Assessment Questions

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1 Assessment Questions AS-1 ( 1 ) Define accounts receivable. The amount billed to customers and owing from them but not yet collected. AS-2 ( 1 ) Describe the presentation of accounts receivable on the balance sheet. Accounts receivable is reported as a current asset. It should be ranked after cash and short-term investments, since accounts receivable is less liquid than cash and short-term investments. AS-3 ( 1 ) How can the subsidiary ledger assist in managing a company s accounts receivable? Since accounts receivables involve keeping track of when sales are made and to whom, the subsidiary ledger can be used to evaluate a customer s payment record, available credit and terms. 81

2 AS-4 ( 1 ) Explain the relationship between the accounts receivable control account and individual customer accounts in the accounts receivable sub-ledger. The accounts receivable subsidiary ledger is used to itemize each specific item. Each sale to a particular customer is shown as a single debit in the customer s account in the sub-ledger. A customer may have several debits reflecting many individual sales during the period. The total of sales for the month for all customers is shown as one debit in the control account. AS-5 ( 2, 3 ) List the names of the alternative methods for accounting for bad debt. Are both methods allowed under GAAP? The two methods for accounting for bad debts are the direct write-off method, and the allowance method. The direct write-off method is not allowed under GAAP unless the loss is determined and written off in the same year in which the revenue was generated. AS-6 ( 2 ) Briefly outline the direct write-off method for dealing with bad debt. When a company generates a credit sale, a debit is made to accounts receivable and a credit is recorded to sales. Once it is determined that the bill will not be paid, the amount must be written off. This is done by crediting (decreasing) accounts receivable and debiting (increasing) bad debt expense. 82

3 Chapter 3 AS-7 ( 4, 5 ) Name two different approaches for estimating the bad debt expense when using the AFDA method. Income Statement Approach: For example, if the sales history of a company suggests that 1% of credit sales will result in bad debts, then that 1% rate is applied to the next financial period. Balance Sheet Approach: Accounts receivable are grouped depending on how long they have been due. To each group a percentage is applied. Each percentage indicates the likelihood that a bad debt will arise. AS-8 ( 6 ) Name two ratios used to assess accounts receivable, and state the formulas used to calculate the ratios. Day Sales Outstanding (DSO) = (Average Net Accounts Receivable Net Credit Sales) x 365 Accounts Receivable Turnover Ratio (ART) = Net Credit Sales Average Net Accounts Receivable AS-9 ( 8 ) What are the risks involved when selling on credit? The major risk of selling on credit is that you will not be paid. If this happens you will lose the cost of your purchase plus any profit on the sale of the product. 83

4 AS-10 ( 2, 3 ) Which method of accounting for bad debt (direct method or allowance method) is more preferable? Support your answer. The allowance method of accounting for bad debts is preferable. Using the allowance method better matches expenses (i.e. bad debt expense) with the revenue earned. With the direct method, the bad debt resulting from a sale may not be known until a year or more after the related sale. AS-11 ( 3, 4, 5 ) If a company uses the allowance method to account for bad debt, which method is best for estimating the allowance: income statement method or balance sheet method? Neither the income statement method nor the balance sheet method is superior. The income statement method is easy to apply, but there is a risk that, if the allowance account is not properly monitored, it may build to an excessively high level. The balance sheet method, on the other hand, requires constantly adjusting the allowance account up and down, depending on the level of receivables. In the past, many small companies used the Income Statement Approach in preparing monthly financial statements but used the Balance Sheet Approach in annual financial statements. Today, however, most businesses have computer software that quickly and easily prepares monthly aging schedules of accounts receivable. Therefore, most businesses today use the Balance Sheet Approach in their monthly as well as annual financial statements. 84

5 Chapter 3 AS-12 ( 8 ) What are the advantages and disadvantages to a company which sells on credit? The major advantage to a company selling on credit is that it may increase sales. The buyer can buy the product or services, then re-sell products to earn money to pay back the seller. The major disadvantage of selling on credit is that the buyer may fail to pay. AS-13 ( 4 ) What pitfalls exist for a company that uses the Income Statement Approach for recording bad debt expense? See question 11 above: The Income Statement Approach is easy to apply, but there is a risk that, if the allowance account is not properly monitored, it can build to an excessively high level. AS-14 ( 6 ) How do you assess the DSO number? The ART ratio? The larger the DSO number, the more days it takes to collect accounts receivables. If the DSO number is greater than the normal credit terms, it indicates that the company is having a tough time collecting from its customers and may soon run short of cash needed to operate the business. The higher the ART ratio, the greater the ability of a company to convert its accounts receivable into cash. 85

