Financial Accounting Test 3 (Milbach)

Allowance for Doubtful Accounts

- "CONTRA-ACCOUNT", also a "contra-ASSET" account)

- always paired with accounts receivable (**means nothing on its own**)

- Increases with a credit balance, has a normal credit balance, but goes on the ASSET side of #BAE

Uncollectible Accounts Expense

-normal expense account (equity account)

- debit to increase

average number of days to collect accounts receivable

365 / (sales /net accounts receivable)

Allowance Method of Accounting for Uncollectible Accounts

- acknowledge that not ALL receivables will ultimately be collected

- this involves making an ESTIMATE- before collectability is known (or in advance of being known) of uncollectible accounts

Two Broad Methods for the Allowance Method (or how to making estimates on gaining accounts receivables back)

- percent of revenues (or % of Sales on Account, % of Credit Sales)

- percent of receivables

What is the goal of estimating accounts receivables?

To better match expenses with revenues? or to avoid overstating accounts receivable?

- BOTH of these questions are objective of using any allowance methods

- One approach toward estimating "bad debts" (uncollectible accounts) will do a better job achieving one objective than the other will (and vise versa)

To match expenses with revenues (% of revenue allowance method)

- Step 1: Determine uncollectible accounts expense (multiply the given % times revenue on account for the period)

- Step 2: The opposite side is a credit to the "allowance for doubtful accounts" account

To avoid overstating accounts receivable (% of receivables allowance method)

- Step 1: Determine a reasonable ending balance for the allowance for doubtful accounts (a given % of the ending A/Rec balance)

- Step 2: Plug a credit to the allowance of doubtful accts to force it to have the desired ending balance from step 1

- Step 3: Debit uncollectible accounts Expense for the same amount as the plug in step 2

Allowance for Doubtful Accounts

- "Overstated" receivables would falsely indicate the amount of future cash inflows

- Because we do not want to overstate assets, we must show accounts receivables at its net realizable value on the balance sheet

GAAP requirements for financial statement presentation

GAAP requires disclosure to both the NRV and the amount of the allowance accounts

1. Show both in the balance sheet or

2. Show only in the NRV on the balance sheet and disclose the amount of the allowance in the notes to the financial statements

allowance method (estimate of uncollectible accounts)

-accounts receivable is not DIRECTLY reduced because none of the receivables have actually been determined to be uncollectible

-nrv (net realizable value) of accounts receivable is reduced

write-off method

- accounts receivable is REDUCED because what was once "receivable" is no longer receivable

- nrv (net realizable value) of accounts recievable DOES NOT CHANGE

write offs of accounts recievable under ANY allowance method (reinstatement)

- asset exchange transaction

- nrv of accounts receivable is not collected

- NO FINANCIAL STATEMENTS ARE AFFECTED!

recovery of account (collection)

- asset exchange transaction

- balance sheet is only affected through mix of assets

- no income statement effect

- cash flows from operating activities increase

percent of recievables method

1. flat % of ending accounts receivable balance ("allowance method")

2. aging of A/R method

*FOR BOTH OF THE ABOVE METHODS, we are first determining what the reported NRV of A/R should be... or really, what the ending balance of the Allowance for Doubtful Accounts should be*

.... then we back into uncollectible accounts expense

aging of accounts receivable method

- "aging": break down of customer amounts due to "buckets"

- buckets are based on days outstanding at the balance sheet date

direct write-off method

when uncollectible accounts are not material, GAAP allows companies to use the direct write-off method of accounting for uncollectibles

- skip the "allowance" part and go straight to the write-off

*THERE IS NO ALLOWANCE FOR DOUBTFUL ACCOUNTS WITH THE DIRECT WRITE-OFF METHOD*

under the direct write-off method

- Uncollectible accounts expense is recognized in the period in which an account

is identified - and written off - as uncollectible

- Fails to match revenues with expenses

- Overstates assets (receivables are reported at face value, rather than NRV)

- Less record-keeping (more convenient)

