BUSINESS
&
INDUSTRY/AUDITING
Assessing the Allowance for
Doubtful Accounts
Using historical data to evaluate the estimation process
by Mark E. Riley. CPA,Ph.D.. and William R. Pasewark. CPA.PhD.
C
alnilatingestimitesofihecollectibilityofac-
ing Standards (SAS) no. 57 and AU section 342,
counts receivable and auditing those estimates AudilingAccounlin^ Emmatcs, which suggest auditors
is difficult. This article describes three tech- compare prior accounting estimates with subsequent
niques for assessing dlowance for doubtful accounts results to evaluate the reliability of the process used
estimates and complying wa'h Statement on Audit- to develop estimates.
BUSINESS
&
INDUSTRY/AUDITING
Exhibit 1 Techniques for Analyzing Estimates af
Uncollectible Receivables
Dell Inc. (in millions)
2006
96
107
W
2008
126
82
n
79
Beginning Ailowance for Doubtful Accounts
Bad Debt Expense
101
Write-Otts
(84)
(77)
(105)
96
126
103
Ending Ailowance for Doubttui Accounts
Technique
Calculation
Example
1. Compare Cumulative Bad Debt Expense
(ZBDE) to Cumulative Write-Otfs (2W0)
over a iVIultiyear Period
IßDE -:- ZWO
($101 + 107 4 82) -^ ($84 4- 77 4 105) =
2. Compare Each Years Beginning-ofYear Ailowance tor Doubttui Accounts
(BADA) to Tbat Year's Write-Otfs (WO)
BADA -:- WO
3, Assess the Aliowance Exhaustion
Rate—Number of years until beginning
allowance (BADA) is completely utilized in
the form of write-otts (WO)
Benchmark'
For 2006 through 2008
1.0 for a multiyear
for 2008
1.0 to 2.0 tor a
typicai year
{$126-$105) = 1.20
Start with BADA for year /
(BADAi). Subtract each year's
annuai WD from BADA, untii
BADA, is exhausted. Divide
remaining ailowance at beginning
ot finai year by write-offs in that
year to compute partial year.
Using 2007 as year /
Unusedatendot1styear:$96-- $ 7 7 - $19
2nd year (partiai year): Remaining $19 is
utilized in 0.18 (S19 -- $105) year.
2007 BADA is exhausted in1.18(1 + 0.18)
years.
1 to 2 years
'These benchmarks represent the authors' opinions of reasonable resuits for each of the metrics demonstrated above. These benchmarks could differ based
on specific circumstances. Therefore, they should only be viewed as broad guideiines.
Accountants have typically reiied on accounts receivable aging as the primary tool
lor evaluating coilectibility. Aging allows
companies to generate estimates of uncollectible accounts at specific times. However, the technique does nol consider the accuracy of past estimates, as mandated by
SAS no. 57. An analysis of historical trends
can provide useful information about an en-
tity's past accuracy and possible biases in estimating its allowance for doubtful accounts.
TECHNIQUES FOR ANALYZING
THE ESTIMATE-GENERATING
PROCESS
Exhibit 1 uses three years of data from Dell
Inc. to descrilje three simple techniques for
assessing past estimates of the allowance for
EXECUTIVE
w Aging is the most common
technique used to value receivabies. However, several other
analysis techniques can provide
insight regarding Ihe accuracy of
prior estimates and the effectiveness of the estimation process.
• Comparing bad debt
expense each year to writeoffs during that year is one
measure of the accuracy of bad
debt estimates. Calculating the
ratio over multiple periods, rather
www.journalofaccountancy.com
than a single year, provides the
most useful information.
• Comparing the beginning allowance for doubtful accounts
to subsequent write-offs
determines the adequacy of the
existing allowance. Lower ratios
Indicate the allowance may be
too low, while higher ratios may
signify the accumulation of excessive allowances.
• The allowance exhaustion
rate is the amount of time it
doubtful accounts. Because ihe techniques
use historical data, ihey give an indication
of the effectiveness of past eslimales. After
they are described, the techniques are
demonstrated using data from three technology companies—Dell, Apple Inc., and
Cisco Systems Inc.—that exhibit markedly différent historical patterns in the estimation and use of their allowances for
SUMMARY
takes to write off an allowance. A
corporation may be accumulating excessive allowances if it
takes several years to exhaust its
allowance for doubtful accounts
receivable balance.
