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Example: Assume Paterno Corp. has $200,000 in sales during 2000. Of these sales, 30% are in cash and 70% are on credit. They estimate that 4% of their credit sales will not be collected.

Now assume that Paterno Corp. has $300,000 in Accounts Receivable prior to this year’s credit sales. The firm estimates that 6% of the A/R balance is not collectible.

Now assume that Paterno Corp. has $300,000 in Accounts Receivable prior to this year’s credit sales. The firm estimates that 6% of the A/R balance is not collectible.

Now assume that Paterno Corp. has $300,000 in Accounts Receivable prior to this year’s credit sales. The firm estimates that 6% of the A/R balance is not collectible.

Now assume that Paterno Corp. has $300,000 in Accounts Receivable prior to this year’s credit sales. The firm estimates that 6% of the A/R balance is not collectible.

Generally, two major issues:

- How to Record Sales Discounts
- How to Record Doubtful Receipts

Discounts

The most prevalent is the cash discount for early payment on the account.

Discounts

The most prevalent is the cash discount for early payment on the account.

Example: 2/10, n/30

Discounts

The most prevalent is the cash discount for early payment on the account.

Example: 2/10, n/30

2% discount if paid within 10 days

Discounts

The most prevalent is the cash discount for early payment on the account.

Example: 2/10, n/30

Net amount due in 30 days.

Discounts

Two methods to record the discount:

- Gross Method: record primary sale at gross amount

Discounts

Two methods to record the discount:

- Gross Method: record primary sale at gross amount

Usually for firms whose clients generally don’t take advantage of the discounts

Discounts

Two methods to record the discount:

- Gross Method: record primary sale at gross amount
- Net Method: record primary sale at net-of-discount amount

Discounts

Two methods to record the discount:

- Gross Method: record primary sale at gross amount
- Net Method: record primary sale at net-of-discount amount

Usually for firms whose clients generally take advantage of the discounts

Discounts

Example: Jan 1st, sell $10,000 of product under 2/10, n/30 terms.

Gross Method

Jan 1 Accts Rec 10,000

Sales 10,000

Discounts

Example: Jan 1st, sell $10,000 of product under 2/10, n/30 terms.

Gross Method

Jan 1 Accts Rec 10,000

Sales 10,000

Recorded as if discount won’t be taken

Discounts

Example: Jan 1st, sell $10,000 of product under 2/10, n/30 terms.

Gross Method

Jan 1 Accts Rec 10,000

Sales 10,000

Net Method

Jan 1 Accts Rec 9,800

Sales 9,800

Discounts

Example: Jan 1st, sell $10,000 of product under 2/10, n/30 terms.

Gross Method

Jan 1 Accts Rec 10,000

Sales 10,000

Net Method

Jan 1 Accts Rec 9,800

Sales 9,800

Recorded as if discount will be taken

Discounts

Example: Jan 9th, receive payment within discount period

Gross Method

Jan 9 Cash 9,800

Sales Discs 200

Accts Rec 10,000

Discounts

Example: Jan 9th, receive payment within discount period

Gross Method

Jan 9 Cash 9,800

Sales Discs200

Accts Rec 10,000

If the discount is actually realized, it is recorded upon receipt of the cash payment. Sales Discounts is a contra-revenue account.

Discounts

Example: Jan 9th, receive payment within discount period

Gross Method

Jan 9 Cash 9,800

Sales Discs 200

Accts Rec 10,000

Net Method

Jan 9 Cash 9,800

Accts Rec 9,800

Discounts

Example: Jan 9th, receive payment within discount period

Gross Method

Jan 9 Cash 9,800

Sales Discs 200

Accts Rec 10,000

Net Method

Jan 9 Cash 9,800

Accts Rec 9,800

Discount has already been recorded on sales date.

Discounts

Example: Jan 29th, receive payment outside discount period

Now assume instead that the payment was sent after the discount period expired.

Discounts

Example: Jan 29th, receive payment outside discount period

Gross Method

Jan 29 Cash 10,000

Accts Rec 10,000

Discounts

Example: Jan 29th, receive payment outside discount period

Gross Method

Jan 29 Cash 10,000

Accts Rec 10,000

No correction needed, since we already assumed the discount would not be taken.

Discounts

Example: Jan 29th, receive payment outside discount period

Gross Method

Jan 29 Cash 10,000

Accts Rec 10,000

Net Method

Jan 29 Cash 10,000

Accts Rec 9,800

Forfeited Discount 200

Discounts

Example: Jan 29th, receive payment outside discount period

Gross Method

Jan 29 Cash 10,000

Accts Rec 10,000

Net Method

Jan 29 Cash 10,000

Accts Rec 9,800

Forfeited Discount 200

Record the forfeited discount (a revenue account).

