Basic Financial Accounting Lecture 6

2017‐11‐12
BASIC FINANCIAL
ACCOUNTING
Receivables and operating assets
AMIN SOHEILI
2017/11/13
Chapter 7:
Receivables and
Investments
Apple Inc.
California-based 40 years old company
Steve Jobs
Skyrocket sales in 2014 over $182 billion
Most of the sales are on credit
”What we are about is not making
boxes for people to get the job
done. We believe that people
with passion can change the
world for the better.” ‐ Steve Jobs
https://www.youtube.com/watch?v=rdIWKytq_q4
© 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as https://www.youtube.com/watch?v=2T8mIqQ0gKA
permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
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Accounts Receivable
 Account receivable: A receivable arising from the sale of goods or
services with a verbal promise to pay
 Companies track the balance owed by each customer on a
subsidiary ledger
© 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as
Module 1: LO 1
Subsidiary Ledger
 Subsidiary ledger: detail for a number of individual items that
collectively make up a single general ledger account
 Control account: general ledger account that is supported by a
subsidiary ledger
Module 1: LO 1
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The Use of a Subsidiary Ledger
 Assume that Apple sells $25,000 of hardware to a school. The journal entry to record the sale would be
as follows:
Module 1: LO 1
Subsidiary Ledger
Module 1: LO 1
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The valuation of Accounts Receivable
Bad debts and allowance for doubtful debts
Two Methods to Account for
Bad Debts A debt that a business will
not be able to collect. It is
 Direct write‐off method: recognition of bad debts an expense and should
appear in the income
expense at the point an account is written off as statement.
uncollectible
 Allowance method: estimating bad debts on the
basis of either net credit sales or accounts
receivable
 Allowance for doubtful accounts: a contra‐asset
account—reduce accounts receivable to its net
realizable value (this is an estimate)
Module 1: LO 1
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Remember
• Accounts receivable (or Debtor’s account):
Money that is owed to the business (by debtor’s) for goods or services
supplied.
• Personal ledger
• What possible scenarios do you see that could happen to the outstanding
money?
• The business gets the money for sure
• The business might be able to collect the money
• The money cannot be collected
9‐Nov‐17 9
Provision for Doubtful Debt

Definition:
• An amount of profit is transferred to a provision to recognize the potential loss if the debt eventually
does become bad.
• This is adjusted up or down in future years, depending upon whether there are more or fewer doubtful
debts to be provided for by the end of the financial period.
• A potential loss leads to a provision for doubtful debts.
• When a payment cannot be expected anymore, the account receivable has to be ‘written off’ as a
bad debt
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Bad debt
• There are a range of possible scenarios concerning a bad debt. These will
include:
• The debtor may be refusing to pay one of a number of invoices
• The debtor may be refusing to pay part of an invoice
• Only a proportion from a number of invoices may be paid due to business failure
• The debtors’ business has failed and nothing will be received
• At the end of the period, the total of bad debts account is transferred to the
income statement as an expense and the receivable is eliminated
9‐Nov‐17 11
Bad debt: journal entries

• When you are certain that a debt (account receivable) will not be
recoverable, you write off the receivable:
Dr Bad debt expense XXX
Cr Debtor’s account XXX
• You need to credit the Debtor’s account as s/he is no longer a debtor

• Bad debt is always an expense and must be shown in the income statement
• Let’s look at an example!
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Example: Bad debt

 Assume that Roberts Corp. makes a $500 sale to Dexter Inc. on November 10, 2016, with credit terms of
2/10, n/60. Roberts makes the following entry on its books on this date:
 Assume further that Dexter is unable to pay and that the account has to be written off. (uncollectible = bad)
To do so, the accounting department makes the following entry:
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Example (cont.): Bad debt – Financial Statement Extracts
Assume the company’s total acc. Receivable was 19,000 BEFORE  Balance sheet effect:
 By ignoring the possibility that
In the balance sheet: not all of its outstanding
Current assets:
accounts receivable will be
Accounts receivable (Debtors) 18,500
collected, Roberts is overstating
the value of this asset at
In the income statement:
December 31, 2016
Gross profit XXX  Income statement effect:
Less Expenses (examples):
 By ignoring the possibility of bad
Bad debt 500
debts on sales made during
Wages XXX
2016, Roberts has violated the
Carriage outwards XXX
matching principle and has
Rent XXX
overstated net income for 2016
Profit before tax XXX
by ignoring bad debts as
9‐Nov‐17
expense 14
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Sometimes there are Surprises...

