Accounting for Receivables and Inventory Cost Flow Chapter 5 PDF

Accounting for Receivables and Inventory Cost Flow Chapter 5  What are Accounts Receivable When a company allows a customer to “buy now and pay later,” the company’s right to collect cash in the future is called an _account receivable_ Typically, a...

Accounting for Receivables and Inventory Cost Flow Chapter 5  What are Accounts Receivable When a company allows a customer to “buy now and pay later,” the company’s right to collect cash in the future is called an _account receivable_ Typically, amounts due from individual accounts receivable are relatively small and the collection period is short. When a longer credit term is needed or when a receivable is large, the seller usually requires the buyer to issue a note reflecting a credit agreement between the parties. The note specifies the maturity date, interest rate, and other credit terms. Receivables evidenced by such notes are called notes receivable. Accounts and notes receivable are reported as assets on the _balance_ _sheet_. Net Realizable Value of Accounts Receivable Most companies do not expect to collect the full amount (face value) of their accounts receivable. Even carefully screened credit customers sometimes don’t pay their bills. The net realizable value of accounts receivable (NRV) represents the amount of receivables a company estimates it will actually collect. The net realizable value is the face value less an allowance for doubtful accounts.  Allowance for Doubtful Accounts The allowance for doubtful accounts represents a company’s estimate of the amount of uncollectible receivables. To illustrate, assume a company with total accounts receivable of $50,000 estimates that $2,000 will not be collected.  Allowance Method Reporting accounts receivable at net realizable value is called the allowance method of accounting for uncollectible accounts. The allowance method requires accountants to estimate the amount of uncollectible accounts. One approach is to base the estimates on a percentage of revenue.  Events 1-3 (Yr1) Event 1: Allen’s Tutoring Services (ATS) recognized $3,750 of service revenue earned on account during Year 1. Event 2: ATS collected $2,750 cash from accounts receivable in Year 1 Event 3: ATS recognized uncollectible accounts expense for accounts expected to be uncollectible in the future. ATS would recognize $75 ($3,750 of revenue x 2%) on the Year 1 income statement. This approach is commonly called the percent of revenue method.  Allen’s Tutoring Transactions (YR1) Bal Sheet Inc Stmt Stmt Asset Liab Stkhld Equity of = + Cash Flow Accts NRV Salary Commo Retained Rev – Exp = Cash Event Rec AR Payable n stock earning Net Inc B B 1 Rec 3750 3750 3750 3750 rev 2 Cash 2750 (275 2750 collec 0) ted 3 (75) (75) 75 (75) E 2750 1000 (75) 3750 75 3675 2750 B  Net Realizable Value The Accounts Receivable account is not reduced directly because none of the receivables have actually been determined to be uncollectible. The decrease in the net realizable value of receivables represents an estimate of what will be uncollectible some time in the future. To distinguish the actual balance in accounts receivable from the net realizable value, accountants use a contra asset account called Allowance for Doubtful Accounts. Analysis of Year 1 Financial Statements  Events 1- 6(Yr2) Event 1: ATS wrote off $70 of uncollectible accounts receivable Event 2: ATS provided $10,000 of tutoring services on account during Year 2 Event 3: ATS collected $8,430 cash from accounts receivable Event 4: ATS recovered a receivable that it had previously written off. This increases both Accounts Receivable and Allowance for Uncollectible Accounts, with zero effect on the NRV. Event 5: ATS recorded collection of the reinstated receivable. Event 6: Using the percent of revenue method, ATS recognized uncollectible accounts expense for Year 2. ATS will recognize $200 ($10,000 revenue  Allen’s Tutoring Transactions (YR2) Bal Sheet Inc Stmt Stmt Asset Liab Stkhld Equity of = + Cash Flow Accts NRV Salary Commo Retained Rev – Exp = Cash Event Rec AR Payable n stock earning Net Inc B B 1 2 3 4 5 6 E B Analysis of the Year 2 Financial Statements  Estimating Uncollectible Accounts Expense Using the Percent of Receivables Method Some accountants believe they can better estimate the amount of uncollectible expense by basing their estimates on a percentage of accounts recivable rather than a percentage of revenue. The approach focuses on estimating the most accurate balance for the Allowance for Doubtful Accounts account that appears on the year-end balance sheet.  