• Evidence suggests that
some companies have great
difficulty in estimating coNectibility. Accountants potentially benefit by using additional tools that
shed light on the accuracy of
past estimates.
Mark E. Riley (meriley@niu.edu) is
an assistant professor at Northern
Illinois University. William R.
Pasewark (w.pasevi'ark@ttu.edu)
is the Webster Professor of
Accounting at Texas Tech University.
To comment or} this article or to
suggest an idea for another
articie, contact Kim Nilsen,
editorial director, at knllsen^
aicpa.org or
919-402-4048.
September 2009 Journal of Accountancy 41
BUSINESS
&
INDUSTRY/AUDITING
Exhibit 2 Analyzing Dell's Estimates of Uncollectible
Accounts Receivable
Multiyear
measure
standard
deviation of
singie-year
measures
Metric
2000
2001
2002
2003
2004
2005
2006
2007
2008
BDE/WO
1.93
1,81
0.98
1.08
1.27
0,94
1.20
1.39
0,78
1.15*
0.39-•
BADA/WO
2.00
1,42
1.73
1.89
1.48
1.26
0.94
1.25
1.20
1.46*"
0.35"
BADA Exhaustion
Rate {years)
1.48
1.33
1.81
1.67
1.35
1.20
0.94
1.18
" "
N/A
N/A
' Multiyear measure of BDE/WO is computed by dividing the sum of bad debt expense recorded from 2000 to 2008 by tfie sum of write-offs for ttie same
period. BOE/WO for each individual year is computed by dividing bad debt expense for each year by write-offs for the same year.
* * Represents standard deviation of nine individual year figures for the period 2000 to 2006.
* * * Multiyear measure of 8ADA/W0 is the average oí the nine annual BADA/WO ratios for the period 2000 to 2008.
* " * Exhaustion rate cannot be determined because the entire beginning allowance for doubtful accounts has not been utilized (in the form of write-offs).
Exhibit 3 Analyzing Apple's Estimates of Uncollectible
Accounts Receivable
Metric
2000
2001
2002
2003
2004
BDE/WO
0.56
0.35
1.00
0.67
0-60
BADA / WO
7.56
3.20
5.10
8.50
9.80
BADA Exhaustion
Rate (years)
6.32
6.18
5.59
6.00
2005
2006
2007
0.89
1.55
0.71
1.00
5.22
4.18
3.06
15.67
2008
Multiyear
measure
Standard
deviation ot
single-year
measures
0.77"
0.35"
6.92-••
4.03"
N/A
N/A
' Multiyear measure ot BDE/WO is computed by dividing the sum of bad debt expense recorded from 2000 to 2008 by the sum of write-offs for the same
period, BDE/WO for each individual year is computed by dividing bad debt expense for each year by write-offs for the same year.
• ' Represents standard deviation of nine individual year figures for ttie period 2000 to 2008.
• " Multiyear measure of BADAAVO is the average of the nine annual BADA/WO ratios for the period 2000 to 2008.
" "
Exhaustion rate cannot be determined because the entire beginning allowance for doubtful accounts has not been utilized (in tfie form of write-offs).
doLibiful accounts. All data used in this article is available in these companies' filings
al secgov.
Technique I: Compare bad debt expense (BDE) to write-offfi (WO). Bad debt
expense recorded in a specific year implies
the necessity for write-offs during that year
and subsequent years. While it is unrealistic to expect estimated bad debt expense
to perfectly match actual write-offs in a
given year, il is reasonable to expect the
ratio of bad debt expense to write-offs to
be close to 1.0 over an extended period.
Ratios calculated for multiple years that
are substantially lower than 1.0 might sug-
42 Journal of Accouniancy
Soplemher 2009
gest the entity tends to underestimate the
impact of collection problems. On the
other hand, multiple-year ratios that significantly exceed 1.0 may signal that the
entity is accumulating an excessive allowance. In addition, inspecting the individual year bad-debt-expense-to-write-offs
ratios, as well as the standard deviation of
those measures, can give a sense of the
consistency of the relationship between
these two figures over time. A standard deviation that is relatively low, when compared vnth the multiyear mean, is an indication of consistency.