• Bad debts recovered:
A previous debt that was bad but is now collectible/ recoverable.
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Bad debt recovered

• When a debt previously written off is recovered, you:
1. Reinstate the debt making the following entries:
Dr Accounts receivable XXX

Cr Bad debt recovered XXX
account
2. When the payment is received in settlement of the debt:
Dr Cash $300
Cr Account receivable $300
3. At the end of the accounting year, the credit balance in the bad debt recovered
account is transferred to either to the bad debts account or credited directly
to the income statement.
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Example: bad debt recovered

In 2007 EC manage to recover an old debt worth $250.
What are the journal entries?
Dr Accounts receivable $250

Cr Bad debt $250
recovered account
At 30 July the debt is paid by cash.

Dr Cash $250
Cr Accounts receivable $250
9‐Nov‐17 17
Remember
• If accounts receivable are not collectible, showing the full amount of
accounts receivable would be misleading
Accounts receivable therefore are shown net of bad debt
• Sometimes it is not certain that a debt will be bad but it there is a strong
element of doubt
9‐Nov‐17 18
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Doubtful debt
Reasons include:
• disputes over the quality of goods or services causing the customer to
withhold payment;
• financial difficulties of a customer, raising doubts whether they will eventually
pay or not;
• customers whose debts have been owing for a long period without good
reason.
9‐Nov‐17 19
Why do we need provisions for doubtful debt?

Application of the prudence principle:
Assets and income shall not be overstated
• Liabilities and charges shall not be understated. Financial statements shall

be neutral.
• Provision must be made on the remaining debtors after bad debts written
off (i.e. debtors net of bad debts)
• Provision can be ’General’ or ’Specific’
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Provision for Doubtful Debt

• How do we record a provision for doubtful debt and how do we estimate it?
• by looking at each individual debt and deciding to what extent it will be bad
(specific)
• by estimating a percentage based on experience, industry norm, pattern of bad
debts experienced in the past with the debtor, economy situation (general)
• by using an Aging Schedule (general)
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Income
Balance sheet
statement
Show as Accounts
Good debts receivable
Adjust provision up/down Deduct closing balance

Doubtful
annually to cover doubtful of provision from
debts debts Accounts receivable
Write off as
Bad debts
expense
9‐Nov‐17 22
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Example Aging Schedule

Aging Schedule for Doubtful Debts
Period debt owing Amount (£) Estimated Provision for
Past due percentage doubtful debts
doubtful (%)
Less than one month 5,000 1 50
1 month to 2 months 3,000 3 90
2 months to 3 800 4 32
months 200 5 10
3 months to 1 year 160 20 32
Over 1 year 9,160 214
9‐Nov‐17 23
Accounting Entries for (Allowance) Provisions for Doubtful Debt

• Year in which the provision is first made:
Dr Expenses (Income statement) $500
Cr Provision for doubtful debt (balance sheet) $500
• In subsequent years: Accounting entries depend on whether there is

• Increase or
• Decrease
in the total provision compared to the previous year.
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Increase or decrease a provision for doubtful debt

Steps involved:
1. Calculate the total provision (Allowance) for the year
2. Compare this total provision to last year’s total provision
3. Determine whether there is an increase or decrease this year compared to
last year
4. The difference (increase or decrease) is entered into the income
statement (loss or gain)
5. The total provision for the year is shown in the balance sheet.
9‐Nov‐17 25
Example: Decrease in provision for doubtful debt

• In 2009, at period end, EC company determines its accounts receivable to be
€ 14,000; of which € 100 are bad debts. For this year, percentage for the
provision for doubtful debts is still 2% of accounts receivable net of bad debt
(debtors).
What are the journal entries?
12‐Nov‐17 26
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Example (cont.)
Journal entries:
Dr Bad debt expense $100
Cr Accounts receivable $100
Dr Provision for doubtful debt $108

Cr Gain (Income statement) $108
• Provision for doubtful debt (total) = (14,000-100)*2%)=278

• provision 2009: 278
• Assume provision for 2008 was 386;
• Decrease: 108 This is a gain (income)!
12‐Nov‐17 27
Chapter 8: operating assets: Property, Plant, Equipment and intangibles

