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alizable value of the receivables and net income, companies must be careful to use good
managed to collect a total of
estimation procedures. These estimates can focus on an examination of either the total
$2.053 billion in loans that had
number of credit sales during the period or the outstanding receivables at year-end to de-
been written off in prior years.
termine their collectibility.

ESTIMATING UNCOLLECTIBLE ACCOUNTS RECEIVABLE AS A PERCENTAGE OF
CREDIT SALES One method of estimating bad debt expense is to estimate uncollectible re-
ceivables as a percentage of credit sales for the period. If a company uses this method, the amount
of uncollectibles will be a straight percentage of the current year s credit sales. That percentage
will be a projection based on experience in prior years, modified for any changes expected for
the current period. For example, in the Farm Land example, credit sales for the year of $300,000
are expected to generate bad debts of $4,500, indicating that 1.5% of all credit sales are expected
252 f253
Selling A Product Or A Service Chapter 6
Selling a Product or a Service



to be uncollectible ($4,500 $300,000 1.5%). Farm Land would evaluate the percentage
each year, in light of its continued experience, to see whether the same percentage still seems
reasonable. In addition, if economic conditions have changed for Farm Land s customers (such
as the onset of a recession making it more likely that debts will remain uncollected), the per-
centage would be adjusted.
When this percentage of sales method is used, the existing balance (if there is one) in Al-
lowance for Bad Debts does not affect the amount computed and is not included in the ad-
justing entry to record bad debt expense. The 1.5% of the current year s sales that is estimated
to be uncollectible is calculated and entered separately, and then added to the existing balance.
For example, if the existing credit balance is $2,000, the $4,500 will be added, making the new
credit balance $6,500. The rationale for not considering the existing $2,000 balance in Allowance
for Bad Debts is that it relates to previous periods sales and reflects the com-
Should a company work pany s estimate (as of the beginning of the year) of prior years accounts re-
ceivable that are expected to be uncollectible.
to reduce its bad debt expense to zero? Ex-
In determining the percentage of credit sales that will be uncollectible, a
plain.
company must estimate the total amount of loss on the basis of experience or
industry averages. Obviously, a company that has been in business for several years should be
able to make more accurate estimates than a new company. Many established companies use a
three- or five-year average as the basis for estimating losses from uncollectible accounts.

ESTIMATING UNCOLLECTIBLE ACCOUNTS RECEIVABLE AS A PERCENTAGE OF
TOTAL RECEIVABLES Another way to estimate uncollectible receivables is to use a per-
centage of total receivables. Using this method, the amount of uncollectibles is a percentage of
the total receivables balance at the end of the period. Assume that Farm Land decides to use
this method and determines that 12% of the $50,000 in the year-end Accounts Receivable will
ultimately be uncollectible. Accordingly, the credit balance in Allowance for Bad Debts should
be $6,000 ($50,000 0.12). If there is no existing balance in Allowance for Bad Debts repre-
senting the estimate of bad accounts left over from prior years, then an entry for $6,000 is made.
If the account has an existing balance, however, only the net amount needed to bring the credit
balance to $6,000 is added. For example, an existing credit balance of $2,000 in Allowance for
Bad Debts results in the following adjusting entry:

Bad Debt Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000
Allowance for Bad Debts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000
To adjust the allowance account to the desired balance
($6,000 $2,000 $4,000).


In all cases, the ending balance in Allowance for Bad Debts should be the amount of total re-
ceivables estimated to be uncollectible.
In estimating bad debt expense, the percentage of sales method focuses on an estimation
based directly on the level of the current year s credit sales. With the percentage of total receiv-
ables method, the focus is on estimating total bad debts existing at the end of the period; this
number is compared to the leftover bad debts from prior years, and the difference is bad debt
expense, the new bad debts created in the current period. These two techniques are merely al-
ternative estimation approaches. In practice, as a check, a company would probably use both
procedures to ensure that they yield roughly consistent results.
Aging Accounts Receivable In the example just given, the correct amount of the ending Al-
lowance for Bad Debts balance was computed by applying the estimated uncollectible percent-
age (12%) to the entire Accounts Receivable balance ($50,000). In a more refined method of
estimating the appropriate ending balance in Allowance for Bad Debts, a company bases its cal-
aging accounts receivable
culations on how long its receivables have been outstanding. With this procedure, called aging
The process of categorizing
accounts receivable, each receivable is categorized according to age, such as current, 1 30 days
each account receivable by
past due, 31 60 days past due, 61 90 days past due, 91 120 days past due, and over 120 days
the number of days it has
past due. Once the receivables in each age classification are totaled, each total is multiplied by
been outstanding.
253
f254 Part 2 Selling A Product Or A Service
Operating Activities



Aging Accounts Receivable
exhibit 6-5


Days Past Due

Customer Balance Current 1 30 31 60 61 90 91 120 Over 120

A. Adams $10,000 $10,000
R. Bartholomew 6,500 $ 5,000 $1,500
F. Christiansen 6,250 5,000 $1,250
G. Dover 7,260 7,260
M. Ellis 4,000 4,000
G. Erkland 2,250 $2,250
R. Fisher 1,500 500 $1,000
J. Palmer 1,500 1,500
E. Zeigler 10,740 4,000 6,740
Totals $50,000 $23,000 $9,990 $12,260 $2,250 $1,000 $1,500



Estimate of Losses from Uncollectible Accounts

Percentage Estimated
Age Balance to Be Uncollectible Amount

Current $23,000 1.5 $ 345
1 30 days past due 9,990 4.0 400
31 60 days past due 12,260 20.0 2,452
61 90 days past due 2,250 40.0 900
91 120 days past due 1,000 60.0 600
Over 120 days past due 1,500 80.0 1,200
Totals $50,000 $5,897*

*Receivables that are likely to be uncollectible.




an appropriate uncollectible percentage (as determined by experience), recognizing that the older
the receivable, the less likely the company is to collect. Exhibit 6-5 shows how Farm Land could
use an aging accounts receivable analysis to estimate the amount of its $50,000 ending balance
in Accounts Receivable that will ultimately be uncollectible.
The allowance for bad debts estimate obtained using the aging method is $5,897. If the ex-
isting credit balance in Allowance for Bad Debts is $2,000, the required adjusting entry is:


Bad Debt Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,897
Allowance for Bad Debts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,897
To adjust the allowance account to the desired ending balance
($5,897 $2,000 $3,897).


The aging of accounts receivable is probably the most accurate method of estimating
caution
uncollectible accounts. It also enables a company to identify its problem customers. Com-
The aging method is merely a
panies that base their estimates of uncollectible accounts on credit sales or total outstanding
more refined technique for es- receivables also often age their receivables as a way of monitoring the individual accounts
timating the desired balance in receivable balances.
Allowance for Bad Debts.
Real-World Illustration of Accounting for Bad Debts
The application of bad debt accounting is illustrated using the financial statements of YAHOO!
for 1997 1999. As shown in Exhibit 6-6, Yahoo! reported accounts receivable at the end of 1999
254 f255
Selling A Product Or A Service Chapter 6
Selling a Product or a Service



Bad Debt Expense for Yahoo!
exhibit 6-6


Ending Ending Bad Debt Allowance
Accounts Bad Debt as a Percentage
Year Receivable Allowance of Accounts Receivable

1999 $65,748* $11,322 17.2%
1998 40,036 5,947 14.9%
1997 14,683 2,772 18.9%

*Dollar amounts are in millions.




of $65.7 million and a bad debt allowance for bad debts of $11.3 million. In other words, credit
customers owed Yahoo! $65.7 million as of the end of 1999; however, Yahoo! s best estimate was
that $11.3 million of this amount would never be collected. This bad debt allowance amounted
to 17.2% of the Accounts Receivable balance, down from 18.9% in 1997 but up from 14.9%
in 1998. For a company operating in a stable economic environment with little change in the
nature of its credit customers, this percentage would be expected to be about the same from year
to year. In the case of Yahoo!, operating in the volatile Internet economy, it appears that there
has been some variation in the collectibility of accounts receivable from one year to the next.



to summarize
Accounts receivable arise from credit sales to customers. Even though com-
panies monitor their customers carefully, there are usually some who do not
pay for the merchandise they purchase. There are two ways of accounting for
losses from uncollectible receivables: the direct write-off method and the al-
lowance method. The allowance method is generally accepted in practice be-
cause it is consistent with the matching principle. Two ways of estimating
losses from uncollectible receivables are (1) as a percentage of credit sales and
(2) as some fraction of total outstanding receivables. A common method for
applying the latter technique uses an aging accounts receivable analysis.




