Chapter 7 - Problem Solutions
Review Questions
1. Account Receivable:
Probable Future Value - The probable future value in accounts receivable is that they represent the right to receive cash at some (usually fixed) date in the future. The cash, in turn, has value in the ability to be exchanged for goods and services in the future.
Ownership - Ownership is evidenced by contracts either written or implied between the buyer and the seller. Invoices and shipping documents usually provide the necessary evidence of proof that a receivable exists.
2.The direct write-off method recognizes bad debt expense (loss) in the period in which the receivable is determined to be unrecoverable, not necessarily in the period in which the original sale was made. The allowance method estimates and records the bad debt expense in the period of the original sale. This method provides a proper matching of the revenues and expenses (bad debt expense) from the sale and is the method that is most consistent with GAAP. The direct write-off method can be used if the results of applying it are not materially different from the results of applying the allowance method.
3.Factoring of accounts receivable means that the receivables are sold to another entity (the factor) which is then responsible for collecting the receivables. If the receivables are factored with recourse the selling entity retained a responsibility for the bad debts that occur, i.e. it may have to buy back the receivables that cannot be collected by the factor. If the receivables are sold without recourse then the responsibility for bad debts falls on the factor. Pledging is another way to obtain cash for receivables. The transaction is considered a loan and collections from the accounts receivable are "pledged" to repay the loan, i.e. they serve as collateral for the loan and the cash flows from their collection go directly to the lender.
4.Accounts receivable typically result from a credit sale and the asset is stated at the gross amount that is to be collected from the customer. Should the customer not pay on time there is usually no additional interest that is charged on the account. Notes receivable on the other hand do not typically result from a credit sale unless the original sale carries with it payment terms such that the customer can pay over an extended period of time. Notes receivable can result from a customer who has had difficulty making payments on their accounts receivable and then negotiates with the seller to get extended credits terms. Notes receivable are typically recorded at their net present value and interest income does accrue on the note over time.
5.Securitization is a process by which a firm can sell a collection of assets, typically a set of accounts receivable or loan receivables (in the case of a bank) to a set of investors. The assets to be sold are typically transferred to a special purpose entity or a trustee who then issues securities to investors that represent ownership in the transferred assets. Investors get a return on their investment as the assets that are transferred are collected.
6.There are several reasons why the gross amount of accounts receivable might not represent the net realizable value. The most obvious is that buyers may default on their payments resulting in a bad debt. A second event would be that the customer decides to return the good that was sold in which case they would no longer owe the amount stated in the account receivable. The firm in this case does get the asset back that was sold but would not be entitled to the profit from the sale. Finally a third event would be if the customer asks for (and gets) a price adjustment. This could happen for a variety of reasons but one common reason would be that the good was damaged in shipment. While it might still be acceptable to the customer, the customer does not want to pay full price for a damaged good.
7.Deferred revenue is a liability account that represents the portion of revenue from a sale that does not yet meet the revenue recognition criteria and therefore cannot be shown on the income statement. This typically happens when a firm receives a prepayment of cash for a product that has yet to be delivered to the customer. A simple example would be cash paid for a magazine subscription that will be delivered each month over the coming year.
Applying Your Knowledge
8.Peters & Scot Company: Journal Entries
a)TransactionDebitCredit
1.Entry for recording Bad Debt Expense
Bad Debt Expense3,000
Allowance for uncollectibles3,000
2.Entry for writing off accounts receivable
Allowance for Uncollectibles500
Accounts Receivable (James Gordon)500
3.Entries for recovery of A/R previously written off
Accounts receivable (James Gordon)500
Allowance for uncollectibles500
Cash500
Accounts Receivable (James Gordon)500
Note on Transaction 1:
$50,000 = Balance in A/R (25% of sales)
Sales = 50,000/25%= $200,000
Bad Debt Expense = $200,000 x 1.5% = $3,000
b) The net realizable value would be the $50,000 less the estimate of bad debts ($3,000) or $47,000.
c) If the amount is underestimated then the income for the period is overstated and the assets of the firm are overstated.