The largest athletic selling in the world
Intangibles are equally important as tangibles
Nike believes Nike trademark is among its most valuable assets registered in
over 100 countries
Converse, All Star, One Star,…
Valuable licenses and patents of revolutionary production of ”AIR”
9‐Nov‐17 28
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Non-Current Assets and Depreciation
Topics
• What is depreciation and what do we need it for?
• Straight line and diminishing balance method of depreciation
• Record depreciation calculations in financial statements.
9‐Nov‐17 30
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Non-current assets: depreciation and amortisation

• Depreciation is part of the original cost of a non-current tangible asset that is
consumed during its period of use by the business.
• Amortisation is the part of the original cost of a non-current intangible asset

that is consumed during its period of use by the business.
• They are treated in the same way
9‐Nov‐17 31
Non-current assets: depreciation

• Depreciation expense is an annual estimation and an expense (shown in
the income statement).
• Depreciation relates to the matching principle and does not involve a flow of
cash (i.e. it is not cash relevant)
9‐Nov‐17 32
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Causes of Depreciation
• Physical deterioration
• Wear and tear
• Erosion, rust, rot and decay
• Economic factors like technical development
• Obsolescence
• Inadequacy
• Time
• Depletion
• Assets that are of wasting character. E.g. mines, oil wells, mineral deposits,
timber.
9‐Nov‐17 33
To calculate depreciation / amortisation

• What are the acquisition costs of the asset?
• What is the expected useful life of the asset?
• What is its residual value (aka scrap- or salvage value)?
• What pattern of depreciation should be used to allocate expense over the
useful life?
Note: Land is the only non-current asset that is not depreciable.
9‐Nov‐17 34
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Acquisition cost: what is given up to obtain the asset?

• Purchased assets:
• Purchase cost
• Plus any costs to prepare the asset for its intended use
(e.g. installation, transport)
• Self-constructed assets:
• Direct costs of construction
• Financing costs (e.g. interest on loans to finance the construction)
9‐Nov‐17 35
Useful life and residual value

• Determining useful life:
• Requires managerial judgement
• An estimation of the period over which the asset will be used, contribute benefits
to the business
• Determining residual value:

• Requires managerial judgement
• Residual value = estimated proceeds at disposal less any expected selling costs
9‐Nov‐17 36
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Different Depreciation Methods

 Straight-line
 Units- of- production method
 Double declining balance method (Accelerated depreciation)
 Sum of years’ digits method
 Depletion unit method
 Units of output method
 Revaluation method
9‐Nov‐17 37
The Straight Line Method

• Assumption:
The use of value occurs evenly over the life of the asset
• The asset therefore is written off in equal instalments over its useful life
Cost – estimated residual value

Useful life in years
• Note: straight-line depreciation also can be expressed as a percentage.