5 ASSESSING HOW WELL COMPANIES MANAGE
THEIR RECEIVABLES
Evaluate a company s
management of its
receivables by computing
As you recall from the DuPont framework explained in Chapter 4, an important element of
and analyzing appropriate
overall company performance is the efficient use of assets. With regard to accounts receivable,
financial ratios.
inefficient use means that too much cash is tied up in the form of receivables. A company that
collects its receivables on a timely basis has cash to pay its bills. Companies that do not do a
good job of collecting receivables are often cash poor, paying interest on short-term loans to
cover their cash shortage or losing interest that could be earned by investing cash.
There are several methods of evaluating how well an organization is managing its accounts
receivable. The most common method involves computing two ratios, accounts receivable
turnover and average collection period. The accounts receivable turnover ratio is an attempt
accounts receivable
turnover A measure used to determine how many times during the year a company is turning over or collecting its re-
to indicate how fast a com-
ceivables. It is a measure of how many times old receivables are collected and replaced by new
pany collects its receiv-
receivables. Accounts receivable turnover is calculated as follows:
ables; computed by divid-
ing sales by average
accounts receivable. Sales Revenue
§§§§
Accounts Receivable Turnover
Average Accounts Receivable
255
f256 Part 2 Selling A Product Or A Service
Operating Activities


Notice that the numerator of this ratio is sales revenue, not credit sales. Conceptually, one
might consider comparing the level of accounts receivable to the amount of credit sales instead
of total sales. However, companies rarely, if ever, disclose how much of their sales are credit
sales. For this ratio, you can think of cash sales as credit sales with a very short collection time
(0 days). Also note that the denominator uses average accounts receivable instead of the ending
balance. This recognizes that sales are generated throughout the year; the average Accounts Re-
ceivable balance is an approximation of the amount that prevailed during the year. If the Ac-
counts Receivable balance is relatively unchanged during the year, then using the ending bal-
ance is acceptable and common. The following are the accounts receivable turnover ratios for
two well-known companies for 1999:

$165.013 billion
Wal-Mart §§ 134.2 times
$1.230 billion

$57.993 billion
§§
Boeing 17.2 times
$3.371 billion


From this analysis, you can see that WAL-MART turns its receivables over much more of-
ten than does BOEING. This is not surprising given the different nature of the two businesses.
Wal-Mart sells primarily to retail customers for cash. Remember, from Wal-Mart s standpoint,
a credit card sale is the same as a cash sale since Wal-Mart receives its money instantly; it is the
credit card company that must worry about collecting the receivable. Boeing, on the other hand,
sells to airlines and governments that have established business credit relationships with Boeing.
Thus, the nature of its business dictates that Boeing has a much larger fraction of its sales tied
up in the form of accounts receivable than does Wal-Mart.
Accounts receivable turnover can then be converted into the number of days it takes to col-
lect receivables by computing a ratio called average collection period. This ratio is computed
average collection period A
measure of the average by dividing 365 (or the number of days in a year) by the accounts receivable turnover as fol-
number of days it takes to
lows:
collect a credit sale; com-
puted by dividing 365 days
365
by the accounts receivable §§§§
Average Collection Period
Accounts Receivable Turnover
turnover.

Computing this ratio for both Wal-Mart and Boeing shows that it takes Wal-Mart only 2.7 days
(365 134.2) on average to collect its receivables, while Boeing takes an average of 21.2 days
(365 17.2).
Consider what might happen to Boeing s average collection period during an economic re-
cession. During a recession, purchasers are often strapped for cash and try to delay paying on
their accounts for as long as possible. Boeing might be faced with airlines that still want to buy
airplanes but wish to stretch out the payment period. The result would be a rise in Boeing s av-
erage collection period; more of Boeing s resources would be tied up in the form of accounts re-
ceivable. In turn, Boeing would have to increase its borrowing in order to pay its own bills since
it would be collecting less cash from its slow-paying customers. Proper receivables management
involves balancing the desire to extend credit in order to increase sales with the need to collect
the cash quickly in order to pay off your own bills.



to summarize
Careful management of accounts receivable is a balance between extending
credit to increase your sales and collecting cash quickly to reduce your need
to borrow. Two ratios commonly used in monitoring the level of receivables
are accounts receivable turnover and average collection period. The level of
these ratios is determined by how well a company manages its receivables, as
well as by what kind of business the company is in.
256 f257
Selling A Product Or A Service Chapter 6
Selling a Product or a Service



6 RECORDING WARRANTY AND SERVICE COSTS
ASSOCIATED WITH A SALE
Match revenues and
expenses by estimating and
recording future warranty
Let s return to the Farm Land example in which 50 sacks of fertilizer were sold for $500. As-
and service costs
sume that as part of each sale, Farm Land offers to send a customer service representative to the
associated with a sale.
home or place of business of any purchaser who wants more detailed instructions on how to ap-
ply the fertilizer. Historical experience suggests that the buyer of one fertilizer sack in ten will
request a visit from a Farm Land representative, and the material and labor cost of each visit av-
erages $35. So, with 50 sacks of fertilizer sold, Farm Land has obligated itself to provide, on av-
erage, $175 in future customer service [(50 10) $35]. Proper matching requires that this
$175 expense be estimated and recognized in the same period in which the associated sale is rec-
ognized. Otherwise, if the company waited to record customer service expense until the actual
visits are requested, this period s sales revenue would be reported in the same income statement
with customer service expense arising from last period s sales. The accountant is giving up some
precision because the service expense must be estimated in advance. This sacrifice in precision
is worth the benefit of being able to better match revenues and expenses.
The entry to recognize Farm Land s estimated service expense from the sale of 50 sacks of
fertilizer is as follows:


Customer Service Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175
Estimated Liability for Service . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175
Estimated customer service costs on sales [(50 10) $35].


The credit entry, Estimated Liability for Service, is a liability. When actual expenses are incurred
in providing the customer service, the liability is eliminated with the following type of entry:


Estimated Liability for Service . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145
Wages Payable (to service employees) . . . . . . . . . . . . . . . . . . . . . . . . . . 100
Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
Actual customer service costs incurred.


This entry shows that supplies and labor were required to honor the service agreements. This
procedure results in the service expense being recognized at the time of sale, not necessarily when
the actual service occurs.
After these two journal entries are made, the remaining balance in Estimated Liability for
Service will be $30, shown as follows:

Estimated Liability for Service

Estimate at time of sale 175
Actual service costs incurred 145
Remaining balance 30


The $30 balance represents the estimated amount of service that still must be provided in
the future resulting from the sale of the 50 sacks of fertilizer. If actual experience suggests that
the estimated service cost is too high, a lower estimate would be made in connection with sub-
sequent fertilizer sales. If estimated liability for service is too low, a higher estimate is made for
subsequent sales. The important point is that the accountant would not try to go back and fix
an estimate that later proves to be inexact; the accountant merely monitors the relationship be-
tween the estimated and actual service costs in order to adjust future estimates accordingly.
The accounting just shown for estimated service costs is the same procedure used for esti-
mated warranty costs. For example, GENERAL MOTORS promises automobile buyers that it
will fix, at no charge to the buyer, certain mechanical problems for a certain period of time. GM
257
f258 Selling A Product Or A Service
Part 2 EM Operating Activities


estimates and records this warranty expense at the time the automobile sales are made. At the
end of 1999, GM reported an existing liability for warranty costs of $15.3 billion. This amount
is what GM estimates it will have to spend on warranty repairs in 2000 (and later years) on cars
sold in 1999 (and earlier).




to summarize
In addition to bad debt expense, there are other costs that must be estimated
and recognized at the time a sale is made in order to ensure the proper match-
ing of revenues and expenses. If a company makes promises about future war-
ranty repairs or continued customer service as part of the sale, the value of
these promises should be estimated and recorded as an expense at the time
of the sale.




Thus far the chapter has covered the main topics associated with selling goods

or services, collecting the proceeds from those sales, and estimating and
recording bad debt expense and service expense. The expanded material will

cover three additional topics. First, an important tool of cash control, the bank
reconciliation, will be explained. Second, the use of receivables to get cash

immediately will be illustrated. Finally, the financial statement implications of

making sales denominated in foreign currencies will be illustrated.