9.Sabre Razor Company
a) Aging Schedule for Accounts Receivable
Estimated Uncollectible:Classification of Accounts / Amount / Percentage / Amount
Not yet due / 500,000 / 0.5 / 2,500
1-30 days past due / 300,000 / 2.5 / 7,500
31-60 days past due / 100,000 / 10 / 10,000
61-90 days past due / 50,000 / 50 / 25,000
91-120 days past due / 10,000 / 90 / 9,000
TOTAL / $54,000
The current credit balance in allowance for collectibles is $25,000. The new balance required is $54,000. Hence the entry for adjustment of the difference of $29,000 is as follows:
Bad Debt Expense29,000
Allowance for Uncollectibles29,000
b) The net amount would be the total balance in the receivables of $960,000 less the balance in the allowance account of $54,000 making the net $906,000.
c) If the amount is underestimated then the income for the period is overstated and the assets of the firm are overstated.
10.a) Gamma Company: Journal Entries
DateTransactionDebitCredit
3/1Notes Receivable10,000
Accounts Receivable (Moon Co.)10,000
6/30Interest Receivable500
Interest Revenue1500
8/31Accounts Payable (Varian Co.)10,750
Notes Receivable10,000
Interest Receivable500
Interest Revenue2250
Notes:
1 $500 = (10,000 x 15% x 4/12)
2 $250 = (10,000 x 15% x 2/12)
Varian Company
8/31Notes Receivable10,000
Interest Receivable750
Accounts Receivable (Gamma Co.)10,750
12/7Cash11,125
Notes Receivable10,000
Interest Receivable750
Interest Revenue1375
Note:
1 $375 = (10,000 x 15% x 3/12)
b) Note to Instructors: This portion of the problem was intended to be dropped and will be in the next printing of the text.
11.a) The Ace Company, Journal Entries, 19x1
1)Accounts Receivable925,000
Sales Revenue925,000
2)Cash1800,000
Accounts Receivable800,000
3)Bad Debt Expense218,500
Allowance for Bad Debt18,500
4)Allowance for Bad Debt5,650
Accounts Receivable5,650
1Sales less ending balance in Accounts Receivable = $925,000 - 125,000 = $800,000
2$18,500 = $925,000 x 2%
Accounts Receivable / Allowance for Uncollectibles✓ / 0 / 0 / ✓
(1) / 925,000 / 800,000 / (2) / (4) / 5,650 / 18,500 / (3)
5,640 / (4)
✓ / 119,350 / 12,850 / ✓
Journal Entries, 19x2
1)Accounts Receivable1,250,000
Sales Revenue 1,250,000
{Entry for Sales}
2)Allowance for Uncollectibles119,200
Accounts Receivable19,200
{Entry for Uncollectibles written off during the year}
3)Cash1,212,150
Accounts Receivable2 1,212,150
{Entry for payments received during the year}
1$19,200 =12,850 + 6,350 (unadjusted trial balance). See the T-account for the allowance account below, $19,200 is a plug figure.
2$1,212,150 = 119,350 + 1,250,000 - 19,200 - 138,000. See the T-account for accounts receivable below, $1,212,150 is a plug figure
Accounts Receivable / Allowance for Uncollectibles✓ / 119,350 / 12,850 / ✓
(1) / 1,250,000 / 19,200 / (2) / (2) plug / 19,200
1,212,150 / (3) plug / TB1 / 6,350
✓ / 138,000 / 35,200 / (4) plug
28,850 / ✓
1TB stands for trial balance
b)
Required Balance in Allowance for Uncollectibles per the Aging method / $28,850Add:Debit balance as per Old Allowance Method / 6,350
Bad Debt Expense (year 20x2) / $35,2001
4)Bad Debt Expense35,200
Allowance for uncollectibles35,200
{Entry for bad debt expense recognition}
1See the T-Account for the allowance account above, the $35,200 is a plug figure.
c) The aging process may give the firm a better measure of the value of its net receivables rather than arriving at the net by default as happens under the percentage of sales method. The auditor may have become more concerned about the balance sheet value of the receivables rather than the income statement.
