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Fundamental

Financial Accounting
Concepts
Fourth Edition
by
Edmonds, McNair, Milam, Olds

PowerPoint® presentation by
J. Lawrence Bergin
7- 2

Chapter 7

Accounting for Accruals:


Advanced Topics-
Receivables and Payables

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Advanced topics include:

■ Accounting for bad


debts
■ Accounting for
interest-bearing notes Want to
learn some
and noninterest accounting?
bearing (discounted)
notes
■ Warranties

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Accounts and Notes Receivable

■ A/R are the expected future


cash receipts of a company.
They are typically small and are
expected to be received within
30 days.
■ N/R are used when longer
credit terms are necessary.
The promissory note specifies
the maturity date, the rate of
interest, and other credit terms.
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Value of Receivables

■ Receivables are reported at


their face value less an
allowance for accounts
which are likely to be
uncollectible.
■ The amount which is
actually expected to be
collected is called the net
realizable value (NRV).

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Allowance Method vs. Direct


Write-Off Method
■ GAAP requires that A/R be reported at
NRV. (A/R minus Allowance)
■ This is done using a valuation allowance:
An ALLOWANCE METHOD.
❐ % of Sales (or “Income Statement”) approach.
❐ Aging (or “Balance Sheet”) approach.
■ With the ALLOWANCE METHOD, an
estimate of the amount that will NOT be
collected is recorded in the same period
that the sales revenue is recorded. Thus,
the MATCHING PRINCIPLE is being followed.
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Allowance Method vs. Direct


Write-Off Method (continued)
■ The DIRECT WRITE-OFF method violates
GAAP because it does NOT follow the
MATCHING principle.
■ With the Direct Write-off method, no estimate
of bad debts is recorded at the time of the
sale. Rather, only after a specific account is deemed
“uncollectible” is a Bad Debt Expense recorded.
■ Since GAAP is only required if the amounts are
MATERIAL (significant), if the amount of uncollectible
A/R is immaterial the Direct Write-off method may be
used.
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7- 8

Transaction Analysis:

■ Assume the following selected events


occurred at Cell-It. For each event:
❐ Determine how the accounting equation
was affected and fill in the horizontal
model. (Assume GAAP must be followed.)
❐ Determine the effect on the financial
statements.
❐ Record the event in t-accounts.

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Transaction Analysis:

The following selected events occurred


at Cell-It during 2004.
1. Provided services to customers for $10,000 on
account.
2. Collected $7,000 on account receivables.
3. At year-end it was estimated that 2% of year’s
credit sales will never be collected.
4. Jane Doe’s $50 account was written-off as
“uncollectible”.
5A&B. $50 cash is unexpectedly received from
Jane Doe.
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Record the five transactions in this


horizontal statements model.
Balance Sheet Inc. Statement Cashflow
Assets = Liab.+ Stk. Equity
Cash+ A/Rec .- Allow. = A/P + C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA
1
2
3
4
5A
5B
Bal.

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1. Provided services to customers for


$10,000 on account.
Balance Sheet Inc. Statement Cashflow
Assets = Liab.+ Stk. Equity
Cash+ A/Rec .- Allow. = A/P + C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA
1
2
3
4
5A
5B
Bal.

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1. Provided services to customers for


$10,000 on account.
Balance Sheet Inc. Statement Cashflow
Assets = Liab.+ Stk. Equity
Cash+ A/Rec .- Allow. = A/P + C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA
1 10000 10000 10000 10000 n.a.
2
3
4
5A
5B
Bal.

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2. Collected $7,000 from account receivable.

Balance Sheet Inc. Statement Cashflow


Assets = Liab.+ Stk. Equity
Cash+ A/Rec .- Allow. = A/P + C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA
1 10000 10000 10000 10000 n.a.
2
3
4
5A
5B
Bal.

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2. Collected $7,000 from account receivable.

Balance Sheet Inc. Statement Cashflow


Assets = Liab.+ Stk. Equity
Cash+ A/Rec .- Allow. = A/P + C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA
1 10000 10000 10000 10000 n.a.
2 7000 (7000) 7000 OA
3
4
5A
5B
Bal.

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3. At year-end it was estimated that 2% of


the year’s credit sales will not be collected.
Balance Sheet Inc. Statement Cashflow
Assets = Liab.+ Stk. Equity
Cash+ A/Rec .- Allow. = A/P + C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA
1 10000 10000 10000 10000 n.a.
2 7000 (7000) 7000 OA
3 200 (200) 200 (200) n.a.
4
5A 2% x $10,000 = $200
5B
Bal.

