6.2 Flashcards
Jole Co. lent $10,000 to a major supplier in exchange for a noninterest-bearing note due in three years and a contract to purchase a fixed amount of merchandise from the supplier at a 10% discount from prevailing market prices over the next 3 years. The market rate for a note of this type is 10%. On issuing the note, Jole should record
Discount on notes receivable:
Prepaid prices:
Yes
Yes
Without established exchange prices or evidence of the note’s market value, the present value of a note with no stated rate or an unreasonable rate should be determined by discounting future payments using an imputed rate. The prevailing rate for similar instruments of issuers with similar credit ratings normally helps determine the appropriate rate. The purpose is to approximate the rate in a similar transaction between independent parties. The stated interest rate may be less than the imputed rate because the lender has received other stated (or unstated) rights and privileges as part of the bargain. The difference between the respective present values of the note calculated at the stated rate and at the imputed rate should be accounted for as the cost of the rights or privileges obtained. Jole Co. will record a discount on the note. In addition, because it has received an other stated (or unstated) right or privilege (the right to purchase merchandise at a discount from prevailing market prices), prepaid purchases also should be recorded at an amount equal to the discount.
Ace Co. sold to King Co. a $20,000, 8%, 5-year note that required five equal annual year-end payments. This note was discounted to yield a 9% rate to King. The present value factors of an ordinary annuity of $1 for five periods are as follows:
8%: 3.992
9%: 3.890
What should be the total interest revenue earned by King on this note?
$5,560.
The equal annual payment based on the terms of the note was $5,010 ($20,000 ÷ 3.992 PV of an ordinary annuity for five periods at 8%). However, the note was discounted at 9%. Thus, the amount King must have paid for the note was the present value of the periodic payments discounted at 9%, or $19,489 ($5,010 × 3.89 PV of an ordinary annuity for five periods at 9%). Total interest revenue earned by King was therefore $5,561 [(5 payments × $5,010) – $19,489 cash paid].
The following information has been compiled by Able Manufacturing Company:
- Sale of company products for the period to customers with net 30-day terms amounting to $150,000.
- Sale of company products for the period to a customer, supported by a note for $25,000, with special terms of net 180 days.
- Balance of trade receivables at the end of the last period was $300,000.
- Collections of open trade receivables during the period was $200,000.
- Rental income for the period, both earned and accrued but not yet collected, from the Able
- Employees’ Credit Union for use of company facilities was $2,000.
The open trade receivables balance to be shown on the statement of financial position for the period is
$250,000
This answer is correct.
The open trade receivables balance is calculated as follows:
Previous ending balance: $300,000
Add: Sales to customers (terms net 30): 150,000
Minus: Collections during period: (200,000)
Open trade receivables reported: $250,000
Milton Co. pledged some of its accounts receivable to Good Neighbor Financing Corporation in return for a loan. Which of the following statements is correct?
Milton will retain control of the receivables.
A pledge (a general assignment) is the use of receivables as collateral (security) for a loan. The borrower agrees to use collections of receivables to repay the loan. Upon default, the lender can sell the receivables to recover the loan proceeds. Because a pledge is a relatively informal arrangement, it is not reflected in the accounts. A transfer of financial assets is a sale only when the transferor relinquishes control. If the transfer (e.g., a pledge) of accounts receivable is not a sale, the transaction is a secured borrowing. The transferor becomes a debtor, and the transferee, a creditor in possession of collateral. However, absent default, the collateral remains an asset of the transferor.
In its December 31 balance sheet, Butler Co. reported trade accounts receivable of $250,000 and related allowance for uncollectible accounts of $20,000. What is the total amount of risk of accounting loss related to Butler’s trade accounts receivable, and what amount of that risk is off-balance-sheet risk?
Risk of accounting loss:
Off-Balance sheet risk:
$230,000.
$0.
Butler’s risk of accounting loss is measured by the net receivables balance ($250,000 accounts receivable – $20,000 allowance for uncollectible accounts = $230,000). Accounting loss is the loss that may have to be recognized due to credit and market risk as a direct result of the rights and obligations of a financial instrument. However, assuming that the carrying amount of these trade receivables approximates their fair value, the accounting loss cannot exceed the amount recognized as an asset. No off-balance-sheet risk of accounting loss results from reported accounts or notes receivable. Off-balance-sheet risk arises because of the existence of conditional rights and obligations that may expose the entity to a risk of accounting loss exceeding the amount recognized in the balance sheet, for example, recourse obligations on receivables sold.
Rand, Inc., accepted from a customer a $40,000, 90-day, 12% interest-bearing note dated August 31. On September 30, Rand discounted the note at the Apex State Bank at 15%. However, the proceeds were not received until October 1. In Rand’s September 30 balance sheet, the amount receivable from the bank, based on a 360-day year, includes accrued interest revenue of
$170.
As determined below, the interest received by Rand if it had held the 90-day note to maturity would have been $1,200. The discount fee charged on a note with a maturity amount of $41,200 ($40,000 face amount + $1,200 interest) discounted at 15% for 60 days is $1,030. The difference of $170 ($1,200 interest – $1,030 discount fee) should be reflected as accrued interest revenue at the balance sheet date because the cash proceeds were not received until the next period.
