ACCOUNTING - CLUTCH CH. 7 - RECEIVABLES AND INVESTMENTS.

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2 CONCEPT: TYPES OF RECEIVABLES Receivables are that represent money owed to the company Accounts Receivable amounts owed to the company from On April 1, the company sells $12,000 worth of goods on account to a customer. Notes Receivable amounts owed to the company, generally from customers, but with - A Note Receivable is a formal written with stated terms On April 1, the company sells $12,000 worth of goods to a customer. On April 30, the customer calls to let the company know that she will not be able to pay on time. She offers a 90-day, 6% note in the same amount. Principal and interest are due upon maturity of the note. Interest Receivable interest that has been, but not yet Dividend Receivable dividend that has been, but not yet Trade Receivables are receivables that arise through the normal course of business Generally, trade receivables include and some from customers Non-trade Receivables are receivables that do not arise through the normal course of business Cash Advances to Employees short-term loan to an employee Loans to other companies Page 2

3 CONCEPT: DIRECT WRITE-OFF METHOD When we allow customers to pay us later, there s a chance we will get paid Bad Debt Expense that result from extending credit, but not getting paid Direct Write-off Method takes bad debt expense when the company decides it will not be able to collect - The direct write-off method is!!! - It is easy to use and acceptable for small companies that rarely have bad debt. - This method does not follow the principle Year 1 Credit Sales February Year 2 Deemed uncollectible by the company EXAMPLE: A company sold items on account to three customers: Quick Quinn owes $150, Slow Joe owes $350, and Sketchy Jack owes $500. Quinn paid after two days. Joe paid after six weeks. Sketchy Jack has still not paid and the company has lost contact with Jack. The company deemed his account uncollectible. Journalize these transactions. Sale Transactions Quinn: Slow Joe: Sketchy Jack: Payment Transactions Quinn: Slow Joe: Sketchy Jack: Page 3

4 CONCEPT: NET RECEIVABLES ALLOWANCE FOR DOUBTFUL ACCOUNTS requires the creation of an allowance account to conform with the principle. Bad Debt Expense that result from extending credit, but not getting paid Allowance for Doubtful Accounts a account paired with - The Allowance is an of bad debt in our accounts receivable Year 1 Credit Sales February Year 2 Deemed uncollectible by the company - There are two ways to calculate bad debt expense using the allowance method: 1. Percentage-of-Sales Method Bad debt expense is estimated as a percentage of sales > In this method, you calculate bad debt expense and then find the ending balance in the allowance 2. Aging-of-Receivables Method Ending balance in ADA is estimated based on the of each receivable EXAMPLE: > In this method, you calculate the ending balance in the allowance and then find bad debt expense A company regularly sells items on account. Currently, accounts receivable total $12,000. However, the company estimates that $800 of this amount is uncollectible. Record the journal entry to create the allowance. Net Accounts Receivable = Gross Accounts Receivable Allowance for Doubtful Accounts T-accounts for AR and ADA Page 4

5 CONCEPT: NET RECEIVABLES PERCENTAGE OF SALES METHOD In this method, we estimate a percentage-of- -sales that will be uncollectible. This is bad debt expense. This is considered an approach An exam question will typically give you a percentage of credit sales this is We can use the BASE formula to find the ending balance in the allowance: BB Allowance + Bad Debt Expense Accounts Written Off = EB Allowance EXAMPLE: A company had credit sales totaling $1,500,000 this year. The company has a policy estimating 2% of credit sales to be uncollectible. The Allowance for Doubtful Accounts has a current credit balance of $12,000. What is the journal entry to record this year s bad debt expense? What is the ending balance in the Allowance for Doubtful Accounts? PRACTICE: A company had credit sales totaling $2,000,000 this year. The company has a policy estimating 1.5% of credit sales to be uncollectible. The Allowance for Doubtful Accounts has a current debit balance of $2,000. What is the journal entry to record this year s bad debt expense? What is the ending balance in the Allowance for Doubtful Accounts? Page 5

6 CONCEPT: NET RECEIVABLES AGING OF RECEIVABLES METHOD In this method, we estimate the amount of uncollectible accounts in the balance of AR based on This is considered a approach An exam question will typically give you an aging schedule use this is to calculate - Easier exam questions will tell you the results of the aging schedule this is We can use the BASE formula to find the bad debt expense: BB Allowance + Bad Debt Expense Accounts Written Off = EB Allowance EXAMPLE: A company has gross accounts receivable totaling $100,000. The company estimates the allowance for doubtful accounts based on the following table. If the allowance for doubtful accounts has a credit balance of $1,000, what is the entry to record this year s bad debt expense? Age Amount Percent Uncollectible 1-30 Days $45,000 1% Days $25,000 3% Days $20,000 5% 91+ Days $10,000 20% PRACTICE: A company has gross accounts receivable totaling $150,000. The company uses the aging-of-receivables method to estimate the allowance for doubtful accounts. The company estimates that the amount of uncollectible receivables will be $3,600. Currently, the allowance for doubtful accounts has a debit balance of $800. What is the journal entry to record this year s bad debt expense? Page 6