Doubtful Receipts

All receivables have some probability of default. The default on payment needs to be recorded appropriately.

Doubtful Receipts

One method of recording default is to record a loss when actual default occurs. This is called the direct write-off method.

Doubtful Receipts

One method of recording default is to record a loss when actual default occurs. This is called the direct write-off method.

Not considered an acceptable method because it does not match revenues with costs effectively.

Doubtful Receipts

The accepted method is called the Allowance Method.

An Allowance for Doubtful Accounts is set up as a contra-receivable account (contra-asset). It holds management’s best estimate for the amount of receivables that will default.

Doubtful Receipts

To determine management’s best estimate for default, use one of two methods:

Doubtful Receipts

To determine management’s best estimate for default, use one of two methods:

- Percentage of Sales Method: a fixed percentage
- of sales will be considered doubtful

Doubtful Receipts

To determine management’s best estimate for default, use one of two methods:

- Percentage of Sales Method: a fixed percentage
- of sales will be considered doubtful

This is also called the income statement approach, since the estimate is based on a percentage of sales revenue.

Doubtful Receipts

To determine management’s best estimate for default, use one of two methods:

- Percentage of Sales Method: a fixed percentage
- of sales will be considered doubtful
- Percentage of Receivables Method: a fixed
- percentage of the receivables balance will be
- considered doubtful

Doubtful Receipts

To determine management’s best estimate for default, use one of two methods:

- Percentage of Sales Method: a fixed percentage
- of sales will be considered doubtful
- Percentage of Receivables Method: a fixed
- percentage of the receivables balance will be
- considered doubtful

This is also called the balance sheet approach, since the estimate is based on a percentage of a balance sheet receivable account.

Doubtful Receipts

Example: Assume Paterno Corp. has $200,000 in sales during 2000. Of these sales, 30% are in cash and 70% are on credit. They estimate that 4% of their credit sales will not be collected.

Doubtful Receipts

Example: Assume Paterno Corp. has $200,000 in sales during 2000. Of these sales, 30% are in cash and 70% are on credit. They estimate that 4% of their credit sales will not be collected.

2000 Credit Sales:

0.70 x $200,000 = $140,000

Doubtful Receipts

Example: Assume Paterno Corp. has $200,000 in sales during 2000. Of these sales, 30% are in cash and 70% are on credit. They estimate that 4% of their credit sales will not be collected.

2000 Credit Sales:

0.70 x $200,000 = $140,000

Estimate of doubtful collections:

0.04 x $140,000 = $5,600

Doubtful Receipts

Journal entry (percentage of sales):

Bad Debt Expense $5,600

Allowance for Doubtful Accts $5,600

Doubtful Receipts

Now assume that Paterno Corp. has $300,000 in Accounts Receivable prior to this year’s credit sales. The firm estimates that 6% of the A/R balance is not collectible.

Doubtful Receipts

Now assume that Paterno Corp. has $300,000 in Accounts Receivable prior to this year’s credit sales. The firm estimates that 6% of the A/R balance is not collectible.

Accts Receivable Beg. Bal. $300,000

Allow. for doubtful Accts. Beg. Bal $18,000

Doubtful Receipts

Now assume that Paterno Corp. has $300,000 in Accounts Receivable prior to this year’s credit sales. The firm estimates that 6% of the A/R balance is not collectible.

Accts Receivable Beg. Bal. $300,000

Allow. for doubtful Accts. Beg. Bal $18,000

Accts Receivable End. Bal $440,000

Doubtful Receipts

Accts Receivable Beg. Bal. $300,000

Allow. for doubtful Accts. Beg. Bal $18,000

Accts Receivable End. Bal $440,000

$300,000 + $140,000 (70% of sales)

Doubtful Receipts

Accts Receivable Beg. Bal. $300,000

Allow. for doubtful Accts. Beg. Bal $18,000

Accts Receivable End. Bal $440,000

Required AFDA End. Bal $26,400

$440,000 x 6%

Doubtful Receipts

Accts Receivable Beg. Bal. $300,000

Allow. for doubtful Accts. Beg. Bal $18,000

Accts Receivable End. Bal $440,000

Required AFDA End. Bal $26,400

Required Entry to Adjust Allowance for doubtful accounts

(percentage of receivables method):

Bad Debt Expense $8,400

Allowance for Doubtful Accts $8,400

Doubtful Receipts

Accts Receivable Beg. Bal. $300,000

Allow. for doubtful Accts. Beg. Bal $18,000

Accts Receivable End. Bal $440,000

Required AFDA End. Bal $26,400

Required Entry to Adjust Allowance for doubtful accounts

(percentage of receivables method):

Bad Debt Expense $8,400

Allowance for Doubtful Accts $8,400

Need to add $8,400 to beginning balance to meet required ending balance.