7 RECONCILING THE BANK ACCOUNT
Reconcile a checking
With the exception of small amounts of petty cash kept for miscellaneous purposes, most cash
account.
is kept in various bank accounts. Generally, only a few employees are authorized to sign checks,
and they must have their signatures on file with the bank.
Each month the business receives a bank statement that shows the cash balance at the be-
ginning of the period, the deposits, the amounts of the checks processed, and the cash balance
at the end of the period. With the statement, the bank includes all of that month s canceled
checks (or at least a listing of the checks), as well as debit and credit memos (for example, an
explanation of charges for NSF [not sufficient funds] checks and service fees). From a bank s
NSF (not sufficient funds)
check A check that is not perspective, customers deposits are liabilities; hence, debit memos reduce the company s cash
honored by a bank because
balance, and credit memos increase the balance.
of insufficient cash in the
The July bank statement for one of Hunt Company s accounts is presented in Exhibit
check writer s account.
6-7. This statement shows all activity in the cash account as recorded by the bank and includes
four bank adjustments to Hunt s balance a bank service charge of $7 (the bank s monthly fee),
$60 of interest paid by First Security Bank on Hunt s average balance, a $425 transfer into an-
other account, and a $3,200 direct deposit made by a customer who regularly deposits payments
directly to Hunt s bank account. Other adjustments that are commonly made by a bank to a
company s account include:
258 f259
Selling A Product Or A Service EM Chapter 6
Selling a Product or a Service



July Bank Statement for Hunt Company
exhibit 6-7


First Security Bank Statement of Account
Helena, Montana 59601

HUNT COMPANY Account Number 325-78126
1900 S. PARK LANE
HELENA, MT 59601 Date of Statement JULY 31, 2003



Check Checks and Deposits and
Number Withdrawals Additions Date Balance

6/30 13,000
620 140 7/01 12,860
621 250 1,500 7/03 14,110
622 860 7/05 13,250
623 210 7/08 13,040
2,140 7/09 15,180
624 205 7/10 14,975
626 310 7/14 14,665
425 T 7/15 14,240
3,200 D 7/18 17,440
628 765 7/19 16,675
629 4,825 7/22 11,850
630 420 7/24 11,430
632 326 1,600 7/25 12,704
2,100 7/26 14,804
633 210 7/29 14,594
635 225 7/31 14,369
7 SC 60 I 7/31 14,422

9,178 10,600 14,422
TOTAL CHECKS AND TOTAL DEPOSITS BALANCE
WITHDRAWALS AND ADDITIONS
NSF Not Sufficient D Direct Deposit I Interest T Transfer Out of Account
Funds SC Service Charge MS Miscellaneous ATM Automated Teller
Machine Transaction




1. NSF (not sufficient funds). This is the cancellation of a prior deposit that could not be col-
lected because of insufficient funds in the check writer s (payer s) account. When a check
is received and deposited in the payee s account, the check is assumed to represent funds
that will be collected from the payer s bank. When a bank refuses to honor a check because
of insufficient funds in the account on which it was written, the check is returned to the
payee s bank and is marked NSF. The amount of the check, which was originally recorded
as a deposit (addition) to the payee s account, is deducted from the account when the check
is returned unpaid.
2. MS (miscellaneous). Other adjustments made by a bank.
3. ATM (automated teller machine) transactions. These are deposits and withdrawals made by
the depositor at automated teller machines.
4. Withdrawals for credit card transactions paid directly from accounts. These types of cards, called
debit cards, are like using plastic checks. Instead of the card holder getting a bill or state-
ment, the amount charged is deducted from the card holder s bank balance.
259
f260 Selling A Product Or A Service
Part 2 EM Operating Activities


It is unusual for the ending balance on the bank statement to equal the amount of cash recorded
in a company s cash account. The most common reasons for differences are:

1. Time period differences. The time period of the bank statement does not coincide with the
timing of the company s postings to the cash account.
2. Deposits in transit. These are deposits that have not been processed by the bank as of the
bank statement date, usually because they were made at or near the end of the month.
3. Outstanding checks. These are checks that have been written and deducted from a company s
cash account but have not cleared or been deducted by the bank as of the bank statement
date.
4. Bank debits. These are deductions made by the bank that have not yet been recorded by
the company. The most common are monthly service charges, NSF checks, and bank trans-
fers out of the account.
5. Bank credits. These are additions made by the bank to a company s account before they are
recorded by the company. The most common source is interest paid by the bank on the
account balance.
6. Accounting errors. These are numerical errors made by either the company or the bank. The
most common is transposition of numbers.

The process of determining the reasons for the differences between the bank balance and
bank reconciliation The
the company s cash account balance is called a bank reconciliation. This usually results in ad-
process of systematically
justing both the bank statement and the book (cash account) balances. If the balances were not
comparing the cash balance
reconciled (if the cash balance were left as is), the figure used on the financial statements would
as reported by the bank
with the cash balance on probably be incorrect, and external users would not have accurate information for decision mak-
the company s books and
ing. More importantly, the bank reconciliation can serve as an independent check to ensure that
explaining any differences.
the cash is being accounted for correctly within the company.
We will use Hunt Company s bank account to illustrate a bank reconciliation. The state-
ment shown in Exhibit 6-7 indicates an ending balance of $14,422 for the month of July. Af-
ter arranging the month s canceled checks in numerical order and examining the bank state-
ment, Hunt s accountant notes the following:

1. A deposit of $3,100 on July 31 was not shown on the bank statement. (It was in transit at
the end of the month.)
2. Checks No. 625 for $326, No. 631 for $426, and No. 634 for $185 are outstanding. Check
No. 627 was voided at the time it was written.
3. The bank s service charge for the month is $7.
4. A direct deposit of $3,200 was made by Joy Company, a regular customer.
5. A transfer of $425 was made out of Hunt s account into the account of Martin Custodial
Service for payment owed.
6. The bank paid interest of $60 on Hunt s average balance.
7. Check No. 630 for Thelma Jones s wages was recorded in the accounting records as $240
instead of the correct amount, $420.
8. The cash account in the general ledger shows a balance on July 31 of $13,937.

The bank reconciliation is shown in Exhibit 6-8. Since the bank and book balances now
agree, the $16,585 adjusted cash balance is the amount that will be reported on the finan-
cial statements. If the adjusted book and bank balances had not agreed, the accountant would
have had to search for errors in bookkeeping or in the bank s figures. When the balances fi-
nally agree, any necessary adjustments are made to the cash account to bring it to the cor-
rect balance. The entries to correct the balance include debits to Cash for all reconciling ad-
ditions to the book balance and credits to Cash for all reconciling deductions from the book
balance. Additions and deductions from the bank balance do not require adjustments to the
company s books; the deposits in transit and the outstanding checks have already been
recorded by the company, and, of course, bank errors are corrected by notifying the bank
and having the bank make corrections. The adjustments required to correct Hunt s cash ac-
count are:
260 f261
Selling A Product Or A Service EM Chapter 6
Selling a Product or a Service



Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,260
Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,200
Interest Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60
To record the additions due to the July bank reconciliation
(a $3,200 deposit made by Joy Company and $60 interest).

Custodial Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 425
Miscellaneous Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Wages Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 612
To record the deductions due to the July bank reconciliation
(service charge, $7; a $180 recording error, check No.
630; bank transfer of $425 to Martin Custodial Service).




to summarize
Because most payments are made by check, companies need to reconcile
monthly bank statements with the cash balance reported on the company s
books. This reconciliation process involves determining reasons for the differ-
ences and bringing the book and bank balances into agreement. Adjusting en-
tries are then made for additions to and deductions from the book balance.