6 AS-15 ( 8 ) Give two examples of accounting reports that can be generated involving accounts receivable. Many receivables-related reports can be generated:1. a report showing the age of receivables should be produced on a regular basis, and monitored closely. The Aging Report is the starting point for collection of overdue receivables. If accounts which are currently overdue by a few days are left to slide, they may become accounts which are seriously overdue, and subsequently uncollectible. 2. A report showing cash collections for the day (or whatever period is deemed most useful). This report allows managers to adequately keep tabs on cash and usefully manage lines of credit with the bank. AS-16 ( 8 ) What internal controls are important for accounts receivable? Is there any one control that is absolutely necessary? Probably the most important internal control related to receivables is a written credit policy related to receivables. A good credit policy would require new customers to pay cash within a certain period of time. After they have established the fact that they can pay on time, the customer would be allowed to buy a limited amount on credit. When the customer has done this for a period, the credit limit may be raised. A good credit policy would also require potential customers to supply a reference from their bank and other suppliers. Requesting the customer s financial statements allows the seller to assess the customer s ability to pay for credit purchases. 86

7 Chapter 3 AS-17 ( 8 ) What ethical problems are related to accounts receivable? Can they be avoided? One problem related to receivables is failure to properly allow for bad debts. A second problem is lack of integrity in the accounts receivable records. Ethical problems related to accounts receivable cannot be completely avoided, however, problems can be mitigated by hiring properly-qualified individuals (e.g. CAs, CGAs, CMAs) to manage or oversee accounts receivable. A second path is the implementation of appropriate internal controls which can prevent, or at least detect ethical gaps. 87

8 Application Questions AP-1 ( 2 ) On June 15, you discover that your customer, Tyrone Huntzinger, has gone bankrupt. He owes you $1,000. Prepare the appropriate journal entry assuming the direct method is used. Jun 15 Bad Debt Expense 1,000 Accounts Receivable Huntzinger 1,000 Write off of amount due from Tyrone-Hurtzinger AP-2 ( 3 ) Refer to AP-1. Assuming that $5,000 had been credited to the allowance account for the year, prepare the journal entry assuming the allowance method is used. Jun 15 Allowance for Doubtful Accounts 1,000 Accounts Receivable Huntzinger 1,000 Write off of amount due from Tyrone-Hurtzinger AP-3 ( 3 ) Your company decides that an allowance for doubtful accounts is required in the amount of $6,000. There is a zero balance in the account. Prepare the journal entry to set up the required allowance. Dec 31 Bad Debt Expense 6,000 Allowance for Doubtful Accounts 6,000 Set up AFDA of $6,000 AP-4 ( 2, 3 ) On December 31, 2011, Mann Company s accounts receivable ledger showed an ending balance of $40,000. The company realized that $2,000 of accounts receivable was deemed uncollectible. Prepare a journal entry to demonstrate the treatment of $2,000 uncollectible amount using (a) direct method and (b) allowance method. 88

9 Chapter 3 a) Direct Method Dec 31 Bad Debt Expense 2,000 Accounts Receivable 2,000 Record bad debt b) Allowance Method Dec 31 Allowance for Doubtful Accounts 2,000 Accounts Receivable 2,000 Record bad debt AP-5 ( 3 ) Your company decides that an allowance for doubtful accounts is required in the amount of $6,000. There is a $4,000 credit balance in the account. Prepare the journal entry to set up the required allowance. Dec 31 Bad Debt Expense 2,000 Allowance for Doubtful Accounts 2,000 To reflect AFDA balance of $6,000 AP-6 ( 2 ) Jane Lee is the owner of a small consulting firm called Lee Solutions. She uses the direct method to account for uncollectible receivables. On April 14, 2010, Lee Solution s accounts receivable account balance was $10,000. A week later, it was discovered that Mr. Joe Black, who owed the firm $1,500, will not be able to make the payment. Required: a) Prepare a journal entry to account for the amount deemed uncollectible. Apr 14 Bad Debt Expense 1,500 Accounts Receivable - Joe Black 1,500 Direct write-off of bad debt from accounts receivable 89