7 CONCEPT: NOTES RECEIVABLE MATURITY DATE AND INTEREST CALCULATION A note receivable is similar to AR, except that it is supported by a contract Different from AR, notes receivable have a and earn Principal the amount of money loaned (or borrowed) Interest the cost of borrowing the principal - Interest is calculated using the following basic formula: Total Interest = Face Value of Note Annual Interest Rate (Time Factor) EXAMPLE: Find the total interest on the following notes: Terms of Note $1,800, 12%, 90 days Interest Computation $2,000, 8%, 9 months $4,500, 4.5%, 1 year Maturity Date the day the note is with the payment of EXAMPLE: Find the maturity date of a 60-day note issued on July 17. Page 7

8 CONCEPT: NOTES RECEIVABLE ACQUIRING AND DISPOSING A note receivable is generally acquired in two situations: A customer on account is having difficulty paying and needs more time: The Goods Company gets a notice from their regular customer, Consistent Chris, that he will not be able to pay his $15,000 account on its due date of August 1. On that day, Consistent Chris delivered a $15,000, 5%, 120-day note. The company loans out extra cash to earn interest revenue: The Goods Company had $12,000 extra cash on hand at the end of the quarter, which it loaned to Quick Cash International with a 3.5%, 30-day note. On the maturity date of the note, the company will receive the principal plus On April 1, The Goods Company had $12,000 extra cash on hand at the end of the quarter, which it loaned to Quick Cash International with a 3.5%, 30-day note. On April 30, Quick Cash paid the note with interest. Page 8

9 CONCEPT: NOTES RECEIVABLE INTEREST RECEIVABLE ADJUSTING ENTRY Adjusting entries include deferrals, accruals, and depreciation. Accrued Revenues revenues earned before is received. POP QUIZ: Interest Receivable is: a) Expenses b) Liabilities c) Assets d) Revenues There are two important dates for recording accrued interest: The period-ending date The Company interest revenue up to this date, but has not received On June 1, Big Money Company loaned $16,000 to No Cash on terms of 8% annual interest for three months. When preparing the June 30 financial statements, Big Money Company would adjust for interest earned up to that date: Cash Receipt Date The Company receives cash, earns remaining interest revenue, and removes the interest receivable On August 1, No Cash repaid the loan plus interest. Interest Revenue Y1: Interest Revenue Y2: Total Interest Revenue: PRACTICE: On April 15, Holden Company received a 60-day, 12% note in the amount of $10,000 from a customer who was having difficulty paying his account. When preparing the April 30 financial statements, the necessary adjusting entry related to interest would include: a) Debit to Note Receivable for $50 b) Debit to Interest Receivable for $50 c) Credit to Interest Receivable for $50 d) Credit to Note Receivable for $50 Page 9

10 CONCEPT: INTRODUCTION TO INVESTMENTS A company may choose to invest in other companies for two main reasons: Excess Cash invest in debt or equity securities to earn Influence buying enough stock in another company could allow you to influence More than % - Example: Buying stock in supplier to obtain consistent, high quality raw materials for production Security any tradable financial instrument that hold monetary value, representing an ownership or creditor relationship Equity Security ownership interest in a corporation - Examples: and - Equity securities tend to earn income through dividends received and capital gains - Capital Gains increases in the value of the security since its purchase EXAMPLE: You purchase 10 shares of Banana Stock for $400. The company pays a dividend of $1 per share. You sell the Banana Stock when the price has increased to $55 per share. How much income did you earn on your investment? Debt Security money that is borrowed and must be repaid with - Example: When we invest in debt or equity securities of another company, we must classify them into one of three categories: Trading Security investments expected to be sold within the near term through active trading Available-for-Sale Security investments held with the intent of selling them - Basically, AFS do not fit into either of the other two categories Held-to-Maturity Security debt securities that the investor intends to hold until the maturity date Classification Initial Measurement Subsequent Measurement Unrealized Gains/Losses Trading Security Available-for-Sale Security Held-to-Maturity Security Page 10

