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2012. What do these ratios indicate about M&S’s financial conditions?
ANSWERS TO IFRS SELF-TEST QUESTIONS
1. b 2. b 3. c 4. b 5. d
Remember to check the book’s companion website to fi nd additional
resources for this chapter.
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Accounting and the
Time Value of Money
1 Identify accounting topics where the time value of 6 Solve future value of ordinary and annuity due
money is relevant. problems.
2 Distinguish between simple and compound 7 Solve present value of ordinary and annuity due
interest. problems.
3 Use appropriate compound interest tables. 8 Solve present value problems related to deferred
annuities and bonds.
4 Identify variables fundamental to solving interest
problems. 9 Apply expected cash flows to present value
measurement.
5 Solve future and present value of 1 problems.
How Do I Measure That?
A significant part of accounting is measurement. And as we discussed in Chapter 2, we have a mixed-attribute measurement
model. That is, many items are measured based on historical cost (e.g., property, plant, and equipment, inventory), but
increasingly accounting measurements are based on fair value (e.g., financial instruments, impairments). Determining fair
value of an item is fairly straightforward when market prices are available (Level 1 in the fair value hierarchy). However, when
a market price is not available, accountants must rely on valuation models to develop a fair value estimate (Level 3 of the fair
value hierarchy).
Developing fair value estimates based on a valuation model generally involves discounted cash flow techniques, which
has three primary elements: (1) estimating the amounts and timing of future cash flows, (2) developing probability estimates
for those cash flows, and (3) determining the appropriate discount rate to apply to the expected cash flows to arrive at a fair
value estimate. Seems pretty straightforward, right? Actually, this can be a challenging process when applied to a variety of
complex assets and liabilities for which GAAP requires a fair value estimate.
Many companies, particularly financial institutions, faced this challenge during the financial crisis when securities markets
seized up to the point that valid market prices for investments and loans were not readily available. Major banks, such as HSBC
Holdings, Wells Fargo, and Bank of America, confronted this issue with respect to their mortgage-backed securities and
interest rate swaps used to hedge interest rate risk. Kohl’s Department Stores dealt with a similar situation for its investment
in auction rates securities (ARS). The fair value of ARS is generally determined at quarterly auctions. However, these auctions
failed during the financial crisis, and Kohl’s and other ARS investors were forced to use a valuation model rather than market
prices to determine fair value.
The FASB provides fair value estimation guidance (FASB ASC 820), but the Board also performs ongoing assessment
of whether and to what extent additional valuation guidance is needed. In this regard, the Board established the Valuation
Resource Group (VRG). The VRG is comprised of accounting and valuation professionals, preparers and users of finan-
cial statements, regulators, and other industry representatives. The VRG provides the Board and the FASB staff with
multiple viewpoints on application issues relating to fair value for financial reporting purposes. Here is a sampling of the
issues discussed by the VRG:
• Measurement of contingent consideration in a business combination.
• Incorporating multi-period excess earnings in valuing intangible assets.
• Effects of premiums and discounts in fair value measurements.
RETPAHC 6
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
CONCEPTUAL FOCUS
> The time value of money is fundamental to the
measurement concept in GAAP.
INTERNATIONAL FOCUS
• Determining the carrying amount of a reporting unit when
performing the goodwill impairment test. > The time value of money concept is universal
and applied the same, regardless of whether a |
• Measurement uncertainty analysis disclosures.
company follows GAAP or IFRS.
As indicated, the list of topics is revealing as to the variety
and complexity of the issues that must be addressed in imple-
menting the fair value measurement principle. Discussion of these items by the VRG helped the FASB develop appropriate
approaches for applying fair value guidance to specific examples. For example, with respect to the contingent consideration
topic, the VRG noted that taxes must be considered when developing future cash flow estimates and that, in some cases,
these tax effects are different for assets and liabilities.
The VRG has and will provide good counsel to the FASB with respect to applying the fair value measurement principle.
After studying this chapter, you should have a better understanding of time value of money principles and discounted cash
flow techniques as they are applied in accounting measurements.
Sources: Ernst and Young, “Valuation Resource Group: Highlights of November 2010 Meeting,” Hot Topic—Update on Major Accounting and
Auditing Activities, No. 2010-59 (5 November 2010).
As we indicated in the opening story, as a financial expert in today’s
PREVIEW OF CHAPTER 6
accounting environment, you will be expected to make present and
future value measurements and to understand their implications.
The purpose of this chapter is to present the tools and techniques that will help you measure the present value
of future cash inflows and outflows. The content and organization of the chapter are as follows.
Accounting and the
Time Value of Money
Basic Time Value Single-Sum More Complex Present Value
Annuities
Concepts Problems Situations Measurement
• Applications • Future value of a • Future value of • Deferred annuities • Choosing an
• The nature of interest single sum ordinary annuity • Valuation of long- appropriate
• Simple interest • Present value of a • Future value of term bonds interest rate
• Compound interest single sum annuity due • Effective-interest • Example of expected
• Fundamental • Solving for other • Examples of FV method of bond cash flow
variables unknowns of annuity discount/premium
• Present value of amortization
ordinary annuity
• Present value of
annuity due
• Examples of PV
of annuity
287
288 Chapter 6 Accounting and the Time Value of Money
BASIC TIME VALUE CONCEPTS
In accounting (and finance), the phrase time value of money indicates a relation-
LEARNING OBJECTIVE 1
ship between time and money—that a dollar received today is worth more than a
Identify accounting topics where the
dollar promised at some time in the future. Why? Because of the opportunity to
time value of money is relevant.
invest today’s dollar and receive interest on the investment. Yet, when deciding
among investment or borrowing alternatives, it is essential to be able to compare
today’s dollar and tomorrow’s dollar on the same footing—to compare “apples to apples.”
Investors do that by using the concept of present value, which has many applications in
accounting.
Applications of Time Value Concepts
Financial reporting uses different measurements in different situations—historical cost
for equipment, net realizable value for inventories, fair value for investments. As we
discussed in Chapters 2 and 5, the FASB increasingly is requiring the use of fair values
in the measurement of assets and liabilities. According to the FASB’s recent guidance on
fair value measurements, the most useful fair value measures are based on market prices
in active markets. Within the fair value hierarchy these are referred to as Level 1. Recall
that Level 1 fair value measures are the least subjective because they are based on quoted
prices, such as a closing stock price in the Wall Street Journal.
However, for many assets and liabilities, market-based fair value information is
not readily available. In these cases, fair value can be estimated based on the expected
future cash flows related to the asset or liability. Such fair value estimates are generally
considered Level 3 (most subjective) in the fair value hierarchy because they are based |
on unobservable inputs, such as a company’s own data or assumptions related to the
expected future cash flows associated with the asset or liability. As discussed in the fair
See the FASB
Codification section value guidance, present value techniques are used to convert expected cash flows into
(page 320). present values, which represent an estimate of fair value. [1]
Because of the increased use of present values in this and other contexts, it is impor-
tant to understand present value techniques.1 We list some of the applications of present
value-based measurements to accounting topics below; we discuss many of these in the
following chapters.
PRESENT VALUE-BASED ACCOUNTING
MEASUREMENTS
1. NOTES. Valuing noncurrent receivables and payables that carry no stated interest rate
or a lower than market interest rate.
2. LEASES. Valuing assets and obligations to be capitalized under long-term leases and
measuring the amount of the lease payments and annual leasehold amortization.
3. PENSIONS AND OTHER POSTRETIREMENT BENEFITS. Measuring service cost
components of employers’ postretirement benefi ts expense and postretirement benefi ts
obligation.
4. LONG-TERM ASSETS. Evaluating alternative long-term investments by discounting
future cash fl ows. Determining the value of assets acquired under deferred payment
contracts. Measuring impairments of assets.
1GAAP addresses present value as a measurements basis for a broad array of transactions, such
as accounts and loans receivable [2], leases [3], postretirement benefits [4], asset impairments
[5], and stock-based compensation [6].
Basic Time Value Concepts 289
5. STOCK-BASED COMPENSATION. Determining the fair value of employee services
in compensatory stock-option plans.
6. BUSINESS COMBINATIONS. Determining the value of receivables, payables, liabili-
ties, accruals, and commitments acquired or assumed in a “purchase.”
7. DISCLOSURES. Measuring the value of future cash fl ows from oil and gas reserves for
disclosure in supplementary information.
8. ENVIRONMENTAL LIABILITIES. Determining the fair value of future obligations for
asset retirements.
In addition to accounting and business applications, compound interest, annuity,
and present value concepts apply to personal finance and investment decisions. In pur-
chasing a home or car, planning for retirement, and evaluating alternative investments,
you will need to understand time value of money concepts.
The Nature of Interest
Interest is payment for the use of money. It is the excess cash received or repaid over and
above the amount lent or borrowed (principal). For example, Corner Bank lends Hillfarm
Company $10,000 with the understanding that it will repay $11,500. The excess over $10,000,
or $1,500, represents interest expense for Hillfarm and interest revenue for Corner Bank.
The lender generally states the amount of interest as a rate over a specific period of
time. For example, if Hillfarm borrowed $10,000 for one year before repaying $11,500,
the rate of interest is 15 percent per year ($1,500 4 $10,000). The custom of expressing
interest as a percentage rate is an established business practice.2 In fact, business manag-
ers make investing and borrowing decisions on the basis of the rate of interest involved,
rather than on the actual dollar amount of interest to be received or paid.
How is the interest rate determined? One important factor is the level of credit risk
(risk of nonpayment) involved. Other factors being equal, the higher the credit risk, the
higher the interest rate. Low-risk borrowers like Microsoft or Intel can probably obtain
a loan at or slightly below the going market rate of interest. However, a bank would
probably charge the neighborhood delicatessen several percentage points above the
market rate, if granting the loan at all.
The amount of interest involved in any financing transaction is a function of three
variables:
VARIABLES IN INTEREST COMPUTATION
1. PRINCIPAL. The amount borrowed or invested.
2. INTEREST RATE. A percentage of the outstanding principal.
3. TIME. The number of years or fractional portion of a year that the principal is outstanding. |
Thus, the following three relationships apply:
• The larger the principal amount, the larger the dollar amount of interest.
• The higher the interest rate, the larger the dollar amount of interest.
• The longer the time period, the larger the dollar amount of interest.
2Federal law requires the disclosure of interest rates on an annual basis in all contracts. That is,
instead of stating the rate as “1% per month,” contracts must state the rate as “12% per year” if
it is simple interest or “12.68% per year” if it is compounded monthly.
290 Chapter 6 Accounting and the Time Value of Money
Simple Interest
Companies compute simple interest on the amount of the principal only. It is the
LEARNING OBJECTIVE 2
return on (or growth of) the principal for one time period. The following equation
Distinguish between simple and
expresses simple interest.3
compound interest.
Interest 5 p 3 i 3 n
where
p 5 principal
i 5 rate of interest for a single period
n 5 number of periods
To illustrate, Barstow Electric Inc. borrows $10,000 for 3 years with a simple interest
rate of 8% per year. It computes the total interest it will pay as follows.
Interest 5 p 3 i 3 n
5 $10,000 3 .08 3 3
5 $2,400
If Barstow borrows $10,000 for 3 months at 8%, the interest is $200, computed as follows.
Interest 5 $10,000 3 .08 3 3/12
5 $200
Compound Interest
John Maynard Keynes, the legendary English economist, supposedly called it
LEARNING OBJECTIVE 3
magic. Mayer Rothschild, the founder of the famous European banking firm,
Use appropriate compound interest
proclaimed it the eighth wonder of the world. Today, people continue to extol its
tables.
wonder and its power. The object of their affection? Compound interest.
We compute compound interest on principal and on any interest earned that has
not been paid or withdrawn. It is the return on (or growth of) the principal for two or
more time periods. Compounding computes interest not only on the principal but also
on the interest earned to date on that principal, assuming the interest is left on deposit.
To illustrate the difference between simple and compound interest, assume that
Vasquez Company deposits $10,000 in the Last National Bank, where it will earn simple
interest of 9% per year. It deposits another $10,000 in the First State Bank, where it will
earn compound interest of 9% per year compounded annually. In both cases, Vasquez will
ILLUSTRATION 6-1
not withdraw any interest until 3 years from the date of deposit. Illustration 6-1 shows the
Simple vs. Compound
computation of interest Vasquez will receive, as well as its accumulated year-end balance.
Interest
Last National Bank First State Bank
Accumulated Accumulated
Simple Interest Simple Compound Interest Compound
Year-End Year-End
Calculation Interest Calculation Interest
Balance Balance
Year 1 $10,000.00 × 9% $ 900.00 $10,900.00 Year 1 $10,000.00 × 9% $ 900.00 $10,900.00
Year 2 $10,000.00 × 9% 9 0 0.00 $11,800.00 Year 2 $10,900.00 × 9% 981.00 $11,881.00
Year 3 $10,000.00 × 9% 9 00.00 $12,700.00 Year 3 $11,881.00 × 9% 1,069.29 $12,950.29
$2,700.00 $$$222555000...222999 $2,950.29
DDDiiiffffffeeerrreeennnccceee
3Business mathematics and business finance textbooks traditionally state simple interest as
I (interest) 5 P (principal) 3 R (rate) 3 T (time).
Basic Time Value Concepts 291
Note in Illustration 6-1 that simple interest uses the initial principal of $10,000 to
compute the interest in all 3 years. Compound interest uses the accumulated balance
(principal plus interest to date) at each year-end to compute interest in the succeeding
year. This explains the larger balance in the compound interest account.
Obviously, any rational investor would choose compound interest, if available, over
simple interest. In the example above, compounding provides $250.29 of additional inter-
est revenue. For practical purposes, compounding assumes that unpaid interest earned
becomes a part of the principal. Furthermore, the accumulated balance at the end of each
year becomes the new principal sum on which interest is earned during the next year. |
Compound interest is the typical interest computation applied in business situa-
tions. This occurs particularly in our economy, where companies use and finance large
amounts of long-lived assets over long periods of time. Financial managers view and
evaluate their investment opportunities in terms of a series of periodic returns, each of
which they can reinvest to yield additional returns. Simple interest usually applies only
to short-term investments and debts that involve a time span of one year or less.
What do the numbers mean? A PRETTY GOOD START
The continuing debate on Social Security reform provides a Why start so early? If the government waited until age 18
great context to illustrate the power of compounding. One to deposit the money, it would grow to only $9,906 with an-
proposed idea is for the government to give $1,000 to every nual compounding. That is, reducing the time invested by a
citizen at birth. This gift would be deposited in an account third results in more than a 50% reduction in retirement
that would earn interest tax-free until the citizen retires. As- money. This example illustrates the importance of starting
suming the account earns a modest 5% annual return until early when the power of compounding is involved.
retirement at age 65, the $1,000 would grow to $23,839. With
monthly compounding, the $1,000 deposited at birth would
grow to $25,617.
Compound Interest Tables (see pages 334–343)
We present five different types of compound interest tables at the end of this chapter.
These tables should help you study this chapter as well as solve other problems involving
interest.
INTEREST TABLES AND THEIR CONTENTS
1. FUTURE VALUE OF 1 TABLE. Contains the amounts to which 1 will accumulate if
deposited now at a specifi ed rate and left for a specifi ed number of periods (Table 6-1).
2. PRESENT VALUE OF 1 TABLE. Contains the amounts that must be deposited now at a
specifi ed rate of interest to equal 1 at the end of a specifi ed number of periods (Table 6-2).
3. FUTURE VALUE OF AN ORDINARY ANNUITY OF 1 TABLE. Contains the amounts
to which periodic rents of 1 will accumulate if the payments (rents) are invested at
the end of each period at a specifi ed rate of interest for a specifi ed number of periods
(Table 6-3).
4. PRESENT VALUE OF AN ORDINARY ANNUITY OF 1 TABLE. Contains the amounts
that must be deposited now at a specifi ed rate of interest to permit withdrawals of 1 at
the end of regular periodic intervals for the specifi ed number of periods (Table 6-4).
5. PRESENT VALUE OF AN ANNUITY DUE OF 1 TABLE. Contains the amounts that
must be deposited now at a specifi ed rate of interest to permit withdrawals of 1 at the
beginning of regular periodic intervals for the specifi ed number of periods (Table 6-5).
292 Chapter 6 Accounting and the Time Value of Money
Illustration 6-2 lists the general format and content of these tables. It shows how
much principal plus interest a dollar accumulates to at the end of each of five periods,
at three different rates of compound interest.
ILLUSTRATION 6-2
FUTURE VALUE OF 1 AT COMPOUND INTEREST
Excerpt from Table 6-1
(EXCERPT FROM TABLE 6-1, PAGE 334)
Period 9% 10% 11%
1 1.09000 1.10000 1.11000
2 1.18810 1.21000 1.23210
3 1.29503 1.33100 1.36763
4 1.41158 1.46410 1.51807
5 1.53862 1.61051 1.68506
The compound tables rely on basic formulas. For example, the formula to determine
the future value factor (FVF) for 1 is:
FVF 5 (1 1 i)n
n,i
where
FVF 5 future value factor for n periods at i interest
n,i
n 5 number of periods
i 5 rate of interest for a single period
Gateway to Financial calculators include preprogrammed FVF n,i and other time value of money
the Profession formulas.
Financial Calculator To illustrate the use of interest tables to calculate compound amounts, assume an
and Spreadsheet Tools
interest rate of 9%. Illustration 6-3 shows the future value to which 1 accumulates (the
future value factor).
ILLUSTRATION 6-3
Beginning-of- Multiplier End-of-Period Formula
Accumulation of Period Period Amount 3 (1 1 i) 5 Amount* (1 1 i)n
Compound Amounts |
1 1.00000 1.09 1.09000 (1.09)1
2 1.09000 1.09 1.18810 (1.09)2
3 1.18810 1.09 1.29503 (1.09)3
*Note that these amounts appear in Table 6-1 in the 9% column.
Throughout our discussion of compound interest tables, note the intentional use of
the term periods instead of years. Interest is generally expressed in terms of an annual
rate. However, many business circumstances dictate a compounding period of less than
one year. In such circumstances, a company must convert the annual interest rate to cor-
respond to the length of the period. To convert the “annual interest rate” into the “com-
pounding period interest rate,” a company divides the annual rate by the number of
compounding periods per year.
In addition, companies determine the number of periods by multiplying the number
of years involved by the number of compounding periods per year. To illustrate,
assume an investment of $1 for 6 years at 8% annual interest compounded quarterly.
Using Table 6-1, page 334, read the factor that appears in the 2% column on the 24th
row—6 years 3 4 compounding periods per year, namely 1.60844, or approximately
$1.61. Thus, all compound interest tables use the term periods, not years, to express the
Basic Time Value Concepts 293
quantity of n. Illustration 6-4 shows how to determine (1) the interest rate per com-
pounding period and (2) the number of compounding periods in four situations of
differing compounding frequency.4
ILLUSTRATION 6-4
12% Annual Interest Rate Interest Rate per Number of
Frequency of
over 5 Years Compounded Compounding Period Compounding Periods
Compounding
Annually (1) .12 4 1 5 .12 5 years 3 1 compounding
per year 5 5 periods
Semiannually (2) .12 4 2 5 .06 5 years 3 2 compoundings
per year 5 10 periods
Quarterly (4) .12 4 4 5 .03 5 years 3 4 compoundings
per year 5 20 periods
Monthly (12) .12 4 12 5 .01 5 years 3 12 compoundings
per year 5 60 periods
How often interest is compounded can substantially affect the rate of return. For
example, a 9% annual interest compounded daily provides a 9.42% yield, or a difference
of 0.42%. The 9.42% is the effective yield.5 The annual interest rate (9%) is the stated,
nominal, or face rate. When the compounding frequency is greater than once a year, the
effective-interest rate will always exceed the stated rate.
Illustration 6-5 shows how compounding for five different time periods affects the
effective yield and the amount earned by an investment of $10,000 for one year.
ILLUSTRATION 6-5
Compounding Periods
Comparison of Different
Interest
Compounding Periods
Rate Annually Semiannually Quarterly Monthly Daily
8% 8.00% 8.16% 8.24% 8.30% 8.33%
$800 $816 $824 $830 $833
9% 9.00% 9.20% 9.31% 9.38% 9.42%
$900 $920 $931 $938 $942
10% 10.00% 10.25% 10.38% 10.47% 10.52%
$1,000 $1,025 $1,038 $1,047 $1,052
4Because interest is theoretically earned (accruing) every second of every day, it is possible to
calculate interest that is compounded continuously. Using the natural, or Napierian, system of
logarithms facilitates computations involving continuous compounding. As a practical matter,
however, most business transactions assume interest to be compounded no more frequently
than daily.
5The formula for calculating the effective rate, in situations where the compounding frequency
(n) is greater than once a year, is as follows.
Effective rate 5 (1 1 i)n 2 1
To illustrate, if the stated annual rate is 8% compounded quarterly (or 2% per quarter), the
effective annual rate is:
Effective rate 5 (1 1 .02)4 2 1
5 (1.02)4 2 1
5 1.0824 2 1
5 .0824
5 8.24%
294 Chapter 6 Accounting and the Time Value of Money
Fundamental Variables
LEARNING OBJECTIVE 4
Identify variables fundamental to The following four variables are fundamental to all compound interest problems.
solving interest problems.
FUNDAMENTAL VARIABLES
1. RATE OF INTEREST. This rate, unless otherwise stated, is an annual rate that must be
adjusted to refl ect the length of the compounding period if less than a year.
2. NUMBER OF TIME PERIODS. This is the number of compounding periods. (A period
may be equal to or less than a year.) |
3. FUTURE VALUE. The value at a future date of a given sum or sums invested assuming
compound interest.
4. PRESENT VALUE. The value now (present time) of a future sum or sums discounted
assuming compound interest.
Illustration 6-6 depicts the relationship of these four fundamental variables in a
time diagram.
ILLUSTRATION 6-6
Basic Time Diagram
Present Future
Value Interest Rate Value
0 1 2 3 4 5
Number of Periods
In some cases, all four of these variables are known. However, at least one variable
is unknown in many business situations. To better understand and solve the problems
in this chapter, we encourage you to sketch compound interest problems in the form of
the preceding time diagram.
SINGLE-SUM PROBLEMS
Many business and investment decisions involve a single amount of money that
LEARNING OBJECTIVE 5
either exists now or will in the future. Single-sum problems are generally classified
Solve future and present value of
into one of the following two categories.
1 problems.
1. Computing the unknown future value of a known single sum of money that is in-
vested now for a certain number of periods at a certain interest rate.
2. Computing the unknown present value of a known single sum of money in the
future that is discounted for a certain number of periods at a certain interest rate.
When analyzing the information provided, determine first whether the problem involves
a future value or a present value. Then apply the following general rules, depending on
the situation:
• If solving for a future value, accumulate all cash flows to a future point. In this in-
stance, interest increases the amounts or values over time so that the future value
exceeds the present value.
Single-Sum Problems 295
• If solving for a present value, discount all cash flows from the future to the present.
In this case, discounting reduces the amounts or values, so that the present value is
less than the future amount.
Preparation of time diagrams aids in identifying the unknown as an item in the future
or the present. Sometimes the problem involves neither a future value nor a present
value. Instead, the unknown is the interest or discount rate, or the number of com-
pounding or discounting periods.
Future Value of a Single Sum
To determine the future value of a single sum, multiply the future value factor by its
present value (principal), as follows.
FV 5 PV (FVF )
n,i
where
FV 5 future value
PV 5 present value (principal or single sum)
FVF 5 future value factor for n periods at i interest
n,i
To illustrate, Bruegger Co. wants to determine the future value of $50,000 invested for
5 years compounded annually at an interest rate of 11%. Illustration 6-7 shows this
investment situation in time-diagram form.
ILLUSTRATION 6-7
Future Value Time
Present Value Interest Rate Future Value Diagram (n 5 5, i 5 11%)
PV = $50,000 i = 11% FFFVVV === ???
0 1 2 3 4 5
Number of Periods
n = 5
Using the future value formula, Bruegger solves this investment problem as follows.
Future value 5 PV (FVF )
n,i
5 $50,000 (FVF )
5,11%
5 $50,000 (1 1 .11)5
5 $50,000 (1.68506)
5 $84,253
To determine the future value factor of 1.68506 in the formula above, Bruegger uses a
financial calculator or reads the appropriate table, in this case Table 6-1 (11% column
and the 5-period row).
Companies can apply this time diagram and formula approach to routine business
situations. To illustrate, assume that Commonwealth Edison Company deposited
$250 million in an escrow account with Northern Trust Company at the beginning of
2014 as a commitment toward a power plant to be completed December 31, 2017.
How much will the company have on deposit at the end of 4 years if interest is 10%,
compounded semiannually?
With a known present value of $250 million, a total of 8 compounding periods
(4 3 2), and an interest rate of 5% per compounding period (.10 4 2), the company can
296 Chapter 6 Accounting and the Time Value of Money
time-diagram this problem and determine the future value as shown in Illustra-
tion 6-8.
ILLUSTRATION 6-8
Future Value Time
Diagram (n 5 8, i 5 5%)
PV = $250,000,000 i = 5% FFFVVV === ??? |
0 1 2 3 4 5 6 7 8
n = 8
Future value 5 $250,000,000 (FVF )
8,5%
5 $250,000,000 (1 1 .05)8
5 $250,000,000 (1.47746)
5 $369,365,000
Using a future value factor found in Table 6-1 (5% column, 8-period row), we find that
the deposit of $250 million will accumulate to $369,365,000 by December 31, 2017.
Present Value of a Single Sum
The Bruegger example on page 295 showed that $50,000 invested at an annually com-
pounded interest rate of 11% will equal $84,253 at the end of 5 years. It follows, then,
that $84,253, 5 years in the future, is worth $50,000 now. That is, $50,000 is the present
value of $84,253. The present value is the amount needed to invest now, to produce a
known future value.
The present value is always a smaller amount than the known future value, due
to earned and accumulated interest. In determining the future value, a company moves
forward in time using a process of accumulation. In determining present value, it moves
backward in time using a process of discounting.
As indicated earlier, a “present value of 1 table” appears at the end of this chapter
as Table 6-2. Illustration 6-9 demonstrates the nature of such a table. It shows the present
value of 1 for five different periods at three different rates of interest.
ILLUSTRATION 6-9
PRESENT VALUE OF 1 AT COMPOUND INTEREST
Excerpt from Table 6-2
(EXCERPT FROM TABLE 6-2, PAGE 337)
Period 9% 10% 11%
1 0.91743 0.90909 0.90090
2 0.84168 0.82645 0.81162
3 0.77218 0.75132 0.73119
4 0.70843 0.68301 0.65873
5 0.64993 0.62092 0.59345
The following formula is used to determine the present value of 1 (present value
factor):
1
PVF 5
n,i (11i)n
where
PVF 5 present value factor for n periods at i interest
n,i
Single-Sum Problems 297
To illustrate, assuming an interest rate of 9%, the present value of 1 discounted for
three different periods is as shown in Illustration 6-10.
ILLUSTRATION 6-10
Discount Formula
Periods 1 4 (1 1 i)n 5 Present Value* 1/(1 1 i)n Present Value of $1
Discounted at 9% for
1 1.00000 1.09 .91743 1/(1.09)1
Three Periods
2 1.00000 (1.09)2 .84168 1/(1.09)2
3 1.00000 (1.09)3 .77218 1/(1.09)3
*Note that these amounts appear in Table 6-2 in the 9% column.
The present value of any single sum (future value), then, is as follows.
PV 5 FV (PVF )
n,i
where
PV 5 present value
FV 5 future value
PVF 5 present value factor for n periods at i interest
n,i
To illustrate, what is the present value of $84,253 to be received or paid in 5 years
discounted at 11% compounded annually? Illustration 6-11 shows this problem as a
time diagram.
ILLUSTRATION 6-11
Present Value Time
Present Future Diagram (n 5 5, i 5 11%)
Value Interest Rate Value
PPPVVV === ??? i = 11% $84,253
0 1 2 3 4 5
Number of Periods
n = 5
Using the formula, we solve this problem as follows.
Present value5FV (PVF )
n,i
5$84,253 (PVF )
5,11%
1
5$84,253
(11.11)5
5$84,253 a(.59345) b
5 $50,000 (rounded by $.06)
To determine the present value factor of 0.59345, use a financial calculator or read the
present value of a single sum in Table 6-2 (11% column, 5-period row).
The time diagram and formula approach can be applied in a variety of situations.
For example, assume that your rich uncle decides to give you $2,000 for a trip to Europe
when you graduate from college 3 years from now. He proposes to finance the trip by
investing a sum of money now at 8% compound interest that will provide you with
$2,000 upon your graduation. The only conditions are that you graduate and that you
tell him how much to invest now.
298 Chapter 6 Accounting and the Time Value of Money
To impress your uncle, you set up the time diagram in Illustration 6-12 and solve
this problem as follows.
ILLUSTRATION 6-12
Present Value Time
Diagram (n 5 3, i 5 8%)
PPPVVV === ??? i = 8% FV = $2,000
0 1 2 3
n = 3
Present value52,000 (PVF )
3,8%
1
5$2,000
(11.08)3
5$2,000 a(.79383) b
5$1,587.66
Advise your uncle to invest $1,587.66 now to provide you with $2,000 upon graduation.
To satisfy your uncle’s other condition, you must pass this course (and many more).
Solving for Other Unknowns in Single-Sum Problems
In computing either the future value or the present value in the previous single-sum illus- |
trations, both the number of periods and the interest rate were known. In many business
situations, both the future value and the present value are known, but the number of peri-
ods or the interest rate is unknown. The following two examples are single-sum problems
(future value and present value) with either an unknown number of periods (n) or an un-
known interest rate (i). These examples, and the accompanying solutions, demonstrate
that knowing any three of the four values (future value, FV; present value, PV; number of
periods, n; interest rate, i) allows you to derive the remaining unknown variable.
Example—Computation of the Number of Periods
The Village of Somonauk wants to accumulate $70,000 for the construction of a veterans
monument in the town square. At the beginning of the current year, the Village depos-
ited $47,811 in a memorial fund that earns 10% interest compounded annually. How
many years will it take to accumulate $70,000 in the memorial fund?
In this illustration, the Village knows both the present value ($47,811) and the future
value ($70,000), along with the interest rate of 10%. Illustration 6-13 depicts this invest-
ment problem as a time diagram.
ILLUSTRATION 6-13
Time Diagram to Solve
for Unknown Number of
Periods PV = $47,811 i = 10% FV = $70,000
nn === ???
Annuities 299
Knowing both the present value and the future value allows the Village to solve for
the unknown number of periods. It may use either the future value or the present value
formulas, as shown in Illustration 6-14.
ILLUSTRATION 6-14
Future Value Approach Present Value Approach
Solving for Unknown
FV 5 PV (FVF ) PV 5 FV (PVF )
n,10% n,10% Number of Periods
$70,000 5 $47,811 (FVF ) $47,811 5 $70,000 (PVF )
n,10% n,10%
$70,000 $47,811
FVF 5 51.46410 PVF 5 5.68301
n,10% $47,811 n,10% $70,000
Using the future value factor of 1.46410, refer to Table 6-1 and read down the 10%
column to find that factor in the 4-period row. Thus, it will take 4 years for the $47,811
to accumulate to $70,000 if invested at 10% interest compounded annually. Or, using the
present value factor of 0.68301, refer to Table 6-2 and read down the 10% column to find
that factor in the 4-period row.
Example—Computation of the Interest Rate
Advanced Design, Inc. needs $1,409,870 for basic research 5 years from now. The com-
pany currently has $800,000 to invest for that purpose. At what rate of interest must it
invest the $800,000 to fund basic research projects of $1,409,870, 5 years from now?
The time diagram in Illustration 6-15 depicts this investment situation.
ILLUSTRATION 6-15
Time Diagram to Solve
for Unknown Interest
PV = $800,000 ii === ??? FV = $1,409,870 Rate
0 1 2 3 4 5
n = 5
Advanced Design may determine the unknown interest rate from either the future value
approach or the present value approach, as Illustration 6-16 shows.
ILLUSTRATION 6-16
Future Value Approach Present Value Approach
Solving for Unknown
FV 5 PV (FVF ) PV 5 FV (PVF )
5,i 5,i Interest Rate
$1,409,870 5 $800,000 (FVF ) $800,000 5 $1,409,870 (PVF )
5,i 5,i
$1,409,870 $800,000
FVF 5 51.76234 PVF 5 5.56743
5, i $800,000 5, i $1,409,870
Using the future value factor of 1.76234, refer to Table 6-1 and read across the 5-period
row to find that factor in the 12% column. Thus, the company must invest the $800,000 at
12% to accumulate to $1,409,870 in 5 years. Or, using the present value factor of .56743 and
Table 6-2, again find that factor at the juncture of the 5-period row and the 12% column.
ANNUITIES
The preceding discussion involved only the accumulation or discounting of a
6 LEARNING OBJECTIVE
single principal sum. However, many situations arise in which a series of dollar
Solve future value of ordinary and
amounts are paid or received periodically, such as installment loans or sales; regu-
annuity due problems.
lar, partially recovered invested funds; or a series of realized cost savings.
300 Chapter 6 Accounting and the Time Value of Money
For example, a life insurance contract involves a series of equal payments made at
equal intervals of time. Such a process of periodic payment represents the accumulation |
of a sum of money through an annuity. An annuity, by definition, requires the follow-
ing: (1) periodic payments or receipts (called rents) of the same amount, (2) the same-
length interval between such rents, and (3) compounding of interest once each interval.
The future value of an annuity is the sum of all the rents plus the accumulated
compound interest on them.
Note that the rents may occur at either the beginning or the end of the periods. If the
rents occur at the end of each period, an annuity is classified as an ordinary annuity. If
the rents occur at the beginning of each period, an annuity is classified as an annuity due.
Future Value of an Ordinary Annuity
One approach to determining the future value of an annuity computes the value to
which each of the rents in the series will accumulate, and then totals their individual
future values.
For example, assume that $1 is deposited at the end of each of 5 years (an ordinary
annuity) and earns 12% interest compounded annually. Illustration 6-17 shows the com-
putation of the future value, using the “future value of 1” table (Table 6-1) for each of the
five $1 rents.
ILLUSTRATION 6-17
END OF PERIOD IN WHICH $1.00 IS TO BE INVESTED
Solving for the Future
Value of an Ordinary Value at End
Present 1 2 3 4 5 of Year 5
Annuity
$1.00 $1.57352
$1.00 1.40493
$1.00 1.25440
$1.00 1.12000
$1.00 1.00000
Total (future value of an ordinary annuity of $1.00 for 5 periods at 12%) $6.35285
Because an ordinary annuity consists of rents deposited at the end of the period,
those rents earn no interest during the period. For example, the third rent earns interest
for only two periods (periods four and five). It earns no interest for the third period
since it is not deposited until the end of the third period. When computing the future
value of an ordinary annuity, the number of compounding periods will always be one
less than the number of rents.
The foregoing procedure for computing the future value of an ordinary annuity
always produces the correct answer. However, it can become cumbersome if the number
of rents is large. A formula provides a more efficient way of expressing the future value
of an ordinary annuity of 1. This formula sums the individual rents plus the compound
interest, as follows.
(11i)n21
FVF-OA 5
n,i i
where
FVF-OA 5 future value factor of an ordinary annuity
n,i
i 5 rate of interest per period
n 5 number of compounding periods
For example, FVF-OA refers to the value to which an ordinary annuity of 1 will
5,12%
accumulate in 5 periods at 12% interest.
Annuities 301
Using the formula above has resulted in the development of tables, similar to those
used for the “future value of 1” and the “present value of 1” for both an ordinary annuity
and an annuity due. Illustration 6-18 provides an excerpt from the “future value of an
ordinary annuity of 1” table.
ILLUSTRATION 6-18
FUTURE VALUE OF AN ORDINARY ANNUITY OF 1
Excerpt from Table 6-3
(EXCERPT FROM TABLE 6-3, PAGE 339)
Period 10% 11% 12%
1 1.00000 1.00000 1.00000
2 2.10000 2.11000 2.12000
3 3.31000 3.34210 3.37440
4 4.64100 4.70973 4.77933
5 6.10510 6.22780 6.35285*
*Note that this annuity table factor is the same as the sum of the future values of 1 factors shown in Illustration 6-17.
Interpreting the table, if $1 is invested at the end of each year for 4 years at 11%
interest compounded annually, the value of the annuity at the end of the fourth year is
$4.71 (4.70973 3 $1.00). Now, multiply the factor from the appropriate line and column
of the table by the dollar amount of one rent involved in an ordinary annuity. The
result: the accumulated sum of the rents and the compound interest to the date of the
last rent.
The following formula computes the future value of an ordinary annuity.
Future value of an ordinary annuity5R (FVF-OA )
n,i
where
R 5 periodic rent
FVF-OA 5 future value of an ordinary annuity
n,i
factor for n periods at i interest
To illustrate, what is the future value of five $5,000 deposits made at the end of each
of the next 5 years, earning interest of 12%? Illustration 6-19 depicts this problem as a |
time diagram.
ILLUSTRATION 6-19
Time Diagram for Future
Future Value Value of Ordinary
Present i = 12% FFFVVV--OOOAAA === ??? Annuity (n 5 5, i 5 12%)
Value R = $5,000 $5,000 $5,000 $5,000 $5,000
0 1 2 3 4 5
n = 5
Use of the formula solves this investment problem as follows.
Future value of an ordinary annuity5R (FVF-OA )
n,i
55,000 (FVF-OA )
5,12%
(11.12)5 21
5$5,000
.12
5$5,000 a(6.35285) b
5$31,764.25
302 Chapter 6 Accounting and the Time Value of Money
To determine the future value of an ordinary annuity factor of 6.35285 in the formula on
page 301, use a financial calculator or read the appropriate table, in this case, Table 6-3
(12% column and the 5-period row).
To illustrate these computations in a business situation, assume that Hightown
Electronics deposits $75,000 at the end of each 6-month period for the next 3 years,
to accumulate enough money to meet debts that mature in 3 years. What is the
future value that the company will have on deposit at the end of 3 years if the
annual interest rate is 10%? The time diagram in Illustration 6-20 depicts this
situation.
ILLUSTRATION 6-20
Time Diagram for Future
Value of Ordinary Future Value
Annuity (n 5 6, i 5 5%) i = 5% FFFVVV--OOOAAA === ???
R = $75,000 $75,000 $75,000 $75,000 $75,000 $75,000
0 1 2 3 4 5 6
n = 6
The formula solution for the Hightown Electronics situation is as follows.
Future value of an ordinary annuity5R (FVF-OA )
n,i
5$75,000 (FVF-OA )
6,5%
(11.05)6 21
5$75,000
.05
5$75,000 a(6.80191) b
5$510,143.25
Thus, six 6-month deposits of $75,000 earning 5% per period will grow to $510,143.25.
What do the numbers mean? DON’T WAIT TO MAKE THAT CONTRIBUTION!
There is great power in compounding of interest, and there
Value of retirement fund at age 65 with $1,000 per year
is no better illustration of this maxim than the case of retire- contributions with a 6% annual return
ment savings, especially for young people. Under current $180,000
tax rules for individual retirement accounts (IRAs), you can 160,000
contribute up to $5,000 in an investment fund, which will 140,000
120,000
grow tax-free until you reach retirement age. What’s more,
100,000
you get a tax deduction for the amount contributed in the
80,000
current year. Financial planners encourage young people to
60,000
take advantage of the tax benefi ts of IRAs. By starting early,
40,000
you can use the power of compounding to grow a pretty
20,000
good nest egg. As shown in the adjacent chart, starting 0
earlier can have a big impact on the value of your retirement 25 30
Age when contributions begin
fund.
Annuities 303
As shown, by setting aside $1,000 each year, beginning when starting those contributions until age 30, your retirement
you are 25 and assuming a rate of return of 6%, your retire- fund will grow only to a value of $111,435 ($1,000 3 111.43478
ment account at age 65 will have a tidy balance of $154,762 (FVF-OA )). That is quite a haircut—about 28%. That is,
35,6%
($1,000 3 154.76197 (FVF-OA )). That’s the power of by delaying or missing contributions, you miss out on the
40,6%
compounding. Not too bad you say, but hey, there are a lot of power of compounding and put a dent in your projected
things you might want to spend that $1,000 on (clothes, a trip nest egg.
to Vegas or Europe, new golf clubs). However, if you delay
Source: Adapted from T. Rowe Price, “A Roadmap to Financial Security for Young Adults,” Invest with Confi dence (troweprice.com).
Future Value of an Annuity Due
The preceding analysis of an ordinary annuity assumed that the periodic rents occur at
the end of each period. Recall that an annuity due assumes periodic rents occur at the
beginning of each period. This means an annuity due will accumulate interest during
the first period (in contrast to an ordinary annuity rent, which will not). In other words,
the two types of annuities differ in the number of interest accumulation periods in-
volved even though the same number of rents occur.
If rents occur at the end of a period (ordinary annuity), in determining the future
value of an annuity there will be one less interest period than if the rents occur at the |
beginning of the period (annuity due). Illustration 6-21 shows this distinction.
ILLUSTRATION 6-21
Future Value of an Annuity of 1 at 12% Comparison of the
Future Value of an
First deposit at end of period Ordinary Annuity with
an Annuity Due
OOrrOddiirnndaainrryya raaynn annnuuniittuyyity Period 1 Period 2 Period 3 Period 4 Period 5
Future value of No interest Interest Interest Interest Interest
an ordinary annuity
(per Table 6-3) 1.00000 2.12000 3.37440 4.77933 6.35285
First deposit at beginning
of period
Period 1 Period 2 Period 3 Period 4 Period 5
AAnnnnuuAiittnyyn dduuuiteey due
Interest Interest Interest Interest Interest
(No table
provided) 1.00000 1.12000 2.37440 3.77933 5.35285 7.11519
In this example, the cash flows from the annuity due come exactly one period earlier
than for an ordinary annuity. As a result, the future value of the annuity due factor is exactly
12% higher than the ordinary annuity factor. For example, the value of an ordinary annuity
factor at the end of period one at 12% is 1.00000, whereas for an annuity due it is 1.12000.
To find the future value of an annuity due factor, multiply the future value of an
ordinary annuity factor by 1 plus the interest rate. For example, to determine the fu-
ture value of an annuity due interest factor for 5 periods at 12% compound interest,
simply multiply the future value of an ordinary annuity interest factor for 5 periods
(6.35285), by one plus the interest rate (1 1 .12), to arrive at 7.11519 (6.35285 3 1.12).
304 Chapter 6 Accounting and the Time Value of Money
To illustrate the use of the ordinary annuity tables in converting to an annuity due,
assume that Sue Lotadough plans to deposit $800 a year on each birthday of her son
Howard. She makes the first deposit on his tenth birthday, at 6% interest compounded
annually. Sue wants to know the amount she will have accumulated for college ex-
penses by her son’s eighteenth birthday.
If the first deposit occurs on Howard’s tenth birthday, Sue will make a total of 8
deposits over the life of the annuity (assume no deposit on the eighteenth birthday), as
shown in Illustration 6-22. Because all the deposits are made at the beginning of the
periods, they represent an annuity due.
ILLUSTRATION 6-22
Annuity Due Time
Future
Diagram
i = 6% Value
R = $800 $800 $800 $800 $800 $800 $800 $800 FFFVVV--AAADDD === ???
0 1 2 3 4 5 6 7 8
n = 8
FV-AD = Future value of an annuity due
Referring to the “future value of an ordinary annuity of 1” table for 8 periods at 6%, Sue
finds a factor of 9.89747. She then multiplies this factor by (1 1 .06) to arrive at the future
value of an annuity due factor. As a result, the accumulated value on Howard’s eigh-
teenth birthday is $8,393.06, as calculated in Illustration 6-23.
ILLUSTRATION 6-23
1. Future value of an ordinary annuity of 1 for 8 periods
Computation of
at 6% (Table 6-3) 9.89747
Accumulated Value of 2. Factor (1 1 .06) 3 1.06
Annuity Due
3. Future value of an annuity due of 1 for 8 periods at 6% 10.49132
4. Periodic deposit (rent) 3 $800
5. Accumulated value on son’s 18th birthday $8,393.06
Depending on the college he chooses, Howard may have enough to finance only part of
his first year of school.
Examples of Future Value of Annuity Problems
The foregoing annuity examples relied on three known values—amount of each rent,
interest rate, and number of periods. Using these values enables us to determine the
unknown fourth value, future value.
The first two future value problems we present illustrate the computations of (1) the
amount of the rents and (2) the number of rents. The third problem illustrates the com-
putation of the future value of an annuity due.
Computation of Rent
Assume that you plan to accumulate $14,000 for a down payment on a condominium
apartment 5 years from now. For the next 5 years, you earn an annual return of 8% com-
pounded semiannually. How much should you deposit at the end of each 6-month period?
The $14,000 is the future value of 10 (5 3 2) semiannual end-of-period payments of
an unknown amount, at an interest rate of 4% (8% 4 2). Illustration 6-24 depicts this |
problem as a time diagram.
Annuities 305
ILLUSTRATION 6-24
Future Value of Ordinary
Future Annuity Time Diagram
Value
(n 5 10, i 5 4%)
i = 4% FV-OA = $14,000
RR === ?? ?? ?? ?? ?? ?? ?? ?? ?? ??
0 1 2 3 4 5 6 7 8 9 10
n = 10
FV-OA = Future value of an ordinary annuity
Using the formula for the future value of an ordinary annuity, you determine the
amount of each rent as follows.
Future value of an ordinary annuity5R (FVF-OA )
n,i
$14,000 5R (FVF-OA )
10,4%
$14,000 5R (12.00611)
R5$1,166.07
Thus, you must make 10 semiannual deposits of $1,166.07 each in order to accumulate
$14,000 for your down payment.
Computation of the Number of Periodic Rents
Suppose that a company’s goal is to accumulate $117,332 by making periodic deposits
of $20,000 at the end of each year, which will earn 8% compounded annually while
accumulating. How many deposits must it make?
The $117,332 represents the future value of n(?) $20,000 deposits, at an 8% annual
rate of interest. Illustration 6-25 depicts this problem in a time diagram.
ILLUSTRATION 6-25
Future Value of Ordinary
Future Annuity Time Diagram,
i = 8% Value to Solve for Unknown
R = $20,000 $20,000 $20,000 FV-OA = $117,332
Number of Periods
0 1 2 3 n
nn === ???
Using the future value of an ordinary annuity formula, the company obtains the
following factor.
Future value of an ordinary annuity5R (FVF-OA )
n,i
$117,332 5$20,000 (FVF-OA )
n,8%
$117,332
FVF-OA 5 55.86660
n,8% $20,000
Use Table 6-3 and read down the 8% column to find 5.86660 in the 5-period row.
Thus, the company must make five deposits of $20,000 each.