10 b) On May 26, 2010, Mr. Joe Black was able to repay 50% of the amount he owed, which had been previously written-off. Prepare the journal entries required to record this transaction. May 26 Accounts Receivable - Joe Black 750 Bad Debt Expense 750 To reinstate the customer s account Cash 750 Accounts Receivable - Joe Black 750 To record receipt of payment on account AP-7 ( 3 ) Your company decides that an allowance for doubtful accounts is required in the amount of $6,000. There is a $1,000 debit balance in the account. Prepare the journal entry to set up the required allowance. Dec 31 Bad Debt Expense 7,000 Allowance for Doubtful Accounts 7,000 To reflect AFDA balance of $6,000 AP-8 ( 3 ) A customer s account in the amount of $2,000 was previously written off. Amazingly, on December 31, you receive a cheque in the mail from the customer with a letter of apology for not paying sooner (the account is 2 years old). Prepare the journal entry by using the allowance method. Dec 31 Accounts Receivable 2,000 Allowance for Doubtful Accounts 2,000 To reverse prior write-off for customer Dec 31 Cash 2,000 Accounts Receivable 2,000 To record receipt of payment from customer 90

11 Chapter 3 AP-9 ( 4 ) Your company uses the income statement approach for estimating bad debts. Last year, credit sales amounted to $1 million. The estimated bad debts are 0.5% of sales. Prepare the journal entry to record bad debt expense for the year. Bad Debt Expense 5,000 Allowance for Doubtful Accounts 5,000 Estimated bad debts for the year 0.5% $1M AP-10 ( 3, 4 ) B&B Inc. uses the allowance method to account for uncollectible receivables. During 2012, the company made total credit sales of $1,250,000, of which $300,000 was currently owed by customers. According to the company s historical sales, 1.5% of the amount will be uncollected. B&B Inc. uses an income statement approach to estimate the amount of uncollectible receivables. Required: Prepare the journal entry to account for the amount deemed uncollectible. Bad Debt Expense 18,750 Allowance for Doubtful Accounts 18,750 To record bad debt expense based on percentage of sales (0.015 $1,250,000) AP-11 ( 3, 5 ) The following chart is prepared by the accountant of Happy Shoes Inc. The percentages are based on historical performance. Aging Category Bad Debt % Balance 30 days 1% $80, days 3% 40,000 over 60 days 5% 20,000 Total 140,000 Happy Shoes Inc. uses the balance sheet approach to estimate uncollectible receivables. 91

12 Required: a) Calculate the company s bad debt. Aging Category Bad Debt % Balance Estimated Bad Debt 30 days 1% $80,000 $ days 3% 40,000 1,200 over 60 days 5% 20,000 1,000 Total $140,000 $3,000 b) Assume that allowance for doubtful accounts has a credit balance of $1,000. Calculate the amount of bad debt expense the company will record. $3,000 - $1,000 = $2,000 AP-12 ( 3, 5 ) Fishy Inc. uses the balance sheet approach to estimate uncollectible receivables. Use the following table to determine the amount of bad debt expense, and prepare the journal entry to record the bad debt expense. The allowance account currently has a zero balance. Aging Category Bad Debt % Balance 30 days 2% $25, days 3% 10,000 over 60 days 4% 2,000 Total $37,000 Aging Category Bad Debt % Balance Estimated Bad Debt 30 days 2% $25,000 $ days 3% 10, over 60 days 4% 2, Total $37,000 $880 Jun 14 Bad Debt Expense 880 Allowance for Doubtful Accounts 880 To record bad debt expense 92

