Accounting for Receivables Chapter Seven McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill...

Accounting

for

Receivables

Chapter Seven

McGraw-Hill/IrwinMcGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

2

Accounts and Notes ReceivableAccounts and Notes Receivable

• A/R are the expected future cash receipts of a company. They are typically small and are expected to be received within 30 days.

• N/R are used when longer credit terms are necessary. The promissory note specifies the maturity date, the rate of interest, and other credit terms.

3

Value of ReceivablesValue of Receivables

• Receivables are reported at their face value less an allowance for accounts which are likely to be uncollectible.

• The amount which is actually expected to be collected is called the net realizable value (NRV).

4

Allowance Method vs. Direct Write-Off Method

Allowance Method vs. Direct Write-Off Method

• GAAP requires that A/R be reported at NRV. (A/R minus Allowance)

• This is done using a valuation allowance: An ALLOWANCE METHOD. – % of Sales (or “Income Statement”) approach.– Aging (or “Balance Sheet”) approach.

• With the ALLOWANCE METHOD, an estimate of the amount that will NOT be collected is recorded in the same period that the sales revenue is recorded. Thus, the MATCHING PRINCIPLE is being followed.

5

Allowance Method vs. Direct Write-Off Method (continued)Allowance Method vs. Direct Write-Off Method (continued)

• The DIRECT WRITE-OFF method violates GAAP because it does NOT follow the MATCHING principle.

• With the Direct Write-off method, no estimate of bad debts is recorded at the time of the sale. Rather, only after a specific account is deemed “uncollectible” is a Bad Debt Expense recorded.

• Since GAAP is only required if the amounts are MATERIAL (significant), if the amount of uncollectible A/R is immaterial the Direct Write-off method may be used.

6

Transaction Analysis: Transaction Analysis:

• Assume the following selected events occurred at Cell-It. For each event:– Determine how the accounting equation

was affected and fill in the horizontal model. (Assume GAAP must be followed.)

– Determine the effect on the financial statements.

– Record the event in t-accounts.

10

1. Provided services to customers for

$10,000 on account.

1. Provided services to customers for

$10,000 on account.

Assets = Liab.+ Stk. Equity

Cash+ A/Rec .- Allow. = A/P + C.Stk.+ R.E. Rev. - Exp. = N. I. OA,IA,FA

1 10000 10000 10000 10000 n.a.

2

3

4

5A

5B Bal.

Balance Sheet Inc. Statement Cashflow

11

2. Collected $7,000 from account receivable.

2. Collected $7,000 from account receivable.



1 10000 10000 10000 10000 n.a.

2 7000 (7000) 7000 OA

3

4

5A

5B Bal.


12

3. At year-end it was estimated that $200 of the current accounts receivable balance will not be

collected.

3. At year-end it was estimated that $200 of the current accounts receivable balance will not be

collected.



1 10000 10000 10000 10000 n.a.

2 7000 (7000) 7000 OA

3

4

5A

5B Bal.


200 (200) 200 (200) n.a.

13

3. At year-end it was estimated that 2% of the year’s credit sales will not be

collected.

3. At year-end it was estimated that 2% of the year’s credit sales will not be

collected.



1 10000 10000 10000 10000 n.a.

2 7000 (7000) 7000 OA

3

4

5A

5B Bal.


200 (200) 200 (200) n.a.

Allowance for Doubtful Accounts is a CONTRA- ASSET account. This account balance is INCREASING by $200 causing TOTAL assets to decrease.

14

4. Jane Doe’s $50 account was written-off

as uncollectible.

4. Jane Doe’s $50 account was written-off

as uncollectible.



1 10000 10000 10000 10000 n.a.

2 7000 (7000) 7000 OA

3

4

5A

5B Bal.


200 (200) 200 (200) n.a.

(50) (50) NO EXPENSE!

Note: This is NOT the Direct Write-off method. Rather, it is a write-off under the ALLOWANCE Method.

15

Effect of Transaction 4 on Acct. Rec. Net Realizable

Value


Value

Before Event 4 After Event 4

A/R $3,000

Allow. (200)

N.R.V.$2,800

Acme Collection Agency

The check is in the mail.