Sales Returns and Allowances

Returns and allowances are handled in the same manner as doubtful collection. An account called Allowance for Sales Returns is set up based on management’s best estimate for returns.

- A written promise to pay
- Usually longer-term and more formal
- Usually for a stated amount and a specified period
- Either formally stated or implicit interest rate

- A written promise to pay
- Usually longer-term and more formal
- Usually for a stated amount and a specified period
- Either formally stated or implicit interest rate

Implicit interest is when there is no formally stated interest rate, but the note is priced at a discount.

- A written promise to pay
- Usually longer-term and more formal
- Usually for a stated amount and a specified period
- Either formally stated or implicit interest rate

Implicit interest is when there is no formally stated interest rate, but the note is priced at a discount.

For example, a $1,000, 1-year note (with no stated interest rate) that sells for $900 has an implied interest rate of 11.1%.

Since notes tend to be longer-term, inflation whittles away the amount we can expect to recover from the note’s proceeds.

Since notes tend to be longer-term, inflation whittles away the amount we can expect to recover from the note’s proceeds.

To handle this, we generally carry long-term notes receivable on the balance sheet at their net present value.

Since notes tend to be longer-term, inflation whittles away the amount we can expect to recover from the note’s proceeds.

To handle this, we generally carry long-term notes receivable on the balance sheet at their net present value.

Short-term notes can be carried at face value, since they will likely not suffer from inflation.

To properly value long-term notes, we need the following information:

To properly value long-term notes, we need the following information:

- Stated interest rate
- Date of issue
- Interest payment schedule
- Principal payment schedule (usually end of note term)
- Market interest rate for similar risk note (discount rate)

Using this information, do the following:

Using this information, do the following:

- Set up repayment timeline.
- Plot actual cash inflows on timeline, using stated interest rate and face value of the note.

Using this information, do the following:

- Set up repayment timeline.
- Plot actual cash inflows on timeline, using stated interest rate and face value of the note.
- Discount plotted cash inflows using market equivalent-risk rate of interest (discount rate).

Example: 4 year note; no stated interest; $10,000 face value

0

Year

1

Year

2

Year

3

Year

4

Valuing Notes Receivable

Example: 4 year note; no stated interest; $10,000 face value

- Set up repayment timeline.

0

Year

1

Year

2

Year

3

Year

4

Valuing Notes Receivable

Example: 4 year note; no stated interest; $10,000 face value

- Plot actual cash inflows on timeline, using stated interest rate and face value of the note.

$0

0

Year

1

Year

2

Year

3

Year

4

Valuing Notes Receivable

Example: 4 year note; no stated interest; $10,000 face value

- Plot actual cash inflows on timeline, using stated interest rate and face value of the note.

$0

$0

0

Year

1

Year

2

Year

3

Year

4

Valuing Notes Receivable

Example: 4 year note; no stated interest; $10,000 face value

- Plot actual cash inflows on timeline, using stated interest rate and face value of the note.

$0

$0

$0

0

Year

1

Year

2

Year

3

Year

4

Valuing Notes Receivable

Example: 4 year note; no stated interest; $10,000 face value

- Plot actual cash inflows on timeline, using stated interest rate and face value of the note.

$0

$0

$0

$0

0

Year

1

Year

2

Year

3

Year

4

Valuing Notes Receivable

Example: 4 year note; no stated interest; $10,000 face value

- Plot actual cash inflows on timeline, using stated interest rate and face value of the note.

$0

$0

$0

$0

$10,000

0

Year

1

Year

2

Year

3

Year

4

Valuing Notes Receivable

Example: 4 year note; no stated interest; $10,000 face value

- Discount plotted cash inflows using market equivalent-risk rate of interest (discount rate).

$0

$0

$0

$0

$10,000

Assume discount rate = 7%.

0

Year

1

Year

2

Year

3

Year

4

1

1.07year

Valuing Notes Receivable

Example: 4 year note; no stated interest; $10,000 face value

- Discount plotted cash inflows using market equivalent-risk rate of interest (discount rate).

