Receivables and Accounting for uncollectible debts

Proprietorships

• Owned by a single individual, and simple to form
• Often operated from home
• A main disadvantage is the unlimited legal liability, where the owner is personally liable for all business debts, risking personal assets like their home or car
• Not taxed, as they are pass-through entities where the income flows through to the individual owner who is then taxed on it
• Have a limited life since they do not live on if the owner decides to shut down, dies, etc.
• Have a limited ability to raise capital since it is just one person's assets and any bank loans they can get

Partnerships

• Consist of two or more people who own and manage a business for-profit
• Moderately complex to form, mainly due to the partnership agreement
• The partnership agreement is very important because it formalizes investments and any limits of the partnerships
• The agreement outlines distribution of income and losses
• Similar to proprietorships, have no limitation on legal liability, meaning the partners are personally liable
• Not taxable, have a limited life, and a limited ability to raise capital
• A key element is participation in income, where net income and losses are distributed according to the partnership agreement
• Without a partnership agreement, net income or loss will be divided equally, regardless of the work done by each partner
• Having a partnership agreement ensures clarity on expectations and how income is divided.

Limited Liability Companies (LLCs)

• Legal entity that provides limited liability to its owners while being treated as a partnership for tax purposes
• The formation process is moderately complex due to the legal requirements
• A main advantage is the limited legal liability, where only the members' investments are subject to the claims of creditors, protecting personal assets
• Not taxable since they are passed through entities with unlimited lives
• Have a moderate ability to raise capital, as the limited legal liability attracts more investors

Fixed Assets Refresher

• Fixed assets are long term, relatively permanent assets used repeatedly in normal business operations.
• Fixed assets include equipment, machinery, buildings, and land.
• The cost of fixed assets includes the purchase price plus all acquisition costs like freight and installation.
• Only necessary costs for preparing the fixed asset for use are included in its cost.
• Unnecessary costs that do not increase the asset's usefulness, such as vandalism costs, are not included.

Depreciation Defined

• Depreciation is the decline in the usefulness of fixed assets, excluding land.
• Depreciation allocates a portion of a fixed asset's cost to expense over its useful life.
• Depreciation expense is debited, and accumulated depreciation is credited.
• Accumulated depreciation is a contra asset account, having the opposite sign as its related accounts.
• Book value is calculated as Fixed Asset Account - Accumulated Depreciation.

Journal Entry Example

• For example, to record a depreciation expense of $1,000 on December 31st, debit depreciation expense and credit accumulated depreciation for $1,000.

Depreciation Terms Defined

• Initial cost is the purchase price plus all acquisition costs.
• Expected useful life is the estimated time the asset will be used in normal operations.
• Residual value is the estimated value of the asset at the end of its useful life.
• Depreciable cost is Initial Cost - Residual Value and is the cost allocated as depreciation expense over the asset's life.

Straight Line Method

• Provides the same depreciation expense amount each year.
• Annual depreciation = (Initial Cost - Residual Value) / Useful Life.
• Straight line percentage = 100% / Number of Years of Expected Useful Life.
• Multiply the straight line percentage by the depreciable cost to get the annual depreciation.

Example of Straight Line

• A machine purchased for $25,000 with a residual value of $5,000 and a useful life of 4 years has a depreciation expense of ($25,000 - $5,000) / 4 = $5,000 per year.
• The straight line percentage is 100% / 4 = 25%.
• Depreciation Expense = 25% * ($25,000 - $5,000) = $5,000 per year.

Units of Activity Method

• Provides variable expense per period due to varying activity levels.
• Provides the same depreciation expense for each unit of activity.
• Depreciation per Unit = (Cost - Residual Value) / Total Estimated Units of Activity.
• Total Depreciation Expense = Depreciation per Unit * Number of Units for the Period.

Example of Units of Activity

• A machine was purchased for $25,000 with a residual value of $5,000 and a useful life of 10,000 hours.
• If the machine was operated for 2,000 hours in the first year, the depreciation expense is calculated as follows:
• Depreciation per unit = ($25,000 - $5,000) / 10,000 hours = $2 per hour.
• Depreciation expense for year one = $2/hour * 2,000 hours = $4,000.