Technique 2: Compare beginning al-
lowance for douhtju} accounts (BADA) to
write-offs (WO). This ratio is computed
each year using the beginn ing-of-year
allowance for doubtful accounts as the
numerator and write-offs of accounts receivable recorded during the year as the
denominator. The beginning-allowanceto-write-offs ratio indicates how adequately the allowance accommodated
subsequent write-offs. Lower ratios suggest
the beginning-of-year allowance may not
have been large enough to absorb impending write-ofTs, while inordinately high
ratios might indicate the entity was accumulating excessive allowances.
www.journalofaccountancy.com
BUSINESS
&
INDUSTRY/AUDITING
Exhibit 4 Analyzing Cisco's Estimates of Uncollectible
Accounts Receivable
Metric
BDE/WO
BADA / WO
ZOOO
1,67
BADA Exhaustion
Rate (years)
1.13
1.13
2001
11.65
1.87
2002
2.07
6.55
1.45
2003
-0.63
3,60
2004
0,83
7,96
2005
0,00
10.53
2006
2.18
14,73
2007
0.40
11.67
2008
1.48
7.22
'"
**"
" "
'**'
"**
" "
Multiyear
measure
1.55'
7.25"'
N/A
standard
deviation ot
single-year
measures
3.68"
4.57"
N/A
' Multiyear measure of BDE/WO is computed by dividing the sum of bad öebt expense recorded from 2000 to 2008 öy the sum of write-offs for the same
period. BDE/WO for each individual year is computed by dividing bad debt expense for each year by write-offs for the same year,
* * Represents standard deviation of nine individual year figures for the period 2000 to 2008,
' * ' Multiyear measure of BADAA/VO is the average of the nine annual BADA/WO ratios for the period 2000 to 2008,
" * " Exhaustion rate cannot be determined because the entire beginning allowance for doubtful accounts has not been utilized {in the form of write-offs).
U is useful 10 examine boih the mean
and standard deviation of the beginningallowance-to-write-offs ratio over a period
of several years. The tnean can be compared to the benchmark figure of one to
Lwo years to determine whether a firm's allowance for doubtful accounts balance is
reasonable in relation to subsequent writeoffs. Meanwhile, the standard deviation of
the ratio measures volatility. A relatively
low standard de\'iation, in comparison to
ihe multiyear mean, signals consistency A
relatively high standard deviation indicates
a volatile relationship between the allowance and subsccjuent write-offs.
Technique 3: Assess the allowance exhciustion rate. Exhaustion rates indicate
[he time (expressed in years) taken to use
the beginning-of-year allowance in the
form of actual write-offs. For example, a
company vvdth a beginning allowance for
doubtful accounts of Î I million in year
one, and write-offs of $700,000 in year
one and $600,000 in year lwo would exhausi its allowance in 1.5 years ($1 million - $700,000 = $300,000 left for the
next year; $300.000 - $600,000 = 0.5
years),
T\m TECHNIQUES IN ACTION
rhe three example corporations, Dell,
,\pple and Cisco—all manufacturers in the
high-tech industry—exhibit very different
www.journalofaccountancy.com
patterns when estimating coUectibiiity and
establishing allowances.
Dell's bad-debt-expense-to-write-off
ratio (see Exhibit 2) for ihe nine years from
2000 to 2008 is 1.15, which is reasonably
close to the benchmark of 1,0. Although
Dell exhibited two years of possible overestimation in relation to actual write-offs
in 2000 and 2001, the company has more
closely matched bad debi expense wiih
write-offs since 2002,
deviation of Dell's beginning-allowance-towrite-offs ratio over nine years is a relatively low 0-35, indicating a good deal of
consistency in ihe relationship between the
allowance for doubtful accounts balance
and subsequent write-offs.
On average, Apple's bad debt expense
(see Exhibit 3) has been significantly lower
than Its write-ofTs for the past nine years.
The muUiyear bad-debt-expense-to-wTiteoff ratio of 0,77 shows that Apple's bad
While economic circumstances vary,
historical trends provide useful information about
the process used to form estimates.
Interestingly, Dell's bad debt expense
increased over the past few years. Dell's increased write-off activity in the past few
years is likely evidence that the higher expenses are warranted. In fact, write-offs
during the pasl four years are only slighlly lower than the beginning balances in
Dell's allowance for doubtful accounts, indicating that Deli has been successful at
predicting anticipated vmte-offs. This conclusion is reinforced by Dell's beginningallowance-to-write-offs ratio and its exhaustion rate, both of which indicate Dell
tends to exhaust its allowance in a little
over one year. In addition, the standard
debt expense for the nine years has fallen
short of ihe write-offs it recorded over the
same period.