13 Chapter 3 AP-13 ( 5 ) Your company uses the balance sheet approach to estimate bad debts. Details of the accounts receivable balances owing on December 31, 2011 are shown below: Aging Category Bad debt % (probability of being uncollectible) Balance Under 30 days 1% $90, days 20% 90,000 Over 60 days 50% 30,000 Total $210,000 a) Calculate the required allowance. Aging Category Bad debt % (probability of being uncollectible) Balance Required allowance Under 30 days 1% $90, days 20% 90,000 18,000 Over 60 days 50% 30,000 15,000 Total $210,000 33,900 b) Write the journal entry to record bad debt expense for the year, assuming that the allowance account has a $20,000 credit balance. Dec 31 Bad Debt Expense 13,900 Allowance for Doubtful Accounts 13,900 To record allowance for doubtful accounts $33,900 - $20,000 AP-14 ( 3, 4 ) During the year 2011, Jaime Corporation made total credit sales of $500,000, of which $25,000 was currently owed by customers. On the basis of historical sales, 1% of that amount will be uncollectible. Jaime Corporation uses the allowance method to account for uncollectible receivables, and uses an income statement approach to estimate the amount of receivables that will not be collected. 93

14 Required: a) Prepare the journal entry to account for the amount deemed uncollectible. Bad Debt Expense 5,000 Allowance for Doubtful Accounts 5,000 To record bad debt expense based on percentage of sales (0.01 $500,000) b) On January 20, 2012, Mrs. L. Green who owes the company $500 informs that she will be unable to pay the amount. Prepare the necessary journal entry. Jan 20 Allowance for Doubtful Accounts 500 Accounts Receivable - L. Green 500 To write off account as uncollectible c) On February 14, 2012, Mrs. L. Green wins a lottery and decides to repay the full amount owing to Jaime Corporation. Prepare the necessary journal entries. Feb 14 Accounts Receivable - L. Green 500 Allowance for Doubtful Accounts 500 To reinstate amount previously written-off Cash 500 Accounts Receivable - L. Green 500 To record receipt of payment from customer AP-15 ( 3 ) On January 1, 2012, Jay Company s allowance for doubtful accounts had a credit balance of $30,000. During 2012, Jay charged $64,000 to bad debt expense, and wrote off $46,000 of uncollectible accounts receivable. What is the balance of allowance for doubtful accounts on December 31, 2012? 94 Allowance for Doubtful Accounts - 1/1/12 $30,000 Add: Bad Debt Expense 64,000 Less: Write-off 46,000 Allowance for Doubtful Accounts - 12/31/12 $48,000

15 Chapter 3 AP-16 ( 6 ) Wechsler Company has net accounts receivable opening balance of $250,000 and ending balance of $300,000. The total sales amount for the year is $1,700,000, of which 80% are on credit. Normal credit terms are 30 days. Calculate the day sales outstanding and the accounts receivable turnover. Comment on the calculated ratios. Day Sales Outstanding = (Average Net Accounts Receivable Net Credit Sales) 365 = (275,000 1,360,000) 365 = 74 days Accounts Receivable Turnover (ART) = Net Credit Sales Average Net Accounts Receivable = (1,700,000 80%) [(300, ,000) 2] = 1,360, ,000 = 4.9 times Since the terms are 30 days and the DSO is 74 days, it appears that the company is having difficulty collecting receivables. The ART should be as close to 12 as possible so 4.9 is not a good turnover. The company should be more aggressive in collecting its accounts. AP-17 ( 7 ) Lakisha Ogata operates a proprietorship selling machinery. Because of the high value of the machinery sold, Lakisha often requires customers to sign a note. Lakisha originally sold a Gadget machine to Neil Marcin for $10,000 on November 14. The sale was initially recorded as an account receivable, but now Lakisha decides to ask Neil to sign a note. On December 1, Neil signs a one-year note to be paid in quarterly installments, plus 5% interest on the balance outstanding. Lakisha s company has a year end of April 30. Required: Prepare an amortization schedule showing the interest and payments due on the note. Use the following format: Date Opening balance Interest Total Payment Closing balance Dec 1 10,000 10,000 Mar 1 10, ,125 2,625 7,500 Jun 1 7, ,594 2,594 5,000 Sep 1 5, ,063 2,563 2,500 Dec 1 2, ,531 2,531 0 Note: The answers have been rounded to the nearest whole number. 95

