1 and all its interest. a= accrue the remaining interest. b= payment.

(Jan. 1-Sept. 30 = 9 mo. (8000 x .08 x 9/12= $480)

Balance Sheet Assets = Liabilities + Equity Inc. State. Cashflow Cash = I/P + N/P(1) + N/P(2) - Disc.+C.Stk+R.E. Rev.- Exp.= N. I. OA,IA,FA 1 8000 8000 2 7360 3 160 4 5a 480 b (8640) (640) (8000)
OA

8000

640 (160) (160) (160) (480)

8000 FA 7360 FA 160 (160) n.a. 160 (160) n.a. 480 (480) n.a (8000) FA (640)

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T6: On Sept. 30, 2005 repaid the 8% discounted note payable from Trans. #2. a= accrue the remaining interest. b= payment.

Balance Sheet Assets = Liabilities + Equity Inc. State. Cashflow Cash = I/P + N/P(1) + N/P(2) - Disc.+C.Stk+R.E. Rev.- Exp.= N. I. OA,IA,FA 1 8000 8000 2 7360 3 160 4 5a 480 b (8640) (640) (8000)
OA 6a

8000

640 (160) (160) (160) (480) 160 160 480

(480) (8000)

(480)

480

8000 FA 7360 FA (160) n.a. (160) n.a. (480) n.a (8000) FA (640) (480) n.a. (7360) FA (640) OA

b (8000)

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Comparison of Journal Entries for Interest Bearing and Discounted Notes
Contra-liabilities are increased by debiting.
Date 2004 Oct. 1 NOTE PAYABLE (Interest bearing) Accounts Debit Credit Cash Note Payable
Borrowed $8000 at 8% for one year

8000 8000

Date 2004 Oct. 1

DISCOUNTED NOTE PAYABLE Accounts Debit Credit Cash Discount on Note Payable Note Payable 7360 640 8000

Borrowed $8000 discounted at 8% for one year

Dec. 31 Interest Expense Interest Payable
Accrued 3 mo. interest (8000x.08x3/12)

160 160

Dec. 31 Interest Expense Discont on Note Payable

160 160

Amortized 3 mo. interest from Discount to Int. Exp.

2005 Sept. 30 Interest Expense Interest Payable
Accrued 9 mo. interest (8000x.08x9/12)

480 480

2005 Sept. 30 Interest Expense Discont on Note Payable

480 480

Amortized 9 mo. interest from Discount to Int. Exp.

Sept. 30 Interest Payable Note Payable Cash
Paid note and all interest

640 8000 8640

Sept. 30 Note Payable Cash

8000 8000

Paid note (which already includes iall nterest)

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Comparison of Ledger Accounts for Interest Bearing and Discounted Notes
INTEREST BEARING NOTE PAYABLE Cash X Beg. Bal. 10/01/04 8000 8640 9/30/05 Note Payable
10/01/04 8000 9/30/05 8000

2004 Exp. Interest Expense 160 12/31/04 480 09/30/05 2005 Exp.

0 Interest Payable 160 12/31/04 480 09/30/05 640 9/30/05 0

NON-INTEREST BEARING (DISCOUNTED) NOTE PAYABLE Cash X Beg. Bal. 10/01/04 7360 8000 9/30/05 Note Payable
10/01/04 8000 9/30/05 8000

2004 Exp. Interest Expense 160 12/31/04 480 09/30/05 2005 Exp.

0 Discount on Note Pay. 160 12/31/04 480 09/30/05 640 9/30/05 0

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Which loan was the better deal for Cell-It?
Calculate the EFFECTIVE INTEREST % of each. Interest bearing note: Eff. Int. %State. received in Eq Inc. = $ Annual Interest ÷ $7,360 from the State. of Ch.Cash Rec’d. CashFlow lender, but still had+8,000 FA 1. No effect $640 No effect $8,000 to pay = ÷ $640 effect for the year.FA 2. No effect No interest +7,360 = 8.0% That’s why the effective 3. +Int. Exp, so - N.I. Decr. R/E, so Dec. Eq, n.a. interest Dec. Eq. 4. +Int. Exp, sobearing note (Discounted note): n.a. Non-Interest - N.I. Decr. R/E, sorate is higher for Note so 5. +Int. Exp, so - N.I. Decr. R/E,#2. Dec. Eq. -8000FA,-640 OA Eff. Int. % = $ Annual Interest ÷ Cash Rec’d. Note #1 (Interest bearing) is = $640 $7,360 a “better÷deal” in this case.
McGraw-Hill/Irwin

Transaction Analysis:

Effect on Financial Statements With note #2 Cell-It only

=

8.7%

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Financial Statement Analysis
s

Accounts Receivable Turnover
Accts/Rec. = Turnover $ Accounts Receivable* Sales

Often the AVERAGE Accts. Rec. is used as the denominator.

Ave. A/R =

Beginning Accts/Rec. + Ending Accts/Rec. 2

This ratio is a measure of how quickly receivables are collected.

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Accounts Receivable Ratios
Accts. Rec. Turnover: (A measure of how fast receivables are collected. Higher is better.) Sales $50,000 = = 10.0 times Accounts. Receiv. $ 5,000 Average Days to collect A/R: (How many days
go by between a credit sale and the time it is collected?) 365 365 Accts. Rec. Turnover = 10.0 = 36.5 days Generally, lower means better.
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Chapter 7

The End
McGraw-Hill/Irwin
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