An Illustration of the Percent of Receivables Method Before adjusting its accounts on Dec. 31, Year 1, Pyramid Corporation had a $56,000 balance in its Accounts Receivable account and a $500 credit balance in its Allowance for Doubtful Accounts account. Pyramid estimates that 6% of its accounts receivable are uncollectible. The balance in the Allowance for Doubtful Accounts account that appears on the December 31, Year 1, balance sheet must be $3,360. Since the Allowance account currently has a $500 balance, Pyramid must add $2,860 ($3,360 – $500) to the Allowance account before preparing the financial statements Accounts Receivable Aging Schedule  Balance Required in Allowance Account The ending balance must be $3,760 in the Allowance for Doubtful Accounts account shown. Since Pyramid has an unadjusted $500 balance in its Allowance account, the amount of uncollectible expense to be recognized is $3,260 ($3,760 required ending balance – $500 current unadjusted balance).  Matching Revenues and Expenses versus Asset Measurement The percent of _ The percent of method, focused revenue method, on determining with its focus on the best estimate determining the of the allowance uncollectible balance, is often accounts called the expense, is often _balance_ called the income _sheet_ statement approach. approach. Either approach provides acceptable results.  Accounting for Notes Receivable Companies do not charge interest on accounts receivable that are not past due. When a company extends credit for a long time or when the credit extended is large, the cost and the potential for disputes both increase. The parties frequently enter into a credit agreement, the terms are legally documented in a _promissory note.  Characteristics of Notes Receivable 1. Maker - The person responsible for making payment on the due date is the maker of the note. The maker may also be called the borrower or debtor. 2. Payee - The person to whom the note is made payable is the payee. The payee may also be called the creditor or lender. The payee loans money to the maker and expects the return of the principal and the interest due. 3. Principal – The amount of money loaned by the payee to the maker of the note is the principal. 4. Interest – The economic benefit earned by the payee for loaning the principal to the maker is interest, which is normally expressed as an annual percentage of the principal amount. 5. Maturity date – The date on which the maker must repay the principal and make the final interest payment to the payee is the maturity date. 6. Collateral – Assets belonging to the maker that are assigned as security to ensure that the principal and will be paid when due are called collateral.  Events 1- 6 Acct for Notes Receivable Event 1: Loan of Money - ATS loaned $15,000 to Stanford Cummings on November 1, Year 1 Event 2: Accrual of Interest -Cummings will repay the principal ($15,000) plus interest of 6 percent of the principal amount (0.06 X $15,000 = $900) on October 31, Year 2. ATS computed the amount of accrued interest Event 3: Collection of Principal and Interest on the Maturity Date. ATS collected $15,900 cash on the maturity date, including $15,000 for the principal plus $900 for the interest. ATS previously accrued interest for two months in Year 1. Since then, ATS has earned an additional 10 months of interest, computed and accrued as follows. Event 3 (cont’d) - Collection of Principal and Interest on the Maturity Date. The total amount of accrued interest is now $900 ($150 accrued in Year 1 plus $750 accrued in Year 2) ATS collected $15,900 cash.  Allen’s Notes Receivable Bal Sheet Inc Stmt Stmt Asset Liab Stkhld Equity of = + Cash Flow Notes Int Salary Commo Retained Rev – Exp = Cash Event Rec Rec Payable n stock earning Net Inc B B 1 2 3 E B Financial Statements The financial statements reveal key differences between the timing of revenue recognition and the exchange of cash. Accrual accounting calls for recognizing revenue in the period in which it is earned regardless of when cash is collected.  Typical Balance Sheet Presentation of Receivables Income Statement Although generally accepted accounting principles require reporting receipts of or payments for interest on the statement of cash flows as operating activities, they do not specify how to classify interest on the income statement. Balance Sheet As with other assets, companies report interest receivable and notes receivable on the balance sheet in order of their liquidity. _liquidity_ refers to how quickly assets are expected to be converted to cash during normal operations.  Accounting for Credit Card Sales Event 1 - Recognition of Revenue and Expense on Credit Card Sales ATS accepts a credit card payment for $1,000 of services rendered. Assume the credit card company charges a 5 percent fee ($1,000 x 0.05 = $50). Event 2 - Collection of Credit Card Receivable The collection of the receivable due from the credit card company is recorded like any other receivable collection. Many businesses find it more efficient to accept third-party credit cards instead of offering credit directly to their customers. Credit card companies service the merchant’s credit sales for a fee that typically ranges between 2 and 8 percent of gross sales.  