However, the beginning-allowance-towrite-offs ratio and exhaustion rates indicate that Apple's allowance for doubtful accounts was exceedingly high prior lo
2000. On average, Apple had a beginningof-lhe-year allowance for doubtful accounts that was almost seven times higher than annual write-offs from 2000 to
2008. The inconsistency in ihe relationship between Apple's allowance balance
and write-offs is evidenced by the high, relative to ihe mean, standard deviation of
September 2009 Journal of Accountancy 43
BUSINESS
ihm ratio over the period. This inference of
inconsistency is confirmed upon review of
ihe wide range (from lows of 3.20 in 2001
and 3.06 in 2007 to a high of 15.67 in
2008) exhibited by Apple's beginning-allowance-to-write-offs ratio over the period.
By recording cumulative bad debt expense that fell short of write-offs over the
past nine years, Apple has taken steps to
adjust its allowance downward over time.
However, Apple does noi appear to have
completely eliminated its excess allowance. Apple's annual write-offs continue, even in 2007 and 2008, to fall far
short of ils beginning allowance.
Apple's exhaustion rale data is particularly informative. The analysis indicates
that Apple maintains an extraordinarily
large allowance for doubtful accounts. As
&
INDUSTRY/AUDITING
to correct ihe estimation problem in 2003
by recognizing a negative expense, the large
bad debt expense recorded in 2002 remained untapped (in the fomi of write-offs)
as of 2008. The atialyses indicate that Cisco
and its auditors might want to consider the
reasons an allowance of this magnitude was
recorded and whether those or other reasons
continue tojustify Cisco's current allowance.
Cisco's estimation history wiih respect lo the
allowance for doubtful accounts illustrates
the potential for overestimates of bad debt
expense to have long-lasting effects.
IMPLICATIONS OF THE
ANALYSIS
Assessing the effectiveness of past estimates provides a potential basis for confidence in future estimates. The techniques
Auditors should keep in mind that accounting
estimates, such as the allowance for doubtful
accounts, can be used to manage earnings.
of the end of 2008, Apple had not yet exhausted the allowance that was in place at
the beginning of 2004. These analyses indicate a possible need for Apple and its auditors to critically re-examine the estimation process.
A review of the bad-debt-expense-towrite-off ratio for Cisco Systems (see Exhibit
4) indicates the relationship Í>etween bad
debt expense and write-oifs has been highly erratic. Cisco's estimation challenges
might be linked to the Internet bubble of
ihe early 2000s. Possibly in anticipation of
customer nonpayment associated with the
bursting of the Internet bubble, Cisco recognized an exceptionally large bad debt expense in 2001 and, to a lesser extent, 2002.
Subsequent write-offs were relatively
small. Similar to Apple, Cisco's beginningallowance-to-write-offs ratio over the nineyear period indicates possibly excessive
allowances. In addition, the rano reveals an
inconsistent relationship between the balance in ihe allowance for doubtful accounts
and later write-offs.
Although an apparent auempt was made
44 Journal of Accounlancy
Septemher 200*^
illustrated in ibis article are designed to
help with and clarify assessment of an entity's past success in estimating its allowance for doubtful accounts. While economic circumstances vary, historical
trends provide useful information about
the process used to form estimates.
in our analysis used the allowance for
doubtful accounts to intentionally misstate
or manipulate any financial results.
However, auditors should keep in mind
that accounting estimates, such as the allowance for doubtful accounts, can be
used to manage earnings. For example, a
company might opportunistically reduce
the allowance in a period of reduced earnings. Auditors are wise to weigh all available evidence, including data related to
prior estimates and the client's current financial condition, when a client proposes a substantial reduction in or increase to
its allowance for doubtful accounts.
A broader look at the industry in which
Apple, Cisco and Dell operate reveals that
estimating the allowance for doubtful accounts is not an easy task. In examining
data for fiscal years starting in 2000 and
ending in 2007 for 111 firms (eight annual
observations per firm, or 888 observations
in total) in the industrial and commercial
machinery and computer equipment
group (two-digit SIC code 35), we found
that 21.1% of corporations had surprisingly large allowances. This group included 65 instances in which firms recorded either negative or no write-oiTs during
the year and 123 cases in which the
BADAAVO ratio was 10.0 or higher.