16


Value


Value


A/R $3,000 A/R $

Allow. (200) Allow.

N.R.V.$2,800 N.R.V. $

2,950

(150)

2,800

17


Value


Value


A/R $3,000 A/R $2,950

Allow. (200) Allow. (150)

N.R.V.$2,800 N.R.V. $2,800

When using an ALLOWANCE method, the Net Realizable Value of accounts receivable does not change as a result of the write-off.

18

Before recording Transaction #5: What happens when an account that has been

written off later pays off his/her account?

Before recording Transaction #5: What happens when an account that has been

written off later pays off his/her account?

Reinstate the account by recording an entry that undoes (reverses) the write-off:– increase (debit) Accounts Receivable– increase (credit) Allowance for

Doubtful Accounts (a contra-asset) Record the entry to show the cash

collection and A/Rec. reduction:– increase (debit) Cash– decrease (credit) Accounts

Receivable

19

5. $50 cash was unexpectedly received from Jane Doe. (5A=Reinstate,

5B=Collect)


5B=Collect)



1 10000 10000 10000 10000 n.a.

2 7000 (7000) 7000 OA

3

4

5A

5B Bal.


200 (200) 200 (200) n.a.


50 50

20


5B=Collect)


5B=Collect)



1 10000 10000 10000 10000 n.a.

2 7000 (7000) 7000 OA

3

4

5A

5B Bal.


200 (200) 200 (200) n.a.


50 50

50 (50) 50 OA

21

Calculate all ending balances.Calculate all ending balances.



1 10000 10000 10000 10000 n.a.

2 7000 (7000) 7000 OA

3

4

5A

5B Bal.


200 (200) 200 (200) n.a.


50 50

50 (50) 50 OA

7050 2950 200 9800 10000 200 9800 7050 bal.

22

What’s the result?After completing the horizontal model fill in

below.


below.

How did the previous transactions affect the financial statements?

20X1 How much Bad Debt Expense should appear on the income statement?….

What is the A/R: NRV at year end?……

How much A/R should be added to the other current assets on the year-end balance sheet?………………………….

23

Final Account BalancesRemember, the Bad Debt EXPENSE is accrued in the year of sale, NOT when the account is written off!

Final Account BalancesRemember, the Bad Debt EXPENSE is accrued in the year of sale, NOT when the account is written off!



1 10000 10000 10000 10000 n.a.

2 7000 (7000) 7000 OA

3

4

5A

5B Bal.


200 (200) 200 (200) n.a.


50 50

50 (50) 50 OA

7050 2950 200 9800 10000 200 9800 7050 bal.

MATCHING PRINCIPLE

24


below.


below.





$ 200

25

Final Account BalancesNet Realizable Value (NRV) = Acct.Rec. - Allowance

Final Account BalancesNet Realizable Value (NRV) = Acct.Rec. - Allowance



1 10000 10000 10000 10000 n.a.

2 7000 (7000) 7000 OA

3

4

5A

5B Bal.


200 (200) 200 (200) n.a.


50 50

50 (50) 50 OA

7050 2950 200 9800 10000 200 9800 7050 bal.

26


below.


below.





$ 200 $ 2,750

$ 2,750

27

Transaction Posted to T-accounts

1. Provided services to customers for $10,000 which will be collected at a later date.

Cash Acct. Rec. Allow. for D.A.

Service Revenue Bad Debt Exp. Retain. Earn.

28


1. Provided services to customers for $10,000 which will be collected at a later date.



(1) 10,000

10,000 (1)

29


2. Collected $7,000 of the Accounts Receivables.



(1) 10,000

10,000 (1)

30


2. Collected $7,000 of the Accounts Receivables.



(2) 7,000 (1) 10,000

7,000 (2)

10,000 (1)

31


3. At Yr. end it was estimated that 2% of the year’s credit sales will never be collected.



(2) 7,000 (1) 10,000

7,000 (2)

10,000 (1)

32


3. At Yr. end it was estimated that 2% of the year’s credit sales will never be collected.



(2) 7,000 (1) 10,000

7,000 (2)

200 (3)

10,000 (1)

(3) 200

33


4. Jane Doe’s $50 account was written-off as uncollectible.



(2) 7,000 (1) 10,000

7,000 (2)

200 (3)

10,000 (1)

(3) 200

34


4. Jane Doe’s $50 account was written-off as uncollectible.



(2) 7,000 (1) 10,000

7,000 (2) 50 (4)

(4) 50 200 (3)

10,000 (1)

(3) 200

35


5a. Jane Doe’s account is reinstated.