Double Declining Balance Method

• Is an accelerated depreciation method.
• Allows for more depreciation to be recorded up front, less in later years (tax benefits)
• Step 1: Determine the straight line percentage (100/Useful Life).
• Step 2: Determine the double declining balance rate (Straight Line Percentage * 2).
• Step 3: Compute depreciation expense (Double Declining Balance Rate * Book Value of Asset).
• The asset cannot be depreciated below the estimated residual value.

Example for Balance Method

• Machine purchased for $25,000, an estimated residual value of $5,000, useful life of 4 years
• Straight line percentage = 100/4 years of useful life = 25%
• Double declining balance rate = straight line percentage multiplied by 2, so 25% * 2 = 50%
• Depreciation expenses for year one = $25,000 *50% = $12,500
• Book value in year two = the initial cost - accumulated depreciation = $25,000 - $12,500 = $12,500
• Year two depreciation expense = the $12,500 * 50% = $6,250 depreciation expense in year two

Repairs and Improvements to Fixed Assets

• Revenue expenditures benefit only the current period (e.g., ordinary maintenance and repairs).
• Capital expenditures improve the asset or extend its useful life.
• Asset improvements increase the asset's value i.e. debit the asset and credit cash.
• Extraordinary repairs, such as an engine overhaul, extend useful life and impact depreciation i.e. debit accumulated depreciation (decreasing it), credit cash.

Disposal & Sale of Fixed Assets

• Discarding fixed assets occurs when an is asset no longer used, has no residual value, and is fully depreciated.
• The journal entry would be debit accumulated depreciation, credit equipment (removing both from books).
• If the asset not fully depreciated requires recording depreciation first before disposal.
• The journal entry is debit accumulated depreciation, credit equipment, debit the difference to Loss on Disposal.

Selling Assets

• Debit cash, debit accumulated depreciation, credit the asset, debit a loss or credit a gain
• The journal entry involved if a gain is recorded if the selling price is more than the book value
• The journal entry involved if a Loss is recorded if the selling price is less than the book value

Natural Resources

• These are assets created through natural growth, removed for sale over one or more years.
• Depletion expense is calculated similarly to units of activity.
• Depletion rate = (Cost of Resource) / (Estimated Total Units of the Resource).
• Depletion expense = Depletion Rate * Quantity Removed.

Intangible Assets

• These are long-term, nonphysical assets.
• Amortization is the decline in usefulness of an intangible asset.
• Patents and copyrights are amortized.
• Trademarks are not amortized.
• Goodwill, an intangible asset from favorable factors, is not amortized but can be impaired.

Practice Problems

• Cost basis is what you pay for the asset, not the market value or offer price.
• Straight line example:
• ($220,000 - $30,000)/10 years = $19,000 per year is the depreciation expense
• Units of Activity Method:
• Depreciation per unit = (Cost - Residual Value)/Total Estimated Units of Activity
• ($220,000 cost - Residual Value $30,000) / 19,000 hours

Units of Activity Method

• Total depreciation expense for the first year is calculated to be $10 per hour.
• Equipment was used for 2,100 hours during the first year.
• Depreciation for year one will be $10 per hour, totaling $21,000.

Double Declining Balance Method

• Initial cost: $220,000
• Residual value: $30,000
• Estimated useful life: 10 years or 19,000 hours
• Step 1: Determine straight-line percentage which is 100% divided by useful life (10 years), resulting in 10%.
• Step 2: Double the straight-line percentage to get 20%.
• Step 3: Multiply book value by the double declining balance rate.
• For year one, book value is the initial cost ($220,000).
• Depreciation expense for year one will be $220,000 times 20%, totaling $44,000.

Book Value Considerations

• Book value changes each year and is calculated as initial cost minus accumulated depreciation.
• Depreciation cannot go below residual value.