Inventory Cost Flow Methods In practice, businesses often pay different amounts for identical items. Suppose the Mountain Bike Company (TMBC) purchases one Model 201 helmet at a cost of $100 and a second Model 201 helmet at a cost of $110. If TMBC sells one of its helmets, should it record $100 or $110 as cost of goods sold? Four acceptable methods for determining the cost are: (1) ________________ (2) ________________(FIFO) (3) ________________(LIFO) (4) __________________.  4 Different Methods 1 – Specific Identification Suppose TMBC tags inventory items so that it can identify which one is sold at the time of sale. 2 - First-In, First-Out (FIFO) The first-in, first-out (FIFO) cost flow method requires that the cost of the items purchased first be assigned to cost of goods sold. Using FIFO, TMBC’s cost of goods sold is $100. 3 - Last-In, First-Out (LIFO) The last-in, first-out cost flow method requires that the cost of the items purchased last be assigned to cost of goods sold. Using FIFO, TMBC’s cost of goods sold is $110. 4 – Weighted Average To use the weighted average cost flow method, first calculate the average cost per unit by dividing the total cost of the inventory available by the total number of  Physical Flow The preceding discussion pertains to the flow of costs_through the accounting records, not the actual physical flow of goods. Goods usually move physically on a FIFO basis, which means that the first items of merchandise acquired by a company (first- in) are the first items sold to its customers (first-out). Cost flow, however, can differ from physical flow.  Effect of Cost Flow on Financial Statements Income Statement The cost flow method a company uses can significantly affect the gross margin reported in the income statement. Balance Sheet Since total product costs are allocated between cost of goods sold and ending inventory, the cost flow method used affects its balance sheet as well as its income statement.  Multiple Layers with Multiple Quantities The previous example illustrates different inventory cost flow methods using only two cost layers ($100 and $110) with only one unit of inventory in each layer. Actual business inventories are considerably more complex. The following information relates to TMBC’s Eraser bike. TMBC paid cash for all bike purchases and sold 43 bikes at a cash price of $350 each.  First In First Out -FIFO Cost of Goods Sold TMBC sold 43 Eraser bikes. The FIFO method transfers to the Cost of Goods Sold account the cost of the first 43 bikes TMBC had available to sell. The expense recognized for the cost is computed as follows: Ending Inventory TMBC had 55 bikes available and sold 43. It would have 12 bikes in ending inventory. The cost assigned equals the cost of goods available for sale minus the cost of goods sold.  Allocation of Cost of Goods Available for Sale - FIFO The FIFO allocation of the cost of goods available for sale between cost of goods sold and ending inventory is shown graphically here: Last In First Out - LIFO Under LIFO, the cost of goods sold is the cost of the last 43 bikes acquired by TMBC. The LIFO cost of the 12 bikes in ending inventory is computed as follows:  Allocation of Cost of Goods Available for Sale - LIFO The LIFO allocation of the cost of goods available for sale between cost of goods sold and ending inventory is shown graphically here:  Weighted-Average Cost Flow The weighted-average cost per unit is determined by dividing the total cost of _____________for sale by the total ________________available for sale. For TMBC, the weighted-average cost per unit is $230 ($12,650 ÷ 55). The cost of goods sold is $9,890 ($230 x 43). The cost assigned to the 12 bikes in ending inventory is $2,760 (12 x $230). Allocation of Cost of Goods Available for Sale – Weighted-Average Cost The weighted-average allocation of the cost of goods available for sale between cost of goods sold and ending inventory is shown graphically here: Effect of Cost Flow on Financial Statements  The Impact of Income Tax FIFO produces the _highest_ gross In contrast, LIFO margin; it also results in recognizing produces the the lowest gross _highest net margin, _lowest net income and the income, and the highest income lowest income tax tax expense. expense. In some instances companies may use one accounting method for financial reporting and a different method to compute income taxes (the tax return must explain any differences). With respect to LIFO, however, the Internal Revenue Service requires that companies using LIFO for income tax purposes must also use LIFO for financial reporting. Full Disclosure and Consistency Generally accepted accounting principles allow each company to choose the inventory cost flow method best suited to its reporting needs. Because results can vary considerably among methods, however, the GAAP principle of _full_ disclosure requires that financial statements disclose the method chosen. In addition, so that a company’s financial statements are comparable from year to year, the GAAP principle of __consitency__ generally requires that companies use the same cost flow method each period.  End of Presentation