Computation of the Future Value
To create his retirement fund, Walter Goodwrench, a mechanic, now works weekends.
Mr. Goodwrench deposits $2,500 today in a savings account that earns 9% interest.
306 Chapter 6 Accounting and the Time Value of Money
He plans to deposit $2,500 every year for a total of 30 years. How much cash will
Mr. Goodwrench accumulate in his retirement savings account, when he retires in
30 years? Illustration 6-26 depicts this problem in a time diagram.
ILLUSTRATION 6-26
Future Value Annuity
Due Time Diagram Future
(n 5 30, i 5 9%) i = 9% Value
R = $2,500 $2,500 $2,500 $2,500 FFFVVV--AAADDD === ???
0 1 2 29 30
n = 30
Using the “future value of an ordinary annuity of 1” table, Mr. Goodwrench computes
the solution as shown in Illustration 6-27.
ILLUSTRATION 6-27
1. Future value of an ordinary annuity of 1 for 30 periods at 9% 136.30754
Computation of
2. Factor (1 1 .09) 3 1.09
Accumulated Value of
3. Future value of an annuity due of 1 for 30 periods at 9% 148.57522
an Annuity Due
4. Periodic rent 3 $2,500
5. Accumulated value at end of 30 years $371,438
Present Value of an Ordinary Annuity
The present value of an annuity is the single sum that, if invested at com-
LEARNING OBJECTIVE 7
pound interest now, would provide for an annuity (a series of withdrawals) for
Solve present value of ordinary and
a certain number of future periods. In other words, the present value of an or-
annuity due problems.
dinary annuity is the present value of a series of equal rents, to withdraw at
equal intervals.
One approach to finding the present value of an annuity determines the present
value of each of the rents in the series and then totals their individual present values. For
example, we may view an annuity of $1, to be received at the end of each of 5 periods,
as separate amounts. We then compute each present value using the table of present
values (see Table 6-2 on pages 336–337), assuming an interest rate of 12%. Illustra-
tion 6-28 shows this approach.
ILLUSTRATION 6-28
END OF PERIOD IN WHICH $1.00 IS TO BE RECEIVED
Solving for the Present
Value of an Ordinary Present Value
Annuity at Beg. of Year 1 1 2 3 4 5
$0.89286 $1.00
.79719 $1.00
.71178 $1.00
.63552 $1.00
.56743 $1.00
$3.60478 Total (present value of an ordinary annuity of $1.00 for five periods at 12%)
Annuities 307
This computation tells us that if we invest the single sum of $3.61 today at 12% inter-
est for 5 periods, we will be able to withdraw $1 at the end of each period for 5 periods.
We can summarize this cumbersome procedure by the following formula.
1
12
(11i)n
PVF-OA 5
n,i i |
The expression PVF-OA refers to the present value of an ordinary annuity of 1 factor
n,i
for n periods at i interest. Ordinary annuity tables base present values on this formula.
Illustration 6-29 shows an excerpt from such a table.
ILLUSTRATION 6-29
PRESENT VALUE OF AN ORDINARY ANNUITY OF 1
Excerpt from Table 6-4
(EXCERPT FROM TABLE 6-4, PAGE 341)
Period 10% 11% 12%
1 0.90909 0.90090 0.89286
2 1.73554 1.71252 1.69005
3 2.48685 2.44371 2.40183
4 3.16986 3.10245 3.03735
5 3.79079 3.69590 3.60478*
*Note that this annuity table factor is equal to the sum of the present value of 1 factors shown in Illustration 6-28.
The general formula for the present value of any ordinary annuity is as follows.
Present value of an ordinary annuity 5 R (PVF-OA )
n,i
where
R 5 periodic rent (ordinary annuity)
PVF-OA 5 present value of an ordinary annuity of 1
n,i
for n periods at i interest
To illustrate with an example, what is the present value of rental receipts of $6,000
each, to be received at the end of each of the next 5 years when discounted at 12%? This
problem may be time-diagrammed and solved as shown in Illustration 6-30.
ILLUSTRATION 6-30
Present Value of
Present Ordinary Annuity Time
Value i = 12% Diagram
PPPVVV--OOOAAA === ??? R = $6,000 $6,000 $6,000 $6,000 $6,000
0 1 2 3 4 5
n = 5
The formula for this calculation is as shown below.
Present value of an ordinary annuity5R (PVF-OA )
n,i
5$6,000 (PVF-OA )
5,12%
5$6,000 (3.60478)
5$21,628.68
The present value of the 5 ordinary annuity rental receipts of $6,000 each is $21,628.68. To
determine the present value of the ordinary annuity factor 3.60478, use a financial calcu-
lator or read the appropriate table, in this case Table 6-4 (12% column and 5-period row).
308 Chapter 6 Accounting and the Time Value of Money
What do the numbers mean? UP IN SMOKE
Time value of money concepts also can be relevant to public Why would some in the state be willing to take just
policy debates. For example, several states had to determine $1.26 billion today for an annuity whose present value is al-
how to receive the payments from tobacco companies as most twice that amount? One reason is that Wisconsin was
settlement for a national lawsuit against the companies for facing a hole in its budget that could be plugged in part by
the healthcare costs of smoking. the lump-sum payment. Also, some believed that the risk
The State of Wisconsin was due to collect 25 years of pay- of not getting paid by the tobacco companies in the future
ments totaling $5.6 billion. The state could wait to collect the makes it prudent to get the money earlier.
payments, or it could sell the payments to an investment bank If this latter reason has merit, then the present value
(a process called securitization). If it were to sell the payments, computation above should have been based on a higher
it would receive a lump-sum payment today of $1.26 billion. interest rate. Assuming a discount rate of 15%, the pres-
Is this a good deal for the state? Assuming a discount rate of ent value of the annuity is $1.448 billion ($5.6 billion 4
8% and that the payments will be received in equal amounts 25 5 $224 million; $224 million 3 6.46415), which is much
(e.g., an annuity), the present value of the tobacco payment is: closer to the lump-sum payment offered to the State of
Wisconsin.
$5.6 billion4255$224 million
$224 million310.67478*5$2.39 billion
*PV-OA (i58%, n525)
Present Value of an Annuity Due
In our discussion of the present value of an ordinary annuity, we discounted the final
rent based on the number of rent periods. In determining the present value of an an-
nuity due, there is always one fewer discount period. Illustration 6-31 shows this
distinction.
ILLUSTRATION 6-31
Present Value of an Annuity of 1 at 12%
Comparison of Present
Value of an Ordinary Rent at end of period
Annuity with an Annuity
Due
Period 1 Period 2 Period 3 Period 4 Period 5
OOrrOddriinndaainrrayy raaynn annnuuniittuyyity
Discount Discount Discount Discount Discount
Present value of
an ordinary annuity
.89286 1.69005 2.40183 3.03735 3.60478 |
(per Table 6-4)
Rent at beginning of period
Period 1 Period 2 Period 3 Period 4 Period 5
AAnnnnuuAiinttyyn uddiuuteey due
No discount Discount Discount Discount Discount
Present value of
annuity due
1.00000 1.89286 2.69005 3.40183 4.03735
(per Table 6-5)
Because each cash flow comes exactly one period sooner in the present value of
the annuity due, the present value of the cash flows is exactly 12% higher than the
present value of an ordinary annuity. Thus, to find the present value of an annuity due
factor, multiply the present value of an ordinary annuity factor by 1 plus the interest
rate (that is, 1 1 i).
Annuities 309
To determine the present value of an annuity due interest factor for 5 periods at
12% interest, take the present value of an ordinary annuity for 5 periods at 12% interest
(3.60478) and multiply it by 1.12 to arrive at the present value of an annuity due, 4.03735
(3.60478 3 1.12). We provide present value of annuity due factors in Table 6-5.
To illustrate, Space Odyssey, Inc., rents a communications satellite for 4 years with
annual rental payments of $4.8 million to be made at the beginning of each year. If the
relevant annual interest rate is 11%, what is the present value of the rental obligations?
Illustration 6-32 shows the company’s time diagram for this problem.
ILLUSTRATION 6-32
Present Value of Annuity
Present Value
Due Time Diagram
PPPVVV--AAADDD === ??? i = 11%
(n 5 4, i 5 11%)
R = $4.8M $4.8M $4.8M $4.8M
0 1 2 3 4
n = 4
PV-AD = the present value of an annuity due
Illustration 6-33 shows the computations to solve this problem.
ILLUSTRATION 6-33
1. Present value of an ordinary annuity of 1 for 4 periods at 11% (Table 6-4) 3.10245
Computation of Present
2. Factor (1 1 .11) 3 1.11
Value of an Annuity Due
3. Present value of an annuity due of 1 for 4 periods at 11% 3.44372
4. Periodic deposit (rent) 3 $4,800,000
5. Present value of payments $16,529,856
Using Table 6-5 also locates the desired factor 3.44371 and computes the present
value of the lease payments to be $16,529,808. (The difference in computations is due to
rounding.)
Examples of Present Value of Annuity Problems
In the following three examples, we demonstrate the computation of (1) the present
value, (2) the interest rate, and (3) the amount of each rent.
Computation of the Present Value of an Ordinary Annuity
You have just won a lottery totaling $4,000,000. You learn that you will receive a check
in the amount of $200,000 at the end of each of the next 20 years. What amount have you
really won? That is, what is the present value of the $200,000 checks you will receive
over the next 20 years? Illustration 6-34 (page 310) shows a time diagram of this enviable
situation (assuming an appropriate interest rate of 10%).
You calculate the present value as follows.
Present value of an ordinary annuity5R (PVF-OA )
n,i
5$200,000 (PVF-OA )
20,10%
5$200,000 (8.51356)
5$1,702,712
310 Chapter 6 Accounting and the Time Value of Money
ILLUSTRATION 6-34
Time Diagram to Solve
for Present Value of i = 10%
Lottery Payments PPPVVV--OOOAAA === ??? R = $200,000 $200,000 $200,000 $200,000
0 1 2 19 20
n = 20
As a result, if the state deposits $1,702,712 now and earns 10% interest, it can withdraw
$200,000 a year for 20 years to pay you the $4,000,000.
Computation of the Interest Rate
Many shoppers use credit cards to make purchases. When you receive the statement
for payment, you may pay the total amount due or you may pay the balance in a certain
number of payments. For example, assume you receive a statement from MasterCard
with a balance due of $528.77. You may pay it off in 12 equal monthly payments of $50
each, with the first payment due one month from now. What rate of interest would you
be paying?
The $528.77 represents the present value of the 12 payments of $50 each at an
unknown rate of interest. The time diagram in Illustration 6-35 depicts this situation.
ILLUSTRATION 6-35
Time Diagram to Solve
for Effective-Interest Rate
Present Value
on Loan
PV-OA = $528.77 ii === ???
R = $50 $50 $50 $50 $50 $50 $50 $50 $50 $50 $50 $50
0 1 2 3 4 5 6 7 8 9 10 11 12
n = 12 |
You calculate the rate as follows.
Present value of an ordinary annuity5R (PVF-OA )
n,i
$528.77 5$50 (PVF-OA )
12,i
$528.77
(PVFOA ) 5 510.57540
12,i $50
Referring to Table 6-4 and reading across the 12-period row, you find 10.57534 in the 2%
column. Since 2% is a monthly rate, the nominal annual rate of interest is 24% (12 3 2%).
The effective annual rate is 26.82423% [(1 1 .02)12 2 1]. Obviously, you are better off
paying the entire bill now if possible.
Computation of a Periodic Rent
Norm and Jackie Remmers have saved $36,000 to finance their daughter Dawna’s
college education. They deposited the money in the Bloomington Savings and Loan
Association, where it earns 4% interest compounded semiannually. What equal amounts
can their daughter withdraw at the end of every 6 months during her 4 college years,
without exhausting the fund? Illustration 6-36 shows a time diagram of this situation.
More Complex Situations 311
ILLUSTRATION 6-36
Time Diagram for
Present Value i = 2% Ordinary Annuity for a
PV-OA = $36,000 RR === ??? ?? ?? ?? ?? ?? ?? ?? College Fund
0 1 2 3 4 5 6 7 8
n = 8
Determining the answer by simply dividing $36,000 by 8 withdrawals is wrong.
Why? Because that ignores the interest earned on the money remaining on deposit.
Dawna must consider that interest is compounded semiannually at 2% (4% 4 2) for
8 periods (4 years 3 2). Thus, using the same present value of an ordinary annuity
formula, she determines the amount of each withdrawal that she can make as follows.
Present value of an ordinary annuity5R (PVF-OA )
n,i
$36,000 5R (PVF-OA )
8,2%
$36,000 5R (7.32548)
R5$4,914.35
MORE COMPLEX SITUATIONS
Solving time value problems often requires using more than one table. For exam-
8 LEARNING OBJECTIVE
ple, a business problem may need computations of both present value of a single
Solve present value problems related
sum and present value of an annuity. Two such common situations are:
to deferred annuities and bonds.
1. Deferred annuities.
2. Bond problems.
Deferred Annuities
A deferred annuity is an annuity in which the rents begin after a specified number of
periods. A deferred annuity does not begin to produce rents until two or more periods
have expired. For example, “an ordinary annuity of six annual rents deferred 4 years”
means that no rents will occur during the first 4 years and that the first of the six rents
will occur at the end of the fifth year. “An annuity due of six annual rents deferred
4 years” means that no rents will occur during the first 4 years and that the first of
six rents will occur at the beginning of the fifth year.
Future Value of a Deferred Annuity
Computing the future value of a deferred annuity is relatively straightforward. Because
there is no accumulation or investment on which interest may accrue, the future value
of a deferred annuity is the same as the future value of an annuity not deferred. That is,
computing the future value simply ignores the deferred period.
To illustrate, assume that Sutton Corporation plans to purchase a land site in 6
years for the construction of its new corporate headquarters. Because of cash flow
problems, Sutton budgets deposits of $80,000 on which it expects to earn 5% annually,
only at the end of the fourth, fifth, and sixth periods. What future value will Sutton
have accumulated at the end of the sixth year? Illustration 6-37 (page 312) shows a time
diagram of this situation.
312 Chapter 6 Accounting and the Time Value of Money
ILLUSTRATION 6-37
Time Diagram for Future
Future Value
Value of Deferred
i = 5% FFFVVV--OOOAAA === ???
Annuity
R = $80,000 $80,000 $80,000
0 1 2 3 4 5 6
n = 3
(first 3 periods are ignored)
Sutton determines the value accumulated by using the standard formula for the
future value of an ordinary annuity:
Future value of an ordinary annuity5R (FVF-OA )
n,i
5$80,000 (FVF-OA )
3,5%
5$80,000 (3.15250)
5$252,200
Present Value of a Deferred Annuity
Computing the present value of a deferred annuity must recognize the interest that
accrues on the original investment during the deferral period.
To compute the present value of a deferred annuity, we compute the present value of |
an ordinary annuity of 1 as if the rents had occurred for the entire period. We then subtract
the present value of rents that were not received during the deferral period. We are left
with the present value of the rents actually received subsequent to the deferral period.
To illustrate, Bob Bender has developed and copyrighted tutorial software for stu-
dents in advanced accounting. He agrees to sell the copyright to Campus Micro Systems
for 6 annual payments of $5,000 each. The payments will begin 5 years from today.
Given an annual interest rate of 8%, what is the present value of the 6 payments?
This situation is an ordinary annuity of 6 payments deferred 4 periods. The time
diagram in Illustration 6-38 depicts this sales agreement.
ILLUSTRATION 6-38
Time Diagram for
Present Value of Deferred
i = 8%
Annuity
PPPVVV === ??? R = $5,000 $5,000 $5,000 $5,000 $5,000 $5,000
0 1 2 3 4 5 6 7 8 9 10
n = 4 n = 6
Two options are available to solve this problem. The first is to use only Table 6-4, as
shown in Illustration 6-39.
ILLUSTRATION 6-39
1. Each periodic rent $5,000
Computation of the
2. Present value of an ordinary annuity of 1 for total periods (10)
Present Value of a
[number of rents (6) plus number of deferred periods (4)] at 8% 6.71008
Deferred Annuity 3. Less: Present value of an ordinary annuity of 1 for the number of
deferred periods (4) at 8% 3.31213
4. Difference 3 3.39795
5. Present value of 6 rents of $5,000 deferred 4 periods $16,989.75
More Complex Situations 313
The subtraction of the present value of an annuity of 1 for the deferred periods
eliminates the nonexistent rents during the deferral period. It converts the present value
of an ordinary annuity of $1.00 for 10 periods to the present value of 6 rents of $1.00,
deferred 4 periods.
Alternatively, Bender can use both Table 6-2 and Table 6-4 to compute the present
value of the 6 rents. He can first discount the annuity 6 periods. However, because the
annuity is deferred 4 periods, he must treat the present value of the annuity as a future
amount to be discounted another 4 periods. The time diagram in Illustration 6-40
depicts this two-step process.
ILLUSTRATION 6-40
Time Diagram for
Present Value of Deferred
Annuity (2-Step Process)
PPPVVV === ??? PPPVVV--OOOAAA === ???$5,000 $5,000 $5,000 $5,000 $5,000 $5,000
0 1 2 3 4 5 6 7 8 9 10
FV (PVF ) R (PVF-OA )
n,i n,i
Calculation using formulas would be done in two steps, as follows.
Step 1: Present value of
an ordinary annuity5R (PVF-OA )
n,i
5$5,000 (PVF-OA )
6,8%
5$5,000 (4.62288)
(Table 6-4, Present value of an ordinary annuity)
5$23,114.40
Step 2: Present value of
a single sum 5FV (PVF )
n,i
5$23,114.40 (PVF )
4,8%
5$23,114.40 (.73503)
(Table 6-2, Present value of a single sum)
5$16,989.78
The present value of $16,989.78 computed above is the same as in Illustration 6-39
although computed differently. (The $0.03 difference is due to rounding.)
Valuation of Long-Term Bonds
A long-term bond produces two cash flows: (1) periodic interest payments during the
life of the bond, and (2) the principal (face value) paid at maturity. At the date of issue,
bond buyers determine the present value of these two cash flows using the market rate
of interest.
The periodic interest payments represent an annuity. The principal represents a
single-sum problem. The current market value of the bonds is the combined present
values of the interest annuity and the principal amount.
To illustrate, Alltech Corporation on January 1, 2014, issues $100,000 of 9% bonds
due in 5 years with interest payable annually at year-end. The current market rate of
interest for bonds of similar risk is 11%. What will the buyers pay for this bond issue?
314 Chapter 6 Accounting and the Time Value of Money
The time diagram in Illustration 6-41 depicts both cash flows.
ILLUSTRATION 6-41
Time Diagram to Solve
for Bond Valuation PPPVVV $100,000 Principal
i = 11%
PPPVVV--OOOAAA $9,000 $9,000 $9,000 $9,000 $9,000 Interest
0 1 2 3 4 5
n = 5
Alltech computes the present value of the two cash flows by discounting at 11% as
follows.
ILLUSTRATION 6-42
1. Present value of the principal: FV (PVF ) 5 $100,000 (.59345) $59,345.00 |
Computation of the 5,11%
2. Present value of the interest payments: R (PVF-OA ) 5 $9,000 (3.69590) 33,263.10
Present Value of an 5,11%
3. Combined present value (market price)—carrying value of bonds $92,608.10
Interest-Bearing Bond
By paying $92,608.10 at date of issue, the buyers of the bonds will realize an effec-
tive yield of 11% over the 5-year term of the bonds. This is true because Alltech dis-
counted the cash flows at 11%.
Effective-Interest Method of Amortization
of Bond Discount or Premium
In the previous example (Illustration 6-42), Alltech Corporation issued bonds at a dis-
count, computed as follows.
ILLUSTRATION 6-43
Maturity value (face amount) of bonds $100,000.00
Computation of Bond
Present value of the principal $59,345.00
Discount
Present value of the interest 33,263.10
Proceeds (present value and cash received) (92,608.10)
Discount on bonds issued $ 7,391.90
Alltech amortizes (writes off to interest expense) the amount of this discount over the
life of the bond issue.
The preferred procedure for amortization of a discount or premium is the effective-
interest method. Under the effective-interest method:
1. The company issuing the bond fi rst computes bond interest expense by multiplying
the carrying value of the bonds at the beginning of the period by the effective-interest
Gateway to
rate.
the Profession
2. The company then determines the bond discount or premium amortization by com-
Use of Spreadsheets to
Calculate Bond Amortization paring the bond interest expense with the interest to be paid.
Present Value Measurement 315
Illustration 6-44 depicts the computation of bond amortization.
ILLUSTRATION 6-44
Bond Interest Expense Bond Interest Paid
Amortization
Carrying Value Effective- Stated Computation
Face Amount Amortization
of Bonds at 3 Interest 2 3 Interest 5
of Bonds Amount
Beginning of Period Rate Rate
q r q r
The effective-interest method produces a periodic interest expense equal to a con-
stant percentage of the carrying value of the bonds. Since the percentage used is the
effective rate of interest incurred by the borrower at the time of issuance, the effective-
interest method results in matching expenses with revenues.
We can use the data from the Alltech Corporation example to illustrate the effective-
interest method of amortization. Alltech issued $100,000 face value of bonds at a dis-
count of $7,391.90, resulting in a carrying value of $92,608.10. Illustration 6-45 shows the
effective-interest amortization schedule for Alltech’s bonds.
ILLUSTRATION 6-45
SCHEDULE OF BOND DISCOUNT AMORTIZATION
Effective-Interest
5-YEAR, 9% BONDS SOLD TO YIELD 11%
Amortization Schedule
Cash Bond Carrying
Interest Interest Discount Value
Date Paid Expense Amortization of Bonds
1/1/12 $ 92,608.10
12/31/12 $ 9,000a $10,186.89b $1,186.89c 93,794.99d
12/31/13 9,000 10,317.45 1,317.45 95,112.44
12/31/14 9,000 10,462.37 1,462.37 96,574.81
12/31/15 9,000 10,623.23 1,623.23 98,198.04
12/31/16 9,000 10,801.96e 1,801.96 100,000.00
$45,000 $52,391.90 $7,391.90
a$100,000 3 .09 5 $9,000 d$92,608.10 1 $1,186.89 5 $93,794.99
b$92,608.10 3 .11 5 $10,186.89 e$0.18 difference due to rounding.
c$10,186.89 2 $9,000 5 $1,186.89
We use the amortization schedule illustrated above for note and bond transactions
in Chapters 7 and 14.
PRESENT VALUE MEASUREMENT
In the past, most accounting calculations of present value relied on the most likely
9 LEARNING OBJECTIVE
cash flow amount. Concepts Statement No. 7 introduces an expected cash flow ap-
Apply expected cash flows to present
proach.6 It uses a range of cash flows and incorporates the probabilities of those
value measurement.
cash flows to provide a more relevant measurement of present value.
To illustrate the expected cash flow model, assume that there is a 30% probability
that future cash flows will be $100, a 50% probability that they will be $200, and a 20%
probability that they will be $300. In this case, the expected cash flow would be $190
[($100 3 0.3) 1 ($200 3 0.5) 1 ($300 3 0.2)]. Traditional present value approaches would
use the most likely estimate ($200). However, that estimate fails to consider the different |
probabilities of the possible cash flows.
6“Using Cash Flow Information and Present Value in Accounting Measurements,” Statement of
Financial Accounting Concepts No. 7 (Norwalk, Conn.: FASB, 2000).
316 Chapter 6 Accounting and the Time Value of Money
Choosing an Appropriate Interest Rate
After determining expected cash flows, a company must then use the proper interest rate
to discount the cash flows. The interest rate used for this purpose has three components:
THREE COMPONENTS OF INTEREST
1. PURE RATE OF INTEREST (2%–4%). This would be the amount a lender would
charge if there were no possibilities of default and no expectation of infl ation.
2. EXPECTED INFLATION RATE OF INTEREST (0%–?). Lenders recognize that in an
infl ationary economy, they are being paid back with less valuable dollars. As a result,
they increase their interest rate to compensate for this loss in purchasing power. When
infl ationary expectations are high, interest rates are high.
3. CREDIT RISK RATE OF INTEREST (0%–5%). The government has little or no credit
risk (i.e., risk of nonpayment) when it issues bonds. A business enterprise, however, de-
pending upon its fi nancial stability, profi tability, etc., can have a low or a high credit risk.
The FASB takes the position that after computing the expected cash flows, a com-
pany should discount those cash flows by the risk-free rate of return. That rate is de-
fined as the pure rate of return plus the expected inflation rate. The Board notes that
the expected cash flow framework adjusts for credit risk because it incorporates the
probability of receipt or payment into the computation of expected cash flows. There-
fore, the rate used to discount the expected cash flows should consider only the pure
rate of interest and the inflation rate.
What do the numbers mean? HOW LOW CAN THEY GO?
Management of the level of interest rates is an important policy But these same low rates may have also resulted in too much
tool of the Federal Reserve Bank and its chair, Ben Bernanke. real estate lending and the growth of a real estate bubble,
Through a number of policy options, the Fed has the ability to as the price of housing was fueled by cheaper low-interest
move interest rates up or down, and these rate changes can mortgage loans. But, as the old saying goes, “What goes up,
affect the wealth of all market participants. For example, if the must come down.” That is what real estate prices did, trig-
Fed wants to raise rates (because the overall economy is get- gering massive loan write-offs, a seizing up of credit mar-
ting overheated), it can raise the discount rate, which is the rate kets, and a slowing economy.
banks pay to borrow money from the Fed. This rate increase So just when a rate cut might help the economy, the Fed’s
will factor into the rates banks and other creditors use to lend rate-cutting toolbox is empty. As a result, the Fed began to
money. As a result, companies will think twice about borrow- explore other options, such as repurchasing long-term gov-
ing money to expand their businesses. The result will be a ernment bonds—referred to as “quantitative easing.” These
slowing economy. A rate cut does just the opposite. It makes repurchases put money into the market, increase the
borrowing cheaper, and it can help the economy expand as demand for long-term bonds, and reduce long-term interest
more companies borrow to expand their operations. rates. The Fed has conducted three rounds of quantitative
Keeping rates low had been the Fed’s policy in the early easing in an attempt to spur the economy out of its persis-
2000s. The low rates did help keep the economy humming. tent funk.
Source: Adam Shell, “Five Investments to Consider if the Fed Uncorks QE3,” USA TODAY (September 1, 2012).
Example of Expected Cash Flow
To illustrate, assume that Al’s Appliance Outlet offers a 2-year warranty on all products
sold. In 2014, Al’s Appliance sold $250,000 of a particular type of clothes dryer. Al’s
Appliance entered into an agreement with Ralph’s Repair to provide all warranty |
Summary of Learning Objectives 317
service on the dryers sold in 2014. To determine the warranty expense to record in 2014
and the amount of warranty liability to record on the December 31, 2014, balance sheet,
Al’s Appliance must measure the fair value of the agreement. Since there is not a ready
market for these warranty contracts, Al’s Appliance uses expected cash flow techniques
to value the warranty obligation.
Based on prior warranty experience, Al’s Appliance estimates the expected cash
outflows associated with the dryers sold in 2014, as shown in Illustration 6-46.
ILLUSTRATION 6-46
Cash Flow Probability Expected
Expected Cash
Estimate 3 Assessment 5 Cash Flow
Outfl ows—Warranties
2014 $3,800 20% $ 760
6,300 50% 3,150
7,500 30% 2,250
Total $6,160
2015 $5,400 30% $1,620
7,200 50% 3,600
8,400 20% 1,680
Total $6,900
Applying expected cash flow concepts to these data, Al’s Appliance estimates
warranty cash outflows of $6,160 in 2014 and $6,900 in 2015.
Illustration 6-47 shows the present value of these cash flows, assuming a risk-free
rate of 5% and cash flows occurring at the end of the year.
ILLUSTRATION 6-47
Expected PV Factor, Present
Present Value of Cash
Year Cash Flow 3 i 5 5% 5 Value
Flows
2014 $6,160 0.95238 $ 5,866.66
2015 6,900 0.90703 6,258.51
Total $12,125.17
KEY TERMS
SUMMARY OF LEARNING OBJECTIVES
annuity, 300
annuity due, 300
compound interest, 290
1 Identify accounting topics where the time value of money is relevant.
deferred annuity, 311
Some of the applications of present value–based measurements to accounting topics are
discounting, 295
(1) notes, (2) leases, (3) pensions and other postretirement benefits, (4) long-term assets,
effective yield, 293
(5) sinking funds, (6) business combinations, (7) disclosures, and (8) installment contracts.
effective-interest
2 Distinguish between simple and compound interest. See items 1 and 2 in method, 314
the Fundamental Concepts on page 318. expected cash flow
approach, 315
3 Use appropriate compound interest tables. In order to identify which of
face rate, 293
the five compound interest tables to use, determine whether you are solving for (1) the
future value, 294
future value of a single sum, (2) the present value of a single sum, (3) the future value of
a series of sums (an annuity), or (4) the present value of a series of sums (an annuity). In future value of an
annuity, 300
addition, when a series of sums (an annuity) is involved, identify whether these sums
are received or paid (1) at the beginning of each period (annuity due) or (2) at the end of interest, 289
each period (ordinary annuity). nominal rate, 293
ordinary annuity, 300
4 Identify variables fundamental to solving interest problems. The follow-
present value, 294
ing four variables are fundamental to all compound interest problems. (1) Rate of interest:
318 Chapter 6 Accounting and the Time Value of Money
principal, 289 unless otherwise stated, an annual rate, adjusted to reflect the length of the compound-
risk-free rate of return, 316 ing period if less than a year. (2) Number of time periods: the number of compounding
simple interest, 290 periods (a period may be equal to or less than a year). (3) Future value: the value at a
stated rate, 293 future date of a given sum or sums invested assuming compound interest. (4) Present
value: the value now (present time) of a future sum or sums discounted assuming com-
time value of money, 288
pound interest.
5 Solve future and present value of 1 problems. See items 5(a) and 6(a) in the
Fundamental Concepts below.
6 Solve future value of ordinary and annuity due problems. See item 5(b)
in the Fundamental Concepts below.
7 Solve present value of ordinary and annuity due problems. See item 6(b)
in the Fundamental Concepts on page 319.
8 Solve present value problems related to deferred annuities and bonds.
Deferred annuities are annuities in which rents begin after a specified number of peri-
ods. The future value of a deferred annuity is computed the same as the future value of
an annuity not deferred. To find the present value of a deferred annuity, compute the |
present value of an ordinary annuity of 1 as if the rents had occurred for the entire
period, and then subtract the present value of rents not received during the deferral
period. The current market price of bonds combines the present values of the interest
annuity and the principal amount.
9 Apply expected cash flows to present value measurement. The ex-
pected cash flow approach uses a range of cash flows and the probabilities of those cash
flows to provide the most likely estimate of expected cash flows. The proper interest
rate used to discount the cash flows is the risk-free rate of return.
FUNDAMENTAL CONCEPTS
1. S IMPLE INTEREST. Interest on principal only, regardless of interest that may have ac-
crued in the past.
2. C OMPOUND INTEREST. Interest accrues on the unpaid interest of past periods as
well as on the principal.
3. R ATE OF INTEREST. Interest is usually expressed as an annual rate, but when the
compounding period is shorter than one year, the interest rate for the shorter period
must be determined.
4. A NNUITY. A series of payments or receipts (called rents) that occur at equal intervals
of time. Types of annuities:
(a) Ordinary Annuity. Each rent is payable (receivable) at the end of the period.
(b) Annuity Due. Each rent is payable (receivable) at the beginning of the period.
5. F UTURE VALUE. Value at a later date of a single sum that is invested at compound
interest.
(a) F uture Value of 1 (or value of a single sum). The future value of $1 (or a single given
sum), FV, at the end of n periods at i compound interest rate (Table 6-1).
(b) F uture Value of an Annuity. The future value of a series of rents invested at com-
pound interest. In other words, the accumulated total that results from a series of
equal deposits at regular intervals invested at compound interest. Both deposits and
interest increase the accumulation.
Demonstration Problem 319
(1) Future Value of an Ordinary Annuity. The future value on the date of the last
rent (Table 6-3).
(2) Future Value of an Annuity Due. The future value one period after the date of
the last rent. When an annuity due table is not available, use Table 6-3 with the
following formula.
Value of annuity due of 1 (Value of ordinary annuity for
5
for n rents n rents) 3 (1 1 interest rate)
6. P RESENT VALUE. The value at an earlier date (usually now) of a given future sum
discounted at compound interest.
(a) Present Value of 1 (or present value of a single sum). The present value (worth) of $1
(or a given sum), due n periods hence, discounted at i compound interest (Table 6-2).
(b) P resent Value of an Annuity. The present value (worth) of a series of rents dis-
counted at compound interest. In other words, it is the sum when invested at com-
pound interest that will permit a series of equal withdrawals at regular intervals.
(1) Present Value of an Ordinary Annuity. The value now of $1 to be received or
paid at the end of each period (rents) for n periods, discounted at i compound
interest (Table 6-4).
(2) Present Value of an Annuity Due. The value now of $1 to be received or paid at
the beginning of each period (rents) for n periods, discounted at i compound
interest (Table 6-5). To use Table 6-4 for an annuity due, apply this formula.
(Present value of an
Present value of annuity due of 1
5 ordinary annuity of n rents)
for n rents
3 (1 1 interest rate)
DEMONSTRATION PROBLEM
Messier Company is a manufacturer of cycling equipment. It is facing several decisions involving time
value of money considerations.
Instructions
Provide the requested information for (a)–(d) below. (Round all answers to the nearest dollar.)
(a) Messier recently signed a lease for a new office building for a lease period of 10 years. Under the
lease agreement, a security deposit of $12,000 is made, with the deposit to be returned at the expira-
tion of the lease, with interest compounded at 10% per year. What amount will the company receive
at the time the lease expires?
(b) Recently, the vice president of operations of the company has requested construction of a new plant |
to meet the increasing demand for the company’s bikes. After a careful evaluation of the request, the
board of directors has decided to raise funds for the new plant by issuing $3,000,000 of 11% term
corporate bonds on March 1, 2014, due on March 1, 2029, with interest payable each March 1 and
September 1. At the time of issuance, the market interest rate for similar financial instruments is
10%. Determine the selling price of the bonds.
(c) The company, having issued the bonds in part (b), is committed to make annual sinking fund
deposits of $90,000. The deposits are made on the last day of each year and yield a return of 10%. Will
the fund at the end of 15 years be sufficient to retire the bonds? If not, what will the deficiency be?
(d) Messier has 50 employees. Recently, after a long negotiation with the local labor union, the com-
pany decided to initiate a pension plan as a part of its employee compensation plan. The plan will
start on January 1, 2014. Each employee covered by the plan is entitled to a pension payment each
year after retirement. As required by accounting standards, the controller of the company needs to
report the pension obligation (liability). The following estimates have been collected.
320 Chapter 6 Accounting and the Time Value of Money
Average length of time to retirement 15 years
Expected life duration after retirement 10 years
Total pension payment expected each year after retirement for all employees $800,000 per year
On the basis of the information above, determine the present value of the pension liability. Assume
payment made at the end of the year and the interest rate to be used is 8%.
Solution
(a) Future value of $12,000 at 10% for 10 years
($12,000 3 2.59374) = $ 31,125
(b) Formula for the interest payments:
PV-OA 5 R (PVF-OA )
n,i
PV-OA 5 $165,000 (PVF-OA )
30,5%
PV-OA 5 $165,000 (15.37245)
PV-OA 5 $2,536,454
Formula for the principal:
PV 5 FV (PVF )
n,i
PV 5 $3,000,000 (PVF )
30,5%
PV 5 $3,000,000 (0.23138)
PV 5 $694,140
The selling price of the bonds 5 $2,536,454 1 $694,140 5 $3,230,594.
(c) Future value of an ordinary annuity of $90,000
at 10% for 15 years ($90,000 3 31.77248) $2,859,523
Defi ciency ($3,000,000 2 $2,859,523) $ 140,477
(d) Compute the value of the deferred annuity and then discount
that amount to the present.
(i) Present value of the expected annual pension payments at the end of the tenth year:
PV-OA 5 R (PVF-OA )
n,i
PV-OA 5 $800,000 (PVF-OA )
10,8%
PV-OA 5 $800,000 (6.71008)
PV-OA 5 $5,368,064
(ii) Present value of the expected annual pension payments at the beginning of the current year:
PV 5 FV (PVF )
n,i
PV 5 $5,368,064 (PVF )
15,8%
PV 5 $5,368,064 (0.31524)
PV 5 $1,692,228
The company’s pension obligation (liability) is $1,692,228.
FASB CODIFICATION
FASB Codification References
[1] FASB ASC 820-10. [Predecessor literature: “Fair Value Measurement,” Statement of Financial Accounting Standards No. 157
(Norwalk, Conn.: FASB, September 2006).]
[2] FASB ASC 310-10. [Predecessor literature: “Accounting by Creditors for Impairment of a Loan,” FASB Statement No. 114
(Norwalk, Conn.: FASB, May 1993).]
[3] FASB ASC 840-30-30. [Predecessor literature: “Accounting for Leases,” FASB Statement No. 13 as amended and interpreted
through May 1980 (Stamford, Conn.: FASB, 1980).]
Questions 321
[4] FASB ASC 715-30-35. [Predecessor literature: “Employers’ Accounting for Pension Plans,” Statement of Financial Accounting
Standards No. 87 (Stamford, Conn.: FASB, 1985).]
[5] FASB ASC 360-10-35. [Predecessor literature: “Accounting for the Impairment or Disposal of Long-Lived Assets,” Statement
of Financial Accounting Standards No. 144 (Norwalk, Conn.: FASB, 2001).]
[6] FASB ASC 718-10-10. [Predecessor literature: “Accounting for Stock-Based Compensation,” Statement of Financial Account-
ing Standards No. 123 (Norwalk, Conn: FASB, 1995); and “Share-Based Payment,” Statement of Financial Accounting Standard
No. 123(R) (Norwalk, Conn: FASB, 2004).]
Exercises
If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in and prepare responses to |
the following. Provide Codification references for your responses.
CE6-1 Access the glossary (“Master Glossary”) to answer the following.
(a) What is the definition of present value?
(b) Briefly describe the term “discount rate adjustment technique.”
(c) Identify the other codification references to present value.
CE6-2 In addition to the list of topics identified in footnote 1 on page 288, identify three areas in which present value is used as
a measurement basis. Briefly describe one topic related to:
(a) Assets. (b) Liabilities. (c) Revenues or expenses.
CE6-3 What is interest cost? Briefly describe imputation of interest.
An additional Codification case can be found in the Using Your Judgment section, on page 333.
Be sure to check the book’s companion website for a Review and Analysis Exercise,
with solution.
Brief Exercises, Exercises, Problems, and many more learning and assessment tools
and resources are available for practice in WileyPLUS.
QUESTIONS
1. What is the time value of money? Why should accoun- (a) 6.71008. (c) .46319.
tants have an understanding of compound interest, (b) 2.15892. (d) 14.48656.
annuities, and present value concepts?
6. Jose Oliva is considering two investment options for a
2. Identify three situations in which accounting measures
$1,500 gift he received for graduation. Both investments
are based on present values. Do these present value
have 8% annual interest rates. One offers quarterly com-
applications involve single sums or annuities, or both
pounding; the other compounds on a semiannual basis.
single sums and annuities? Explain.
Which investment should he choose? Why?
3. What is the nature of interest? Distinguish between 7. Regina Henry deposited $20,000 in a money market cer-
“simple interest” and “compound interest.”
tificate that provides interest of 10% compounded quar-
4. What are the components of an interest rate? Why is it terly if the amount is maintained for 3 years. How much
important for accountants to understand these compo- will Regina Henry have at the end of 3 years?
nents? 8. Will Smith will receive $80,000 on December 31, 2019
5. The following are a number of values taken from com- (5 years from now), from a trust fund established by his
pound interest tables involving the same number of peri- father. Assuming the appropriate interest rate for dis-
ods and the same rate of interest. Indicate what each of counting is 12% (compounded semiannually), what is the
these four values represents. present value of this amount today?
322 Chapter 6 Accounting and the Time Value of Money
9. What are the primary characteristics of an annuity? of each year, with the rents deferred 3 years. What is the
Differentiate between an “ordinary annuity” and an present value of the five rents discounted at 12%?
“annuity due.” 17. Answer the following questions.
10. Kehoe, Inc. owes $40,000 to Ritter Company. How much (a) On May 1, 2014, Goldberg Company sold some ma-
would Kehoe have to pay each year if the debt is retired chinery to Newlin Company on an installment con-
through four equal payments (made at the end of the tract basis. The contract required five equal annual
year), given an interest rate on the debt of 12%? (Round to payments, with the first payment due on May 1, 2014.
two decimal places.) What present value concept is appropriate for this
11. The Kellys are planning for a retirement home. They situation?
estimate they will need $200,000 4 years from now to (b) On June 1, 2014, Seymour Inc. purchased a new ma-
purchase this home. Assuming an interest rate of 10%, chine that it does not have to pay for until May 1, 2016.
what amount must be deposited at the end of each of the The total payment on May 1, 2016, will include both
4 years to fund the home price? (Round to two decimal principal and interest. Assuming interest at a 12% rate,
places.) the cost of the machine would be the total payment
12. Assume the same situation as in Question 11, except that multiplied by what time value of money concept?
the four equal amounts are deposited at the beginning of (c) Costner Inc. wishes to know how much money it will |
the period rather than at the end. In this case, what have available in 5 years if five equal amounts of
amount must be deposited at the beginning of each $35,000 are invested, with the first amount invested
period? (Round to two decimals.) immediately. What interest table is appropriate for
13. Explain how the future value of an ordinary annuity in- this situation?
terest table is converted to the future value of an annuity (d) Megan Hoffman invests in a “jumbo” $200,000, 3-year
due interest table. certificate of deposit at First Wisconsin Bank. What
table would be used to determine the amount accu-
14. Explain how the present value of an ordinary annuity in-
mulated at the end of 3 years?
terest table is converted to the present value of an annuity
due interest table. 18. Recently, Glenda Estes was interested in purchasing a
Honda Acura. The salesperson indicated that the price of
15. In a book named Treasure, the reader has to figure out
the car was either $27,600 cash or $6,900 at the end of each
where a 2.2 pound, 24 kt gold horse has been buried. If the
of 5 years. Compute the effective-interest rate to the near-
horse is found, a prize of $25,000 a year for 20 years is
est percent that Glenda would pay if she chooses to make
provided. The actual cost to the publisher to purchase an
the five annual payments.
annuity to pay for the prize is $245,000. What interest rate
(to the nearest percent) was used to determine the amount 19. Recently, property/casualty insurance companies have been
of the annuity? (Assume end-of-year payments.) criticized because they reserve for the total loss as much as
5 years before it may happen. The IRS has joined the de-
16. Alexander Enterprises leases property to Hamilton, Inc.
bate because it says the full reserve is unfair from a taxation
Because Hamilton, Inc. is experiencing financial difficulty,
viewpoint. What do you believe is the IRS position?
Alexander agrees to receive five rents of $20,000 at the end
BRIEF EXERCISES
(Unless instructed otherwise, round answers to the nearest dollar.)
5 BE6-1 Chris Spear invested $15,000 today in a fund that earns 8% compounded annually. To what amount
will the investment grow in 3 years? To what amount would the investment grow in 3 years if the fund
earns 8% annual interest compounded semiannually?
5 BE6-2 Tony Bautista needs $25,000 in 4 years. What amount must he invest today if his investment earns
12% compounded annually? What amount must he invest if his investment earns 12% annual interest
compounded quarterly?
5 BE6-3 Candice Willis will invest $30,000 today. She needs $150,000 in 21 years. What annual interest rate
must she earn?
5 BE6-4 Bo Newman will invest $10,000 today in a fund that earns 5% annual interest. How many years will
it take for the fund to grow to $17,100?
Exercises 323
6 BE6-5 Sally Medavoy will invest $8,000 a year for 20 years in a fund that will earn 12% annual interest. If
the first payment into the fund occurs today, what amount will be in the fund in 20 years? If the first
payment occurs at year-end, what amount will be in the fund in 20 years?
6 BE6-6 Steve Madison needs $250,000 in 10 years. How much must he invest at the end of each year, at
11% interest, to meet his needs?
5 BE6-7 John Fillmore’s lifelong dream is to own his own fishing boat to use in his retirement. John has
recently come into an inheritance of $400,000. He estimates that the boat he wants will cost $300,000 when
he retires in 5 years. How much of his inheritance must he invest at an annual rate of 12% (compounded
annually) to buy the boat at retirement?
5 BE6-8 Refer to the data in BE6-7. Assuming quarterly compounding of amounts invested at 12%, how
much of John Fillmore’s inheritance must be invested to have enough at retirement to buy the boat?
6 BE6-9 Morgan Freeman is investing $16,380 at the end of each year in a fund that earns 10% interest. In
how many years will the fund be at $100,000?
7 BE6-10 Henry Quincy wants to withdraw $30,000 each year for 10 years from a fund that earns 8% interest. |
How much must he invest today if the first withdrawal is at year-end? How much must he invest today if
the first withdrawal takes place immediately?
7 BE6-11 Leon Tyler’s VISA balance is $793.15. He may pay it off in 12 equal end-of-month payments of $75
each. What interest rate is Leon paying?
7 BE6-12 Maria Alvarez is investing $300,000 in a fund that earns 8% interest compounded annually. What
equal amounts can Maria withdraw at the end of each of the next 20 years?
6 BE6-13 Adams Inc. will deposit $30,000 in a 12% fund at the end of each year for 8 years beginning Decem-
ber 31, 2014. What amount will be in the fund immediately after the last deposit?
7 BE6-14 Amy Monroe wants to create a fund today that will enable her to withdraw $25,000 per year for
8 years, with the first withdrawal to take place 5 years from today. If the fund earns 8% interest, how much
must Amy invest today?
8 BE6-15 Clancey Inc. issues $2,000,000 of 7% bonds due in 10 years with interest payable at year-end. The
current market rate of interest for bonds of similar risk is 8%. What amount will Clancey receive when it
issues the bonds?
7 BE6-16 Zach Taylor is settling a $20,000 loan due today by making 6 equal annual payments of $4,727.53.
Determine the interest rate on this loan, if the payments begin one year after the loan is signed.
7 BE6-17 Consider the loan in BE6-16. What payments must Zach Taylor make to settle the loan at the same
interest rate but with the 6 payments beginning on the day the loan is signed?
EXERCISES
(Unless instructed otherwise, round answers to the nearest dollar. Interest rates are per annum unless
otherwise indicated.)
3 E6-1 (Using Interest Tables) For each of the following cases, indicate (a) to what rate columns, and (b) to
what number of periods you would refer in looking up the interest factor.
