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Accounting Principles: A Business Perspective

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James Don Edwards, PhD, D.H.C. J.M. Tull Professor Emeritus of Accounting

Terry College of Business University of Georgia

Roger H. Hermanson, PhD Regents Professor Emeritus of Accounting

Ernst & Young-J. W. Holloway Memorial Professor Emeritus Georgia State University

Funding for the first Global Text edition was provided by

Endeavour International Corporation, Houston, Texas, USA.

The Global Text Project is funded by the Jacobs Foundation, Zurich, Switzerland.

This book is licensed under a Creative Commons Attribution 3.0 License

This book is licensed under a Creative Commons Attribution 3.0 License

9. Receivables and payables Learning objectives

After studying this chapter, you should be able to:

• Account for uncollectible accounts receivable under the allowance method.

• Record credit card sales and collections.

• Define liabilities, current liabilities, and long-term liabilities.

• Define and account for clearly determinable, estimated, and contingent liabilities.

• Account for notes receivable and payable, including calculation of interest.

• Account for borrowing money using an interest-bearing note versus a non interest-bearing note.

• Analyze and use the financial results—accounts receivable turnover and the number of days' sales in accounts

receivable.

A career in litigation support What is litigation support? It does not mean working in an attorney's office. It involves assisting legal counsel in

attempting to gain favorable verdicts in a court of law. Persons involved in litigation support generally work for a

public accounting firm, a consulting firm, or as a sole proprietor or in partnership with others. An experienced

litigation support person can expect to earn an income well into six figures.

Litigation support in a broad sense encompasses fraud auditing, valuation analysis, investigative accounting,

and forensic accounting. The practice of litigation support involves assisting legal counsel in such things as product

liability disputes, shareholder disputes, contract breaches, and major losses reported by entities. These

investigations require the accountant to gather and evaluate evidence to assess the integrity and dollar amounts

surrounding the aforementioned situations.

The accountant can be, and often is, requested to serve as an expert witness in a court of law. This experience

requires knowledge of accounting and auditing in addition to possessing good communication skills, appropriate

credentials, relevant experience, and critical information that could result in successful resolution of the issue.

What kind of person pursues litigation support as a career? It takes a very special individual. The person must

be part accountant, part auditor, part lawyer, and part skilled businessperson. An undergraduate accounting

degree, an MBA, and a law degree would be the perfect educational background needed for such a career. Many

universities offer a combined MBA/JD program. Such a program fulfills the graduate needs of the litigation support

person.

In addition to the degree, work experience in the business sector is essential. A career in public accounting,

industry, or with a government agency would serve as valuable experience in pursuing a career in litigation support.

Accounting Principles: A Business Perspective 396 A Global Text

9. Receivables and payables

Much of the growth of business in recent years is due to the immense expansion of credit. Managers of

companies have learned that by granting customers the privilege of charging their purchases, sales and profits

increase. Using credit is not only a convenient way to make purchases but also the only way many people can own

high-priced items such as automobiles.

This chapter discusses receivables and payables. For a company, a receivable is any sum of money due to be

paid to that company from any party for any reason. Similarly, a payable describes any sum of money to be paid by

that company to any party for any reason.

Primarily, receivables arise from the sale of goods and services. The two types of receivables are accounts

receivable, which companies offer for short-term credit with no interest charge; and notes receivable, which

companies sometimes extend for both short-and long-term credit with an interest charge. We pay particular

attention to accounting for uncollectible accounts receivable.

Like their customers, companies use credit, which they show as accounts payable or notes payable. Accounts

payable normally result from the purchase of goods or services and do not carry an interest charge. Short-term

notes payable carry an interest charge and may arise from the same transactions as accounts payable, but they can

also result from borrowing money from a bank or other institution. Chapter 4 identified accounts payable and

short-term notes payable as current liabilities. A company also incurs other current liabilities, including payables

such as sales tax payable, estimated product warranty payable, and certain liabilities that are contingent on the

occurrence of future events. Long-term notes payable usually result from borrowing money from a bank or other

institution to finance the acquisition of plant assets. As you study this chapter and learn how important credit is to

our economy, you will realize that credit in some form will probably always be with us.

Accounts receivable In Chapter 3, you learned that most companies use the accrual basis of accounting since it better reflects the

actual results of the operations of a business. Under the accrual basis, a merchandising company that extends credit

records revenue when it makes a sale because at this time it has earned and realized the revenue. The company has

earned the revenue because it has completed the seller's part of the sales contract by delivering the goods. The

company has realized the revenue because it has received the customer's promise to pay in exchange for the goods.

This promise to pay by the customer is an account receivable to the seller. Accounts receivable are amounts that

customers owe a company for goods sold and services rendered on account. Frequently, these receivables resulting

from credit sales of goods and services are called trade receivables.

When a company sells goods on account, customers do not sign formal, written promises to pay, but they agree

to abide by the company's customary credit terms. However, customers may sign a sales invoice to acknowledge

purchase of goods. Payment terms for sales on account typically run from 30 to 60 days. Companies usually do not

charge interest on amounts owed, except on some past-due amounts.

Because customers do not always keep their promises to pay, companies must provide for these uncollectible

accounts in their records. Companies use two methods for handling uncollectible accounts. The allowance method

provides in advance for uncollectible accounts. The direct write-off method recognizes bad accounts as an expense

at the point when judged to be uncollectible and is the required method for federal income tax purposes. However,

since the allowance method represents the accrual basis of accounting and is the accepted method to record

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uncollectible accounts for financial accounting purposes, we only discuss and illustrate the allowance method in

this text.

Even though companies carefully screen credit customers, they cannot eliminate all uncollectible accounts.

Companies expect some of their accounts to become uncollectible, but they do not know which ones. The matching

principle requires deducting expenses incurred in producing revenues from those revenues during the accounting

period. The allowance method of recording uncollectible accounts adheres to this principle by recognizing the

uncollectible accounts expense in advance of identifying specific accounts as being uncollectible. The required entry

has some similarity to the depreciation entry in Chapter 3 because it debits an expense and credits an allowance

(contra asset). The purpose of the entry is to make the income statement fairly present the proper expense and the

balance sheet fairly present the asset. Uncollectible accounts expense (also called doubtful accounts expense

or bad debts expense) is an operating expense that a business incurs when it sells on credit. We classify

uncollectible accounts expense as a selling expense because it results from credit sales. Other accountants might

classify it as an administrative expense because the credit department has an important role in setting credit terms.

To adhere to the matching principle, companies must match the uncollectible accounts expense against the

revenues it generates. Thus, an uncollectible account arising from a sale made in 2010 is a 2010 expense even

though this treatment requires the use of estimates. Estimates are necessary because the company sometimes

cannot determine until 2008 or later which 2010 customer accounts will become uncollectible.

Recording the uncollectible accounts adjustment A company that estimates uncollectible accounts

makes an adjusting entry at the end of each accounting period. It debits Uncollectible Accounts Expense, thus

recording the operating expense in the proper period. The credit is to an account called Allowance for Uncollectible

Accounts.

As a contra account to the Accounts Receivable account, the Allowance for Uncollectible Accounts (also

called Allowance for doubtful accounts or Allowance for bad debts) reduces accounts receivable to their net

realizable value. Net realizable value is the amount the company expects to collect from accounts receivable.

When the firm makes the uncollectible accounts adjusting entry, it does not know which specific accounts will

become uncollectible. Thus, the company cannot enter credits in either the Accounts Receivable control account or

the customers' accounts receivable subsidiary ledger accounts. If only one or the other were credited, the Accounts

Receivable control account balance would not agree with the total of the balances in the accounts receivable

subsidiary ledger. Without crediting the Accounts Receivable control account, the allowance account lets the

company show that some of its accounts receivable are probably uncollectible.

To illustrate the adjusting entry for uncollectible accounts, assume a company has USD 100,000 of accounts

receivable and estimates its uncollectible accounts expense for a given year at USD 4,000. The required year-end

adjusting entry is:

Dec. 31 Uncollectible Accounts Expense (-SE) 4,000 Allowance for Uncollectible Accounts (-A) 4,000 To record estimated uncollectible accounts.

The debit to Uncollectible Accounts Expense brings about a matching of expenses and revenues on the income

statement; uncollectible accounts expense is matched against the revenues of the accounting period. The credit to

Allowance for Uncollectible Accounts reduces accounts receivable to their net realizable value on the balance sheet.

Accounting Principles: A Business Perspective 398 A Global Text

9. Receivables and payables

When the books are closed, the firm closes Uncollectible Accounts Expense to Income Summary. It reports the

allowance on the balance sheet as a deduction from accounts receivable as follows:

Brice Company Balance Sheet

2010 December 31 Current assets Cash $21,200 Accounts receivable $ 100,000 Less: Allowance for uncollectible accounts 4,000 96,000

Estimating uncollectible accounts Accountants use two basic methods to estimate uncollectible accounts

for a period. The first method—percentage-of-sales method—focuses on the income statement and the relationship

of uncollectible accounts to sales. The second method—percentage-of-receivables method—focuses on the balance

sheet and the relationship of the allowance for uncollectible accounts to accounts receivable.

Percentage-of-sales method The percentage-of-sales method estimates uncollectible accounts from the

credit sales of a given period. In theory, the method is based on a percentage of prior years' actual uncollectible

accounts to prior years' credit sales. When cash sales are small or make up a fairly constant percentage of total

sales, firms base the calculation on total net sales. Since at least one of these conditions is usually met, companies

commonly use total net sales rather than credit sales. The formula to determine the amount of the entry is:

Amount of journal entry for uncollectible accounts – Net sales (total or credit) x Percentage estimated as

uncollectible

To illustrate, assume that Rankin Company's uncollectible accounts from 2008 sales were 1.1 per cent of total

net sales. A similar calculation for 2009 showed an uncollectible account percentage of 0.9 per cent. The average

for the two years is 1 per cent [(1.1 +0.9)/2]. Rankin does not expect 2010 to differ from the previous two years.

Total net sales for 2010 were USD 500,000; receivables at year-end were USD 100,000; and the Allowance for

Uncollectible Accounts had a zero balance. Rankin would make the following adjusting entry for 2010:

Dec. 31 Uncollectible Accounts Expense (-SE) 5,000 Allowance for Uncollectible Accounts (-A) 5,000 To record estimated uncollectible accounts ($500,000 X 0.01).

Using T-accounts, Rankin would show:

Uncollectible Accounts Expense Allowance for Uncollectible Accounts Dec. 31 Bal. before Adjustment 5,000 adjustment -0-

Dec. 31 Adjustment 5,000 Bal. after adjustment 5,000

Rankin reports Uncollectible Accounts Expense on the income statement. It reports the accounts receivable less

the allowance among current assets in the balance sheet as follows:

Accounts receivable $ 100,000 Less: Allowance for uncollectible accounts 5,000 $ 95,000 Or Rankin's balance sheet could show: Accounts receivable (less estimated uncollectible accounts, $5,000) $95,000

On the income statement, Rankin would match the uncollectible accounts expense against sales revenues in the

period. We would classify this expense as a selling expense since it is a normal consequence of selling on credit.

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The Allowance for Uncollectible Accounts account usually has either a debit or credit balance before the year-

end adjustment. Under the percentage-of-sales method, the company ignores any existing balance in the allowance

when calculating the amount of the year-end adjustment (except that the allowance account must have a credit

balance after adjustment).

For example, assume Rankin's allowance account had a USD 300 credit balance before adjustment. The

adjusting entry would still be for USD 5,000. However, the balance sheet would show USD 100,000 accounts

receivable less a USD 5,300 allowance for uncollectible accounts, resulting in net receivables of USD 94,700. On the

income statement, Uncollectible Accounts Expense would still be 1 per cent of total net sales, or USD 5,000.

In applying the percentage-of-sales method, companies annually review the percentage of uncollectible accounts

that resulted from the previous year's sales. If the percentage rate is still valid, the company makes no change.

However, if the situation has changed significantly, the company increases or decreases the percentage rate to

reflect the changed condition. For example, in periods of recession and high unemployment, a firm may increase

the percentage rate to reflect the customers' decreased ability to pay. However, if the company adopts a more

stringent credit policy, it may have to decrease the percentage rate because the company would expect fewer

uncollectible accounts.