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3. At year-endAllowance for Doubtfulthat


it was estimated Accounts
2% ofis
a CONTRA- ASSET account. This
the year’s credit sales
account will not
balance be collected.
is INCREASING by
$200 causing TOTAL assets to
Balance Sheet Inc. Statement Cashflow
decrease.
Assets = Liab.+ Stk. Equity
Cash+ A/Rec .- Allow. = A/P + C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA
1 10000 10000 10000 10000 n.a.
2 7000 (7000) 7000 OA
3 200 (200) 200 (200) n.a.
4
5A 2% x $10,000 = $200
5B
Bal.

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4. Jane Doe’s $50 account was written-off

as uncollectible.
Balance Sheet Inc. Statement Cashflow
Assets = Liab.+ Stk. Equity
Cash+ A/Rec .- Allow. = A/P + C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA
1 10000 10000 10000 10000 n.a.
2 7000 (7000) 7000 OA
3 200 (200) 200 (200) n.a.
4
5A
5B
Bal.

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4. Jane Doe’s $50 account was written-off

as uncollectible.
Balance Sheet Inc. Statement Cashflow
Assets = Liab.+ Stk. Equity
Cash+ A/Rec .- Allow. = A/P + C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA
1 10000 10000 10000 10000 n.a.
2 7000 (7000) 7000 OA
3 200 (200) 200 (200) n.a.
4 (50) (50) NO EXPENSE!

5A
5B
Bal.
Note: This is NOT the Direct Write-off method. Rather, it is a
write-off under the ALLOWANCE Method.
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Effect of Transaction 4 on
Acct. Rec. Net Realizable Value

Before Event 4 After Event 4


A/R $ A/R $
Allow. Allow.
N.R.V. $ N.R.V. $
Acme Collection
Agency

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Effect of Transaction 4 on
Acct. Rec. Net Realizable Value

Before Event 4 After Event 4


A/R $3,000
Allow. (200)
N.R.V. $2,800
The check is Acme Collection
in the mail. Agency

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Effect of Transaction 4 on
Acct. Rec. Net Realizable Value

Before Event 4 After Event 4


A/R $3,000 A/R $2,950
Allow. (200) Allow. (150)
N.R.V. $2,800 N.R.V. $2,800

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Effect of Transaction 4 on
Acct. Rec. Net Realizable Value

Before Event 4 After Event 4


A/R $3,000 A/R $2,950
Allow. (200) Allow. (150)
N.R.V. $2,800 N.R.V. $2,800

When using an ALLOWANCE method, the


Net Realizable Value of accounts receivable
does not change as a result of the write-off.
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Before recording Transaction #5:
What happens when an account that has been
written off later pays off his/her account?

① Reinstate the account by recording an


entry that undoes (reverses) the write-off:
❐ increase (debit) Accounts Receivable

❐ increase (credit) Allowance for

Doubtful Accounts (a contra-asset)


② Record the entry to show the cash
collection and A/Rec. reduction:
❐ increase (debit) Cash

❐ decrease (credit) Accounts

Receivable

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5. $50 cash was unexpectedly received


from Jane Doe. (5A=Reinstate, 5B=Collect)
Balance Sheet Inc. Statement Cashflow
Assets = Liab.+ Stk. Equity
Cash+ A/Rec .- Allow. = A/P + C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA
1 10000 10000 10000 10000 n.a.
2 7000 (7000) 7000 OA
3 200 (200) 200 (200) n.a.
4 (50) (50) NO EXPENSE!

5A 50 50
5B
Bal.

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5. $50 cash was unexpectedly received


from Jane Doe. (5A=Reinstate, 5B=Collect)
Balance Sheet Inc. Statement Cashflow
Assets = Liab.+ Stk. Equity
Cash+ A/Rec .- Allow. = A/P + C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA
1 10000 10000 10000 10000 n.a.
2 7000 (7000) 7000 OA
3 200 (200) 200 (200) n.a.
4 (50) (50) NO EXPENSE!

5A 50 50
5B 50 (50) 50
OA
Bal.

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Calculate all ending balances.

Balance Sheet Inc. Statement Cashflow


Assets = Liab.+ Stk. Equity
Cash+ A/Rec .- Allow. = A/P + C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA
1 10000 10000 10000 10000 n.a.
2 7000 (7000) 7000 OA
3 200 (200) 200 (200) n.a.
4 (50) (50) NO EXPENSE!

5A 50 50
5B 50 (50) 50
OA
Bal. 7050 2950 200 9800 10000 200 9800 7050 bal.