1. In a future value of 1 table
Annual Number of
Rate Years Invested Compounded
a. 9% 9 Annually
b. 12% 5 Quarterly
c. 10% 15 Semiannually
2. In a present value of an annuity of 1 table
Annual Number of Number of Frequency of
Rate Years Involved Rents Involved Rents
a. 9% 25 25 Annually
b. 10% 15 30 Semiannually
c. 12% 7 28 Quarterly
324 Chapter 6 Accounting and the Time Value of Money
2 5 E6-2 (Simple and Compound Interest Computations) Alan Jackson invests $20,000 at 8% annual interest,
leaving the money invested without withdrawing any of the interest for 8 years. At the end of the 8 years,
Alan withdraws the accumulated amount of money.
Instructions
(a) Compute the amount Alan would withdraw assuming the investment earns simple interest.
(b) Compute the amount Alan would withdraw assuming the investment earns interest compounded
annually.
(c) Compute the amount Alan would withdraw assuming the investment earns interest compounded
semiannually.
5 6 E6-3 (Computation of Future Values and Present Values) Using the appropriate interest table, answer
7 each of the following questions. (Each case is independent of the others.)
(a) What is the future value of $7,000 at the end of 5 periods at 8% compounded interest?
(b) What is the present value of $7,000 due 8 periods hence, discounted at 11%?
(c) What is the future value of 15 periodic payments of $7,000 each made at the end of each period and
compounded at 10%?
(d) What is the present value of $7,000 to be received at the end of each of 20 periods, discounted at
5% compound interest?
6 7 E6-4 (Computation of Future Values and Present Values) Using the appropriate interest table, answer
the following questions. (Each case is independent of the others).
(a) What is the future value of 20 periodic payments of $4,000 each made at the beginning of each
period and compounded at 8%?
(b) What is the present value of $2,500 to be received at the beginning of each of 30 periods, discounted
at 10% compound interest?
(c) What is the future value of 15 deposits of $2,000 each made at the beginning of each period and
compounded at 10%? (Future value as of the end of the fifteenth period.)
(d) What is the present value of six receipts of $1,000 each received at the beginning of each period, |
discounted at 9% compounded interest?
7 E6-5 (Computation of Present Value) Using the appropriate interest table, compute the present values of
the following periodic amounts due at the end of the designated periods.
(a) $30,000 receivable at the end of each period for 8 periods compounded at 12%.
(b) $30,000 payments to be made at the end of each period for 16 periods at 9%.
(c) $30,000 payable at the end of the seventh, eighth, ninth, and tenth periods at 12%.
5 6 E6-6 (Future Value and Present Value Problems) Presented below are three unrelated situations.
7 (a) Dwayne Wade Company recently signed a lease for a new office building, for a lease period of
10 years. Under the lease agreement, a security deposit of $12,000 is made, with the deposit to be
returned at the expiration of the lease, with interest compounded at 10% per year. What amount will
the company receive at the time the lease expires?
(b) Serena Williams Corporation, having recently issued a $20 million, 15-year bond issue, is committed
to make annual sinking fund deposits of $600,000. The deposits are made on the last day of each
year and yield a return of 10%. Will the fund at the end of 15 years be sufficient to retire the bonds?
If not, what will the deficiency be?
(c) Under the terms of his salary agreement, president Rex Walters has an option of receiving either an
immediate bonus of $40,000, or a deferred bonus of $70,000 payable in 10 years. Ignoring tax consid-
erations and assuming a relevant interest rate of 8%, which form of settlement should Walters accept?
8 E6-7 (Computation of Bond Prices) What would you pay for a $50,000 debenture bond that matures in
15 years and pays $5,000 a year in interest if you wanted to earn a yield of:
(a) 8%? (b) 10%? (c) 12%?
8 E6-8 (Computations for a Retirement Fund) Clarence Weatherspoon, a super salesman contemplating
retirement on his fifty-fifth birthday, decides to create a fund on an 8% basis that will enable him to with-
draw $20,000 per year on June 30, beginning in 2018 and continuing through 2021. To develop this fund,
Clarence intends to make equal contributions on June 30 of each of the years 2014–2017.
Instructions
(a) How much must the balance of the fund equal on June 30, 2017, in order for Clarence Weatherspoon
to satisfy his objective?
(b) What are each of Clarence’s contributions to the fund?
Exercises 325
5 E6-9 (Unknown Rate) LEW Company purchased a machine at a price of $100,000 by signing a note pay-
able, which requires a single payment of $123,210 in 2 years. Assuming annual compounding of interest,
what rate of interest is being paid on the loan?
5 E6-10 (Unknown Periods and Unknown Interest Rate) Consider the following independent situations.
(a) Mike Finley wishes to become a millionaire. His money market fund has a balance of $92,296 and
has a guaranteed interest rate of 10%. How many years must Mike leave that balance in the fund in
order to get his desired $1,000,000?
(b) Assume that Sally Williams desires to accumulate $1 million in 15 years using her money market
fund balance of $182,696. At what interest rate must Sally’s investment compound annually?
7 E6-11 (Evaluation of Purchase Options) Sosa Excavating Inc. is purchasing a bulldozer. The equipment
has a price of $100,000. The manufacturer has offered a payment plan that would allow Sosa to make 10
equal annual payments of $16,274.53, with the first payment due one year after the purchase.
Instructions
(a) How much total interest will Sosa pay on this payment plan?
(b) Sosa could borrow $100,000 from its bank to finance the purchase at an annual rate of 9%. Should
Sosa borrow from the bank or use the manufacturer’s payment plan to pay for the equipment?
7 E6-12 (Analysis of Alternatives) The Black Knights Inc., a manufacturer of low-sugar, low-sodium,
low-cholesterol TV dinners, would like to increase its market share in the Sunbelt. In order to do so, Black
Knights has decided to locate a new factory in the Panama City area. Black Knights will either buy or lease
a site depending upon which is more advantageous. The site location committee has narrowed down the |
available sites to the following three buildings.
Building A: Purchase for a cash price of $600,000, useful life 25 years.
Building B: Lease for 25 years with annual lease payments of $69,000 being made at the beginning of
the year.
Building C: Purchase for $650,000 cash. This building is larger than needed; however, the excess space
can be sublet for 25 years at a net annual rental of $7,000. Rental payments will be received at the end
of each year. The Black Knights Inc. has no aversion to being a landlord.
Instructions
In which building would you recommend that The Black Knights Inc. locate, assuming a 12% cost of funds?
8 E6-13 (Computation of Bond Liability) George Hincapie Inc. manufactures cycling equipment. Recently,
the vice president of operations of the company has requested construction of a new plant to meet the in-
creasing demand for the company’s bikes. After a careful evaluation of the request, the board of directors
has decided to raise funds for the new plant by issuing $2,000,000 of 11% term corporate bonds on March 1,
2014, due on March 1, 2029, with interest payable each March 1 and September 1. At the time of issuance,
the market interest rate for similar financial instruments is 10%.
Instructions
As the controller of the company, determine the selling price of the bonds.
8 E6-14 (Computation of Pension Liability) Nerwin, Inc. is a furniture manufacturing company with 50
employees. Recently, after a long negotiation with the local labor union, the company decided to initiate a
pension plan as a part of its compensation plan. The plan will start on January 1, 2014. Each employee
covered by the plan is entitled to a pension payment each year after retirement. As required by accounting
standards, the controller of the company needs to report the pension obligation (liability). On the basis of
a discussion with the supervisor of the Personnel Department and an actuary from an insurance company,
the controller develops the following information related to the pension plan.
Average length of time to retirement 15 years
Expected life duration after retirement 10 years
Total pension payment expected each year after retirement
for all employees. Payment made at the end of the year. $700,000 per year
The interest rate to be used is 8%.
Instructions
On the basis of the information above, determine the present value of the pension obligation (liability).
5 6 E6-15 (Investment Decision) Andrew Bogut just received a signing bonus of $1,000,000. His plan is to
invest this payment in a fund that will earn 8%, compounded annually.
326 Chapter 6 Accounting and the Time Value of Money
Instructions
(a) If Bogut plans to establish the AB Foundation once the fund grows to $1,999,000, how many years
until he can establish the foundation?
(b) Instead of investing the entire $1,000,000, Bogut invests $300,000 today and plans to make 9 equal
annual investments into the fund beginning one year from today. What amount should the pay-
ments be if Bogut plans to establish the $1,999,000 foundation at the end of 9 years?
6 E6-16 (Retirement of Debt) Jesper Parnevik borrowed $70,000 on March 1, 2012. This amount plus ac-
crued interest at 12% compounded semiannually is to be repaid March 1, 2022. To retire this debt, Jesper
plans to contribute to a debt retirement fund five equal amounts starting on March 1, 2017, and for the next
4 years. The fund is expected to earn 10% per annum.
Instructions
How much must be contributed each year by Jesper Parnevik to provide a fund sufficient to retire the debt
on March 1, 2022?
7 E6-17 (Computation of Amount of Rentals) Your client, Keith Moreland Leasing Company, is preparing
a contract to lease a machine to Souvenirs Corporation for a period of 25 years. Moreland has an invest-
ment cost of $365,755 in the machine, which has a useful life of 25 years and no salvage value at the end of
that time. Your client is interested in earning an 11% return on its investment and has agreed to accept
25 equal rental payments at the end of each of the next 25 years. |
Instructions
You are requested to provide Moreland with the amount of each of the 25 rental payments that will yield
an 11% return on investment.
7 E6-18 (Least Costly Payoff) Assume that Sonic Foundry Corporation has a contractual debt outstanding.
Sonic has available two means of settlement. It can either make immediate payment of $2,600,000, or it can
make annual payments of $300,000 for 15 years, each payment due on the last day of the year.
Instructions
Which method of payment do you recommend, assuming an expected effective interest rate of 8% during
the future period?
7 E6-19 (Least Costly Payoff) Assuming the same facts as those in E6-18 except that the payments must
begin now and be made on the first day of each of the 15 years, what payment method would you
recommend?
9 E6-20 (Expected Cash Flows) For each of the following, determine the expected cash flows.
Cash Flow Probability
Estimate Assessment
(a) $ 4,800 20%
6,300 50%
7,500 30%
(b) $ 5,400 30%
7,200 50%
8,400 20%
(c) $(1,000) 10%
3,000 80%
5,000 10%
9 E6-21 (Expected Cash Flows and Present Value) Keith Bowie is trying to determine the amount to set
aside so that he will have enough money on hand in 2 years to overhaul the engine on his vintage used car.
While there is some uncertainty about the cost of engine overhauls in 2 years, by conducting some research
online, Keith has developed the following estimates.
Engine Overhaul Probability
Estimated Cash Outfl ow Assessment
$200 10%
450 30%
600 50%
750 10%
Instructions
How much should Keith Bowie deposit today in an account earning 6%, compounded annually, so that he
will have enough money on hand in 2 years to pay for the overhaul?
Problems 327
9 E6-22 (Fair Value Estimate) Killroy Company owns a trade name that was purchased in an acquisition of
McClellan Company. The trade name has a book value of $3,500,000, but according to GAAP, it is assessed
for impairment on an annual basis. To perform this impairment test, Killroy must estimate the fair value of
the trade name. (You will learn more about intangible asset impairments in Chapter 12.) It has developed
the following cash flow estimates related to the trade name based on internal information. Each cash flow
estimate reflects Killroy’s estimate of annual cash flows over the next 8 years. The trade name is assumed
to have no salvage value after the 8 years. (Assume the cash flows occur at the end of each year.)
Probability
Cash Flow Estimate Assessment
$380,000 20%
630,000 50%
750,000 30%
Instructions
(a) What is the estimated fair value of the trade name? Killroy determines that the appropriate discount
rate for this estimation is 8%.
(b) Is the estimate developed for part (a) a Level 1 or Level 3 fair value estimate? Explain.
EXERCISES SET B
See the book’s companion website, at www.wiley.com/college/kieso, for an additional
set of exercises.
PROBLEMS
(Unless instructed otherwise, round answers to the nearest dollar. Interest rates are per annum unless
otherwise indicated.)
5 7 P6-1 (Various Time Value Situations) Answer each of these unrelated questions.
(a) On January 1, 2014, Fishbone Corporation sold a building that cost $250,000 and that had accumu-
lated depreciation of $100,000 on the date of sale. Fishbone received as consideration a $240,000
non-interest-bearing note due on January 1, 2017. There was no established exchange price for the
building, and the note had no ready market. The prevailing rate of interest for a note of this type on
January 1, 2014, was 9%. At what amount should the gain from the sale of the building be reported?
(b) On January 1, 2014, Fishbone Corporation purchased 300 of the $1,000 face value, 9%, 10-year bonds
of Walters Inc. The bonds mature on January 1, 2024, and pay interest annually beginning January
1, 2015. Fishbone purchased the bonds to yield 11%. How much did Fishbone pay for the bonds?
(c) Fishbone Corporation bought a new machine and agreed to pay for it in equal annual installments
of $4,000 at the end of each of the next 10 years. Assuming that a prevailing interest rate of 8%
applies to this contract, how much should Fishbone record as the cost of the machine? |
(d) Fishbone Corporation purchased a special tractor on December 31, 2014. The purchase agreement
stipulated that Fishbone should pay $20,000 at the time of purchase and $5,000 at the end of each of
the next 8 years. The tractor should be recorded on December 31, 2014, at what amount, assuming
an appropriate interest rate of 12%?
(e) Fishbone Corporation wants to withdraw $120,000 (including principal) from an investment fund
at the end of each year for 9 years. What should be the required initial investment at the beginning
of the first year if the fund earns 11%?
5 6 P6-2 (Various Time Value Situations) Using the appropriate interest table, provide the solution to each of
7 the following four questions by computing the unknowns.
(a) What is the amount of the payments that Ned Winslow must make at the end of each of 8 years to
accumulate a fund of $90,000 by the end of the eighth year, if the fund earns 8% interest, com-
pounded annually?
(b) Robert Hitchcock is 40 years old today and he wishes to accumulate $500,000 by his sixty-fifth birth-
day so he can retire to his summer place on Lake Hopatcong. He wishes to accumulate this amount
328 Chapter 6 Accounting and the Time Value of Money
by making equal deposits on his fortieth through his sixty-fourth birthdays. What annual deposit
must Robert make if the fund will earn 12% interest compounded annually?
(c) Diane Ross has $20,000 to invest today at 9% to pay a debt of $47,347. How many years will it take
her to accumulate enough to liquidate the debt?
(d) Cindy Houston has a $27,600 debt that she wishes to repay 4 years from today; she has $19,553 that
she intends to invest for the 4 years. What rate of interest will she need to earn annually in order to
accumulate enough to pay the debt?
5 7 P6-3 (Analysis of Alternatives) Assume that Wal-Mart Stores, Inc. has decided to surface and maintain
for 10 years a vacant lot next to one of its stores to serve as a parking lot for customers. Management is
considering the following bids involving two different qualities of surfacing for a parking area of 12,000
square yards.
Bid A: A surface that costs $5.75 per square yard to install. This surface will have to be replaced at the
end of 5 years. The annual maintenance cost on this surface is estimated at 25 cents per square yard for
each year except the last year of its service. The replacement surface will be similar to the initial surface.
Bid B: A surface that costs $10.50 per square yard to install. This surface has a probable useful life of
10 years and will require annual maintenance in each year except the last year, at an estimated cost of
9 cents per square yard.
Instructions
Prepare computations showing which bid should be accepted by Wal-Mart. You may assume that the cost
of capital is 9%, that the annual maintenance expenditures are incurred at the end of each year, and that
prices are not expected to change during the next 10 years.
7 P6-4 (Evaluating Payment Alternatives) Howie Long has just learned he has won a $500,000 prize in
the lottery. The lottery has given him two options for receiving the payments. (1) If Howie takes all the
money today, the state and federal governments will deduct taxes at a rate of 46% immediately. (2) Al-
ternatively, the lottery offers Howie a payout of 20 equal payments of $36,000 with the first payment
occurring when Howie turns in the winning ticket. Howie will be taxed on each of these payments at a
rate of 25%.
Instructions
Assuming Howie can earn an 8% rate of return (compounded annually) on any money invested during
this period, which pay-out option should he choose?
5 7 P6-5 (Analysis of Alternatives) Julia Baker died, leaving to her husband Brent an insurance policy con-
tract that provides that the beneficiary (Brent) can choose any one of the following four options.
(a) $55,000 immediate cash.
(b) $4,000 every 3 months payable at the end of each quarter for 5 years.
(c) $18,000 immediate cash and $1,800 every 3 months for 10 years, payable at the beginning of each
3-month period. |
(d) $4,000 every 3 months for 3 years and $1,500 each quarter for the following 25 quarters, all pay-
ments payable at the end of each quarter.
Instructions
If money is worth 2½% per quarter, compounded quarterly, which option would you recommend that
Brent exercise?
8 P6-6 (Purchase Price of a Business) During the past year, Stacy McGill planted a new vineyard on 150
acres of land that she leases for $30,000 a year. She has asked you, as her accountant, to assist her in deter-
mining the value of her vineyard operation.
The vineyard will bear no grapes for the first 5 years (1–5). In the next 5 years (6–10), Stacy estimates
that the vines will bear grapes that can be sold for $60,000 each year. For the next 20 years (11–30), she ex-
pects the harvest will provide annual revenues of $110,000. But during the last 10 years (31–40) of the
vineyard’s life, she estimates that revenues will decline to $80,000 per year.
During the first 5 years, the annual cost of pruning, fertilizing, and caring for the vineyard is estimated
at $9,000; during the years of production, 6–40, these costs will rise to $12,000 per year. The relevant market
rate of interest for the entire period is 12%. Assume that all receipts and payments are made at the end of
each year.
Instructions
Dick Button has offered to buy Stacy’s vineyard business by assuming the 40-year lease. On the basis of the
current value of the business, what is the minimum price Stacy should accept?
Problems 329
5 6 P6-7 (Time Value Concepts Applied to Solve Business Problems) Answer the following questions re-
lated to Dubois Inc.
7
(a) Dubois Inc. has $600,000 to invest. The company is trying to decide between two alternative uses
of the funds. One alternative provides $80,000 at the end of each year for 12 years, and the other
is to receive a single lump-sum payment of $1,900,000 at the end of the 12 years. Which alterna-
tive should Dubois select? Assume the interest rate is constant over the entire investment.
(b) Dubois Inc. has completed the purchase of new Dell computers. The fair value of the equipment is
$824,150. The purchase agreement specifies an immediate down payment of $200,000 and semian-
nual payments of $76,952 beginning at the end of 6 months for 5 years. What is the interest rate, to
the nearest percent, used in discounting this purchase transaction?
(c) Dubois Inc. loans money to John Kruk Corporation in the amount of $800,000. Dubois accepts an 8% note
due in 7 years with interest payable semiannually. After 2 years (and receipt of interest for 2 years), Dubois
needs money and therefore sells the note to Chicago National Bank, which demands interest on the note
of 10% compounded semiannually. What is the amount Dubois will receive on the sale of the note?
(d) Dubois Inc. wishes to accumulate $1,300,000 by December 31, 2024, to retire bonds outstanding. The
company deposits $200,000 on December 31, 2014, which will earn interest at 10% compounded
quarterly, to help in the retirement of this debt. In addition, the company wants to know how much
should be deposited at the end of each quarter for 10 years to ensure that $1,300,000 is available at
the end of 2024. (The quarterly deposits will also earn at a rate of 10%, compounded quarterly.)
(Round to even dollars.)
7 P6-8 (Analysis of Alternatives) Ellison Inc., a manufacturer of steel school lockers, plans to purchase a
new punch press for use in its manufacturing process. After contacting the appropriate vendors, the pur-
chasing department received differing terms and options from each vendor. The Engineering Department
has determined that each vendor’s punch press is substantially identical and each has a useful life of 20
years. In addition, Engineering has estimated that required year-end maintenance costs will be $1,000 per
year for the first 5 years, $2,000 per year for the next 10 years, and $3,000 per year for the last 5 years. Fol-
lowing is each vendor’s sale package.
Vendor A: $55,000 cash at time of delivery and 10 year-end payments of $18,000 each. Vendor A of- |
fers all its customers the right to purchase at the time of sale a separate 20-year maintenance service
contract, under which Vendor A will perform all year-end maintenance at a one-time initial cost of
$10,000.
Vendor B: Forty semiannual payments of $9,500 each, with the first installment due upon delivery.
Vendor B will perform all year-end maintenance for the next 20 years at no extra charge.
Vendor C: Full cash price of $150,000 will be due upon delivery.
Instructions
Assuming that both Vendors A and B will be able to perform the required year-end maintenance, that
Ellison’s cost of funds is 10%, and the machine will be purchased on January 1, from which vendor should
the press be purchased?
5 7 P6-9 (Analysis of Business Problems) James Kirk is a financial executive with McDowell Enterprises.
Although James Kirk has not had any formal training in finance or accounting, he has a “good sense” for
numbers and has helped the company grow from a very small company ($500,000 sales) to a large opera-
tion ($45 million in sales). With the business growing steadily, however, the company needs to make a
number of difficult financial decisions in which James Kirk feels a little “over his head.” He therefore has
decided to hire a new employee with “numbers” expertise to help him. As a basis for determining whom
to employ, he has decided to ask each prospective employee to prepare answers to questions relating to the
following situations he has encountered recently. Here are the questions.
(a) In 2013, McDowell Enterprises negotiated and closed a long-term lease contract for newly con-
structed truck terminals and freight storage facilities. The buildings were constructed on land
owned by the company. On January 1, 2014, McDowell took possession of the leased property. The
20-year lease is effective for the period January 1, 2014, through December 31, 2033. Advance rental
payments of $800,000 are payable to the lessor (owner of facilities) on January 1 of each of the first
10 years of the lease term. Advance payments of $400,000 are due on January 1 for each of the last
10 years of the lease term. McDowell has an option to purchase all the leased facilities for $1 on
December 31, 2033. At the time the lease was negotiated, the fair value of the truck terminals and
freight storage facilities was approximately $7,200,000. If the company had borrowed the money to
purchase the facilities, it would have had to pay 10% interest. Should the company have purchased
rather than leased the facilities?
330 Chapter 6 Accounting and the Time Value of Money
(b) Last year the company exchanged a piece of land for a non-interest-bearing note. The note is to be
paid at the rate of $15,000 per year for 9 years, beginning one year from the date of disposal of the
land. An appropriate rate of interest for the note was 11%. At the time the land was originally pur-
chased, it cost $90,000. What is the fair value of the note?
(c) The company has always followed the policy to take any cash discounts on goods purchased. Re-
cently, the company purchased a large amount of raw materials at a price of $800,000 with terms
1/10, n/30 on which it took the discount. McDowell has recently estimated its cost of funds at 10%.
Should McDowell continue this policy of always taking the cash discount?
5 7 P6-10 (Analysis of Lease vs. Purchase) Dunn Inc. owns and operates a number of hardware stores in the
New England region. Recently, the company has decided to locate another store in a rapidly growing area of
Maryland. The company is trying to decide whether to purchase or lease the building and related facilities.
Purchase: The company can purchase the site, construct the building, and purchase all store fi xtures.
The cost would be $1,850,000. An immediate down payment of $400,000 is required, and the remaining
$1,450,000 would be paid off over 5 years at $350,000 per year (including interest payments made at end of
year). The property is expected to have a useful life of 12 years, and then it will be sold for $500,000. As the |
owner of the property, the company will have the following out-of-pocket expenses each period.
Property taxes (to be paid at the end of each year) $40,000
Insurance (to be paid at the beginning of each year) 27,000
Other (primarily maintenance which occurs at the end of each year) 16,000
$83,000
Lease: First National Bank has agreed to purchase the site, construct the building, and install the ap-
propriate fi xtures for Dunn Inc. if Dunn will lease the completed facility for 12 years. The annual costs for
the lease would be $270,000. Dunn would have no responsibility related to the facility over the 12 years.
The terms of the lease are that Dunn would be required to make 12 annual payments (the fi rst payment
to be made at the time the store opens and then each following year). In addition, a deposit of $100,000 is
required when the store is opened. This deposit will be returned at the end of the twelfth year, assuming
no unusual damage to the building structure or fi xtures.
Instructions
Which of the two approaches should Dunn Inc. follow? (Currently, the cost of funds for Dunn Inc. is 10%.)
8 P6-11 (Pension Funding) You have been hired as a benefit consultant by Jean Honore, the owner of Attic
Angels. She wants to establish a retirement plan for herself and her three employees. Jean has provided the
following information. The retirement plan is to be based upon annual salary for the last year before retirement
and is to provide 50% of Jean’s last-year annual salary and 40% of the last-year annual salary for each em-
ployee. The plan will make annual payments at the beginning of each year for 20 years from the date of retire-
ment. Jean wishes to fund the plan by making 15 annual deposits beginning January 1, 2014. Invested funds
will earn 12% compounded annually. Information about plan participants as of January 1, 2014, is as follows.
Jean Honore, owner: Current annual salary of $48,000; estimated retirement date January 1, 2039.
Colin Davis, fl ower arranger: Current annual salary of $36,000; estimated retirement date January 1, 2044.
Anita Baker, sales clerk: Current annual salary of $18,000; estimated retirement date January 1, 2034.
Gavin Bryars, part-time bookkeeper: Current annual salary of $15,000; estimated retirement date January 1, 2029.
In the past, Jean has given herself and each employee a year-end salary increase of 4%. Jean plans to con-
tinue this policy in the future.
Instructions
(a) Based upon the above information, what will be the annual retirement benefit for each plan partici-
pant? (Round to the nearest dollar.) (Hint: Jean will receive raises for 24 years.)
(b) What amount must be on deposit at the end of 15 years to ensure that all benefits will be paid?
(Round to the nearest dollar.)
(c) What is the amount of each annual deposit Jean must make to the retirement plan?
8 P6-12 (Pension Funding) Craig Brokaw, newly appointed controller of STL, is considering ways to reduce
his company’s expenditures on annual pension costs. One way to do this is to switch STL’s pension fund
assets from First Security to NET Life. STL is a very well-respected computer manufacturer that recently
has experienced a sharp decline in its financial performance for the first time in its 25-year history. Despite
financial problems, STL still is committed to providing its employees with good pension and postretire-
ment health benefits.
Under its present plan with First Security, STL is obligated to pay $43 million to meet the expected
value of future pension benefits that are payable to employees as an annuity upon their retirement from the
Problems 331
company. On the other hand, NET Life requires STL to pay only $35 million for identical future pension
benefits. First Security is one of the oldest and most reputable insurance companies in North America. NET
Life has a much weaker reputation in the insurance industry. In pondering the significant difference in
annual pension costs, Brokaw asks himself, “Is this too good to be true?”
Instructions
Answer the following questions. |
(a) Why might NET Life’s pension cost requirement be $8 million less than First Security’s requirement
for the same future value?
(b) What ethical issues should Craig Brokaw consider before switching STL’s pension fund assets?
(c) Who are the stakeholders that could be affected by Brokaw’s decision?
7 9 P6-13 (Expected Cash Flows and Present Value) Danny’s Lawn Equipment sells high-quality lawn mow-
ers and offers a 3-year warranty on all new lawn mowers sold. In 2014, Danny sold $300,000 of new spe-
cialty mowers for golf greens for which Danny’s service department does not have the equipment to do the
service. Danny has entered into an agreement with Mower Mavens to provide all warranty service on
the special mowers sold in 2014. Danny wishes to measure the fair value of the agreement to determine the
warranty liability for sales made in 2014. The controller for Danny’s Lawn Equipment estimates the follow-
ing expected warranty cash outflows associated with the mowers sold in 2014.
Cash Flow Probability
Year Estimate Assessment
2015 $2,500 20%
4,000 60%
5,000 20%
2016 $3,000 30%
5,000 50%
6,000 20%
2017 $4,000 30%
6,000 40%
7,000 30%
Instructions
Using expected cash flow and present value techniques, determine the value of the warranty liability for
the 2014 sales. Use an annual discount rate of 5%. Assume all cash flows occur at the end of the year.
7 9 P6-14 (Expected Cash Flows and Present Value) At the end of 2014, Sawyer Company is conducting an
impairment test and needs to develop a fair value estimate for machinery used in its manufacturing opera-
tions. Given the nature of Sawyer’s production process, the equipment is for special use. (No secondhand
market values are available.) The equipment will be obsolete in 2 years, and Sawyer’s accountants have
developed the following cash flow information for the equipment.
Net Cash Flow Probability
Year Estimate Assessment
2015 $6,000 40%
9,000 60%
2016 $ (500) 20%
2,000 60%
4,000 20%
Scrap value
2016 $ 500 50%
900 50%
Instructions
Using expected cash flow and present value techniques, determine the fair value of the machinery at the
end of 2014. Use a 6% discount rate. Assume all cash flows occur at the end of the year.
8 9 P6-15 (Fair Value Estimate) Murphy Mining Company recently purchased a quartz mine that it intends
to work for the next 10 years. According to state environmental laws, Murphy must restore the mine site to
its original natural prairie state after it ceases mining operations at the site. To properly account for the
mine, Murphy must estimate the fair value of this asset retirement obligation. This amount will be recorded
as a liability and added to the value of the mine on Murphy’s books. (You will learn more about these asset
retirement obligations in Chapters 10 and 13.)
332 Chapter 6 Accounting and the Time Value of Money
There is no active market for retirement obligations such as these, but Murphy has developed the fol-
lowing cash flow estimates based on its prior experience in mining-site restoration. It will take 3 years to
restore the mine site when mining operations cease in 10 years. Each estimated cash outflow reflects an
annual payment at the end of each year of the 3-year restoration period.
Restoration Estimated Probability
Cash Outflow Assessment
$15,000 10%
22,000 30%
25,000 50%
30,000 10%
Instructions
(a) What is the estimated fair value of Murphy’s asset retirement obligation? Murphy determines that
the appropriate discount rate for this estimation is 5%. Round calculations to the nearest dollar.
(b) Is the estimate developed for part (a) a Level 1 or Level 3 fair value estimate? Explain.
PROBLEMS SET B
See the book’s companion website, at www.wiley.com/college/kieso, for an additional
set of problems.
USING YOUR JUDGMENT
FINANCIAL REPORTING
Financial Reporting Problem
The Procter & Gamble Company (P&G)
The financial statements of P&G are presented in Appendix 5B. The company's complete annual
report, including the notes to the financial statements, can be accessed at the book’s companion website,
www.wiley.com/college/kieso. |
Instructions
(a) Examining each item in P&G’s balance sheet, identify those items that require present value, discount-
ing, or interest computations in establishing the amount reported. (The accompanying notes are an
additional source for this information.)
(b) (1) What interest rates are disclosed by P&G as being used to compute interest and present values?
(2) Why are there so many different interest rates applied to P&G’s financial statement elements (assets,
liabilities, revenues, and expenses)?
Financial Statement Analysis Case
Consolidated Natural Gas Company
Consolidated Natural Gas Company (CNG), with corporate headquarters in Pittsburgh, Pennsylvania, is
one of the largest producers, transporters, distributors, and marketers of natural gas in North America.
Periodically, the company experiences a decrease in the value of its gas- and oil-producing properties,
and a special charge to income was recorded in order to reduce the carrying value of those assets.
Assume the following information. In 2013, CNG estimated the cash inflows from its oil- and gas-
producing properties to be $375,000 per year. During 2014, the write-downs described above caused the
estimate to be decreased to $275,000 per year. Production costs (cash outflows) associated with all these prop-
erties were estimated to be $125,000 per year in 2013, but this amount was revised to $155,000 per year in 2014.
Instructions
(Assume that all cash flows occur at the end of the year.)
(a) Calculate the present value of net cash flows for 2013–2015 (three years), using the 2013 estimates and
a 10% discount factor.
(b) Calculate the present value of net cash flows for 2014–2016 (three years), using the 2014 estimates and
a 10% discount factor.
Using Your Judgment 333
(c) Compare the results using the two estimates. Is information on future cash flows from oil- and gas-
producing properties useful, considering that the estimates must be revised each year? Explain.
Accounting, Analysis, and Principles
Johnson Co. accepts a note receivable from a customer in exchange for some damaged inventory. The note
requires the customer make semiannual installments of $50,000 each for 10 years. The first installment
begins six months from the date the customer took delivery of the damaged inventory. Johnson’s manage-
ment estimates that the fair value of the damaged inventory is $679,517.
Accounting
(a) What interest rate is Johnson implicitly charging the customer? Express the rate as an annual rate but
assume semiannual compounding.
(b) At what dollar amount do you think Johnson should record the note receivable on the day the cus-
tomer takes delivery of the damaged inventory?
Analysis
Assume the note receivable for damaged inventory makes up a significant portion of Johnson’s assets. If
interest rates increase, what happens to the fair value of the receivable? Briefly explain why.
Principles
The Financial Accounting Standards Board recently issued an accounting standard that allows companies
to report assets such as notes receivable at fair value. Discuss how fair value versus historical cost poten-
tially involves a trade-off of one desired quality of accounting information against another.
BRIDGE TO THE PROFESSION
Professional Research
At a recent meeting of the accounting staff in your company, the controller raised the issue of using present
value techniques to conduct impairment tests for some of the company’s fixed assets. Some of the more
senior members of the staff admitted having little knowledge of present value concepts in this context, but
they had heard about a FASB Concepts Statement that may be relevant. As the junior staff in the depart-
ment, you have been asked to conduct some research of the authoritative literature on this topic and report
back at the staff meeting next week.
Instructions
If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in and access
the FASB Statements of Financial Accounting Concepts. When you have accessed the documents, you can use |
the search tool in your Internet browser to respond to the following items. (Provide paragraph citations.)
(a) Identify the recent concept statement that addresses present value measurement in accounting.
(b) What are some of the contexts in which present value concepts are applied in accounting measurement?
(c) Provide definitions for the following terms:
(1) Best estimate.
(2) Estimated cash flow (contrasted to expected cash flow).
(3) Fresh-start measurement.
(4) Interest methods of allocation.
Additional Professional Resources
See the book’s companion website, at www.wiley.com/college/kieso, for professional
simulations as well as other study resources.
Remember to check the book’s companion website to fi nd additional
resources for this chapter.
