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. www.journalofaccountancy.com Copyright © 2012. BrainMass Inc. All rights reserved. May not be reproduced in any form without permission from the publisher, except fair uses permitted under U.S. or applicable copyright law. A BrainMass eBook 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 Get More Need to Know Books at http://www.brainmass.com/needtoknow/ EBSCO Publishing : eBook Collection (EBSCOhost) - printed on 2/27/2017 12:37 AM via COLORADO STATE UNIVERSITY - GLOBAL CAMPUS AN: 529793 ; S., Scott.; Everything You Need to Know About the Time Value of Money Account: ns125356 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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