8 USING RECEIVABLES TO GET CASH
IMMEDIATELY
Understand how
receivables can be used by
a company to get cash
Sometimes companies need cash prior to the due dates of their receivables. Often, in these cir-
immediately.
cumstances, such companies will sell or factor their accounts receivables to financing or fac-
toring companies. Factoring companies charge a percentage of the receivable, usually ranging



July Bank Reconciliation for Hunt Company
exhibit 6-8


Hunt Company
Bank Reconciliation
July 31, 2003

Balance per bank statement . . . . . . . . . . $14,422 Balance per books . . . . . . . . . . . . . . . $13,937

Additions to bank balance: Additions to book balance:
Deposit in transit. . . . . . . . . . . . . . . . . . . 3,100 Direct deposit . . . . . . . . . . . . . . . . . . . $ 3,200
Total . . . . . . . . . . . . . . . . . . . . . . . . . . $17,522 Interest . . . . . . . . . . . . . . . . . . . . . . . . 60 3,260
Total . . . . . . . . . . . . . . . . . . . . . . . . $17,197

Deductions from bank balance: Deductions from book balance:
Outstanding checks: 625 . . . . . . . . . . . . . $326 Service charge . . . . . . . . . . . . . . .... $ 7
631 . . . . . . . . . . . . . 426 Bank transfer . . . . . . . . . . . . . . . .... 425
634 . . . . . . . . . . . . . 185 (937) Error in recording check No. 630
(for Jones s wages) . . . . . . . . . .... 180 (612)
Adjusted bank balance . . . . . . . . . . . . . . $16,585 Adjusted book balance . . . . . . . . .... $16,585
261
f262 Selling A Product Or A Service
Part 2 EM Operating Activities


from 2 to 15%, to buy receivables. If a company has notes receivable, these notes can be sold
to a bank or finance company; selling a note is called discounting the note.

Selling or Factoring Accounts Receivable
To illustrate, assume that Reno Trucking Company has a $1,000 receivable from Bunker Met-
als that has terms n/30. Rather than wait the 30 days to collect the receivable, Reno Trucking
could sell or factor the receivable at the Easy-Money Factoring Company for a 5% discount
fee. If Reno Trucking needs the money to pay drivers salaries and other expenses and factors
the receivable, it would receive 95% of the $1,000, or $950, from Easy-Money Factoring. Some-
times accounts receivable are factored with recourse, meaning that Reno Trucking must pay
the receivable if Bunker Metals defaults. At times, usually for a larger discount fee, receivables
are sold without recourse, meaning that Reno Trucking has no obligation to pay, even if
Bunker Metals defaults.
As an actual example, there is a small trucking company in Salt Lake City that owns five
trucks and has another seven owner-operated trucks leased to it. The company primarily hauls
steel from a large manufacturing plant in Utah to Chicago and hauls reclining chairs back to
Utah from Chicago. Because the company is always pressed for cash, every receivable it has is
factored at a rate of 6%. This means that the company receives only $94 on every $100 of re-
ceivables. Since the trucking company generally collects the receivables in 60 days, and there are
approximately six 60-day periods in a year, the company is effectively paying 36% interest (6%
6). Better cash management could make the company much more profitable.

Discounting Notes Receivable
An account receivable is an informal agreement between the seller and the credit buyer. No for-
mal contract is drawn up, and no interest rate is specified on the account (unless the customer
fails to pay within the specified time). Sometimes customers sign formal contracts, called notes,
when they buy merchandise or services on credit. Even more often, customers from whom ac-
counts receivable are past due sign interest-bearing notes to receive additional time to make pay-
ment. A note receivable is a claim against someone, evidenced by an unconditional written
note receivable A claim
against a debtor, evidenced promise to pay a sum of money on or before a specified future date. Depending on the length
by an unconditional written of time until the due date, the note may be classified as a current asset or a long-term asset. In
promise to pay a certain
addition, it may be either a trade note receivable or a nontrade note receivable. A trade note re-
sum of money on or before
ceivable represents an amount due from a customer who purchased merchandise. Businesses of-
a specified future date.
ten accept notes receivable from customers because they are contractual obligations that usually
earn interest. A nontrade note receivable arises from the lending of money to an individual or
company other than a customer (for example, an employee). Exhibit 6-9 shows a typical note
receivable.
maker A person (entity)
There are several key terms associated with a note receivable. The maker of a note is the
who signs a note to borrow
person or entity who signs the note and who must make payment on or before the due date.
money and who assumes
The payee is the person or entity to whom payment will be made. The principal is the face
responsibility to pay the
note at maturity. amount of the note. The maturity date is the date the note becomes due. The interest rate is
the percentage of the principal that the payee annually charges the maker for the loan; the in-
payee The person (entity)
terest is the dollar amount paid by the maker in accordance with this rate. Interest can also be
to whom payment on a
thought of as the service charge, or rent, for the use of money. The formula for computing the
note is to be made.
interest on a note is:
principal The amount that
will be paid on a note or
Principal Interest Rate Time (in terms of a year) Interest
other obligation at the ma-
turity date.
For example, if Komatsu Company accepts from Solomon Company a 12%, three-month,
maturity date The date on $2,000 note receivable, the interest is calculated as:
which a note or other oblig-
ation becomes due.
$2,000 0.12 3/12 $60
interest rate The cost of us-
Note that the 12% stated interest rate is based on a one-year period, even though the note
ing money, expressed as
is only for three months. Interest rates are traditionally stated in annual terms no matter what
an annual percentage.
262 f263
Selling A Product Or A Service EM Chapter 6
Selling a Product or a Service



Note Receivable
exhibit 6-9



$2,000 Helena, Montana July 15, 2003
PRINCIPAL LOCATION DATE

Ninety (90) days AFTER DATE PROMISES
Solomon Company

TO PAY TO THE ORDER OF Komatsu Company
PAYEE

DOLLARS
Two thousand and no/100

PAYABLE AT First Security Bank

FOR VALUE RECEIVED, WITH INTEREST AT 12 percent per annum


John Doe
SIGNATURE OF MAKER




the term length of the credit agreement. If the $2,000 note is accepted in settlement of Solomon s
unpaid account with Komatsu Company, the journal entry to record the note in Komatsu s
books is:

Notes Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
Accepted 3-month, 12% note from Solomon Company in lieu of
payment of its account receivable.


When the note matures and payment is made (three months later), Komatsu s entry to record
the receipt of cash would be:


Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,060
Notes Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
Interest Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60
Received payment from Solomon Company for $2,000 note plus
interest.


Principal plus interest ($2,060 in this example) is known as the maturity value of the note.
maturity value The amount
of an obligation to be col- If the note is not paid by the maturity date, negotiations with the maker usually result in the
lected or paid at maturity;
company extending the period for payment, issuing a new note, or retaining an attorney or col-
equal to principal plus any
lection agency to collect the money. If the note eventually proves to be worthless, it is written
interest.
off as a loss against Allowance for Bad Debts. Often, when an agency or attorney is attempting
to collect notes receivable, they are classified on the balance sheet as special receivables.
Because notes receivable are contractual promises to pay money in the future, they are nego-
tiable. They can be sold to banks and other financial institutions. The selling of a note to a finan-
cial institution is referred to as discounting a note receivable. This means that the holder of a
discounting a note receiv-
able The process of the note who needs cash before a note matures can sell the note (simply by endorsing it) to a financial
payee s selling notes to a institution. The maker of the note, therefore, owes the money to the financial institution or other
financial institution for less
endorsee. To a financial institution, purchasing a note for cash is just like making a loan; cash is
than the maturity value.
given out now in return for repayment of principal with interest in the future. To a company sell-
ing a note, discounting is a way of receiving cash earlier than would otherwise be possible.
263
f264 Selling A Product Or A Service
Part 2 EM Operating Activities




to summarize
Companies that need cash prior to the time their accounts receivable are due
often factor or sell those receivables to factoring companies that charge a
factoring fee. Notes receivable are formal, interest-bearing credit agreements
between a company and credit customers. Notes receivable are negotiable and
can be discounted, or sold.