Depletion Calculation

• ABC Company purchased mining rights for $250,000 and expects to harvest 1 million tons of iron ore over 5 years.
• In the current year, ABC mined 200,000 tons of ore.

Depletion per Unit Calculation

• Depletion per unit is original cost of natural resource ($250,000 is cost of mining rights divided by the number of units to be harvested (1 million tons of ore)
• Depletion per unit of ore will be $250,000 divided by 1 million tons, equaling $0.25 per ton

Total Depletion Expense

• Total depreciation expense is calculated as depletion per unit ($0.25 per ton) times the number of tons mined in year one (200,000 tons)
• Total depletion expense will be $0.25 per ton times 200,000 tons, totaling $50,000

Recording Depletion

• Depletion expense will be debited for $50,000
• accumulated depreciation will be credited for $50,000
• Entry involves a debit to depletion expense for $50,000

Current Liabilities

• Debts paid out of current assets, due within one year.

Types of Current Liabilities

• Accounts Payable: for numerous transactions, mainly buying things on account.
• Current Portion of Long-Term Debt: installments due within the year of debts like a mortgage.
• Short-Term Notes Payable: Discussed further.

Notes Payable

• Can be issued to purchase merchandise or assets, functioning like accounts payable.
• Can satisfy an earlier account payable.
• Involves a more formal commitment than accounts payable.

Example: 90-day, 12% Note for $1,000

• December 1st: Debit Accounts Payable for $1,000, Credit Notes Payable for $1,000.
• After 90 days: Debit Notes Payable for $1,000.
• Interest Calculation: Face value x Interest rate x (Term/360).
• Interest Expense: $1,000 x 12% x (90/360) = $30.
• Credit Cash for total payment: $1,000 + $30 = $1,030

Discounted Note

• Borrower receives face value less the discount.
• Discount Calculation: Face Value x Discount Rate x (Term/360).
• Proceeds: Face Value - Discount.

Example: $10,000, 90-day, 15% Discounted Note

• Discount Calculation: $10,000 x 15% x (90/360) = $375.
• Proceeds: $10,000 - $375 = $9,625.
• Debit Cash for $9,625, Debit Interest Expense for $375, Credit Notes Payable for $10,000.

Comparison of Note Types

• Regular Notes Payable: Receive full face value upfront, pay back face value plus interest.
• Discounted Notes Payable: Receive face value less discount, pay back only the face value.

Payroll and Payroll Taxes

• Payroll: Amount paid to employees for services during a period.
• Gross Pay: Total earnings, including overtime.
• Net Pay: Total earnings less deductions, the amount the employee takes home.
• Net Pay equals Gross Pay minus all Deductions.

Employee Federal Income Tax

• Withheld from employee earnings and paid to the government.
• Withholding amount depends on allowances (deductions) based on marital status, dependents, etc.
• Calculated using withholding tables.

FICA Taxes

• Social Security: 6% on all earnings, provides payments for retirees, survivors, and disability insurance.
• Medicare: 1.5% on all earnings, provides health insurance for senior citizens.
• Total FICA tax: 7.5% on earnings.

Computing Net Pay

• Gross earnings: Hours worked x Wage.
• Deductions: Federal income tax, Social Security, Medicare, etc.
• Net Pay: Gross earnings - Total Deductions.

Accounting Systems for Payroll and Taxes

• Two journal entries: one for employees and one for employers.
• The employer journalizes both entries.

Employee Entry

• Debit Salaries Expense for gross pay.
• Credit all tax payables (income taxes, Social Security, Medicare).
• Credit Salaries Payable for net pay.
• Salaries expense is debited with total wages, showing where the money spent is going.

Employer Entry

• Records and pays payroll taxes.
• Payroll taxes recorded as liabilities when payroll is paid to employees.
• Employers must match FICA taxes.
• Employers pay both federal and state unemployment taxes.
• Debit Payroll Tax Expense for the total amount.
• Credit all tax payables individually.

Fringe Benefits

• Benefits in addition to salary and wages (vacations, medical, retirement).
• Pensions: Cash payments to retired employees.