Percentage-of-receivables method The percentage-of-receivables method estimates uncollectible

accounts by determining the desired size of the Allowance for Uncollectible Accounts. Rankin would multiply the

ending balance in Accounts Receivable by a rate (or rates) based on its uncollectible accounts experience. In the

percentage-of-receivables method, the company may use either an overall rate or a different rate for each age

category of receivables.

To calculate the amount of the entry for uncollectible accounts under the percentage-of-receivables method

using an overall rate, Rankin would use:

Amount of entry for uncollectible accounts – (Accounts receivable ending balance x percentage estimated as

uncollectible) – Existing credit balance in allowance for uncollectible accounts or existing debit balance in

allowance for uncollectible accounts

Using the same information as before, Rankin makes an estimate of uncollectible accounts at the end of 2010.

The balance of accounts receivable is USD 100,000, and the allowance account has no balance. If Rankin estimates

that 6 per cent of the receivables will be uncollectible, the adjusting entry would be:

Dec. 31 Uncollectible Accounts Expense (-SE) 6,000 Allowance for Uncollectible Accounts (-A) 6,000 To record estimated uncollectible accounts ($100,000 X 0.06).

Using T-accounts, Rankin would show:

Uncollectible Accounts Expense Allowance for Uncollectible Accounts Dec. 31 Bal. before Adjustment 6,000 Adjustment -0-

Dec. 31 Adjustment 6,000 Bal. after Adjustment 6,000

If Rankin had a USD 300 credit balance in the allowance account before adjustment, the entry would be the

same, except that the amount of the entry would be USD 5,700. The difference in amounts arises because

Accounting Principles: A Business Perspective 400 A Global Text

9. Receivables and payables

management wants the allowance account to contain a credit balance equal to 6 per cent of the outstanding

receivables when presenting the two accounts on the balance sheet. The calculation of the necessary adjustment is

[(USD 100,000 X 0.06)-USD 300] = USD 5,700. Thus, under the percentage-of-receivables method, firms consider

any existing balance in the allowance account when adjusting for uncollectible accounts. Using T-accounts, Rankin

would show:

Uncollectible Accounts Expense Allowance for Uncollectible Accounts Dec. 31 Bal. before Adjustment 5,700 Adjustment 300

Dec. 31 Adjustment 5,700 Bal. after Adjustment 6,000

ALLEN COMPANY Accounts Receivable Aging Schedule

2010 December 31

Customer

Accounts Receivable Balance

Not Yet Due

Days Past Due

1-30 31-60 61-90 Over 90

X $ 5,000 $ 5,000 Y 14,000 $ 12,000 $2,000 Z 400 $200 200 All others 808,600 $ 560,000 240,000 2,000 600 6,000

$ 828,000 $ 560,000 $252,000 $4,000 $800 $11,200

Percentage estimated as uncollectible Estimated amount uncollectible

1% 5% 10% 25% 50%

$ 24,400 $ 5,600 $ 12,600 $ 400 $200 $ 5,600

Exhibit 77: Accounts receivable aging schedule

As another example, suppose that Rankin had a USD 300 debit balance in the allowance account before

adjustment. Then, a credit of USD 6,300 would be necessary to get the balance to the required USD 6,000 credit

balance. The calculation of the necessary adjustment is [(USD 100,000 X 0.06) + USD 300] = USD 6,300. Using T-

accounts, Rankin would show:

Uncollectible Accounts Expense Allowance for Uncollectible Accounts Dec. 31 Bal. before Dec. 31 Adjustment 6,300 Adjustment 300 Adjustment 6,300

Bal. after Adjustment 6,000

No matter what the pre-adjustment allowance account balance is, when using the percentage-of-receivables

method, Rankin adjusts the Allowance for Uncollectible Accounts so that it has a credit balance of USD 6,000—

equal to 6 per cent of its USD 100,000 in Accounts Receivable. The desired USD 6,000 ending credit balance in the

Allowance for Uncollectible Accounts serves as a "target" in making the adjustment.

So far, we have used one uncollectibility rate for all accounts receivable, regardless of their age. However, some

companies use a different percentage for each age category of accounts receivable. When accountants decide to use

a different rate for each age category of receivables, they prepare an aging schedule. An aging schedule classifies

accounts receivable according to how long they have been outstanding and uses a different uncollectibility

percentage rate for each age category. Companies base these percentages on experience. In Exhibit 77, the aging

schedule shows that the older the receivable, the less likely the company is to collect it.

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Classifying accounts receivable according to age often gives the company a better basis for estimating the total

amount of uncollectible accounts. For example, based on experience, a company can expect only 1 per cent of the

accounts not yet due (sales made less than 30 days before the end of the accounting period) to be uncollectible. At

the other extreme, a company can expect 50 per cent of all accounts over 90 days past due to be uncollectible. For

each age category, the firm multiplies the accounts receivable by the percentage estimated as uncollectible to find

the estimated amount uncollectible.

The sum of the estimated amounts for all categories yields the total estimated amount uncollectible and is the

desired credit balance (the target) in the Allowance for Uncollectible Accounts.

Since the aging schedule approach is an alternative under the percentage-of-receivables method, the balance in

the allowance account before adjustment affects the year-end adjusting entry amount recorded for uncollectible

accounts. For example, the schedule in Exhibit 77 shows that USD 24,400 is needed as the ending credit balance in

the allowance account. If the allowance account has a USD 5,000 credit balance before adjustment, the adjustment

would be for USD 19,400.

The information in an aging schedule also is useful to management for other purposes. Analysis of collection

patterns of accounts receivable may suggest the need for changes in credit policies or for added financing. For

example, if the age of many customer balances has increased to 61-90 days past due, collection efforts may have to

be strengthened. Or, the company may have to find other sources of cash to pay its debts within the discount

period. Preparation of an aging schedule may also help identify certain accounts that should be written off as

uncollectible.

An accounting perspective:

Business insight

According to the Fair Debt Collection Practices Act, collection agencies can call persons only

between 8 am and 9 pm, and cannot use foul language. Agencies can call employers only if the

employers allow such calls. And, they can threaten to sue only if they really intend to do so.

Write-off of receivables As time passes and a firm considers a specific customer's account to be uncollectible,

it writes that account off. It debits the Allowance for Uncollectible Accounts. The credit is to the Accounts

Receivable control account in the general ledger and to the customer's account in the accounts receivable subsidiary

ledger. For example, assume Smith's USD 750 account has been determined to be uncollectible. The entry to write

off this account is:

Allowance for Uncollectible Accounts (-SE) 750 Accounts Receivable—Smith (-A) 750 To write off Smith's account as uncollectible.

The credit balance in Allowance for Uncollectible Accounts before making this entry represented potential

uncollectible accounts not yet specifically identified. Debiting the allowance account and crediting Accounts

Receivable shows that the firm has identified Smith's account as uncollectible. Notice that the debit in the entry to

write off an account receivable does not involve recording an expense. The company recognized the uncollectible

Accounting Principles: A Business Perspective 402 A Global Text

9. Receivables and payables

accounts expense in the same accounting period as the sale. If Smith's USD 750 uncollectible account were

recorded in Uncollectible Accounts Expense again, it would be counted as an expense twice.

A write-off does not affect the net realizable value of accounts receivable. For example, suppose that Amos

Company has total accounts receivable of USD 50,000 and an allowance of USD 3,000 before the previous entry;

the net realizable value of the accounts receivable is USD 47,000. After posting that entry, accounts receivable are

USD 49,250, and the allowance is USD 2,250; net realizable value is still USD 47,000, as shown here:

Before Entry for After Write-Off Write-Off Write-Off

Accounts receivable $ 50,000 Dr. $750 Cr. $ 49,250 Dr. Allowance for uncollectible accounts 3,000 Cr. 750 Dr. 2,250 Cr. Net realizable value $47,000 $ 47,000

You might wonder how the allowance account can develop a debit balance before adjustment. To explain this,

assume that Jenkins Company began business on 2009 January 1, and decided to use the allowance method and

make the adjusting entry for uncollectible accounts only at year-end. Thus, the allowance account would not have

any balance at the beginning of 2009. If the company wrote off any uncollectible accounts during 2009, it would

debit Allowance for Uncollectible Accounts and cause a debit balance in that account. At the end of 2009, the

company would debit Uncollectible Accounts Expense and credit Allowance for Uncollectible Accounts. This

adjusting entry would cause the allowance account to have a credit balance. During 2010, the company would again

begin debiting the allowance account for any write-offs of uncollectible accounts. Even if the adjustment at the end

of 2009 was adequate to cover all accounts receivable existing at that time that would later become uncollectible,

some accounts receivable from 2010 sales may be written off before the end of 2010. If so, the allowance account

would again develop a debit balance before the end-of-year 2010 adjustment.

Uncollectible accounts recovered Sometimes companies collect accounts previously considered to be

uncollectible after the accounts have been written off. A company usually learns that an account has been written

off erroneously when it receives payment. Then the company reverses the original write-off entry and reinstates the

account by debiting Accounts Receivable and crediting Allowance for Uncollectible Accounts for the amount

received. It posts the debit to both the general ledger account and to the customer's accounts receivable subsidiary

ledger account. The firm also records the amount received as a debit to Cash and a credit to Accounts Receivable.

And it posts the credit to both the general ledger and to the customer's accounts receivable subsidiary ledger

account.

To illustrate, assume that on May 17 a company received a USD 750 check from Smith in payment of the account

previously written off. The two required journal entries are:

May 17 Accounts Receivable—Smith (+A) Allowance for Uncollectible Accounts (-A) To reverse original write-off of Smith account.

750 750

May 17 Cash (+A) Accounts Receivable—Smith (-A) To record collection of account.

750 750

The debit and credit to Accounts Receivable—Smith on the same date is to show in Smith's subsidiary ledger

account that he did eventually pay the amount due. As a result, the company may decide to sell to him in the future.

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When a company collects part of a previously written off account, the usual procedure is to reinstate only that

portion actually collected, unless evidence indicates the amount will be collected in full. If a company expects full

payment, it reinstates the entire amount of the account.

Because of the problems companies have with uncollectible accounts when they offer customers credit, many

now allow customers to use bank or external credit cards. This policy relieves the company of the headaches of

collecting overdue accounts.

A broader perspective:

GECS allowance for losses on financing receivables

Recognition of losses on financing receivables. The allowance for losses on small-balance

receivables reflects management's best estimate of probable losses inherent in the portfolio

determined principally on the basis of historical experience. For other receivables, principally the

larger loans and leases, the allowance for losses is determined primarily on the basis of

management's best estimate of probable losses, including specific allowances for known troubled

accounts.

All accounts or portions thereof deemed to be uncollectible or to require an excessive collection

cost are written off to the allowance for losses. Small-balance accounts generally are written off

when 6 to 12 months delinquent, although any such balance judged to be uncollectible, such as an

account in bankruptcy, is written down immediately to estimated realizable value. Large-balance

accounts are reviewed at least quarterly, and those accounts with amounts that are judged to be

uncollectible are written down to estimated realizable value.

When collateral is repossessed in satisfaction of a loan, the receivable is written down against the

allowance for losses to estimated fair value of the asset less costs to sell, transferred to other assets

and subsequently carried at the lower of cost or estimated fair value less costs to sell. This

accounting method has been employed principally for specialized financing transactions.

(In millions) 2000 1999 1998 Balance at January 1 $3,708 $3,223 $2,745 Provisions charged To operations 2,045 1,671 1,603 Net transfers related to companies acquired or sold 22 271 386 Amounts written off-net

(1,741) (1,457) (1,511)

Balance at December 31 $4,034 $3,708 $3,223 Source: General Electric Company, 2000 Annual Report.

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9. Receivables and payables

An accounting perspective:

Uses of technology

Auditors use expert systems to review a client's internal control structure and to test the

reasonableness of a client's Allowance for Uncollectible Accounts balance. The expert system

reaches conclusions based on rules and information programmed into the expert system software.

The rules are modeled on the mental processes that a human expert would use in addressing the

situation. In the medical field, for instance, the rules constituting the expert system are derived

from modeling the diagnostic decision processes of the foremost experts in a given area of

medicine. A physician can input information from a remote location regarding the symptoms of a

certain patient, and the expert system will provide a probable diagnosis based on the expert model.

In a similar fashion, an accountant can feed client information into the expert system and receive

an evaluation as to the appropriateness of the account balance or internal control structure.