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What’s the result?


After completing the horizontal model fill in below.

How did the previous transactions affect the financial statements?


20X1

How much Bad Debt Expense should


appear on the income statement?….

What is the A/R: NRV at year end?……

How much A/R should be added to the


other current assets on the year-end
balance sheet?………………………….

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Final Account Balances
Remember, the Bad Debt EXPENSE is accrued in the
year of sale, NOT when the account is written off!
Balance Sheet Inc. Statement Cashflow
Assets = Liab.+ Stk. Equity
Cash+ A/Rec .- Allow. = A/P + C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA
1 10000 10000 10000 10000 n.a.
2 7000 (7000) 7000 OA
3 200 (200) 200 (200) n.a.
4 (50) (50) NO EXPENSE!

5A 50 50
5B 50 (50) 50
OA
Bal. 7050 2950 200 9800 10000 200 9800 7050 bal.

MATCHING PRINCIPLE
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What’s the result?


After completing the horizontal model fill in below.

How did the previous transactions affect the financial statements?


20X1

How much Bad Debt Expense should


appear on the income statement?…. $ 200

What is the A/R: NRV at year end?……

How much A/R should be added to the


other current assets on the year-end
balance sheet?………………………….

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Final Account Balances


Net Realizable Value (NRV) = Acct.Rec. - Allowance

Balance Sheet Inc. Statement Cashflow


Assets = Liab.+ Stk. Equity
Cash+ A/Rec .- Allow. = A/P + C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA
1 10000 10000 10000 10000 n.a.
2 7000 (7000) 7000 OA
3 200 (200) 200 (200) n.a.
4 (50) (50) NO EXPENSE!

5A 50 50
5B 50 (50) 50
OA
Bal. 7050 2950 200 9800 10000 200 9800 7050 bal.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003


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What’s the result?


After completing the horizontal model fill in below.

How did the previous transactions affect the financial statements?


20X1

How much Bad Debt Expense should


appear on the income statement?…. $ 200

What is the A/R: NRV at year end?…… $ 2,750

How much A/R should be added to the


other current assets on the year-end
balance sheet?…………………………. $ 2,750

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Transactions Posted to T-accounts
Post the five transactions to these Ledger accounts.

Cash Acct. Rec. Allow. for D.A.

Service Revenue Bad Debt Exp.


Retain. Earn.

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Transaction Posted to T-accounts
1. Provided services to customers for $10,000
which will be collected at a later date.

Cash Acct. Rec. Allow. for D.A.

Service Revenue Bad Debt Exp.


Retain. Earn.

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Transaction Posted to T-accounts
1. Provided services to customers for $10,000
which will be collected at a later date.

Cash Acct. Rec. Allow. for D.A.


(1) 10,000

Service Revenue Bad Debt Exp.


10,000 (1)
Retain. Earn.

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Transaction Posted to T-accounts
2. Collected $7,000 of the Accounts Receivables.

Cash Acct. Rec. Allow. for D.A.


(1) 10,000

Service Revenue Bad Debt Exp.


10,000 (1)
Retain. Earn.

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Transaction Posted to T-accounts
2. Collected $7,000 of the Accounts Receivables.

Cash Acct. Rec. Allow. for D.A.


(1) 10,000 7,000 (2)
(2) 7,000

Service Revenue Bad Debt Exp.


10,000 (1)
Retain. Earn.

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Transaction Posted to T-accounts
3. At Yr. end it was estimated that 2% of the year’s

credit sales will never be collected.


Cash Acct. Rec. Allow. for D.A.
(1) 10,000 7,000 (2)
(2) 7,000

Service Revenue Bad Debt Exp.


10,000 (1)
Retain. Earn.

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Transaction Posted to T-accounts
3. At Yr. end it was estimated that 2% of the year’s

credit sales will never be collected.


Cash Acct. Rec. Allow. for D.A.
(2) 7,000 (1) 10,000 7,000 (2) 200 (3)

Service Revenue Bad Debt Exp.


10,000 (1) (3) 200
Retain. Earn.

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Transaction Posted to T-accounts
4. Jane Doe’s $50 account was written-off as
uncollectible.

Cash Acct. Rec. Allow. for D.A.


(1) 10,000 7,000 (2) 200 (3)
(2) 7,000

Service Revenue Bad Debt Exp.


10,000 (1) (3) 200
Retain. Earn.

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Transaction Posted to T-accounts
4. Jane Doe’s $50 account was written-off as
uncollectible.

Cash Acct. Rec. Allow. for D.A.