DIRECT WRITE OFF METHOD

- debit: uncollectible accounts expense

- credit: accounts receivable

susequent recovery and collect of write off method

1. debit: accounts receivable

credit: uncollectible accts exp

2. debit: cash

credit: accounts receivable

when a company allows customers to "buy now and pay later," the company's right to collect cash in the future is

accounts receivable (these receivables are typically SMALL and the COLLECTION PERIOD IS SHORT)

When a longer credit term is needed, or when the receivable is LARGE, the company usually requires the customer to issue a note that specifies the maturity (due) date, interest rate, and other terms. This is when the company records a...

notes receivable

maker

borrower/debtor

payee

creditor/lender

principal

amount of money loaned

interest

expressed annually; interest compensates the lender for giving up the right to use the loaned cash while the borrower has it

maturity date

date on which borrower must repay the principal along with interest

collateral

assets owned by the borrower, pledges to ensure that the principal and interest are paid when due; if borrower doesn't pay, lender assumes ownership of the collateral

Notes receivable: issuance

- asset exchange transaction

- no income statement effect

- cash outflow: INVESTING ACTIVITIES

investing activities

no longer reserved for purchase and sale of land

assets are reported on the balance sheet in order of

liquidity

liquidity

- how quickly assets are expected to be converted to cash

- cash, then, is listed first

rather than maintaining a credit-granting department...

many companies find it more cost-efficient to accept third-party credit cards

ex: Visa, Mastercard, Discovery, AmEx

accounts receivable turnover ratio

- measures how fast accounts receivable are collected in cash

- (sales) / (net accounts receivable)

How do credit card companies make money?

- Charge interest to their customers for balances outstanding

- **Charge a service fee to companies who accept credit cards from

customers**

For credit card fees... transactions are run through the machine

for the amount of sales revenue

settlement

- The credit card company will cut a check (or transfer money) to the vendor for the amount of the transactions, less a service fee

- In other words, the credit card company pays a net amount to the vendor (gross sales - credit card processing fee)

- Fees range between 1% and 5% and are specified in an agreement

Between the time of sale and settlement by the credit card company...

**the

vendor has an account receivable from the credit card company for the

NET amount (sales revenue - processing fee)**

credit sales

offering customers the option to pay "on account"

direct costs of extending credit to customers

- uncollectible accounts expense

- record keeping costs

indirect costs

- Opportunity cost: when a customer can delay payment, the creditor

forgoes the ability to invest the amount the customer owes

■ At a minimum, that money could be earning interest at the bank

■ If the company has to borrow money to make the payments it owes, this problem is worse!

accounts recievable turnover

- # of times A/R is converted to cash in a year (higher is better)

- Generally, use NRV of A/R in the denominator

- If available, use Credit Sales (i.e., Sales on Account) instead of total Sales

average number of days to collect accounts receivable (avg. collection period)

- How many days, on average, it takes a company to collect A/R

- Shorter is better!!!

length of operating cycle

- Average time it takes a business to convert inventory to A/Rec (to

sell inventory), plus

- Average time it takes to convert A/Rec to cash (to collect A/R)

operating cycle

add: avg days in inventory + avg days to collect A/R

*shorter operating cycles are generally better*

tangible assets

- physical presence; can be seen and touched

- ex: property, plant, equipment, natural resources, land

intangible assets

- rights or privileges; while paper evidence of their existence is usually available, the asset, itself, cannot be seen/touched

- ex: identifiable lives like patent and copyrights, unidentifiable lives like renewable franchises, trademarks and goodwill

cost of long-term assets

- any cost incurred to acquire the asset and get it ready for its intended use

- exceptions: fines, damage to asset during acquisition/installation, etc. (costs that presumably could have been avoided)