We noted allowances that were possibly inadequate in almost 5% of the fimi
years we examined, finding 44 cases in
which annual write-offs exceeded the begitining allowances for the years in wbich
the write-offs occurred. Initial results of
our research indicate that such inconsistencies in the relationship between the beginning allowance for doubtful accounts
and the amount of write-offs taken during
the year exist in other industries as well.
AU section 342.04 states that estimates'
subjective nature makes these decisions
vulnerable to bias and that such bias is likely to be present under any economic conditions. If prior trends suggest that an audit
client has regularly over- or underestimated its allowance, but has not done so in an
effort to manipulate net income or financial ratios, then the treatment under FASB
Statement no. 154, Accouniing Changes anJ
It is crucial for accounting professionError Corrections, is clear. The adjustment als to use all available tools to understand
is considered a change in estimate and is the effectiveness of pasl estimates and
accounted for prospectively.
maintain the confidence of financial stateOn the other hand, if prior misstale- ment users in the stated net receivables.
ments oí the allowance were material lo The techniques demonstrated in this artithe financial statements as a whole and cle will help auditors comply with SAS no,
were intentional, a restatement of prior pe- 57 and assess clients' current allowances
riods is required. We're aware of no evi- by providing valuable iníonnation aboui
•
dence indicating that any of the companies the accuracy of past estimates.
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Everything You Need to Know About the Time Value of Money
4.4 Computing a Project’s Modified Internal Rate of Return ............................................................. 53
4.5 Section Summary .......................................................................................................................... 55
5. Valuing Debt Instruments ..................................................................................................... 56
Glossary ....................................................................................................................................... 61
Additional Resources .................................................................................................................. 66
About The Author ....................................................................................................................... 67
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5
1. Simple versus Compound Interest
To begin this section, watch this two-part video series on interest:
https://www.khanacademy.org/economics-finance-domain/core-finance/interest-tutorial/interestbasics-tutorial/v/introduction-to-interest
https://www.khanacademy.org/economics-finance-domain/core-finance/interest-tutorial/interestbasics-tutorial/v/interest--part-2
Simple interest is the amount of interest determined on the principal balance only. If we put
$10,000 in the bank for two years and earn 3% interest on it, we use the following formula to
calculate the amount of interest:
Interest = Principal x Rate (annual rate) x Time (in terms of years)
So, Interest = $10,000 x .03 x 2 = $600
We receive interest for each year based on the $10,000 alone.
With compounded interest, we receive interest on the interest. So, at the end of the first year,
we would have earned one year of interest, or $10,000 x .03 x 1 = $300. We now have $10,300
in the bank. So at the end of Year 2, our interest will change to $10,300 x .03 x 1 = $309. The
total interest earned over the two years is $609, instead of $600 under simple interest.
Ideally, we will receive interest on interest if we are putting money into an investment, but only
pay simple interest if we are talking about a loan. That is rarely the case, however, and we will
see that compounded interest applies to most real-world business scenarios.
One problem arises when we are dealing with several years, where a manual calculation is tedious.
Instead of using manual calculations repeatedly, we can use time value of money tables. There are five
different, but related, tables.
Click on the following items to learn more about the five time value of money tables.
Future Value of 1
Present Value of 1
Future Value of an Ordinary Annuity of 1
Present Value of an Ordinary Annuity of 1
Present Value of an Annuity Due of 1
The tables are lengthy and covered in this week’s reading in your textbook. Below is an excerpt
of what a table might look like:
Kieso, Weygandt, & Warfield, 2016
The period is the number of periods we are looking at, and the percent is the interest rate, which
is usually referred to as the discount rate in the context of discussing time value of money. So, if
we want to know how much we would have if we put $10,000 in the bank for three years at 10%,
we would have to begin by going to the row that has period = 3 and the column with 10% on top.
This would give us a table factor of 1.33.
Other terminology with which you should be familiar pertains to the number of times that
interest compounds; this means, how many times interest is calculated and paid during the year.
Here is a table that breaks down the number of times with the term:
Annually
1 time a year
Semi-annually
2 times a year
Quarterly
4 times a year
Monthly
12 times a year
Daily
365 times a year
\
2. Time Value of Money Calculations
Now that you have been introduced to the differences between simple and compound interest and
have learned about the tables, you are ready to learn the steps for calculating the future or present
value of either a lump sum or type of annuity. Here are the basic steps for time value of money
problems.
Practice
Now practice what you just learned. Work on the following exercise, which is similar to what
you might find in the Critical Thinking assignment for this week.