16 Prepare the journal entries to reflect the transactions related to the receivable and note. Nov 14 Accounts Receivable 10,000 Sales Revenue 10,000 Dec 1 Notes Receivable 10,000 Accounts Receivable 10,000 Mar 1 Cash 2,625 Notes Receivable 2,500 Interest Revenue 125 Apr 30 Interest Receivable 63 Interest Revenue 63 Jun 1 Cash 2,594 Notes Receivable 2,500 Interest Receivable 63 Interest Revenue 31 Sep 1 Cash 2,563 Notes Receivable 2,500 Interest Revenue 63 Dec 1 Cash 2,531 Notes Receivable 2,500 Interest Revenue 31 AP-18 ( 7 ) Larry Jim owns a toy shop called Larry s Toys. The total accounts receivable balance of Larry s Toys on December 31, 2010 was $100,000. On January 1, 2011, Mr. L. Smith who owes the company $15,000 informs that he will be unable to pay the amount owing in the present year. However, he agrees to sign a two-year note to be paid in semi-annual installments, plus 3% interest on the balance outstanding. 96

17 Chapter 3 Required: Calculate the interest revenue and payment amounts. Date Opening Balance Interest Total Payment Closing Balance Jan 1, 2011 $15,000 $15,000 Jul 1, ,000 $225 $15,225 $3,975 11,250 Jan 1, , ,419 3,919 7,500 Jul 1, , ,613 3,863 3,750 Jan 1, , ,806 3,806 0 AP-19 ( 3 ) In 2010, Upper Machine Sales Company sold equipment on credit in the amount of $950,000. Total cash collections during the year were $820,000. The company determined that $7,000 of accounts receivable would not be collected and wrote them off. At the end of 2010, management decided to increase its allowance percentage to 1% of credit sales comparing to the 0.5% from last year because of the amount of accounts receivable that proved to be uncollectible during the year. At the end of 2009, the company had $135,000 in accounts receivable and a credit balance of $6,000 in allowance for doubtful accounts. Assume the company has a year end of December 31. Required: a) Prepare the necessary journal entries to record all 2010 transactions including sales, collection, the write-off, and the new allowance amount. Disregard the dates when recording the transactions. Accounts Receivable 950,000 Sales Revenue 950,000 To record sales on account Cash 820,000 Accounts Receivable 820,000 To record cash collection Allowance for Doubtful Accounts 7,000 Accounts Receivable 7,000 To write-off accounts as uncollectible Bad Debt Expense 9,500 Allowance for Doubtful Accounts 9,500 To record allowance for doubtful accounts 97

18 b) Show the amount of net accounts receivable on the balance sheet as at December 31, Accounts Receivable, December 31, 2010 ($135,000 + $950,000 $820,000 $7,000) $258,000 Less: Allowance for Doubtful Accounts ($6,000 $7,000 + $9,500) (8,500) Net Accounts Receivable $249,500 AP-20 ( 3 ) The 2009 and 2010 sales and accounts receivable information for Velcary Company are shown below: In 2009, sales for the year totaled $1,200,000 with 60% on credit. At December 31 year end, the accounts receivable had a debit balance of $55,000. The management estimated that 0.5% of all credit sales would be uncollectible. The company wrote off $3,100 worth of accounts receivable at the end of the year. During the year 2010, sales totaled $1,630,000 with 60% on credit. At the end of 2010, accounts receivable has a debit balance of $76,000. Allowance for doubtful accounts has a debit balance of $4,500. The bad debt expense for the year have not been determined or recorded. After reviewing the write-offs, the company decided that the estimated percentage for AFDA should be increased from 0.5% to 0.75%. Required: a) Prepare the journal entry to record the bad debt expense for Bad Debt Expense 7,335 Allowance for Doubtful Accounts 7,335 To record allowance for doubtful accounts ($1,630, = $7,335) b) Prepare a T-Account for the Allowance for Doubtful Accounts and enter all related transactions for year 2009 and ALLOWANCE FOR DOUBTFUL ACCOUNTS 2009 Write-offs 3,100 3,600 ($1,200, % 0.6) 500 Balance of Write-offs 5,000 7,335 ($1,630, %) 2,835 Balance of