(1) 10,000 7,000 (2) (4) 50 200 (3)
(2) 7,000
50 (4)

Service Revenue Bad Debt Exp.


10,000 (1) (3) 200
Retain. Earn.

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Effect of Transaction 4 on
Acct. Rec. Net Realizable Value

Before Event 4 After Event 4


A/R $3,000 A/R $2,950
Allow. (200) Allow. (150)
N.R.V. $2,800 N.R.V. $2,800

Net realizable value of accounts


receivable did not change as a result of
the write-off.
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Transaction Posted to T-accounts
5a. Jane Doe’s account is reinstated.

Cash Acct. Rec. Allow. for D.A.


(1) 10,000 7,000 (2) (4) 50 200 (3)
(2) 7,000
50 (4)

Service Revenue Bad Debt Exp.


10,000 (1) (3) 200
Retain. Earn.

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Transaction Posted to T-accounts
5a. Jane Doe’s account is reinstated.

Cash Acct. Rec. Allow. for D.A.


(1) 10,000 7,000 (2) (4) 50 200 (3)
(2) 7,000
50 (4) 50 (5a)
5a 50

Service Revenue Bad Debt Exp.


10,000 (1) (3) 200
Retain. Earn.

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Transaction Posted to T-accounts
5b. Jane Doe’s account is collected.

Cash Acct. Rec. Allow. for D.A.


(1) 10,000 7,000 (2) (4) 50 200 (3)
(2) 7,000
50 (4) 50 (5a)
5a 50

Service Revenue Bad Debt Exp.


10,000 (1) (3) 200
Retain. Earn.

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Transaction Posted to T-accounts
5b. Jane Doe’s account is collected.

Cash Acct. Rec. Allow. for D.A.


(1) 10,000 7,000 (2) (4) 50 200 (3)
(2) 7,000
50 (4) 50 (5a)
5b 50 5a 50 50 (5b)

Service Revenue Bad Debt Exp.


10,000 (1) (3) 200
Retain. Earn.

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Transaction Posted to T-accounts
Closing entries at the end of Year 1.

Cash Acct. Rec. Allow. for D.A.


(1) 10,000 7,000 (2) (4) 50 200 (3)
(2) 7,000
50 (4) 50 (5a)
5b 50 5a 50 50 (5b)

Service Revenue Bad Debt Exp.


10,000 (1) (3) 200
Retain. Earn.

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Transaction Posted to T-accounts
Closing entries at the end of Year 1.

Cash Acct. Rec. Allow. for D.A.


(1) 10,000 7,000 (2) (4) 50 200 (3)
(2) 7,000
50 (4) 50 (5a)
5b 50 5a 50 50 (5b)

Service Revenue Bad Debt Exp.


10,000 (1) (3) 200
Retain. Earn.
(c) 10,000 200 (c) (c) 200 10,000 (c)

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Transaction Posted to T-accounts
Balances of all accounts after Year 1 closings.

Cash Acct. Rec. Allow. for D.A.


(1) 10,000 7,000 (2) (4) 50 200 (3)
(2) 7,000
50 (4) 50 (5a)
5b 50 5a 50 50 (5b)
200 bal.
bal. 7,050 bal 2,950

Service Revenue Bad Debt Exp.


10,000 (1) (3) 200
Retain. Earn.
(c) 10,000 200 (c) (c) 200 10,000 (c)
0 bal bal. 0 9,800 bal.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003
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Summary:
Accounting for Bad Debts
■ Allowance method
❐ GAAP
❐ Required if company has a
significant amount of bad
debts.
❐ Matches bad debt expense
(on the income statement) with
the sale.
❐ Requires an adjusting journal
entry before closing the books.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003


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Summary:
Accounting for Bad Debts
■ Direct Write-off method
❐ Violates GAAP (Matching)
❐ No estimates of bad debts are made,
so no allowance account is used.
❐ Used by small businesses with few
account receivables or large
business with few collection problems.
❐ No entry until time specific account is
deemed “bad” (uncollectible).

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Direct Write-off Method for


Accounting for Bad Debts
■ Direct Write-off method

Entry to write off J. Jones’ $100


account:

Cash+Acct.Rec. = A/P +C. Stk.+Ret.E. Rev.- Exp. = N.I. Cashflow

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Direct Write-off Method for


Accounting for Bad Debts
■ Direct Write-off method

Entry to write off J. Jones’ $100


account:
Bad Debt Expense 100
Acct. Rec.-Jones 100

Cash+Acct.Rec. = A/P +C. Stk.+Ret.E. Rev.- Exp. = N.I. Cashflow

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Direct Write-off Method for


Accounting for Bad Debts
■ Direct Write-off method

Entry to write off J. Jones’ $100


account:
Bad Debt Expense 100
Acct. Rec.-Jones 100

Cash+Acct.Rec. = A/P +C. Stk.+Ret.E. Rev.- Exp. = N.I. Cashflow


(100) (100) +100 (100) n.a.
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Accrued Liabilities: Warranty Costs

■ Why give warranties?