What is the future value of $20,000 deposited now that will compound semi-annually for two
years at 16%?
Following the four steps above, we have:
Step 1 16%/2 times per year = 8% per period
Step 2 2 years x 2 times per year = 4 periods
Step 3 Going to the row for 4 periods and the column for 8%, the table factor is 1.36049
Step 4 $20,000 x 1.36049 = $27,209.80
These steps are the same whether we are looking at future value or present value. Let’s try
another calculation, looking at a sample of present value of a lump sum:
I would like to have $10,000 for a down payment on a home in five years. I can earn 9% on my
funds, so how much would I need to put in the bank to have that much available in the future?
Following the four steps, we have:
Step 1 9%/1 time per year = 9% per period
Step 2 5 years x 1 time per year = 5 periods
Step 3 Going to the row for 5 periods and the column for 9%, the table factor is .64993
Step 4 $10,000 x .64993 = $6,499.30
Annuities will follow similar steps as listed above, except that Step 4 for an ordinary annuity will
change to:
Step 4 Using your answer to Step 3, take the Table Factor x Payment Amount Given = Future
or Present Value
Let’s look at a type of annuity scenario you may encounter:
If I put $10,000 in the bank at the end of each year for the next four years at a 10% return,
compounded annually, how much will I have at the end of the four years?
Following the four steps, we have:
Step 1 10%/1 time per year = 10% per period
Step 2 4 years x 1 time per year = 4 periods
Step 3 Going to the row for 4 periods and the column for 10%, the table factor is 4.64100
Step 4 $10,000 x 4.64100 = $46,410.00
In the scenario above, we are depositing at the end of each period. If, instead, we are depositing
at the beginning of each period, we will have exactly one full extra year of interest, so there is an
addition to Step 3. The new Step 3 will be:
Step 3 Using your answers to Step 1 and Step 2 above, go to the applicable table and locate the
table factor. Take the table factor x (1 + interest rate for 1 year) to get the annuity due table
factor. Then proceed to Step 4 as normal.
Let’s look at the preceding data and complete the four steps for an annuity due now:
Step 1 10%/1 time per year = 10% per period
Step 2 4 years x 1 time per year = 4 periods
Step 3 Going to the row for 4 periods and the column for 10%, the table factor is 4.64100; now
multiply that by (1+.10), so 4.64100 * 1.10 = 5.1051
Step 4 $10,000 x 5.1051 = $51,051.00
To calculate the present value of an annuity, you would instead look at a desired stream of
payments in the future and figure out how much to put away now in order to have that amount
available in the future. The steps for an ordinary annuity are the same as before. A good example
follows:
How much money would need to be deposited now to have $5,000 a year at the end of the year
for the next five years at an interest rate of 8%?
Following the four steps, we have:
Step 1 8%/1 time per year = 8% per period
Step 2 5 years x 1 time per year = 5 periods
Step 3 Going to the row for 5 periods and the column for 8%, the table factor is 3.99271
Step 4 $5,000 x 3.99271 = $19,963.55
The other alternative to an ordinary annuity, as mentioned previously, is an annuity due. The
same change is made as before—adding the interest rate factor to 1 and then multiplying that by
the table factor in Step 3. Instead of doing that, you can also use the present value of an annuity
due table (below) and redo this same problem.
Following the four steps, we have:
Step 1 8%/1 time per year = 8% per period
Step 2 5 years x 1 time per year = 5 periods
Step 3 Going to the row for 5 periods and the column for 8%, the table factor is 4.31213. If you
go to the preceding table, recall that the table factor was 3.99271, and we could instead multiply
this by (1 + .08) or 1.08, which would equal 4.31213.
Step 4 $5,000 x 4.31213 = $21,560.63
Time value of money also can be used for more complex situations. One such situation involves
bonds and calculating the bond issuance price. Bonds have a stated rate on them that will net
different prices depending on what the market is doing. For example, if the market rate is higher
than our stated rate, that means investors can get more in the market elsewhere, so we need to
discount our bonds; that is, put them on sale at a lower price in order to entice investors to buy
them. The opposite also holds true. If the bonds are paying more than the market value, we can
charge a premium price. Here are the steps for calculating the bond issuance price:
Step 1 Determine the amount of periodic interest actually paid by the bonds by calculating the
Principal x Rate x Time. Make sure to use period of time based on when the interest is paid and
the stated interest rate for that period of time. For example, if we are talking about semiannual
interest payments, time will be half a year and the stated rate will be one half of the stated annual
rate. Note that the stated rate is used only to determine the amount of interest paid on the bonds.