- proceeds made from sale of scraps or sale of the old asset--> offset the cost

THESE ARE ALMOST ALWAYS **ONE TIME** COSTS!!! (RELATED TO ONE MAIN EVENT)

the original cost (or the historical cost) of an asset includes all of the following for buildings

purchase price, sales taxes, title fees, realtor & attorney fees,

remodeling costs

the original cost (or the historical cost) of an asset includes all of the following for equipment

purchase price (less discounts; in other words, purchase price = the amount actually paid), sales taxes, delivery & installation costs, costs to modify/adapt equipment for its intended use

the original cost (or the historical cost) of an asset includes all of the following for land

purchase price, sales taxes, title fees, realtor & attorney fees, costs to remove any existing structures/buildings ("razing" costs), grading (leveling/clearing) & any other costs to prepare the land

the following phrases are equivalent

- amount to be capatilized

- cost of the asset

- amount of cost, or dollar amount recorded in the respective asset account

basket purchase

- acquisition of a group of assets in a single transaction

- cost of each individual asset might not be known

- For example: When you buy a house, you technically buy a house and a designated plot of land for some "total" price. But that price is not usually broken out across the land and the house.

accounting rules treat ___ differently from the building, which means we need to break out the total cost across each type of asset

LAND

relative market value method

- Based on appraised (third party) estimates of the value of each

item

- We can come up with estimates of relative cost (in other words,

the % of the total cost that should be allocated to each asset)

relative market value method (continued)

The total cost is STILL the amount paid (i.e., the historical cost)

- The appraisal simply gives us a way to assign relative weights

(i.e., proportional costs of each asset) to the PRICE WE ACTUALLY PAID for the "basket" of assets

expense

use of an asset in the course of business

depreciation expense

tangible LONG-TERM assets

depreciated assets

- Office buildings

- Manuf. Plants

- Warehouses

- Equipment

- Machinery

- Vehicles

straight line depreciation method

same amount of depreciation expense every year of the assets life

double-declining balance depreciation method

more depreciation expense in early years, decreasing expense through life of asset

units of production depreciation method

depreciation expense depends on how much the asset is actually used each period

total lifetime depreciation expense (if asset is kept to retirement) will be the ___ across all methods

same

accumulated depreciation

- Contra-Asset Account (like the Allowance for Doubtful Accounts, mechanically)

- As the account title suggests, the balance in this account accumulates over time

accumulated depreciation

historical cost- accumulated depreciation = book value of asset

- No matter which method is used for depreciation, At the end of the asset's life,

Total Accumulated Depreciation = (Cost - Salvage Value)

(& Book Value will = Salvage Value)

depreciation expense

amount of an asset's cost that is allocated to expense during an accounting period

accumulated depreciation

- contra-asset (normal balance is a credit balance)

- sum of depreciation expense recognized so far for a given asset

- subtract balance from the asset's cost in determining book value of asset

salvage value

- Estimated amount for which we can sell the asset at the end of its useful life;

- More formally: Expected market value of fully depreciated asset

depreciable cost

- = original cost- salvage value

- Total amount of depreciation to be recognized for a given asset

book value

- = original cost - accumulated depreciation

- a.k.a., Carrying value of the asset

units of production method

- This is an activity-based depreciation method; depreciation expense is

based on actual asset usage. The expense will vary year-to-year.

- Step 1: determine a way to measure the asset's productive capacity

- The measurement should reflect the nature of the asset. For example:

■ Miles to be driven

■ Widgets to be produced

■ Hours to be operated

■ Step 2: Determine the depreciation expense per unit of production

depreciation expense per Unit formula (step 2 in from units of production method)

= (Cost - Salvage Value) / (Total Productive Capacity)

* you only do the per unit calculation ONCE

annual depreciation expense (step 3 in from units of production method)

= cost per unit (from step 2) * the actual number of units used (or produced)

*** an asset cannot be depreciated below its salvage value

life cycle of operational assets

- acquire funding

- buy asset

- use asset

- retire asset

The IRS dictates how much a firm can/must depreciate each year for a given type of asset

- Otherwise, all companies would pick the depreciation method that maximized reported expenses (to minimize taxable income)

- Further, all companies would ONLY purchase assets on January 1 (to maximize the amount of expense claimed per year & reduce taxable income

Tax law requires use of the ___ (MACRS, pronounced like "makers")

modified accelerated cost recovery system

maximum allowable depreciation expense for tax reporting =

cost of the asset * the % for a given year

NO consideration of salvage value...

for tax reporting, we depreciate 100% of the cost of the asset

half-year convention

the % for year 1 already factors this in. You don't have to do anything for your calculations.