$40,000 × 12% × (90 ÷ 360) = $1,200 interest
$41,200 × 15% × (60 ÷ 360) = (1,030) discount fee
Accrued interest revenue $170
Gar Co. factored its receivables without recourse with Ross Bank. Gar received cash as a result of this transaction, which is best described as a
Sale of Gar’s accounts receivable to Ross, with the risk of uncollectible accounts transferred to Ross.
When receivables are factored without recourse, the transaction is treated as a sale and the buyer accepts the risk of collectibility. The seller bears no responsibility for credit losses. A sale without recourse is not a loan. In a sale without recourse, the buyer assumes the risk of uncollectible accounts.
The following information relates to Jay Co.’s accounts receivable for the year just ended:
Accounts receivable, 1/1: $650,000
Credit sales for the year: 2,700,000
Sales returns for the year: 75,000
Accounts written off during the year: 40,000
Collections from customers during the year: 2,150,000
Estimated uncollectible accounts at 12/31: 110,000
What amount should Jay report for accounts receivable, before allowance for uncollectible accounts, at December 31?
$1,085,000.
The ending balance in accounts receivable consists of the $650,000 beginning debit balance, plus debits for $2,700,000 of credit sales, minus credits for $2,150,000 of collections, $40,000 of accounts written off, and $75,000 of sales returns.
During the year, Hauser Co. wrote off a customer’s account receivable. Hauser used the allowance method for uncollectible accounts. What impact would the write-off have on net income and total assets?
Net Income:
Total Assets:
no effect
no effect
When using the allowance method, accounts that are written off are charged to the allowance account. The write-off of a particular bad debt has no effect on expenses and net income. Furthermore, write-offs do not affect the carrying amount of net accounts receivable because the reductions of gross accounts receivable and the allowance are the same.
After being held for 40 days, a 120-day, 12% interest-bearing note receivable was discounted at a bank at 15%. The proceeds received from the bank upon discounting is the
Maturity amount minus the discount at 15%.
The cash proceeds from discounting the note will equal the maturity amount (face amount + total interest receivable at 12% for 120-day term of the note) minus the bank’s discount (maturity amount × 15% for 80 days).
Bee Co. uses the direct write-off method to account for uncollectible accounts receivable. During an accounting period, Bee’s cash collections from customers equal sales adjusted for the addition or deduction of the following amounts:
Accounts written off:
Increase in AR balance:
Deduction
Deduction
The direct write-off method debits bad debt expense and credits accounts receivable when an account is written off. Sales are recorded by a debit to accounts receivable or cash and a credit to sales. Accordingly, in the reconciliation of sales to cash collections, an increase in accounts receivable reflects sales without collections. Write-offs of accounts receivable likewise represent sales without collections. Consequently, the increase in accounts receivable and the accounts written off are deductions in reconciling sales to cash collections.
Leaf Co. purchased from Oak Co. a $20,000, 8%, 5-year note that required five equal, annual year-end payments of $5,009. The note was discounted to yield a 9% rate to Leaf. At the date of purchase, Leaf recorded the note at its present value of $19,485. What should be the total interest revenue earned by Leaf over the life of this note?
$5,560.
Leaf Co. will receive cash of $25,045 ($5,009 × 5). Hence, interest revenue is $5,560 ($25,045 – $19,485 present value).
Based on the industry average, Davis Corporation estimates that its bad debts should average 3% of credit sales. The balance in the allowance for uncollectible accounts at the beginning of Year 3 was $140,000. During Year 3, credit sales totaled $10,000,000, accounts of $100,000 were deemed to be uncollectible, and payment was received on a $20,000 account that had previously been written off as uncollectible. The entry to record bad debt expense at the end of Year 3 would include a credit to the allowance for uncollectible accounts of
$300,000.
Bad debt expense is based on the income statement approach. It treats bad debt expense as a function of sales on account. Thus, it is projected to be $300,000 ($10,000,000 × 3%). The entry to record bad debt expense is
Bad debt expense $300,000
Allowance for doubtful accounts $300,000
Johnson Company uses the allowance method to account for uncollectible accounts receivable. After recording the estimate of uncollectible accounts expense for the current year, Johnson decided to write off in the current year the $10,000 account of a customer who had filed for bankruptcy. What effect does this write-off have on the company’s current net income and total current assets, respectively?
Net Income:
Total Current Assets
No effect
No effect
Johnson uses the allowance method. Thus, when a specific amount is written off, the journal entry is
Allowance for doubtful accounts $10,000
Accounts receivable $10,000
The write-off of a bad debt has no effect on expenses, net income, and total current assets.
Inge Co. determined that the net value of its accounts receivable at December 31, based on an aging of the receivables, was $325,000. Additional information is as follows:
Allowance for uncollectible accounts at 1/1: $30,000
Uncollectible accounts written off during the year: 18,000
Uncollectible accounts recovered during the year: 2,000
Accounts receivable at 12/31: 350,000
For the year, what would be Inge’s uncollectible accounts expense?
$11,000.
The allowance for uncollectible accounts before year-end adjustment is $14,000 ($30,000 beginning balance – $18,000 write-offs + $2,000 recovered). The balance should be $25,000 ($350,000 year-end A/R – $325,000 net value based on aging). Thus, the allowance account should be credited and uncollectible accounts expense debited for $11,000 ($25,000 desired balance – $14,000).