Credit cards are either nonbank (e.g. American Express) or bank (e.g. VISA and MasterCard) charge cards that

customers use to purchase goods and services. For some businesses, uncollectible account losses and other costs of

extending credit are a burden. By paying a service charge of 2 per cent to 6 per cent, businesses pass these costs on

to banks and agencies issuing national credit cards. The banks and credit card agencies then absorb the

uncollectible accounts and costs of extending credit and maintaining records.

Usually, banks and agencies issue credit cards to approved credit applicants for an annual fee. When a business

agrees to honor these credit cards, it also agrees to pay the percentage fee charged by the bank or credit agency.

When making a credit card sale, the seller checks to see if the customer's card has been canceled and requests

approval if the sale exceeds a prescribed amount, such as USD 50. This procedure allows the seller to avoid

accepting lost, stolen, or canceled cards. Also, this policy protects the credit agency from sales causing customers to

exceed their established credit limits.

The seller's accounting procedures for credit card sales differ depending on whether the business accepts a

nonbank or a bank credit card. To illustrate the entries for the use of nonbank credit cards (such as American

Express), assume that a restaurant American Express invoices amounting to USD 1,400 at the end of a day.

American Express charges the restaurant a 5 per cent service charge. The restaurant uses the Credit Card

Expense account to record the credit card agency's service charge and makes the following entry: Accounts Receivable—American Express (+A) 1,330 Credit Card Expense (-SE) 70 Sales (+SE) 1,400 To record credit card sales.

The restaurant mails the invoices to American Express. Sometime later, the restaurant receives payment from

American Express and makes the following entry:

Cash (+A) 1,330 Accounts Receivable – American Express (-A) 1,330 To record remittance from American Express.

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To illustrate the accounting entries for the use of bank credit cards (such as VISA or MasterCard), assume that a

retailer has made sales of USD 1,000 for which VISA cards were accepted and the service charge is USD 30 (which

is 3 per cent of sales). VISA sales are treated as cash sales because the receipt of cash is certain. The retailer deposits

the credit card sales invoices in its VISA checking account at a bank just as it deposits checks in its regular checking

account. The entry to record this deposit is:

Cash (+A) 970 Credit Card Expense (-SE) 30 Sales (+SE) 1,000 To record credit Visa card sales.

An accounting perspective:

Business insight

Recent innovations in credit cards include picture IDs on cards to reduce theft, credits toward

purchases of new automobiles (e.g. General Motors cards), credit toward free trips on airlines, and

cash rebates on all purchases. Discover Card, for example, remits a percentage of all charges back

to credit card holders. Also, some credit card companies have reduced interest rates on unpaid

balances and have eliminated the annual fee.

Just as every company must have current assets such as cash and accounts receivable to operate, every company

incurs current liabilities in conducting its operations. Corporations (IBM and General Motors), partnerships (CPA

firms), and single proprietorships (corner grocery stores) all have one thing in common—they have liabilities. The

next section discusses some of the current liabilities companies incur.

Current liabilities Liabilities result from some past transaction and are obligations to pay cash, provide services, or deliver goods

at some future time. This definition includes each of the liabilities discussed in previous chapters and the new

liabilities presented in this chapter. The balance sheet divides liabilities into current liabilities and long-term

liabilities. Current liabilities are obligations that (1) are payable within one year or one operating cycle,

whichever is longer, or (2) will be paid out of current assets or create other current liabilities. Long-term

liabilities are obligations that do not qualify as current liabilities. This chapter focuses on current liabilities and

Chapter 15 describes long-term liabilities.

Note the definition of a current liability uses the term operating cycle. An operating cycle (or cash cycle) is the

time it takes to begin with cash, buy necessary items to produce revenues (such as materials, supplies, labor, and/or

finished goods), sell goods or services, and receive cash by collecting the resulting receivables. For most companies,

this period is no longer than a few months. Service companies generally have the shortest operating cycle, since

they have no cash tied up in inventory. Manufacturing companies generally have the longest cycle because their

cash is tied up in inventory accounts and in accounts receivable before coming back. Even for manufacturing

companies, the cycle is generally less than one year. Thus, as a practical matter, current liabilities are due in one

year or less, and long-term liabilities are due after one year from the balance sheet date.

The operating cycles for various businesses follow:

Accounting Principles: A Business Perspective 406 A Global Text

9. Receivables and payables

Type of Business Operating Cycle Service company selling for cash only Instantaneous Service company selling on credit Cash -> Accounts Receivable -> Cash Merchandising company selling for cash Cash -> Inventory -> Cash Merchandising company selling on credit Cash -> Inventory -> Accounts receivable -> Cash Manufacturing company selling for cash Cash -> Materials inventory -> Work in process

inventory -> Finished goods inventory -> Accounts Receivable -> Cash

Current liabilities fall into these three groups:

• Clearly determinable liabilities. The existence of the liability and its amount are certain. Examples

include most of the liabilities discussed previously, such as accounts payable, notes payable, interest payable,

unearned delivery fees, and wages payable. Sales tax payable, federal excise tax payable, current portions of

long-term debt, and payroll liabilities are other examples.

• Estimated liabilities. The existence of the liability is certain, but its amount only can be estimated. An

example is estimated product warranty payable.

• Contingent liabilities. The existence of the liability is uncertain and usually the amount is uncertain

because contingent liabilities depend (or are contingent) on some future event occurring or not occurring.

Examples include liabilities arising from lawsuits, discounted notes receivable, income tax disputes, penalties

that may be assessed because of some past action, and failure of another party to pay a debt that a company

has guaranteed.

The following table summarizes the characteristics of current liabilities:

Is the Is the Existence Amount

Type of Liability Certain? Certain? Clearly determinable liabilities Yes Yes Estimated liabilities Yes No Contingent liabilities No No

Clearly determinable liabilities have clearly determinable amounts. In this section, we describe liabilities not

previously discussed that are clearly determinable—sales tax payable, federal excise tax payable, current portions of

long-term debt, and payroll liabilities. Later in this chapter, we discuss clearly determinable liabilities such as notes

payable.

Sales tax payable Many states have a state sales tax on items purchased by consumers. The company selling

the product is responsible for collecting the sales tax from customers. When the company collects the taxes, the

debit is to Cash and the credit is to Sales Tax Payable. Periodically, the company pays the sales taxes collected to the

state. At that time, the debit is to Sales Tax Payable and the credit is to Cash.

To illustrate, assume that a company sells merchandise in a state that has a 6 per cent sales tax. If it sells goods

with a sales price of USD 1,000 on credit, the company makes this entry: Accounts Receivable (+A) 1,060 Sales (+SE) 1,000 Sales Tax Payable (+L) 60 To record sales and sales tax payable.

Now assume that sales for the entire period are USD 100,000 and that USD 6,000 is in the Sales Tax Payable

account when the company remits the funds to the state taxing agency. The following entry shows the payment to

the state: Sales Tax Payable (-L) 6,000

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Cash (-A) 6,000

An alternative method of recording sales taxes payable is to include these taxes in the credit to Sales. For

instance, the previous company could record sales as follows:

Accounts Receivable (+A) 1,060 Sales (+SE) 1,060

When recording sales taxes in the same account as sales revenue, the firm must separate the sales tax from sales

revenue at the end of the accounting period. To make this separation, it adds the sales tax rate to 100 per cent and

divides this percentage into recorded sales revenue. For instance, assume that total recorded sales revenues for an

accounting period are USD 10,600, and the sales tax rate is 6 per cent. To find the sales revenue, use the following

formula:

Sales= Amount recorded for sales account 100 per centsales tax rate

= USD 10,600 106 per cent

=USD 10,000

The sales revenue is USD 10,000 for the period. Sales tax is equal to the recorded sales revenue of USD 10,600

less actual sales revenue of USD 10,000, or USD 600.

Federal excise tax payable Consumers pay federal excise tax on some goods, such as alcoholic beverages,

tobacco, gasoline, cosmetics, tires, and luxury automobiles. The entries a company makes when selling goods

subject to the federal excise tax are similar to those made for sales taxes payable. For example, assume that the

Dixon Jewelry Store sells a diamond ring to a young couple for USD 2,000. The sale is subject to a 6 per cent sales

tax and a 10 per cent federal excise tax. The entry to record the sale is:

Accounts Receivable (+A) 2,320 Sales (+L) 2,000 Sales Tax Payable (+L) 120 Federal Excise Tax Payable 200 To record the sale of a diamond ring.

The company records the remittance of the taxes to the federal taxing agency by debiting Federal Excise Tax

Payable and crediting Cash.

Current portions of long-term debt Accountants move any portion of long-term debt that becomes due

within the next year to the current liability section of the balance sheet. For instance, assume a company signed a

series of 10 individual notes payable for USD 10,000 each; beginning in the 6th year, one comes due each year

through the 15th year. Beginning in the 5th year, an accountant would move a USD 10,000 note from the long-term

liability category to the current liability category on the balance sheet. The current portion would then be paid

within one year.

Accounting Principles: A Business Perspective 408 A Global Text

9. Receivables and payables

An accounting perspective:

Uses of technology

Many companies use service bureaus to process their payrolls because these bureaus keep up to

date on rates, bases, and changes in the laws affecting payroll. Companies can either send their

data over the Internet or have the service bureaus pick up time sheets and other data. Managers

instruct service bureaus either to print the payroll checks or to transfer data back to the company

over the Internet so it can print the checks.

Payroll liabilities In most business organizations, accounting for payroll is particularly important because (1)

payrolls often are the largest expense that a company incurs, (2) both federal and state governments require

maintaining detailed payroll records, and (3) companies must file regular payroll reports with state and federal

governments and remit amounts withheld or otherwise due. Payroll liabilities include taxes and other amounts

withheld from employees' paychecks and taxes paid by employers.

Employers normally withhold amounts from employees' paychecks for federal income taxes; state income taxes;

FICA (social security) taxes; and other items such as union dues, medical insurance premiums, life insurance

premiums, pension plans, and pledges to charities. Assume that a company had a payroll of USD 35,000 for the

month of April 2010. The company withheld the following amounts from the employees' pay: federal income taxes,

USD 4,100; state income taxes, USD 360; FICA taxes, USD 2,678; and medical insurance premiums, USD 940. This

entry records the payroll:

2010 April 30 Salaries Expense (-SE) 35,000

Employees' Federal Income Taxes Payable (+L) 4,100 Employees' State Income Taxes Payable (+L) 360 FICA Taxes Payable (+L) 2,678 Employees' Medical Insurance Premiums Payable (+L)

940

Salaries Payable (+L) 26,922 To record the payroll for the month ending April 30.

All accounts credited in the entry are current liabilities and will be reported on the balance sheet if not paid prior

to the preparation of financial statements. When these liabilities are paid, the employer debits each one and credits

Cash.

Employers normally record payroll taxes at the same time as the payroll to which they relate. Assume the payroll

taxes an employer pays for April are FICA taxes, USD 2,678; state unemployment taxes, USD 1,890; and federal

unemployment taxes, USD 280. The entry to record these payroll taxes would be:

2010 April 30 Payroll Taxes Expense (-SE)

FICA Taxes Payable (+L) State Unemployment Taxes Payable (+L) Federal Unemployment Taxes Payable (+L) To record employer's payroll taxes.

4,848 2,678 1,890 280

These amounts are in addition to the amounts withheld from employees' paychecks. The credit to FICA Taxes

Payable is equal to the amount withheld from the employees' paychecks. The company can credit both its own and

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the employees' FICA taxes to the same liability account, since both are payable at the same time to the same agency.

When these liabilities are paid, the employer debits each of the liability accounts and credits Cash.

An accounting perspective:

Uses of technology

One of the basic components in accounting software packages is the payroll module. As long as

companies update this module each time rates, bases, or laws change, they can calculate

withholdings, print payroll checks, and complete reporting forms for taxing agencies. In addition

to calculating the employer's payroll taxes, this software maintains all accounting payroll records.

Managers of companies that have estimated liabilities know these liabilities exist but can only estimate the

amount. The primary accounting problem is to estimate a reasonable liability as of the balance sheet date. An

example of an estimated liability is product warranty payable.