9 FOREIGN CURRENCY TRANSACTIONS
Account for the impact of
All of the sales illustrated to this point in the text have been denominated in U.S. dollars. How-
changing exchange rates
on the value of accounts ever, many U.S. companies do a large portion of their business in foreign countries. For exam-
receivable denominated in
ple, 29% of MICROSOFT s sales in 1999 were denominated in currencies other than the U.S.
foreign currencies.
dollar. So, what would Microsoft have to do to record a software sale denominated in Japanese
yen or British pounds? This section answers that question.
When a U.S. company sells a good or provides a service to a party in a foreign country, the
transaction amount is frequently denominated in U.S. dollars. The U.S. dollar is a relatively sta-
ble currency, and buyers from Azerbaijan to Zimbabwe are often eager to avoid the uncertainty
associated with payments denominated in their local currencies. For example, no matter where
they are located, buyers and sellers of crude oil almost always write the contract price in terms
of U.S. dollars. A U.S. company accounts for a sales contract with a foreign buyer with the sales
price denominated in U.S. dollars in the way illustrated previously in this chapter; no new ac-
counting issues are raised. However, if a U.S. company enters into a transaction in which the
price is denominated in a foreign currency, the U.S. company must use special accounting pro-
cedures to recognize the change in the value of the transaction as foreign currency exchange rates
fluctuate. For example, if Microsoft makes a sale with a price of 100,000 Indonesian rupiah,
Microsoft knows that it will eventually collect 100,000 rupiah, but Microsoft does not know
what those rupiah will be worth, in U.S. dollar terms, until the actual rupiah payment is re-
ceived. Such a transaction is called a foreign currency transaction; the accounting for these
foreign currency transac-
tion A sale in which the transactions is demonstrated in the following section.
price is denominated in a
currency other than the cur-
Foreign Currency Transaction Example
rency of the seller s home
country.
To illustrate the accounting for a sale denominated in a foreign currency, assume that Ameri-
can Company sold goods with a price of 20,000,000 Korean won on March 23 to one of its
Korean customers. Payment in Korean won is due July 12. American Company prepares quar-
terly financial statements on June 30. The following exchange rates apply:


U.S. Dollar Value of
One Korean Won Event

March 23 $0.0010 Sale
June 30 0.0007 Financial statements prepared
July 12 0.0008 Payment received on account



On March 23, each Korean won is worth one-tenth of one U.S. cent. In other words, it takes
1,000 Korean won (1/0.0010) to buy one U.S. dollar. At this exchange rate, the 20,000,000-
Korean-won contract is worth $20,000 (20,000,000 $0.0010).
On March 23, American Company records the sale and the account receivable in its books
as follows:
264 f265
Selling A Product Or A Service EM Chapter 6
Selling a Product or a Service



Accounts Receivable (fc) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000
Sales Revenue. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000


Note that this journal entry is exactly the same as those illustrated earlier in the chapter. The
(fc) indicates that the Accounts Receivable asset is denominated in a foreign currency and, thus,
subject to exchange rate fluctuations. Because the financial statements of American Com-
fyi pany are reported in U.S. dollars, all transaction amounts must be converted into their
U.S. dollar equivalents when they are entered into the formal accounting system.
The wide fluctuations in ex-
On June 30, American Company prepares its quarterly financial statements. Because
change rates in this illustration
the 20,000,000-Korean-won contract price has not yet been collected in cash, American
are unusual, but not unprece-
Company still has a receivable denominated in Korean won and must reflect the effect of
dented. For example, as part of
the change in the exchange rate on the U.S. dollar value of that receivable. In this case
the Asian financial crisis of
the Korean won has decreased in value and is worth only $0.0007 on June 30. If Amer-
1997, the number of Korean
ican Company had to settle the contract on June 30, it would receive only $14,000
won needed to purchase one
(20,000,000 $0.0007). Thus, American Company must recognize an exchange loss of
U.S. dollar increased from
$6,000, or 20,000,000 ($0.0010 $0.0007). On July 12, American Company receives
917.77 on October 23, 1997, to payment from its Korean customer. In the interim the value of the Korean won has in-
1,952.68 on December 23, 1997. creased slightly to $0.0008. When the receivable is collected, the 20,000,000 Korean won
are worth $16,000 (20,000,000 $0.0008), so now American Company has experienced
a gain relative to its position on June 30. The effects of the fluctuation in the value of the Ko-
rean won can be summarized as follows:


U.S. Dollar Value
of the Receivable Gain or Loss

March 23 $20,000 Not applicable
June 30 14,000 $6,000 loss
July 12 16,000 $2,000 gain



This information would be reported in American Company s three primary financial state-
ments in the second quarter (ending June 30) and the third quarter (beginning July 1) as follows:


Second Quarter:

Income Statement Balance Sheet Statement of Cash Flows

Sales revenue $20,000 Accounts receivable $14,000 Cash collected from customers $ 0
Foreign exchange loss (6,000)


Third Quarter:

Income Statement Balance Sheet Statement of Cash Flows

Sales revenue $ 0 Cash $16,000 Cash collected from customers $16,000
Foreign exchange gain 2,000 Accounts receivable 0




The net result of the sale in the second quarter, the collection of cash in the third quarter, and
the changing exchange rates in between is to record a sale of $20,000, the collection of cash of
$16,000, and a net exchange loss of $4,000 (a $6,000 loss in the second quarter and a $2,000
gain in the third quarter). The important point to note is that the sale is measured at the ex-
change rate on the date of sale and that any fluctuations between the sale date and the settle-
ment date are recognized as exchange gains or losses.
265
f266 Selling A Product Or A Service
Part 2 EM Operating Activities


What could American Company have done in the previous example to reduce its exposure
to the risk associated with changing exchange rates? The easiest thing would have been to de-
nominate the transaction in U.S. dollars. Then the risk of exchange rate changes would have
fallen on the Korean company. Secondly, American Company could have locked in the price of
Korean won by entering into a forward contract with a foreign currency broker. A forward con-
tract is an example of a derivative contract. Derivatives are becoming more and more com-
monplace in today s business environment, and in Chapter 12 we examine derivatives and their
uses and risks.



to summarize
When a U.S. company makes a sale that is denominated in a foreign currency,
the sale is called a foreign currency transaction. The sale is measured at the
exchange rate on the date of sale, and any fluctuations between the sale date
and the settlement date are recognized as exchange gains or losses.




review of learning objectives

Understand the three basic types of business activi- Properly account for the collection of cash and de-
3
1 ties: operating, investing, and financing. The three scribe the business controls necessary to safeguard
major types of business activities are: (1) operating activities, cash. The amount of cash collected from customers can be re-
(2) investing activities, and (3) financing activities. Operating duced because of sales discounts and sales returns and al-
activities include selling products or services, buying inventory lowances. Sales discounts are reductions in the payments re-
for resale, and incurring and paying for necessary expenses as- quired of customers who pay their accounts quickly. Sales
sociated with the primary activities of a business. Investing ac- returns and allowances are payment reductions granted to dis-
tivities include purchasing property, plant, and equipment for satisfied customers. On an income statement, sales discounts
use in the business or purchasing investments, such as stocks and sales returns and allowances are subtracted from gross sales
and bonds of other companies. Financing activities include to arrive at net sales. Cash is a tempting target for fraud or
raising money by means other than operations to finance a theft, so companies must carefully monitor and control the
business. The two common financing activities are borrowing way cash is handled and accounted for. Common controls in-
(debt financing) and selling ownership or equity interests (eq- clude (1) separation of duties in the handling of and accounting
uity financing) in the company. for cash, (2) daily deposits of all cash receipts, and (3) pay-
ment of all expenditures by prenumbered checks.
Use the two revenue recognition criteria to decide
2 when the revenue from a sale or service should be Record the losses resulting from credit customers who
4
recorded in the accounting records. Revenue is recognized do not pay their bills. Accounts receivable balances are
when the work is done and when cash collectibility is reason- generally collected from 10 to 60 days after the date of sale.
ably assured. The entries to record revenue from the sale of There are two ways to account for losses from uncollectible
merchandise or from the performance of a service involve deb- receivables: the direct write-off method and the allowance
its to Cash or Accounts Receivable and credits to Sales Rev- method. Only the allowance method is generally acceptable
enue or Service Revenue. In general, revenues are recognized because it matches expenses with revenues. Losses from un-
at the time of a sale. If cash is collected before a service is pro- collectible receivables can be estimated (1) as a percentage of
vided or a product is delivered, however, then revenue should total credit sales for the period or (2) as a percentage of total
not be recognized until the promised action has been com- outstanding receivables. One technique for estimating uncol-
pleted. Revenue for long-term contracts is recognized in pro- lectible receivables as a percentage of total receivables is to per-
portion to the amount of the contract completed. form an aging of accounts receivable.
266 f267
Selling A Product Or A Service EOC Chapter 6
Selling a Product or a Service