Types of Pension Plans

• Defined Contribution Plans: Both employer and employee contribute.
• Defined Benefit Plans: Companies pay employees fixed annual pensions (rare).

Contingent Liabilities

• Potential liabilities that may arise from past transactions only if certain events occur in the future.
• Categorized and handled based on probability and estimability:
  • Probable and estimable: Record and disclose the liability.
  • Probable but not estimable: Disclose the liability.
  • Reasonably possible: Disclose the liability.
  • Remote: Do not disclose.

Partnership Formation (Accounting Perspective)

• The investments of each partner are recorded separately
• Assets contributed are debited to the partnership asset accounts, and any liabilities are credited to partnership liability accounts
• The partnership capital account is credited for the net amount, which is assets less liabilities

Dividing Partnership Income

• Income or losses are divided as specified in the partnership agreement
• If there is no agreement, income or losses are divided equally
• Common methods for dividing income are based on the services of the partners, or based on both the services of partners and investments

Method 1: Services of Partners

• This method divides partnership income based on the services provided by each partner, recognized through salary allowances
• Under this system, the services are rewarded with a higher salary than partners who do less work
• Net income is used to pay out salaries first, with any remaining income then divided as specified in the partnership agreement.
• E.g. income divided equally or in a specific ratio

Method 2: Services of Partners and Investments

• This method recognizes services through salary allowances, and also rewards partners who invested more in the company
• Net income is used to pay out partner salary allowances, then interest is paid on capital investments
• Lastly, any remaining income left over is divided per the partnership agreement.

Dividing Partnership Income

• Net income of $25,000, is reduced by a $10,000 salary allowance and $25,000 interest payment, leading to a $10,000 net loss.
• The $10,000 net loss is split between partners, resulting in a $5,000 loss for each.
• Partner A's net income is calculated as $6,000 (initial)+ $15,000 - $5,000 (loss) = $16,000.
• Partner B's net income is calculated as $4,000 (initial) + $15,000 - $5,000 (loss) = $9,000.
• Total net income remains $25,000, distributed as $16,000 to Partner A and $9,000 to Partner B.

Partnership Admission: Purchasing an Interest

• Involves transferring owner's equity from the selling partner's capital account to the new partner's capital account.
• Requires debiting the existing owner's capital account and crediting the new partner's capital account.
• Total assets and total owner's equity remain unchanged as it's a simple equity transfer.

Partnership Admission: Contributing Assets

• Results in an addition to owner's equity, often through cash contributions but can include equipment or inventory.
• Requires debiting the contributed assets to increase them and crediting owner's equity to admit the new partner.
• Total assets and total owner's equity increase as a result of the new contribution.

Partner Bonuses: Overview

• Paid due to expected future contributions to higher-than-normal profits from new or existing partners.
• Distinct from typical employee bonuses; specific to admitting a new partner.

Bonus to Existing Partners

• Occurs when the new partner pays more than the ownership interest is worth.
• The new partner might overpay to join a successful business, effectively giving a bonus to existing partners.
• Example: Paying $50,000 for a $40,000 interest stake results in a $10,000 bonus to existing partners.

Bonus to New Partners

• Occurs when the new partner pays less than the ownership interest is worth.
• Existing partners might accept less payment to attract a partner with valuable skills or contacts.
• Example: Paying $20,000 for a $30,000 interest stake results in a $10,000 bonus to the new partner.

Dividing Partnership Income: Example

• Bob and Frank form a partnership with investments of $360,000 and $180,000, respectively.
• The year's net income totals $250,000.

Scenario A: No Partnership Agreement

• In the absence of a partnership agreement, net income ($250,000) is split evenly.
• Bob receives $125,000, and Frank receives $125,000.