Step 2 Determine the market interest rate per period (also referred to as the yield rate) and the
number of periods. Using these two numbers, go to the present value of an ordinary annuity table
and find the table factor. Note that the market rate is used only to determine present values.
Step 3 Multiply the Interest Payment per Period from Step 1 x Table Factor from Step 2. This is
the present value of the interest payments for the bonds.
Step 4 Using the same market interest rate per period and the number of periods for the market
rate in Step 2, go to the present value of 1 table and locate the table factor. This is the present
value of the maturity value of the bonds.
Step 5 Multiply the Table Factor from Step 4 x Principal Amount of the bond that will be paid
back.
Step 6 Add the answer to Step 3 + Step 5 to get the bond issuance price. Thus, the issuance
price of the bonds is the present value of the interest payments plus the present value of the
maturity value.
3. Cash and Receivables
A category on the balance sheet that is considered the most liquid under current assets is cash
and cash equivalents. The cash piece is obvious, but cash equivalents is not always so obvious.
Basically, cash equivalents include the highly liquid investments that can or will be very easily
converted into cash within a short period of time. The typical threshold for cash equivalents is
three months or 90 days. Examples include money market funds, treasury bills, and commercial
paper.
The cash category will not normally include restricted cash that has been set aside for a specific
purpose or compensating balances. It should also not be negative, so if any bank account gets
overdrawn, that negative balance should be included in the current liabilities section, not
subtracted from the positive balances in other bank accounts.
When we sell an item, we will very often have our customer put this "on account,” generating an
account receivable that will be due to us. We post this receivable at the amount of the exchange,
but very often, there may be potential discounts involved. One such discount is the cash
discount—a percentage that might be taken off if the invoice is paid quickly. Invoices will show
the terms in a format similar to this:
2/10 n/30
What this means is that 2% can be taken off if paid within 10 days, and the invoice has an
original due date of 30 days from the date. The company will decide on the terms, but this is a
popular one. There are two different methods that can be used in handling these discounts:
•
Gross Method – Assumes up front that the discount will not be taken, and so accounts
receivable is debited and revenue is credited for the full amount owed. When payment comes
in, if the discount is taken, then cash is debited for the amount received, the receivable is
credited for the amount originally debited, and the difference is a debit to sales discounts, which
is a contra revenue account representing a reduction in gross revenue.
•
Net Method – Assumes up front that the discount is taken, and so accounts receivable is
debited for the amount of the sale less the discount, and revenue is credited for the same
amount. When the payment comes in within the discount period, the accounts receivable is
credited for that amount. If the client does not take advantage of the discount, then the
accounts receivable is credited for the discounted amount, cash is debited for the higher
amount received, and a credit is recorded in the account sales discounts forfeited, which
represents an increase to revenue.
Bad debt is a common problem in many companies. The matching principle tells companies that
they need to match revenue with their applicable expenses in the same time period. This is
complicated when it comes to bad debt, because most often we don’t know who won’t pay until
months down the road. Consequently, a company needs to estimate this bad debt in the period
that the sale is made using the allowance method instead of waiting until an account is known to
be uncollectible. This also results in reducing the total value of accounts receivable to its net
realizable value (NRV). U.S. GAAP requires that the balance sheet value of accounts receivable
represents the net amount the company expects to collect (NRV), not the gross amount that
customers owe. Let’s first look at the two methods of recording uncollectibles using this
allowance method in which we can estimate bad debt based on either the percentage of sales
approach or the percentage of receivables approach, whichever we think would give a better
estimate. Let’s look at each of these in more detail:
•
Percentage of Sales Approach – This approach takes the sales for the period and multiplies that
by some determined estimated percent. The journal entry to record this estimate is:
Debit Bad Debt Expense
$X
Credit Allowance for Doubtful Accounts
$X
As bad debt comes in, we debit the allowance account and credit the applicable accounts
receivable. We do not consider the existing allowance balance because we are basing our
estimates on the sales.
•
Percentage of Receivables Approach – This approach takes the receivables for the period and
multiplies that by some determined estimated percent. The journal entry to record the estimate
is the same as above. What is different, however, is that this amount tells us what the allowance
balance should be, so the amount that we actually write off will be based on the existing
balance in the allowance account and what it should be. For example, if the allowance account
has a $1,000 credit balance, and our percent of receivables method estimates that $3,000
should be the allowance balance, then the journal entry will only be for $2,000 to adjust for the
difference.