334 Chapter 6 Accounting and the Time Value of Money
TABLE 6-1 FUTURE VALUE OF 1 (FUTURE VALUE OF A SINGLE SUM)
FVF (1 i)n
n,i
(n)
Periods 2% 21⁄ 2% 3% 4% 5% 6%
1 1.02000 1.02500 1.03000 1.04000 1.05000 1.06000
2 1.04040 1.05063 1.06090 1.08160 1.10250 1.12360
3 1.06121 1.07689 1.09273 1.12486 1.15763 1.19102
4 1.08243 1.10381 1.12551 1.16986 1.21551 1.26248
5 1.10408 1.13141 1.15927 1.21665 1.27628 1.33823
6 1.12616 1.15969 1.19405 1.26532 1.34010 1.41852
7 1.14869 1.18869 1.22987 1.31593 1.40710 1.50363
8 1.17166 1.21840 1.26677 1.36857 1.47746 1.59385
9 1.19509 1.24886 1.30477 1.42331 1.55133 1.68948
10 1.21899 1.28008 1.34392 1.48024 1.62889 1.79085
11 1.24337 1.31209 1.38423 1.53945 1.71034 1.89830
12 1.26824 1.34489 1.42576 1.60103 1.79586 2.01220
13 1.29361 1.37851 1.46853 1.66507 1.88565 2.13293
14 1.31948 1.41297 1.51259 1.73168 1.97993 2.26090
15 1.34587 1.44830 1.55797 1.80094 2.07893 2.39656
16 1.37279 1.48451 1.60471 1.87298 2.18287 2.54035
17 1.40024 1.52162 1.65285 1.94790 2.29202 2.69277
18 1.42825 1.55966 1.70243 2.02582 2.40662 2.85434
19 1.45681 1.59865 1.75351 2.10685 2.52695 3.02560
20 1.48595 1.63862 1.80611 2.19112 2.65330 3.20714
21 1.51567 1.67958 1.86029 2.27877 2.78596 3.39956
22 1.54598 1.72157 1.91610 2.36992 2.92526 3.60354
23 1.57690 1.76461 1.97359 2.46472 3.07152 3.81975
24 1.60844 1.80873 2.03279 2.56330 3.22510 4.04893
25 1.64061 1.85394 2.09378 2.66584 3.38635 4.29187
26 1.67342 1.90029 2.15659 2.77247 3.55567 4.54938
27 1.70689 1.94780 2.22129 2.88337 3.73346 4.82235
28 1.74102 1.99650 2.28793 2.99870 3.92013 5.11169
29 1.77584 2.04641 2.35657 3.11865 4.11614 5.41839
30 1.81136 2.09757 2.42726 3.24340 4.32194 5.74349
31 1.84759 2.15001 2.50008 3.37313 4.53804 6.08810
32 1.88454 2.20376 2.57508 3.50806 4.76494 6.45339
33 1.92223 2.25885 2.65234 3.64838 5.00319 6.84059
34 1.96068 2.31532 2.73191 3.79432 5.25335 7.25103
35 1.99989 2.37321 2.81386 3.94609 5.51602 7.68609
36 2.03989 2.43254 2.89828 4.10393 5.79182 8.14725
37 2.08069 2.49335 2.98523 4.26809 6.08141 8.63609
38 2.12230 2.55568 3.07478 4.43881 6.38548 9.15425
39 2.16474 2.61957 3.16703 4.61637 6.70475 9.70351
40 2.20804 2.68506 3.26204 4.80102 7.03999 10.28572
Future Value of 1 335
TABLE 6-1 FUTURE VALUE OF 1
(n)
8% 9% 10% 11% 12% 15% Periods
1.08000 1.09000 1.10000 1.11000 1.12000 1.15000 1
1.16640 1.18810 1.21000 1.23210 1.25440 1.32250 2
1.25971 1.29503 1.33100 1.36763 1.40493 1.52088 3
1.36049 1.41158 1.46410 1.51807 1.57352 1.74901 4
1.46933 1.53862 1.61051 1.68506 1.76234 2.01136 5
1.58687 1.67710 1.77156 1.87041 1.97382 2.31306 6
1.71382 1.82804 1.94872 2.07616 2.21068 2.66002 7
1.85093 1.99256 2.14359 2.30454 2.47596 3.05902 8
1.99900 2.17189 2.35795 2.55803 2.77308 3.51788 9
2.15892 2.36736 2.59374 2.83942 3.10585 4.04556 10
2.33164 2.58043 2.85312 3.15176 3.47855 4.65239 11
2.51817 2.81267 3.13843 3.49845 3.89598 5.35025 12
2.71962 3.06581 3.45227 3.88328 4.36349 6.15279 13
2.93719 3.34173 3.79750 4.31044 4.88711 7.07571 14
3.17217 3.64248 4.17725 4.78459 5.47357 8.13706 15
3.42594 3.97031 4.59497 5.31089 6.13039 9.35762 16
3.70002 4.32763 5.05447 5.89509 6.86604 10.76126 17
3.99602 4.71712 5.55992 6.54355 7.68997 12.37545 18
4.31570 5.14166 6.11591 7.26334 8.61276 14.23177 19
4.66096 5.60441 6.72750 8.06231 9.64629 16.36654 20
5.03383 6.10881 7.40025 8.94917 10.80385 18.82152 21 |
5.43654 6.65860 8.14028 9.93357 12.10031 21.64475 22
5.87146 7.25787 8.95430 11.02627 13.55235 24.89146 23
6.34118 7.91108 9.84973 12.23916 15.17863 28.62518 24
6.84847 8.62308 10.83471 13.58546 17.00000 32.91895 25
7.39635 9.39916 11.91818 15.07986 19.04007 37.85680 26
7.98806 10.24508 13.10999 16.73865 21.32488 43.53532 27
8.62711 11.16714 14.42099 18.57990 23.88387 50.06561 28
9.31727 12.17218 15.86309 20.62369 26.74993 57.57545 29
10.06266 13.26768 17.44940 22.89230 29.95992 66.21177 30
10.86767 14.46177 19.19434 25.41045 33.55511 76.14354 31
11.73708 15.76333 21.11378 28.20560 37.58173 87.56507 32
12.67605 17.18203 23.22515 31.30821 42.09153 100.69983 33
13.69013 18.72841 25.54767 34.75212 47.14252 115.80480 34
14.78534 20.41397 28.10244 38.57485 52.79962 133.17552 35
15.96817 22.25123 30.91268 42.81808 59.13557 153.15185 36
17.24563 24.25384 34.00395 47.52807 66.23184 176.12463 37
18.62528 26.43668 37.40434 52.75616 74.17966 202.54332 38
20.11530 28.81598 41.14479 58.55934 83.08122 232.92482 39
21.72452 31.40942 45.25926 65.00087 93.05097 267.86355 40
336 Chapter 6 Accounting and the Time Value of Money
TABLE 6-2 PRESENT VALUE OF 1 (PRESENT VALUE OF A SINGLE SUM)
1
PVF (1 i) n
n,i (1 i)n
(n)
Periods 2% 21⁄ 2% 3% 4% 5% 6%
1 .98039 .97561 .97087 .96154 .95238 .94340
2 .96117 .95181 .94260 .92456 .90703 .89000
3 .94232 .92860 .91514 .88900 .86384 .83962
4 .92385 .90595 .88849 .85480 .82270 .79209
5 .90573 .88385 .86261 .82193 .78353 .74726
6 .88797 .86230 .83748 .79031 .74622 .70496
7 .87056 .84127 .81309 .75992 .71068 .66506
8 .85349 .82075 .78941 .73069 .67684 .62741
9 .83676 .80073 .76642 .70259 .64461 .59190
10 .82035 .78120 .74409 .67556 .61391 .55839
11 .80426 .76214 .72242 .64958 .58468 .52679
12 .78849 .74356 .70138 .62460 .55684 .49697
13 .77303 .72542 .68095 .60057 .53032 .46884
14 .75788 .70773 .66112 .57748 .50507 .44230
15 .74301 .69047 .64186 .55526 .48102 .41727
16 .72845 .67362 .62317 .53391 .45811 .39365
17 .71416 .65720 .60502 .51337 .43630 .37136
18 .70016 .64117 .58739 .49363 .41552 .35034
19 .68643 .62553 .57029 .47464 .39573 .33051
20 .67297 .61027 .55368 .45639 .37689 .31180
21 .65978 .59539 .53755 .43883 .35894 .29416
22 .64684 .58086 .52189 .42196 .34185 .27751
23 .63416 .56670 .50669 .40573 .32557 .26180
24 .62172 .55288 .49193 .39012 .31007 .24698
25 .60953 .53939 .47761 .37512 .29530 .23300
26 .59758 .52623 .46369 .36069 .28124 .21981
27 .58586 .51340 .45019 .34682 .26785 .20737
28 .57437 .50088 .43708 .33348 .25509 .19563
29 .56311 .48866 .42435 .32065 .24295 .18456
30 .55207 .47674 .41199 .30832 .23138 .17411
31 .54125 .46511 .39999 .29646 .22036 .16425
32 .53063 .45377 .38834 .28506 .20987 .15496
33 .52023 .44270 .37703 .27409 .19987 .14619
34 .51003 .43191 .36604 .26355 .19035 .13791
35 .50003 .42137 .35538 .25342 .18129 .13011
36 .49022 .41109 .34503 .24367 .17266 .12274
37 .48061 .40107 .33498 .23430 .16444 .11579
38 .47119 .39128 .32523 .22529 .15661 .10924
39 .46195 .38174 .31575 .21662 .14915 .10306
40 .45289 .37243 .30656 .20829 .14205 .09722
Present Value of 1 337
TABLE 6-2 PRESENT VALUE OF 1
(n)
8% 9% 10% 11% 12% 15% Periods
.92593 .91743 .90909 .90090 .89286 .86957 1
.85734 .84168 .82645 .81162 .79719 .75614 2
.79383 .77218 .75132 .73119 .71178 .65752 3
.73503 .70843 .68301 .65873 .63552 .57175 4
.68058 .64993 .62092 .59345 .56743 .49718 5
.63017 .59627 .56447 .53464 .50663 .43233 6
.58349 .54703 .51316 .48166 .45235 .37594 7
.54027 .50187 .46651 .43393 .40388 .32690 8
.50025 .46043 .42410 .39092 .36061 .28426 9
.46319 .42241 .38554 .35218 .32197 .24719 10
.42888 .38753 .35049 .31728 .28748 .21494 11
.39711 .35554 .31863 .28584 .25668 .18691 12
.36770 .32618 .28966 .25751 .22917 .16253 13
.34046 .29925 .26333 .23199 .20462 .14133 14
.31524 .27454 .23939 .20900 .18270 .12289 15
.29189 .25187 .21763 .18829 .16312 .10687 16
.27027 .23107 .19785 .16963 .14564 .09293 17
.25025 .21199 .17986 .15282 .13004 .08081 18
.23171 .19449 .16351 .13768 .11611 .07027 19
.21455 .17843 .14864 .12403 .10367 .06110 20
.19866 .16370 .13513 .11174 .09256 .05313 21
.18394 .15018 .12285 .10067 .08264 .04620 22 |
.17032 .13778 .11168 .09069 .07379 .04017 23
.15770 .12641 .10153 .08170 .06588 .03493 24
.14602 .11597 .09230 .07361 .05882 .03038 25
.13520 .10639 .08391 .06631 .05252 .02642 26
.12519 .09761 .07628 .05974 .04689 .02297 27
.11591 .08955 .06934 .05382 .04187 .01997 28
.10733 .08216 .06304 .04849 .03738 .01737 29
.09938 .07537 .05731 .04368 .03338 .01510 30
.09202 .06915 .05210 .03935 .02980 .01313 31
.08520 .06344 .04736 .03545 .02661 .01142 32
.07889 .05820 .04306 .03194 .02376 .00993 33
.07305 .05340 .03914 .02878 .02121 .00864 34
.06763 .04899 .03558 .02592 .01894 .00751 35
.06262 .04494 .03235 .02335 .01691 .00653 36
.05799 .04123 .02941 .02104 .01510 .00568 37
.05369 .03783 .02674 .01896 .01348 .00494 38
.04971 .03470 .02430 .01708 .01204 .00429 39
.04603 .03184 .02210 .01538 .01075 .00373 40
338 Chapter 6 Accounting and the Time Value of Money
(cid:59)(cid:40)(cid:41)(cid:51)(cid:44)(cid:3)(cid:29)(cid:20)(cid:26) (cid:45)(cid:60)(cid:59)(cid:60)(cid:57)(cid:44)(cid:3)(cid:61)(cid:40)(cid:51)(cid:60)(cid:44)(cid:3)(cid:54)(cid:45)(cid:3)(cid:40)(cid:53)(cid:3)(cid:54)(cid:57)(cid:43)(cid:48)(cid:53)(cid:40)(cid:57)(cid:64)(cid:3)(cid:40)(cid:53)(cid:53)(cid:60)(cid:48)(cid:59)(cid:64)(cid:3)(cid:54)(cid:45)(cid:3)(cid:24)
(cid:15)(cid:24) (cid:80)(cid:16)(cid:85) (cid:24)
(cid:45)(cid:61)(cid:45)(cid:20)(cid:54)(cid:40)
(cid:85)(cid:19)(cid:80) (cid:80)
((cid:85))
Periods 2% 21⁄ 2% 3% 4% 5% 6%
1 1.00000 1.00000 1.00000 1.00000 1.00000 1.00000
2 2.02000 2.02500 2.03000 2.04000 2.05000 2.06000
3 3.06040 3.07563 3.09090 3.12160 3.15250 3.18360
4 4.12161 4.15252 4.18363 4.24646 4.31013 4.37462
5 5.20404 5.25633 5.30914 5.41632 5.52563 5.63709
6 6.30812 6.38774 6.46841 6.63298 6.80191 6.97532
7 7.43428 7.54743 7.66246 7.89829 8.14201 8.39384
8 8.58297 8.73612 8.89234 9.21423 9.54911 9.89747
9 9.75463 9.95452 10.15911 10.58280 11.02656 11.49132
10 10.94972 11.20338 11.46338 12.00611 12.57789 13.18079
11 12.16872 12.48347 12.80780 13.48635 14.20679 14.97164
12 13.41209 13.79555 14.19203 15.02581 15.91713 16.86994
13 14.68033 15.14044 15.61779 16.62684 17.71298 18.88214
14 15.97394 16.51895 17.08632 18.29191 19.59863 21.01507
15 17.29342 17.93193 18.59891 20.02359 21.57856 23.27597
16 18.63929 19.38022 20.15688 21.82453 23.65749 25.67253
17 20.01207 20.86473 21.76159 23.69751 25.84037 28.21288
18 21.41231 22.38635 23.41444 25.64541 28.13238 30.90565
19 22.84056 23.94601 25.11687 27.67123 30.53900 33.75999
20 24.29737 25.54466 26.87037 29.77808 33.06595 36.78559
21 25.78332 27.18327 28.67649 31.96920 35.71925 39.99273
22 27.29898 28.86286 30.53678 34.24797 38.50521 43.39229
23 28.84496 30.58443 32.45288 36.61789 41.43048 46.99583
24 30.42186 32.34904 34.42647 39.08260 44.50200 50.81558
25 32.03030 34.15776 36.45926 41.64591 47.72710 54.86451
26 33.67091 36.01171 38.55304 44.31174 51.11345 59.15638
27 35.34432 37.91200 40.70963 47.08421 54.66913 63.70577
28 37.05121 39.85980 42.93092 49.96758 58.40258 68.52811
29 38.79223 41.85630 45.21885 52.96629 62.32271 73.63980
30 40.56808 43.90270 47.57542 56.08494 66.43885 79.05819
31 42.37944 46.00027 50.00268 59.32834 70.76079 84.80168
32 44.22703 48.15028 52.50276 62.70147 75.29883 90.88978
33 46.11157 50.35403 55.07784 66.20953 80.06377 97.34316
34 48.03380 52.61289 57.73018 69.85791 85.06696 104.18376
35 49.99448 54.92821 60.46208 73.65222 90.32031 111.43478
36 51.99437 57.30141 63.27594 77.59831 95.83632 119.12087
37 54.03425 59.73395 66.17422 81.70225 101.62814 127.26812
38 56.11494 62.22730 69.15945 85.97034 107.70955 135.90421
39 58.23724 64.78298 72.23423 90.40915 114.09502 145.05846
40 60.40198 67.40255 75.40126 95.02552 120.79977 154.76197
Future Value of an Ordinary Annuity of 1 339
TABLE 6-3 FUTURE VALUE OF AN ORDINARY ANNUITY OF 1
(n)
8% 9% 10% 11% 12% 15% Periods
1.00000 1.00000 1.00000 1.00000 1.00000 1.00000 1
2.08000 2.09000 2.10000 2.11000 2.12000 2.15000 2
3.24640 3.27810 3.31000 3.34210 3.37440 3.47250 3
4.50611 4.57313 4.64100 4.70973 4.77933 4.99338 4
5.86660 5.98471 6.10510 6.22780 6.35285 6.74238 5
7.33592 7.52334 7.71561 7.91286 8.11519 8.75374 6 |
8.92280 9.20044 9.48717 9.78327 10.08901 11.06680 7
10.63663 11.02847 11.43589 11.85943 12.29969 13.72682 8
12.48756 13.02104 13.57948 14.16397 14.77566 16.78584 9
14.48656 15.19293 15.93743 16.72201 17.54874 20.30372 10
16.64549 17.56029 18.53117 19.56143 20.65458 24.34928 11
18.97713 20.14072 21.38428 22.71319 24.13313 29.00167 12
21.49530 22.95339 24.52271 26.21164 28.02911 34.35192 13
24.21492 26.01919 27.97498 30.09492 32.39260 40.50471 14
27.15211 29.36092 31.77248 34.40536 37.27972 47.58041 15
30.32428 33.00340 35.94973 39.18995 42.75328 55.71747 16
33.75023 36.97371 40.54470 44.50084 48.88367 65.07509 17
37.45024 41.30134 45.59917 50.39593 55.74972 75.83636 18
41.44626 46.01846 51.15909 56.93949 63.43968 88.21181 19
45.76196 51.16012 57.27500 64.20283 72.05244 102.44358 20
50.42292 56.76453 64.00250 72.26514 81.69874 118.81012 21
55.45676 62.87334 71.40275 81.21431 92.50258 137.63164 22
60.89330 69.53194 79.54302 91.14788 104.60289 159.27638 23
66.76476 76.78981 88.49733 102.17415 118.15524 184.16784 24
73.10594 84.70090 98.34706 114.41331 133.33387 212.79302 25
79.95442 93.32398 109.18177 127.99877 150.33393 245.71197 26
87.35077 102.72314 121.09994 143.07864 169.37401 283.56877 27
95.33883 112.96822 134.20994 159.81729 190.69889 327.10408 28
103.96594 124.13536 148.63093 178.39719 214.58275 377.16969 29
113.28321 136.30754 164.49402 199.02088 241.33268 434.74515 30
123.34587 149.57522 181.94343 221.91317 271.29261 500.95692 31
134.21354 164.03699 201.13777 247.32362 304.84772 577.10046 32
145.95062 179.80032 222.25154 275.52922 342.42945 644.66553 33
158.62667 196.98234 245.47670 306.83744 384.52098 765.36535 34
172.31680 215.71076 271.02437 341.58955 431.66350 881.17016 35
187.10215 236.12472 299.12681 380.16441 484.46312 1014.34568 36
203.07032 258.37595 330.03949 422.98249 543.59869 1167.49753 37
220.31595 282.62978 364.04343 470.51056 609.83053 1343.62216 38
238.94122 309.06646 401.44778 523.26673 684.01020 1546.16549 39
259.05652 337.88245 442.59256 581.82607 767.09142 1779.09031 40
340 Chapter 6 Accounting and the Time Value of Money
TABLE 6-4 PRESENT VALUE OF AN ORDINARY ANNUITY OF 1
1
1
(1 i)n
PVF-OA
n,i i
(n)
Periods 2% 21⁄ 2% 3% 4% 5% 6%
1 .98039 .97561 .97087 .96154 .95238 .94340
2 1.94156 1.92742 1.91347 1.88609 1.85941 1.83339
3 2.88388 2.85602 2.82861 2.77509 2.72325 2.67301
4 3.80773 3.76197 3.71710 3.62990 3.54595 3.46511
5 4.71346 4.64583 4.57971 4.45182 4.32948 4.21236
6 5.60143 5.50813 5.41719 5.24214 5.07569 4.91732
7 6.47199 6.34939 6.23028 6.00205 5.78637 5.58238
8 7.32548 7.17014 7.01969 6.73274 6.46321 6.20979
9 8.16224 7.97087 7.78611 7.43533 7.10782 6.80169
10 8.98259 8.75206 8.53020 8.11090 7.72173 7.36009
11 9.78685 9.51421 9.25262 8.76048 8.30641 7.88687
12 10.57534 10.25776 9.95400 9.38507 8.86325 8.38384
13 11.34837 10.98319 10.63496 9.98565 9.39357 8.85268
14 12.10625 11.69091 11.29607 10.56312 9.89864 9.29498
15 12.84926 12.38138 11.93794 11.11839 10.37966 9.71225
16 13.57771 13.05500 12.56110 11.65230 10.83777 10.10590
17 14.29187 13.71220 13.16612 12.16567 11.27407 10.47726
18 14.99203 14.35336 13.75351 12.65930 11.68959 10.82760
19 15.67846 14.97889 14.32380 13.13394 12.08532 11.15812
20 16.35143 15.58916 14.87747 13.59033 12.46221 11.46992
21 17.01121 16.18455 15.41502 14.02916 12.82115 11.76408
22 17.65805 16.76541 15.93692 14.45112 13.16300 12.04158
23 18.29220 17.33211 16.44361 14.85684 13.48857 12.30338
24 18.91393 17.88499 16.93554 15.24696 13.79864 12.55036
25 19.52346 18.42438 17.41315 15.62208 14.09394 12.78336
26 20.12104 18.95061 17.87684 15.98277 14.37519 13.00317
27 20.70690 19.46401 18.32703 16.32959 14.64303 13.21053
28 21.28127 19.96489 18.76411 16.66306 14.89813 13.40616
29 21.84438 20.45355 19.18845 16.98371 15.14107 13.59072
30 22.39646 20.93029 19.60044 17.29203 15.37245 13.76483
31 22.93770 21.39541 20.00043 17.58849 15.59281 13.92909
32 23.46833 21.84918 20.38877 17.87355 15.80268 14.08404
33 23.98856 22.29188 20.76579 18.14765 16.00255 14.23023
34 24.49859 22.72379 21.13184 18.41120 16.19290 14.36814
35 24.99862 23.14516 21.48722 18.66461 16.37419 14.49825 |
36 25.48884 23.55625 21.83225 18.90828 16.54685 14.62099
37 25.96945 23.95732 22.16724 19.14258 16.71129 14.73678
38 26.44064 24.34860 22.49246 19.36786 16.86789 14.84602
39 26.90259 24.73034 22.80822 19.58448 17.01704 14.94907
40 27.35548 25.10278 23.11477 19.79277 17.15909 15.04630
Present Value of an Ordinary Annuity of 1 341
TABLE 6-4 PRESENT VALUE OF AN ORDINARY ANNUITY OF 1
(n)
8% 9% 10% 11% 12% 15% Periods
.92593 .91743 .90909 .90090 .89286 .86957 1
1.78326 1.75911 1.73554 1.71252 1.69005 1.62571 2
2.57710 2.53130 2.48685 2.44371 2.40183 2.28323 3
3.31213 3.23972 3.16986 3.10245 3.03735 2.85498 4
3.99271 3.88965 3.79079 3.69590 3.60478 3.35216 5
4.62288 4.48592 4.35526 4.23054 4.11141 3.78448 6
5.20637 5.03295 4.86842 4.71220 4.56376 4.16042 7
5.74664 5.53482 5.33493 5.14612 4.96764 4.48732 8
6.24689 5.99525 5.75902 5.53705 5.32825 4.77158 9
6.71008 6.41766 6.14457 5.88923 5.65022 5.01877 10
7.13896 6.80519 6.49506 6.20652 5.93770 5.23371 11
7.53608 7.16073 6.81369 6.49236 6.19437 5.42062 12
7.90378 7.48690 7.10336 6.74987 6.42355 5.58315 13
8.24424 7.78615 7.36669 6.98187 6.62817 5.72448 14
8.55948 8.06069 7.60608 7.19087 6.81086 5.84737 15
8.85137 8.31256 7.82371 7.37916 6.97399 5.95424 16
9.12164 8.54363 8.02155 7.54879 7.11963 6.04716 17
9.37189 8.75563 8.20141 7.70162 7.24967 6.12797 18
9.60360 8.95012 8.36492 7.83929 7.36578 6.19823 19
9.81815 9.12855 8.51356 7.96333 7.46944 6.25933 20
10.01680 9.29224 8.64869 8.07507 7.56200 6.31246 21
10.20074 9.44243 8.77154 8.17574 7.64465 6.35866 22
10.37106 9.58021 8.88322 8.26643 7.71843 6.39884 23
10.52876 9.70661 8.98474 8.34814 7.78432 6.43377 24
10.67478 9.82258 9.07704 8.42174 7.84314 6.46415 25
10.80998 9.92897 9.16095 8.48806 7.89566 6.49056 26
10.93516 10.02658 9.23722 8.54780 7.94255 6.51353 27
11.05108 10.11613 9.30657 8.60162 7.98442 6.53351 28
11.15841 10.19828 9.36961 8.65011 8.02181 6.55088 29
11.25778 10.27365 9.42691 8.69379 8.05518 6.56598 30
11.34980 10.34280 9.47901 8.73315 8.08499 6.57911 31
11.43500 10.40624 9.52638 8.76860 8.11159 6.59053 32
11.51389 10.46444 9.56943 8.80054 8.13535 6.60046 33
11.58693 10.51784 9.60858 8.82932 8.15656 6.60910 34
11.65457 10.56682 9.64416 8.85524 8.17550 6.61661 35
11.71719 10.61176 9.67651 8.87859 8.19241 6.62314 36
11.77518 10.65299 9.70592 8.89963 8.20751 6.62882 37
11.82887 10.69082 9.73265 8.91859 8.22099 6.63375 38
11.87858 10.72552 9.75697 8.93567 8.23303 6.63805 39
11.92461 10.75736 9.77905 8.95105 8.24378 6.64178 40
342 Chapter 6 Accounting and the Time Value of Money
TABLE 6-5 PRESENT VALUE OF AN ANNUITY DUE OF 1
1
1
(1 i)n 1
PVF-AD 1
n,i i
(n)
Periods 2% 21⁄ 2% 3% 4% 5% 6%
1 1.00000 1.00000 1.00000 1.00000 1.00000 1.00000
2 1.98039 1.97561 1.97087 1.96154 1.95238 1.94340
3 2.94156 2.92742 2.91347 2.88609 2.85941 2.83339
4 3.88388 3.85602 3.82861 3.77509 3.72325 3.67301
5 4.80773 4.76197 4.71710 4.62990 4.54595 4.46511
6 5.71346 5.64583 5.57971 5.45182 5.32948 5.21236
7 6.60143 6.50813 6.41719 6.24214 6.07569 5.91732
8 7.47199 7.34939 7.23028 7.00205 6.78637 6.58238
9 8.32548 8.17014 8.01969 7.73274 7.46321 7.20979
10 9.16224 8.97087 8.78611 8.43533 8.10782 7.80169
11 9.98259 9.75206 9.53020 9.11090 8.72173 8.36009
12 10.78685 10.51421 10.25262 9.76048 9.30641 8.88687
13 11.57534 11.25776 10.95400 10.38507 9.86325 9.38384
14 12.34837 11.98319 11.63496 10.98565 10.39357 9.85268
15 13.10625 12.69091 12.29607 11.56312 10.89864 10.29498
16 13.84926 13.38138 12.93794 12.11839 11.37966 10.71225
17 14.57771 14.05500 13.56110 12.65230 11.83777 11.10590
18 15.29187 14.71220 14.16612 13.16567 12.27407 11.47726
19 15.99203 15.35336 14.75351 13.65930 12.68959 11.82760
20 16.67846 15.97889 15.32380 14.13394 13.08532 12.15812
21 17.35143 16.58916 15.87747 14.59033 13.46221 12.46992
22 18.01121 17.18455 16.41502 15.02916 13.82115 12.76408
23 18.65805 17.76541 16.93692 15.45112 14.16300 13.04158
24 19.29220 18.33211 17.44361 15.85684 14.48857 13.30338
25 19.91393 18.88499 17.93554 16.24696 14.79864 13.55036
26 20.52346 19.42438 18.41315 16.62208 15.09394 13.78336
27 21.12104 19.95061 18.87684 16.98277 15.37519 14.00317 |
28 21.70690 20.46401 19.32703 17.32959 15.64303 14.21053
29 22.28127 20.96489 19.76411 17.66306 15.89813 14.40616
30 22.84438 21.45355 20.18845 17.98371 16.14107 14.59072
31 23.39646 21.93029 20.60044 18.29203 16.37245 14.76483
32 23.93770 22.39541 21.00043 18.58849 16.59281 14.92909
33 24.46833 22.84918 21.38877 18.87355 16.80268 15.08404
34 24.98856 23.29188 21.76579 19.14765 17.00255 15.23023
35 25.49859 23.72379 22.13184 19.41120 17.19290 15.36814
36 25.99862 24.14516 22.48722 19.66461 17.37419 15.49825
37 26.48884 24.55625 22.83225 19.90828 17.54685 15.62099
38 26.96945 24.95732 23.16724 20.14258 17.71129 15.73678
39 27.44064 25.34860 23.49246 20.36786 17.86789 15.84602
40 27.90259 25.73034 23.80822 20.58448 18.01704 15.94907
Present Value of an Annuity Due of 1 343
TABLE 6-5 PRESENT VALUE OF AN ANNUITY DUE OF 1
(n)
8% 9% 10% 11% 12% 15% Periods
1.00000 1.00000 1.00000 1.00000 1.00000 1.00000 1
1.92593 1.91743 1.90909 1.90090 1.89286 1.86957 2
2.78326 2.75911 2.73554 2.71252 2.69005 2.62571 3
3.57710 3.53130 3.48685 3.44371 3.40183 3.28323 4
4.31213 4.23972 4.16986 4.10245 4.03735 3.85498 5
4.99271 4.88965 4.79079 4.69590 4.60478 4.35216 6
5.62288 5.48592 5.35526 5.23054 5.11141 4.78448 7
6.20637 6.03295 5.86842 5.71220 5.56376 5.16042 8
6.74664 6.53482 6.33493 6.14612 5.96764 5.48732 9
7.24689 6.99525 6.75902 6.53705 6.32825 5.77158 10
7.71008 7.41766 7.14457 6.88923 6.65022 6.01877 11
8.13896 7.80519 7.49506 7.20652 6.93770 6.23371 12
8.53608 8.16073 7.81369 7.49236 7.19437 6.42062 13
8.90378 8.48690 8.10336 7.74987 7.42355 6.58315 14
9.24424 8.78615 8.36669 7.98187 7.62817 6.72448 15
9.55948 9.06069 8.60608 8.19087 7.81086 6.84737 16
9.85137 9.31256 8.82371 8.37916 7.97399 6.95424 17
10.12164 9.54363 9.02155 8.54879 8.11963 7.04716 18
10.37189 9.75563 9.20141 8.70162 8.24967 7.12797 19
10.60360 9.95012 9.36492 8.83929 8.36578 7.19823 20
10.81815 10.12855 9.51356 8.96333 8.46944 7.25933 21
11.01680 10.29224 9.64869 9.07507 8.56200 7.31246 22
11.20074 10.44243 9.77154 9.17574 8.64465 7.35866 23
11.37106. 10.58021 9.88322 9.26643 8.71843 7.39884 24
11.52876 10.70661 9.98474 9.34814 8.78432 7.43377 25
11.67478 10.82258 10.07704 9.42174 8.84314 7.46415 26
11.80998 10.92897 10.16095 9.48806 8.89566 7.49056 27
11.93518 11.02658 10.23722 9.54780 8.94255 7.51353 28
12.05108 11.11613 10.30657 9.60162 8.98442 7.53351 29
12.15841 11.19828 10.36961 9.65011 9.02181 7.55088 30
12.25778 11.27365 10.42691 9.69379 9.05518 7.56598 31
12.34980 11.34280 10.47901 9.73315 9.08499 7.57911 32
12.43500 11.40624 10.52638 9.76860 9.11159 7.59053 33
12.51389 11.46444 10.56943 9.80054 9.13535 7.60046 34
12.58693 11.51784 10.60858 9.82932 9.15656 7.60910 35
12.65457 11.56682 10.64416 9.85524 9.17550 7.61661 36
12.71719 11.61176 10.67651 9.87859 9.19241 7.62314 37
12.77518 11.65299 10.70592 9.89963 9.20751 7.62882 38
12.82887 11.69082 10.73265 9.91859 9.22099 7.63375 39
12.87858 11.72552 10.75697 9.93567 9.23303 7.63805 40
Cash and Receivables
1 Identify items considered cash. 6 Explain accounting issues related to recognition
and valuation of notes receivable.
2 Indicate how to report cash and related items.
7 Explain the fair value option.
3 Define receivables and identify the different types
of receivables. 8 Explain accounting issues related to disposition
of accounts and notes receivable.
4 Explain accounting issues related to recognition
of accounts receivable. 9 Describe how to report and analyze receivables.
5 Explain accounting issues related to valuation
of accounts receivable.
Please Release Me?
In recent quarters, several U.S. banks have reported increases in net income compared to the same quarter in the previous
year. How did the market greet this news? With a resounding “blah.” For example, Wells Fargo’s report led to a share price
decline of 8.4 percent, and Citigroup saw a 1.7 percent drop in its share price when it announced earnings. What gives?
It seems that the source of earnings increase matters to the market. And in the case of banks, a significant portion of
recent earnings increases are the result of decreases in the banks’ bad debt expense, not increased revenues on loans and |
investments. These decreases happen when the banks’ reserves that have accumulated in the allowance for loan losses are
judged to be too high. How big is the effect? As shown in the chart below, in a recent quarter, of the $14.3 billion in earnings
reported by the top 10 U.S. banks, $3.5 billion came from releasing loan loss reserves. For Citi, without the reserve release, it
would have reported a loss.
RETPAHC 7
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
Loan-Loss Reserve Releases at Big Banks
$127.2 billion
10 Biggest Banks: Citigroup:
reserves
4Q 2011 Results 4Q 2011 Results
10 Biggest Banks: Earnings:
Loan-loss reserves $14.3b
at year-end 2011
After-Tax
Reserve
After-Tax Release:
Reserve Release:*
$1.3b
$3.5b
Earnings:
$26.7b $1.2b
2011 releases
before taxes
*After-tax reserve releases
Sources: The companies; WSJ research based on pretax releases and effective tax rate for period. Source: Wall Street Journal
CONCEPTUAL FOCUS
> See the Underlying Concepts on pages 352,
356, and 373.
> Read the Evolving Issue on page 374 for a
As shown in the left side of the chart, the 10 largest banks discussion of accounting for loan losses.
had $127.2 billion in the allowance for loan losses at the end of
2011, and $26.7 billion was drawn down (released) in that same INTERNATIONAL FOCUS
year.
So is this a problem? Supposedly, reserves should be > See the International Perspectives on
pages 365, 370, and 372.
released when there is a decline in the likelihood that loans will
not be paid. However, some market-watchers doubt that banks > Read the IFRS Insights on pages 408–412
for a discussion of:
can afford to keep up the pace of reserve releases. Lowering
—Impairment evaluation
reserves could increase pressure on profits that are being hit
—Recovery of impairment losses
by slow economic growth, low interest rates, and tighter rules.
According to one analyst, “The releases are masking some
horrible operating performance. . . . The bottom line is your
earnings power is decreasing.”
To be fair, analysts often criticize banks when they increase the allowance for loan losses during profitable periods. In
some cases, the banks are accused of managing earnings. That is, in good times they increase loan loss reserves, which
reduces (or smoothes) earnings. Then in bad times, the reserves can be released, thereby increasing earnings. The SEC has
reprimanded some banks for this alleged earnings management—in not only the tough times, but the good times as well.
Sources: S. Kapner, “Citi Shines, but Investors Shrug,” Wall Street Journal (October 18, 2011), p. C1; and M. Rapoport, “Banks Depleting
Earnings Backstop: Days Numbered for Using Reserves to Increase Profit,” Wall Street Journal (February 8, 2012), p. C1.
As our opening story indicates, measurement and remeasurement
PREVIEW OF CHAPTER 7
of the allowance for doubtful accounts has important implications
for accurate reporting of net accounts receivable, operating profits,
net income, and assets. In this chapter, we discuss cash and receivables—two assets that are important to banks
such as Citigroup and nonbank companies such as Wal-Mart Stores, Inc. The content and organization of the
chapter are as follows.
Cash and Receivables
Cash Accounts Receivable Notes Receivable Special Issues
• What is cash? • Recognition of accounts • Recognition of notes • Fair value option
• Reporting cash receivable receivable • Disposition of accounts and
• Summary of cash-related • Valuation of accounts • Valuation of notes notes receivable
items receivable receivable • Presentation and analysis
345
346 Chapter 7 Cash and Receivables
CASH
What Is Cash?
Cash, the most liquid of assets, is the standard medium of exchange and the basis for
LEARNING OBJECTIVE 1
measuring and accounting for all other items. Companies generally classify cash as
Identify items considered cash.
a current asset. Cash consists of coin, currency, and available funds on deposit at the
bank. Negotiable instruments such as money orders, certified checks, cashier’s
checks, personal checks, and bank drafts are also viewed as cash. What about savings ac- |
counts? Banks do have the legal right to demand notice before withdrawal. But, because
banks rarely demand prior notice, savings accounts nevertheless are considered cash.
Some negotiable instruments provide small investors with an opportunity to earn
interest. These items, more appropriately classified as temporary investments than as
cash, include money market funds, money market savings certificates, certificates of
deposit (CDs), and similar types of deposits and “short-term paper.”1 These securities
usually contain restrictions or penalties on their conversion to cash. Money market
funds that provide checking account privileges, however, are usually classified as cash.
Certain items present classification problems: Companies treat postdated checks
and I.O.U.s as receivables. They also treat travel advances as receivables if collected
from employees or deducted from their salaries. Otherwise, companies classify the
travel advance as a prepaid expense. Postage stamps on hand are classified as part of
office supplies inventory or as a prepaid expense. Because petty cash funds and change
funds are used to meet current operating expenses and liquidate current liabilities,
companies include these funds in current assets as cash.
Reporting Cash
Although the reporting of cash is relatively straightforward, a number of issues
LEARNING OBJECTIVE 2
merit special attention. These issues relate to the reporting of:
Indicate how to report cash and related
items.
1. Cash equivalents.
2. Restricted cash.
3. Bank overdrafts.
Cash Equivalents
A current classification that has become popular is “Cash and cash equivalents.”2 Cash
equivalents are short-term, highly liquid investments that are both (a) readily convertible to
known amounts of cash, and (b) so near their maturity that they present insignificant risk
of changes in value because of changes in interest rates. Generally, only investments with
original maturities of three months or less qualify under these definitions. Examples of cash
1A variety of “short-term paper” is available for investment. For example, certificates of deposit (CDs)
represent formal evidence of indebtedness, issued by a bank, subject to withdrawal under the specific
terms of the instrument. Issued in various denominations, they have maturities anywhere from 7 days
to 10 years and generally pay interest at the short-term interest rate in effect at the date of issuance.
In money-market funds, a variation of the mutual fund, the mix of Treasury bills and commer-
cial paper making up the fund’s portfolio determines the yield. Most money-market funds require
an initial minimum investment of $1,000; many allow withdrawal by check or wire transfer.
Treasury bills are U.S. government obligations generally issued with 4-, 13-, and 26-week
maturities; they are sold at weekly government auctions in denominations of $1,000 up to a
maximum purchase of $5 million.
Commercial paper is a short-term note issued by corporations with good credit ratings.
Often issued in $5,000 and $10,000 denominations, these notes generally yield a higher rate than
Treasury bills.
2Accounting Trends and Techniques recently indicated that approximately 2 percent of the companies
surveyed use the caption “Cash,” 89 percent use “Cash and cash equivalents,” and 2 percent use
a caption such as “Cash and marketable securities” or similar terminology.
Cash 347
equivalents are Treasury bills, commercial paper, and money market funds. Some compa-
nies combine cash with temporary investments on the balance sheet. In these cases, they
describe the amount of the temporary investments either parenthetically or in the notes.
Most individuals think of cash equivalents as cash. Unfortunately, that is not always
the case. Companies like Kohl’s and ADC Telecommunications have found out the
hard way and are taking sizable write-downs on cash equivalents. Their losses resulted
because they purchased auction-rate notes that declined in value. These notes carry
interest rates that usually reset weekly and often have long-maturity dates (as long as |
30 years). Companies argued that such notes should be classified as cash equivalents
because they can be routinely traded at auction on a daily basis. (In short, they are liquid
and risk-free.) Auditors agreed and permitted cash-equivalent treatment even though
maturities extended well beyond three months. But when the credit crunch hit, the
auctions stopped, and the value of these securities dropped because no market existed.
In retrospect, the cash-equivalent classification was misleading.
It now appears likely that the FASB will eliminate the cash-equivalent classification
from financial statement presentations altogether. Companies will now report only cash.
If an asset is not cash and is short-term in nature, it should be reported as a temporary
investment. An interesting moral to this story is that when times are good, some careless
accounting may work. But in bad times, it quickly becomes apparent that sloppy
accounting can lead to misleading and harmful effects for users of the financial statements.
Restricted Cash
Petty cash, payroll, and dividend funds are examples of cash set aside for a particular
purpose. In most situations, these fund balances are not material. Therefore, companies
do not segregate them from cash in the financial statements. When material in amount,
companies segregate restricted cash from “regular” cash for reporting purposes. Com-
panies classify restricted cash either in the current assets or in the long-term assets sec-
tion, depending on the date of availability or disbursement. Classification in the current
section is appropriate if using the cash for payment of existing or maturing obligations
(within a year or the operating cycle, whichever is longer). On the other hand, compa-
nies show the restricted cash in the long-term section of the balance sheet if holding the
cash for a longer period of time. Among other potential restrictions, companies need to
determine whether any of the cash in accounts outside the United States is restricted by
regulations against exportation of currency.
Cash classified in the long-term section is frequently set aside for plant expansion,
retirement of long-term debt, or, in the case of International Thoroughbred Breeders,
for entry fee deposits.
ILLUSTRATION 7-1
International Thoroughbred Breeders
Disclosure of Restricted
Cash
Restricted cash and investments (See Note) $3,730,000
Note: Restricted Cash. At year-end, the Company had approximately $3,730,000, which was
classified as restricted cash and investments. These funds are primarily cash received from horsemen
for nomination and entry fees to be applied to upcoming racing meets, purse winnings held in trust for
horsemen, and amounts held for unclaimed ticketholder winnings.
Banks and other lending institutions often require customers to maintain minimum cash
balances in checking or savings accounts. The SEC defines these minimum balances, called
compensating balances, as “that portion of any demand deposit (or any time deposit or
certificate of deposit) maintained by a corporation which constitutes support for existing
See the FASB
borrowing arrangements of the corporation with a lending institution. Such arrangements Codification section
would include both outstanding borrowings and the assurance of future credit availability.” [1] (page 385).
348 Chapter 7 Cash and Receivables
To avoid misleading investors about the amount of cash available to meet recurring
obligations, the SEC recommends that companies state separately legally restricted
deposits held as compensating balances against short-term borrowing arrangements
among the “Cash and cash equivalent items” in current assets. Companies should clas-
sify separately restricted deposits held as compensating balances against long-term
borrowing arrangements as noncurrent assets in either the investments or other assets
sections, using a caption such as “Cash on deposit maintained as compensating balance.”
In cases where compensating balance arrangements exist without agreements that
r estrict the use of cash amounts shown on the balance sheet, companies should describe |
the arrangements and the amounts involved in the notes.
Bank Overdrafts
Bank overdrafts occur when a company writes a check for more than the amount in its cash
account. Companies should report bank overdrafts in the current liabilities section, adding
them to the amount reported as accounts payable. If material, companies should disclose
these items separately, either on the face of the balance sheet or in the related notes.3
Bank overdrafts are generally not offset against the cash account. A major exception
is when available cash is present in another account in the same bank on which the over-
draft occurred. Offsetting in this case is required.
Summary of Cash-Related Items
Cash and cash equivalents include the medium of exchange and most negotiable instru-
ments. If the item cannot be quickly converted to coin or currency, a company separately
classifies it as an investment, receivable, or prepaid expense. Companies segregate and
classify cash that is unavailable for payment of currently maturing liabilities in the long-
term assets section. Illustration 7-2 summarizes the classification of cash-related items.
ILLUSTRATION 7-2
Classification of Cash, Cash Equivalents, and Noncash Items
Classifi cation of Cash-
Item Classification Comment
Related Items
Cash Cash If unrestricted, report as cash.
If restricted, identify and classify as current
and noncurrent assets.
Petty cash and Cash Report as cash.
change funds
Short-term paper Cash equivalents Investments with maturity of less than
3 months, often combined with cash.
Short-term paper Temporary investments Investments with maturity of 3 to 12 months.
Postdated checks Receivables Assumed to be collectible.
and I.O.U.s
Travel advances Receivables Assumed to be collected from employees or
deducted from their salaries.
Postage on hand Prepaid expenses May also be classified as office supplies
(as stamps or in inventory.
postage meters)
Bank overdrafts Current liability If right of offset exists, reduce cash.
Compensating Cash separately classified Classify as current or noncurrent in the
balances as a deposit maintained balance sheet. Disclose separately in
as compensating balance notes details of the arrangement.
3Bank overdrafts usually occur because of a simple oversight by the company writing the check.
Banks often expect companies to have overdrafts from time to time and therefore negotiate a fee
as payment for this possible occurrence. However, at one time, E. F. Hutton (a large brokerage
firm) began intentionally overdrawing its accounts by astronomical amounts—on some days
exceeding $1 billion—thus obtaining interest-free loans that it could invest. Because the amounts
were so large and fees were not negotiated in advance, E. F. Hutton came under criminal
investigation for its actions.
Accounts Receivable 349
What do the numbers mean? LUCK OF THE IRISH
Recently, Apple executives explained what they are plan- So when investors analyze an annual report and fi nd a
ning to do with their $98 billion in cash (pay a $2.65 dividend company reporting a large cash balance, they may believe
and buy back some of their shares). However, what they that this cash is available for increased dividends or for
were really talking about was not the full $98 billion but the acquisitions in the United States. But that is not necessarily
$34 billion the company has here in the United States. The so—much of the cash may be overseas and may never return.
other $64 billion is sitting in overseas subsidiaries and may Unfortunately, the problem is getting bigger, not smaller.
never fi nd its way back to the United States. The reason: U.S. Untaxed foreign earnings are now growing at a much faster
tax laws allow companies to defer taxes on their profi ts from rate than earnings generated in the United States. For example,
international operations until they bring the cash back into in a recent fi ve-year period, the accumulated untaxed foreign
the country. earnings have reached over $1 trillion and are growing at
So what do many companies do? Either the cash just sits a rate of 22 percent as compared to 5 percent for domestic |
there in foreign bank accounts or is reinvested in factories earnings. A majority of these earnings are concentrated in
and acquisitions overseas. After all, why should a company three sectors—health care, technology, and industrials.
send its cash back to the United States when it can reinvest Presented below is a chart that shows total accumulated
this cash overseas without any tax payments? As a result, untaxed foreign earnings, untaxed foreign earnings for
companies now have the incentive to move as much of their the current year and its relationship to net income, and
earnings overseas to low-tax jurisdictions such as a country cash fl ow provided by operations for the top fi ve companies
like Ireland. As one expert noted, it cannot be the luck of the in the S&P 500. Note that the top 40 companies in the S&P
Irish that explains the extraordinary and systematic profi t- 500 have 73 percent of the total untaxed foreign earnings in
ability of Irish subsidiaries of U.S. companies. the index.
Untaxed
Foreign
Accumulated Untaxed Earnings
Untaxed Untaxed Foreign as a % of
Foreign Foreign Earnings as Operating
Earnings Earnings in a % of Net Cash
Company (UFE)* Current Year* Income Flow
Microsoft $ 44,800 $15,300 66% 57%
Pfi zer 63,000 14,800 169 73
ExxonMobil 47,000 12,000 28 22
Apple 23,400 11,100 43 30
General Electric 102,000 8,000 56 24
*In $ millions.
What this all tells us is that the U.S. taxpayer is presently foreign deposits, and cash generated from foreign operations
holding the bag because many of these companies may never where untaxed foreign earnings were reported. Capital
be taxed as the cash from these earnings will not be invested markets are well served when good information is provided.
in the Unites States. At a minimum, investors need more You would think that cash is cash and the amount is certain,
information about foreign earnings, the amount of cash in but unfortunately some cash is better than other cash.
Source: J. Ciesielski, “Growing, Glowing Earnings: S&P 500’s 2011 Untaxed Income,” The Analyst’s Accounting Observer (March 26, 2012).
ACCOUNTS RECEIVABLE
Receivables are claims held against customers and others for money, goods, or
3 LEARNING OBJECTIVE
services. For financial statement purposes, companies classify receivables as either
Define receivables and identify the
current (short-term) or noncurrent (long-term). Companies expect to collect cur-
different types of receivables.
rent receivables within a year or during the current operating cycle, whichever is
longer. They classify all other receivables as noncurrent. Receivables are further classi-
fied in the balance sheet as either trade or nontrade receivables.
350 Chapter 7 Cash and Receivables
Customers often owe a company amounts for goods bought or services rendered.
A company may subclassify these trade receivables, usually the most significant item
it possesses, into accounts receivable and notes receivable. Accounts receivable are oral
promises of the purchaser to pay for goods and services sold. They represent “open ac-
counts” resulting from short-term extensions of credit. A company normally collects
them within 30 to 60 days. Notes receivable are written promises to pay a certain sum
of money on a specified future date. They may arise from sales, financing, or other trans-
actions. Notes may be short-term or long-term.
Nontrade receivables arise from a variety of transactions. Some examples of
nontrade receivables are:
1. Advances to offi cers and employees.
2. Advances to subsidiaries.
3. Deposits paid to cover potential damages or losses.
4. Deposits paid as a guarantee of performance or payment.
5. Dividends and interest receivable.
6. Claims against:
(a) Insurance companies for casualties sustained.
(b) Defendants under suit.
(c) Governmental bodies for tax refunds.
(d) Common carriers for damaged or lost goods.
(e) Creditors for returned, damaged, or lost goods.
(f) Customers for returnable items (crates, containers, etc.).
Because of the peculiar nature of nontrade receivables, companies generally report |
them as separate items in the balance sheet. Illustration 7-3 shows the reporting of trade
and nontrade receivables in the balance sheets of Molson Coors Brewing Company and
Seaboard Corporation.
Molson Coors Brewing Company Seaboard Corporation
(in thousands) (in thousands)
Current assets Current assets
Cash and cash equivalents $ 377,023 Cash and cash equivalents $ 47,346
Accounts and notes receivable Short-term investments 286,660
Trade, less allowance for Receivables
doubtful accounts of $8,827 758,526 Trade $251,005
Current notes receivable and other Due from foreign affiliates 90,019
receivables, less allowance for Other 26,349
doubtful accounts of $3,181 112,626 367,373
Inventories 369,521 Allowance for doubtful
Maintenance and operating supplies, accounts (8,060)
less allowance for obsolete Net receivables 359,313
supplies of $10,556 34,782 Inventories 392,946
Other current assets, less allowance for Deferred income taxes 19,558
advertising supplies of $948 124,336 Other current assets 77,710
Total current assets $1,776,814
Total current assets $1,183,533
ILLUSTRATION 7-3
Receivables Balance
The basic issues in accounting for accounts and notes receivable are the same: recog-
Sheet Presentations
nition, valuation, and disposition. We discuss these basic issues for accounts and notes
receivable next.
Accounts Receivable 351
Recognition of Accounts Receivable
In most receivables transactions, the amount to be recognized is the exchange
4 LEARNING OBJECTIVE
price between the two parties. The exchange price is the amount due from the
Explain accounting issues related to
debtor (a customer or a borrower). Some type of business document, often an
recognition of accounts receivable.
invoice, serves as evidence of the exchange price. Two factors may complicate the
measurement of the exchange price: (1) the availability of discounts (trade and cash
discounts), and (2) the length of time between the sale and the due date of payments
(the interest element).
Trade Discounts
Prices may be subject to a trade or quantity discount. Companies use such trade discounts
to avoid frequent changes in catalogs, to alter prices for different quantities purchased,
or to hide the true invoice price from competitors.
Trade discounts are commonly quoted in percentages. For example, say your cell
phone has a list price of $90, and the manufacturer sells it to Best Buy for list less a
30 percent trade discount. The manufacturer then records the receivable at $63 per
phone. The manufacturer, per normal practice, simply deducts the trade discount from
the list price and bills the customer net.
As another example, Maxwell House at one time sold a 10-ounce jar of its in-
stant coffee listing at $5.85 to supermarkets for $5.05, a trade discount of approxi-
mately 14 percent. The supermarkets in turn sold the instant coffee for $5.20 per jar.
Maxwell House records the receivable and related sales revenue at $5.05 per jar,
not $5.85.
Cash Discounts (Sales Discounts)
Companies offer cash discounts (sales discounts) to induce prompt payment. Cash dis-
counts generally presented in terms such as 2/10, n/30 (2 percent if paid within 10 days,
gross amount due in 30 days), or 2/10, E.O.M., net 30, E.O.M. (2 percent if paid any time
before the tenth day of the following month, with full payment due by the thirtieth of
the following month).
Companies usually take sales discounts unless their cash is severely limited. Why?
A company that receives a 1 percent reduction in the sales price for payment within 10
days, total payment due within 30 days, effectively earns 18.25 percent [.01 4 (20/365)],
or at least avoids that rate of interest cost.
Companies usually record sales and related sales discount transactions by en-
tering the receivable and sale at the gross amount. Under this method, companies
recognize sales discounts only when they receive payment within the discount period.
The income statement shows sales discounts as a deduction from sales to arrive at net
sales.
Some contend that sales discounts not taken reflect penalties added to an established |
price to encourage prompt payment. That is, the seller offers sales on account at a slightly
higher price than if selling for cash. The cash discount offered offsets the increase. Thus,
customers who pay within the discount period actually purchase at the cash price. Those
who pay after expiration of the discount period pay a penalty for the delay—an amount
in excess of the cash price. Per this reasoning, some companies record sales and receiv-
ables net. They subsequently debit any discounts not taken to Accounts Receivable and
credit to Sales Discounts Forfeited. The entries in Illustration 7-4 (page 352) show the dif-
ference between the gross and net methods.
If using the gross method, a company reports sales discounts as a deduction from
sales in the income statement. Proper expense recognition dictates that the company
also reasonably estimates the expected discounts to be taken and charges that amount
352 Chapter 7 Cash and Receivables
ILLUSTRATION 7-4
Gross Method Net Method
Entries under Gross and
Net Methods of
Sales of $10,000, terms 2/10, n/30
Recording Cash (Sales)
Discounts Accounts Receivable 10,000 Accounts Receivable 9,800
Sales Revenue 10,000 Sales Revenue 9,800
Payment on $4,000 of sales received within discount period
Cash 3,920 Cash 3,920
Sales Discounts 80 Accounts Receivable 3,920
Accounts Receivable 4,000
Payment on $6,000 of sales received after discount period
Cash 6,000 Accounts Receivable 120
Accounts Receivable 6,000 Sales Discounts Forfeited 120
Cash 6,000
Accounts Receivable 6,000
against sales. If using the net method, a company considers Sales Discounts Forfeited as
an “Other revenue” item.4
Theoretically, the recognition of Sales Discounts Forfeited is correct. The receivable
is stated closer to its realizable value, and the net sales figure measures the revenue
recognized from the sale. As a practical matter, however, companies seldom use the net
method because it requires additional analysis and bookkeeping. For example, the net
method requires adjusting entries to record sales discounts forfeited on accounts receiv-
able that have passed the discount period.
Nonrecognition of Interest Element
Ideally, a company should measure receivables in terms of their present value, that is,
the discounted value of the cash to be received in the future. When expected cash
receipts require a waiting period, the receivable face amount is not worth the amount
that the company ultimately receives.
To illustrate, assume that Best Buy makes a sale on account for $1,000 with payment
due in four months. The applicable annual rate of interest is 12 percent, and payment is
made at the end of four months. The present value of that receivable is not $1,000 but
$961.54 ($1,000 3 .96154). In other words, the $1,000 Best Buy receives four months from
now is not the same as the $1,000 received today.
Underlying Concepts Theoretically, any revenue after the period of sale is interest revenue. In
practice, companies ignore interest revenue related to accounts receivable
Materiality means it must make
because the amount of the discount is not usually material in relation to the net
a difference to a decision-maker.
income for the period. The profession specifically excludes from present value
The FASB believes that present
considerations “receivables arising from transactions with customers in the nor-
value concepts can be ignored
mal course of business which are due in customary trade terms not exceeding
for short-term receivables.
approximately one year.” [2]
Valuation of Accounts Receivable
Reporting of receivables involves (1) classification and (2) valuation on the balance
LEARNING OBJECTIVE 5
sheet. Classification involves determining the length of time each receivable will
Explain accounting issues related to
be outstanding. Companies classify receivables intended to be collected within a
valuation of accounts receivable.
4To the extent that discounts not taken reflect a short-term financing, some argue that companies
could use an interest revenue account to record these amounts.
Accounts Receivable 353 |
year or the operating cycle, whichever is longer, as current. All other receivables are
classified as long-term.
Companies value and report short-term receivables at net realizable value—the
net amount they expect to receive in cash. Determining net realizable value requires
estimating both uncollectible receivables and any returns or allowances to be granted.
Uncollectible Accounts Receivable
As one revered accountant aptly noted, the credit manager’s idea of heaven probably
would be a place where everyone (eventually) paid his or her debts.5 Unfortunately, this
situation often does not occur. For example, a customer may not be able to pay because
of a decline in its sales revenue due to a downturn in the economy. Similarly, individuals
may be laid off from their jobs or faced with unexpected hospital bills. Companies
record credit losses as debits to Bad Debt Expense (or Uncollectible Accounts Expense).
Such losses are a normal and necessary risk of doing business on a credit basis.
Two methods are used in accounting for uncollectible accounts: (1) the direct write-
off method and (2) the allowance method. The following sections explain these methods.
Direct Write-Off Method for Uncollectible Accounts
Under the direct write-off method, when a company determines a particular account to
be uncollectible, it charges the loss to Bad Debt Expense. Assume, for example, that on
December 10 Cruz Co. writes off as uncollectible Yusado’s $8,000 balance. The entry is:
December 10
Bad Debt Expense 8,000
Accounts Receivable (Yusado) 8,000
(To record write-off of Yusado account)
Under this method, Bad Debt Expense will show only actual losses from uncollectibles.
The company will report accounts receivable at its gross amount.