■ When should expense be recognized?

We will
repair or
replace this
item...

Warranty

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Warranties…When to “expense”?
General Principle
■ According to GAAP, the entire
estimated warranty expense must
be recorded in the period the sale
is made, NOT in the period when
the actual warranty cost is paid.
(Matching principle is being followed.)
■ A warranty liability is recorded along with the
expense. This liability is REDUCED whenever cash is
paid to service a product still under warranty.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003


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Transaction Analysis

■ The following selected warranty


related events occurred at Cell-It.
For each event:
❐ Determine how the financial statements
are affected and fill in the horizontal model.
❐ Record each event directly in LEDGER
accounts.

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Transaction Analysis

■ The following selected events occurred at Cell-It.


(Perpetual inventory method is used.)
1. On 1/1/04 sold merchandise for $5,000 cash that
had originally cost $4,000. These goods were
sold with a two-year warranty.
2. Estimated that $100 of warranty cost will be
incurred over the next two years on the goods
sold in #1.
3. During 2005 a customer returned for repair, goods
still under warranty. The cost of the repair was $30
cash.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003
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Horizontal Model Transaction Analysis

Balance Sheet C=CofGS,W=War.exp.


Assets = Liab.+ Stk. Equity Inc. State.
Cashflow
Cash+ A/R + M.Inv. = W/P+C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA
1a

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1a. Sold (on 1/1/04 with 2 yr. warranty) for $5,000 cash,
1b. merchandise that originally cost $4,000.
(perpetual inventory method is used.)
Balance Sheet C=CofGS,W=War.exp.
Assets = Liab.+ Stk. Equity Inc. State.
Cashflow
Cash+ A/R + M.Inv. = W/P+C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA
5000 5000 5000 5000 5000 OA
1a (4000) (4000) C 4000 (4000) n.a.
1b

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Before recording Transaction #2:


Warranties…When to “expense”
■ According to GAAP, the entire
estimated warranty expense must
be recorded in the period the sale
is made, NOT in the period when
the actual warranty cost is paid.
(Matching principle is being followed.)
■ A warranty liability is recorded along with the
expense. This liability is REDUCED whenever cash is
paid to service a product still under warranty.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003


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2. Estimated that $100 of warranty cost will be
incurred over the next two years on the
goods sold in #1.
Balance Sheet C=CofGS,W=War.exp.
Assets = Liab.+ Stk. Equity Inc. State.
Cashflow
Cash+ A/R + M.Inv. = W/P+C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA
5000 5000 5000 5000 5000 OA
1a (4000) (4000) C 4000 (4000) n.a.
1b
2 100 (100) w 100 (100) n.a.

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3. During 2005 a customer returned for repair
goods still under warranty. The cost of the
repair was $30 cash.
Balance Sheet C=CofGS,W=War.exp.
Assets = Liab.+ Stk. Equity Inc. State.
Cashflow
Cash+ A/R + M.Inv. = W/P+C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA
5000 5000 5000 5000 5000 OA
1a (4000) (4000) C 4000 (4000) n.a.
1b
2 100 (100) w 100 (100) n.a.
3 (30) (30) n.a. n.a. n.a. n.a. (30) OA

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SUMMARY QUESTIONS

Balance Sheet C=CofGS,W=War.exp.


Assets = Liab.+ Stk. Equity Inc. State.
Cashflow
Cash+ A/R + M.Inv. = W/P+C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA
5000 5000 5000 5000 5000 OA
1a (4000) (4000) C 4000 (4000) n.a.
1b
2 100 (100) w 100 (100) n.a.
3. (30) (30) n.a. n.a. n.a. n.a. (30) OA
Questions: 2004 2005
1. Warranty Expense for the year: $100
2. Warranty liability on year-end bal. sheet:
3. Cash outflow related to warranty work:
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003
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SUMMARY QUESTIONS

Balance Sheet C=CofGS,W=War.exp.