11 CONCEPT: INVESTMENTS IN TRADING SECURITIES A Trading Security is an investment expected to be sold within the near term through active trading Trading securities earn income from received and changes in Classification Initial Measurement Subsequent Measurement Unrealized Gains/Losses A journal entry is recorded when the trading security is purchased: On November 1, Year 1, ABC Company purchased 500 shares of XYZ Company common stock at a market price of $60 per share. ABC Company expects to sell the securities in the near future. The company earns dividend revenue for any dividends received from the investee: On December 10, Year 1, XYZ Company declared and paid a dividend of $1 per share. Page 11

12 The company takes any unrealized gains and losses on reporting dates Note that the unrealized gains and losses are shown on for trading securities If the market price of the investment has since last revaluation If the market price of the investment has since last revaluation On December 31, Year 1, XYZ Company stock had a market value of $65 per share. On December 31, Year 2, XYZ Company stock had a market value of $50 per share. Page 12

13 The company takes a realized gain or loss on the date of sale Note that the realized gains and losses are shown on for all securities If the selling price of the investment is since last revaluation If the selling price of the investment is since last revaluation On February 12, Year 3, ABC Company sold its investment in XYZ Company stock at a market value of $70 per share. PRACTICE: Reset Company held investments in trading securities with a fair value of $180,000 as of December 31, Reset had originally purchased the investments at a price of $152,000 on January 1, What is the appropriate amount for Reset to report for these investments on its December 31, 2017 balance sheet? a) $180,000 b) $152,000 c) $28,000 gain d) Cannot be determined PRACTICE: Chitty Company often has excess cash on hand to invest. Suppose that Chitty purchases 640 shares of Bang Company common stock at a price of $35 per share. Chitty expects to hold the stock for under three months and then sell it. This purchase occurred on December 9, As of December 31, the market price of Chitty stock had increased to $41 per share. Chitty s journal entry on December 31, 2018 related to the investment in Bang Company stock would include: a) A debit to Unrealized Gain on the Income Statement for $3,840 b) A debit to Investments on the Balance Sheet for $3,840 c) A credit to Unrealized Gain in Other Comprehensive Income for $3,840 d) A debit to Cash for $3,840 Page 13

14 CONCEPT: INVESTMENTS IN AVAILABLE-FOR-SALE SECURITIES An available-for-sale (AFS) security is an investment held with the intent of being sold (but not actively trading) AFS securities earn income from received and changes in Classification Initial Measurement Subsequent Measurement Unrealized Gains/Losses A journal entry is recorded when the available-for-sale security is purchased: On November 1, Year 1, ABC Company purchased 500 shares of XYZ Company common stock at a total price of $40,000. ABC Company intends to sell the investment and has classified them as available-for-sale. The company earns dividend revenue for any dividends received from the investee: On December 10, Year 1, XYZ Company declared and paid a dividend of $1 per share. Page 14

15 The company takes any unrealized gains and losses on reporting dates Note that the unrealized gains and losses are shown on for AFS securities If the market price of the investment has since last revaluation If the market price of the investment has since last revaluation On December 31, Year 1, XYZ Company stock had a market value of $65 per share. On December 31, Year 2, XYZ Company stock had a market value of $90 per share. Page 15

16 The company takes a realized gain or loss on the date of sale Note that the realized gains and losses are shown on for all securities If the selling price of the investment is since last revaluation If the selling price of the investment is since last revaluation On February 12, Year 3, ABC Company sold its investment in XYZ Company stock at a market value of $70 per share. PRACTICE: Reset Company held investments in available-for-sale securities with a fair value of $180,000 as of December 31, Reset had originally purchased the investments at a price of $152,000 on January 1, What is the appropriate amount for Reset to report for these investments on its December 31, 2017 balance sheet? a) $180,000 b) $152,000 c) $28,000 gain d) Cannot be determined PRACTICE: Chitty Company often has excess cash on hand to invest. Suppose that Chitty purchases 640 shares of Bang Company common stock at a price of $35 per share. Chitty classifies the investment as available-for-sale securities. This purchase occurred on December 9, As of December 31, the market price of Chitty stock had increased to $41 per share. Chitty s journal entry on December 31, 2018 related to the investment in Bang Company stock would include: a) A debit to Unrealized Gain on the Income Statement for $3,840 b) A debit to Investments on the Balance Sheet for $3,840 c) A credit to Unrealized Gain in Other Comprehensive Income for $3,840 d) A debit to Cash for $3,840 e) Two of the answers are correct Page 16