Supporters of the direct write-off-method (which is often used for tax purposes)
contend that it records facts, not estimates. It assumes that a good account receivable
resulted from each sale, and that later events revealed certain accounts to be uncollect-
ible and worthless. From a practical standpoint, this method is simple and convenient
to apply. But the direct write-off method is theoretically deficient. It usually fails to
record expenses in the same period as associated revenues. Nor does it result in receiv-
ables being stated at net realizable value on the balance sheet. As a result, using the
direct write-off method is not considered appropriate, except when the amount
uncollectible is immaterial.
Allowance Method for Uncollectible Accounts
The allowance method of accounting for bad debts involves estimating uncollectible
accounts at the end of each period. This ensures that companies state receivables on
the balance sheet at their net realizable value. Net realizable value is the net amount the
company expects to receive in cash. The FASB considers the collectibility of receivables
a loss contingency. Thus, the allowance method is appropriate in situations where it is
probable that an asset has been impaired and that the amount of the loss can be reason-
ably estimated. [3]
Although estimates are involved, companies can predict the percentage of uncol-
lectible receivables from past experiences, present market conditions, and an analysis of
the outstanding balances. Many companies set their credit policies to provide for a
certain percentage of uncollectible accounts. (In fact, many feel that failure to reach that
5William J. Vatter, Managerial Accounting (Englewood Cliffs, N.J.: Prentice-Hall, 1950), p. 60.
354 Chapter 7 Cash and Receivables
percentage means that they are losing sales due to overly restrictive credit policies.)
Thus, the FASB requires the allowance method for financial reporting purposes when
bad debts are material in amount. This method has three essential features:
1. Companies estimate uncollectible accounts receivable. They match this estimated
expense against revenues in the same accounting period in which they record the
revenues.
2. Companies debit estimated uncollectibles to Bad Debt Expense and credit them to
Allowance for Doubtful Accounts (a contra asset account) through an adjusting |
entry at the end of each period.
3. When companies write off a specifi c account, they debit actual uncollectibles to
Allowance for Doubtful Accounts and credit that amount to Accounts Receivable.
Recording Estimated Uncollectibles. To illustrate the allowance method, assume that
Brown Furniture has credit sales of $1,800,000 in 2014. Of this amount, $150,000
remains uncollected at December 31. The credit manager estimates that $10,000
of these sales will be uncollectible. The adjusting entry to record the estimated
uncollectibles is:
December 31, 2014
Bad Debt Expense 10,000
Allowance for Doubtful Accounts 10,000
(To record estimate of uncollectible accounts)
Brown reports Bad Debt Expense in the income statement as an operating expense.
Thus, the estimated uncollectibles are matched with sales in 2014. Brown records the
expense in the same year it made the sales.
As Illustration 7-5 shows, the company deducts the allowance account from accounts
receivable in the current assets section of the balance sheet.
ILLUSTRATION 7-5
BROWN FURNITURE
Presentation of
BALANCE SHEET (PARTIAL)
Allowance for Doubtful
Accounts Current assets
Cash $ 15,000
Accounts receivable $150,000
Less: Allowance for doubtful accounts 10,000 140,000
Inventory 300,000
Prepaid insurance 25,000
Total current assets $480,000
Allowance for Doubtful Accounts shows the estimated amount of claims on customers
that the company expects will become uncollectible in the future.6 Companies use a
contra account instead of a direct credit to Accounts Receivable because they do not
know which customers will not pay. The credit balance in the allowance account will
absorb the specific write-offs when they occur. The amount of $140,000 in Illustration 7-5
represents the net realizable value of the accounts receivable at the statement
date. Companies do not close Allowance for Doubtful Accounts at the end of the
fiscal year.
6The account description employed for the allowance account is usually Allowance for Doubtful
Accounts or simply Allowance. Accounting Trends and Techniques recently indicated that approxi-
mately 83 percent of the companies surveyed used “allowance” in their description.
Accounts Receivable 355
Recording the Write-Off of an Uncollectible Account. When companies have exhausted
all means of collecting a past-due account and collection appears impossible, the company
should write off the account. In the credit card industry, for example, it is standard
practice to write off accounts that are 210 days past due.
To illustrate a receivables write-off, assume that the financial vice president of
Brown Furniture authorizes a write-off of the $1,000 balance owed by Randall Co. on
March 1, 2015. The entry to record the write-off is:
March 1, 2015
Allowance for Doubtful Accounts 1,000
Accounts Receivable (Randall Co.) 1,000
(Write-off of Randall Co. account)
Bad Debt Expense does not increase when the write-off occurs. Under the allowance
method, companies debit every bad debt write-off to the allowance account rather
than to Bad Debt Expense. A debit to Bad Debt Expense would be incorrect because the
company has already recognized the expense when it made the adjusting entry for esti-
mated bad debts. Instead, the entry to record the write-off of an uncollectible account
reduces both Accounts Receivable and Allowance for Doubtful Accounts.
Recovery of an Uncollectible Account. Occasionally, a company collects from a cus-
tomer after it has written off the account as uncollectible. The company makes two
entries to record the recovery of a bad debt: (1) It reverses the entry made in writing off
the account. This reinstates the customer’s account. (2) It journalizes the collection in the
usual manner.
To illustrate, assume that on July 1, 2015, Randall Co. pays the $1,000 amount that
Brown had written off on March 1. These are the entries:
July 1, 2015
Accounts Receivable (Randall Co.) 1,000
Allowance for Doubtful Accounts 1,000
(To reverse write-off of account)
Cash 1,000
Accounts Receivable (Randall Co.) 1,000
(Collection of account)
Note that the recovery of a bad debt, like the write-off of a bad debt, affects only |
balance sheet accounts. The net effect of the two entries above is a debit to Cash and a
credit to Allowance for Doubtful Accounts for $1,000.7
Bases Used for Allowance Method. To simplify the preceding explanation, we assumed
we knew the amount of the expected uncollectibles. In “real life,” companies must
estimate that amount when they use the allowance method. Two bases are used to
determine this amount: (1) percentage of sales and (2) percentage of receivables. Both
bases are generally accepted. The choice is a management decision. It depends on the
relative emphasis that management wishes to give to expenses and revenues on the one
hand or to net realizable value of the accounts receivable on the other. The choice is
whether to emphasize income statement or balance sheet relationships. Illustration 7-6
(page 356) compares the two bases.
7If using the direct write-off approach, the company debits the amount collected to Cash and
credits a revenue account entitled Uncollectible Amounts Recovered, with proper notation in the
customer’s account.
356 Chapter 7 Cash and Receivables
ILLUSTRATION 7-6
Comparison of Bases for
Estimating Uncollectibles
Percentage of Sales Percentage of Receivables
Allowance
Accounts
Bad Debt for
Sales Receivable
Expense Doubtful
Accounts
Emphasis on Income Statement Emphasis on Balance Sheet
Relationships Relationships
Underlying Concepts The percentage-of-sales basis results in a better matching of expenses
with revenues—an income statement viewpoint. The percentage-of-receivables
The percentage-of-sales method
basis produces the better estimate of net realizable value—a balance sheet view-
illustrates the expense recogni-
point. Under both bases, the company must determine its past experience with
tion principle, which relates
bad debt losses.
expenses to revenues recognized.
Percentage-of-sales (income statement) approach. In the percentage-of-sales approach,
management estimates what percentage of credit sales will be uncollectible. This
percentage is based on past experience and anticipated credit policy.
The company applies this percentage to either total credit sales or net credit sales
of the current year. To illustrate, assume that Gonzalez Company elects to use the
percentage-of-sales basis. It concludes that 1 percent of net credit sales will become
uncollectible. If net credit sales for 2014 are $800,000, the estimated bad debts expense
is $8,000 (1% 3 $800,000). The adjusting entry is:
December 31, 2014
Bad Debt Expense 8,000
Allowance for Doubtful Accounts 8,000
After the adjusting entry is posted, assuming the allowance account already has a credit
balance of $1,723, the accounts of Gonzalez Company will show the following:
ILLUSTRATION 7-7
Bad Debt Expense Allowance for Doubtful Accounts
Bad Debt Accounts
Dec. 31 Adj. 8,000 Jan. 1 Bal. 1,723
after Posting
Dec. 31 Adj. 8,000
Dec. 31 Bal. 9,723
The amount of bad debt expense and the related credit to the allowance account are
unaffected by any balance currently existing in the allowance account. Because the bad
debt expense estimate is related to a nominal account (Sales Revenue), any balance in
the allowance is ignored. Therefore, the percentage-of-sales method achieves a proper
matching of cost and revenues. This method is frequently referred to as the income
statement approach.
Percentage-of-receivables (balance sheet) approach. Using past experience, a company can
estimate the percentage of its outstanding receivables that will become uncollectible,
without identifying specific accounts. This procedure provides a reasonably accurate
Accounts Receivable 357
estimate of the receivables’ realizable value. But, it does not fit the concept of matching
cost and revenues. Rather, it simply reports receivables in the balance sheet at net realiz-
able value. Hence, it is referred to as the percentage-of-receivables (or balance sheet)
approach.
Companies may apply this method using one composite rate that reflects an esti-
mate of the uncollectible receivables. Or, companies may set up an aging schedule of
accounts receivable, which applies a different percentage based on past experience to |
the various age categories. An aging schedule also identifies which accounts require
special attention by indicating the extent to which certain accounts are past due. The
schedule of Wilson & Co. in Illustration 7-8 is an example.
ILLUSTRATION 7-8
WILSON & CO.
Accounts Receivable
AGING SCHEDULE
Aging Schedule
Balance Under 60–90 91–120 Over
Name of Customer Dec. 31 60 days days days 120 days
Western Stainless Steel Corp. $ 98,000 $ 80,000 $18,000
Brockway Steel Company 320,000 320,000
Freeport Sheet & Tube Co. 55,000 $55,000
Allegheny Iron Works 74,000 60,000 $14,000
$547,000 $460,000 $18,000 $14,000 $55,000
Summary
Percentage
Estimated to Be Required Balance
Age Amount Uncollectible in Allowance
Under 60 days old $460,000 4% $18,400
60–90 days old 18,000 15% 2,700
91–120 days old 14,000 20% 2,800
Over 120 days 55,000 25% 13,750
Year-end balance of allowance for doubtful accounts $37,650
Wilson reports bad debt expense of $37,650 for this year, assuming that no balance
existed in the allowance account.
To change the illustration slightly, assume that the allowance account had a credit
balance of $800 before adjustment. In this case, Wilson adds $36,850 ($37,650 2 $800)
to the allowance account and makes the following entry.
Bad Debt Expense 36,850
Allowance for Doubtful Accounts 36,850
Wilson therefore states the balance in the allowance account at $37,650. If the
Allowance for Doubtful Accounts balance before adjustment had a debit balance of
$200, then Wilson records bad debt expense of $37,850 ($37,650 desired balance 1 $200
debit balance). In the percentage-of-receivables method, Wilson cannot ignore the
balance in the allowance account because the percentage is related to a real account
(Accounts Receivable).
Companies usually do not prepare an aging schedule to determine bad debt expense.
Rather, they prepare it as a control device to determine the composition of receivables
and to identify delinquent accounts. Companies base the estimated loss percentage
developed for each category on previous loss experience and the advice of credit
department personnel.
358 Chapter 7 Cash and Receivables
Whether using a composite rate or an aging schedule, the primary objective of the
percentage of outstanding receivables method for financial statement purposes is to report
receivables in the balance sheet at net realizable value. However, it is deficient in that it may
not match the bad debt expense to the period in which the sale takes place.
Gateway to The allowance for doubtful accounts as a percentage of receivables will vary, depend-
the Profession ing on the industry and the economic climate. Companies such as Eastman Kodak, Gen-
Tutorial on Recording eral Electric, and Monsanto have recorded allowances ranging from $3 to $6 per $100 of
Uncollectible Accounts
accounts receivable. Other large companies, such as CPC International ($1.48), Texaco
($1.23), and USX Corp. ($0.78), have had bad debt allowances of less than $1.50 per $100.
At the other extreme are hospitals that allow for $15 to $20 per $100 of accounts receivable.
Regardless of the method chosen—percentage-of-sales or -receivables—determining
the expense associated with uncollectible accounts requires a large degree of judgment.
Recent concern exists that, similar to Citigroup in our opening story, some banks use
this judgment to manage earnings. By overestimating the amounts of uncollectible loans
in a good earnings year, the bank can “save for a rainy day” in a future period. In future
(less-profitable) periods, banks can reduce the overly conservative allowance for
loan loss account to increase earnings.8
What do the numbers mean? I’M STILL WAITING
Small companies are in a bind. Many of their suppliers are de-
March 2012 March 2011
manding payment earlier, and their customers (represented by Company Size Percentage
their a ccounts receivable) are taking longer to pay. That means Change
1 to 4 Employees
companies with the least clout get squeezed the hardest. As 10.5%
one company executive noted, “The slowdown of currency, of 5 to 9
14.0% |
money, the exchange, puts us in a very precarious position.”
The average time small companies took to collect ac- 10 to 19
11.8%
counts receivable increased to 27 days in 2010 from about 23
20 to 49
days in the previous four-year period. Many small compa- 8.0%
nies are seeing their payments from larger customers
50 to 99
stretch from 30 days to 60 and even 90 days after an in- 6.9%
voice is issued. Wal-Mart Stores, Inc., for example, took 100 to 249
5.8%
29.5 days to pay its bills in the fi rst quarter of 2010, up from
27 days a year earlier. Apple took 52 days, up from 43 days 250 to 499
7.1%
a year earlier. As one individual stated, “If you are working
500 to 999
with one of these large companies, as your only customer, 14.6%
they have the power. They can go to somebody else, but you
Over 1000
can’t go anywhere.” 27.8%
The chart on the right indicates that, overall, companies 0 2 4 6 8 Days
are increasing their payment times past the due date regard- Source: Experian-Moody’s Q1 2012 benchmark report.
less of their size. For example, in the fi rst quarter of 2012,
companies paid their bills an average of 7.6 days past due, a The recession is taking its toll. As companies get squeezed
14.1 percent increase from the same period the previous pe- between late payments and tighter credit terms, nonpayments
riod. The very small companies and the large companies often result. As a result, much judgment must be exercised in
generally have delayed payment the most. determining the proper percentage to record for bad debts.
Sources: Anonymous, “A Cash-Flow Crisis Is the Recession’s Legacy,” Bloomberg Businessweek (March 28–April 3, 2011), pp. 59–60; and
A. Loten, “Small Firms’ Big Customers Are Slow to Pay,” Wall Street Journal (June 7, 2012), p. B7.
8 The SEC brought action against Suntrust Banks, requiring a reversal of $100 million of bad
debt expense. This reversal increased after-tax profit by $61 million. Recall from our earnings
management discussion in Chapter 4 that increasing or decreasing income through management
manipulation can reduce the quality of financial reports.
Notes Receivable 359
NOTES RECEIVABLE
A note receivable is supported by a formal promissory note, a written promise to
6 LEARNING OBJECTIVE
pay a certain sum of money at a specific future date. Such a note is a negotiable
Explain accounting issues related to
instrument that a maker signs in favor of a designated payee who may legally
recognition and valuation of notes
and readily sell or otherwise transfer the note to others. Although all notes con-
receivable.
tain an interest element because of the time value of money, companies classify
them as interest-bearing or non-interest-bearing. Interest-bearing notes have a stated
rate of interest. Zero-interest-bearing notes (non-interest-bearing) include interest as
part of their face amount. Notes receivable are considered fairly liquid, even if long-
term, because companies may easily convert them to cash (although they might pay a
fee to do so).
Companies frequently accept notes receivable from customers who need to extend
the payment period of an outstanding receivable. Or they require notes from high-risk
or new customers. In addition, companies often use notes in loans to employees and
subsidiaries, and in the sales of property, plant, and equipment. In some industries (e.g.,
the pleasure and sport boat industry), notes support all credit sales. The majority of
notes, however, originate from lending transactions. The basic issues in accounting for
notes receivable are the same as those for accounts receivable: recognition, valuation,
and disposition.
Recognition of Notes Receivable
Companies generally record short-term notes at face value (less allowances) because the
interest implicit in the maturity value is immaterial. A general rule is that notes treated
as cash equivalents (maturities of three months or less and easily converted to cash) are
not subject to premium or discount amortization.
However, companies should record and report long-term notes receivable at
the present value of the cash they expect to collect. When the interest stated on an |
interest-bearing note equals the effective (market) rate of interest, the note sells at
face value.9 When the stated rate differs from the market rate, the cash exchanged
(present value) differs from the face value of the note. Companies then record this
difference, either a discount or a premium, and amortize it over the life of a note to
approximate the effective (market) interest rate. This illustrates one of the many
situations in which time value of money concepts are applied to accounting
measurement.
Note Issued at Face Value
To illustrate the discounting of a note issued at face value, assume that Bigelow
Corp. lends Scandinavian Imports $10,000 in exchange for a $10,000, three-year note
bearing interest at 10 percent annually. The market rate of interest for a note of
s imilar risk is also 10 percent. We show the time diagram depicting both cash flows
in Illustration 7-9 (page 360).
9The stated interest rate, also referred to as the face rate or the coupon rate, is the rate contracted
as part of the note. The effective-interest rate, also referred to as the market rate or the effective
yield, is the rate used in the market to determine the value of the note—that is, the discount rate
used to determine present value.
360 Chapter 7 Cash and Receivables
ILLUSTRATION 7-9
Time Diagram for Note Present Value $10,000 Principal
Issued at Face Value
i = 10%
PPPVVV---OOOAAA $1,000 $1,000 $1,000 Interest
0 1 2 3
n = 3
Bigelow computes the present value or exchange price of the note as follows.
ILLUSTRATION 7-10
Face value of the note $10,000
Present Value of Note—
Present value of the principal:
Stated and Market Rates
$10,000 (PVF3,10%) 5 $10,000 3 .75132 $7,513
the Same Present value of the interest:
$1,000 (PVF-OA3,10%) 5 $1,000 3 2.48685 2,487
Present value of the note 10,000
Difference $ –0–
In this case, the present value of the note equals its face value because the effective
You can use a financial
and stated rates of interest are also the same. Bigelow records the receipt of the note as
calculator to solve this
problem. follows.
Calculator Solution for
Present Value of
Note Receivable Notes Receivable 10,000
Inputs Answer Cash 10,000
N 3
Bigelow recognizes the interest earned each year as follows.
I 10
Cash 1,000
Interest Revenue 1,000
PV ? –10,000
PMT 1,000 Note Not Issued at Face Value
Zero-Interest-Bearing Notes. If a company receives a zero-interest-bearing note, its
FV 10,000 present value is the cash paid to the issuer. Because the company knows both the future
amount and the present value of the note, it can compute the interest rate. This rate is
often referred to as the implicit interest rate. Companies record the difference between
the future (face) amount and the present value (cash paid) as a discount and amortize it
to interest revenue over the life of the note.
To illustrate, Jeremiah Company receives a three-year, $10,000 zero-interest-bearing
note, the present value of which is $7,721.80. The implicit rate that equates the total cash
to be received ($10,000 at maturity) to the present value of the future cash flows
($7,721.80) is 9 percent (the present value of 1 for three periods at 9 percent is .77218). We
show the time diagram depicting the one cash flow in Illustration 7-11.
Notes Receivable 361
ILLUSTRATION 7-11
Present Value $10,000 Principal Time Diagram for Zero-
Interest-Bearing Note
i = 9%
PPPVVV---OOOAAA $0 $0 $0 Interest
Calculator Solution for
Effective-Interest Rate
0 1 2 3 on Note
n = 3 Inputs Answer
N 3
Jeremiah records the transaction as follows. I ? 9
Notes Receivable 10,000.00
Discount on Notes Receivable ($10,000 2 $7,721.80) 2,278.20 PV –7,721.80
Cash 7,721.80
Discount on Notes Receivable is a valuation account. Companies report it on the PMT 0
balance sheet as a contra asset account to notes receivable. They then amortize the
discount, and recognize interest revenue annually using the effective-interest method. FV 10,000
Illustration 7-12 shows the three-year discount amortization and interest revenue
schedule.
ILLUSTRATION 7-12
SCHEDULE OF NOTE DISCOUNT AMORTIZATION |
Discount Amortization
EFFECTIVE-INTEREST METHOD
Schedule—Effective-
0% NOTE DISCOUNTED AT 9%
Interest Method
Carrying
Cash Interest Discount Amount
Received Revenue Amortized of Note
Date of issue $ 7,721.80
End of year 1 $ –0– $ 694.96a $ 694.96b 8,416.76c
End of year 2 –0– 757.51 757.51 9,174.27
End of year 3 –0– 825.73d 825.73 10,000.00
$ –0– $2,278.20 $2,278.20
a$7,721.80 3 .09 5 $694.96 c$7,721.80 1 $694.96 5 $8,416.76
b$694.96 2 0 5 $694.96 d5¢ adjustment to compensate for rounding
Jeremiah records interest revenue at the end of the first year using the effective-
interest method as follows.
Discount on Notes Receivable 694.96
Interest Revenue ($7,721.80 3 9%) 694.96
The amount of the discount, $2,278.20 in this case, represents the interest revenue
Jeremiah will receive from the note over the three years.
Interest-Bearing Notes. Often the stated rate and the effective rate differ. The zero-interest-
bearing note is one example.
To illustrate a more common situation, assume that Morgan Corp. makes a loan
to Marie Co. and receives in exchange a three-year, $10,000 note bearing interest at
10 percent annually. The market rate of interest for a note of similar risk is 12 percent.
We show the time diagram depicting both cash flows in Illustration 7-13 (page 362).
362 Chapter 7 Cash and Receivables
ILLUSTRATION 7-13
Time Diagram for Present Value $10,000 Principal
Interest-Bearing Note
i = 12%
PPPVVV---OOOAAA $1,000 $1,000 $1,000 Interest
0 1 2 3
n = 3
Morgan computes the present value of the two cash flows as follows.
ILLUSTRATION 7-14
Face value of the note $10,000
Computation of Present
Present value of the principal:
Value—Effective Rate
$10,000 (PVF3,12%) 5 $10,000 3 .71178 $7,118
Different from Stated Present value of the interest:
Rate $1,000 (PVF-OA3,12%) 5 $1,000 3 2.40183 2,402
Present value of the note 9,520
Difference (Discount) $ 480
In this case, because the effective rate of interest (12 percent) exceeds the stated rate
(10 percent), the present value of the note is less than the face value. That is, Morgan
exchanged the note at a discount. Morgan records the receipt of the note at a discount
as follows.
Notes Receivable 10,000
Discount on Notes Receivable 480
Cash 9,520
Morgan then amortizes the discount and recognizes interest revenue annually u sing
the effective-interest method. Illustration 7-15 shows the three-year discount amortiza-
tion and interest revenue schedule.
ILLUSTRATION 7-15
SCHEDULE OF NOTE DISCOUNT AMORTIZATION
Discount Amortization
EFFECTIVE-INTEREST METHOD
Schedule—Effective-
10% NOTE DISCOUNTED AT 12%
Interest Method
Carrying
Cash Interest Discount Amount
Received Revenue Amortized of Note
Date of issue $ 9,520
End of year 1 $1,000a $1,142b $142c 9,662d
End of year 2 1,000 1,159 159 9,821
End of year 3 1,000 1,179 179 10,000
$3,000 $3,480 $480
a$10,000 3 10% 5 $1,000 c$1,142 2 $1,000 5 $142
b$9,520 3 12% 5 $1,142 d$9,520 1 $142 5 $9,662
On the date of issue, the note has a present value of $9,520. Its unamortized discount—
additional interest revenue spread over the three-year life of the note—is $480.
At the end of year 1, Morgan receives $1,000 in cash. But its interest revenue is
$1,142 ($9,520 3 12%). The difference between $1,000 and $1,142 is the amortized
discount, $142. Morgan records receipt of the annual interest and amortization of the
discount for the first year as follows (amounts per amortization schedule).
Cash 1,000
Discount on Notes Receivable 142
Interest Revenue 1,142
Notes Receivable 363
The carrying amount of the note is now $9,662 ($9,520 1 $142). Morgan repeats this
process until the end of year 3.
When the present value exceeds the face value, the note is exchanged at a premium.
Companies record the premium on a note receivable as a debit and amortize it using the
effective-interest method over the life of the note as annual reductions in the amount of
interest revenue recognized.
Notes Received for Property, Goods, or Services. When a note is received in exchange
for property, goods, or services in a bargained transaction entered into at arm’s length,
the stated interest rate is presumed to be fair unless: |
1. No interest rate is stated, or
2. The stated interest rate is unreasonable, or
3. The face amount of the note is materially different from the current cash sales price
for the same or similar items or from the current fair value of the debt instrument. [4]
In these circumstances, the company measures the present value of the note by the
Calculator Solution for
fair value of the property, goods, or services or by an amount that reasonably approxi- Effective-Interest
Rate on Note
mates the fair value of the note.
Inputs Answer
To illustrate, Oasis Development Co. sold a corner lot to Rusty Pelican as a restau-
rant site. Oasis accepted in exchange a five-year note having a maturity value of $35,247 N 5
and no stated interest rate. The land originally cost Oasis $14,000. At the date of sale, the
land had a fair value of $20,000. Given the criterion above, Oasis uses the fair value of
I ? 12
the land, $20,000, as the present value of the note. Oasis therefore records the sale as:
Notes Receivable 35,247
PV –20,000
Discount on Notes Receivable ($35,247 2 $20,000) 15,247
Land 14,000
Gain on Disposal of Land ($20,000 2 $14,000) 6,000 PMT 0
Oasis amortizes the discount to interest revenue over the five-year life of the note
using the effective-interest method. FV 35,247
Choice of Interest Rate
In note transactions, other factors involved in the exchange, such as the fair value of the
property, goods, or services, determine the effective or real interest rate. But, if a com-
pany cannot determine that fair value and if the note has no ready market, determining
the present value of the note is more difficult. To estimate the present value of a note
under such circumstances, the company must approximate an applicable interest rate
that may differ from the stated interest rate. This process of interest-rate approximation
is called imputation. The resulting interest rate is called an imputed interest rate.
The prevailing rates for similar instruments, from issuers with similar credit ratings,
affect the choice of a rate. Restrictive covenants, collateral, payment schedule, and the exist-
ing prime interest rate also impact the choice. A company determines the imputed interest
rate when it receives the note. It ignores any subsequent changes in prevailing interest rates.
Valuation of Notes Receivable
Like accounts receivable, companies record and report short-term notes receivable at
their net realizable value—that is, at their face amount less all necessary allowances. The
primary notes receivable allowance account is Allowance for Doubtful Accounts. The
computations and estimations involved in valuing short-term notes receivable and in
recording bad debt expense and the related allowance exactly parallel that for trade
accounts receivable. Companies estimate the amount of uncollectibles by using either a
percentage-of-sales revenue or an analysis of the receivables.
364 Chapter 7 Cash and Receivables
Long-term notes receivable involve additional estimation problems. For example,
the value of a note receivable can change significantly over time from its original cost.
That is, with the passage of time, historical numbers become less and less relevant. As
discussed earlier (in Chapters 2, 5, and 6), the FASB requires that for financial instru-
ments such as receivables, companies disclose not only their cost but also their fair value
in the notes to the financial statements.
Impairments. A note receivable may become impaired. A note receivable is considered
impaired when it is probable that the creditor will be unable to collect all amounts due
(both principal and interest) according to the contractual terms of the receivable. In this
case, a loss is recorded for the amount of the impairment. Appendix 7B further discusses
impairments of receivables.
What do the numbers mean? ECONOMIC CONSEQUENCES AND WRITE-OFFS
The massive write-downs that fi nancial fi rms are posting better answer? Should you just let everybody say they
have begun to spur a backlash among some investors and think it’s going to recover?” |
executives, who are blaming accounting rules for exaggerat- Others who favor the use of market values say that for all its
ing the losses and are seeking new, more forgiving ways to imperfections, market value also imposes discipline on compa-
value investments. nies. “It forces you to realistically confront what’s happening to
The rules—which last made headlines back in the Enron you much quicker, so it plays a useful purpose,” said Sen. Jack
era—require companies to value many of the securities they Reed (D., R.I.), a member of the Senate banking committee.
hold at whatever price prevails in the market, no matter how Japan stands out as an example of how ignoring problems
sharply those prices swing. can lead to years-long stagnation. “Look at Japan, where
Some analysts and executives argue this triggers a dom- they ignored write-downs at all their fi nancial institutions
ino effect. The market falls, forcing banks to take write-offs, when loans went bad,” said Jeff Mahoney, general counsel at
pushing the market lower, causing more write-offs. Compa- the Council for Institutional Investors.
nies like AIG and Citicorp argue that their write-downs may In addition, companies don’t always have the luxury of
never actually result in a true charge to the company. It’s a waiting out a storm until assets recover the long-term value
sore point because companies feel they are being forced to that executives believe exists. A classic example relates to
take big fi nancial hits on holdings that they have no intention many European banks that hold loans to countries like
of actually selling at current prices. Greece, Spain, Ireland, and Portugal. Although these loans
Companies believe they are strong enough to simply are clearly toxic (values overstated), some banks still contend
keep the holdings in their portfolios until the crisis passes. that they should not be written down (partly because they
Forcing companies to value securities based on what they can be held to maturity). However, this contention is suspect,
would fetch if sold today “is an attempt to apply liqui- and impairment losses are rising. For example, Bankia
dation accounting to a going concern,” says one analyst. Group, Spain’s third largest bank, recently restated its 2011
Bob Herz, former FASB chairperson, acknowledges the dif- results to show a €3.3 billion ($4.2 billion) loss rather than the
fi culty but notes, “you tell me what a better answer is. . . . previously reported €40.9 billion profi t.
Is just pretending that things aren’t decreasing in value a
Sources: Adapted from David Reilly, “Wave of Write-Offs Rattles Market: Accounting Rules Blasted as Dow Falls; A $600 Billion Toll?” Wall
Street Journal (March 1, 2008), p. Al; and J. Weil, “The E4 Smiled While Spain’s Banks Cooked the Books,” Bloomberg (June 14, 2012).
SPECIAL ISSUES
Three additional special issues for accounting and reporting of receivables relate to the
following.
1. Fair value option.
2. Disposition of receivables.
3. Presentation and disclosure.
Special Issues 365
Fair Value Option
Recently, the FASB has given companies the option to use fair value as the basis
7 LEARNING OBJECTIVE
of measurement in the financial statements. [5] The Board believes that fair value
Explain the fair value option.
measurement for financial instruments provides more relevant and understand-
able information than historical cost. It considers fair value to be more relevant
because it reflects the current cash equivalent value of financial instruments. As
International
a result, companies now have the option to record fair value in their accounts for
Perspective
most financial instruments, including receivables.
IFRS also has the fair value
If companies choose the fair value option, the receivables are recorded at
option.
fair value, with unrealized holding gains or losses reported as part of net in-
come. An unrealized holding gain or loss is the net change in the fair value of
the receivable from one period to another, exclusive of interest revenue. As a result, the |
company reports the receivable at fair value each reporting date. In addition, it reports
the change in value as part of net income.
Companies may elect to use the fair value option at the time the financial instru-
ment is originally recognized or when some event triggers a new basis of accounting
(such as when a business acquisition occurs). If a company elects the fair value option
for a financial instrument, it must continue to use fair value measurement for that in-
strument until the company no longer owns this instrument. If the company does not
elect the fair value option for a given financial instrument at the date of recognition, it
may not use this option on that specific instrument in subsequent periods.
Recording Fair Value Option
Assume that Escobar Company has notes receivable that have a fair value of $810,000
and a carrying amount of $620,000. Escobar decides on December 31, 2014, to use the
fair value option for these receivables. This is the first valuation of these recently
acquired receivables. Having elected to use the fair value option, Escobar must value
these receivables at fair value in all subsequent periods in which it holds these receiv-
ables. Similarly, if Escobar elects not to use the fair value option, it must use its carrying
amount for all future periods.
When using the fair value option, Escobar reports the receivables at fair value, with
any unrealized holding gains and losses reported as part of net income. The unrealized
holding gain is the difference between the fair value and the carrying amount at
December 31, 2014, which for Escobar is $190,000 ($810,000 2 $620,000). At December
31, 2014, Escobar makes an adjusting entry to record the increase in value of notes
receivable and to record the unrealized holding gain, as follows.
December 31, 2014
Notes Receivable 190,000
Unrealized Holding Gain or Loss—Income 190,000
Escobar adds the difference between fair value and the cost of the notes receivable
to arrive at the fair value reported on the balance sheet. In subsequent periods, the com-
pany will report any change in fair value as an unrealized holding gain or loss. For
example, if at December 31, 2015, the fair value of the notes receivable is $800,000,
Escobar would recognize an unrealized holding loss of $10,000 ($810,000 2 $800,000)
and reduce the Notes Receivable account.
Disposition of Accounts and Notes Receivable
8 LEARNING OBJECTIVE
In the normal course of events, companies collect accounts and notes receivable Explain accounting issues related to
disposition of accounts and notes
when due and then remove them from the books. However, the growing size
receivable.
and significance of credit sales and receivables has led to changes in this “normal
366 Chapter 7 Cash and Receivables
course of events.” In order to accelerate the receipt of cash from receivables, the owner
may transfer accounts or notes receivables to another company for cash.
There are various reasons for this early transfer. First, for competitive reasons, pro-
viding sales financing for customers is virtually mandatory in many industries. In the
sale of durable goods, such as automobiles, trucks, industrial and farm equipment, com-
puters, and appliances, most sales are on an installment contract basis. Many major
companies in these industries have created wholly owned subsidiaries specializing in
receivables financing. For example, Ford has Ford Motor Credit, and John Deere has
John Deere Credit.
Second, the holder may sell receivables because money is tight and access to normal
credit is unavailable or too expensive. Also, a firm may sell its receivables, instead of
borrowing, to avoid violating existing lending agreements.
Finally, billing and collection of receivables are often time-consuming and costly.
Credit card companies such as MasterCard, Visa, American Express, Diners Club,
Discover, and others take over the collection process and provide merchants with
immediate cash.
Conversely, some purchasers of receivables buy them to obtain the legal protection
of ownership rights afforded a purchaser of assets versus the lesser rights afforded a |
secured creditor. In addition, banks and other lending institutions may need to
purchase receivables because of legal lending limits. That is, they cannot make any
additional loans but they can buy receivables and charge a fee for this service.
The transfer of receivables to a third party for cash happens in one of two ways:
1. Secured borrowing.
2. Sales of receivables.
Secured Borrowing
A company often uses receivables as collateral in a borrowing transaction. In fact, a
creditor often requires that the debtor designate (assign) or pledge10 receivables as secu-
rity for the loan. If the loan is not paid when due, the creditor can convert the collateral
to cash—that is, collect the receivables.
To illustrate, on March 1, 2014, Howat Mills, Inc. provides (assigns) $700,000 of its
accounts receivable to Citizens Bank as collateral for a $500,000 note. Howat Mills con-
tinues to collect the accounts receivable; the account debtors are not notified of the
arrangement. Citizens Bank assesses a finance charge of 1 percent of the accounts receiv-
able and interest on the note of 12 percent. Howat Mills makes monthly payments to the
bank for all cash it collects on the receivables. Illustration 7-16 shows the entries for the
secured borrowing for Howat Mills and Citizens Bank.
In addition to recording the collection of receivables, Howat Mills must recognize
all discounts, returns and allowances, and bad debts. Each month Howat Mills uses the
proceeds from the collection of the accounts receivable to retire the note obligation. In
addition, it pays interest on the note.11
Sales of Receivables
Sales of receivables have increased substantially in recent years. A common type is a sale
to a factor. Factors are finance companies or banks that buy receivables from businesses
10If a company transfers the receivables for custodial purposes, the custodial arrangement is
often referred to as a pledge.
11What happens if Citizens Bank collected the transferred accounts receivable rather than Howat
Mills? Citizens Bank would simply remit the cash proceeds to Howat Mills, and Howat Mills
would make the same entries shown in Illustration 7-16. As a result, Howat Mills reports these
“collaterized” receivables as an asset on the balance sheet.
Special Issues 367
Howat Mills, Inc. Citizens Bank
Transfer of accounts receivable and issuance of note on March 1, 2014
Cash 493,000 Notes Receivable 500,000
Interest Expense 7,000* Interest Revenue 7,000*
Notes Payable 500,000 Cash 493,000
*(1% 3 $700,000)
Collection in March of $440,000 of accounts less cash discounts of $6,000
plus receipt of $14,000 sales returns
Cash 434,000
Sales Discounts 6,000
Sales Returns and Allowances 14,000 (No entry)
Accounts Receivable
($440,000 1 $14,000 5 $454,000) 454,000
Remitted March collections plus accrued interest to the bank on April 1, 2014
Interest Expense 5,000* Cash 439,000
Notes Payable 434,000 Interest Revenue 5,000*
Cash 439,000 Notes Receivable 434,000
*($500,000 3 .12 3 1/12)
Collection in April of the balance of accounts less $2,000 written off as uncollectible
Cash 244,000
Allowance for Doubtful Accounts 2,000 (No entry)
Accounts Receivable 246,000*
*($700,000 2 $454,000)
Remitted the balance due of $66,000 ($500,000 2 $434,000) on the note plus interest on May 1, 2014
Interest Expense 660* Cash 66,660
Notes Payable 66,000 Interest Revenue 660*
Cash 66,660 Notes Receivable 66,000
*($66,000 3 .12 3 1/12)
ILLUSTRATION 7-16
for a fee and then collect the remittances directly from the customers. Factoring receiv- Entries for Transfer of
ables is traditionally associated with the textile, apparel, footwear, furniture, and home Receivables—Secured
furnishing industries.12 Illustration 7-17 shows a typical factoring arrangement. Borrowing
ILLUSTRATION 7-17
Basic Procedures in
FACTOR
(2) Requests credit review Factoring
(6) Makes payment
(3) Approves credit
(4) Advances cash
CUSTOMER (1) Places order COMPANY
Retailer Manufacturer
or (5) Ships goods or
Wholesaler Distributor
12Credit cards like MasterCard and Visa are a type of factoring arrangement. Typically, the |
purchaser of the receivable charges a ¾–1½ percent commission of the receivables purchased
(the commission is 4–5 percent for credit card factoring).
368 Chapter 7 Cash and Receivables
A recent phenomenon in the sale (transfer) of receivables is securitization. Securiti-
zation takes a pool of assets, such as credit card receivables, mortgage receivables, or car
loan receivables, and sells shares in these pools of interest and principal payments. This,
in effect, creates securities backed by these pools of assets. Virtually every asset with a
payment stream and a long-term payment history is a candidate for securitization.
What are the differences between factoring and securitization? Factoring usually
involves sale to only one company, fees are high, the quality of the receivables is low,
and the seller afterward does not service the receivables. In a securitization, many inves-
tors are involved, margins are tight, the receivables are of generally higher quality, and
the seller usually continues to service the receivables.
In either a factoring or a securitization transaction, a company sells receivables on
either a without recourse or a with recourse basis.13
Sale without Recourse. When buying receivables without recourse, the purchaser
assumes the risk of collectibility and absorbs any credit losses. The transfer of accounts
receivable in a nonrecourse transaction is an outright sale of the receivables both in form
(transfer of title) and substance (transfer of control). In nonrecourse transactions, as in
any sale of assets, the seller debits Cash for the proceeds and credits Accounts Receiv-
able for the face value of the receivables. The seller recognizes the difference, reduced by
any provision for probable adjustments (discounts, returns, allowances, etc.), as a Loss
on Sale of Receivables. The seller uses a Due from Factor account (reported as a receiv-
able) to account for the proceeds retained by the factor to cover probable sales discounts,
sales returns, and sales allowances.
Gateway to To illustrate, Crest Textiles, Inc. factors $500,000 of accounts receivable with Com-
the Profession mercial Factors, Inc., on a without recourse basis. Crest Textiles transfers the receivable
Comprehensive Illustration records to Commercial Factors, which will receive the collections. Commercial Factors
of Sale without Recourse
assesses a finance charge of 3 percent of the amount of accounts receivable and retains
an amount equal to 5 percent of the accounts receivable (for probable adjustments).
ILLUSTRATION 7-18
Crest Textiles and Commercial Factors make the following journal entries for the receiv-
Entries for Sale of
ables transferred without recourse.
Receivables without
Recourse
Crest Textiles, Inc. Commercial Factors, Inc.
Cash 460,000 Accounts (Notes) Receivable 500,000
Due from Factor 25,000* Due to Customer (Crest Textiles) 25,000
Loss on Sale of Receivables 15,000** Interest Revenue 15,000
Accounts (Notes) Receivable 500,000 Cash 460,000
*(5% 3 $500,000) **(3% 3 $500,000)
In recognition of the sale of receivables, Crest Textiles records a loss of $15,000. The
factor’s net income will be the difference between the financing revenue of $15,000 and
the amount of any uncollectible receivables.
Sale with Recourse. For receivables sold with recourse, the seller guarantees payment
to the purchaser in the event the debtor fails to pay. To record this type of transaction,
the seller uses a financial components approach because the seller has a continuing
involvement with the receivable. Values are now assigned to such components as the
13Recourse is the right of a transferee of receivables to receive payment from the transferor of
those receivables for (1) failure of the debtors to pay when due, (2) the effects of prepayments, or
(3) adjustments resulting from defects in the eligibility of the transferred receivables. [6]
Special Issues 369
recourse provision, servicing rights, and agreement to reacquire. In this approach, each
party to the sale only recognizes the assets and liabilities that it controls after the sale. |
To illustrate, assume the same information as in Illustration 7-18 for Crest Textiles
and for Commercial Factors, except that Crest Textiles sold the receivables on a with
recourse basis. Crest Textiles determines that this recourse liability has a fair value of
$6,000. To determine the loss on the sale of the receivables, Crest Textiles computes the
net proceeds from the sale as follows.
ILLUSTRATION 7-19
Cash received $460,000
Net Proceeds
Due from factor 25,000 $485,000
Computation
Less: Recourse liability 6,000
Net proceeds $479,000
Net proceeds are cash or other assets received in a sale less any liabilities incurred.
Crest Textiles then computes the loss as follows.
ILLUSTRATION 7-20
Carrying (book) value $500,000
Loss on Sale
Net proceeds 479,000
Computation
Loss on sale of receivables $ 21,000
Illustration 7-21 shows the journal entries for both Crest Textiles and Commercial
Factors for the receivables sold with recourse.
ILLUSTRATION 7-21
Crest Textiles, Inc. Commercial Factors, Inc.
Entries for Sale of
Cash 460,000 Accounts Receivable 500,000
Receivables with
Due from Factor 25,000 Due to Customer
Recourse
Loss on Sale of (Crest Textiles) 25,000
Receivables 21,000 Interest Revenue 15,000
Accounts (Notes) Cash 460,000
Receivable 500,000
Recourse Liability 6,000
In this case, Crest Textiles recognizes a loss of $21,000. In addition, it records a liabil- Gateway to
the Profession
ity of $6,000 to indicate the probable payment to Commercial Factors for uncollectible
receivables. If Commercial Factors collects all the receivables, Crest Textiles eliminates Tutorial on the Disposition
of Receivables
its recourse liability and increases income. Commercial Factors’ net income is the
interest revenue of $15,000. It will have no bad debts related to these receivables.
Secured Borrowing versus Sale
The FASB concluded that a sale occurs only if the seller surrenders control of the receiv-
ables to the buyer. The following three conditions must be met before a company can
record a sale:
1. The transferred asset has been isolated from the transferor (put beyond reach of the
transferor and its creditors).
370 Chapter 7 Cash and Receivables
2. The transferees have obtained the right to pledge or exchange either the transferred
assets or benefi cial interests in the transferred assets.
3. The transferor does not maintain effective control over the transferred assets through
an agreement to repurchase or redeem them before their maturity.
If the three conditions are met, a sale occurs. Otherwise, the transferor should record
the transfer as a secured borrowing. If sale accounting is appropriate, a company must
still consider assets obtained and liabilities incurred in the transaction. Illustration 7-22
shows the rules of accounting for transfers of receivables.
ILLUSTRATION 7-22
Accounting for Transfers
of Receivables Transfer of Receivables
Does it meet three conditions?
1. Transferred assets isolated from transferor.
2. Transferee has right to pledge or sell assets.
3. Transferor does not maintain control through
repurchase agreement.
Yes No
Is there continuing involvement? Record as secured borrowing:
1. Record liability.
2. Record interest expense.
Yes No
Record as a sale: Record as a sale:
1. Reduce receivables. 1. Reduce receivables.
2. Recognize assets 2. Record gain or loss.
obtained and
liabilities incurred.
3. Record gain or loss.
International
Perspective
With recent changes in U.S.
GAAP, the accounting guidance As indicated, if there is continuing involvement in a sale transaction, a company
for transfers is substantially must record the assets obtained and liabilities incurred.14
converged.
14In response to the financial crisis, which was partly caused by securitizations gone bad (see the
“What Do the Numbers Mean?” box on page 371), the FASB issued new rules to tighten up the
conditions when a transfer of receivables is recorded as a sale. The changes in the rules apply
primarily to transfers that involve participating interests (which is the case for many securitiza-
tions). In order for a transfer with participating interests to be accounted for as a sale, all |
participating investors must have a pro rata share ownership interest in the transferred assets.
That is, all parties to the transfer must receive benefits or be exposed to risks of the transferred
assets in proportion to their ownership share. If these criteria are not met (e.g., some investors
get paid first or others absorb more losses than others on the transferred receivables), then the
transfer is accounted for as a secured borrowing. [7] As a result of these new rules, sale treat-
ment for transfers of receivables will be significantly reduced.
In response to the use of repurchase agreements by some financial institutions during the
financial crisis (e.g., Lehman Brothers’ Repo 105) to “window-dress” their balance sheets and show
lower leverage, the FASB also recently issued new guidance on transfers of assets in repurchase
agreements. [8] The new rules tighten the requirements for meeting the control criterion, which
raises the bar for companies to be able to assert sale accounting in a repurchase agreement.
Special Issues 371
What do the numbers mean? RETURN TO LENDER
It used to be that lenders of mortgages and other types of payment stream and a long-term payment history is a candi-
debt securities carried them on their books as a loan receiv- date for securitization. And, for a while, everyone was happy
able. But thanks to Wall Street, many lenders learned how to to be part of the mortgage securitization game. The graphic
package these loans together and sell (securitize) them, and below illustrates the way the process worked.
record a gain on the sale. In fact, virtually every asset with a
Borrower Lender Investment Bank MORTGAGE-BACKED Investors
SECURITY
Packages the loans Choose what to buy
into a mortgage-backed based on their
security deal, often
appetites for risk
known as a
and reward.
securitization.
HIGH
RISK
Works with a Often sells loan to Sells the securitization, sorted by risk,
lender to get a investment bank to investors. Lower-rated slices take
home-purchase loan or special-purpose the first defaults when mortgages go
or a refinancing. entity. bad but offer higher returns. LOW
RISK
What they get
Financing needed to Takes upfront fees Collects fees for packaging the loans into Earn interest on the
purchase a home for making the loan. bond deal. securities and absorb any
or cash from gain or loss in price.
refinancing.