Estimated product warranty payable When companies sell products such as computers, often they must

guarantee against defects by placing a warranty on their products. When defects occur, the company is obligated to

reimburse the customer or repair the product. For many products, companies can predict the number of defects

based on experience. To provide for a proper matching of revenues and expenses, the accountant estimates the

warranty expense resulting from an accounting period's sales. The debit is to Product Warranty Expense and the

credit to Estimated Product Warranty Payable.

To illustrate, assume that a company sells personal computers and warrants all parts for one year. The average

price per computer is USD 1,500, and the company sells 1,000 computers in 2010. The company expects 10 per

cent of the computers to develop defective parts within one year. By the end of 2010, customers have returned 40

computers sold that year for repairs, and the repairs on those 40 computers have been recorded. The estimated

average cost of warranty repairs per defective computer is USD 150. To arrive at a reasonable estimate of product

warranty expense, the accountant makes the following calculation:

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9. Receivables and payables

Number of computers sold 1,000 Percent estimated to develop defects X 10% Total estimated defective computers 100 Deduct computers returned as defective to date 40 Estimated additional number to become defective during warranty period 60 Estimated average warranty repair cost per compute: X $ 150 Estimated product warranty payable $9,000

The entry made at the end of the accounting period is:

Product Warranty Expense (-SE) 9,000 Estimated Product Warranty Payable (+L) 9,000 To record estimated product warranty expense.

When a customer returns one of the computers purchased in 2010 for repair work in 2008 (during the warranty

period), the company debits the cost of the repairs to Estimated Product Warranty Payable. For instance, assume

that Evan Holman returns his computer for repairs within the warranty period. The repair cost includes parts, USD

40, and labor, USD 160. The company makes the following entry:

Estimated Product Warranty Payable (-L) 200 Repair Parts Inventory (-A) 40 Wages Payable (+L) 160 To record replacement of parts under warranty.

An accounting perspective:

Business insight

Another estimated liability that is quite common relates to clean-up costs for industrial pollution.

One company had the following note in its recent financial statements:

In the past, the Company treated hazardous waste at its chemical facilities. Testing of the ground

waters in the areas of the treatment impoundments at these facilities disclosed the presence of

certain contaminants. In compliance with environmental regulations, the Company developed a

plan that will prevent further contamination, provide for remedial action to remove the present

contaminants, and establish a monitoring program to monitor ground water conditions in the

future. A similar plan has been developed for a site previously used as a metal pickling facility.

Estimated future costs of USD 2,860,000 have been accrued in the accompanying financial

statements…to complete the procedures required under these plans.

When liabilities are contingent, the company usually is not sure that the liability exists and is uncertain about

the amount. FASB Statement No. 5 defines a contingency as "an existing condition, situation, or set of

circumstances involving uncertainty as to possible gain or loss to an enterprise that will ultimately be resolved

when one or more future events occur or fail to occur".29

According to FASB Statement No. 5, if the liability is probable and the amount can be reasonably estimated,

companies should record contingent liabilities in the accounts. However, since most contingent liabilities may not

29 FASB, Statement of Financial Accounting Standards No. 5, "Accounting for Contingencies" (Stamford, Conn.,

1975). Copyright © by Financial Accounting Standards Board, High Ridge Park, Stamford, Connecticut 06905,

USA.

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occur and the amount often cannot be reasonably estimated, the accountant usually does not record them in the

accounts. Instead, firms typically disclose these contingent liabilities in notes to their financial statements.

Many contingent liabilities arise as the result of lawsuits. In fact, 469 of the 957 companies contacted in the

AICPA's annual survey of accounting practices reported contingent liabilities resulting from litigation.30

The following two examples from annual reports are typical of the disclosures made in notes to the financial

statements. Be aware that just because a suit is brought, the company being sued is not necessarily guilty. One

company included the following note in its annual report to describe its contingent liability regarding various

lawsuits against the company:

Contingent liabilities:

Various lawsuits and claims, including those involving ordinary routine litigation incidental to its business, to

which the Company is a party, are pending, or have been asserted, against the Company. In addition, the Company

was advised…that the United States Environmental Protection Agency had determined the existence of PCBs in a

river and harbor near Sheboygan, Wisconsin,USA, and that the Company, as well as others, allegedly contributed to

that contamination. It is not presently possible to determine with certainty what corrective action, if any, will be

required, what portion of any costs thereof will be attributable to the Company, or whether all or any portion of

such costs will be covered by insurance or will be recoverable from others. Although the outcome of these matters

cannot be predicted with certainty, and some of them may be disposed of unfavorably to the Company,

management has no reason to believe that their disposition will have a materially adverse effect on the consolidated

financial position of the Company.

Another company dismissed an employee and included the following note to disclose the contingent liability

resulting from the ensuing litigation:

Contingencies:

…A jury awarded USD 5.2 million to a former employee of the Company for an alleged breach of contract and

wrongful termination of employment. The Company has appealed the judgment on the basis of errors in the judge's

instructions to the jury and insufficiency of evidence to support the amount of the jury's award. The Company is

vigorously pursuing the appeal.

The Company and its subsidiaries are also involved in various other litigation arising in the ordinary course of

business.

Since it presently is not possible to determine the outcome of these matters, no provision has been made in the

financial statements for their ultimate resolution. The resolution of the appeal of the jury award could have a

significant effect on the Company's earnings in the year that a determination is made; however, in management's

opinion, the final resolution of all legal matters will not have a material adverse effect on the Company's financial

position.

Contingent liabilities may also arise from discounted notes receivable, income tax disputes, penalties that may

be assessed because of some past action, and failure of another party to pay a debt that a company has guaranteed.

30 AICPA, Accounting Trends & Techniques (New York, 2000), p. 100.

Accounting Principles: A Business Perspective 412 A Global Text

9. Receivables and payables

The remainder of this chapter discusses notes receivable and notes payable. Business transactions often involve

one party giving another party a note.

Notes receivable and notes payable A note (also called a promissory note) is an unconditional written promise by a borrower (maker) to pay a

definite sum of money to the lender (payee) on demand or on a specific date. On the balance sheet of the lender

(payee), a note is a receivable; on the balance sheet of the borrower (maker), a note is a payable. Since the note is

usually negotiable, the payee may transfer it to another party, who then receives payment from the maker. Look at

the promissory note in Exhibit 78.

A customer may give a note to a business for an amount due on an account receivable or for the sale of a large

item such as a refrigerator. Also, a business may give a note to a supplier in exchange for merchandise to sell or to a

bank or an individual for a loan. Thus, a company may have notes receivable or notes payable arising from

transactions with customers, suppliers, banks, or individuals.

Companies usually do not establish a subsidiary ledger for notes. Instead, they maintain a file of the actual notes

receivable and copies of notes payable.

Most promissory notes have an explicit interest charge. Interest is the fee charged for use of money over a

period. To the maker of the note, or borrower, interest is an expense; to the payee of the note, or lender, interest is a

revenue. A borrower incurs interest expense; a lender earns interest revenue. For convenience, bankers sometimes

calculate interest on a 360-day year; we calculate it on that basis in this text. (Some companies use a 365-day year.)

Exhibit 78: Promissory note

The basic formula for computing interest is:

Interest=Principal× Rate×Time , or I=P×R×T

Principal is the face value of the note. The rate is the stated interest rate on the note; interest rates are

generally stated on an annual basis. Time, which is the amount of time the note is to run, can be either days or

months.

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To show how to calculate interest, assume a company borrowed USD 20,000 from a bank. The note has a

principal (face value) of USD 20,000, an annual interest rate of 10 per cent, and a life of 90 days. The interest

calculation is:

Interest=USD 20,000×0.10× 90 360

Interest = USD 500

Note that in this calculation we expressed the time period as a fraction of a 360-day year because the interest

rate is an annual rate.

The maturity date is the date on which a note becomes due and must be paid. Sometimes notes require

monthly installments (or payments) but usually all of the principal and interest must be paid at the same time as in

Exhibit 78. The wording in the note expresses the maturity date and determines when the note is to be paid. A note

falling due on a Sunday or a holiday is due on the next business day. Examples of the maturity date wording are:

• On demand. "On demand, I promise to pay…" When the maturity date is on demand, it is at the option of

the holder and cannot be computed. The holder is the payee, or another person who legally acquired the note

from the payee.

• On a stated date. "On 2010 July 18, I promise to pay…" When the maturity date is designated, computing

the maturity date is not necessary.

• At the end of a stated period.

(a) "One year after date, I promise to pay…" When the maturity is expressed in years, the note matures

on the same day of the same month as the date of the note in the year of maturity.

(b) "Four months after date, I promise to pay…" When the maturity is expressed in months, the note

matures on the same date in the month of maturity. For example, one month from 2010 July 18, is 2010

August 18, and two months from 2010 July 18, is 2010 September 18. If a note is issued on the last day

of a month and the month of maturity has fewer days than the month of issuance, the note matures on

the last day of the month of maturity. A one-month note dated 2010 January 31, matures on 2010

February 28.

(c) “Ninety days after date, I promise to pay…" When the maturity is expressed in days, the exact

number of days must be counted. The first day (date of origin) is omitted, and the last day (maturity

date) is included in the count. For example, a 90-day note dated 2010 October 19, matures on 2008

January 17, as shown here:

Life of note (days) 90 days Days remaining in October not counting date of origin of note: Days to count in October (31 – 19) 12 Total days in November 30 Total Days in December 31 73 Maturity date in January 17 days

Sometimes a company receives a note when it sells high-priced merchandise; more often, a note results from the

conversion of an overdue account receivable. When a customer does not pay an account receivable that is due, the

company (creditor) may insist that the customer (debtor) gives a note in place of the account receivable. This action

Accounting Principles: A Business Perspective 414 A Global Text

9. Receivables and payables

allows the customer more time to pay the balance due, and the company earns interest on the balance until paid.

Also, the company may be able to sell the note to a bank or other financial institution.

To illustrate the conversion of an account receivable to a note, assume that Price Company (maker) had

purchased USD 18,000 of merchandise on August 1 from Cooper Company (payee) on account. The normal credit

period has elapsed, and Price cannot pay the invoice. Cooper agrees to accept Price's USD 18,000, 15 per cent, 90-

day note dated September 1 to settle Price's open account. Assuming Price paid the note at maturity and both

Cooper and Price have a December 31 year-end, the entries on the books of the payee and the maker are:

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Aug. 1

Cooper Company, Payee Accounts Receivable—Price Company (+A) Sales (+SE) To record sale of merchandise on account.

18,000 18,000

Sept. 1 Notes Receivable (+A) Accounts Receivable—Price Company (-A) To record exchange of a note from Price Company for open account.

18,000 18,000

Nov. 30 Cash (+A) Notes Receivable (-A) Interest Revenue ($18,000 X 0.15 X 90/

360 ). (+SE)

To record receipt of Price Company note principal and interest.

18,675 18,000 675

Aug. 1

Price Company, Maker Purchase (+A) Accounts Payable—Cooper Company (+L) To record purchase of merchandise on account.

18,000 18,000

Sept. 1 Accounts Payable—Cooper Company (-L) Notes Payable (+L) To record exchange of a note to Cooper Company for open account.

18,000 18,000

Nov. 30 Notes Payable (-L) Interest Expense ($18,000 X 0.15 X 90/360). (-SE) Cash (-A) To record payment of note principal and interest.

18,000 675

18,675

The USD 18,675 paid by Price to Cooper is called the maturity value of the note. Maturity value is the amount

that the maker must pay on a note on its maturity date; typically, it includes principal and accrued interest, if any.

Sometimes the maker of a note does not pay the note when it becomes due. The next section describes how to

record a note not paid at maturity.

A dishonored note is a note that the maker failed to pay at maturity. Since the note has matured, the holder or

payee removes the note from Notes Receivable and records the amount due in Accounts Receivable (or Dishonored

Notes Receivable).

At the maturity date of a note, the maker should pay the principal plus interest. If the interest has not been

accrued in the accounting records, the maker of a dishonored note should record interest expense for the life of the

note by debiting Interest Expense and crediting Interest Payable. The payee should record the interest earned and

remove the note from its Notes Receivable account. Thus, the payee of the note should debit Accounts Receivable

for the maturity value of the note and credit Notes Receivable for the note's face value and Interest Revenue for the

interest. After these entries have been posted, the full liability on the note—principal plus interest—is included in

the records of both parties. Interest continues to accrue on the note until it is paid, replaced by a new note, or

written off as uncollectible. To illustrate, assume that Price did not pay the note at maturity. The entries on each

party's books are: Cooper Company, Payee

Nov. 30 Accounts Receivable—Price Company (+A) 18,675 Notes Receivable (-A) 18,000 Interest Revenue (+SE) 675 To record dishonor of Price Company note. Price Company, Maker

Nov. 30 Interest Expense (-SE) 675 Interest Payable (+L) 675 To record interest on note payable.