Scenario B: With Salary and Interest Allowances

• Salary allowances are $35,000 for Bob and $50,000 for Frank, totaling $85,000.
• Interest is paid at 5% on original investments: $18,000 for Bob and $9,000 for Frank, totaling $27,000.
• Remaining income calculation: $250,000 (net income) - $85,000 (salaries) - $27,000 (interest) = $138,000.
• The remaining income of $138,000 is divided equally: $69,000 each.
• Bob's net income: $35,000 (salary) + $18,000 (interest) + $69,000 (remaining income) = $122,000.
• Frank's net income: $50,000 (salary) + $9,000 (interest) + $69,000 (remaining income) = $128,000.

Corporation Overview

• A corporation is a separate legal entity from its owners and operators.
• Advantages of a corporation include:
  • Distinct legal existence
  • Continuous life
  • Ability to raise large capital
  • Limited legal liability for owners
• Disadvantages of a corporation include:
  • Separation of ownership from management (agency problems)
  • Double taxation of dividends
  • Increased regulation
• Corporations issue stock representing ownership shares.
• Stockholders elect a board of directors, who appoint officers (CEO, CFO, etc.) to manage daily operations.

Stockholder's Equity

• Stockholder's equity comes from paid-in capital and retained earnings.
• Paid-in capital is contributions from stockholders.
• Retained earnings is accumulated net income not paid as dividends.
• Initial Public Offering (IPO) is a company's first stock issuance to the public.
• Seasoned Equity Offering is issuing additional stock after the IPO.
• Net income increases owner's equity, while net losses decrease it.
• Dividends are distributions of earnings to stockholders, reducing owner's equity.

Characteristics of Stock

• Authorized Stock: Total number of shares a corporation can issue (stated in its charter).
• Issued Stock: Shares that have been sold to stockholders.
• Outstanding Stock: Shares currently held by stockholders.
• Treasury stock is the difference between issued and outstanding stock (reacquired stock).
• Par value is a dollar value assigned to each share, important for journalizing but not reflective of market value.

Classes of Stock

• Common Stock:
  • Each share has equal rights
  • Includes voting rights
  • Rights to share in earnings distributions (dividends), and assets upon liquidation
  • Common stockholders are paid last during liquidation, after creditors and preferred stockholders.
• Preferred Stock:
  • May have preferential rights over common stock.
  • Priority for dividends
• Cumulative Preferred Stock:
  • Entitles holders to fixed regular dividends.
  • Holders receive unpaid dividends from prior years (dividends in arrears) before common stockholders.
• Dividends in Arrears:
  • Unpaid cumulative preferred stock dividends.
  • Must be paid before common stock dividends.

Calculating Dividends for Preferred and Common Stock

• Preferred stockholders are given first priority in receiving their set dividend amount, calculated by number of shares × par value per share × set dividend %.
• Any remaining is then distributed to common stock holders.
• Unpaid preferred dividends carry over to the next period.

Issuing Stock

• Stock can be issued at par value or at a premium (above par).
• When stock is sold at a premium, the excess over par is credited to "Paid-in Capital in Excess of Par."
• The journal entry for issuing stock at a premium:
  • Debit Cash for the total amount received.
  • Credit Common/Preferred Stock (number of shares x par value).
  • Credit Paid-in Capital in Excess of Par (difference between issue price and par value x number of shares).
• Stock sold for less than par is sold at a discount (rare).

Accounting for Dividends

• Cash Dividend: Cash distribution of earnings to shareholders.
  • Requires sufficient retained earnings and cash
  • Formal action by the board of directors is needed
• Dividend Dates:
  • Date of Declaration:
    • Dividend is formally authorized, creating a liability.
    • Debit Cash Dividends and credit Cash Dividends Payable.
  • Date of Record:
    • Determines which stockholders receive the dividend.
    • No journal entry.
  • Date of Payment:
    • Dividend is paid.
    • Debit Cash Dividends Payable and credit Cash.
• Stock Dividend:
  • Distribution of shares to stockholders
  • Affects stockholders' equity only
  • Transfers retained earnings to paid-in capital
  • Stock is transferred at market value including any paid in capital in excess of par

Stock Dividend Example

• To journalize:
  • Debit Stock Dividends.
  • Credit Stock Dividends Distributable
• Stock is transferred/issued at market value
• The journal entries for a 2% stock dividend includes:
  • Debit Stock Dividends
  • Credit Stock Dividends Distributable
  • Credit Paid-in Capital in Excess of Par
• On the payment date, debit Stock Dividend Distributable and credit Common Stock as the common stock gets issued.