- the date the asset was purchased does NOT matter

revision of estimates: depreciation is based on several estimates

- useful life

- salvage value

- productivity capacity

revision of estimates: Estimates are frequently revised upon learning new information

- GAAP treatment for revision of estimates:

- No correction of prior periods

- Incorporate new information into current and future calculations

revenue expenditures (cost that are expensed)

Costs incurred to keep an asset in good

working order

- Routine maintenance

- Minor repairs

** operating activities

capital expenditures (costs that are capitalized)

Substantial amounts spent to improve the quality, or extend the life, of an asset

- Improve quality

** investing activities

depletion of natural resources

natural resources

- timber land

- oil and gas reserves

- mineral deposits

- coal mines, copper mines

- stone quarries

** acquisition cost- includes purchase price, exploration, surveys, estimates, etc.

depletion charge per unit of resource =

(cost -salvage value) / (total estimated units recoverable)

periodic depletion expense =

(depletion charge per unit) * (# of units extracted and sold this period)

note for # of units extracted and sold this period: WE WILL ALWAYS assume that the amount extracted was sold in the same period!!!

depletion expense

- There is NO such thing as "accumulated depletion"

- The journal entry to record depletion instead reduces the asset, itself

patents (know) (intangible assets with identifiable (finite) lives)

- Granted by U.S. Patent Office; legal life of 20 years

- Owner has exclusive legal right to produce and sell a product that has one

or more unique features

- Internally developed patentsExpense all costs as incurred

- Externally acquired (purchased) patents--> Capitalize costs incurred to obtain

(purchase price) and to defend (legal fees) the patent

copyrights (know) (intangible assets with identifiable (finite) lives)

- Protects written work, musical compositions, works of art, and other intellectual property for the exclusive benefit of the creator or persons assigned the right by the creator

- Cost includes purchase price paid and any legal costs associated with obtaining and defending the copyrightcan capitalize, but most expense

- Granted by the federal government; last for the life of the creator + 70 years

trademarks (know) (intangible asset with unidentifiable (indefinite)

- Logo, name, symbol, emblem, slogan {anything followed by TM }

- Registered with federal government; indefinite legal life

- Costs to design, purchase, or defend a trademark --> capitalize

franchises (know) (intangible asset with unidentifiable (indefinite)

- Grant exclusive rights to sell products or perform services in

specific geographic areas

- May be granted by governments (broadcasting rights) or private

businesses (restaurant chains)

- Legal & useful life is a matter of judgment

goodwill (know) (intangible asset with unidentifiable (indefinite)

- Inherent value associated with reputation, location, superior

products, etc.

- Financially, goodwill is the premium a buyer would pay for a business

over-and-above the fair value of the net identifiable assets of the company being purchased

goodwill

the excess of cost over fair value of net tangible assets acquired in a business acquisition

amortization

- If capitalized, the costs of intangible assets with identifiable useful lives are expensed on a straight-line basis

An intangible asset should be amortized over the shorter of two periods:

- legal life

- useful life

impairment testing for intangible assets with unidentifiable (indefinite) lives

- impairment is the situation where the carrying value of the intangible asset is greater than the amount someone would pay for it (i.e., the "fair value" of that asset)

- Must test indefinite-lived intangibles for impairment at least annually

- If fair value < book value,

- Impairment loss = Fair value - Book Value

most states require retailers to collect ___ on goods sold to their customers

sales tax

Retailers collect the tax from customers and remit the tax to the _________.

- the state at regular intervals

- this activity does not affect the retailer's revenues or expenses

contigent liabilities

a potential obligation arising from a past event. The amount or existence of the obligation depends on some future event

example: a pending lawsuit

Accounting standards require companies to classify contingent liabilities into ____ of three categories

one