When unable to pay a note at maturity, sometimes the maker pays the interest on the original note or includes

the interest in the face value of a new note that replaces the old note. Both parties account for the new note in the

Accounting Principles: A Business Perspective 416 A Global Text

9. Receivables and payables

same manner as the old note. However, if it later becomes clear that the maker of a dishonored note will never pay,

the payee writes off the account with a debit to Uncollectible Accounts Expense (or to an account with a title such as

Loss on Dishonored Notes) and a credit to Accounts Receivable. The debit should be to the Allowance for

Uncollectible Accounts if the payee made an annual provision for uncollectible notes receivable.

Assume that Price Company pays the interest at the maturity date and issues a new 15 per cent, 90-day note for

USD 18,000. The entries on both sets of books would be:

Cooper Company, Payee Price Company, Maker Cash (+A) Interest Revenue (+SE) To record the receipt of interest on Price Company note.

675 675

Interest Expense (-SE) Cash (-A) To record the payment of interest on note to Cooper Company.

675 675

(Optional entry) Notes Receivable (+A) Notes Receivable (-A) To replace old 15%, 90-day note from Price Company with new 15%, 90-day note.

18,000 18,000

(Optional entry) Notes Payable (-L) Notes Payable (+L) To replace old 15%, 90-day note to Cooper Company with new 15%, 90-day note.

18,000 18,000

Although the second entry on each set of books has no effect on the existing account balances, it indicates that

the old note was renewed (or replaced). Both parties substitute the new note, or a copy, for the old note in a file of

notes.

Now assume that Price Company does not pay the interest at the maturity date but instead includes the interest

in the face value of the new note. The entries on both sets of books would be:

Cooper Company, Payee Price Company, Maker Notes Receivable (+A) 18,675 Interest Expense (-SE) 675 Interest Revenue (+SE) 675 Notes Payable (-L) 18,000 Notes Receivable (-A) 18,000 Notes Payable (+L) 18,675 To record the To record the replacement of the replacement of the old Price Company old $18,000, 15%, $18,000, 15%, 90- 90-day note to day note with a Cooper Company with new $18,675, 15%, a new $18,675, 15%, 90-day note. 90-day note.

On an interest-bearing note, even though interest accrues, or accumulates, on a day-to-day basis, usually both

parties record it only at the note's maturity date. If the note is outstanding at the end of an accounting period,

however, the time period of the interest overlaps the end of the accounting period and requires an adjusting entry at

the end of the accounting period. Both the payee and maker of the note must make an adjusting entry to record the

accrued interest and report the proper assets and revenues for the payee and the proper liabilities and expenses for

the maker. Failure to record accrued interest understates the payee's assets and revenues by the amount of the

interest earned but not collected and understates the maker's expenses and liabilities by the interest expense

incurred but not yet paid.

Payee's books To illustrate how to record accrued interest on the payee's books, assume that the payee, Cooper

Company, has a fiscal year ending on October 31 instead of December 31. On October 31, Cooper would make the

following adjusting entry relating to the Price Company note:

Oct. 3 Interest Receivable (+A) 450

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1 Interest Revenue ($18,000 X 0.15 X 60/360) (+SE)

450

To record interest earned on Price Company note for the period September 1 through October 31.

The Interest Receivable account shows the interest earned but not yet collected. Interest receivable is a

current asset in the balance sheet because the interest will be collected in 30 days. The interest revenue appears in

the income statement. When Price pays the note on November 30, Cooper makes the following entry to record the

collection of the note's principal and interest:

Nov. 3 0

Cash (+A) 18,675

Notes Receivable (-A) 18,000 Interest Receivable (-A) 450 Interest Revenue (+SE) 225 To record collection of Price Company note and interest.

Note that the entry credits the Interest Receivable account for the USD 450 interest accrued from September 1

through October 31, which was debited to the account in the previous entry, and credits Interest Revenue for the

USD 225 interest earned in November.

Maker's books Assume Price Company's accounting year also ends on October 31 instead of December 31.

Price's accounting records would be incomplete unless the company makes an adjusting entry to record the liability

owed for the accrued interest on the note it gave to Cooper Company. The required entry is:

Oct. 3 1

Interest Expense ($18,000 X 0.15 X 60/360) (- SE)

450

Interest Payable (+L) 450 To record accrued interest on note to Cooper Company for the period September 1 through October 31.

The Interest Payable account, which shows the interest expense incurred but not yet paid, is a current

liability in the balance sheet because the interest will be paid in 30 days. Interest expense appears in the income

statement. When the note is paid, Price makes the following entry:

Nov. 3 0

Notes Payable (-L) 18,000

Interest Payable (-L) 450 Interest Expense (-SE) 225 Cash (-A) 18,675 To record payment of principal and interest on note to Cooper Company.

In this illustration, Cooper's financial position made it possible for the company to carry the Price note to the

maturity date. Alternatively, Cooper could have sold, or discounted, the note to receive the proceeds before the

maturity date. This topic is reserved for a more advanced text.

Short-term financing through notes payable A company sometimes needs short-term financing. This situation may occur when (1) the company's cash

receipts are delayed because of lenient credit terms granted customers, or (2) the company needs cash to finance

the buildup of seasonal inventories, such as before Christmas. To secure short-term financing, companies issue

interest-bearing or non interest-bearing notes.

Accounting Principles: A Business Perspective 418 A Global Text

9. Receivables and payables

Interest-bearing notes To receive short-term financing, a company may issue an interest-bearing note to a

bank. An interest-bearing note specifies the interest rate charged on the principal borrowed. The company receives

from the bank the principal borrowed; when the note matures, the company pays the bank the principal plus the

interest.

Accounting for an interest-bearing note is simple. For example, assume the company's accounting year ends on

December 31. Needham Company issued a USD 10,000, 90-day, 9 per cent note on 2009 December 1. The

following entries would record the loan, the accrual of interest on 2009 December 31 and its payment on 2010

March 1:

2009 Dec.

1 Cash (+A) Notes Payable (+L) To record 90-day bank loan.

10,000 10,000

31 Interest Expense (-SE) Interest Payable (+L) To record accrued interest on a note payable at year-end ($10,000 X 0.09 X 30/360).

75 75

2010 Mar.

1 Notes Payable (-L) Interest Expense ($10,000 X 0.09 X 60/360) (-SE) Interest Payable (-L) Cash (-A) To record principal and interest paid on bank loan.

10,000 150 75

10,225

Non interest-bearing notes (discounting notes payable) A company may also issue a non interest-

bearing note to receive short-term financing from a bank. A non interest-bearing note does not have a stated

interest rate applied to the face value of the note. Instead, the note is drawn for a maturity amount less a bank

discount; the borrower receives the proceeds. A bank discount is the difference between the maturity value of the

note and the cash proceeds given to the borrower. The cash proceeds are equal to the maturity amount of a note

less the bank discount. This entire process is called discounting a note payable. The purpose of this process is to

introduce interest into what appears to be a non interest-bearing note. The meaning of discounting here is to

deduct interest in advance.

Because interest is related to time, the bank discount is not interest on the date the loan is made; however, it

becomes interest expense to the company and interest revenue to the bank as time passes. To illustrate, assume that

on 2009 December 1, Needham Company presented its USD 10,000, 90-day, non interest-bearing note to the bank,

which discounted the note at 9 per cent. The discount is USD 225 (USD 10,000 X 0.09 X 90/360), and the proceeds

to Needham are USD 9,775. The entry required on the date of the note's issue is:

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2009 Dec. 1 Cash (+A)

Discount on Notes Payable (-L) Notes Payable (+L) Issued a 90-day note to bank.

9,775 225

10,000

Needham credits Notes Payable for the face value of the note. Discount on notes payable is a contra account

used to reduce Notes Payable from face value to the net amount of the debt. The balance in the Discount on Notes

Payable account appears on the balance sheet as a deduction from the balance in the Notes Payable account.

Over time, the discount becomes interest expense. If Needham paid the note before the end of the fiscal year, it

would charge the entire USD 225 discount to Interest Expense and credit Discount on Notes Payable. However, if

Needham's fiscal year ended on December 31, an adjusting entry would be required as follows:

2009 Dec. 3

1 Interest Expense (-SE) Discount on Notes Payable (+L) To record accrued interest on note payable at year-end.

75 75

This entry records the interest expense incurred by Needham for the 30 days the note has been outstanding. The

expense can be calculated as USD 10,000 X 0.09 X 30/360, or 30/90 X USD 225. Notice that for entries involving

discounted notes payable, no separate Interest Payable account is needed. The Notes Payable account already

contains the total liability that will be paid at maturity, USD 10,000. From the date the proceeds are given to the

borrower to the maturity date, the liability grows by reducing the balance in the Discount on Notes Payable contra

account. Thus, the current liability section of the 2009 December 31, balance sheet would show:

Current Liabilities: Notes payable $ 10,000 Less: Discount on notes payable 150 $ 9,850

When the note is paid at maturity, the entry is:

2010 Mar. 1 Notes Payable (-L) 10,000

Interest Expense (-SE) 150 Cash (-A) 10,000 Discount on Notes Payable (+L) 150 To record note payment and interest expense.

The T-accounts for Discount on Notes Payable and for Interest Expense appear as follows: Discount on Notes Payable Interest Expense

2009 Dec. 1 225

2009 Dec. 31 75

2009 Dec. 31 75

2009 Dec. 31 To close 75

Dec. 31

Balance 150 2010 2010

Mar. 1 150 Mar. 1 150

In Exhibit 79, we compare the journal entries for interest-bearing notes and non-interest-bearing notes used by

Needham Company.

Accounting Principles: A Business Perspective 420 A Global Text

9. Receivables and payables

Interest-Bearing Notes Non interest-Bearing Notes 2009 2009 Dec. 1 Cash (+A) 10,000 Dec. 1 Cash (+A) 9,775

Notes Payable (+L) 10,00 0

Discount on Notes Payable (-L) 225

To record 90-day bank loan, Notes Payable (+L) To record 90-day bank loan.

10,000

31 Interest Expense (-SE) 75 31 Interest Expense (-SE) 75 Interest Payable (+L) 75 Discount on Notes Payable (+L) 75 To record accrued interest on a note payable at year-end.

To record accrued interest on a note payable at year-end.

2010 2010 Mar. 1 Notes Payable (-L) 10,000 Mar. 1 Notes Payable (-L) 10,000

Interest Expense (-SE) 150 Interest Expense (-SE) 150 Interest Payable (-L) 75 Cash (-A) 10,000 Cash (-A) To record note principal and interest payment.

10,22 5

Discount on Notes Payable (+L) To record note payment and interest expense.

150

Exhibit 79: Comparison between interest-bearing notes and noninterest-bearing notes

Analyzing and using the financial results—Accounts receivable turnover and number of days' sales in accounts receivable Accounts receivable turnover is the number of times per year that the average amount of accounts

receivable is collected. To calculate this ratio divide net credit sales, or net sales, by the average net accounts

receivable (accounts receivable after deducting the allowance for uncollectible accounts):

Accounts receivable turnover= Net credit salesnet sales

Average net accounts receivable

Ideally, average net accounts receivable should represent weekly or monthly averages; often, however, beginning

and end-of-year averages are the only amounts available to users outside the company. Although analysts should

use net credit sales, frequently net credit sales are not known to those outside the company. Instead, they use net

sales in the numerator.

Generally, the faster firms collect accounts receivable, the better. A company with a high accounts receivable

turnover ties up a smaller proportion of its funds in accounts receivable than a company with a low turnover. Both

the company's credit terms and collection policies affect turnover. For instance, a company with credit terms of

2/10, n/30 would expect a higher turnover than a company with terms of n/60. Also, a company that aggressively

pursues overdue accounts receivable has a higher turnover of accounts receivable than one that does not.