Stock Splits

• Reduces the par value of common stock and issues proportional additional shares therefore, can increase the authorized shares of stock.
• Reduces market price per share to make stock more accessible.
• No journal entry is required because the stock split does not change the total $ amount of equity.
• Example of a Four-For-One Split:
  • A stockholder would receive four shares for every one previously held and it lowers the price.

Treasury Stock

• Stock that a corporation has reacquired, and decreases shares outstanding.
• Reasons for reacquisition:
  • Resale
  • Employee bonuses
  • Support market price of the stock
• Accounting for Treasury Stock:
  • Debit Treasury Stock (for purchase price)
  • Credit Cash
• When reselling treasury stock:
  • Debit Cash (for selling price)
  • Credit Treasury Stock (at cost)
  • Debit/Credit Paid-in Capital from Sale of Treasury Stock (for the difference)

Statement of Cash Flows Overview

• Reports a company's cash inflows and outflows for a specific period.
• Provides insights into a company's ability to:
  • Generate cash from operations
  • Maintain and expand operating capacity
  • Meet financial obligations
  • Pay dividends
• Helps investors identify underlying issues not apparent from the income statement and balance sheet.
• Enron's collapse highlighted the importance of the statement, where high revenues contrasted with a lack of cash flow.

Types of Cash Flow Activities

• Operating activities: Affect the net income of the company through daily operations
• Investing activities: Relate to transactions involving investments in non-current assets
• Financing activities: Transactions affecting the company's debt and equity

Operating Activities Inflows and Outflows

• Cash inflow: Sale of products or services
• Cash outflow: Purchase of inventory or payment to employees

Investing Activities Inflows and Outflows

• Cash inflow: Sale of property, plant, and equipment (PP&E) or sale of investments
• Cash outflow: Purchase of PP&E or purchasing investments

Financing Activities Inflows and Outflows

• Cash inflow: Issuing long-term liabilities or issuing stock
• Cash outflow: Paying dividends or repurchasing common stock

Direct Method for Operating Activities

• Directly reports cash receipts and cash payments.
• Data may not be readily available in accounting records.
• The presence of receivables and payables complicates its use.
• Example: Net cash flow from operating activities is calculated by subtracting cash payments for merchandise, operating expenses, interest, and income taxes from cash received from customers.

Indirect Method for Operating Activities

• Begins with net income and adjusts for revenues and expenses not involving cash.
• Commonly used in practice.
• Used to calculate leverage free cash flow
• Start with net income
• Add depreciation, amortization, and other non-cash expenses: These are expenses that reduce net income but do not involve an actual cash outflow
• Add losses on the disposal of assets: These losses do not represent a cash outflow
• Add decreases in assets: A decrease in assets implies that the company is receiving cash
• Add increases in liabilities: An increase in liabilities means the company is holding onto cash rather than paying it out
• Deduct gains on the disposal of assets as these are basically a non-cash increase
• Deduct increases in assets: An increase in assets typically requires a cash payment
• Deduct decreases in liabilities: A decrease in liabilities usually involves a cash payment
• Assets are the opposite sign and liabilities are the same sign

Statement of Cash Flows Format

• Cash flows from operating activities
• Cash flows from investing activities
• Cash flows from financing activities
• Increase or decrease in cash
• Cash at the beginning of the period
• Cash at the end of the period (beginning cash + increase or - decrease)
• Non-cash investing and financing activities

Free Cash Flow

• Measures the operating cash flow available after purchasing PP&E to maintain current operations
• Positive free cash flow: Considered favorable, indicating financial flexibility such as funding growth/acquisitions, retiring debt, repurchasing stock, and paying dividends.
• Negative free cash flow: Lacks financial flexibility.
• Free cash flow = cash flows from operating activities - cash used to purchase PPE