12.This decision would have no effect on cash sales. For credit sales, if the customer decided to use the company’s credit card (called a proprietary credit card) this would result in a delay in the company receiving cash for the sale. Typically third-party credit cards would settle up on a daily basis for the amount of the purchase so that the company would receive the cash quickly. However, there is also typically a fee to process the credit card transaction so the company actually receives something less than the full purchase price (the fees are typically in a range of 1-2% of the sales amount). If the proprietary credit card was used the company might avoid this fee but would also incur all of the expenses of running the collection process with its customers (billing, etc.). However, in return for this the company would also be entitled to charge fees for late payments, interest on the credit card balance, etc. that would be new revenues to the company. Therefore, while there would be a delay in the receipts of cash the firm would ultimately realize more cash from the sales (fees, interest, etc.). Whether this would be good news or bad news from the investors’ point of view would depend on whether the investment that would need to be made in the credit card operation would result in a high enough return to the investors. The profitability of this new venture would depend on the additional revenues earned from fees, interest, etc. less the costs of running the operation. Without more information about the details it would be difficult to determine whether this is good or bad for the investor.
Using Real Data
13.a. The following T-accounts were used to record the entries made during the year with the collections from customers being calculated from the other data provided.
Accounts Receivable / Allowance for Bad DebtsBB / 135,205 / 8,984 / BB
Sales / 561,549 / 565,578 / Collections / 4,714 / Expense
3,094 / Writeoff / Writeoff / 3,094
EB / 128,382 / 10,604 / EB
Bad Debt Expense
4,714
Journal Entries are as follows:
Sales:Accounts Receivable561,549
Sales Revenue561,549
Collections:Cash565,578
Accounts Receivable565,578
Bad Debt Expense:Bad Debt Expense4,714
Allowance for Bad Debts4,714
Writeoffs:Allowance for Bad Debts3,094
Accounts Receivable3,094
The following table is used to answer questions b. and c.
Date / Net Receivables / Turnover / Days / BD Expense /Sales / Allowance /Gross / Writeoff /Sales11/30/2003 / 117,778 / 4.6 / 79.3 / 0.84% / 8.3% / 0.55%
11/30/2002 / 126,221 / 4.3 / 85.2 / 0.64% / 6.6% / 0.85%
11/30/2001 / 140,163 / 4.4 / 83.8 / 0.61% / 6.8% / 0.26%
11/30/2000 / 135,421 / 4.9 / 75.2 / 0.22% / 5.4% / 0.35%
11/30/1999 / 144,921 / 5.3 / 69.4 / 0.24% / 5.6% / 0.26%
11/30/1998 / 131,342
b. The turnover ratios are shown in the table above.
c. For the years from 1998 through 2002 the number of days of receivables steadily increased from 69.4 to 85.2 indicating that the company was having trouble collecting its accounts receivable. While the days decreased in 2003 it is still much higher than it was five years earlier. The bad debt expense to sales ratio also has been increasing consistently over the five year period indicating worse expense with customer defaults. This is also reflected in the allowance to gross receivables ratio. While the actual writeoffs to sales have shown some erratic behavior over the five year period the writeoffs peaked in 2002 but there were also a significant number of writeoffs in 2003.
14. The following table contains the results of the calculations of the turnover ratios for part a) through c):
Part (a)Average Receivables / 299,477
Sales / 1,995,860
Turnover / 6.66
Days of A/R / 54.8
In this part the average is the simple average of the beginning and ending balance in accounts receivable from 2/28/2002 and 2/28/2003
Part (b)Average Receivables / 526,234
Sales / 2,032,063
Turnover / 3.86
Days of A/R / 94.5
In this part the average is the simple average of the beginning and ending balance in accounts receivable from 11/30/2001 and 11/30/2002
Part (c)Average Receivables / 357,199
Sales / 1,995,860
Turnover / 5.59
Days of A/R / 65.3
In this part the average is computed by adding together the accounts receivable balances from 2/28/2002 through 2/28/2003 and dividing by 5.
d) Obviously, the business of American Greetings is very seasonal with much of their sales coming during the holiday period of Thanksgiving and Christmas resulting in large accounts receivable at 11/30 each year. By 2/28 many of these receivables have been collected. Using the full year’s sales and dividing by either of the quarterly amounts probably distorts the collection experience of the company. Depending on the nature of the question that you ask, either of these might be appropriate calculation. If you want to know something about the average collection time for all of the receivables of the company then perhaps it would be better to utilize the average calculation done in part c). Better yet, you might try to obtain quarterly sales figures and determine the quarterly collection of receivables. Within the company you might also do this monthly to obtain an even better refinement of the calculation. In terms of performance measurement you would want to compare the current quarter or month with the comparable month in the prior year.