• 20% p.a. straight-line depreciation means equal instalments over 5 years; 25%
over 4 years etc.
9‐Nov‐17 38
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Example 8‐2—Computing
Depreciation Using the Straight Line
Method
 Assume that on January 1, 2016, ExerCo, a manufacturer of exercise
equipment, purchased a machine for $20,000
 The machine’s estimated life would be five years, and its residual value at the
end of 2020 would be $2,000
 The annual depreciation should be calculated as follows:
Depreciation = Acquisition Cost – Residual Value
Life
= ($20,000‐$2,000)/5
= $3,600
Module 2: LO 5
Depreciation Using the Straight Line
Method (continued)
 An asset’s book value is defined as its acquisition cost minus its total amount
of accumulated depreciation
 The book value of the machine in this example is $16,400 at the end of 2016:
Book Value = Acquisition Cost – Accumulated Depreciation
= $20,000‐$3,600
= $16,400
Module 2: LO 5
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Units‐of‐Production Method
 Depreciation is determined as a function of the number of units
the asset produces
Total Number of Units in Asset’s Life
 The annual depreciation for a given year can be calculated based
on the number of units produced during that year, as follows:
Annual Depreciation = Depreciation per Unit x Units Produced in Current Year
Module 2: LO 5
Depreciation Using the Units‐of‐
Production Method
 ExerCo has estimated that the total number of units that will be produced during the asset’s five‐year life
is 18,000
 During 2016, ExerCo produced 4,000 units
 The depreciation per unit for ExerCo’s machine can be calculated as follows:
Total Number of Units in Asset’s Life
= ($20,000 ‐ $2,000)/18,000
= $1 per unit
Annual Depreciation = Depreciation per Unit x Units Produced in Current Year
= $1 per Unit x 4,000 Units
= $4,000
Module 2: LO 5
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Double declining balance method
• Assumption:
The use of value in earlier periods is higher than in later periods.
• The asset therefore is written off more in earlier periods and less
in later periods.
• The method is used when it is clear that the benefits achieved
from the asset are highest when the asset is new.
• A given or calculated percentage is applied to the net book
value.
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Depreciation Using the Double‐
Declining‐Balance Method
 Assume that ExerCo wants to depreciate its asset using the double‐declining‐
balance method
 The straight‐line rate for the ExerCo asset with a five‐year life is as follows:
100% / 5 Years = 20%
 The second step is to double the straight‐line rate, as follows:
2 x 20% = 40%
Module 2: LO 5
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Example 8‐4—Computing Depreciation
Using the Double‐Declining‐Balance
Method (continued)
 This rate will be applied in all years to the asset’s book value at the beginning
of each year
 As depreciation is recorded, the book value declines and a constant rate is
applied to a declining amount
 However, the machine cannot be depreciated below its residual value
 The amount of depreciation for 2016 would be calculated as follows:
Depreciation = Beginning Book Value x Rate
= $20,000 x 40%
= $8,000
Module 2: LO 5
Example 8‐4—Computing Depreciation
Using the Double‐Declining‐Balance
Method (continued)
 The amount of depreciation for 2017 would be calculated as follows:
Depreciation = Beginning Book Value x Rate
= ($20,000 ‐ $8,000) x 40%
= $4,800
Module 2: LO 5
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Exhibit 8‐1—Comparision of
Depreciation and Book Values of
Straight‐Line and Double‐Declining
Balance Methods
Module 2: LO 5
Exhibit 8‐2—Management’s Choice of
Depreciation Method
Module 2: LO 5
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Change in Depreciation Estimate
 Change in the life of the asset or in its residual value
 Recorded prospectively
 The depreciation recorded in prior years is not corrected or restated
 The new estimate should affect the current year and future years
Module 2: LO 6
Example 8‐5—Calculating a Change in
Depreciation Estimate
 ExerCo purchased a machine on January 1, 2016, for $20,000 and estimates that the machine’s life would be
five years and its residual value at the end of five years would be $2,000
 At the beginning of 2018, ExerCo believes that the total machine life will be seven years, or another five years
beyond the two years the machine has been used
 The amount to be depreciated over that time period should be calculated as follows:
Depreciation = Remaining Depreciable Amount/Remaining Life
= $10,800/5 Years
= $2,160
Module 2: LO 6
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Example 8‐5—Calculating a Change in
Depreciation Estimate (continued)
 The journal entry to record depreciation for the year 2018 is as follows:
Module 2: LO 6
26

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2017‐11‐12

The valuation of Accounts Receivable

Bad debts and allowance for doubtful debts

Provision for Doubtful Debt

• A potential loss leads to a provision for doubtful debts.

Bad debt: journal entries

• You need to credit the Debtor’s account as s/he is no longer a debtor

Example: Bad debt

Example (cont.): Bad debt – Financial Statement Extracts

Sometimes there are Surprises...

Bad debt recovered

Dr Accounts receivable XXX

Example: bad debt recovered

Dr Accounts receivable $250

At 30 July the debt is paid by cash.

Why do we need provisions for doubtful debt?

Assets and income shall not be overstated

• Liabilities and charges shall not be understated. Financial statements shall

• Provision can be ’General’ or ’Specific’

Provision for Doubtful Debt

Adjust provision up/down Deduct closing balance

Example Aging Schedule

Accounting Entries for (Allowance) Provisions for Doubtful Debt

• In subsequent years: Accounting entries depend on whether there is

Increase or decrease a provision for doubtful debt

Example: Decrease in provision for doubtful debt

What are the journal entries?

Dr Provision for doubtful debt $108

• Provision for doubtful debt (total) = (14,000-100)*2%)=278

Chapter 8: operating assets: Property, Plant, Equipment and intangibles

Non-Current Assets and Depreciation

Non-current assets: depreciation and amortisation

• Amortisation is the part of the original cost of a non-current intangible asset

• They are treated in the same way

Non-current assets: depreciation

To calculate depreciation / amortisation

Note: Land is the only non-current asset that is not depreciable.

Acquisition cost: what is given up to obtain the asset?

Useful life and residual value

• Determining residual value:

Different Depreciation Methods

The Straight Line Method

Cost – estimated residual value

• Note: straight-line depreciation also can be expressed as a percentage.

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