Assets = Liab.+ Stk. Equity Inc. State.
Cashflow
Cash+ A/R + M.Inv. = W/P+C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA
5000 5000 5000 5000 5000 OA
1a (4000) (4000) C 4000 (4000) n.a.
1b
2 100 (100) w 100 (100) n.a.
3. (30) (30) n.a. n.a. n.a. n.a. (30) OA
Questions: 2004 2005
1. Warranty Expense for the year: $100
2. Warranty liability on year-end bal. sheet: $100
3. Cash outflow related to warranty work:
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003
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SUMMARY QUESTIONS

Balance Sheet C=CofGS,W=War.exp.


Assets = Liab.+ Stk. Equity Inc. State.
Cashflow
Cash+ A/R + M.Inv. = W/P+C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA
5000 5000 5000 5000 5000 OA
1a (4000) (4000) C 4000 (4000) n.a.
1b
2 100 (100) w 100 (100) n.a.
3. (30) (30) n.a. n.a. n.a. n.a. (30) OA
Questions: 2004 2005
1. Warranty Expense for the year: $100
2. Warranty liability on year-end bal. sheet: $100
3. Cash outflow related to warranty work: $ 0
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003
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SUMMARY QUESTIONS

Balance Sheet C=CofGS,W=War.exp.


Assets = Liab.+ Stk. Equity Inc. State.
Cashflow
Cash+ A/R + M.Inv. = W/P+C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA
5000 5000 5000 5000 5000 OA
1a (4000) (4000) C 4000 (4000) n.a.
1b
2 100 (100) w 100 (100) n.a.
3. (30) (30) n.a. n.a. n.a. n.a. (30) OA
Questions: 2004 2005
1. Warranty Expense for the year: $100 $ 0
2. Warranty liability on year-end bal. sheet: $100
3. Cash outflow related to warranty work: $ 0
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003
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SUMMARY QUESTIONS

Balance Sheet C=CofGS,W=War.exp.


Assets = Liab.+ Stk. Equity Inc. State.
Cashflow
Cash+ A/R + M.Inv. = W/P+C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA
5000 5000 5000 5000 5000 OA
1a (4000) (4000) C 4000 (4000) n.a.
1b
2 100 (100) w 100 (100) n.a.
3. (30) (30) n.a. n.a. n.a. n.a. (30) OA
70 balance
Questions: 2004 2005
1. Warranty Expense for the year: $100 $ 0
2. Warranty liability on year-end bal. sheet: $100 $ 70
3. Cash outflow related to warranty work: $ 0
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003
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SUMMARY QUESTIONS

Balance Sheet C=CofGS,W=War.exp.


Assets = Liab.+ Stk. Equity Inc. State.
Cashflow
Cash+ A/R + M.Inv. = W/P+C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA
5000 5000 5000 5000 5000 OA
1a (4000) (4000) C 4000 (4000) n.a.
1b
2 100 (100) w 100 (100) n.a.
3. (30) (30) n.a. n.a. n.a. n.a. (30) OA
70 balance
Questions: 2004 2005
1. Warranty Expense for the year: $100 $ 0
2. Warranty liability on year-end bal. sheet: $100 $ 70
3. Cash outflow related to warranty work: $ 0 ($30)OA
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003
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Transactions Posted to T-accounts
1. In 2004, sold for $5000 cash (1A), units costing $4000 (1B).
2. During 2004, estimated $100 warranty cost over two years.
3. During 2005, paid $30 cash to repair units sold in 2004.
Warranty
Cash Payable Sales
Bal. X 30 (3) (3) 30 100 (2) 5,000 (1A)
(1A) 5,000

Inventory Cost of Goods Sold


Bal. X 4,000 (1B) (1B) 4,000

Entries (not shown here) to close Sales, Warranty


Expense
Cost of Goods Sold, and Warranty
(2) 100
Expense to Retained Earnings would
have been made at the end of 2004.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003
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Notes Payable: Transaction


Analysis

■Assume the following selected


events occurred at Cell-It. For
each event:
❐Determine how the financial statements
are affected and fill in the
horizontal statements model.
❐Record the event in the Journal and
Post to the Ledger.