Now let’s look at a couple of other journal entries related to bad debt:
•
When we determine that a customer actually won’t pay:
Debit Allowance for Doubtful Accounts
$X
Credit Accounts Receivable
•
$X
If a customer pays on an account that we had previously written off:
Debit Accounts Receivable
$X
Credit Allowance for Doubtful Accounts
$X
(to write back up the account)
Debit Cash
$X
Credit Accounts Receivable
$X
(to record the payment received)
Now, practice using an example that is similar to Option 1 of the Critical Thinking
assignment for this week.
Manilow Corporation operates in an industry that has a high rate of bad debts. Before any yearend adjustments, the balance in Manilow’s accounts receivable account is $555,000, and the
allowance for doubtful accounts has a credit balance of $40,000. The year-end balance reported
in the balance sheet for the allowance for doubtful accounts will be based on the aging schedule
shown below:
Days Account Outstanding Amount Probability of Collection
Less than 16 days
$300,000
.98
Between 16 and 30 days
$100,000
.90
Between 31 and 45 days
$ 80,000
.85
Between 46 and 60 days
$ 40,000
.80
Between 61 and 75 days
Over 75 days
•
•
•
$ 20,000
$ 15,000
.55
.20
What is the appropriate balance for the allowance for doubtful accounts at year end?
Show how accounts receivable would be presented on the balance sheet.
What is the dollar effect of the year-end bad debt adjustment on the before-tax income?
Solution:
(a) The allowance for doubtful accounts should have a balance of $57,000 at year end. The
supporting calculations are shown below:
Days Account
Outstanding
Amount
Expected
Percentage
Uncollectible
Estimated Uncollectible
0–15 days
$300,000
.02
$ 6,000
16–30 days
100,000
.10
10,000
31–45 days
80,000
.15
12,000
46–60 days
40,000
.20
8,000
61–75 days
20,000
.45
9,000
Over 75 days
15,000
.80
12,000
Balance for Allowance for Doubtful Accounts
$57,000
(b)
Accounts receivable
Less: Allowance for doubtful accounts..
Accounts receivable (net)
$555,000
57,000
$498,000
(c) The year-end bad debt adjustment would decrease before-tax income by $17,000, as
computed below:
Estimated amount required in the Allowance
for Doubtful Accounts
Balance in the account after write-off of uncollectible
accounts but before adjustment
Required charge to expense
$57,000
40,000
$17,000
Some small businesses that do not have a material amount of receivables may use the direct
write-off method instead of the allowance method. Under this method, we record bad debt
when we actually know a customer won’t be paying us. This does not follow the matching
principle, because most of the time the bad debt is recorded in a later period, so this is not an
acceptable method under GAAP.
Notes receivable represents money that we expect to receive in the future, is usually based on a more
formal contractual agreement than accounts receivable, and is associated with some predetermined
interest rate. The contractual agreement is referred to as a promissory note. The general rule is that we
record notes receivable at the present value of the cash we expect to actually collect. In order to figure
out the present value of a note, we follow similar steps as for bonds, as covered earlier in this lecture.
Click each tab below to learn more about the three steps involved in determining the present
value of a note.
Step 1
Find the table factor in the Present Value of 1 table for the interest rate, at the market rate, and for the
number of periods. Multiply this table factor by the principal to be received.
Step 2
Find the table factor in the Present Value of an Ordinary Annuity table for the interest rate, at the
market rate, and for the number of periods. Multiply this by the interest payment required using the
stated rate.
Step 3
Add your two answers for Steps 1 and 2 and deduct this from the principal amount of the note to get
the difference that is put into the discount account.
Then as payments come in, we reduce the discount account by the amount we determine to be
amortized by multiplying the prior carrying value of the note by the market rate of interest. We
take the difference between this and the cash received to figure out how much of a discount to
take.
We have to be concerned with the valuation of receivables because they are an important piece
of our balance sheet. We need to make sure that if we have pledged them, or factored them, that
we then account for this correctly within the financial statements. We also might have sales with
or without recourse, and it is important that we record this correctly as well. If we give some type
of guarantee, we need to consider it when we are figuring out our loss (or gain) on the sale of
receivables.
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