(2) 7,000 (1) 10,000

7,000 (2) 50 (4)

(4) 50 200 (3)

10,000 (1)

(3) 200

36


5a. Jane Doe’s account is reinstated.



(2) 7,000 (1) 10,000

5a 50

7,000 (2) 50 (4)

(4) 50 200 (3)

50 (5a)

10,000 (1)

(3) 200

37


5b. Jane Doe’s account is collected.



(2) 7,000 (1) 10,000

5a 50

7,000 (2) 50 (4)

(4) 50 200 (3)

50 (5a)

10,000 (1)

(3) 200

38


5b. Jane Doe’s account is collected.



(2) 7,000

5b 50

(1) 10,000

5a 50

7,000 (2) 50 (4) 50 (5b)

(4) 50 200 (3)

50 (5a)

10,000 (1)

(3) 200

39


Closing entries at the end of Year 1.



(2) 7,000

5b 50

(1) 10,000

5a 50

7,000 (2) 50 (4) 50 (5b)

(4) 50 200 (3)

50 (5a)

10,000 (1)

(3) 200

40


Closing entries at the end of Year 1.



(2) 7,000

5b 50

(1) 10,000

5a 50

7,000 (2) 50 (4) 50 (5b)

(4) 50 200 (3)

50 (5a)

10,000 (1) (c) 10,000

(3) 200 200 (c)

(c) 200 10,000 (c)

41


Balances of all accounts after Year 1 closings.



(2) 7,000

5b 50

bal. 7,050

(1) 10,000

5a 50 bal 2,950

7,000 (2) 50 (4) 50 (5b)

(4) 50 200 (3)

50 (5a) 200 bal.

10,000 (1) (c) 10,000 0 bal

(3) 200 200 (c) bal. 0

(c) 200 10,000 (c) 9,800 bal.

42

Summary: Accounting for Bad Debts


• Allowance method– GAAP– Required if company has a

significant amount of bad debts.

– Matches bad debt expense (on the income statement) with the sale.

– Requires an adjusting journal entry before closing the books.

43



• Direct Write-off method– Violates GAAP (Matching)– No estimates of bad debts are made,

so no allowance account is used.– Used by small businesses with few

account receivables or large business with few collection problems.

– No entry until time specific account is deemed “bad” (uncollectible).

44

Direct Write-off Method for Accounting for Bad Debts

Direct Write-off Method for Accounting for Bad Debts

• Direct Write-off method

Entry to write off J. Jones’ $100 account:

Bad Debt Expense 100

Acct. Rec.-Jones 100

Cash+Acct.Rec. = A/P +C. Stk.+Ret.E. Rev.- Exp. = N.I. Cashflow

(100) (100) +100 (100) n.a.

7-45

Notes Receivable

Event 1 Loan of Money

On November 1, 2013, ATS loans $15,000 cash to Stanford Cummings. Cummings issues ATS a note promising to repay the loan, with interest, in one year. Event No. Assets = Liab. + Equity Rev. – Exp. = Net Inc. Cash Flow

1 Cash + Notes Rec.(15,000) 15,000 = NA + NA NA – NA = NA (15,000) IA

BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW ASSETS = LIABILITIES + EQUITY STATEMENT

Accts Int. Accts Int. Note Com. Ret. Net OA,IA,FA

Cash + CD + Receiv. + Rec. + Land = Pay. + Pay. + Pay. + Stk. + Earn. Rev. - Exp. = Inc. $ amt

BB 1,650 1,500 1,000 2,000 150 1,650 bal.

1 2,000 2,000 2,000 2,000

2 1,200 (1,200) 1,200 (1,200)

3 1,500 (1,500) 1,500 OA

4 (1,000) (1,000) (1,000) OA

5 (500) 500 (500) IA

6

7

8

EB + + + + = + + + + - = bal.