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Notes Payable: Transaction


Analysis
Assume the following events occurred at Cell-It.
1. On Oct. 1, 2004 Cell-It borrowed $8,000 cash by issuing a note
payable with a one-year term and an 8% stated interest rate. All
interest will be paid at maturity. This is an “interest bearing” note.
2. On Oct. 1, 2004 Cell-It issued an $8,000 face value, discounted note
payable with a one-year term and an 8% stated discount rate. This
is called a “Discounted” or “Non-interest bearing” note.
3. On Dec. 31, 2004 recorded interest related to the 8% interest-
bearing note issued on Oct. 1st (see #1).
4. On Dec. 31, 2004 recorded interest related to the 8% discounted
(non-interest bearing) note issued on Oct. 1st (see #2).
5. On Sept. 30, 2005 repaid the 8% non-discounted note payable (#1),
plus all interest.
6. On Sept. 30, 2005 repaid the 8% discounted note payable (#2).
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Horizontal Model Transaction Analysis

Balance Sheet
Assets = Liabilities + Equity Inc. State. Cashflow
Cash = I/P + N/P(1) + N/P(2) - Disc.+C.Stk+R.E. Rev.- Exp.= N. I. OA,IA,FA
1

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T1: On Oct. 1, 2004 Cell-it borrowed $8,000
at 8% for 1 year on an interest bearing
note. All interest to be paid at maturity.
Balance Sheet
Assets = Liabilities + Equity Inc. State. Cashflow
Cash = I/P + N/P(1) + N/P(2) - Disc.+C.Stk+R.E. Rev.- Exp.= N. I. OA,IA,FA
1 8000 8000 8000 FA

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T2: On Oct. 1, 2004 Cell-it issued an $8,000 face
value, one year note payable discounted at
8%. (A noninterest bearing note.)

Balance Sheet
Assets = Liabilities + Equity Inc. State. Cashflow
Cash = I/P + N/P(1) + N/P(2) - Disc.+C.Stk+R.E. Rev.- Exp.= N. I. OA,IA,FA
1 8000 8000 8000 FA
2 7360 8000 640 7360 FA

The interest is INCLUDED in the Note Payable. The


interest must be subtracted to calculate the amount of
cash the borrower receives on the issue date.
Note Payable $8000
Interest ($8000 x .08 x 12/12) (640) Since no time
has past, the
Cash to borrower $7360 $640 is NOT an
EXPENSE yet.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003
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T2: On Oct. 1, 2004 Cell-it issued an $8,000 face
value, one year note payable discounted at
8%. (A noninterest bearing note.)

Balance Sheet
Assets = Liabilities + Equity Inc. State. Cashflow
Cash = I/P + N/P(1) + N/P(2) - Disc.+C.Stk+R.E. Rev.- Exp.= N. I. OA,IA,FA
1 8000 8000 8000 FA
2 7360 8000 640 7360 FA

Discount on Note Payable is a contra liability account.


Its balance is SUBTRACTED from the Note Payable
account to obtain the total liability for the Note.
Note Payable 8000
Less: Discount on N/P (640)
Total Note Liability 7360

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T3: On Dec. 31, 2004 recorded interest
related to the note in #1.
Oct. 1-Dec. 31 = 3 mo. (8000 x .08 x 3/12=160)
Balance Sheet
Assets = Liabilities + Equity Inc. State. Cashflow
Cash = I/P + N/P(1) + N/P(2) - Disc.+C.Stk+R.E. Rev.- Exp.= N. I. OA,IA,FA
1 8000 8000 8000 FA
2 7360 8000 640 7360 FA
3 160 (160) 160 (160) n.a.

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T4: On Dec. 31, 2004 recorded interest related to


the discounted (noninterest bearing) note in #2.

Balance Sheet
Assets = Liabilities + Equity Inc. State. Cashflow
Cash = I/P + N/P(1) + N/P(2) - Disc.+C.Stk+R.E. Rev.- Exp.= N. I. OA,IA,FA
1 8000 8000 8000 FA
2 7360 8000 640 7360 FA
3 160 (160) 160 (160) n.a.
4 (160) (160) 160 (160) n.a.

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T5: On Sept. 30, 2005 repaid the 8% note from
Transaction #1 and all its interest.
a= accrue the remaining interest. b= payment.
(Jan. 1-Sept. 30 = 9 mo. (8000 x .08 x 9/12= $480)
Balance Sheet
Assets = Liabilities + Equity Inc. State. Cashflow
Cash = I/P + N/P(1) + N/P(2) - Disc.+C.Stk+R.E. Rev.- Exp.= N. I. OA,IA,FA
1 8000 8000 8000 FA
2 7360 8000 640 7360 FA
3 160 (160) 160 (160) n.a.
4 (160) (160) 160 (160) n.a.
5a 480 (480) 480 (480) n.a
b (8640) (640) (8000) (8000) FA
(640)
OA

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T6: On Sept. 30, 2005 repaid the 8%
discounted note payable from Trans. #2.
a= accrue the remaining interest. b= payment.