19 Chapter 3 c) What are the net accounts receivable at the end of 2010? Accounts Receivable, December 31, 2010 $76,000 Less: Allowance for Doubtful Accounts (2,835) Net Accounts Receivable $73,165 AP-21 ( 8 ) Suppose a company has a bonus plan that rewards managers for achieving a certain level of reported net income. What incentives might management have to influence the estimated amount of uncollectible accounts receivable? A bonus plan that rewards managers for achieving a certain level of reported net income may encourage management to decrease the estimated amount of uncollectible accounts receivable. This lower estimate will result in lower bad debt expense and, therefore, higher reported net income. AP-22 ( 5 ) Nortelle Canada operates in an industry that has a high rate of bad debts. Before the year end adjustments, Nortelle Canada s accounts receivable has a debit balance of $536,000 and the allowance for doubtful accounts had a credit balance of $20,000. The year-end balance reported on the balance sheet for the allowance for doubtful accounts will be based on the aging schedule shown below: Aging Category Bad Debt % Balance Less than 16 days 2% $300, days 3% 100, days 5% 75, days 10% 32, days 20% 18,000 Over 75 days 40% 11,000 99

20 Required: a) What is the balance for the Allowance for Doubtful Accounts at year end? Aging Category Bad Debt % Balance Estimated Amount of Bad Debt Less than 16 days 2% $300,000 $6, days 3% 100,000 3, days 5% 75,000 3, days 10% 32,000 3, days 20% 18,000 3,600 Over 75 days 40% 11,000 4,400 The balance for the allowance for doubtful accounts at the year-end is: $6,000 + $3,000 + $3,750 + $3,200 + $3,600 + $4,400 = $23,950 b) Prepare the journal entry to record bad debt expense for the year Bad Debt Expense 3,950 Allowance for Doubtful Accounts 3,950 To record allowance for doubtful accounts ($23,950 20,000 = $3,950) AP-23 ( 6 ) A company s relevant accounts receivable information for year 2010 and 2011 is provided below: Average Net Accounts Receivable $1,486,739 $1,769,032 Net Credit Sales 23,075,635 22,107,

21 Chapter 3 Required: a) Calculate the accounts receivable turnover ratio for year 2010 and ART = Net Credit Sales Average Net Accounts Receivable 2011: 23,075,635 1,486,739 = 15.5 times 2010: 22,107,539 1,769,032 = 12.5 times b) Calculate the days-sales-outstanding for year 2010 and Day Sales Outstanding = 365 ART 2011: = 24 days 2010: = 29 days c) Compare and discuss the results from part a) and b). It takes the company 5 days less to collect accounts receivable from 2010 to If the credit term is 30 days, the company is performing well in collecting funds for both years. While net credit sales increased about 4.4% from 2010 to 2011, the average accounts receivable decreased almost 16%. AP-24 ( 6 ) The following information relevant to accounts receivable is presented for Dommar Company (in thousands of dollars): Accounts Receivable $319 $422 $501 Allowance for Doubtful Accounts Net Credit Sales $4,377 $3,598 $2,

22 Required: a) Calculate the Accounts Receivable Turnover Ratio for year 2010 and ART = Net Credit Sales Average Net Accounts Receivable Net Accounts Receivable = Total Accounts Receivable Allowance for Doubtful Accounts 2010: 3,598 [( ) 2] = 8.1 times 2011: 4,377 [( ) 2] = 12.4 times b) Calculate the Day Sales Outstanding for year 2010 and Day Sales Outstanding = 365 ART 2010: = 45 days 2011: =29 days c) At the 2010 year end, Dommar Company agreed to sell some of its accounts receivable with a fee paid to the purchaser. Why do you think a company would pay a fee to sell its accounts receivable? Selling accounts receivable to other parties who then collect from customers allows a company to increase its cash flow quickly when needed. d) Dommar Company sold the accounts receivable on a limited recourse basis. Research and define the meaning of selling on a limited recourse basis. Selling on a limited recourse basis means that the party who purchases the accounts receivable assumes primary responsibility for collection and absorbs any credit losses. 102

23 Chapter 3 AP-25 ( 7 ) On May 1, 2010, People s Networks sold computer networking supplies to Canadian Autos for $36,000. The cost of the supplies is $15,000. Instead of paying immediately, Canadian Autos signed a note receivable with 11% annual interest, payable in eight months with the principal amount. People s Networks has a year end of October 31. Required: a) Record the journal entry when the sale is made; assume People s Networks uses the perpetual inventory system. May 1 Notes Receivable 36,000 Sales Revenue 36,000 To record sales for notes receivable May 1 Cost of Goods Sold 15,000 Inventory 15,000 To record cost of goods sold b) Prepare journal entries for the year end adjustment. Oct 31 Interest Receivable 1,980 Interest Revenue 1,980 To record accrued interest revenue c) Prepare journal entries for receipt of payment from Canadian Autos on January 1, Jan 1 Cash 38,640 Notes Receivable 36,000 Interest Receivable 1,980 Interest Revenue 660 To record the receipt of payment for principle and interest 103