15. a) The accounts receivable turnover is calculated as:
Turnover = 1,556,843,000/ (1,048,793,000 + 1,020,701,000)/2 = 1.50
b) Accounts receivable make up 51% of the assets of True North (1,048,793,000/2,063,290,000)
c) This means that these ten accounts make up approximately 10% of the total assets of the firm. Should one or more of these accounts become bad this could have a significant effect on the assets of the firm. The total of these customer accounts are approximately $200 million of the receivable. Since net income was only $61 million in 2000 the writeoff of a major customer could seriously affect income. If the $200 million was spread evenly across the top ten customers they would represent $20 million in receivables. The writeoff of just one of these customers would reduce net income by 1/3. Had such a writeoff occurred in one of the previous two years there would have been an even bigger effect on income. This poses what is called concentration of risk in that a significant portion of receivables is concentrated in a small number of large customers.
16. a) The T-account below represents the net effects of recognizing credit losses during 2001. Note that we made an assumption that the amounts reported in the balance sheet for the allowance amounts should be in 000s.
Allowance for Credit Losses4,217,000 / BB
Writeoffs / 26,157,000 / 42,500,000 / Provision for loss
20,560,000 / EB
The journal entries that would be made during 2001 to record these amounts would be:
Provision for Credit Losses42,500,000
Allowance for Credit Losses42,500,000
Allowance for Credit Losses26,157,000
Other Receivables26,157,000
b) In the table below we provide the data for this question. Note that financial services revenues constitute almost 20% of the company’s income. In terms of the rate of return on the investment in receivables this income appears quite high. If we use just the investment in “other receivables’ the rate of return is 33.6%. However, the line right below this on the balance sheet is called “residual interest in installment contract and mortgage receivables.” This represents the company’s retained interest in the installment contracts that they sold. When we include this amount in the total investment the rate of return is still fairly high at 26.9%.
Amount / Percent of TotalFinancial Services / 227,916,000 / 19.8%
Total Revenues / 1,150,956,000
Receivables / 677,784,000
Fin Serv/Rec / 33.6%
Residual Interest in Receivables / 170,122,000
Total Investment in receivables / 847,906,000
Fin Serv/Total Rec / 26.9%
c) The following table shows the ratio of credit losses to total revenues over the last three year. You can see that the estimate of credit losses has significantly increased over this three year period of time by almost a factor of 4.
Year / 2001 / 2000 / 1999Revenues / 1,150,956,000 / 1,293,345,000 / 1,344,283,000
Credit Losses / 42,500,000 / 20,800,000 / 12,459,000
Losses/Revenue / 3.7% / 1.6% / 0.9%
d) From the cash flow statement you can see that while income has been declining over the last three years the cash from operations has been increasing. A significant reason for the decline in income has been the increase in the provision for credit losses but note that these are non-cash losses. Also note that the company had a significant decline in its inventory during 2001 (which helped to improve cash flow) relative to the increases in inventory during 2000 and 1999.
The second line that is called “net cash provided by operating activities” includes the cash flows related to the company’s investment in and sale of installment contract receivables that it originates in the course of its normal operations. Note further that there are three lines in the investing activities section that refers to the acquisition of installment contract receivable, proceeds from sales of these receivable and principal collected on these receivable. These are contract receivables that do not originate from Clayton’s business but are bought from an outside entity, typically a bank. The company then packages some of these contract receivables with some of their own and sells them via the special purpose entity.
Beyond the Book
The answers depend on the company selected.
7-1