$0

$0

$0

$0

$10,000

Assume discount rate = 7%.

Therefore, discount multiplier =

0

Year

1

Year

2

Year

3

Year

4

Valuing Notes Receivable

Example: 4 year note; no stated interest; $10,000 face value

- Discount plotted cash inflows using market equivalent-risk rate of interest (discount rate).

$0

$0

$0

$0

$10,000

0 x 1/1.070

0

Year

1

Year

2

Year

3

Year

4

Valuing Notes Receivable

Example: 4 year note; no stated interest; $10,000 face value

- Discount plotted cash inflows using market equivalent-risk rate of interest (discount rate).

$0

$0

$0

$0

$10,000

$0

0

Year

1

Year

2

Year

3

Year

4

Valuing Notes Receivable

Example: 4 year note; no stated interest; $10,000 face value

- Discount plotted cash inflows using market equivalent-risk rate of interest (discount rate).

$0

$0

$0

$0

$10,000

$0

$0

0

Year

1

Year

2

Year

3

Year

4

Valuing Notes Receivable

Example: 4 year note; no stated interest; $10,000 face value

- Discount plotted cash inflows using market equivalent-risk rate of interest (discount rate).

$0

$0

$0

$0

$10,000

$0

$0

$0

$0

10,000 x 1/1.074

0

Year

1

Year

2

Year

3

Year

4

Valuing Notes Receivable

Example: 4 year note; no stated interest; $10,000 face value

- Discount plotted cash inflows using market equivalent-risk rate of interest (discount rate).

$0

$0

$0

$0

$10,000

$0

$0

$0

$0

$7,629

Example: 4 year note; no stated interest; $10,000 face value

The journal entry to record this note is:

Example: 4 year note; no stated interest; $10,000 face value

The journal entry to record a purchase of this note for cash is:

Notes Receivable $10,000

Discount, Notes Rec. $2,371

Cash $7,629

Example: 4 year note; 9% stated interest; $10,000 face value

0

Year

1

Year

2

Year

3

Year

4

Valuing Notes Receivable

Example: 4 year note; 9% stated interest; $10,000 face value

- Set up repayment timeline.

0

Year

1

Year

2

Year

3

Year

4

Valuing Notes Receivable

Example: 4 year note; 9% stated interest; $10,000 face value

- Plot actual cash inflows on timeline, using stated interest rate and face value of the note.

$0

$900

$900

$900

$900

$10,000

0

Year

1

Year

2

Year

3

Year

4

Valuing Notes Receivable

Example: 4 year note; 9% stated interest; $10,000 face value

- Plot actual cash inflows on timeline, using stated interest rate and face value of the note.

$0

$900

$900

$900

$900

$10,000

9% x $10,000

of interest paid annually

0

Year

1

Year

2

Year

3

Year

4

Valuing Notes Receivable

Example: 4 year note; 9% stated interest; $10,000 face value

- Plot actual cash inflows on timeline, using stated interest rate and face value of the note.

$0

$900

$900

$900

$900

$10,000

Repayment of principal (stated amount) at the maturity of note

0

Year

1

Year

2

Year

3

Year

4

1

1.13year

Valuing Notes Receivable

Example: 4 year note; 9% stated interest; $10,000 face value

- Discount plotted cash inflows using market equivalent-risk rate of interest (discount rate).

$0

$900

$900

$900

$900

$10,000

Assume discount rate = 13%.

Therefore, discount multiplier =

0

Year

1

Year

2

Year

3

Year

4

Valuing Notes Receivable

Example: 4 year note; 9% stated interest; $10,000 face value

- Discount plotted cash inflows using market equivalent-risk rate of interest (discount rate).

$0

$900

$900

$900

$900

$10,000

$0

900 x 1/1.131

0

Year

1

Year

2

Year

3

Year

4

Valuing Notes Receivable

Example: 4 year note; 9% stated interest; $10,000 face value

- Discount plotted cash inflows using market equivalent-risk rate of interest (discount rate).

$0

$900

$900

$900

$900

$10,000

$0

$796

0

Year

1

Year

2

Year

3

Year

4

Valuing Notes Receivable

Example: 4 year note; 9% stated interest; $10,000 face value

- Discount plotted cash inflows using market equivalent-risk rate of interest (discount rate).

$0

$900

$900

$900

$900

$10,000

$0

$796

$705

$624

$6,685

0

Year

1

Year

2

Year

3

Year

4

Valuing Notes Receivable

Example: 4 year note; 9% stated interest; $10,000 face value

- Discount plotted cash inflows using market equivalent-risk rate of interest (discount rate).