Evaluate a company s management of its receivables about some cash transactions before the company does (such
5 by computing and analyzing appropriate financial ra- as bank service charges).
tios. Careful management of accounts receivable is a balance
between extending credit to increase sales and collecting cash Understand how receivables can be used by a com-
8
quickly to reduce the need to borrow. Two ratios commonly pany to get cash immediately. Sometimes companies
used in monitoring the level of receivables are accounts re- that need cash in a hurry sell or factor their receivables. Com-
ceivable turnover and average collection period. The level of panies buying receivables, known as factoring or financing
these ratios is determined by how well a company manages its companies, usually charge a discount of 2 to 15% of the re-
receivables, as well as by what kind of business the company ceivable. Receivables can be factored with or without recourse.
is in. A note receivable is a claim against a debtor, evidenced by an
unconditional written promise to pay a sum of money on or
Match revenues and expenses by estimating and before a specified future date. The amount of interest to be
6 recording future warranty and service costs associ- earned annually is equal to: principal interest rate time
ated with a sale. If a company makes promises about future period (in terms of one year) of the note. Notes can be dis-
warranty repairs or continued customer service as part of a counted at a bank or other financial institution. Discounting
sale, the value of these promises is estimated and recorded as allows the original payee of a note to receive money prior to
an expense at the time of the sale. If experience suggests that the maturity date.
the original estimate was in error, adjustments are made to
the estimates made in relation to subsequent sales; however, Account for the impact of changing exchange rates
9
no attempt is made to go back and fix the original esti- on the value of accounts receivable denominated in
mates. foreign currencies. U.S. companies transact large amounts of
business with foreign parties. When the transaction is de-
nominated in U.S. dollars, no new accounting issues are in-
troduced. However, when a U.S. company enters into a trans-
Reconcile a checking account. Most cash is kept in action in which the price is denominated in a foreign currency,
7 bank accounts, which are reconciled each month. Bank the U.S. company must use special accounting procedures to
reconciliations adjust the bank and book balances so that they recognize the change in the value of the transaction as foreign
are the same correct amount. Differences arise between the currency exchange rates fluctuate. The sale is measured at the
book and bank balances because the company knows about exchange rate on the date of sale, and any fluctuations between
some cash transactions before the bank does (such as deposits the sale date and the settlement date are recognized as exchange
in transit and outstanding checks) and because the bank knows gains or losses.




key terms and concepts

accounts receivable 249 investing activities 240 discounting a note receivable 263
accounts receivable turnover 255 net realizable value of accounts foreign currency transaction 264
receivable 252
aging accounts receivable 253 interest rate 262
net sales 248
allowance for bad debts 251 maker 262
operating activities 239
allowance method 250 maturity date 262
receivables 249
average collection period 256 maturity value 263
revenue recognition 242
bad debt expense 250 note receivable 262
sales discounts 246
bad debts 249 NSF (not sufficient funds) checks
sales returns and allowances 247 258
cash 248
payee 262
contra account 247
principal 262
direct write-off method 249
financing activities 240
gross sales 248 bank reconciliation 260
267
f268 Selling A Product Or A Service
Part 2 EOC Operating Activities




review problem

Douglas Company sells furniture. Approximately 10% of its sales are cash; the remainder are
Accounting for Receivables
on credit. During the year ended December 31, 2003, the company had net credit sales of
and Warranty Obligations
$2,200,000. As of December 31, 2003, total accounts receivable were $800,000, and Allowance
for Bad Debts had a debit balance of $1,100 prior to adjustment. In the past, approximately
1% of credit sales have proved to be uncollectible. An aging analysis of the individual accounts
receivable revealed that $32,000 of the Accounts Receivable balance appeared to be uncollectible.
The largest credit sale during the year occurred on December 4, 2003, for $72,000 to Aaron
Company. Terms of the sale were 2/10, n/30. On December 13, Aaron Company paid $60,000
of the receivable balance and took advantage of the 2% discount. The remaining $12,000 was
still outstanding on March 31, 2004, when Douglas Company learned that Aaron Company
had declared bankruptcy. Douglas wrote the receivable off as uncollectible.
On December 31, 2003, Douglas Company estimated that it would cost $11,000 in labor
and various expenditures to service the furniture it had sold (under 90-day warranty agreements)
during the last three months of 2003. During January 2004, the company spent $430 in labor
and $600 for supplies to perform service on defective furniture that was sold during the year 2003.
Required: Prepare the following journal entries:
1. The sale of $72,000 of furniture on December 4, 2003, to Aaron Company on credit.
2. The collection of $58,800 from Aaron Company on December 13, 2003, assuming the
company allows the discount on partial payment.
3. Record Bad Debt Expense on December 31, 2003, using the percentage of credit sales method.
4. Record Bad Debt Expense on December 31, 2003, using the aging of receivables method.
5. Record estimated warranty expense on December 31, 2003.
6. Record actual expenditures to service defective furniture under the warranty agreements on
January 31, 2004.
7. Write off the balance of the Aaron Company receivable as uncollectible, March 31, 2004.

The journal entries would be recorded as follows:
Solution
1. Dec. 4, 2003 Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72,000
Sales Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72,000
Sold $72,000 of furniture to Aaron Company on credit.
2. Dec. 13, 2003 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58,800
Sales Discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200
Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000
Collected $58,800 from Aaron Company on
December 4 sale and recognized the 2% discount
taken (0.02 $60,000 $1,200).
3. Dec. 31, 2003 Bad Debt Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,000
Allowance for Bad Debts . . . . . . . . . . . . . . . . . . . . . . . 22,000
Recorded bad debt expense as 1% of credit sales of
$2,200,000 ($2,200,000 0.01 $22,000).
Note: When using the percentage of credit sales method to estimate bad debt expense, the existing balance in
the allowance for bad debts account is ignored.

4. Dec. 31, 2003 Bad Debt Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33,100
Allowance for Bad Debts . . . . . . . . . . . . . . . . . . . . . . . 33,100
Recorded bad debt expense using the aging of
accounts receivable method ($32,000 $1,100 debit
balance).
Note: When using the percentage of total receivables method (e.g., by aging receivables) to estimate bad debt
expense, the existing balance in Allowance for Bad Debts must be taken into consideration so that the new bal-
ance is the amount of receivables not expected to be collected.
268 f269
Selling A Product Or A Service EOC Chapter 6
Selling a Product or a Service


5. Dec. 31, 2003 Customer Service Expense . . . . . . . . . . . . . . . . . . . . . . . 11,000
Estimated Liability for Service . . . . . . . . . . . . . . . . . . . 11,000
Estimated customer service (warranty) costs on
furniture sold during the last three months of 2003.
(The warranty period is 90 days.)
6. Jan. 31, 2004 Estimated Liability for Service . . . . . . . . . . . . . . . . . . . . . 1,030
Wages Payable (to service employees) . . . . . . . . . . . . . 430
Supplies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600
Actual customer service costs incurred.
7. March 31, 2004 Allowance for Bad Debts . . . . . . . . . . . . . . . . . . . . . . . . . 12,000
Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000
Wrote off the balance in the Aaron Company account
as uncollectible.




discussion questions

1. What are the three types of basic business activities? 11. Why is the aging of accounts receivable usually more
2. Why is the purchase of inventory for resale to cus- accurate than basing the estimate on total receivables?
tomers classified as an operating activity rather than an 12. Why is it important to monitor operating ratios such as
investing activity? accounts receivable turnover?
3. When should revenues be recognized and reported? 13. Why must the customer service expense (warranty)
4. Why do you think misstatements of revenues (e.g., rec- sometimes be recorded in the period prior to when the
ognizing revenues before they are earned) is one of the actual customer services will be performed?
most common ways to manipulate financial statements?
5. Why is it important to have separate sales returns and
allowances and sales discounts accounts? Wouldn t it be
much easier to directly reduce the sales revenue account 14. What are the major reasons that the balance of a bank
for these adjustments? statement is usually different from the cash book bal-
6. Why do companies usually have more controls for cash ance (Cash per the general ledger)?
than for other assets? 15. Why don t the additions and deductions from the bank
7. What are three generally practiced controls for cash, balance on a bank reconciliation require adjustment by
and what is the purpose of each control? the company?
8. Why do most companies tolerate having a small per- 16. What is the advantage of having a note receivable over
centage of uncollectible accounts receivable? having an account receivable?
9. Why does the accounting profession require the use of 17. Why would someone discount a note receivable?
the allowance method of accounting for losses due to 18. Why would someone factor an account receivable?
bad debts rather than the direct write-off method? 19. Do all transactions by U.S. companies with foreign par-
10. With the allowance method, why is the net balance, or ties require special accounting procedures by the U.S.
net realizable value, of Accounts Receivable the same af- companies? Explain.
ter the write-off of a receivable as it was prior to the
write-off of the uncollectible account?