17 CONCEPT: HELD-TO-MATURITY INVESTMENT Stated Rate = Market Rate The price of the bond will be the face value Stated Rate < Market Rate The price of the bond will be the face value Stated Rate > Market Rate The price of the bond will be the face value Premium Bonds are initially purchased and the respective journal entry is made: On January 1, 2018, ABC Company purchases $50,000 of 9% bonds payable maturing in five years. Interest is payable semi-annually on January 1 and July 1. The market interest rate was equal to 8%. The bonds were issued at 108. January 1, 2018 Amortization Amount = Total Bond Premium or Discount Total Number of Interest Periods Interest is paid in cash. A journal entry is made for interest revenue and premium amortization: On January 1, 2018, ABC Company purchases $50,000 of 9% bonds payable maturing in five years. Interest is payable semi-annually on January 1 and July 1. The market interest rate was equal to 8%. The bonds were issued at 108. July 1, 2018 Page 17

18 Discount Bonds are initially purchased and the respective journal entry is made: On January 1, 2018, ABC Company purchases $50,000 of 9% bonds payable maturing in five years. Interest is payable semi-annually on January 1 and July 1. The market interest rate was equal to 10%. The bonds were issued at 94. January 1, 2018 Amortization Amount = Total Bond Premium or Discount Total Number of Interest Periods Interest is paid in cash. A journal entry is made for interest expense and discount amortization: On January 1, 2018, ABC Company purchases $50,000 of 9% bonds payable maturing in five years. Interest is payable semi-annually on January 1 and July 1. The market interest rate was equal to 10%. The bonds were issued at 94. July 1, 2018 Page 18

19 CONCEPT: EQUITY METHOD INVESTMENTS When we have significant influence over another company, GAAP requires the use of the equity method No Influence % ownership of common stock use method - If you own just a few shares of a company, you cannot influence any decision-making at that company Significant Influence % ownership of common stock use method - With enough common stock, you can influence who is voted onto the decision-making board of directors Controlling Interest % ownership of common stock use method - With enough common stock, you can sway all the votes and have complete control of the company - Consolidation accounting is beyond the scope of this course The equity method of accounting has four common journal entries that are made: Purchase of Investment when your company purchases enough shares to have significant influence Net Income/Loss of Investee your investment income is based on the net income/loss of the investee Dividends Received dividends received are investment income in the equity method Sale of Investment when you sell your investment, you take a gain/loss - The amount of gain/loss is based on the difference between the selling price and book value A journal entry is recorded when the equity method investment is purchased: On January 1, Year 1, Big Old Company purchased 50,000 shares of Small Boy Company s 125,000 outstanding shares of common stock at a market price of $25 per share. Page 19

20 Investment Income = % Ownership Net Income of Investee The company earns investment income based on their percentage ownership of the investee s net income: On December 31, Year 1, Small Boy Company reported net income of $560,000. The company can also have an investment loss based on their percentage ownership of the investee s net loss: On December 31, Year 2, Small Boy Company reported a net loss of $100,000. The company reduces their investment asset based on their percentage of investee dividends received: In January Year 3, Small Boy Company declared and paid dividends of $420,000. Page 20

21 Use a T-account to keep track of the balance in the Investment Asset account: The company reports a gain on sale of investment if the selling price the book value of the investment: On January 2, Year 3, Big Old Company sold its investment in Small Boy Company for $1,400,000. The company reports a loss on sale of investment if the selling price the book value of the investment: On January 2, Year 3, Big Old Company sold its investment in Small Boy Company for $1,100,000. Page 21

22 PRACTICE: On January 3, Johnson Corp acquired 35% of the outstanding common stock of Small Company for $350,000. For the year ended December 31, Small Company reported net income of $150,000 and paid cash dividends of $70,000 on its common stock. At December 31, the carrying value of Johnson Corp s investment in Small Company under the equity method is: a) $322,000 b) $350,000 c) $378,000 d) $398,000 PRACTICE: On January 4, The Jones Company purchased 35,000 out of the 87,500 outstanding shares of Miller Company for $400,000. During the year, the Miller Company reported net income of $240,000 and paid cash dividends of $60,000, while the Jones Company reported net income of $450,000 and paid cash dividends of $80,000. What is the carrying value of Jones Company s investment in Miller Company at the end of the year under the equity method? a) $400,000 b) $472,000 c) $496,000 d) None of the above PRACTICE: GT Company owns 9,000 of the 48,000 shares of outstanding common stock of Bell Company. GT Company should account for this investment using the: a) Market method b) Equity method c) Lower-of-cost-or-market method d) Consolidation method Page 22