For example, we calculated these accounts receivable turnovers for the following hypothetical companies:

Accounts Receivable Net Sales Average (millions) Net Turnover

Abercrombie & Fitch $ 1,238 $ 14 88.43 The Limited, Inc. 10,105 1,012 10.00

We calculate the number of days' sales in accounts receivable (also called the average collection period

for accounts receivable) as follows:

Number of days ' sales per accounts receivable = Number of days per a year 365

Accounts receivable turnover

This ratio measures the average liquidity of accounts receivable and gives an indication of their quality. The

faster a firm collects receivables, the more liquid (the closer to being cash) they are and the higher their quality. The

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longer accounts receivable remain outstanding, the greater the probability they never will be collected. As the time

period increases, so does the probability that customers will declare bankruptcy or go out of business.

Based on 365 days, we calculated the number of days' sales for each of these hypothetical companies:

Accounts Receivable Company Turnover Number of

Day's Sales in Abercrombie & Fitch 88.43 4.1 The Limited, Inc. 10.00 36.5

These companies have collection periods ranging from 4.1 to 36.5 days. Assuming credit terms of 2/10, n/30,

one would expect the average collection period to be under 30 days. If customers do not pay within 10 days and take

the discount offered, they incur an annual interest rate of 36.5 per cent on these funds. (They lose a 2 per cent

discount and get to use the funds another 20 days, which is equivalent to an annual rate of 36.5 per cent.)

Having studied receivables and payables in this chapter, you will study plant assets in the next chapter. These

long-term assets include land and depreciable assets such as buildings, machinery, and equipment.

Understanding the learning objectives

• Companies use two methods to account for uncollectible accounts receivable: the allowance method, which

provides in advance for uncollectible accounts; and the direct write-off method, which recognizes uncollectible

accounts as an expense when judged uncollectible. The allowance method is the preferred method and is the

only method discussed and illustrated in this text.

• The two basic methods for estimating uncollectible accounts under the allowance method are the

percentage-of-sales method and the percentage-of-receivables method.

• The percentage-of-sales method focuses attention on the income statement and the relationship of

uncollectible accounts to sales. The debit to Uncollectible Accounts Expense is a certain per cent of credit sales

or total net sales.

• The percentage-of-receivables method focuses attention on the balance sheet and the relationship of the

allowance for uncollectible accounts to accounts receivable. The credit to the Allowance for Uncollectible

Accounts is the amount necessary to bring that account up to a certain percentage of the Accounts Receivable

balance. Either one overall percentage or an aging schedule may be used.

• Credit cards are charge cards used by customers to charge purchases of goods and services. These cards are

of two types—nonbank credit cards (such as American Express) and bank credit cards (such as VISA).

• The sale is recorded at the gross amount of the sale, and the cash or receivable is recorded at the net

amount the company will receive.

• Liabilities result from some past transaction and are obligations to pay cash, provide services, or deliver

goods at some time in the future.

• Current liabilities are obligations that (1) are payable within one year or one operating cycle, whichever is

longer, or (2) will be paid out of current assets or create other current liabilities.

• Long-term liabilities are obligations that do not qualify as current liabilities.

Accounting Principles: A Business Perspective 422 A Global Text

9. Receivables and payables

• Clearly determinable liabilities are those for which the existence of the liability and its amount are certain.

An example is accounts payable.

• Estimated liabilities are those for which the existence of the liability is certain, but its amount can only be

estimated. An example is estimated product warranty payable.

• Contingent liabilities are those for which the existence, and usually the amount, are uncertain because

these liabilities depend (or are contingent) on some future event occurring or not occurring. An example is a

liability arising from a lawsuit.

• A promissory note is an unconditional written promise by a borrower (maker) to pay the lender (payee) or

someone else who legally acquired the note a certain sum of money on demand or at a definite time.

• Interest is the fee charged for the use of money through time.

Interest=Principal×Rate of interest×Time.

• Companies sometimes need short-term financing. Short-term financing may be secured by issuing interest-

bearing notes or by issuing non interest-bearing notes.

• An interest-bearing note specifies the interest rate that will be charged on the principal borrowed.

• A non interest-bearing note does not have a stated interest rate applied to the face value of the note.

• Calculate accounts receivable turnover by dividing net credit sales, or net sales, by average net accounts

receivable.

• Calculate the number of days' sales in accounts receivable (or average collection period) by dividing the

number of days in the year by the accounts receivable turnover.

• Together, these ratios show the liquidity of accounts receivable and give some indication of their quality.

Generally, the higher the accounts receivable turnover, the better; and the shorter the average collection

period, the better.

Demonstration problem

Demonstration problem A a. Prepare the journal entries for the following transactions:

As of the end of 2010, Post Company estimates its uncollectible accounts expense to be 1 per cent of sales. Sales

in 2010 were USD 1,125,000.

On 2011 January 15, the company decided that the account for John Nunn in the amount of USD 750 was

uncollectible.

On 2011 February 12, John Nunn's check for USD 750 arrived.

b. Prepare the journal entries in the records of Lyle Company for the following:

On 2010 June 15, Lyle Company received a USD 22,500, 90-day, 12 per cent note dated 2010 June 15, from

Stone Company in payment of its account.

Assume that Stone Company did not pay the note at maturity. Lyle Company decided that the note was

uncollectible.

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Demonstration problem B a. Prepare the entries on the books of Cromwell Company assuming the company

borrowed USD 10,000 at 7 per cent from First National Bank and signed a 60-day non interest-bearing note

payable on 2009 December 1, accrued interest on 2009 December 31, and paid the debt on the maturity date.

b. Prepare the entries on the books of Cromwell Company assuming it purchased equipment from Jones

Company for USD 5,000 and signed a 30-day, 9 per cent interest-bearing note payable on 2010 February 24.

Cromwell paid the note on its maturity date.

Solution to demonstration problem

Solution to demonstration problem A

a.

1. 2010 Dec.

31 Uncollectible Accounts Expense (-SE) Allowance for Uncollectible Accounts (-A) To record estimated Uncollectible accounts for the year.

11,250 11,250

2. 2011 Jan.

15 Allowance for Uncollectible Accounts (+A) Accounts Receivable—John Nunn (-A) To write off the account of John Nunn as Uncollectible.

750 750

3. Feb. 12 Accounts Receivable—John Nunn (+A) Allowance for Uncollectible Accounts (-A) To correct the write-off of John Nunn's account on January 15.

750 750

12 Cash (+A) Accounts Receivable—John Nunn (-A) To record the collection of John Nunn's account receivable.

750 750

b.

1. 2010 June

15 Notes Receivable (+A) Accounts Receivable—Stone Company (-A) To record receipt of a note from Stone Company.

22,500 22,500

2. Sept 13 Accounts Receivable—Stone Company (+A) Notes Receivable (-A) Interest Revenue(+SE) To record the default of the Stone Company note of $22,500. Interest revenue was $675.

23,175 22,500 675

13 Allowance for Uncollectible Accounts* (+A) Accounts Receivable—Stone Company (-A) To write off the Stone Company as uncollectible.

23,175 23,175

*This debt assumes that Notes Receivable were taken into consideration when an allowance was established. If

not, the debit should be to Loss from Dishonored Notes Receivable.

Solution to demonstration problem B

a.

2009 Dec.

1 Cash (+A) Bank Discount ($10,000 X 0.07 X '0'/36)) (+A) Notes Payable (+L)

9,883.33 116.67

10,000.00 31 Interest Expense (-SE)

Bank Discount (-A) ($10,000 X 0.07 X ^/36))

58.33 58.33

2010 Jan.

30 Notes Payable (-L) Interest Expense (-SE) Bank Discount (-A) Cash (-A)

10,000.00 58.33

58.33 10,000.00

b. 2010 Feb

2 4

Equipment (+A) Notes Payable (+L)

5,000.00 5,000.00

Mar 2 Notes Payable (-L) 5,000.00

Accounting Principles: A Business Perspective 424 A Global Text

9. Receivables and payables

6 Interest Expense (-SE) Cash (-A) ($5,000 X 0.09 X 30/360) = $37.50

37.50 5,037.50 675

Key terms Accounts receivable turnover Net credit sales (or net sales) divided by average net accounts receivable. Aging schedule A means of classifying accounts receivable according to their age; used to determine the necessary balance in an Allowance for Uncollectible Accounts. A different uncollectibility percentage rate is used for each age category. Allowance for Uncollectible Accounts A contra-asset account to the Accounts Receivable account; it reduces accounts receivable to their net realizable value. Also called Allowance for Doubtful Accounts or Allowance for Bad Debts. Bad debts expense See Uncollectible accounts expense. Bank discount The difference between the maturity value of a note and the actual amount—the note's proceeds—given to the borrower. Cash proceeds The maturity amount of a note less the bank discount. Clearly determinable liabilities Liabilities whose existence and amount are certain. Examples include accounts payable, notes payable, interest payable, unearned delivery fees, wages payable, sales tax payable, federal excise tax payable, current portions of long-term debt, and various payroll liabilities. Contingent liabilities Liabilities whose existence is uncertain. Their amount is also usually uncertain. Both their existence and amount depend on some future event that may or may not occur. Examples include liabilities arising from lawsuits, discounted notes receivable, income tax disputes, penalties that may be assessed because of some past action, and failure of another party to pay a debt that a company has guaranteed. Credit Card Expense account Used to record credit card agency's service charges for services rendered in processing credit card sales. Credit cards Nonbank charge cards (e.g. American Express) and bank charge cards (e.g. VISA and MasterCard) that customers use to charge their purchases of goods and services. Current liabilities Obligations that (1) are payable within one year or one operating cycle, whichever is longer, or (2) will be paid out of current assets or result in the creation of other current liabilities. Discount on Notes Payable A contra account used to reduce Notes Payable from face value to the net amount of the debt. Discounting a note payable The act of borrowing on a non interest-bearing note drawn for a maturity amount, from which a bank discount is deducted, and the proceeds are given to the borrower. Dishonored note A note that the maker failed to pay at maturity. Estimated liabilities Liabilities whose existence is certain, but whose amount can only be estimated. An example is estimated product warranty payable. Interest The fee charged for use of money over a period of time (I = P X R X T). Interest Payable account An account showing the interest expense incurred but not yet paid; reported as a current liability in the balance sheet. Interest Receivable account An account showing the interest earned but not yet collected; reported as a current asset in the balance sheet. Liabilities Obligations that result from some past transaction and are obligations to pay cash, perform services, or deliver goods at some time in the future. Long-term liabilities Obligations that do not qualify as current liabilities. Maker (of a note) The party who prepares a note and is responsible for paying the note at maturity. Maturity date The date on which a note becomes due and must be paid. Maturity value The amount that the maker must pay on the note on its maturity date. Net realizable value The amount the company expects to collect from accounts receivable. Number of days' sales in accounts receivable The number of days in a year (365) divided by the accounts receivable turnover. Operating cycle The time it takes to start with cash, buy necessary items to produce revenues (such as materials, supplies, labor, and/or finished goods), sell goods or services, and receive cash by collecting the resulting receivables.

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Payable Any sum of money due to be paid by a company to any party for any reason. Payee (of a note) The party who receives a note and will be paid cash at maturity. Percentage-of-receivables method A method for determining the desired size of the Allowance for Uncollectible Accounts by basing the calculation on the Accounts Receivable balance at the end of the period. Percentage-of-sales method A method of estimating the uncollectible accounts from the sales of a given period's total net credit sales or net sales. Principal (of a note) The face value of a note. Promissory note An unconditional written promise by a borrower (maker) to pay a definite sum of money to the lender (payee) on demand or at a specific date. Rate (of a note) The stated interest rate on the note. Receivable Any sum of money due to be paid to a company from any party for any reason. Time (of a note) The amount of time the note is to run; can be expressed in days, months, or years. Trade receivables Amounts customers owe a company for goods sold or services rendered on account. Also called accounts receivable or trade accounts receivable. Uncollectible accounts expense An operating expense that a business incurs when it sells on credit; also called doubtful accounts expense or bad debts expense.

Self test

True-false

Indicate whether each of the following statements is true or false.

The percentage-of-sales method estimates the uncollectible accounts from the ending balance in Accounts

Receivable.

Under the allowance method, uncollectible accounts expense is recognized when a specific customer's account is

written off.

Bank credit card sales are treated as cash sales because the receipt of cash is certain.

Liabilities result from some future transaction.

Current liabilities are classified as clearly determinable, estimated, and contingent.