discussion cases

CASE 6-1 ZZZZ BEST AND FICTITIOUS RECEIVABLES
ZZZZ BEST was a Los Angeles based company specializing in carpet cleaning and insurance
restoration. Prior to allegations of fraud and its declaration of bankruptcy in 1988, ZZZZ Best
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was touted as one of the hottest stocks on Wall Street. In 1987, after only six years in business,
the company had a market valuation exceeding $211 million, giving its genius president a pa-
per fortune of $109 million. Lawsuits, however, alleged that the company was nothing more
than a massive fraud scheme that fooled major banks, two CPA firms, an investment banker,
and a prestigious law firm.
ZZZZ Best was started as a carpet-cleaning business by Barry Minkow, a 15-year-old high
school student, in 1981. Although ZZZZ Best had impressive growth as a carpet-cleaning busi-
ness, the growth was not nearly fast enough for the impatient Minkow. In 1985, ZZZZ Best
announced that it was expanding into the insurance restoration business, restoring buildings that
had been damaged by fire, floods, and other disasters. During 1985 and 1986, ZZZZ Best re-
ported undertaking several large insurance restoration projects. The company reported high prof-
its from these restoration jobs. A public stock offering in 1986 stated that 86% of ZZZZ Best
Corporation s business was in the insurance restoration area.
Based on the company s high growth and reported income in 1987, a spokesperson for a
large brokerage house was quoted in Business Week as saying that Barry Minkow is a great man-
ager and ZZZZ Best is a great company. He recommended that his clients buy ZZZZ Best
stock. That same year, the Association of Collegiate Entrepreneurs and the Young Entrepre-
neurs Organization placed Minkow on their list of the top 100 young entrepreneurs in Amer-
ica; and the mayor of Los Angeles honored Minkow with a commendation that said that he had
set a fine entrepreneurial example of obtaining the status of a millionaire at the age of 18.
Unfortunately, ZZZZ Best s insurance business, its impressive growth, and its high reported
income were totally fictitious. In fact, the company never once made a legitimate profit. Barry
Minkow himself later said that he was a fraudster who convincingly deceived almost everyone
involved with the company. Through the use of widespread collusion among company officials,
Minkow was even able to hide the fraud from ZZZZ Best s external auditor. For example, when
ZZZZ Best reported an $8.2 million contract to restore a building in San Diego, the external
auditor demanded to see the building; this was difficult since neither the building nor the job
existed. However, officials of ZZZZ Best gained access to a construction site and led the audi-
tor through a tour of an unfinished building in San Diego to show that the restoration work
was ongoing. The situation became very complicated for ZZZZ Best when the auditor later
asked to see the finished job. ZZZZ Best had to spend $1 million to lease the building and hire
contractors to finish six of the eight floors in ten days. The auditor was led on another tour and
wrote a memo saying, Job looks very good. The auditor was subsequently faulted for looking
only at what ZZZZ Best officials chose to show, without making independent inquiries.
Minkow s house of cards finally came crashing down as it became apparent to banks, sup-
pliers, investors, and the auditors that the increasing difficulty ZZZZ Best was having with pay-
ing its bills was entirely inconsistent with a company reporting so much revenue and profit. In
January 1988, a federal grand jury in Los Angeles returned a 57-count indictment, charging 11
individuals including ZZZZ Best founder and president, Barry Minkow with engaging in a
massive fraud scheme. Minkow was later convicted and sentenced to 25 years in a federal pen-
itentiary in Colorado.
ZZZZ Best grossly inflated its operating results by reporting bogus revenue and receivables.
What factors prevent a company from continuing to report fraudulent results indefinitely? What
could the auditor have done to uncover the ZZZZ Best fraud?
Source: This description is based on articles in The Wall Street Journal, Forbes, and investigative proceedings
of the U.S. House of Representatives, Subcommittee on Energy and Commerce hearings: The Wall Street Jour-
nal, July 7, 1987, p. 1; July 9, 1987, p. 1; August 23, 1988, p. 1; U.S. House of Representatives, Subcommittee
on Oversight and Investigation of the Committee on Energy and Commerce, January 27, 1988; U.S. House of
Representatives, Subcommittee on Oversight and Investigation of the Committee on Energy and Commerce,
February 1, 1988; Daniel Akst, How Barry Minkow Fooled the Auditors, Forbes, October 2, 1989, p. 126.


CASE 6-2 RECOGNIZING REVENUE
HealthCare, Inc.,* operates a number of medical testing facilities around the United States. Drug
manufacturers, such as MERCK and BRISTOL-MYERS SQUIBB, contract with HealthCare

*The name of the actual company has been changed.
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for testing of their newly developed drugs and other medical treatments. HealthCare advertises,
gets patients, and then administers the drugs or other experimental treatments, under a doctor s
care, to determine their effectiveness. The Food and Drug Administration requires such human
testing before allowing drugs to be prescribed by doctors and sold by pharmacists. A typical con-
tract might read as follows:
HealthCare, Inc., will administer the new drug, Lexitol, to 50 pa-
tients, once a week for 10 weeks, to determine its effectiveness in treat-
ing male baldness. Merck will pay HealthCare, Inc., $100 per patient
visit, to be billed at the conclusion of the test period. The total amount
of the contract is $50,000 (50 patients 10 visits $100 per visit).
Given these kinds of contracts, when should HealthCare recognize revenue when contracts are
signed, when patient visits take place, when drug manufacturers are billed, or when cash is col-
lected?


CASE 6-3 CREDIT POLICY REVIEW
The president, vice president, and sales manager of Moorer Corporation were discussing the
company s present credit policy. The sales manager suggested that potential sales were being lost
to competitors because of Moorer Corporation s tight restrictions on granting credit to con-
sumers. He stated that if credit policies were loosened, the current year s estimated credit sales
of $3,000,000 could be increased by at least 20% next year with an increase in uncollectible ac-
counts receivable of only $10,000 over this year s amount of $37,500. He argued that because
the company s cost of sales is only 25% of revenues, the company would certainly come out
ahead.
The vice president, however, suggested that a better alternative to easier credit terms would
be to accept consumer credit cards such as VISA or MASTERCARD. She argued that this al-
ternative could increase sales by 40%. The credit card finance charges to Moorer Corporation
would be 4% of the additional sales.
At this point, the president interrupted by saying that he wasn t at all sure that increasing
credit sales of any kind was a good thing. In fact, he suggested that the $37,500 of uncollectible
accounts receivable was altogether too high. He wondered whether the company should dis-
continue offering sales on account.
With the information given, determine whether Moorer Corporation would be better off
under the sales manager s proposal or the vice president s proposal. Also, address the president s
suggestion that credit sales of all types be abolished.




exercises

EXERCISE 6-1 RECOGNIZING REVENUE
Supposedly, there is an over 200-year wait to buy GREEN BAY PACKERS season football
tickets. The fiscal year-end (when they close their books) for the Green Bay Packers is March
30 of each year. If the Packers sell their season football tickets in February for the coming
football season, when should the revenue from those ticket sales be recognized?


EXERCISE 6-2 RECOGNIZING REVENUE
James Dee Company cleans the outside walls of buildings. The average job generates revenue
of $800,000 and takes about two weeks to complete. Customers are required to pay for a job
within 30 days after its completion. James Dee Company guarantees its work for five years
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if the building walls get dirty within five years, James Dee will clean them again at no charge.
James Dee is considering recognizing revenue using one of the following methods:
a. Recognize revenue when James Dee signs the contract to do the job.
b. Recognize revenue when James Dee begins the work.
c. Recognize revenue immediately after the completion of the job.
d. Recognize revenue 30 days after the completion of the job when the cash is collected.
e. Wait until the five-year guarantee period is over before recognizing any revenue.
Which revenue recognition option would you recommend to James Dee? Explain your answer.

EXERCISE 6-3 RECOGNIZING REVENUE LONG-TERM CONSTRUCTION
PROJECTS
In the year 2002, Salt Lake City, Utah, will host the Winter Olympics. To get ready for the
Olympics, most of the major roads and highways in and around Salt Lake City are being ren-
ovated. It will take over three years to complete the highway projects, and WASATCH CON-
STRUCTORS, the construction company performing the work, probably doesn t want to
wait until the work is completed to recognize revenue. How would you suggest that the rev-
enue on these highway construction projects be recognized?