$0

$900

$900

$900

$900

$10,000

$0

$796

$705

$624

$6,685

NPV = 796 + 705 + 624 + 6,685 = $8,810

Example: 4 year note; 9% stated interest; $10,000 face value

The journal entry to record a purchase of this note for cash is:

Notes Receivable $10,000

Discount, Notes Rec. $1,190

Cash $8,810

0

Year

1

Year

2

Year

3

Year

4

1

1.06year

Valuing Notes Receivable

Example: 4 year note; 9% stated interest; $10,000 face value

Now assume that inflation is low, so discount rate is only 6%.

$0

$900

$900

$900

$900

$10,000

Assume discount rate = 6%.

Therefore, discount multiplier =

0

Year

1

Year

2

Year

3

Year

4

Valuing Notes Receivable

Example: 4 year note; 9% stated interest; $10,000 face value

$0

$900

$900

$900

$900

$10,000

$0

$849

$801

$756

$8,634

0

Year

1

Year

2

Year

3

Year

4

Valuing Notes Receivable

Example: 4 year note; 9% stated interest; $10,000 face value

$0

$900

$900

$900

$900

$10,000

$0

$849

$801

$756

$8,634

NPV = 849 + 801 + 756 + 8,634 = $11,040

Example: 4 year note; 9% stated interest; $10,000 face value

The journal entry to record a purchase of this note for cash is:

Notes Receivable $10,000

Premium, Notes Rec. $1,040

Cash $11,040

Example: 4 year note; 9% stated interest; $10,000 face value

The journal entry to record a purchase of this note for cash is:

Notes Receivable $10,000

Premium, Notes Rec. $1,040

Cash $11,040

The premium reflects the amount we overpay in order to get a note with an interest rate that pays more than the inflation rate.

Amortization of Discount

Amortization of Discount

Go back to our 13% interest rate example:

Example: 4 year note; 9% stated interest; $10,000 face value

The journal entry to record a purchase of this note for cash is:

Notes Receivable $10,000

Discount, Notes Rec. $1,190

Cash $8,810

Amortization of Discount

At date of purchase, the balance sheet carries the note:

Note Receivable $10,000

Less: Discount $1,190

Carrying Value $8,810

Amortization of Discount

At date of purchase, the balance sheet carries the note:

Note Receivable $10,000

Less: Discount $1,190

Carrying Value $8,810

Amortization amount each year =

Amortization of Discount

At date of purchase, the balance sheet carries the note:

Note Receivable $10,000

Less: Discount $1,190

Carrying Value $8,810

Amortization amount each year =

Carrying value x interest rate (discount rate) – interest actually paid

Amortization of Discount

At date of purchase, the balance sheet carries the note:

Note Receivable $10,000

Less: Discount $1,190

Carrying Value $8,810

Amortization amount each year =

Carrying value x interest rate (discount rate) – interest actually paid

Year 1 amortization =

Amortization of Discount

At date of purchase, the balance sheet carries the note:

Note Receivable $10,000

Less: Discount $1,190

Carrying Value $8,810

Amortization amount each year =

Carrying value x interest rate (discount rate) – interest actually paid

Year 1 amortization = (8,810 x 0.13)

Amortization of Discount

At date of purchase, the balance sheet carries the note:

Note Receivable $10,000

Less: Discount $1,190

Carrying Value $8,810

Amortization amount each year =

Carrying value x interest rate (discount rate) – interest actually paid

Year 1 amortization = (8,810 x 0.13) - 900

Amortization of Discount

At date of purchase, the balance sheet carries the note:

Note Receivable $10,000

Less: Discount $1,190

Carrying Value $8,810

Amortization amount each year =

Carrying value x interest rate (discount rate) – interest actually paid

Year 1 amortization = (8,810 x 0.13)– 900 = $245

Amortization of Discount

Actual interest revenue reported each year is equal to actual interest paid + the amount of discount amortized (or – the amount of premium amortized)

Amortization of Discount

Actual interest revenue reported each year is equal to actual interest paid + the amount of discount amortized (or – the amount of premium amortized)

Journal entry to record receipt of year 1 interest:

Amortization of Discount

Actual interest revenue reported each year is equal to actual interest paid + the amount of discount amortized (or – the amount of premium amortized)

Journal entry to record receipt of year 1 interest:

Cash $900

Disc, Notes Rec $245

Interest Revenue, Notes Rec $1,145

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