If the loan
goes bad Can be forced to take May push back loan to lender, or be forced to May have legal recourse
back loan if there's eat any loss. against the bank if they can
House can be an early default or show the quality of the
repossessed. documentation loan or loan documentation
is questionable. was misrepresented.
As indicated, once the mortgage loan is signed by the bor- their loans, and the credit markets collapsed. The result was
rower, the lender sells the loans to an investment bank or a a credit crisis.
trust (special-purpose entity), reports a gain, and generally So, who loses? Investors, primarily. But many investors
earns fees for servicing the debt. The trust, with the help of are not ready to let lenders off the hook. They argue that in
the investment bank, raises the money to buy these loans by many of these sales, the lender must take back loans that de-
selling some type of interest-bearing security to the investing faulted or contained mistakes or fraud (bogus appraisals,
public. These investors are happy because they earn a return infl ated borrower incomes, and other misrepresentations).
that they believe is excellent, given the risk they take. For example, Countrywide Financial Corp., the largest mort-
There were two big problems with these arrangements. gage lender in the United States, indicated that its liability
First, as indicated in our discussion in the text, the lender has for such claims increased by nearly $600 million from March
to make sure it does not keep control. Otherwise, it cannot 31, 2007, to March 31, 2008.
sell the receivable and receive gain-on-sale treatment. Unfor- The moral of the story is that accounting matters. Lenders |
tunately, the accounting rules were loose enough that lenders have strong incentives to want to report upfront gains on sales
were able to argue that they do not have control in most of loans. But, in most cases, these gains should never have been
cases. Second, lenders realized that lending to subprime bor- booked. In response, the FASB has issued new rules to tighten
rowers could be very profi table. They focused on these cus- up “gain-on-sale” accounting for securitizations with partici-
tomers because the bank earns a fee for origination of the pating interests (see footnote 14 on page 370). With these new
loan, sells the loans for a gain, and earns servicing revenue— rules, lenders will have to keep the loan on its balance sheet.
a triple bump to the bottom line. However, when the housing Under these conditions, lenders would be much less likely to
market collapsed, the subprime borrowers could not repay lend so much money to individuals with poor credit ratings.
Source: M. Hudson, “How Wall Street Stoked the Mortgage Meltdown,” Wall Street Journal (June 27, 2007), p. A10.
372 Chapter 7 Cash and Receivables
Presentation and Analysis
LEARNING OBJECTIVE 9
Presentation of Receivables
Describe how to report and analyze
receivables. The general rules in classifying receivables are:
1. Segregate the different types of receivables that a company possesses, if material.
2. Appropriately offset the valuation accounts against the proper receivable
accounts.
3. Determine that receivables classifi ed in the current assets section will be converted
into cash within the year or the operating cycle, whichever is longer.
4. Disclose any loss contingencies that exist on the receivables.
5. Disclose any receivables designated or pledged as collateral.
6. Disclose the nature of credit risk inherent in the receivables, how that risk is analyzed
and assessed in arriving at the allowance for credit losses, and the changes and
reasons for those changes in the allowance for credit losses.
With respect to additional disclosures, companies are required to disaggregate based on
type of receivable. In response to demands for additional information about credit risk,
the FASB recently issued rules for companies to provide the following disclosures about
its receivables on a disaggregated basis: (1) a roll-forward schedule of the allowance for
doubtful accounts from the beginning of the reporting period to the end of the reporting
period, (2) the nonaccrual status of receivables by class of receivables, and (3) impaired
receivables by type of receivable. In addition, companies should disclose credit quality
indicators and the aging of past due receivables. [9]
Companies must disclose concentrations of credit risk for all financial instru-
ments (including receivables). Concentrations of credit risk exist when receivables
have common characteristics that may affect their collection. These common charac-
teristics might be companies in the same industry or same region of the country. For
example, Quantum Corporation reported that sales of its disk drives to its top five
customers (including Hewlett-Packard) represented nearly 40 percent of its revenues
in a recent year. Financial statements users want to know if a substantial amount of
receivables from such sales are to customers facing uncertain economic conditions.
International No numerical guidelines are provided as to what is meant by a “concentra-
Perspective tion of credit risk.”15
Holding receivables that it will The assets sections of Colton Corporation’s balance sheet in Illustration 7-23
receive in a foreign currency show many of the disclosures required for receivables.
represents risk that the
Analysis of Receivables
exchange rate may move
against the company. This results Accounts Receivable Turnover. Analysts frequently compute financial ratios to
in a decrease in the amount evaluate the liquidity of a company’s accounts receivable. To assess the liquid-
collected in terms of U.S. dollars. ity of the receivables, they use the accounts receivable turnover ratio. This ratio |
Companies engaged in cross- measures the number of times, on average, a company collects receivables
border transactions often
d uring the period. The ratio is computed by dividing net sales by average (net)
“hedge” these receivables by
receivables outstanding during the year. Theoretically, the numerator should
buying contracts to exchange
include only net credit sales, but this information is frequently unavailable.
currencies at specifi ed amounts
However, if the relative amounts of credit and cash sales remain fairly constant,
at future dates.
the trend indicated by the ratio will still be valid. Barring significant seasonal
15Three items should be disclosed with an identified concentration: (1) information on the
characteristic that determines the concentration, (2) the amount of loss that could occur upon
nonperformance, and (3) information on any collateral related to the receivable. [10]
Special Issues 373
ILLUSTRATION 7-23
COLTON CORPORATION
Disclosure of Receivables
BALANCE SHEET (PARTIAL)
AS OF DECEMBER 31, 2014
Current assets
Cash and cash equivalents $ 1,870,250
Accounts and notes receivable (Note 2) $10,509,673
Less: Allowance for doubtful accounts 500,226
10,009,447
Advances to subsidiaries due 9/30/14 2,090,000
Federal income taxes refundable 146,704
Dividends and interest receivable 75,500
Other receivables and claims (including debit
balances in accounts payable) 174,620 12,496,271
Total current assets $14,366,521
Noncurrent receivables
Notes receivable from officers and key employees 376,090
Segregate different types
Claims receivable (litigation settlement to be collected
of receivables
over four years) 585,000
Note 2: Accounts and Notes Receivable. A ll noncurrent receivables are due within five years from the
balance sheet date. Trade receivables that are less than three months past due are not considered
impaired. At December 31, the aging analysis of receivables is as follows.
Past Due but Not Impaired
Neither Past
Amounts Due or ,30 30–60 60–90 90–120 .120 Disclose aging of
($000) Total Impaired days days days days days receivables
2014 10,510 5,115 2,791 1,582 570 360 92
As at December 31, 2014, trade receivables at initial value of $109 were impaired and fully provided for.
The following table summarises movements in the provision for impairment of receivables.
Total
$000
At January 1, 2014 98
Presentation of impaired
Expense for the year 26
receivables
Written off (9)
Recoveries (6)
At December 31, 2014 109
Certain subsidiaries transferred receivable balances amounting to $1,014 to a bank in exchange for cash
during the year ended December 31, 2014. The transaction has been accounted for as a secured
Disclose collateral
borrowing. In case of default under the loan agreement, the borrower has the right to receive the cash
arrangements
flows from the receivables transferred. Without default, the subsidiaries will collect the receivables and
assign new receivables as collateral.
factors, average receivables outstanding can be computed from the beginning Underlying Concepts
and ending balances of net trade receivables.
Providing information that will
To illustrate, Best Buy reported 2011 net sales of $50,705 million, its begin-
help users assess a company’s
ning and ending accounts receivable balances were $2,288 million and $2,348
current liquidity and prospective
million, respectively. Illustration 7-24 shows the computation of its accounts
cash fl ows is a primary objective
receivable turnover. of accounting.
ILLUSTRATION 7-24
Net Sales Accounts Receivable
5 Computation of
Average Trade Receivables (net) Turnover
Accounts Receivable
$50,705 5 21.9 times, or every 16.7 days (365 4 21.9) Turnover
($2,288 1 $2,348)/2
374 Chapter 7 Cash and Receivables
This information16 shows how successful the company is in collecting its outstand-
ing receivables. If possible, an aging schedule should also be prepared to help determine
how long receivables have been outstanding. A satisfactory accounts receivable turn-
over may have resulted because certain receivables were collected quickly though
others have been outstanding for a relatively long period. An aging schedule would |
You will reveal such patterns.
want to
Often the accounts receivable turnover is transformed to days to collect accounts
read the
receivable or days outstanding—an average collection period. In this case, 21.9 is
IFRS INSIGHTS
on pages 408–412 divided into 365 days, resulting in 16.7 days. Companies frequently use the average
collection period to assess the effectiveness of a company’s credit and collection poli-
for discussion of
cies. The general rule is that the average collection period should not greatly exceed the
IFRS related to cash
credit term period. That is, if customers are given a 60-day period for payment, then the
and receivables.
average collection period should not be too much in excess of 60 days.
Evolving Issue A CURE FOR “TOO LITTLE, TOO LATE”?
A significant accounting weakness revealed during the if the credit quality deteriorates and if there is an expecta-
financial crisis relates to the accounting for loan losses (or tion that substantially all of the contractual cash flows will
allowance for doubtful accounts). The concern is that the not be recovered.
existing GAAP (and IFRS) results in allowances for loan loss In response to criticisms that the three-bucket model is
that tend to be at their lowest level when they are needed the overly complex, the FASB is exploring a second model—
most—at the beginning of a downward-trending economic referred to as the “Current Expected Credit Loss” (CECL)
cycle (the “too little, too late” concern). Therefore, the FASB model. Unlike the three-bucket approach, the CECL model
and IASB have been working to develop a standard that en- uses a single-measurement objective—current estimate of
sures that the allowance for loan loss balance better reflects lifetime expected credit losses—in contrast to the three-
all estimated credit losses. bucket model’s requirement to distinguish between “12
The Boards agree that a company should recognize an months of expected credit losses” (Bucket 1) and “lifetime
impairment in net income when it does not expect to collect expected credit losses” (Buckets 2 and 3).
all contractual amounts due on a loan. Furthermore, the Under the CECL model, the impairment estimate reflects
Boards indicate that it is inappropriate to defer an impair- management’s estimate of the contractual cash flows that the
ment loss over the life of a loan. In other words, if a com- company does not expect to collect. Thus, the balance sheet
pany does not expect to collect all amounts due, a loss exists will reflect the current estimate of expected credit losses at
and should be recognized immediately. The Boards are ex- the reporting date, while the income statement will indicate
ploring two different approaches to an improved impair- the effects of credit deterioration or improvement that has
ment model. taken place during the period.
The first approach, referred to as the three-bucket ap- While these proposed models represent a significant
proach, would classify loans and other financial assets into change from current practice, they have gained support
three buckets, which reflect assets of increasing severity of because the loan loss allowance captures expected losses
impairment. In this model, financial assets start out in in response to deterioration in credit quality. In addition,
Bucket 1 with reserves equal to 12 months of expected in contrast to current GAAP, which is based on an “in-
losses. Then, assets move to Bucket 2 or 3, and reserves in- curred loss” model, estimated loan losses are recognized
crease to reflect expected losses over the life of those assets earlier.
Source: K. Tysiac, “FASB Takes New Path in Contentious Financial Instruments Project,” Journal of Accountancy (August 31, 2012).
16Several figures other than 365 could be used. A common alternative is 360 days because it is
divisible by 30 (days) and 12 (months). Use 365 days in any homework computations.
Summary of Learning Objectives 375
KEY TERMS
SUMMARY OF LEARNING OBJECTIVES
accounts receivable, 350
accounts receivable
turnover, 372 |
1 Identify items considered cash. To be reported as “cash,” an asset must be
aging schedule, 357
readily available for the payment of current obligations and free from contractual
allowance method, 353
restrictions that limit its use in satisfying debts. Cash consists of coin, currency, and
bank overdrafts, 348
available funds on deposit at the bank. Negotiable instruments such as money orders,
cash, 346
certified checks, cashier’s checks, personal checks, and bank drafts are also viewed as
cash discounts, 351
cash. Savings accounts are usually classified as cash.
cash equivalents, 346
2 Indicate how to report cash and related items. Companies report cash as compensating
a current asset in the balance sheet. The reporting of other related items are as follows. balances, 347
(1) Restricted cash: The SEC recommends that companies state separately legally re- direct write-off
stricted deposits held as compensating balances against short-term borrowing among method, 353
the “Cash and cash equivalent items” in current assets. Restricted deposits held against factoring receivables, 367
long-term borrowing arrangements should be separately classified as noncurrent assets
fair value option, 365
in either the investments or other assets sections. (2) Bank overdrafts: Companies should
financial components
report overdrafts in the current liabilities section and usually add them to the amount
approach, 368
reported as accounts payable. If material, these items should be separately disclosed
imputed interest rate, 363
either on the face of the balance sheet or in the related notes. (3) Cash equivalents: Com-
net realizable value, 353
panies often report this item together with cash as “Cash and cash equivalents.”
nontrade receivables, 350
3 Define receivables and identify the different types of receivables. notes receivable, 350
Receivables are claims held against customers and others for money, goods, or services. percentage-of-receivables
The receivables are classified into three types: (1) current or noncurrent, (2) trade or approach, 357
nontrade, and (3) accounts receivable or notes receivable. percentage-of-sales
approach, 356
4 Explain accounting issues related to recognition of accounts receivable.
promissory note, 359
Two issues that may complicate the measurement of accounts receivable are (1) the
receivables, 349
availability of discounts (trade and cash discounts), and (2) the length of time
restricted cash, 347
between the sale and the payment due dates (the interest element).
sales discounts, 351
Ideally, companies should measure receivables in terms of their present value—that
securitization, 368
is, the discounted value of the cash to be received in the future. The profession specifically
excludes from the present value considerations receivables arising from normal business trade discounts, 351
transactions that are due in customary trade terms within approximately one year. trade receivables, 349
unrealized holding gain
5 Explain accounting issues related to valuation of accounts receivable.
or loss, 365
Companies value and report short-term receivables at net realizable value—the net
without recourse, 368
amount expected to be received in cash, which is not necessarily the amount legally
with recourse, 368
receivable. Determining net realizable value requires estimating uncollectible receivables.
zero-interest-bearing
6 Explain accounting issues related to recognition and valuation of notes, 359
notes receivable. Companies record short-term notes at face value and long-term
notes receivable at the present value of the cash they expect to collect. When the interest
stated on an interest-bearing note equals the effective (market) rate of interest, the note
sells at face value. When the stated rate differs from the effective rate, a company re-
cords either a discount or premium. Like accounts receivable, companies record and
report short-term notes receivable at their net realizable value. The same is also true of
long-term receivables.
7 Explain the fair value option. Companies have the option to record receiv- |
ables at fair value. Once the fair value option is chosen, the receivable is reported on the
balance sheet at fair value, with the change in fair value recorded in income.
8 Explain accounting issues related to disposition of accounts and notes
receivable. To accelerate the receipt of cash from receivables, the owner may transfer
the receivables to another company for cash in one of two ways. (1) Secured borrowing:
376 Chapter 7 Cash and Receivables
A creditor often requires that the debtor designate or pledge receivables as security for
the loan. (2) Sales (factoring) of receivables: Factors are finance companies or banks that
buy receivables from businesses and then collect the remittances directly from the
customers. In many cases, transferors may have some continuing involvement with the
receivable sold. Companies use a financial components approach to record this type of
transaction.
9 Describe how to report and analyze receivables. Companies should report
receivables with appropriate offset of valuation accounts against receivables, classify
receivables as current or noncurrent, identify pledged or designated receivables, and
disclose the credit risk inherent in the receivables. Analysts assess receivables based on
turnover and the days outstanding.
APPENDIX 7A CASH CONTROLS
Cash is the asset most susceptible to improper diversion and use. Management
LEARNING OBJECTIVE 10
faces two problems in accounting for cash transactions: (1) to establish proper
Explain common techniques employed
controls to prevent any unauthorized transactions by officers or employees, and
to control cash.
(2) to provide information necessary to properly manage cash on hand and cash
transactions. Yet even with sophisticated control devices, errors can and do happen. For
example, the Wall Street Journal ran a story entitled “A $7.8 Million Error Has a Happy
Ending for a Horrified Bank.” The story described how Manufacturers Hanover Trust Co.
mistakenly overpaid about $7.8 million in cash dividends to its stockholders. (As
implied in the headline, most stockholders returned the monies.)
To safeguard cash and to ensure the accuracy of the accounting records for cash,
companies need effective internal control over cash. Provisions of the Sarbanes-Oxley
Act call for enhanced efforts to increase the quality of internal control (for cash and
other assets). Such efforts are expected to result in improved financial reporting. In this
appendix, we discuss some of the basic control issues related to cash.
USING BANK ACCOUNTS
To obtain desired control objectives, a company can vary the number and location of
banks and the types of bank accounts. For large companies operating in multiple loca-
tions, the location of bank accounts can be important. Establishing collection accounts in
strategic locations can accelerate the flow of cash into the company by shortening the
time between a customer’s mailing of a payment and the company’s use of the cash.
Multiple collection centers generally reduce the size of a company’s collection float. This
is the difference between the amount on deposit according to the company’s
International
records and the amount of collected cash according to the bank record.
Perspective
Large, multilocation companies frequently use lockbox accounts to collect
Multinational corporations often in cities with heavy customer billing. The company rents a local post office box
have cash accounts in more and authorizes a local bank to pick up the remittances mailed to that box number.
than one currency. For fi nancial The bank empties the box at least once a day and immediately credits the com-
statement purposes, these
pany’s account for collections. The greatest advantage of a lockbox is that it
corporations typically translate
accelerates the availability of collected cash. Generally, in a lockbox arrangement
these currencies into U.S.
the bank microfilms the checks for record purposes and provides the company
dollars, using the exchange rate
with a deposit slip, a list of collections, and any customer correspondence. Thus, |
in effect at the balance sheet date.
a lockbox system improves the control over cash and accelerates collection of
Appendix 7A: Cash Controls 377
cash. If the income generated from accelerating the receipt of funds exceeds the cost of
the lockbox system, then it is a worthwhile undertaking.
The general checking account is the principal bank account in most companies and
frequently the only bank account in small businesses. A company deposits in and
disburses cash from this account. A company cycles all transactions through it. For
example, a company deposits from and disburses to all other bank accounts through the
general checking account.
Companies use imprest bank accounts to make a specific amount of cash available
for a limited purpose. The account acts as a clearing account for a large volume of checks
or for a specific type of check. To clear a specific and intended amount through the
imprest account, a company transfers that amount from the general checking account or
other source. Companies often use imprest bank accounts for disbursing payroll checks,
dividends, commissions, bonuses, confidential expenses (e.g., officers’ salaries), and
travel expenses.
THE IMPREST PETTY CASH SYSTEM
Almost every company finds it necessary to pay small amounts for miscellaneous
expenses such as taxi fares, minor office supplies, and employees’ lunches. Disbursements
by check for such items is often impractical, yet some control over them is important. A simple
method of obtaining reasonable control, while adhering to the rule of disbursement
by check, is the imprest system for petty cash disbursements. This is how the system works:
1. The company designates a petty cash custodian, and gives the custodian a small
amount of currency from which to make payments. It records transfer of funds to
petty cash as:
Petty Cash 300
Cash 300
2. The petty cash custodian obtains signed receipts from each individual to whom he
or she pays cash, attaching evidence of the disbursement to the petty cash receipt.
Petty cash transactions are not recorded until the fund is reimbursed; someone
other than the petty cash custodian records those entries.
3. When the supply of cash runs low, the custodian presents to the controller or accounts
payable cashier a request for reimbursement supported by the petty cash receipts and
other disbursement evidence. The custodian receives a company check to replenish
the fund. At this point, the company records transactions based on petty cash receipts.
Supplies Expense 42
Postage Expense 53
Miscellaneous Expense 76
Cash Over and Short 2
Cash 173
4. If the company decides that the amount of cash in the petty cash fund is excessive,
it lowers the fund balance as follows.
Cash 50
Petty Cash 50
Subsequent to establishment, a company makes entries to the Petty Cash account
only to increase or decrease the size of the fund.
A company uses a Cash Over and Short account when the petty cash fund fails to
prove out. That is, an error occurs such as incorrect change, overpayment of expense, or
lost receipt. If cash proves out short (i.e., the sum of the receipts and cash in the fund is
less than the imprest amount), the company debits the shortage to the Cash Over and
378 Chapter 7 Cash and Receivables
Short account. If cash proves out over, it credits the overage to Cash Over and Short. The
company closes Cash Over and Short only at the end of the year. It generally shows
Cash Over and Short on the income statement as an “Other expense or revenue.”
There are usually expense items in the fund except immediately after reimburse-
ment. Therefore, to maintain accurate financial statements, a company must reimburse
the funds at the end of each accounting period and also when nearly depleted.
Under the imprest system, the petty cash custodian is responsible at all times for
the amount of the fund on hand either as cash or in the form of signed receipts. These
receipts provide the evidence required by the disbursing officer to issue a reimburse-
ment check. Further, a company follows two additional procedures to obtain more |
complete control over the petty cash fund:
1. A superior of the petty cash custodian makes surprise counts of the fund from time
to time to determine that a satisfactory accounting of the fund has occurred.
2. The company cancels or mutilates petty cash receipts after they have been submitted
for reimbursement, so that they cannot be used to secure a second reimbursement.
PHYSICAL PROTECTION OF CASH BALANCES
Not only must a company safeguard cash receipts and cash disbursements through in-
ternal control measures, but it must also protect the cash on hand and in banks. Because
receipts become cash on hand and disbursements are made from cash in banks, ade-
quate control of receipts and disbursements is part of the protection of cash balances,
along with certain other procedures.
Physical protection of cash is so elementary a necessity that it requires little discus-
sion. A company should make every effort to minimize the cash on hand in the office. It
should only have on hand a petty cash fund, the current day’s receipts, and perhaps
funds for making change. Insofar as possible, it should keep these funds in a vault, safe,
or locked cash drawer. The company should transmit intact each day’s receipts to the
bank as soon as practicable. Accurately stating the amount of available cash both in internal
management reports and in external financial statements is also extremely important.
Every company has a record of cash received, disbursed, and the balance. Because
of the many cash transactions, however, errors or omissions may occur in keeping this
record. Therefore, a company must periodically prove the balance shown in the general
ledger. It can count cash actually present in the office—petty cash, change funds, and
undeposited receipts—for comparison with the company records. For cash on deposit,
a company prepares a bank reconciliation—a reconciliation of the company’s record
and the bank’s record of the company’s cash.
RECONCILIATION OF BANK BALANCES
At the end of each calendar month the bank supplies each customer with a bank state-
ment (a copy of the bank’s account with the customer) together with the customer’s
checks that the bank paid during the month.17 If neither the bank nor the customer made
any errors, if all deposits made and all checks drawn by the customer reached the bank
17As we mentioned in Chapter 7, paper checks continue to be used as a means of payment.
However, ready availability of desktop publishing software and hardware has created new
opportunities for check fraud in the form of duplicate, altered, and forged checks. At the same
time, new fraud-fighting technologies, such as ultraviolet imaging, high-capacity barcodes, and
biometrics, are being developed. These technologies convert paper documents into electronically
processed document files, thereby reducing the risk of fraud.
Appendix 7A: Cash Controls 379
within the same month, and if no unusual transactions occurred that affected either the
company’s or the bank’s record of cash, the balance of cash reported by the bank to the
customer equals that shown in the customer’s own records. This condition seldom
occurs due to one or more of the reconciling items presented below. Hence, a company
expects differences between its record of cash and the bank’s record. Therefore, it must
reconcile the two to determine the nature of the differences between the two amounts.
RECONCILING ITEMS
1. DEPOSITS IN TRANSIT. End-of-month deposits of cash recorded on the depositor’s
books in one month are received and recorded by the bank in the following month.
2. OUTSTANDING CHECKS. Checks written by the depositor are recorded when written
but may not be recorded by (may not “clear”) the bank until the next month.
3. BANK CHARGES. Charges recorded by the bank against the depositor’s balance for
such items as bank services, printing checks, not-suffi cient-funds (NSF) checks, and
safe-deposit box rentals. The depositor may not be aware of these charges until the
receipt of the bank statement.
4. BANK CREDITS. Collections or deposits by the bank for the benefi t of the depositor |
that may be unknown to the depositor until receipt of the bank statement. Examples are
note collection for the depositor and interest earned on interest-bearing checking
accounts.
5. BANK OR DEPOSITOR ERRORS. Errors on either the part of the bank or the part of
the depositor cause the bank balance to disagree with the depositor’s book balance.
A bank reconciliation is a schedule explaining any differences between the bank’s
and the company’s records of cash. If the difference results only from transactions not
yet recorded by the bank, the company’s record of cash is considered correct. But, if
some part of the difference arises from other items, either the bank or the company must
adjust its records.
A company may prepare two forms of a bank reconciliation. One form reconciles
from the bank statement balance to the book balance or vice versa. The other form
reconciles both the bank balance and the book balance to a correct cash balance. Most
companies use this latter form. Illustration 7A-1 shows a sample of that form and its
common reconciling items.
ILLUSTRATION 7A-1
Balance per bank statement (end of period) $$$
Bank Reconciliation
Add: Deposits in transit $$
Form and Content
Undeposited receipts (cash on hand) $$
Bank errors that understate the bank statement balance $$ $$
$$$
Deduct: Outstanding checks $$
Bank errors that overstate the bank statement balance $$ $$
Correct cash balance $$$
Balance per depositor’s books $$$
Add: Bank credits and collections not yet recorded in the books $$
Book errors that understate the book balance $$ $$
$$$
Deduct: Bank charges not yet recorded in the books $$
Book errors that overstate the book balance $$ $$
Correct cash balance $$$
380 Chapter 7 Cash and Receivables
This form of reconciliation consists of two sections: (1) “Balance per bank state-
ment” and (2) “Balance per depositor’s books.” Both sections end with the same “Cor-
rect cash balance.” The correct cash balance is the amount to which the books must be
adjusted and is the amount reported on the balance sheet. Companies prepare adjust-
ing journal entries for all the addition and deduction items appearing in the “Balance
per depositor’s books” section. Companies should immediately call to the bank’s atten-
tion any errors attributable to it.
To illustrate, Nugget Mining Company’s books show a cash balance at the Denver
National Bank on November 30, 2014, of $20,502. The bank statement covering the
month of November shows an ending balance of $22,190. An examination of Nugget’s
accounting records and November bank statement identified the following reconciling
items.
1. A deposit of $3,680 that Nugget mailed November 30 does not appear on the bank
statement.
2. Checks written in November but not charged to the November bank statement are:
Check #7327 $ 150
#7348 4,820
#7349 31
3. Nugget has not yet recorded the $600 of interest collected by the bank November 20
on Sequoia Co. bonds held by the bank for Nugget.
4. Bank service charges of $18 are not yet recorded on Nugget’s books.
5. The bank returned one of Nugget’s customer’s checks for $220 with the bank
statement, marked “NSF.” The bank treated this bad check as a disbursement.
6. Nugget discovered that it incorrectly recorded check #7322, written in November
for $131 in payment of an account payable, as $311.
7. A check for Nugent Oil Co. in the amount of $175 that the bank incorrectly charged
to Nugget accompanied the statement.
Nugget reconciled the bank and book balances to the correct cash balance of $21,044
as shown in Illustration 7A-2.
ILLUSTRATION 7A-2
NUGGET MINING COMPANY
Sample Bank
BANK RECONCILIATION
Reconciliation
DENVER NATIONAL BANK, NOVEMBER 30, 2014
Balance per bank statement (end of period) $22,190
Add: Deposit in transit (1) $3,680
Bank error—incorrect check charged to
account by bank (7) 175 3,855
26,045
Deduct: Outstanding checks (2) 5,001
Correct cash balance $21,044
Balance per books $20,502
Add: Interest collected by the bank (3) $ 600
Error in recording check #7322 (6) 180 780
21,282
Deduct: Bank service charges (4) 18
NSF check returned (5) 220 238 |
Correct cash balance $21,044
Appendix 7B: Impairments of Receivables 381
The journal entries required to adjust and correct Nugget’s books in early December
2014 are taken from the items in the “Balance per books” section and are as follows.
Cash 600
Interest Revenue 600
(To record interest on Sequoia Co. bonds, collected by bank)
Cash 180
Accounts Payable 180
(To correct error in recording amount of check #7322)
Gateway to
Office Expense (bank charges) 18 the Profession
Cash 18
Expanded Discussion of a
(To record bank service charges for November) Four-Column Bank
Reconciliation
Accounts Receivable 220
Cash 220
(To record customer’s check returned NSF)
After posting the entries, Nugget’s cash account will have a balance of $21,044.
Nugget should return the Nugent Oil Co. check to Denver National Bank, informing the
bank of the error.
KEY TERMS
SUMMARY OF LEARNING OBJECTIVE
bank reconciliation, 379
FOR APPENDIX 7A
imprest system for petty
cash, 377
not-sufficient-funds (NSF)
10 Explain common techniques employed to control cash. The common checks, 379
techniques employed to control cash are as follows. (1) Using bank accounts: A company
can vary the number and location of banks and the types of accounts to obtain desired
control objectives. (2) The imprest petty cash system: It may be impractical to require small
amounts of various expenses be paid by check, yet some control over them is important.
(3) Physical protection of cash balances: Adequate control of receipts and disbursements is
a part of the protection of cash balances. Every effort should be made to minimize the
cash on hand in the office. (4) Reconciliation of bank balances: Cash on deposit is not avail-
able for count and is proved by preparing a bank reconciliation.
APPENDIX 7B IMPAIRMENTS OF RECEIVABLES
Companies continually evaluate their receivables to determine their ultimate
11 LEARNING OBJECTIVE
collectibility. As discussed in the chapter, the FASB considers the collectibility of
Describe the accounting for a loan
receivables a loss contingency. Thus, the allowance method is appropriate in situa-
impairment.
tions where it is probable that an asset has been impaired and the amount of the
loss can be reasonably estimated. Generally, companies start with historical loss
rates and modify these rates for changes in economic conditions that could affect a
borrower’s ability to repay the loan. The discussion in the chapter assumed use of this
approach to determine the amount of bad debts to be recorded for a period.
However, for long-term receivables such as loans that are identified as impaired,
companies perform an additional impairment evaluation.18 GAAP has specific rules for
18A loan is defined as “a contractual right to receive money on demand or on fixed and deter-
minable dates that is recognized as an asset in the creditor’s statement of financial position.” For
example, accounts receivable with terms exceeding one year are considered loans. [11]
382 Chapter 7 Cash and Receivables
measurement and reporting of these impairments. These rules relate to determining the
value of these loans and how much loss to recognize if the holder of the loans plans to
keep them in hope that the market will recover. More complex rules arise when these
loans are sold as part of the securitization process, especially when the original terms of
the notes are modified.19
IMPAIRMENT MEASUREMENT AND REPORTING
A company considers a loan receivable impaired when it is probable, based on current
information and events, that it will not collect all amounts due (both principal and inter-
est). If a loan is determined to be individually impaired, the company should measure
the loss due to the impairment. This impairment loss is calculated as the difference
between the investment in the loan (generally the principal plus accrued interest) and
the expected future cash flows discounted at the loan’s historical effective-interest rate.20
When using the historical effective loan rate, the value of the investment will change
only if some of the legally contracted cash flows are reduced. A company recognizes a |
loss in this case because the expected future cash flows are now lower. The company
ignores interest rate changes caused by current economic events that affect the fair value
of the loan. In estimating future cash flows, the creditor should use reasonable and sup-
portable assumptions and projections. [13]
Impairment Loss Example
At December 31, 2013, Ogden Bank recorded an investment of $100,000 in a loan to Carl
King. The loan has an historical effective-interest rate of 10 percent, the principal is due
in full at maturity in three years, and interest is due annually. Unfortunately, King is
experiencing financial difficulty and thinks he will have a difficult time making full
payment. The loan officer performs a review of the loan’s expected future cash flows
and utilizes the present value method for measuring the required impairment loss.
Illustration 7B-1 shows the cash flow schedule prepared by the loan officer.
ILLUSTRATION 7B-1
Contractual Expected Loss of
Impaired Loan Cash
Dec. 31 Cash Flow Cash Flow Cash Flow
Flows
2014 $ 10,000 $ 5,000 $ 5,000
2015 10,000 5,000 5,000
2016 $110,000 105,000 5,000
Total cash flows $130,000 $115,000 $15,000
As indicated, this loan is impaired. The expected cash flows of $115,000 are less than
the contractual cash flows, including principal and interest, of $130,000. The amount of
the impairment to be recorded equals the difference between the recorded investment of
$100,000 and the present value of the expected cash flows, as shown in Illustration 7B-2.
19Note that the impairment test shown in this appendix only applies to specific loans. However,
if the loans are bundled into a security (e.g., the mortgage-backed securities), the impairment
test is different. Impairments of securities are measured based on fair value. We discuss this
accounting in Chapter 17.
20The creditor may also, for the sake of expediency, use the market price of the loan (if such a
price is available) or the fair value of the collateral if it is a collateralized loan. [12] Recognize
that if the value of the investment is based on the historical rate, generally the resultant value
will not be equal to the fair value of the loan in subsequent periods. We consider this accounting
inconsistent with fair value principles as applied to other financial instruments.
Appendix 7B: Impairments of Receivables 383
ILLUSTRATION 7B-2
Recorded investment $100,000
Computation of
Less: Present value of $100,000 due in 3 years at 10%
Impairment Loss
(Table 6-2); FV (PVF3,10%); ($100,000 3 .75132) $75,132
Present value of $5,000 interest payable annually
for 3 years at 10% R (PVF-OA3,10%); ($5,000 3 2.48685) 12,434 87,566
Loss on impairment $ 12,434
The loss due to the impairment is $12,434. Why isn’t it $15,000 ($130,000 2 $115,000)?
Because Ogden Bank must measure the loss at a present-value amount, not at an undis-
counted amount, when it records the loss.
Recording Impairment Losses
Ogden Bank (the creditor) recognizes an impairment loss of $12,434 by debiting Bad
Debt Expense for the expected loss. At the same time, it reduces the overall value of the
receivable by crediting Allowance for Doubtful Accounts. The journal entry to record
the loss is therefore as follows.21
Bad Debt Expense 12,434
Allowance for Doubtful Accounts 12,434
What entry does Carl King (the debtor) make? The debtor makes no entry because he
still legally owes $100,000.
In some cases, debtors like King negotiate a modification in the terms of the loan
agreement. In such cases, the accounting entries from Ogden Bank are the same as the
situation in which the loan officer must estimate the future cash flows—except that the
calculation for the amount of the loss becomes more reliable (because the revised
expected cash flow amounts are contractually specified in the loan agreement).22 The
entries related to the debtor in this case often change; they are discussed in Appendix 14A.
What do the numbers mean? LOST IN TRANSLATION
Floyd Norris, noted fi nancial writer for the New York Times, Translation: The rating agencies that evaluated the risk |
recently wrote in his blog that he attended a conference to level of these securities made many miscalculations.
discuss the fi nancial crisis in subprime lending. He high- Some structured fi nance products that were given supe-
lighted, and provided “translations” of, some of the state- rior ratings are no longer worth much.
ments he heard at that conference: • “The plumbing of the U.S. economy has been deeply
• “There is a problem of misaligned incentives.” damaged. It is a long window of vulnerability.”
Translation: Many parties in the lending process were Translation: The U.S. has caused a fi nancial crisis as a
complicit in not performing due diligence on loans result of poor lending practices, and many fi nancial
because there were lots of fees to be had if the loans were institutions are fi ghting to survive.
made, good loans or bad. • “I’m glad that this time we did not cause it.”
• “It is pretty clear that there was a failure in some key Translation: Other countries realized they had caused
assumptions that were supporting our analytics and our fi nancial crises in the past but were not to blame for the
models.” current U.S. fi nancial situation.
21In the event of a loan write-off, the company charges the loss against the allowance. In
subsequent periods, if revising estimated expected cash flows based on new information, the
company adjusts the allowance account and bad debt expense account (either increased or
decreased depending on whether conditions improved or worsened) in the same fashion as the
original impairment. We use the terms “loss” and “bad debt expense” interchangeably through-
out this discussion. Companies should charge losses related to receivables transactions to Bad
Debt Expense or the related Allowance for Doubtful Accounts because they use these accounts
to recognize changes in values affecting receivables.
22Many alternatives are permitted to recognize income by Ogden Bank in subsequent periods. [14]
384 Chapter 7 Cash and Receivables
• “What you see is what you get. If you don’t see it, it will balance sheets. Their continuing interest in some of the
get you.” loans that they supposedly sold is now coming back to
Translation: A large number of fi nancial institutions have them and they will have to report losses.
to take losses on assets that are not reported on their
Source: Floyd Norris blog, http://www.norris.blogs.nytimes.com/ (accessed June 2008).
KEY TERM
SUMMARY OF LEARNING OBJECTIVE
impairment, 382
FOR APPENDIX 7B
11 Describe the accounting for a loan impairment. A creditor bases an
impairment loan loss on the difference between the present value of the future cash
flows (using the historical effective-interest rate) and the carrying amount of the note.
DEMONSTRATION PROBLEM
The trial balance before adjustment for Slamar Company shows the following balances.
Debit Credit
Net sales $860,000
Accounts receivable 338,000
Allowance for doubtful accounts $4,240
Consider the following independent situations:
1. To obtain additional cash, Slamar factors without recourse $50,000 of accounts receivable with
Pierce Finance. The finance charge is 11% of the amount factored.
2. To obtain a 1-year loan of $75,000, Slamar assigns $80,000 of specific receivable accounts to Milo
Financial. The finance charge is 9% of the loan; the cash is received and the accounts turned over to
Milo Financial.
3. The company wants to maintain Allowance for Doubtful Accounts at 6% of gross accounts
receivable.
4. The company wishes to increase the allowance account by 2% of net sales.
Instructions
(a) Using the data above, give the journal entries required to record situations 1–4.
(b) Discuss how analysis based on the current ratio and the accounts receivable turnover would be
affected if Slamar had transferred the receivables in situation 1 using a secured borrowing.
Solution
(a)
1. Cash 44,500
Loss on Sale of Receivables ($50,000 3 11%) 5,500
Accounts Receivable 50,000
2. Cash 68,250
Interest Expense ($75,000 3 9%) 6,750
Notes Payable 75,000
FASB Codifi cation 385
3. Bad Debt Expense 24,520 |
Allowance for Doubtful Accounts [($338,000 3 6%) 1 $4,240] 24,520
4. Bad Debt Expense 17,200
Allowance for Doubtful Accounts ($860,000 3 2%) 17,200
(b) With a secured borrowing, the receivables would stay on Slamar’s books, and Slamar would record a
note payable. This would reduce the current ratio and accounts receivable turnover.
FASB CODIFICATION
FASB Codification References
[1] FASB ASC 210-10-S99-1. [Predecessor literature: “Amendments to Regulations S-X and Related Interpretations and Guide-
lines Regarding the Disclosure of Compensating Balances and Short-Term Borrowing Arrangements,” Accounting Series
Release No. 148, Securities and Exchange Commission (November 13, 1973).]
[2] FASB ASC 835-30-15-3. [Predecessor literature: “Interest on Receivables and Payables,” Opinions of the Accounting Principles
Board No. 21 (New York: AICPA, 1971), par. 3(a).]
[3] FASB ASC 310-10-35-8. [Predecessor literature: “Accounting for Contingencies,” Statement of Financial Accounting Standards
No. 5 (Stamford, Conn.: FASB, 1975), par. 8.]
[4] FASB ASC 835-30-05. [Predecessor literature: “Interest on Receivables and Payables,” Opinions of the Accounting Principles
Board No. 21 (New York: AICPA, 1971), par. 3(a).]
[5] FASB ASC 825-10-25. [Predecessor literature: “The Fair Value Option for Financial Assets and Liabilities—Including an
Amendment to FASB No. 115,” Statement of Financial Accounting Standards No. 159 (Norwalk, Conn.: FASB, 2007).]
[6] FASB ASC 860-40 and FASB ASC 860-10-5-15. [Predecessor literature: “Accounting for Transfers and Servicing of Financial
Assets and Extinguishments of Liabilities,” Statement of Financial Accounting Standards No. 140 (Stamford, Conn.: FASB,
2000), p. 155.]
[7] FASB ASC 860-10-40. [Predecessor literature: None.]
[8] FASB ASC 860. [Predecessor literature: “Transfers and Servicing,” Accounting Standards Update 2011–03 (April 2011).]
[9] FASB ASC 310-10-50. [Predecessor literature: None.]
[10] FASB ASC 825-10-50-20 through 22. [Predecessor literature: “Disclosures about Fair Value of Financial Instruments,”
Statement of Financial Accounting Standards No. 107 (Norwalk, Conn.: FASB, 1991), par. 15.]
[11] FASB ASC 310-10-35-22. [Predecessor literature: “Accounting by Creditors for Impairment of a Loan,” FASB Statement
No. 114 (Norwalk, Conn.: FASB, May 1993).]
[12] FASB ASC 310-10-35-22. [Predecessor literature: “Accounting by Creditors for Impairment of a Loan,” FASB Statement
No. 114 (Norwalk, Conn.: FASB, May 1993), par. 13.]
[13] FASB ASC 310-10-35-26. [Predecessor literature: “Accounting by Creditors for Impairment of a Loan,” FASB Statement
No. 114 (Norwalk, Conn.: FASB, May 1993), par. 15.]
[14] FASB ASC 310-10-35-40. [Predecessor literature: “Accounting by Creditors for Impairment of a Loan—Income Recognition
and Disclosures,” FASB Statement No. 118 (Norwalk, Conn.: FASB, October 1994).]
Exercises
If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in and prepare responses to
the following. Provide Codification references for your responses.
CE7-1 Access the glossary (“Master Glossary”) to answer the following.
(a) What is the definition of cash?
(b) What is the definition of securitization?
(c) What are the three contexts that give rise to recourse?
CE7-2 Carrie Underwood believes that by establishing a loss contingency for uncollectible receivables, a company provides
financial protection against the loss. What does the authoritative literature say about this belief?
386 Chapter 7 Cash and Receivables
CE7-3 In addition to securitizations, what are the other types of transfers of financial assets identified in the Codification?
CE7-4 The controller for Nesheim Construction Company believes that it is appropriate to offset a note payable to Oregon Bank
against an account receivable from Oregon Bank related to remodeling services provided to the bank. What is the
authoritative guidance concerning the criteria to be met to allow such offsetting?
An additional Codification case can be found in the Using Your Judgment section, on page 407. |
Be sure to check the book’s companion website for a Review and Analysis Exercise,
with solution.
Brief Exercises, Exercises, Problems, and many more learning and assessment tools
and resources are available for practice in WileyPLUS.
Note: All asterisked Questions, Exercises, and Problems relate to material in the appendices to the chapter.
QUESTIONS
1. What may be included under the heading of “cash”? 6. What are two methods of recording accounts receivable
2. In what accounts should the following items be classified? transactions when a cash discount situation is involved?
Which is more theoretically correct? Which is used in
(a) Coins and currency.
practice more of the time? Why?
(b) U.S. Treasury (government) bonds.
7. What are the basic problems that occur in the valuation of
(c) Certificate of deposit. accounts receivable?
(d) Cash in a bank that is in receivership. 8. What is the theoretical justification of the allowance
(e) NSF check (returned with bank statement). method as contrasted with the direct write-off method of
(f) Deposit in foreign bank (exchangeability limited). accounting for bad debts?
(g) Postdated checks. 9. Indicate how well the percentage-of-sales method and the
aging method accomplish the objectives of the allowance
(h) Cash to be used for retirement of long-term bonds.
method of accounting for bad debts.
(i) Deposits in transit.
10. Of what merit is the contention that the allowance method
(j) 100 shares of Dell stock (intention is to sell in one
lacks the objectivity of the direct write-off method? Dis-
year or less).
cuss in terms of accounting’s measurement function.
(k) Savings and checking accounts.
11. Explain how the accounting for bad debts can be used for
(l) Petty cash. earnings management.
(m) Stamps. 12. Because of calamitous earthquake losses, Bernstein Com-
(n) Travel advances. pany, one of your client’s oldest and largest customers,
3. Define a “compensating balance.” How should a compen- suddenly and unexpectedly became bankrupt. Approxi-
mately 30% of your client’s total sales have been made to
sating balance be reported?
Bernstein Company during each of the past several years.
4. Springsteen Inc. reported in a recent annual report “Re-
The amount due from Bernstein Company—none of
stricted cash for debt redemption.” What section of the
which is collectible—equals 22% of total accounts receiv-
balance sheet would report this item?
able, an amount that is considerably in excess of what was
5. What are the reasons that a company gives trade dis- determined to be an adequate provision for doubtful
counts? Why are trade discounts not recorded in the ac- accounts at the close of the preceding year. How would
counts like cash discounts? your client record the write-off of the Bernstein Company
Brief Exercises 387
receivable if it is using the allowance method of account- 20. Horizon Outfitters Company includes in its trial balance
ing for bad debts? Justify your suggested treatment. for December 31 an item for Accounts Receivable $789,000.
13. What is the normal procedure for handling the collection This balance consists of the following items:
of accounts receivable previously written off using the Due from regular customers $523,000
direct write-off method? The allowance method? Refund receivable on prior year’s income
taxes (an established claim) 15,500
14. On January 1, 2014, Lombard Co. sells property for which Travel advance to employees 22,000
it had paid $690,000 to Sargent Company, receiving in Loan to wholly owned subsidiary 45,500
return Sargent’s zero-interest-bearing note for $1,000,000 Advances to creditors for goods ordered 61,000
Accounts receivable assigned as security
payable in 5 years. What entry would Lombard make to
for loans payable 75,000
record the sale, assuming that Lombard frequently sells
Notes receivable past due plus interest on
similar items of property for a cash sales price of $640,000? these notes 47,000
15. What is “imputed interest”? In what situations is it neces- Total $789,000
sary to impute an interest rate for notes receivable? What |
Illustrate how these items should be shown in the balance
are the considerations in imputing an appropriate interest
sheet as of December 31.
rate?
16. What is the fair value option? Where do companies that 21. What is the accounts receivable turnover, and what type
of information does it provide?
elect the fair value option report unrealized holding gains
and losses? 22. You are evaluating Woodlawn Racetrack for a potential
17. Indicate three reasons why a company might sell its loan. An examination of the notes to the financial state-
ments indicates restricted cash at year-end amounts to
receivables to another company.