Balance Sheet
Assets = Liabilities + Equity Inc. State. Cashflow
Cash = I/P + N/P(1) + N/P(2) - Disc.+C.Stk+R.E. Rev.- Exp.= N. I. OA,IA,FA
1 8000 8000 8000 FA
2 7360 8000 640 7360 FA
3 160 (160) 160 (160) n.a.
4 (160) (160) 160 (160) n.a.
5a 480 (480) 480 (480) n.a
b (8640) (640) (8000) (8000) FA
(640)
OA
6a (480) (480) 480 (480) n.a.
b (8000) (8000) (7360) FA
(640) OA
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Comparison of Journal Entries for


Interest Bearing and Discounted Notes
Contra-liabilities are increased by debiting.
NOTE PAYABLE (Interest bearing) DISCOUNTED NOTE PAYABLE
Date Accounts Debit Credit Date Accounts Debit Credit
2004 2004
Oct. 1 Cash 8000 Oct. 1 Cash 7360
Note Payable 8000 Discount on Note Payable 640
Borrowed $8000 at 8% for one year Note Payable 8000
Borrowed $8000 discounted at 8% for one year

Dec. 31 Interest Expense 160 Dec. 31 Interest Expense 160


Interest Payable 160 Discont on Note Payable 160
Accrued 3 mo. interest (8000x.08x3/12) Amortized 3 mo. interest from Discount to Int. Exp.

2005 2005
Sept. 30 Interest Expense 480 Sept. 30 Interest Expense 480
Interest Payable 480 Discont on Note Payable 480
Accrued 9 mo. interest (8000x.08x9/12) Amortized 9 mo. interest from Discount to Int. Exp.

Sept. 30 Interest Payable 640 Sept. 30 Note Payable 8000


Note Payable 8000 Cash 8000
Cash 8640 Paid note (which already includes iall nterest)
Paid note and all interest
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Comparison of Ledger Accounts for
Interest Bearing and Discounted Notes
INTEREST BEARING NOTE PAYABLE
2004 Exp.
Cash Note Payable Interest Expense
Beg. Bal. X 10/01/04 8000 12/31/04 160
10/01/04 8000 9/30/05 8000 09/30/05 480
8640 9/30/05 0
2005 Exp.
Interest Payable
160 12/31/04
480 09/30/05
9/30/05 640
0

NON-INTEREST BEARING (DISCOUNTED) NOTE PAYABLE


2004 Exp.
Cash Note Payable Interest Expense
Beg. Bal. X 10/01/04 8000 12/31/04 160
10/01/04 7360 9/30/05 8000 09/30/05 480
8000 9/30/05 0
2005 Exp.
Discount on Note Pay.
160 12/31/04
480 09/30/05
9/30/05 640
0
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Which loan was the better deal for Cell-It?


Transaction Analysis:
Calculate the EFFECTIVE INTEREST % of each.
Interest bearing note:
Effect on Financial Statements
With note #2 Cell-It only
Eff. Int. %State.
Inc. = $ Annual Interest
received
State. ÷ $7,360
of Ch. Cash
in Eq Rec’d.
from the
CashFlow
1. = $640
No effect lender, but
÷ still
No effect had+8,000
$8,000 to payFA
2. No effect $640 interest for the
No effect year.FA
+7,360
= 8.0% That’s why theEq,
effective
3. +Int. Exp, so - N.I. Decr. R/E, so Dec. n.a.
Non-Interest
4. +Int. Exp, sobearing interest
note
- N.I. Decr. sorate
Dec.isEq.
(Discounted
R/E, higher for
note):n.a.
Note
5. +Int. Exp, so - N.I. Decr. R/E,#2.
so Dec. Eq. -8000FA,-640 OA
Eff. Int. % = $ Annual Interest ÷ Cash Rec’d.
Note #1 (Interest bearing) is
= $640 a “better÷deal” $7,360
in this case.
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Financial Statement Analysis

■ Accounts Receivable Turnover


Sales
Accts/Rec. =
Turnover $ Accounts Receivable*
Often the AVERAGE Accts. Rec. is used as the denominator.
Beginning Accts/Rec. + Ending Accts/Rec.
Ave. A/R =
2
This ratio is a measure of how
quickly receivables are collected.

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Accounts Receivable Ratios


Accts. Rec. Turnover: (A measure of how fast
receivables are collected. Higher is better.)
Sales $50,000
= = 10.0 times
Accounts. Receiv. $ 5,000
Average Days to collect A/R: (How many days
go by between a credit sale and the time it is collected?)
365 365
Accts. Rec. Turnover = 10.0 = 36.5 days
Generally, lower means better.
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Chapter 7

The End
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003