EXERCISE 6-4 REVENUE RECOGNITION
Yummy, Inc., is a franchiser that offers for sale an exclusive franchise agreement for $30,000.
Under the terms of the agreement, the purchaser of a franchise receives a variety of services
associated with the construction of a Yummy Submarine and Yogurt Shop, access to various
product supply services, and continuing management advice and assistance once the retail unit
is up and running. The contract calls for the franchise purchaser to make cash payments of
$10,000 per year for three years to Yummy, Inc.
How should Yummy, Inc., account for the sale of a franchise contract? Specifically, when
should the revenue and receivable be recognized?

EXERCISE 6-5 CONTROL OF CASH
Molly Maloney is an employee of Marshall Company, a small manufacturing concern. Her
responsibilities include opening the daily mail, depositing the cash and checks received into
the bank, and making the accounting entries to record the receipt of cash and the reduction
of receivables. Explain how Maloney might be able to misuse some of Marshall s cash receipts.
As a consultant, what control procedures would you recommend?

EXERCISE 6-6 RECORDING SALES TRANSACTIONS
On June 24, 2003, Hansen Company sold merchandise to Jill Selby for $80,000 with terms
2/10, n/30. On June 30, Selby paid $39,200 on her account and was allowed a discount for
the timely payment. On July 20, Selby paid $24,000 on her account and returned $16,000 of
merchandise, claiming that it did not meet contract terms.
Record the necessary journal entries on June 24, June 30, and July 20.

EXERCISE 6-7 RECORDING SALES TRANSACTIONS
Lopez Company sold merchandise on account to Atlantic Company for $4,000 on June 3,
2003, with terms 2/10, n/30. On June 7, 2003, Lopez Company received $200 of returned
merchandise from Atlantic Company and issued a credit memorandum for the appropriate
amount. Lopez Company received payment for the balance of the bill on June 21, 2003.
Record the necessary journal entries on June 3, June 7, and June 21.

EXERCISE 6-8 ESTIMATING BAD DEBTS
The trial balance of Stardust Company at the end of its 2003 fiscal year included the follow-
ing account balances:
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Account

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $48,900
Allowance for bad debts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500 (debit balance)


The company has not yet recorded any bad debt expense for 2003.
Determine the amount of bad debt expense to be recognized by Stardust Company for
2003, assuming the following independent situations:
1. An aging accounts receivable analysis indicates that probable uncollectible accounts re-
ceivable at year-end amount to $4,500.
2. Company policy is to maintain a provision for uncollectible accounts receivable equal to
3% of outstanding accounts receivable.
3. Company policy is to estimate uncollectible accounts receivable as equal to 0.5% of the
previous year s annual sales, which were $200,000.

EXERCISE 6-9 ACCOUNTING FOR BAD DEBTS
The following data were associated with the accounts receivable and uncollectible accounts of
Hilton, Inc., during 2003:
a. The opening credit balance in Allowance for Bad Debts was $900,000 at January 1,
2003.
b. During 2003, the company realized that specific accounts receivable totaling $920,000
had gone bad and had been written off.
c. An account receivable of $50,000 was collected during 2003. This account had previ-
ously been written off as a bad debt in 2002.
d. The company decided that Allowance for Bad Debts would be $920,000 at the end of
2003.
1. Prepare journal entries to show how these events would be recognized in the accounting
system using:
a. The direct write-off method.
b. The allowance method.
2. Discuss the advantages and disadvantages of each method with respect to the matching
principle.


EXERCISE 6-10 ACCOUNTING FOR UNCOLLECTIBLE ACCOUNTS RECEIVABLE
Dodge Company had the following information relating to its accounts receivable at Decem-
ber 31, 2002, and for the year ended December 31, 2003:
Accounts receivable balance at 12/31/02 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 900,000
Allowance for bad debts at 12/31/02 (credit balance) . . . . . . . . . . . . . . . . . . . . . . . . . 50,000
Gross sales during 2003 (all credit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000,000
Collections from customers during 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,500,000
Accounts written off as uncollectible during 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000
Estimated uncollectible receivables at 12/31/03 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110,000

Dodge Company uses the percentage of receivables method to estimate bad debt expense.
1. At December 31, 2003, what is the balance of Dodge Company s Allowance for Bad
Debts? What is the bad debt expense for 2003?
2. At December 31, 2003, what is the balance of Dodge Company s gross accounts receiv-
able?

EXERCISE 6-11 AGING OF ACCOUNTS RECEIVABLE
Cicero Company s accounts receivable reveal the following balances:
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Age of Accounts Receivable Balance

Current . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $600,000
1 30 days past due . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320,000
31 60 days past due . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000
61 90 days past due . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000
91 120 days past due . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000


The credit balance in Allowance for Bad Debts is now $26,000. After a thorough analysis of
its collection history, the company estimates that the following percentages of receivables will
eventually prove uncollectible:
Current. . . . . . . . . . . . . . . . . . . . . . . . . . . . 0.4%
1 30 days past due . . . . . . . . . . . . . . . . . . 3.0
31 60 days past due. . . . . . . . . . . . . . . . . . 12.0
61 90 days past due. . . . . . . . . . . . . . . . . . 60.0
91 120 days past due . . . . . . . . . . . . . . . . . 90.0

Prepare an aging schedule for the accounts receivable, and give the journal entry for recording
the necessary change in the allowance for bad debts account.

EXERCISE 6-12 AGING OF ACCOUNTS RECEIVABLE
The following aging of accounts receivable is for Harry Company at the end of its first year
of business:

Aging of Accounts Receivable
December 31, 2003

Less Than 30 31 to 60 61 to 90 Over 90
Overall Days Days Days Days
Ken Nelson $ 10,000 $ 8,000 $1,000 $1,000
Elaine Anderson 40,000 31,000 $ 4,000 5,000
Bryan Crist 12,000 3,000 4,000 2,000 3,000
Renee Warner 60,000 50,000 10,000
Nelson Hsia 16,000 10,000 6,000
Stella Valerio 25,000 20,000 5,000
Totals $163,000 $122,000 $24,000 $8,000 $9,000


Harry Company has collected the following bad debt information from a consultant familiar
with Harry s industry:

Percentage
Ultimately
Age of Account Uncollectible
Less than 30 days 2%
31 60 days 10
61 90 days 30
Over 90 days 75


1. Compute the appropriate Allowance for Bad Debts as of December 31, 2003.
2. Make the journal entry required to record this allowance. Remember that, since this is
Harry s first year of operations, the allowance account at the beginning of the year was $0.
3. What is Harry s net accounts receivable balance as of December 31, 2003?

EXERCISE 6-13 DIRECT WRITE-OFF VERSUS ALLOWANCE METHOD
The vice president for Tres Corporation provides you with the following list of accounts re-
ceivable written off in the current year. (These accounts were recognized as bad debt ex-
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pense at the time they were written off; i.e., the company was using the direct write-off
method.)

Date Customer Amount

March 30 Rasmussen Company $12,000
July 31 Dodge Company 7,500
September 30 Larsen Company 10,000
December 31 Peterson Company 12,000


Tres Corporation s sales are all on an n/30 credit basis. Sales for the current year total
$3,600,000, and analysis has indicated that uncollectible receivable losses historically approxi-
mate 1.5% of sales.
1. Do you agree or disagree with Tres Corporation s policy concerning recognition of bad
debt expense? Why or why not?
2. If Tres were to use the percentage of sales method for recording bad debt expense, by
how much would income before income taxes change for the current year?

EXERCISE 6-14 ACCOUNTING FOR UNCOLLECTIBLE RECEIVABLES
PERCENTAGE OF SALES METHOD
The trial balance of Sporting House, Inc., shows a $100,000 outstanding balance in Accounts
Receivable at the end of 2002. During 2003, 75% of the total credit sales of $4,000,000 was
collected, and no receivables were written off as uncollectible. The company estimated that
1.5% of the credit sales would be uncollectible. During 2004, the account of Larry Johnson,
who owed $1,200, was judged to be uncollectible and was written off. At the end of 2004,
the amount previously written off was collected in full from Mr. Johnson.
Prepare the necessary journal entries for recording all the preceding transactions relating
to uncollectibles on the books of Sporting House, Inc.

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