24 d) What items would be included on the balance sheet and income statement of People s Networks as at October 31, 2010 with respect to this note? The notes receivable of $36,000 and interest receivable of $1,980 would be included under the current asset category on the October 31, 2010 balance sheet. The sales revenue of $36,000 and interest revenue of $1,980 should be included on the October 31, 2010 income statement. AP-26 ( 7 ) On January 1, 2010, Beta Company determined that it would not be able to pay the account receivable that was owed to Star Inc. Beta Company was confident that it would have sufficient cash one year later, therefore signed a one-year notes payable for the $10,000 that was owed. The annual interest rate is 9%, payable on July 1 and January 1. Star Inc. has a year end of June 30. Required: a) Record journal entries for Star Inc. when the note is signed. Jan 1 Notes Receivable 10,000 Accounts Receivable 10,000 To record notes receivable in replacement of accounts receivable b) Prepare journal entries for the year end adjustment. June 30 Interest Receivable 450 Interest Revenue 450 To record accrued interest revenue c) Prepare journal entries for the receipt of first interest payment. July 1 Cash 450 Interest Receivable 450 To record receipt of interest payment 104

25 Chapter 3 d) Prepare journal entries for receipt of payment from Beta Company on January 1, Jan 1 Cash 10,450 Notes Receivable 10,000 Interest Revenue 450 To record receipt of principal and interest 105

26 Case Study CS-1 ( 1, 2, 3, 7 ) You are the Chief Financial Officer for Stanton Feery and Company. Mr. Stanton s friend, Shad Baxtor, is starting up a new company, and needs some advice on accounts receivable and bad debt accounting practices. Mr. Stanton has asked you to meet with Mr. Baxtor, and answer a few questions. He hands you a list of things that Shad Baxtor wants clarified. Here is the handwritten list: What are accounts receivable? What are bad debts? When are amounts considered bad debts? Are there different ways of accounting for bad debt expenses? How are bad debts shown on the financial statements? Which method is best for accounting for bad debts? What kind of reports are important for accounts receivable? What is an aging list? What is the difference between a credit sale and a cash sale? How can you assess the quality of accounts receivable? Should I sell on credit? Are there risks involved? a) What are accounts receivable? Accounts receivable are amounts to be collected from customers from trade sales. There are other receivables such as miscellaneous receivables for sale of non-trade items, and loans receivable for amounts loaned (not for sales) to people and companies. b) What are bad debts? Bad debts are accounts receivable that cannot be collected for various reasons. 106

27 Chapter 3 c) When are amounts considered bad debts? Amounts are considered bad debts when it is assured that they cannot be collected (e.g. the debtor is bankrupt). d) Are there different ways of accounting for bad debt expenses? Bad debt may be accounted for using either the direct write-off or allowance method. e) How are bad debts shown on the financial statements? Bad debt expense is shown as a separate line on the income statement. The allowance for bad debt is deducted from the balance of accounts receivable. f) Which method is best for accounting for bad debts? The allowance method, because it better matches expenses with revenue. g) Which reports are helpful in analyzing a company s accounts receivable? A list of all current active customers, past customers not active in the last 12 months, customer activity report listing value of purchases per month, customer activity report listing value of sales per product, customer list categorized according to sales representative or geographic location, a list of overdue accounts only. 107

28 h) What is an aging list? An aging list is a list that breaks down accounts receivable amounts by the number of days until due or past due. For example, it separates sales that are due within 30 days from sales that are overdue by 30, 60, 90 or 120 days. i) What is the difference between a credit sale and a cash sale? For cash sales, the cash is received immediately. For credit sales, the cash is collected at some future date. j) How can you assess the quality of accounts receivable? Days Sales Outstanding and Accounts Receivable Turnover can be used to assess the quality of receivables. k) What is the impact of selling on credit and what is the potential risk involved? Selling on credit may increase sales. The risk, however, is that customers may not pay, which will result in you having to record a bad debt expense. This, in turn, will reduce Net Income for the period. 108