$100,000. Explain how you would use this information in
18. When is the financial components approach to recording
evaluating Woodlawn’s liquidity.
the transfers of receivables used? When should a transfer
*2 3. Distinguish among the following: (1) a general checking
of receivables be recorded as a sale?
account, (2) an imprest bank account, and (3) a lockbox
19. Moon Hardware is planning to factor some of its receiv-
account.
ables. The cash received will be used to pay for inventory
* 24. What are the general rules for measuring and recognizing
purchases. The factor has indicated that it will require
gain or loss by both the debtor and the creditor in an
“recourse” on the sold receivables. Explain to the controller
impairment?
of Moon Hardware what “recourse” is and how the re-
course will be reflected in Moon’s financial statements *2 5. What is meant by impairment of a loan? Under what cir-
after the sale of the receivables. cumstances should a creditor recognize an impaired loan?
BRIEF EXERCISES
1 BE7-1 Kraft Enterprises owns the following assets at December 31, 2014.
Cash in bank—savings account 68,000 Checking account balance 17,000
Cash on hand 9,300 Postdated checks 750
Cash refund due from IRS 31,400 Certifi cates of deposit (180-day) 90,000
What amount should be reported as cash?
4 BE7-2 Restin Co. uses the gross method to record sales made on credit. On June 1, 2014, it made sales of
$50,000 with terms 3/15, n/45. On June 12, 2014, Restin received full payment for the June 1 sale. Prepare
the required journal entries for Restin Co.
4 BE7-3 Use the information from BE7-2, assuming Restin Co. uses the net method to account for cash dis-
counts. Prepare the required journal entries for Restin Co.
5 BE7-4 Wilton, Inc. had net sales in 2014 of $1,400,000. At December 31, 2014, before adjusting entries, the
balances in selected accounts were: Accounts Receivable $250,000 debit, and Allowance for Doubtful Ac-
counts $2,400 credit. If Wilton estimates that 2% of its net sales will prove to be uncollectible, prepare the
December 31, 2014, journal entry to record bad debt expense.
5 BE7-5 Use the information presented in BE7-4 for Wilton, Inc.
(a) Instead of estimating the uncollectibles at 2% of net sales, assume that 10% of accounts receivable
will prove to be uncollectible. Prepare the entry to record bad debt expense.
388 Chapter 7 Cash and Receivables
(b) Instead of estimating uncollectibles at 2% of net sales, assume Wilton prepares an aging schedule
that estimates total uncollectible accounts at $24,600. Prepare the entry to record bad debt expense.
6 BE7-6 Milner Family Importers sold goods to Tung Decorators for $30,000 on November 1, 2014, accepting
Tung’s $30,000, 6-month, 6% note. Prepare Milner’s November 1 entry, December 31 annual adjusting en-
try, and May 1 entry for the collection of the note and interest.
6 BE7-7 Dold Acrobats lent $16,529 to Donaldson, Inc., accepting Donaldson’s 2-year, $20,000, zero-interest-
bearing note. The implied interest rate is 10%. Prepare Dold’s journal entries for the initial transaction,
recognition of interest each year, and the collection of $20,000 at maturity.
8 BE7-8 On October 1, 2014, Chung, Inc. assigns $1,000,000 of its accounts receivable to Seneca National
Bank as collateral for a $750,000 note. The bank assesses a finance charge of 2% of the receivables assigned
and interest on the note of 9%. Prepare the October 1 journal entries for both Chung and Seneca. |
8 BE7-9 Wood Incorporated factored $150,000 of accounts receivable with Engram Factors Inc. on a without-
recourse basis. Engram assesses a 2% finance charge of the amount of accounts receivable and retains an
amount equal to 6% of accounts receivable for possible adjustments. Prepare the journal entry for Wood
Incorporated and Engram Factors to record the factoring of the accounts receivable to Engram.
8 BE7-10 Use the information in BE7-9 for Wood. Assume that the receivables are sold with recourse. Prepare
the journal entry for Wood to record the sale, assuming that the recourse liability has a fair value of $7,500.
8 BE7-11 Arness Woodcrafters sells $250,000 of receivables to Commercial Factors, Inc. on a with recourse
basis. Commercial assesses a finance charge of 5% and retains an amount equal to 4% of accounts receiv-
able. Arness estimates the fair value of the recourse liability to be $8,000. Prepare the journal entry for
Arness to record the sale.
8 BE7-12 Use the information presented in BE7-11 for Arness Woodcrafters but assume that the recourse
liability has a fair value of $4,000, instead of $8,000. Prepare the journal entry and discuss the effects of this
change in the value of the recourse liability on Arness’s financial statements.
9 BE7-13 Recent financial statements of General Mills, Inc. report net sales of $12,442,000,000. Accounts
receivable are $912,000,000 at the beginning of the year and $953,000,000 at the end of the year. Compute
General Mills’ accounts receivable turnover. Compute General Mills’ average collection period for accounts
receivable in days.
10 *B E7-14 Finman Company designated Jill Holland as petty cash custodian and established a petty cash
fund of $200. The fund is reimbursed when the cash in the fund is at $15. Petty cash receipts indicate funds
were disbursed for office supplies $94 and miscellaneous expense $87. Prepare journal entries for the estab-
lishment of the fund and the reimbursement.
10 *B E7-15 Horton Corporation is preparing a bank reconciliation and has identified the following potential
reconciling items. For each item, indicate if it is (1) added to balance per bank statement, (2) deducted from
balance per bank statement, (3) added to balance per books, or (4) deducted from balance per books.
(a) Deposit in transit $5,500. (d) Outstanding checks $7,422.
(b) Bank service charges $25. (e) NSF check returned $377.
(c) Interest credited to Horton’s account $31.
10 *B E7-16 Use the information presented in BE7-15 for Horton Corporation. Prepare any entries necessary to
make Horton’s accounting records correct and complete.
11 *B E7-17 Assume that Toni Braxton Company has recently fallen into financial difficulties. By reviewing all
available evidence on December 31, 2014, one of Toni Braxton’s creditors, the National American Bank,
determined that Toni Braxton would pay back only 65% of the principal at maturity. As a result, the bank
decided that the loan was impaired. If the loss is estimated to be $225,000, what entry(ies) should National
American Bank make to record this loss?
EXERCISES
1 E7-1 (Determining Cash Balance) The controller for Clint Eastwood Co. is attempting to determine the
amount of cash to be reported on its December 31, 2014, balance sheet. The following information is provided.
1. Commercial savings account of $600,000 and a commercial checking account balance of $900,000 are
held at First National Bank of Yojimbo.
Exercises 389
2. Money market fund account held at Volonte Co. (a mutual fund organization) permits Eastwood to
write checks on this balance, $5,000,000.
3. Travel advances of $180,000 for executive travel for the first quarter of next year (employee to reim-
burse through salary reduction).
4. A separate cash fund in the amount of $1,500,000 is restricted for the retirement of long-term debt.
5. Petty cash fund of $1,000.
6. An I.O.U. from Marianne Koch, a company customer, in the amount of $190,000.
7. A bank overdraft of $110,000 has occurred at one of the banks the company uses to deposit its cash |
receipts. At the present time, the company has no deposits at this bank.
8. The company has two certificates of deposit, each totaling $500,000. These CDs have a maturity of
120 days.
9. Eastwood has received a check that is dated January 12, 2015, in the amount of $125,000.
10. Eastwood has agreed to maintain a cash balance of $500,000 at all times at First National Bank of
Yojimbo to ensure future credit availability.
11. Eastwood has purchased $2,100,000 of commercial paper of Sergio Leone Co. which is due in 60 days.
12. Currency and coin on hand amounted to $7,700.
Instructions
(a) Compute the amount of cash to be reported on Eastwood Co.’s balance sheet at December 31, 2014.
(b) Indicate the proper reporting for items that are not reported as cash on the December 31, 2014,
balance sheet.
1 E7-2 (Determining Cash Balance) Presented below are a number of independent situations.
Instructions
For each individual situation, determine the amount that should be reported as cash. If the item(s) is not
reported as cash, explain the rationale.
1. Checking account balance $925,000; certificate of deposit $1,400,000; cash advance to subsidiary of
$980,000; utility deposit paid to gas company $180.
2. Checking account balance $600,000; an overdraft in special checking account at same bank as
normal checking account of $17,000; cash held in a bond sinking fund $200,000; petty cash fund
$300; coins and currency on hand $1,350.
3. Checking account balance $590,000; postdated check from customer $11,000; cash restricted due to
maintaining compensating balance requirement of $100,000; certified check from customer $9,800;
postage stamps on hand $620.
4. Checking account balance at bank $37,000; money market balance at mutual fund (has checking
privileges) $48,000; NSF check received from customer $800.
5. Checking account balance $700,000; cash restricted for future plant expansion $500,000; short-term
Treasury bills $180,000; cash advance received from customer $900 (not included in checking ac-
count balance); cash advance of $7,000 to company executive, payable on demand; refundable de-
posit of $26,000 paid to federal government to guarantee performance on construction contract.
3 4 E7-3 (Financial Statement Presentation of Receivables) Jim Carrie Company shows a balance of $181,140
in the Accounts Receivable account on December 31, 2013. The balance consists of the following.
Installment accounts due in 2014 $23,000
Installment accounts due after 2014 34,000
Overpayments to vendors 2,640
Due from regular customers, of which $40,000 represents
accounts pledged as security for a bank loan 79,000
Advances to employees 1,500
Advance to subsidiary company (due in 2015) 81,000
Instructions
Illustrate how the information above should be shown on the balance sheet of Jim Carrie Company on
December 31, 2013.
3 4 E7-4 (Determining Ending Accounts Receivable) Your accounts receivable clerk, Mitra Adams, to whom
you pay a salary of $1,500 per month, has just purchased a new Acura. You decided to test the accuracy of
the accounts receivable balance of $82,000 as shown in the ledger.
The following information is available for your first year in business.
(1) Collections from customers $198,000
(2) Merchandise purchased 320,000
(3) Ending merchandise inventory 90,000
(4) Goods are marked to sell at 40% above cost
390 Chapter 7 Cash and Receivables
Instructions
Compute an estimate of the ending balance of accounts receivable from customers that should appear in
the ledger and any apparent shortages. Assume that all sales are made on account.
4 E7-5 (Recording Sales Gross and Net) On June 3, Arnold Company sold to Chester Company merchan-
dise having a sale price of $3,000 with terms of 2/10, n/60, f.o.b. shipping point. An invoice totaling $90,
terms n/30, was received by Chester on June 8 from John Booth Transport Service for the freight cost. On
June 12, the company received a check for the balance due from Chester Company.
Instructions
(a) Prepare journal entries on the Arnold Company books to record all the events noted above under |
each of the following bases.
(1) Sales and receivables are entered at gross selling price.
(2) Sales and receivables are entered at net of cash discounts.
(b) Prepare the journal entry under basis 2, assuming that Chester Company did not remit payment
until July 29.
4 E7-6 (Recording Sales Transactions) Presented below is information from Perez Computers Incorporated.
July 1 Sold $20,000 of computers to Robertson Company with terms 3/15, n/60. Perez uses the gross
method to record cash discounts.
10 Perez received payment from Robertson for the full amount owed from the July transactions.
17 Sold $200,000 in computers and peripherals to The Clark Store with terms of 2/10, n/30.
30 The Clark Store paid Perez for its purchase of July 17.
Instructions
Prepare the necessary journal entries for Perez Computers.
5 E7-7 (Recording Bad Debts) Duncan Company reports the following financial information before
adjustments.
Dr. Cr.
Accounts Receivable $100,000
Allowance for Doubtful Accounts $ 2,000
Sales Revenue (all on credit) 900,000
Sales Returns and Allowances 50,000
Instructions
Prepare the journal entry to record Bad Debt Expense assuming Duncan Company estimates bad debts at
(a) 1% of net sales and (b) 5% of accounts receivable.
5 E7-8 (Recording Bad Debts) At the end of 2014, Aramis Company has accounts receivable of $800,000
and an allowance for doubtful accounts of $40,000. On January 16, 2015, Aramis Company determined that its
receivable from Ramirez Company of $6,000 will not be collected, and management authorized its write-off.
Instructions
(a) Prepare the journal entry for Aramis Company to write off the Ramirez receivable.
(b) What is the net realizable value of Aramis Company’s accounts receivable before the write-off of the
Ramirez receivable?
(c) What is the net realizable value of Aramis Company’s accounts receivable after the write-off of the
Ramirez receivable?
5 E7-9 (Computing Bad Debts and Preparing Journal Entries) The trial balance before adjustment of Reba
McIntyre Inc. shows the following balances.
Dr. Cr.
Accounts Receivable $90,000
Allowance for Doubtful Accounts 1,750
Sales Revenue (all on credit) $680,000
Instructions
Give the entry for estimated bad debts assuming that the allowance is to provide for doubtful accounts on
the basis of (a) 4% of gross accounts receivable and (b) 1% of net sales.
5 E7-10 (Bad-Debt Reporting) The chief accountant for Dickinson Corporation provides you with the
following list of accounts receivable written off in the current year.
Exercises 391
Date Customer Amount
March 31 E. L. Masters Company $7,800
June 30 Stephen Crane Associates 6,700
September 30 Amy Lowell’s Dress Shop 7,000
December 31 R. Frost, Inc. 9,830
Dickinson Corporation follows the policy of debiting Bad Debt Expense as accounts are written off.
The chief accountant maintains that this procedure is appropriate for financial statement purposes because
the Internal Revenue Service will not accept other methods for recognizing bad debts.
All of Dickinson Corporation’s sales are on a 30-day credit basis. Sales for the current year total
$2,200,000, and research has determined that bad debt losses approximate 2% of sales.
Instructions
(a) Do you agree or disagree with Dickinson’s policy concerning recognition of bad debt expense? Why
or why not?
(b) By what amount would net income differ if bad debt expense was computed using the percentage-
of-sales approach?
5 E7-11 (Bad Debts—Aging) Danica Patrick, Inc. includes the following account among its trade receivables.
Hopkins Co.
1/1 Balance forward 700 1/28 Cash (#1710) 1,100
1/20 Invoice #1710 1,100 4/2 Cash (#2116) 1,350
3/14 Invoice #2116 1,350 4/10 Cash (1/1 Balance) 155
4/12 Invoice #2412 1,710 4/30 Cash (#2412) 1,000
9/5 Invoice #3614 490 9/20 Cash (#3614 and
10/17 Invoice #4912 860 part of #2412) 790
11/18 Invoice #5681 2,000 10/31 Cash (#4912) 860
12/20 Invoice #6347 800 12/1 Cash (#5681) 1,250
12/29 Cash (#6347) 800
Instructions
Age the balance and specify any items that apparently require particular attention at year-end.
4 5 E7-12 (Journalizing Various Receivable Transactions) Presented below is information related to James |
8 Garfield Corp.
July 1 James Garfi eld Corp. sold to Warren Harding Co. merchandise having a sales price of $8,000 with terms
2/10, net/60. Garfi eld records its sales and receivables net.
5 Accounts receivable of $9,000 (gross) are factored with Andrew Jackson Credit Corp. without recourse
at a fi nancing charge of 9%. Cash is received for the proceeds; collections are handled by the fi nance
company. (These accounts were all past the discount period.)
9 Specifi c accounts receivable of $9,000 (gross) are pledged to Alf Landon Credit Corp. as security for a
loan of $6,000 at a fi nance charge of 6% of the amount of the loan. The fi nance company will make the
collections. (All the accounts receivable are past the discount period.)
Dec. 29 Warren Harding Co. notifi es Garfi eld that it is bankrupt and will pay only 10% of its account. Give the
entry to write off the uncollectible balance using the allowance method. (Note: First record the increase
in the receivable on July 11 when the discount period passed.)
Instructions
Prepare all necessary entries in general journal form for Garfield Corp.
8 E7-13 (Assigning Accounts Receivable) On April 1, 2014, Rasheed Company assigns $400,000 of its ac-
counts receivable to the Third National Bank as collateral for a $200,000 loan due July 1, 2014. The assign-
ment agreement calls for Rasheed Company to continue to collect the receivables. Third National Bank
assesses a finance charge of 2% of the accounts receivable, and interest on the loan is 10% (a realistic rate of
interest for a note of this type).
Instructions
(a) Prepare the April 1, 2014, journal entry for Rasheed Company.
(b) Prepare the journal entry for Rasheed’s collection of $350,000 of the accounts receivable during the
period from April 1, 2014, through June 30, 2014.
(c) On July 1, 2014, Rasheed paid Third National all that was due from the loan it secured on April 1,
2014. Prepare the journal entry to record this payment.
392 Chapter 7 Cash and Receivables
5 8 E7-14 (Journalizing Various Receivable Transactions) The trial balance before adjustment for Phil
Collins Company shows the following balances.
Dr. Cr.
Accounts Receivable $82,000
Allowance for Doubtful Accounts 2,120
Sales Revenue $430,000
Instructions
Using the data above, give the journal entries required to record each of the following cases. (Each situation
is independent.)
1. To obtain additional cash, Collins factors without recourse $25,000 of accounts receivable with Stills
Finance. The finance charge is 10% of the amount factored.
2. To obtain a 1-year loan of $55,000, Collins assigns $65,000 of specific receivable accounts to Crosby
Financial. The finance charge is 8% of the loan; the cash is received and the accounts turned over to
Crosby Financial.
3. The company wants to maintain the Allowance for Doubtful Accounts at 5% of gross accounts
receivable.
4. The company wishes to increase the allowance account by 1½% of net sales.
8 E7-15 (Transfer of Receivables with Recourse) Ames Quartet Inc. factors receivables with a carrying
amount of $200,000 to Joffrey Company for $160,000 on a with recourse basis.
Instructions
The recourse provision has a fair value of $1,000. This transaction should be recorded as a sale. Prepare the
appropriate journal entry to record this transaction on the books of Ames Quartet Inc.
8 E7-16 (Transfer of Receivables with Recourse) Beyoncé Corporation factors $175,000 of accounts receiv-
able with Kathleen Battle Financing, Inc. on a with recourse basis. Kathleen Battle Financing will collect
the receivables. The receivables records are transferred to Kathleen Battle Financing on August 15, 2014.
Kathleen Battle Financing assesses a finance charge of 2% of the amount of accounts receivable and also
reserves an amount equal to 4% of accounts receivable to cover probable adjustments.
Instructions
(a) What conditions must be met for a transfer of receivables with recourse to be accounted for as a
sale?
(b) Assume the conditions from part (a) are met. Prepare the journal entry on August 15, 2014, for |
Beyoncé to record the sale of receivables, assuming the recourse obligation has a fair value of $2,000.
8 E7-17 (Transfer of Receivables without Recourse) JFK Corp. factors $300,000 of accounts receivable with
LBJ Finance Corporation on a without recourse basis on July 1, 2014. The receivables records are trans-
ferred to LBJ Finance, which will receive the collections. LBJ Finance assesses a finance charge of 1½% of
the amount of accounts receivable and retains an amount equal to 4% of accounts receivable to cover sales
discounts, returns, and allowances. The transaction is to be recorded as a sale.
Instructions
(a) Prepare the journal entry on July 1, 2014, for JFK Corp. to record the sale of receivables without
recourse.
(b) Prepare the journal entry on July 1, 2014, for LBJ Finance Corporation to record the purchase of
receivables without recourse.
6 E7-18 (Note Transactions at Unrealistic Interest Rates) On July 1, 2014, Agincourt Inc. made two sales.
1. It sold land having a fair value of $700,000 in exchange for a 4-year zero-interest-bearing promissory
note in the face amount of $1,101,460. The land is carried on Agincourt’s books at a cost of $590,000.
2. It rendered services in exchange for a 3%, 8-year promissory note having a face value of $400,000
(interest payable annually).
Agincourt Inc. recently had to pay 8% interest for money that it borrowed from British National Bank. The
customers in these two transactions have credit ratings that require them to borrow money at 12% interest.
Instructions
Record the two journal entries that should be recorded by Agincourt Inc. for the sales transactions above
that took place on July 1, 2014.
6 7 E7-19 (Notes Receivable with Unrealistic Interest Rate) On December 31, 2012, Ed Abbey Co. performed
environmental consulting services for Hayduke Co. Hayduke was short of cash, and Abbey Co. agreed to
Exercises 393
accept a $200,000 zero-interest-bearing note due December 31, 2014, as payment in full. Hayduke is some-
what of a credit risk and typically borrows funds at a rate of 10%. Abbey is much more creditworthy and
has various lines of credit at 6%.
Instructions
(a) Prepare the journal entry to record the transaction of December 31, 2012, for the Ed Abbey Co.
(b) Assuming Ed Abbey Co.’s fiscal year-end is December 31, prepare the journal entry for December
31, 2013.
(c) Assuming Ed Abbey Co.’s fiscal year-end is December 31, prepare the journal entry for December
31, 2014.
9 E7-20 (Analysis of Receivables) Presented below is information for Jones Company.
1. Beginning-of-the-year Accounts Receivable balance was $15,000.
2. Net sales (all on account) for the year were $100,000. Jones does not offer cash discounts.
3. Collections on accounts receivable during the year were $70,000.
Instructions
(a) Prepare (summary) journal entries to record the items noted above.
(b) Compute Jones’s accounts receivable turnover for the year. The company does not believe it will
have any bad debts.
(c) Use the turnover ratio computed in (b) to analyze Jones’s liquidity. The turnover ratio last year was 6.0.
8 E7-21 (Transfer of Receivables) Use the information for Jones Company as presented in E7-20. Jones is
planning to factor some accounts receivable at the end of the year. Accounts totaling $25,000 will be trans-
ferred to Credit Factors, Inc. with recourse. Credit Factors will retain 5% of the balances for probable adjust-
ments and assesses a finance charge of 4%. The fair value of the recourse obligation is $1,200.
Instructions
(a) Prepare the journal entry to record the sale of the receivables.
(b) Compute Jones’s accounts receivable turnover for the year, assuming the receivables are sold, and
discuss how factoring of receivables affects the turnover ratio.
10 *E 7-22 (Petty Cash) Carolyn Keene, Inc. decided to establish a petty cash fund to help ensure internal con-
trol over its small cash expenditures. The following information is available for the month of April.
1. On April 1, it established a petty cash fund in the amount of $200.
2. A summary of the petty cash expenditures made by the petty cash custodian as of April 10 is as
follows. |
Delivery charges paid on merchandise purchased $60.00
Supplies purchased and used 25.00
Postage expense 33.00
I.O.U. from employees 17.00
Miscellaneous expense 36.00
The petty cash fund was replenished on April 10. The balance in the fund was $27.
3. The petty cash fund balance was increased $100 to $300 on April 20.
Instructions
Prepare the journal entries to record transactions related to petty cash for the month of April.
10 *E 7-23 (Petty Cash) The petty cash fund of Fonzarelli’s Auto Repair Service, a sole proprietorship, contains
the following.
1. Coins and currency $ 15.20
2. Postage stamps 2.90
3. An I.O.U. from Richie Cunningham, an
employee, for cash advance 40.00
4. Check payable to Fonzarelli’s Auto Repair from
Pottsie Weber, an employee, marked NSF 34.00
5. Vouchers for the following:
Stamps $ 20.00
Two Rose Bowl tickets for Nick Fonzarelli 170.00
Printer cartridge 14.35 204.35
$296.45
The general ledger account Petty Cash has a balance of $300.
394 Chapter 7 Cash and Receivables
Instructions
Prepare the journal entry to record the reimbursement of the petty cash fund.
10 *E 7-24 (Bank Reconciliation and Adjusting Entries) Angela Lansbury Company deposits all receipts and
makes all payments by check. The following information is available from the cash records.
June 30 Bank Reconciliation
Balance per bank $ 7,000
Add: Deposits in transit 1,540
Deduct: Outstanding checks (2,000)
Balance per books $ 6,540
Month of July Results
Per Bank Per Books
Balance July 31 $8,650 $9,250
July deposits 5,000 5,810
July checks 4,000 3,100
July note collected (not included in July deposits) 1,000 —
July bank service charge 15 —
July NSF check from a customer, returned by the bank 335 —
(recorded by bank as a charge)
Instructions
(a) Prepare a bank reconciliation going from balance per bank and balance per book to correct cash
balance.
(b) Prepare the general journal entry or entries to correct the Cash account.
10 *E 7-25 (Bank Reconciliation and Adjusting Entries) Logan Bruno Company has just received the August
31, 2014, bank statement, which is summarized below.
County National Bank Disbursements Receipts Balance
Balance, August 1 $ 9,369
Deposits during August $32,200 41,569
Note collected for depositor, including $40 interest 1,040 42,609
Checks cleared during August $34,500 8,109
Bank service charges 20 8,089
Balance, August 31 8,089
The general ledger Cash account contained the following entries for the month of August.
Cash
Balance, August 1 10,050 Disbursements in August 34,903
Receipts during August 35,000
Deposits in transit at August 31 are $3,800, and checks outstanding at August 31 total $1,050. Cash on
hand at August 31 is $310. The bookkeeper improperly entered one check in the books at $146.50 which
was written for $164.50 for supplies (expense); it cleared the bank during the month of August.
Instructions
(a) Prepare a bank reconciliation dated August 31, 2014, proceeding to a correct balance.
(b) Prepare any entries necessary to make the books correct and complete.
(c) What amount of cash should be reported in the August 31 balance sheet?
11 * E7-26 (Impairments) On December 31, 2014, Iva Majoli Company borrowed $62,092 from Paris Bank,
signing a 5-year, $100,000 zero-interest-bearing note. The note was issued to yield 10% interest. Unfortu-
nately, during 2016, Majoli began to experience financial difficulty. As a result, at December 31, 2016, Paris
Bank determined that it was probable that it would receive back only $75,000 at maturity. The market rate
of interest on loans of this nature is now 11%.
Instructions
(a) Prepare the entry to record the issuance of the loan by Paris Bank on December 31, 2014.
(b) Prepare the entry, if any, to record the impairment of the loan on December 31, 2016, by Paris Bank.
Problems 395
11 * E7-27 (Impairments) On December 31, 2014, Conchita Martinez Company signed a $1,000,000 note to
Sauk City Bank. The market interest rate at that time was 12%. The stated interest rate on the note was 10%,
payable annually. The note matures in 5 years. Unfortunately, because of lower sales, Conchita Martinez’s |
financial situation worsened. On December 31, 2016, Sauk City Bank determined that it was probable that
the company would pay back only $600,000 of the principal at maturity. However, it was considered likely
that interest would continue to be paid, based on the $1,000,000 loan.
Instructions
(a) Determine the amount of cash Conchita Martinez received from the loan on December 31, 2014.
(b) Prepare a note amortization schedule for Sauk City Bank up to December 31, 2016.
(c) Determine the loss on impairment that Sauk City Bank should recognize on December 31, 2016.
EXERCISES SET B
See the book’s companion website, at www.wiley.com/college/kieso, for an additional
set of exercises.
PROBLEMS
2 P7-1 (Determine Proper Cash Balance) Francis Equipment Co. closes its books regularly on December 31,
but at the end of 2014 it held its cash book open so that a more favorable balance sheet could be prepared
for credit purposes. Cash receipts and disbursements for the first 10 days of January were recorded as
December transactions. The information is given below.
1. January cash receipts recorded in the December cash book totaled $45,640, of which $28,000 repre-
sents cash sales, and $17,640 represents collections on account for which cash discounts of $360 were
given.
2. January cash disbursements recorded in the December check register liquidated accounts payable
of $22,450 on which discounts of $250 were taken.
3. The ledger has not been closed for 2014.
4. The amount shown as inventory was determined by physical count on December 31, 2014.
The company uses the periodic method of inventory.
Instructions
(a) Prepare any entries you consider necessary to correct Francis’s accounts at December 31.
(b) To what extent was Francis Equipment Co. able to show a more favorable balance sheet at Decem-
ber 31 by holding its cash book open? (Compute working capital and the current ratio.) Assume that
the balance sheet that was prepared by the company showed the following amounts:
Dr. Cr.
Cash $39,000
Accounts receivable 42,000
Inventory 67,000
Accounts payable $45,000
Other current liabilities 14,200
5 P7-2 (Bad-Debt Reporting) The following are a series of unrelated situations.
1. Halen Company’s unadjusted trial balance at December 31, 2014, included the following accounts.
Debit Credit
Allowance for doubtful accounts $4,000
Net sales $1,200,000
Halen Company estimates its bad debt expense to be 1½% of net sales. Determine its bad debt
expense for 2014.
396 Chapter 7 Cash and Receivables
2. An analysis and aging of Stuart Corp. accounts receivable at December 31, 2014, disclosed the
following.
Amounts estimated to be uncollectible $ 180,000
Accounts receivable 1,750,000
Allowance for doubtful accounts (per books) 125,000
What is the net realizable value of Stuart’s receivables at December 31, 2014?
3. Shore Co. provides for doubtful accounts based on 3% of credit sales. The following data are avail-
able for 2014.
Credit sales during 2014 $2,400,000
Allowance for doubtful accounts 1/1/14 17,000
Collection of accounts written off in prior years
(customer credit was reestablished) 8,000
Customer accounts written off as uncollectible during 2014 30,000
What is the balance in Allowance for Doubtful Accounts at December 31, 2014?
4. At the end of its first year of operations, December 31, 2014, Darden Inc. reported the following
information.
Accounts receivable, net of allowance for doubtful accounts $950,000
Customer accounts written off as uncollectible during 2014 24,000
Bad debt expense for 2014 84,000
What should be the balance in accounts receivable at December 31, 2014, before subtracting the
allowance for doubtful accounts?
5. The following accounts were taken from Bullock Inc.’s trial balance at December 31, 2014.
Debit Credit
Net credit sales $750,000
Allowance for doubtful accounts $ 14,000
Accounts receivable 310,000
If doubtful accounts are 3% of accounts receivable, determine the bad debt expense to be reported
for 2014.
Instructions
Answer the questions relating to each of the five independent situations as requested. |
5 P7-3 (Bad-Debt Reporting—Aging) Manilow Corporation operates in an industry that has a high rate of
bad debts. Before any year-end adjustments, the balance in Manilow’s Accounts Receivable account was
$555,000 and Allowance for Doubtful Accounts had a credit balance of $40,000. The year-end balance
reported in the balance sheet for Allowance for Doubtful Accounts will be based on the aging schedule
shown below.
Probability of
Days Account Outstanding Amount 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 20,000 .55
Over 75 days 15,000 .00
Instructions
(a) What is the appropriate balance for Allowance for Doubtful Accounts at year-end?
(b) Show how accounts receivable would be presented on the balance sheet.
(c) What is the dollar effect of the year-end bad debt adjustment on the before-tax income?
(CMA adapted)
5 P7-4 (Bad-Debt Reporting) From inception of operations to December 31, 2014, Fortner Corporation pro-
vided for uncollectible accounts receivable under the allowance method. Provisions were made monthly at
2% of credit sales, bad debts written off were charged to the allowance account; recoveries of bad debts
previously written off were credited to the allowance account, and no year-end adjustments to the allow-
ance account were made. Fortner’s usual credit terms are net 30 days.
Problems 397
The balance in Allowance for Doubtful Accounts was $130,000 at January 1, 2014. During 2014, credit
sales totaled $9,000,000, interim provisions for doubtful accounts were made at 2% of credit sales, $90,000
of bad debts were written off, and recoveries of accounts previously written off amounted to $15,000. Fort-
ner installed a computer system in November 2014, and an aging of accounts receivable was prepared for
the first time as of December 31, 2014. A summary of the aging is as follows.
Classifi cation by Balance in Estimated %
Month of Sale Each Category Uncollectible
November–December 2014 $1,080,000 2%
July–October 650,000 10%
January–June 420,000 25%
Prior to 1/1/14 150,000 80%
$2,300,000
Based on the review of collectibility of the account balances in the “prior to 1/1/14” aging category, addi-
tional receivables totaling $60,000 were written off as of December 31, 2014. The 80% uncollectible estimate
applies to the remaining $90,000 in the category. Effective with the year ended December 31, 2014, Fortner
adopted a different method for estimating the allowance for doubtful accounts at the amount indicated by
the year-end aging analysis of accounts receivable.
Instructions
(a) Prepare a schedule analyzing the changes in Allowance for Doubtful Accounts for the year ended
December 31, 2014. Show supporting computations in good form. (Hint: In computing the 12/31/14
allowance, subtract the $60,000 write-off.)
(b) Prepare the journal entry for the year-end adjustment to Allowance for Doubtful Accounts balance
as of December 31, 2014.
(AICPA adapted)
5 P7-5 (Bad-Debt Reporting) Presented below is information related to the Accounts Receivable accounts
of Gulistan Inc. during the current year 2014.
1. An aging schedule of the accounts receivable as of December 31, 2014, is as follows.
% to Be Applied after
Age Net Debit Balance Correction Is Made
Under 60 days $172,342 1%
60–90 days 136,490 3%
91–120 days 39,924* 6%
Over 120 days 23,644 $3,700 defi nitely uncollectible;
$372,400 estimated remainder
uncollectible is 25%
*The $3,240 write-off of receivables is related to the 91-to-120 day category.
2. The Accounts Receivable control account has a debit balance of $372,400 on December 31, 2014.
3. Two entries were made in the Bad Debt Expense account during the year: (1) a debit on December
31 for the amount credited to Allowance for Doubtful Accounts, and (2) a credit for $3,240 on
November 3, 2014, and a debit to Allowance for Doubtful Accounts because of a bankruptcy.
4. Allowance for Doubtful Accounts is as follows for 2014.
Allowance for Doubtful Accounts
Nov. 3 Uncollectible accounts Jan. 1 Beginning balance 8,750 |
written off 3,240 Dec. 31 5% of $372,400 18,620
5. A credit balance exists in Accounts Receivable (60–90 days) of $4,840, which represents an advance
on a sales contract.
Instructions
Assuming that the books have not been closed for 2014, make the necessary correcting entries.
3 4 P7-6 (Journalize Various Accounts Receivable Transactions) The balance sheet of Starsky Company at
5 December 31, 2013, includes the following.
Notes receivable $ 36,000
Accounts receivable 182,100
Less: Allowance for doubtful accounts 17,300 $200,800
398 Chapter 7 Cash and Receivables
Transactions in 2014 include the following.
1. Accounts receivable of $138,000 were collected including accounts of $60,000 on which 2% sales
discounts were allowed.
2. $5,300 was received in payment of an account which was written off the books as worthless in 2013.
3. Customer accounts of $17,500 were written off during the year.
4. At year-end, Allowance for Doubtful Accounts was estimated to need a balance of $20,000. This
estimate is based on an analysis of aged accounts receivable.
Instructions
Prepare all journal entries necessary to reflect the transactions above.
8 P7-7 (Assigned Accounts Receivable—Journal Entries) Salen Company finances some of its current
operations by assigning accounts receivable to a finance company. On July 1, 2014, it assigned, under guar-
antee, specific accounts amounting to $150,000. The finance company advanced to Salen 80% of the
accounts assigned (20% of the total to be withheld until the finance company has made its full recovery),
less a finance charge of ½% of the total accounts assigned.
On July 31, Salen Company received a statement that the finance company had collected $80,000 of
these accounts and had made an additional charge of ½% of the total accounts outstanding as of July 31.
This charge is to be deducted at the time of the first remittance due Salen Company from the finance com-
pany. (Hint: Make entries at this time.) On August 31, 2014, Salen Company received a second statement
from the finance company, together with a check for the amount due. The statement indicated that the
finance company had collected an additional $50,000 and had made a further charge of ½% of the balance
outstanding as of August 31.
Instructions
Make all entries on the books of Salen Company that are involved in the transactions above.
(AICPA adapted)
6 P7-8 (Notes Receivable with Realistic Interest Rate) On October 1, 2014, Arden Farm Equipment
Company sold a pecan-harvesting machine to Valco Brothers Farm, Inc. In lieu of a cash payment Valco
Brothers Farm gave Arden a 2-year, $120,000, 8% note (a realistic rate of interest for a note of this type). The
note required interest to be paid annually on October 1. Arden’s financial statements are prepared on a
calendar-year basis.
Instructions
Assuming Valco Brothers Farm fulfills all the terms of the note, prepare the necessary journal entries for
Arden Farm Equipment Company for the entire term of the note.
6 P7-9 (Notes Receivable Journal Entries) On December 31, 2014, Oakbrook Inc. rendered services to Beghun
Corporation at an agreed price of $102,049, accepting $40,000 down and agreeing to accept the balance in four
equal installments of $20,000 receivable each December 31. An assumed interest rate of 11% is imputed.
Instructions
Prepare the entries that would be recorded by Oakbrook Inc. for the sale and for the receipts and interest
on the following dates. (Assume that the effective-interest method is used for amortization purposes.)
(a) December 31, 2014. (c) December 31, 2016. (e) December 31, 2018.
(b) December 31, 2015. (d) December 31, 2017.
6 P7-10 (Comprehensive Receivables Problem) Braddock Inc. had the following long-term receivable
account balances at December 31, 2013.
Note receivable from sale of division $1,500,000
Note receivable from offi cer 400,000
Transactions during 2014 and other information relating to Braddock’s long-term receivables were as
follows.
1. The $1,500,000 note receivable is dated May 1, 2013, bears interest at 9%, and represents the balance |
of the consideration received from the sale of Braddock’s electronics division to New York Com-
pany. Principal payments of $500,000 plus appropriate interest are due on May 1, 2014, 2015, and
2016. The first principal and interest payment was made on May 1, 2014. Collection of the note
installments is reasonably assured.
2. The $400,000 note receivable is dated December 31, 2013, bears interest at 8%, and is due on Decem-
ber 31, 2016. The note is due from Sean May, president of Braddock Inc. and is collateralized by
10,000 shares of Braddock’s common stock. Interest is payable annually on December 31, and all
interest payments were paid on their due dates through December 31, 2014. The quoted market
price of Braddock’s common stock was $45 per share on December 31, 2014.
Problems 399
3. On April 1, 2014, Braddock sold a patent to Pennsylvania Company in exchange for a $100,000 zero-
interest-bearing note due on April 1, 2016. There was no established exchange price for the patent, and
the note had no ready market. The prevailing rate of interest for a note of this type at April 1, 2014, was
12%. The present value of $1 for two periods at 12% is 0.797 (use this factor). The patent had a carrying
value of $40,000 at January 1, 2014, and the amortization for the year ended December 31, 2014, would
have been $8,000. The collection of the note receivable from Pennsylvania is reasonably assured.
4. On July 1, 2014, Braddock sold a parcel of land to Splinter Company for $200,000 under an install-
ment sale contract. Splinter made a $60,000 cash down payment on July 1, 2014, and signed a 4-year
11% note for the $140,000 balance. The equal annual payments of principal and interest on the note
will be $45,125 payable on July 1, 2015, through July 1, 2018. The land could have been sold at an
established cash price of $200,000. The cost of the land to Braddock was $150,000. Circumstances are
such that the collection of the installments on the note is reasonably assured.
Instructions
(a) Prepare the long-term receivables section of Braddock’s balance sheet at December 31, 2014.
(b) Prepare a schedule showing the current portion of the long-term receivables and accrued interest
receivable that would appear in Braddock’s balance sheet at December 31, 2014.
(c) Prepare a schedule showing interest revenue from the long-term receivables that would appear on
Braddock’s income statement for the year ended December 31, 2014.
8 9 P7-11 (Income Effects of Receivables Transactions) Sandburg Company requires additional cash for its
business. Sandburg has decided to use its accounts receivable to raise the additional cash and has asked
you to determine the income statement effects of the following contemplated transactions.
1. On July 1, 2014, Sandburg assigned $400,000 of accounts receivable to Keller Finance Company.
Sandburg received an advance from Keller of 80% of the assigned accounts receivable less a
commission of 3% on the advance. Prior to December 31, 2014, Sandburg collected $220,000 on the
assigned accounts receivable, and remitted $232,720 to Keller, $12,720 of which represented interest
on the advance from Keller.
2. On December 1, 2014, Sandburg sold $300,000 of net accounts receivable to Wunsch Company for
$270,000. The receivables were sold outright on a without recourse basis.
3. On December 31, 2014, an advance of $120,000 was received from First Bank by pledging $160,000 of
Sandburg’s accounts receivable. Sandburg’s first payment to First Bank is due on January 30, 2015.
Instructions
Prepare a schedule showing the income statement effects for the year ended December 31, 2014, as a result
of the above facts.
10 *P 7-12 (Petty Cash, Bank Reconciliation) Bill Jovi is reviewing the cash accounting for Nottleman, Inc., a local
mailing service. Jovi’s review will focus on the petty cash account and the bank reconciliation for the month
ended May 31, 2014. He has collected the following information from Nottleman’s bookkeeper for this task.
Petty Cash
1. The petty cash fund was established on May 10, 2014, in the amount of $250. |
2. Expenditures from the fund by the custodian as of May 31, 2014, were evidenced by approved receipts for
the following.
Postage expense $33.00
Mailing labels and other supplies 65.00
I.O.U. from employees 30.00
Shipping charges (to customer) 57.45
Newspaper advertising 22.80
Miscellaneous expense 15.35
On May 31, 2014, the petty cash fund was replenished and increased to $300; currency and coin in the fund
at that time totaled $26.40.
Bank Reconciliation
THIRD NATIONAL BANK
BANK STATEMENT
Disbursements Receipts Balance
Balance, May 1, 2014 $8,769
Deposits $28,000
Note payment direct from customer (interest of $30) 930
Checks cleared during May $31,150
Bank service charges 27
Balance, May 31, 2014 6,522
400 Chapter 7 Cash and Receivables
Nottleman’s Cash Account
Balance, May 1, 2014 $ 8,850
Deposits during May 2014 31,000
Checks written during May 2014 (31,835)
Deposits in transit are determined to be $3,000, and checks outstanding at May 31 total $850. Cash on hand
(besides petty cash) at May 31, 2014, is $246.
Instructions
(a) Prepare the journal entries to record the transactions related to the petty cash fund for May.
(b) Prepare a bank reconciliation dated May 31, 2014, proceeding to a correct cash balance, and prepare
the journal entries necessary to make the books correct and complete.
(c) What amount of cash should be reported in the May 31, 2014, balance sheet?
10 * P7-13 (Bank Reconciliation and Adjusting Entries) The cash account of Aguilar Co. showed a ledger
balance of $3,969.85 on June 30, 2014. The bank statement as of that date showed a balance of $4,150. Upon
comparing the statement with the cash records, the following facts were determined.
1. There were bank service charges for June of $25.
2. A bank memo stated that Bao Dai’s note for $1,200 and interest of $36 had been collected on June 29,
and the bank had made a charge of $5.50 on the collection. (No entry had been made on Aguilar’s
books when Bao Dai’s note was sent to the bank for collection.)
3. Receipts for June 30 for $3,390 were not deposited until July 2.
4. Checks outstanding on June 30 totaled $2,136.05.
5. The bank had charged the Aguilar Co.’s account for a customer’s uncollectible check amounting to
$253.20 on June 29.
6. A customer’s check for $90 had been entered as $60 in the cash receipts journal by Aguilar on June 15.
7. Check no. 742 in the amount of $491 had been entered in the cash journal as $419, and check no. 747
in the amount of $58.20 had been entered as $582. Both checks had been issued to pay for purchases
of equipment.
Instructions
(a) Prepare a bank reconciliation dated June 30, 2014, proceeding to a correct cash balance.
(b) Prepare any entries necessary to make the books correct and complete.
10 * P7-14 (Bank Reconciliation and Adjusting Entries) Presented below is information related to Haselhof
Inc.
Balance per books at October 31, $41,847.85; receipts $173,523.91; disbursements $164,893.54. Balance
per bank statement November 30, $56,274.20.
The following checks were outstanding at November 30.
1224 $1,635.29
1230 2,468.30
1232 2,125.15
1233 482.17
Included with the November bank statement and not recorded by the company were a bank debit
memo for $27.40 covering bank charges for the month, a debit memo for $372.13 for a customer’s check
returned and marked NSF, and a credit memo for $1,400 representing bond interest collected by the bank
in the name of Haselhof Inc. Cash on hand at November 30 recorded and awaiting deposit amounted to
$1,915.40.
Instructions
(a) Prepare a bank reconciliation (to the correct balance) at November 30, for Haselhof Inc. from the
information above.
(b) Prepare any journal entries required to adjust the cash account at November 30.
11 *P 7-15 (Loan Impairment Entries) On January 1, 2014, Botosan Company issued a $1,200,000, 5-year, zero-
interest-bearing note to National Organization Bank. The note was issued to yield 8% annual interest.
Unfortunately, during 2015 Botosan fell into financial trouble due to increased competition. After review-
ing all available evidence on December 31, 2015, National Organization Bank decided that the loan was |
impaired. Botosan will probably pay back only $800,000 of the principal at maturity.
Instructions
(a) Prepare journal entries for both Botosan Company and National Organization Bank to record the
issuance of the note on January 1, 2014. (Round to the nearest $10.)
Concepts for Analysis 401
(b) Assuming that both Botosan Company and National Organization Bank use the effective-interest
method to amortize the discount, prepare the amortization schedule for the note.
(c) Under what circumstances can National Organization Bank consider Botosan’s note to be impaired?
(d) Compute the loss National Organization Bank will suffer from Botosan’s financial distress on
December 31, 2015. What journal entries should be made to record this loss?
PROBLEMS SET B
See the book’s companion website, at www.wiley.com/college/kieso, for an additional
set of problems.
CONCEPTS FOR ANALYSIS
CA7-1 (Bad-Debt Accounting) Simms Company has significant amounts of trade accounts receivable.
Simms uses the allowance method to estimate bad debts instead of the direct write-off method. During the
year, some specific accounts were written off as uncollectible, and some that were previously written off as
uncollectible were collected.
Instructions
(a) What are the deficiencies of the direct write-off method?
(b) What are the two basic allowance methods used to estimate bad debts, and what is the theoretical
justification for each?
(c) How should Simms account for the collection of the specific accounts previously written off as
uncollectible?
CA7-2 (Various Receivable Accounting Issues) Kimmel Company uses the net method of accounting for
sales discounts. Kimmel also offers trade discounts to various groups of buyers.
On August 1, 2014, Kimmel sold some accounts receivable on a without recourse basis. Kimmel
incurred a finance charge.
Kimmel also has some notes receivable bearing an appropriate rate of interest. The principal and total
interest are due at maturity. The notes were received on October 1, 2014, and mature on September 30, 2016.
Kimmel’s operating cycle is less than one year.
Instructions
(a) (1) U sing the net method, how should Kimmel account for the sales discounts at the date of sale?
What is the rationale for the amount recorded as sales under the net method?
(2) Using the net method, what is the effect on Kimmel’s sales revenues and net income when cus-
tomers do not take the sales discounts?
(b) What is the effect of trade discounts on sales revenues and accounts receivable? Why?
(c) How should Kimmel account for the accounts receivable factored on August 1, 2014? Why?