A dishonored note is removed from Notes Receivable, and the total amount due is recorded in Accounts

Receivable.

When an interest-bearing note is given to a bank when taking out a loan, the difference between the cash

proceeds and the maturity amount is debited to Discount on Notes Payable.

Multiple-choice

Select the best answer for each of the following questions.

Which of the following statements is false?

a. Any existing balance in the Allowance for Uncollectible Accounts is ignored in calculating the uncollectible

accounts expense under the percentage-of-sales method except that the allowance account must have a credit

balance after adjustment.

b. The percentage-of-receivables method may use either an overall rate or a different rate for each age category.

c. The Allowance for Uncollectible Accounts reduces accounts receivable to their net realizable value.

Accounting Principles: A Business Perspective 426 A Global Text

9. Receivables and payables

d. A write-off of an account reduces the net amount shown for accounts receivable on the balance sheet.

e. None of the above.

Hunt Company estimates uncollectible accounts using the percentage-of-receivables method and expects that 5

per cent of outstanding receivables will be uncollectible for 2010. The balance in Accounts Receivable is USD

200,000, and the allowance account has a USD 3,000 credit balance before adjustment at year-end. The

uncollectible accounts expense for 2010 will be:

a. USD 7,000.

b. USD 10,000.

c. USD 13,000.

d. USD 9,850.

e. None of the above.

Which type of company typically has the longest operating cycle?

a. Service company.

b. Merchandising company.

c. Manufacturing company.

d. All equal.

Maxwell Company records its sales taxes in the same account as sales revenues. The sales tax rate is 6 per cent.

At the end of the current period, the Sales account has a balance of USD 265,000. The amount of sales tax payable

is:

a. USD 12,000.

b. USD 15,000.

c. USD 15,900.

d. USD 18,000.

Dawson Company sells fax machines. During 2010, the company sold 2,000 fax machines. The company

estimates that 5 per cent of the machines require repairs under warranty. To date, 30 machines have been repaired.

The estimated average cost of warranty repairs per defective fax machine is USD 200. The required amount of the

adjusting entry to record estimated product warranty payable is:

a. USD 400,000.

b. USD 6,000.

c. USD 14,000.

d. USD-0-.

To compute interest on a promissory note, all of the following elements must be known except:

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a. The face value of the note.

b. The stated interest rate.

c. The name of the payee.

d. The life of the note.

e. None of the above.

Keats Company issued its own USD 10,000, 90-day, non interest-bearing note to a bank. If the note is

discounted at 10 per cent, the proceeds to Keats are:

a. USD 10,000.

b. USD 9,000.

c. USD 9,750.

d. USD 10,250.

e. None of the above.

Now turn to “Answers to self-test” at the back of the chapter to check your answers.

Questions ➢ In view of the difficulty in estimating future events, would you recommend that accountants wait

until collections are made from customers before recording sales revenue? Should they wait until

known accounts prove to be uncollectible before charging an expense account?

➢ The credit manager of a company has established a policy of seeking to completely eliminate all

losses from uncollectible accounts. Is this policy a desirable objective for a company? Explain.

➢ What are the two major purposes of establishing an allowance for uncollectible accounts?

➢ In view of the fact that it is impossible to estimate the exact amount of uncollectible accounts

receivable for any one year in advance, what exactly does the Allowance for Uncollectible Accounts

account contain after a number of years?

➢ What must be considered before adjusting the allowance for uncollectible accounts under the

percentage-of-receivables method?

➢ How might information in an aging schedule prove useful to management for purposes other than

estimating the size of the required allowance for uncollectible accounts?

➢ For a company using the allowance method of accounting for uncollectible accounts, which of the

following directly affects its reported net income: (1) the establishment of the allowance, (2) the

writing off of a specific account, or (3) the recovery of an account previously written off as

uncollectible?

➢ Why might a retailer agree to sell by credit card when such a substantial discount is taken by the

credit card agency in paying the retailer?

Accounting Principles: A Business Perspective 428 A Global Text

9. Receivables and payables

➢ Define liabilities, current liabilities, and long-term liabilities.

➢ What is an operating cycle? Which type of company is likely to have the shortest operating cycle, and

which is likely to have the longest operating cycle? Why?

➢ Describe the differences between clearly determinable, estimated, and contingent liabilities. Give one

or more examples of each type.

➢ In what instances might a company acquire notes receivable?

➢ How is the maturity value of a note calculated?

➢ What is a dishonored note receivable and how is it reported in the balance sheet?

➢ Under what circumstances does the account Discount on Notes Payable arise? How is it reported in

the financial statements? Explain why.

➢ Real world question Refer to "A Broader Perspective: GECS allowance for losses on financing

receivables". What factors are taken into account by the General Electric Company in determining

the adjusting entry to establish the desired balance in the Allowance for Losses?

➢ Real world question Refer to "A Broader Perspective: GECS allowance for losses on financing

receivables". Explain how the General Electric Company writes off uncollectibles.

Exercises

Exercise A The accounts of Stackhouse Company as of 2010 December 31, show Accounts Receivable, USD

190,000; Allowance for Uncollectible Accounts, USD 950 (credit balance); Sales, USD 920,000; and Sales Returns

and Allowances, USD 12,000. Prepare journal entries to adjust for possible uncollectible accounts under each of the

following assumptions:

a. Uncollectible accounts are estimated at 1 per cent of net sales.

b. The allowance is to be increased to 3 per cent of accounts receivable.

Exercise B Compute the required balance of the Allowance for Uncollectible Accounts for the following

receivables:

Accounts Age Probability Receivable (months) of Collection $180,000 Less than 1 95% 90,000 1-3 85 39,000 3-6 75 12,000 6-9 35 2,250 9-12 10

Exercise C On 2009 April 1, Kelley Company, which uses the allowance method of accounting for uncollectible

accounts, wrote off Bob Dyer's USD 400 account. On 2009 December 14, the company received a check in that

amount from Dyer marked "in full payment of account". Prepare the necessary entries.

Exercise D Jamestown Furniture Mart, Inc., sold USD 80,000 of furniture in May to customers who used their

American Express credit cards. Such sales are subject to a 3 per cent discount by American Express (a nonbank

credit card),

a. Prepare journal entries to record the sales and the subsequent receipt of cash from the credit card company.

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b. Do the same as requirement (a), but assume the credit cards used were VISA cards (a bank credit card).

Exercise E Dunwoody Discount Toys, Inc., sells merchandise in a state that has a 5 per cent sales tax. Rather

than record sales taxes collected in a separate account, the company records both the sales revenue and the sales

taxes in the Sales account. At the end of the first quarter of operations, when it is time to remit the sales taxes to the

state taxing agency, the company has USD 420,000 in the Sales account. Determine the correct amount of sales

revenue and the amount of sales tax payable.

Exercise F Assume the following note appeared in the annual report of a company:

In 2009, two small retail customers filed separate suits against the company alleging misrepresentation,

breach of contract, conspiracy to violate federal laws, and state antitrust violations arising out of their purchase

of retail grocery stores through the company from a third party. Damages sought range up to USD 10 million in

each suit for actual and treble damages and punitive damages of USD 2 million in one suit and USD 10 million in

the other. The company is vigorously defending the actions and management believes there will be no adverse

financial effect.

What kind of liability is being reported? Why is it classified this way? Do you think it is possible to calculate a

dollar amount for this obligation? How much would the company have to pay if it lost the suit and had to pay the

full amount?

Exercise G Determine the maturity date for each of the following notes: Issue Date Life 2010 January 13 30 days 2010 January 31 90 days 2010 June 4 1 year 2010 December 2 1 month

Exercise H Crawford, Inc., gave a USD 20,000, 120-day, 12 per cent note to Dunston, Inc., in exchange for

merchandise. Crawford uses periodic inventory procedure. Prepare journal entries to record the issuance of the

note and the entries needed at maturity for both parties, assuming payment is made.

Exercise I Based on the facts in the previous exercise, prepare the entries that Crawford, Inc., and Dunston,

Inc., would make at the maturity date, assuming Crawford defaults.

Exercise J John Wood is negotiating a bank loan for his company, Wood, Inc., of USD 16,000 for 90 days. The

bank's current interest rate is 10 per cent. Prepare Wood's entries to record the loan under each of the following

assumptions:

a. Wood signs a note for USD 16,000. Interest is deducted in calculating the proceeds turned over to him.

b. Wood signs a note for USD 16,000 and receives that amount. Interest is to be paid at maturity.

Exercise K Based on the previous exercise, prepare the entry or entries that would be made at the maturity

date for each alternative, assuming the loan is paid before the end of the accounting period.

Exercise L Pistol Pete provides communication services and products, as well as network equipment and

computer systems, to businesses, consumers, communications services providers, and government agencies. The

following amounts were included in its 2010 annual report:

(Millions)

Accounting Principles: A Business Perspective 430 A Global Text

9. Receivables and payables

Net sales USD 79,609

Receivables, net, 2009 December 31 29,275

Receivables, net, 2008 December 31 28,623

Calculate the accounts receivable turnover and the number of days' sales in accounts receivable. Use net sales

instead of net credit sales in the calculation. Comment on the results.

Problems

Problem A As of 2009 December 31, Fargo Company's accounts prior to adjustment show:

Allowance for uncollectible accounts (credit balance)

Accounts receivable $ 40,000 Allowance for uncollectible accounts (credit balance) 750 Sales 250,000

Fargo Company estimates uncollectible accounts at 1 per cent of sales.

On 2010 February 23, the account of Dan Hall in the amount of USD 300 was considered uncollectible and

written off. On 2010 August 12, Hall remitted USD 200 and indicated that he intends to pay the balance due as

soon as possible. By 2010 December 31, no further remittance had been received from Hall and no further

remittance was expected.

a. Prepare journal entries to record all of these transactions and adjusting entries.

b. Give the entry necessary as of 2009 December 31, if Fargo Company estimated its uncollectible accounts at 8

per cent of outstanding receivables rather than at 1 per cent of sales.

Problem B At the close of business, Jim's Restaurant had credit card sales of USD 12,000. Of this amount,

USD 4,000 were VISA (bank credit card) sales invoices, which can be deposited in a bank for immediate credit, less

a discount of 3 per cent. The balance of USD 8,000 consisted of American Express (nonbank credit card) charges,

subject to a 5 per cent service charge. These invoices were mailed to American Express. Shortly thereafter, a check

was received.

Prepare journal entries for all these transactions.

Problem C Ruiz Company sells merchandise in a state that has a 5 per cent sales tax. On 2010 January 2, Ruiz

sold goods with a sales price of USD 80,000 on credit. Sales taxes collected are recorded in a separate account.

Assume that sales for the entire month were USD 900,000. On 2010 January 31, the company remitted the sales

taxes collected to the state taxing agency.

a. Prepare the general journal entries to record the January 2 sales revenue. Also prepare the entry to show the

remittance of the taxes on January 31.

b. Now assume that the merchandise sold on January 2 also is subject to federal excise taxes of 12 per cent. The

federal excise taxes collected are remitted to the proper agency on January 31. Show the entries on January 2 and

January 31.

Problem D Honest Tim's Auto Company sells used cars and warrants all parts for one year. The average price

per car is USD 10,000, and the company sold 900 in 2009. The company expects 30 per cent of the cars to develop

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defective parts within one year of sale. The estimated average cost of warranty repairs per defective car is USD 600.

By the end of the year, 80 cars sold that year had been returned and repaired under warranty. On 2010 January 4, a

customer returned a car purchased in 2009 for repairs under warranty. The repairs were made on January 8. The

cost of the repairs included parts, USD 400, and labor, USD 210.

a. Calculate the amount of the estimated product warranty payable.

b. Prepare the entry to record the estimated product warranty payable on 2009 December 31.

c. Prepare the entry to record the repairs made on 2010 January 8.

Problem E Celoron Power Boat Company is in the power boat manufacturing business. As of 2010 September

1, the balance in its Notes Receivable account is USD 256,000. The balance in Dishonored Notes Receivable is USD

60,660 (includes the interest of USD 600 and the protest fee of USD 60). A schedule of the notes (including the

dishonored note) is as follows:

Face Date Interest Amount Maker of Note Life Rate $ 100,000 C. Glass Co. 2009/6/01 120 days 12% 72,000 A. Lamp Co. 2009/6/15 90 8 84,000 C. Wall Co. 2009/7/01 90 10 60,000 N. Case Co. 2009/7/01 60 6 $316,000

Following are Celoron Power Boat Company's transactions for September:

Sept. 10 Received USD 36,660 from N. Case Company as full settlement of the amount due from it. The

company does not charge losses on notes to the Allowance for Uncollectible Accounts account.