(d) How should Kimmel account for the note receivable and the related interest on December 31, 2014?
Why?
CA7-3 (Bad-Debt Reporting Issues) Clark Pierce conducts a wholesale merchandising business that sells
approximately 5,000 items per month with a total monthly average sales value of $250,000. Its annual bad
debt rate has been approximately 1½% of sales. In recent discussions with his bookkeeper, Mr. Pierce has
become confused by all the alternatives apparently available in handling the Allowance for Doubtful
Accounts balance. The following information has been presented to Pierce.
1. An allowance can be set up (a) on the basis of a percentage of sales or (b) on the basis of a valuation
of all past due or otherwise questionable accounts receivable. Those considered uncollectible can be
charged to such allowance at the close of the accounting period, or specific items can be charged off
directly against (1) Gross Sales or to (2) Bad Debt Expense in the year in which they are determined
to be uncollectible.
2. Collection agency and legal fees, and so on, incurred in connection with the attempted recovery of
bad debts can be charged to (a) Bad Debt Expense, (b) Allowance for Doubtful Accounts, (c) Legal
Expense, or (d) Administrative Expense.
3. Debts previously written off in whole or in part but currently recovered can be credited to (a) Other
Revenue, (b) Bad Debt Expense, or (c) Allowance for Doubtful Accounts.
402 Chapter 7 Cash and Receivables |
Instructions
Which of the foregoing methods would you recommend to Mr. Pierce in regard to (1) allowances and
charge-offs, (2) collection expenses, and (3) recoveries? State briefly and clearly the reasons supporting
your recommendations.
CA7-4 (Basic Note and Accounts Receivable Transactions)
Part 1: On July 1, 2014, Wallace Company, a calendar-year company, sold special-order merchandise on
credit and received in return an interest-bearing note receivable from the customer. Wallace Company will
receive interest at the prevailing rate for a note of this type. Both the principal and interest are due in one
lump sum on June 30, 2015.
Instructions
When should Wallace Company report interest revenue from the note receivable? Discuss the rationale for
your answer.
Part 2: On December 31, 2014, Wallace Company had significant amounts of accounts receivable as a
result of credit sales to its customers. Wallace uses the allowance method based on credit sales to estimate
bad debts. Past experience indicates that 2% of credit sales normally will not be collected. This pattern is
expected to continue.
Instructions
(a) Discuss the rationale for using the allowance method based on credit sales to estimate bad debts.
Contrast this method with the allowance method based on the balance in the trade receivables
accounts.
(b) How should Wallace Company report the allowance for doubtful accounts on its balance sheet at
December 31, 2014? Also, describe the alternatives, if any, for presentation of bad debt expense in
Wallace Company’s 2014 income statement.
(AICPA adapted)
CA7-5 (Sale of Notes Receivable) Corrs Wholesalers Co. sells industrial equipment for a standard 3-year
note receivable. Revenue is recognized at time of sale. Each note is secured by a lien on the equipment and
has a face amount equal to the equipment’s list price. Each note’s stated interest rate is below the custom-
er’s market rate at date of sale. All notes are to be collected in three equal annual installments beginning
one year after sale. Some of the notes are subsequently sold to a bank with recourse, some are subsequently
sold without recourse, and some are retained by Corrs. At year end, Corrs evaluates all outstanding notes
receivable and provides for estimated losses arising from defaults.
Instructions
(a) What is the appropriate valuation basis for Corrs’s notes receivable at the date it sells equipment?
(b) How should Corrs account for the sale, without recourse, of a February 1, 2014, note receivable sold
on May 1, 2014? Why is it appropriate to account for it in this way?
(c) At December 31, 2014, how should Corrs measure and account for the impact of estimated losses
resulting from notes receivable that it
(1) Retained and did not sell?
(2) Sold to bank with recourse?
(AICPA adapted)
CA7-6 (Zero-Interest-Bearing Note Receivable) On September 30, 2013, Rolen Machinery Co. sold a
machine and accepted the customer’s zero-interest-bearing note. Rolen normally makes sales on a cash
basis. Since the machine was unique, its sales price was not determinable using Rolen’s normal pricing
practices.
After receiving the first of two equal annual installments on September 30, 2014, Rolen immedi-
ately sold the note with recourse. On October 9, 2015, Rolen received notice that the note was dishon-
ored, and it paid all amounts due. At all times prior to default, the note was reasonably expected to be
paid in full.
Instructions
(a) (1) How should Rolen determine the sales price of the machine?
(2) How should Rolen report the effects of the zero-interest-bearing note on its income statement
for the year ended December 31, 2013? Why is this accounting presentation appropriate?
(b) What are the effects of the sale of the note receivable with recourse on Rolen’s income statement for
the year ended December 31, 2014, and its balance sheet at December 31, 2014?
(c) How should Rolen account for the effects of the note being dishonored?
Concepts for Analysis 403
CA7-7 (Reporting of Notes Receivable, Interest, and Sale of Receivables) On July 1, 2014, Moresan |
Company sold special-order merchandise on credit and received in return an interest-bearing note receiv-
able from the customer. Moresan will receive interest at the prevailing rate for a note of this type. Both the
principal and interest are due in one lump sum on June 30, 2015.
On September 1, 2014, Moresan sold special-order merchandise on credit and received in return a
zero-interest-bearing note receivable from the customer. The prevailing rate of interest for a note of this
type is determinable. The note receivable is due in one lump sum on August 31, 2016.
Moresan also has significant amounts of trade accounts receivable as a result of credit sales to its cus-
tomers. On October 1, 2014, some trade accounts receivable were assigned to Indigo Finance Company on
a non-notification (Moresan handles collections) basis for an advance of 75% of their amount at an interest
charge of 8% on the balance outstanding.
On November 1, 2014, other trade accounts receivable were sold on a without recourse basis. The fac-
tor withheld 5% of the trade accounts receivable factored as protection against sales returns and allowances
and charged a finance charge of 3%.
Instructions
(a) How should Moresan determine the interest revenue for 2014 on the:
(1) Interest-bearing note receivable? Why?
(2) Zero-interest-bearing note receivable? Why?
(b) How should Moresan report the interest-bearing note receivable and the zero-interest-bearing note
receivable on its balance sheet at December 31, 2014?
(c) How should Moresan account for subsequent collections on the trade accounts receivable assigned
on October 1, 2014, and the payments to Indigo Finance? Why?
(d) How should Moresan account for the trade accounts receivable factored on November 1, 2014?
Why?
(AICPA adapted)
CA7-8 (Accounting for Zero-Interest-Bearing Note) Soon after beginning the year-end audit work on
March 10 at Engone Company, the auditor has the following conversation with the controller.
C ontroller: T he year ended March 31st should be our most profitable in history and, as a consequence,
the board of directors has just awarded the officers generous bonuses.
udAit: orI thought profits were down this year in the industry, according to your latest interim report.
Controller: Well, they were down, but 10 days ago we closed a deal that will give us a substantial in-
crease for the year.
Auditor: Oh, what was it?
C ontroller: W ell, you remember a few years ago our former president bought stock in Henderson En-
terprises because he had those grandiose ideas about becoming a conglomerate. For 6 years
we have not been able to sell this stock, which cost us $3,000,000 and has not paid a nickel
in dividends. Thursday we sold this stock to Bimini Inc. for $4,000,000. So, we will have a
gain of $700,000 ($1,000,000 pretax) which will increase our net income for the year to
$4,000,000, compared with last year’s $3,800,000. As far as I know, we’ll be the only com-
pany in the industry to register an increase in net income this year. That should help the
market value of the stock!
Auditor: Do you expect to receive the $4,000,000 in cash by March 31st, your fiscal year-end?
C ontroller: N o. Although Bimini Inc. is an excellent company, they are a little tight for cash because
of their rapid growth. Consequently, they are going to give us a $4,000,000 zero-interest-
bearing note with payments of $400,000 per year for the next 10 years. The first payment is
due on March 31 of next year.
Auditor: Why is the note zero-interest-bearing?
C ontroller: B ecause that’s what everybody agreed to. Since we don’t have any interest-bearing debt,
the funds invested in the note do not cost us anything and besides, we were not getting any
dividends on the Henderson Enterprises stock.
Instructions
Do you agree with the way the controller has accounted for the transaction? If not, how should the transac-
tion be accounted for?
CA7-9 (Receivables Management) As the manager of the accounts receivable department for Beavis
Leather Goods, Ltd., you recently noticed that Kelly Collins, your accounts receivable clerk who is paid |
$1,200 per month, has been wearing unusually tasteful and expensive clothing. (This is Beavis’s first year
in business.) This morning, Collins drove up to work in a brand new Lexus.
404 Chapter 7 Cash and Receivables
Naturally suspicious by nature, you decide to test the accuracy of the accounts receivable balance
of $192,000 as shown in the ledger. The following information is available for your first year (precisely
9 months ended September 30, 2014) in business.
(1) Collections from customers $188,000
(2) Merchandise purchased 360,000
(3) Ending merchandise inventory 90,000
(4) Goods are marked to sell at 40% above cost.
Instructions
Assuming all sales were made on account, compute the ending accounts receivable balance that should
appear in the ledger, noting any apparent shortage. Then, draft a memo dated October 3, 2014, to Mark
Price, the branch manager, explaining the facts in this situation. Remember that this problem is serious, and
you do not want to make hasty accusations.
CA7-10 (Bad-Debt Reporting) Marvin Company is a subsidiary of Hughes Corp. The controller believes
that the yearly allowance for doubtful accounts for Marvin should be 2% of net credit sales. Given the
recession and the high interest rate environment, the president, nervous that the parent company might
expect the subsidiary to sustain its 10% growth rate, suggests that the controller increase the allowance for
doubtful accounts to 3% yearly. The president thinks that the lower net income, which reflects a 6% growth
rate, will be a more sustainable rate for Marvin Company.
Instructions
(a) In a recessionary environment with tight credit and high interest rates:
(1) Identify steps Marvin Company might consider to improve the accounts receivable situation.
(2) Then evaluate each step identified in terms of the risks and costs involved.
(b) Should the controller be concerned with Marvin Company’s growth rate in estimating the allowance?
Explain your answer.
(c) Does the president’s request pose an ethical dilemma for the controller? Give your reasons.
USING YOUR JUDGMENT
FINANCIAL REPORTING
Financial Reporting Problem
The Procter & Gamble Company (P&G)
The financial statements of P&G are presented in Appendix 5B. The company’s complete annual report,
including the notes to the financial statements, can be accessed at the book’s companion website, www.
wiley.com/college/kieso.
Instructions
Refer to P&G’s financial statements and the accompanying notes to answer the following questions.
(a) What criteria does P&G use to classify “Cash and cash equivalents” as reported in its balance sheet?
(b) As of June 30, 2011, what balances did P&G have in cash and cash equivalents? What were the major
uses of cash during the year?
(c) P&G reports no allowance for doubtful accounts, suggesting that bad debt expense is not material for
this company. Is it reasonable that a company like P&G would not have material bad debt expense?
Explain.
Comparative Analysis Case
The Coca-Cola Company and PepsiCo, Inc.
Instructions
Go to the book’s companion website and use the information found there to answer the following ques-
tions related to The Coca-Cola Company and PepsiCo, Inc.
(a) What were the cash and cash equivalents reported by Coca-Cola and PepsiCo at the end of 2011? What
does each company classify as cash equivalents?
Using Your Judgment 405
(b) What were the accounts receivable (net) for Coca-Cola and PepsiCo at the end of 2011? Which com-
pany reports the greater allowance for doubtful accounts (amount and percentage of gross receivable)
at the end of 2011?
(c) Assuming that all “net operating revenues” (Coca-Cola) and all “net sales” (PepsiCo) were net
credit sales, compute the accounts receivable turnover for 2011 for Coca-Cola and PepsiCo; also com-
pute the days outstanding for receivables. What is your evaluation of the difference?
Financial Statement Analysis Cases
Case 1 Occidental Petroleum Corporation
Occidental Petroleum Corporation reported the following information in a recent annual report.
Occidental Petroleum Corporation |
Consolidated Balance Sheets
(in millions)
Current Prior
Assets at December 31, year year
Current assets
Cash and cash equivalents $ 683 $ 146
Trade receivables, net of allowances 804 608
Receivables from joint ventures, partnerships, and other 330 321
Inventories 510 491
Prepaid expenses and other 147 307
Total current assets 2,474 1,873
Long-term receivables, net 264 275
Notes to Consolidated Financial Statements
Cash and Cash Equivalents. Cash equivalents consist of highly liquid investments. Cash equivalents
totaled approximately $661 million and $116 million at current and prior year-ends, respectively.
Trade Receivables. Occidental has agreement to sell, under a revolving sale program, an undivided
percentage ownership interest in a designated pool of non-interest-bearing receivables. Under this
program, Occidental serves as the collection agent with respect to the receivables sold. An interest in
new receivables is sold as collections are made from customers. The balance sold at current year-end
was $360 million.
Instructions
(a) What items other than coin and currency may be included in “cash”?
(b) What items may be included in “cash equivalents”?
(c) What are compensating balance arrangements, and how should they be reported in financial
statements?
(d) What are the possible differences between cash equivalents and short-term (temporary) investments?
(e) Assuming that the sale agreement meets the criteria for sale accounting, cash proceeds were
$345 million, the carrying value of the receivables sold was $360 million, and the fair value of the
recourse liability was $15 million, what was the effect on income from the sale of receivables?
(f) Briefly discuss the impact of the transaction in (e) on Occidental’s liquidity.
Case 2 Microsoft Corporation
Microsoft is the leading developer of software in the world. To continue to be successful Microsoft must
generate new products, which requires significant amounts of cash. The following is the current asset and
current liability information from Microsoft’s current balance sheets (in millions). Following the Microsoft
data is the current asset and current liability information from Oracle’s current balance sheets (in millions).
Oracle is another major software developer.
406 Chapter 7 Cash and Receivables
Microsoft Corporation
Balance Sheets (partial)
As of June 30
(in millions)
Current assets 2011 2010
Cash and equivalents $ 9,610 $ 5,505
Short-term investments 43,162 31,283
Accounts receivable 14,987 13,014
Other 7,159 5,874
Total current assets $74,918 $55,676
Total current liabilities $28,774 $26,147
Oracle
Balance Sheets (partial)
As of May 31
(in millions)
Current assets 2011 2010
Cash and equivalents $16,163 $ 9,914
Short-term investments 12,685 8,555
Receivables 6,628 5,585
Other current assets 3,698 2,950
Total current assets $39,174 $27,004
Current liabilities $14,192 $14,691
Part 1 (Cash and Cash Equivalents)
Instructions
(a) What is the definition of a cash equivalent? Give some examples of cash equivalents. How do cash
equivalents differ from other types of short-term investments?
(b) Calculate (1) the current ratio and (2) working capital for each company for 2011 and discuss your
results.
(c) Is it possible to have too many liquid assets?
Part 2 (Accounts Receivable)
Microsoft provided the following disclosure related to its accounts receivable.
Allowance for Doubtful Accounts. The allowance for doubtful accounts refl ects our best estimate of prob-
able losses inherent in the accounts receivable balance. We determine the allowance based on known troubled
accounts, historical experience, and other currently available evidence. Activity in the allowance for doubtful
accounts is as follows:
(in millions)
Balance at Charged to
beginning of costs Balance at
Year Ended June 30 period and expenses Write-offs end of period
2009 $153 $360 $(62) $451
2010 451 45 (121) 375
2011 375 14 (56) 333
Instructions
(a) Compute Microsoft’s accounts receivable turnover for 2011 and discuss your results. Microsoft had
sales revenue of $69,943 million in 2011.
(b) Reconstruct the summary journal entries for 2011 based on the information in the disclosure. |
(c) Briefly discuss how the accounting for bad debts affects the analysis in Part 2 (a).
Using Your Judgment 407
Accounting, Analysis, and Principles
The Flatiron Pub provides catering services to local businesses. The following information was available
for The Flatiron Pub for the years ended December 31, 2013 and 2014.
December December
31, 2013 31, 2014
Cash $ 2,000 $ 1,685
Accounts receivable 46,000 ?
Allowance for doubtful accounts 550 ?
Other current assets 8,500 7,925
Current liabilities 37,000 44,600
Total credit sales 205,000 255,000
Collections on accounts receivable 190,000 228,000
Flatiron management is preparing for a meeting with its bank concerning renewal of a loan and has col-
lected the following information related to the above balances.
1. The cash reported at December 31, 2014, reflects the following items: petty cash $1,575 and postage
stamps $110. The other current assets balance at December 31, 2014, includes the checking account
balance of $4,000.
2. On November 30, 2014, Flatiron agreed to accept a 6-month, $5,000 note bearing 12% interest, payable
at maturity, from a major client in settlement of a $5,000 bill. The above balances do not reflect this
transaction.
3. Flatiron factored some accounts receivable at the end of 2014. It transferred accounts totaling $10,000
to Final Factor, Inc. with recourse. Final Factor will receive the collections from Flatiron’s customers
and will retain 2% of the balances. Final Factor assesses Flatiron a finance charge of 3% on this transfer.
The fair value of the recourse liability is $400. However, management has determined that the amount
due from the factor and the fair value of the resource obligation have not been recorded, and neither
are included in the balances above.
4. Flatiron charged off uncollectible accounts with balances of $1,600. On the basis of the latest available
information, the 2014 provision for bad debts is estimated to be 2.5% of accounts receivable.
Accounting
(a) Based on the above transactions, determine the balance for (1) Accounts Receivable and (2) Allowance
for Doubtful Accounts at December 31, 2014.
(b) Prepare the current assets section of The Flatiron Pub’s balance sheet at December 31, 2014.
Analysis
(a) Compute Flatiron’s current ratio and accounts receivable turnover for December 31, 2014. Use these
measures to analyze Flatiron’s liquidity. The accounts receivable turnover in 2013 was 4.37.
(b) Discuss how the analysis you did above of Flatiron’s liquidity would be affected if Flatiron had trans-
ferred the receivables in a secured borrowing transaction.
Principles
What is the conceptual basis for recording bad debt expense based on the percentage-of-receivables
approach at December 31, 2014?
BRIDGE TO THE PROFESSION
Professional Research: FASB Codifi cation
As the new staff person in your company’s treasury department, you have been asked to conduct research
related to a proposed transfer of receivables. Your supervisor wants the authoritative sources for the fol-
lowing items that are discussed in the securitization agreement.
Instructions
If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in and
prepare responses to the following. Provide Codification references for your responses.
408 Chapter 7 Cash and Receivables
(a) Identify relevant Codification section that addresses transfers of receivables.
(b) What are the objectives for reporting transfers of receivables?
(c) Provide definitions for the following:
(1) Transfer.
(2) Recourse.
(3) Collateral.
(d) Provide other examples (besides recourse and collateral) that qualify as continuing involvement.
Additional Professional Resources
See the book’s companion website, at www.wiley.com/college/kieso, for professional
simulations as well as other study resources.
IFRS INSIGHTS
The basic accounting and reporting issues related to recognition and measurement
LEARNING OBJECTIVE 12
of receivables, such as the use of allowance accounts, how to record discounts, use
Compare the accounting procedures |
of the allowance method to account for bad debts, and factoring, are similar for
for cash and receivables under GAAP
and IFRS. both IFRS and GAAP. IAS 1 (“Presentation of Financial Statements”) is the only
standard that discusses issues specifically related to cash. IFRS 7 (“Financial In-
struments: Disclosure”) and IAS 39 (“Financial Instruments: Recognition and Measure-
ment”) are the two international standards that address issues related to financial
instruments and more specifically receivables.
RELEVANT FACTS
Following are the key similarities and differences between GAAP and IFRS related to
cash and receivables.
Similarities
• The accounting and reporting related to cash is essentially the same under both IFRS
and GAAP. In addition, the defi nition used for cash equivalents is the same.
• Like GAAP, cash and receivables are generally reported in the current assets section
of the statement of fi nancial position under IFRS.
• Similar to GAAP, IFRS requires that loans and receivables be accounted for at amor-
tized cost, adjusted for allowances for doubtful accounts. IFRS sometimes refers to
these allowances as provisions. The entry to record the allowance would be as follows.
Bad Debt Expense xxxxxx
Provision for Doubtful Accounts xxxxxx
Differences
• Under IFRS, companies may report cash and receivables as the last items in current
assets under IFRS. Under GAAP, these items are reported in order of liquidity.
• While IFRS implies that receivables with different characteristics should be reported
separately, there is no standard that mandates this segregation. GAAP has explicit
guidance in the area.
IFRS Insights 409
• The fair value option is similar under GAAP and IFRS but not identical. The interna-
tional standard related to the fair value option is subject to certain qualifying
criteria not in the U.S. standard. In addition, there is some difference in the fi nancial
instruments covered.
• Under IFRS, bank overdrafts are generally reported as cash. Under GAAP, such
balances are reported as liabilities.
• IFRS and GAAP differ in the criteria used to account for transfers of receivables. IFRS
is a combination of an approach focused on risks and rewards and loss of control.
GAAP uses loss of control as the primary criterion. In addition, IFRS generally
permits partial transfers; GAAP does not.
ABOUT THE NUMBERS
Impairment Evaluation Process
IFRS provides detailed guidelines to assess whether receivables should be considered
uncollectible (often referred to as impaired). GAAP does not identify a specific approach.
Under IFRS, companies assess their receivables for impairment each reporting period
and start the impairment assessment by considering whether objective evidence indi-
cates that one or more loss events have occurred. Examples of possible loss events are:
• Signifi cant fi nancial problems of the customer.
• Payment defaults.
• Renegotiation of terms of the receivable due to fi nancial diffi culty of the customer.
• Measurable decrease in estimated future cash fl ows from a group of receivables since
initial recognition, although the decrease cannot yet be identifi ed with individual
assets in the group.
A receivable is considered impaired when a loss event indicates a negative impact on
the estimated future cash flows to be received from the customer (IAS 39, paragraphs
58–70). The IASB requires that the impairment assessment should be performed as
follows.
1. Receivables that are individually signifi cant are considered for impairment sepa-
rately; if impaired, the company recognizes it. Receivables that are not individually
signifi cant may also be assessed individually, but it is not necessary to do so.
2. Any receivable individually assessed that is not considered impaired is included
with a group of assets with similar credit-risk characteristics and collectively
assessed for impairment.
3. Any receivables not individually assessed are collectively assessed for impairment.
To illustrate, assume that Hector Company has the following receivables classified
into individually significant and all other receivables. |
Individually significant receivables
Yaan Company $ 40,000
Randon Inc. 100,000
Fernando Co. 60,000
Blanchard Ltd. 50,000 $250,000
All other receivables 500,000
Total $750,000
Hector determines that Yaan’s receivable is impaired by $15,000, and Blanchard’s receiv-
able is totally impaired. Both Randon’s and Fernando’s receivables are not considered
410 Chapter 7 Cash and Receivables
impaired. Hector also determines a composite rate of 2% is appropriate to measure
impairment on all other receivables. The total impairment is computed as follows.
Accounts Receivable Impairments
Individually assessed receivables
Yaan Company $15,000
Blanchard Ltd. 50,000
Collectively assessed receivables $500,000
Add: Randon Inc. 100,000
Fernando Co. 60,000
Total collectively assessed receivables $660,000
Collectively assessed impairments ($660,000 3 2%) 13,200
Total impairment $78,200
Hector therefore has an impairment related to its receivables of $78,200. The most con-
troversial part of this computation is that Hector must include in the collective assess-
ment the receivables from Randon and Fernando that were individually assessed and
not considered impaired. The rationale for including Randon and Fernando in the col-
lective assessment is that companies often do not have all the information at hand to
make an informed decision for individual assessment.
Recovery of Impairment Loss
The accounting for loan impairments is similar between GAAP and IFRS. Subsequent to
recording an impairment, events or economic conditions may change such that the
extent of the impairment loss decreases (e.g., due to an impairment in the debtor’s credit
rating). Under IFRS, some or all of the previously recognized impairment loss shall be
reversed either directly, with a debit to Accounts Receivable, or by debiting the allow-
ance account and crediting Bad Debt Expense. Such reversals of impairment losses are
not allowed under GAAP.
To illustrate, recall the Ogden Bank impairment example of page 382. In that situa-
tion, Ogden Bank (the creditor) recognized an impairment loss of $12,434 by debiting
Bad Debt Expense for the expected loss. At the same time, it reduced the overall value
of the receivable by crediting Allowance for Doubtful Accounts. Ogden made the fol-
lowing entry to record the loss.
Bad Debt Expense 12,434
Allowance for Doubtful Accounts 12,434
Now, assume that in the year following the impairment recorded by Ogden, Carl
King (the borrower) has worked his way out of financial difficulty. Ogden now expects
to receive all payments on the loan according to the original loan terms. Based on this
new information, the present value of the expected payments is $100,000. Thus, Ogden
makes the following entry to reverse the previously recorded impairment.
Allowance for Doubtful Accounts 12,434
Bad Debt Expense 12,434
Note that the reversal of impairment losses shall not result in carrying amount of the
receivable that exceeds the amortized cost that would have been reported had the
impairment not been recognized. Under GAAP, reversal of an impairment is not per-
mitted. Rather, the balance of the loan after the impairment becomes the new basis for
the loan.
IFRS Insights 411
ON THE HORIZON
The question of recording fair values for financial instruments will continue to be an
important issue to resolve as the Boards work toward convergence. Both the IASB and
the FASB have indicated that they believe that financial statements would be more trans-
parent and understandable if companies recorded and reported all financial instruments
at fair value. That said, in IFRS 9, which was issued in 2009, the IASB created a split
model, where some financial instruments are recorded at fair value but other financial
assets, such as loans and receivables, can be accounted for at amortized cost if certain
criteria are met. Critics say that this can result in two companies with identical securities
accounting for those securities in different ways. A proposal by the FASB would require
that nearly all financial instruments, including loans and receivables, be accounted for at |
fair value. It has been suggested that IFRS 9 will likely be changed or replaced as the
FASB and IASB continue to deliberate the best treatment for financial instruments. In
fact, one member of the IASB said that companies should ignore IFRS 9 and continue to
report under the old standard, because in his opinion, it is extremely likely that it would
be changed before the mandatory adoption date of this standard in 2015.
IFRS SELF-TEST QUESTIONS
1. Under IFRS, cash and cash equivalents are reported:
(a) the same as GAAP.
(b) as separate items.
(c) similar to GAAP, except for the reporting of bank overdrafts.
(d) always as the first items in the current assets section.
2. Under IFRS, receivables are to be reported on the balance sheet at:
(a) amortized cost.
(b) amortized cost adjusted for estimated loss provisions.
(c) historical cost.
(d) replacement cost.
3. Which of the following statements is false?
(a) Receivables include equity securities purchased by the company.
(b) Receivables include credit card receivables.
(c) Receivables include amounts owed by employees as result of company loans to employees.
(d) Receivables include amounts resulting from transactions with customers.
4. Under IFRS:
(a) the entry to record estimated uncollected accounts is the same as GAAP.
(b) loans and receivables should only be tested for impairment as a group.
(c) it is always acceptable to use the direct write-off method.
(d) all financial instruments are recorded at fair value.
5. Which of the following statements is true?
(a) The fair value option requires that some types of financial instruments be recorded at fair value.
(b) The fair value option requires that all noncurrent financial instruments be recorded at amor-
tized cost.
(c) The fair value option allows, but does not require, that some types of financial instruments be
recorded at fair value.
(d) The FASB and IASB would like to reduce the reliance on fair value accounting for financial
instruments in the future.
IFRS CONCEPTS AND APPLICATION
IFRS7-1 Briefly describe the impairment evaluation process and assessment of receivables on an individ-
ual or collective basis.
412 Chapter 7 Cash and Receivables
IFRS7-2 What are some steps taken by both the FASB and IASB to move to fair value measurement for
financial instruments? In what ways have some of the approaches differed?
IFRS7-3 On December 31, 2014, Firth Company borrowed $62,092 from Paris Bank, signing a 5-year,
$100,000 zero-interest-rate note. The note was issued to yield 10% interest. Unfortunately, during 2016,
Firth began to experience financial difficulty. As a result, at December 31, 2016, Paris Bank determined that
it was probable that it would collect only $75,000 at maturity. The market rate of interest on loans of this
nature is now 11%.
Instructions
(a) Prepare the entry (if any) to record the impairment of the loan on December 31, 2016, by Paris Bank.
(b) Prepare the entry on March 31, 2017, if Paris learns that Firth will be able to repay the loan under the
original terms.
Professional Research
IFRS7-4 As the new staff person in your company’s treasury department, you have been asked to conduct
research related to a proposed transfer of receivables. Your supervisor wants the authoritative sources for
the following items that are discussed in the receivables transfer agreement.
Instructions
Access the IFRS authoritative literature at the IASB website (http://eifrs.iasb.org/). (Click on the IFRS tab and
then register for free eIFRS access if necessary.) When you have accessed the documents, you can use the
search tool in your Internet browser to prepare responses to the following items. (a) Identify relevant IFRSs
that address transfers of receivables. (b) What are the objectives for reporting transfers of receivables?
(c) Provide the definition for “Amortized cost.”
International Financial Reporting Problem
Marks and Spencer plc
IFRS7-5 The financial statements of Marks and Spencer plc (M&S) are available at the book’s compan-
ion website or can be accessed at http://annualreport.marksandspencer.com/_assets/downloads/Marks-and- |
Spencer-Annual-report-and-financial-statements-2012.pdf.
Instructions
Refer to M&S’s financial statements and the accompanying notes to answer the following questions.
(a) What criteria does M&S use to classify “Cash and cash equivalents” as reported in its statement
of financial position?
(b) As of 31 March 2012, what balances did M&S have in cash and cash equivalents? What were the
major uses of cash during the year?
(c) What amounts related to trade receivables does M&S report? Does M&S have any past due but
not impaired receivables?
ANSWERS TO IFRS SELF-TEST QUESTIONS
1. c 2. b 3. a 4. a 5. c
Remember to check the book’s companion website to fi nd additional
resources for this chapter.
This page is intentionally left blank
Valuation of Inventories:
A Cost-Basis Approach
RETPAHC 8
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1 Identify major classifications of inventory. 6 Explain the significance and use of a LIFO
reserve.
2 Distinguish between perpetual and periodic
inventory systems. 7 Understand the effect of LIFO liquidations.
3 Determine the goods included in inventory and 8 Explain the dollar-value LIFO method.
the effects of inventory errors on the financial
9 Identify the major advantages and disadvantages
statements.
of LIFO.
4 Understand the items to include as inventory cost.
10 Understand why companies select given inventory
5 Describe and compare the cost flow assumptions methods.
used to account for inventories.
To Switch or Not to Switch
Many companies use the last-in, first-out (LIFO) cost flow assumption in the accounting for inventories. LIFO has a lot going
for it in terms of tax savings and providing an income number that better reflects the gross profit associated with inventories
with different historical costs. However, in the wake of international convergence discussions (LIFO is not permitted under
IFRS) and tax policy debates (LIFO is one of a number of “tax loopholes” that if closed could help address our budget and
deficit challenges), more companies are seriously considering the switch from LIFO to first-in, first-out (FIFO) or average-
cost inventory methods. For example, of the 449 large public companies surveyed by the AICPA in 2012, just 163 indicated
LIFO use ( a 25% decline relative to 2001). Here are some of the reasons to support the switch from LIFO.
• While many believe that LIFO provides a more useful income measure, other methods, such as
FIFO and average-cost, better reflect the current value of inventory on the balance sheet.
• Many companies discontinued LIFO use to support uniformity of inventory valuation across
operations. That is, companies were using LIFO in their U.S. operations but FIFO and/or
average-cost in international units. The switch from LIFO simplifies the external reporting
for these multinational companies.
• There is also a “bandwagon” effect—when some companies make the switch, their peers likely
follow suit to enhance comparability for financial statement users.
• The recent periods of low inflation have resulted in less significant tax benefits associated
with LIFO use. That is, in times of rising costs, by expensing the most recently purchased
items, cost of goods sold is higher (compared to FIFO or average-cost) and taxable income
is lower. A number of companies do not believe the smaller tax benefits of LIFO offset the
costs. For example, Kraft Foods switched from LIFO to average-cost in 2009, noting that in
the recent stable price environment, its cost of goods sold was $95 million higher under
average-cost.
CONCEPTUAL FOCUS
> See the Underlying Concepts on
pages 422, 425, and 427.
> Read the Evolving Issue on page 445
• Finally, the companies most resistant to make the switch
for a discussion of LIFO.
from LIFO are those with large inventory balances. That is,
the higher the inventory balance, the higher the additional
INTERNATIONAL FOCUS
tax payment will be upon the switch to FIFO. However, a
growing number of companies have implemented just-
> See the International Perspectives on
in-time (JIT) or other lean manufacturing techniques, under |
pages 421, 426, 429, 431, and 444.
which much lower inventories are kept on hand. In the
> IFRS Insights related to inventory
extreme, JIT leads to zero inventory and no LIFO effect
are presented in Chapter 9 on
relative to other methods. For example, JCPenney
pages 525–534.
recently switched from LIFO to FIFO in the same period
that it rolled out its “Door-to-Floor” lean inventory strategy.
As a result, the accounting effect of the change to FIFO
was immaterial.
The merits of LIFO use (about which you will learn more in this chapter) are many. However, these benefits appear to be
waning. We expect more companies to weigh a voluntary switch away from LIFO in the future.
Source: Adapted from L. Hughes, J. Livingstone, and D. Upton, “Switching from LIFO: Strategies for Change,” The CPA Journal (April 2011),
pp. 26–29.
As our opening story indicates, the accounting choice related to
PREVIEW OF CHAPTER 8
inventory is affected by operating strategies, tax consequences, and
is important for providing information that is useful for predicting
financial performance. In this chapter, we discuss the basic issues related to accounting and reporting for
inventory. The content and organization of the chapter are as follows.
Valuation of Inventories:
A Cost-Basis Approach
Physical Goods
Costs Included in Cost Flow
Inventory Issues Included in LIFO: Special Issues Basis for Selection
Inventory Assumptions
Inventory
• Classification • Goods in transit • Product costs • Specific • LIFO reserve • Summary of
• Cost flow • Consigned goods • Period costs identification • LIFO liquidation inventory
• Control • Special sales • Purchase • Average-cost • Dollar-value LIFO valuation
• Basic inventory agreements discounts • FIFO • Comparison of methods
valuation • Effect of • LIFO LIFO approaches
inventory errors • Advantages of
LIFO
• Disadvantages
of LIFO
415
416 Chapter 8 Valuation of Inventories: A Cost-Basis Approach
INVENTORY ISSUES
Classifi cation
Inventories are asset items that a company holds for sale in the ordinary course of
LEARNING OBJECTIVE 1
business, or goods that it will use or consume in the production of goods to be
Identify major classifications of
sold. The description and measurement of inventory require careful attention. The
inventory.
investment in inventories is frequently the largest current asset of merchandising
(retail) and manufacturing businesses.
A merchandising concern, such as Wal-Mart Stores, Inc., usually purchases its
merchandise in a form ready for sale. It reports the cost assigned to unsold units left on
hand as merchandise inventory. Only one inventory account, Inventory, appears in the
financial statements.
Manufacturing concerns, on the other hand, produce goods to sell to merchandising
firms. Many of the largest U.S. businesses are manufacturers, such as Boeing, IBM,
ExxonMobil, Procter & Gamble, Ford, and Motorola. Although the products they pro-
duce may differ, manufacturers normally have three inventory accounts—Raw Materials,
Work in Process, and Finished Goods.
A company reports the cost assigned to goods and materials on hand but not yet
placed into production as raw materials inventory. Raw materials include the wood to
make a baseball bat or the steel to make a car. These materials can be traced directly to
the end product.
At any point in a continuous production process, some units are only partially pro-
cessed. The cost of the raw material for these unfinished units, plus the direct labor cost
applied specifically to this material and a ratable share of manufacturing overhead
costs, constitute the work in process inventory.
Companies report the costs identified with the completed but unsold units on hand
at the end of the fiscal period as finished goods inventory. Illustration 8-1 contrasts the
financial statement presentation of inventories of Wal-Mart Stores, Inc. (a merchandising
company) with those of Sherwin-Williams Company (a manufacturing company.) The
ILLUSTRATION 8-1 remainder of the balance sheet is essentially similar for the two types of companies.
Comparison of |
Presentation of Current
Assets for Merchandising
and Manufacturing
Companies
Merchandising Company Manufacturing Company
Wal-Mart Stores, Inc. Sherwin-Williams Company
Balance Sheet Balance Sheet
January 31, 2012 December 31, 2011
Current assets (in millions) Current assets (in thousands)
Cash and cash equivalents $ 6,550 Cash and cash equivalents $ 32,696
Receivables, net 5,937 Accounts receivable, less
Inventories 40,714 allowance 989,873
Prepaid expenses and other 1,774 Inventories:
Total current assets $54,975 Finished goods $730,727
Work in process and
raw materials 196,082 926,809
Deferred income taxes 149,207
Other current assets 163,008
Total current assets $ 2,261,593
Inventory Issues 417
A manufacturing company like Sherwin-Williams also might include a Manufac-
turing or Factory Supplies Inventory account. In it, Sherwin-Williams would include
such items as machine oils, nails, cleaning material, and the like—supplies that are used
in production but are not the primary materials being processed.
Illustration 8-2 shows the differences in the flow of costs through a merchandising
company and a manufacturing company.
ILLUSTRATION 8-2
MERCHANDISING COMPANY Flow of Costs through
Manufacturing and
Inventory
Merchandising
Cost of Cost of Companies
goods goods
Raw Materials
purchased sold
Actual Materials Cost of Goods Sold
materials used
cost
MANUFACTURING COMPANY
Work in Process Finished Goods
Labor
Cost of Cost of
Actual Labor goods goods
labor applied manufactured sold
cost
Overhead
Actual Overhead
overhead applied
cost
Inventory Cost Flow
Companies that sell or produce goods report inventory and cost of goods sold at
2 LEARNING OBJECTIVE
the end of each accounting period. The flow of costs for a company is as follows.
Distinguish between perpetual and
Beginning inventory plus the cost of goods purchased is the cost of goods avail-
periodic inventory systems.
able for sale. As goods are sold, they are assigned to cost of goods sold. Those
goods that are not sold by the end of the accounting period represent ending inventory.
Illustration 8-3 describes these relationships.
ILLUSTRATION 8-3
Beginning Cost of Goods Inventory Cost Flow
Inventory Purchased
Cost of Goods
Available for Sale
Cost of Ending
Goods Sold Inventory
Companies use one of two types of systems for maintaining accurate inventory
records for these costs—the perpetual system or the periodic system.
418 Chapter 8 Valuation of Inventories: A Cost-Basis Approach
Perpetual System
A perpetual inventory system continuously tracks changes in the Inventory account.
That is, a company records all purchases and sales (issues) of goods directly in the In-
ventory account as they occur. The accounting features of a perpetual inventory system
are as follows.
1. Purchases of merchandise for resale or raw materials for production are debited to
Inventory rather than to Purchases.
2. Freight-in is debited to Inventory, not Purchases. Purchase returns and allowances
and purchase discounts are credited to Inventory rather than to separate accounts.
3. Cost of goods sold is recorded at the time of each sale by debiting Cost of Goods
Sold and crediting Inventory.
4. A subsidiary ledger of individual inventory records is maintained as a control measure.
The subsidiary records show the quantity and cost of each type of inventory on hand.
The perpetual inventory system provides a continuous record of the balances in both
the Inventory account and the Cost of Goods Sold account.
Periodic System
Under a periodic inventory system, a company determines the quantity of inventory
on hand only periodically, as the name implies. It records all acquisitions of inventory
during the accounting period by debiting the Purchases account. A company then adds
the total in the Purchases account at the end of the accounting period to the cost of the
inventory on hand at the beginning of the period. This sum determines the total cost of
the goods available for sale during the period.
To compute the cost of goods sold, the company then subtracts the ending inven-
tory from the cost of goods available for sale. Note that under a periodic inventory |
system, the cost of goods sold is a residual amount that depends on a physical count of
ending inventory. This process is referred to as “taking a physical inventory.” Compa-
nies that use the periodic system take a physical inventory at least once a year.
Comparing Perpetual and Periodic Systems
To illustrate the difference between a perpetual and a periodic system, assume that Fesmire
Company had the following transactions during the current year.
Beginning inventory 100 units at $6 5 $ 600
Purchases 900 units at $6 5 $5,400
Sales 600 units at $12 5 $7,200
Ending inventory 400 units at $6 5 $2,400
Fesmire records these transactions during the current year as shown in Illustration 8-4.
When a company uses a perpetual inventory system and a difference exists between
the perpetual inventory balance and the physical inventory count, it needs a separate
entry to adjust the perpetual inventory account. To illustrate, assume that at the end of
the reporting period, the perpetual inventory account reported an inventory balance of
$4,000. However, a physical count indicates inventory of $3,800 is actually on hand. The
entry to record the necessary write-down is as follows.
Inventory Over and Short 200
Inventory 200
Perpetual inventory overages and shortages generally represent a misstatement of
cost of goods sold. The difference results from normal and expected shrinkage, breakage,
Inventory Issues 419
ILLUSTRATION 8-4
Perpetual Inventory System Periodic Inventory System
Comparative Entries—
Perpetual vs. Periodic
Beginning inventory, 100 units at $6
The Inventory account shows the inventory The Inventory account shows the inventory
on hand at $600. on hand at $600.
Purchase 900 units at $6
Inventory 5,400 Purchases 5,400
Accounts Payable 5,400 Accounts Payable 5,400
Sale of 600 units at $12
Accounts Receivable 7,200 Accounts Receivable 7,200
Sales Revenue 7,200 Sales Revenue 7,200
Cost of Goods Sold 3,600 (No entry)
(600 at $6)
Inventory 3,600
End-of-period entries for inventory accounts, 400 units at $6
No entry necessary. Inventory (ending, by count) 2,400
The Inventory account shows the ending Cost of Goods Sold 3,600
balance of $2,400 ($600 1 $5,400 2 $3,600). Purchases 5,400
Inventory (beginning) 600
shoplifting, incorrect recordkeeping, and the like. Inventory Over and Short therefore
adjusts Cost of Goods Sold. In practice, companies sometimes report Inventory Over
and Short in the “Other revenues and gains” or “Other expenses and losses” section of
the income statement.
Note that a company using the periodic inventory system does not report the
account Inventory Over and Short. The reason: The periodic method does not have
accounting records against which to compare the physical count. As a result, a company
buries inventory overages and shortages in cost of goods sold.
Inventory Control
For various reasons, management is vitally interested in inventory planning and con-
trol. Whether a company manufactures or merchandises goods, it needs an accurate
accounting system with up-to-date records. It may lose sales and customers if it does not
stock products in the desired style, quality, and quantity. Further, companies must mon-
itor inventory levels carefully to limit the financing costs of carrying large amounts of
inventory.
In a perfect world, companies would like a continuous record of both their inven-
tory levels and their cost of goods sold. The popularity and affordability of accounting
software makes the perpetual system cost-effective for many kinds of businesses. Com-
panies like Target, Best Buy, and Sears Holdings now incorporate the recording of sales
with optical scanners at the cash register into perpetual inventory systems.
However, many companies cannot afford a complete perpetual system. But, most
of these companies need current information regarding their inventory levels, to pro-
tect against stock-outs or overpurchasing, and to aid in preparation of monthly or
quarterly financial data. As a result, these companies use a modified perpetual inven-
tory system. This system provides detailed inventory records of increases and decreases |
in quantities only—not dollar amounts. It is merely a memorandum device outside the
double-entry system, which helps in determining the level of inventory at any point
in time.
420 Chapter 8 Valuation of Inventories: A Cost-Basis Approach
Whether a company maintains a complete perpetual inventory in quantities and
dollars or a modified perpetual inventory system, it probably takes a physical inventory
once a year. No matter what type of inventory records companies use, they all face the
danger of loss and error. Waste, breakage, theft, improper entry, failure to prepare or
record requisitions, and other similar possibilities may cause the inventory records to
differ from the actual inventory on hand. Thus, all companies need periodic verification
of the inventory records by actual count, weight, or measurement, with the counts com-
pared with the detailed inventory records. As indicated earlier, a company corrects the
records to agree with the quantities actually on hand.
Insofar as possible, companies should take the physical inventory near the end of
their fiscal year, to properly report inventory quantities in their annual accounting
reports. Because this is not always possible, however, physical inventories taken within
two or three months of the year’s end are satisfactory if a company maintains detailed
inventory records with a fair degree of accuracy.1
What do the numbers mean? STAYING LEAN
Wal-Mart Stores, Inc. uses its buying power in the supply that when placed over the bar code corresponding to a
chain to purchase an increasing proportion of its goods di- particular item, will tell them how many of the items the
rectly from manufacturers and on a combined basis across store sold yesterday, last week, and over the same period last
geographic borders. Wal-Mart estimates that it saves 5–15% year. It will tell them how many of those items are in stock,
across its supply chain by implementing direct purchasing how many are on the way, and how many the neighboring
on a combined basis for the 15 countries in which it operates. Walmart stores are carrying (in case one store runs out).
Thus, Wal-Mart has a good handle on what products it needs Wal-Mart’s inventory management practices have helped it
to stock, and it gets the best prices when it purchases. become one of the top-ranked companies on the Fortune 500
Wal-Mart also provides a classic example of the use of in terms of sales.
tight inventory controls. Department managers use a scanner
Source: J. Birchall, “Walmart Aims to Cut Supply Chain Cost,” Financial Times (January 4, 2010).
Basic Issues in Inventory Valuation
Goods sold (or used) during an accounting period seldom correspond exactly to the
goods bought (or produced) during that period. As a result, inventories either increase
or decrease during the period. Companies must then allocate the cost of all the goods
available for sale (or use) between the goods that were sold or used and those that are
still on hand. The cost of goods available for sale or use is the sum of (1) the cost of the
goods on hand at the beginning of the period, and (2) the cost of the goods acquired or
produced during the period. The cost of goods sold is the difference between (1) the cost
of goods available for sale during the period, and (2) the cost of goods on hand at the
end of the period. Illustration 8-5 shows these calculations.
ILLUSTRATION 8-5
Beginning inventory, Jan. 1 $100,000
Computation of Cost of
Cost of goods acquired or produced during the year 800,000
Goods Sold
Total cost of goods available for sale 900,000
Ending inventory, Dec. 31 (200,000)
Cost of goods sold during the year $700,000
1Some companies have developed methods of determining inventories, including statistical
sampling, that are sufficiently reliable to make unnecessary an annual physical count of each
item of inventory.
Physical Goods Included in Inventory 421
Valuing inventories can be complex. It requires determining the following. International
Perspective
1. The physical goods to include in inventory (who owns the goods?—goods |