? The A. Lamp Company note was collected when due.

? The C. Glass Company note was not paid at maturity.

? C. Wall Company paid its note at maturity.

30 Received a new 60-day, 12 per cent note from C. Glass Company for the total balance due on the dishonored

note. The note was dated as of the maturity date of the dishonored note. Celoron Power Boat Company accepted the

note in good faith.

Prepare dated journal entries for these transactions.

Problem F Premium Office Equipment, Inc., discounted its own USD 30,000, non interest-bearing, 180-day

note on 2009 November 16, at Niagara County Bank at a discount rate of 12 per cent.

Prepare dated journal entries for:

a. The original discounting on November 16.

b. The adjustment required at the end of the company's calendar-year accounting period.

c. Payment at maturity.

Accounting Principles: A Business Perspective 432 A Global Text

9. Receivables and payables

Alternate problems

Alternate problem A The following selected accounts are for Keystone, Inc., a name brand shoe wholesale

store, as of 2009 December 31. Prior to closing the accounts and making allowance for uncollectible accounts

entries, the USD 5,000 account of Morgan Company is to be written off (this was a credit sale of 2009 February 12).

Accounts receivable $ 360,000 Allowance for uncollectible accounts (credit) 6,000 Sales 1,680,000

Sales returns and allowances 30,000

a. Prepare journal entries to record all of these transactions and the uncollectible accounts expense for the

period. Assume the estimated expense is 2 per cent of net sales.

b. Give the entry to record the estimated expense for the period if the allowance account is to be adjusted to 5

per cent of outstanding receivables instead of as in (a).

Alternate problem B The cash register at Frank's Restaurant at the close of business showed cash sales of

USD 7,500 and credit card sales of USD 10,000 (USD 6,000 VISA and USD 4,000 American Express). The VISA

(bank credit card) invoices were discounted 5 per cent when they were deposited. The American Express (nonbank

credit card) charges were mailed to the company and were subject to a 5 per cent service charge. A few days later,

Frank received a check for the net amount of the American Express credit card charges.

Prepare journal entries for all of these transactions.

Alternate problem C Beacham Hardware, Inc., sells merchandise in a state that has a 6 per cent sales tax. On

2010 July 1, it sold goods with a sales price of USD 20,000 on credit. Sales taxes collected are recorded in a separate

account. Assume that sales for the entire month were USD 400,000. On 2010 July 31, the company remitted the

sales taxes collected to the state taxing agency.

a. Prepare the general journal entries to record the July 1 sales revenue and sales tax payable. Also prepare the

entry to show the remittance of the taxes on July 31.

b. Now assume that the merchandise sold also is subject to federal excise taxes of 10 per cent in addition to the 6

per cent sales tax. The company remitted the federal excise taxes collected to the proper agency on July 31. Show

the entries on July 1 and July 31.

Alternate problem D Quick Wheels, Inc., sells racing bicycles and warrants all parts for one year. The average

price per bicycle is USD 560, and the company sold 4,000 in 2009. The company expects 20 per cent of the bicycles

to develop defective parts within one year of sale. The estimated average cost of warranty repairs per defective

bicycle is USD 40. By the end of the year, 500 bicycles sold that year had been returned and repaired under

warranty. On 2010 January 2, a customer returned a bicycle purchased in 2009 for repairs under warranty. The

repairs were made on January 3. The cost of the repairs included parts, USD 25, and labor, USD 15.

a. Calculate the amount of the estimated product warranty payable.

b. Prepare the entry to record the estimated product warranty payable on 2009 December 31.

c. Prepare the entry to record the repairs made on 2010 January 3.

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Alternate problem E Vance Commercial Properties, Inc., has an accounting period of one year, ending on

July 31. On 2009 July 1, the balances of certain ledger accounts are Notes Receivable, USD 654,000; and Notes

Payable, USD 900,000. A schedule of the notes receivable is as follows:

Face Date Interest Amount Maker of Note Life Rate $ 270,000 Parker Co. 2009/5/15 60 days 12% 120,000 Dot Co. 2009/5/31 60 12 264,000 Fixx Co. 2009/6/15 30 10 $654,000

The note payable is a 60-day bank loan dated 2009 May 20. Notes Payable—Discount was debited for the

discount of USD 6,000. Following are the company's transactions during July:

July 1 Vance Commercial Properties, Inc., discounted its own USD 90,000, 60-day, non interest-bearing note at

Key Bank. The discount rate is 10 per cent, and the note was dated today.

3 Received a 20-day, 12 per cent note, dated today, from Sox Company in settlement of an account receivable of

USD 36,000.

6 Purchased merchandise from Link Company, USD 288,000, and issued a 60-day, 12 per cent note, dated

today, for the purchase.

8 Sold merchandise to Fan Company, USD 360,000. A 30-day, 12 per cent note, dated today, is received to cover

the sale.

14 Received payment on the Parker Company note dated 2009 June 15.

15 Fixx Company sent a USD 120,000, 30-day, 12 per cent note, dated today, and a check to cover the part of the

old note not covered by the new note, plus all interest expense incurred on the prior note.

19 The note payable dated 2009 May 20, was paid in full.

23 Sox Company dishonored its note of July 3 and sent a check for the interest on the dishonored note and a

new 30-day, 12 per cent note dated 2009 July 23.

30 The Dot Company note dated 2009 May 31, was paid with interest in full.

Prepare dated journal entries for these transactions and necessary July 31 adjusting entries.

Alternate problem F On 2010 November 1, Grand Strand Property Management, Inc., discounted its own

USD 50,000, 180-day, non interest-bearing note at its bank at 18 per cent. The note was paid on its maturity date.

The company uses a calendar-year accounting period.

Prepare dated journal entries to record (a) the discounting of the note, (b) the year-end adjustment, and (c) the

payment of the note.

Beyond the numbers—Critical thinking

Business decision case A Sally Stillwagon owns a hardware store; she sells items for cash and on account.

During 2009, which seemed to be a typical year, some of her company's operating data and other data were as

follows:

Sales: For cash $1,200,000 On credit 2,200,000

Accounting Principles: A Business Perspective 434 A Global Text

9. Receivables and payables

Cost of obtaining credit reports on customers 3,600 Cost incurred in paying a part-time bookkeeper to keep the accounts receivable subsidiary ledger up to date 12,000 Cost associated with preparing and mailing invoices to customers and other collection activities 18,000 Uncollectible accounts expense 45,000 Average outstanding accounts receivable balance (on which Stillwagon estimates she could have earned 10 per cent if it had been invested in other assets) 180,000

A national credit card agency has tried to convince Stillwagon that instead of carrying her own accounts

receivable, she should accept only the agency's credit card for sales on credit. The agency would pay her two days

after she submits sales charges, deducting 6 per cent from the amount and paying her 94 per cent.

a. Using the data given, prepare an analysis showing whether or not Stillwagon would benefit from switching to

the credit card method of selling on credit.

b. What other factors should she take into consideration?

Business decision case B Jim Perry operates a large fruit and vegetable stand on the outskirts of a city. In a

typical year he sells USD 600,000 of goods to regular customers. His sales are 40 per cent for cash and 60 per cent

on credit. He carries all of the credit himself. Only after a customer has a USD 300 unpaid balance on which no

payments have been made for two months does he refuse that customer credit for future purchases. His income

before taxes is approximately USD 95,000. The total of uncollectible accounts for a given year is USD 48,000.

You are one of Perry's regular customers. He knows that you are taking a college course in accounting and has

asked you to tell him your opinion of several alternatives recommended to him to reduce or eliminate the USD

48,000 per year uncollectible accounts expense. The alternatives are as follows:

• Do not sell on credit.

• Sell on credit by national credit card only.

• Allow customers to charge only until their account balances reach USD 50.

• Allow a bill collector to go after uncollectible accounts and keep half of the amount collected.

Write a report for Perry about the advisability of following any of these alternatives.

Annual report analysis C Visit the Internet site:

http://www.cocacola.com

Locate the most recent annual reports of The Coca-Cola Company. Calculate accounts receivable turnover and

the number of days' sales in accounts receivable and prepare a written comment on the results.

Group project D In groups of two or three students, write a two-page, double-spaced paper on one of the

following topics:

Which is better—the percentage-of-sales method or the percentage-of-receivables method?

Why not eliminate bad debts by selling only for cash?

Why allow customers to use credit cards when credit card expense is so high?

Should banks be required to use 365 days instead of 360 days in interest calculations?

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Present your analysis in a convincing manner, without spelling or grammatical errors. Include a cover page with

the title and authors' names.

Group project E "Lapping" of accounts receivable has been used to conceal the fact that payments received on

accounts receivable have been "borrowed" and used by an employee for personal use. With one or two other

students, research this topic in the library. Write a paper to your instructor describing how this technique works

and the steps that can be taken to detect it once it occurs and to prevent it in the future.

Group project F In a group of two or three students, visit a fairly large company in your community to

investigate the effectiveness of its management of accounts receivable. Inquire about its credit and sales discount

policies, collection policies, and how it establishes the amount for the adjusting entry for uncollectible accounts at

year-end. Also ask about how it decides to write off accounts as uncollectible. Calculate its accounts receivable

turnover and average collection period for each of the last two years. In view of its credit policies, does its collection

period seem reasonable?

Using the Internet—A view of the real world

Visit one of the following Internet sites:

http://www.federatedinvestors.com

http://www.dreyfus.com

http://www.invesco.com

Follow some of the other options available at the site. Write a report to your instructor on your experience,

describing some of the things you learned at this site. You may want to pretend that you invested in one or more of

these funds for the duration of the quarter or semester and see how your investment would have fared during that

period. Many investors with a limited amount to invest can have a diversified portfolio by investing in mutual

funds. Thus, they spread their risk by investing in a mutual fund that, in turn, invests in many different companies.

Visit Procter & Gamble's site at:

http://www.pg.com

Procter & Gamble markets more than 250 brands to nearly five billion consumers in over 140 countries. Click on

any items that deal with financial news, annual report summary, stock quote, and anything else that looks

interesting. Write a memo to your instructor summarizing your findings. Include in your memo some of the

financial highlights contained in the annual report summary.

Answers to self test

True-false

False. The percentage-of-sales method estimates the uncollectible accounts from the net credit sales or net

sales of a given period.

False. Uncollectible accounts expense is recognized at the end of the accounting period in an adjusting entry.

True. The retailer deposits the credit card invoices directly in a special checking account.

False. Liabilities result from a past transaction.

Accounting Principles: A Business Perspective 436 A Global Text

9. Receivables and payables

True. Current liabilities are classified into those three categories.

True. The note has passed its maturity date and should be removed from the Notes Receivable account. The

maturity value plus any protest fee should be debited to Accounts Receivable.

False. Discount on Notes Payable is recorded when a non interest-bearing note is issued.

Multiple-choice

d. A write-off of an account receivable results in a debit to Allowance for Uncollectible Accounts and a credit to

Accounts Receivable for the same amount. The net amount (accounts receivable minus allowance for uncollectible

accounts) does not change.

a. The uncollectible accounts expense for 2010 is computed as follows: Allowance balance after adjustment ($200,000 X 0.05) $ 10,000 Balance before adjustment ( 3,000) Uncollectible accounts expense $7,000

c. Manufacturing companies tend to have the longest operating cycle. They must invest cash in raw materials,

convert these raw materials into work in process and then finished goods, sell the items on account, and then collect

the accounts receivable.

b. USD 265,000

1.06 =USD 250,000 ;

USD 265,000 – USD 250,000 = USD 15,000.

c. 2,000×5 per cent=100 machines is defective.

100 – 30 already returned = 70 more expected to be returned.

70×USD 200=USD 14,000 estimated product warranty payable.

c. The name of the payee is not needed to compute interest expense on a promissory note.

c. The proceeds from a bank are computed as follows:

Discount amount=USD 10,000 X 0.10× 90 360

= USD 250

Proceeds = USD 10,000 – USD 250 = USD 9,750

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