Let’s review how to calculate interest. The basic formula is:

Principal X Rate X Time

$ borrowed or investedANNUAL rate

Time since interest was last recorded.

On Nov. 1, 2013 ATS loans $15,000 cash to Cummings at 6% for 1 year.

How much interest should be accrued on December 31, 2013? Principal X Rate X Time = Interest

$15,000 X .06 X 2/12 = $150.00rate for 12 mo. November through December

Calculating and recording interest earned on the Note…

7-47

Interest Revenue

Event 2 Recognition of Interest Revenue

At the end of 2011, ATS must accrue interest on its note receivable.

$15,000 × 6% × 2/12 = $150 interest revenue$15,000 × 6% × 2/12 = $150 interest revenue

Event No. Assets = Liab. + Equity Rev. – Exp. = Net Inc. Cash Flow

2 150 = NA + 150 150 – NA = 150 NA

Interest Receivable

7-48

Collection of a Note ReceivableEvent 3 Collection of Principal and Interest

On November 1, 2012, ATS collects the principal and interest due on the note receivable. ATS first recognizes interest revenue for the 10 months of 2012.

$15,000 × 6% × 10/12 = $750 interest revenue$15,000 × 6% × 10/12 = $750 interest revenue


3a 750 = NA + 750 750 – NA = 750 NA

Interest Receivable

7-49

Collection of a Note ReceivableEvent 3 Collection of Principal and Interest

Now that the entire $900 of interest receivable has been accrued, ATS records the collection of $15,900 in principal and interest on the note.


3b NA = NA + NA NA – NA = NA 15,000 IA900 OA

Account Title Debit CreditCash 15,900 Notes receivable 15,000 Interest receivable 900

Asset Exchange Transaction

50

Credit Card Sales

Rather than maintaining a credit granting department, many companies find it cost

beneficial to accept credit cards. The credit card company deducts a fee, usually between

2% and 8%, from the gross amount of the sales, and pays the merchant the net balance

(gross sales less credit card fee).

51

Credit Card Sales


1 9,800 = NA + 9,800 10,000 – 200 = 9,800 NA

Event 1 Recording a Credit Card Sale

Matrix, Inc. accepts a credit card in payment for servicesof $10,000. The credit card company charges a fee of 2%

of the gross sale.

Account Title Debit CreditAccounts Receivable 9,800 Credit Card Expense 200 Service Revenue 10,000

52

Credit Card Sales


2 Cash + Acct. Rec.9,800 (9,800) = NA + NA NA – NA = NA 9,800 OA

Event 2 Collection of a Credit Card Receivable

Matrix, Inc. collects the full amount due from thecredit card company.

Account Title Debit CreditCash 9,800 Accounts Receivable 9,800

53

Financial Statement Analysis• Accounts Receivable Turnover

Sales = $ Accounts Receivable*

Accts/Rec. Turnover

This ratio is a measure of how quickly receivables are collected.

Often the AVERAGE Accts. Rec. is used as the denominator.

Ave. A/R = Beginning Accts/Rec. + Ending Accts/Rec. 2

54

Accounts Receivable Ratios

Accts. Rec. Turnover: (A measure of how fast receivables are collected. Higher is better.)

Sales $50,000 Accounts. Receiv. $ 5,000

= = 10.0 times

Average Days to collect A/R: (How many days go by between a credit sale and the time it is collected?) 365 365Accts. Rec. Turnover 10.0= = 36.5 days

Generally, lower means better.

55

Length of Operating Cycle

Ave. days to sell inventory 60.8 days

+ Ave. days to collect receivables 36.5 days

Length of Operating Cycle 97.3 days

Remember from Chapter 6 that a company’s operating cycle is the time it takes to convert inventory to cash by selling it plus the time it takes to convert accounts receivable back into cash.

So, the Operating Cycle is:

56

Chapter 7

The End

57

Notes Payable: Transaction Analysis - Appendix

Notes Payable: Transaction Analysis - Appendix

Assume the following selected events occurred at Cell-It. For each event: Determine how the financial statements

are affected and fill in the horizontal statements model.

Record the event in the Journal and Post to the Ledger.

58

Notes Payable: Transaction Analysis

Notes Payable: Transaction Analysis

Assume the following events occurred at Cell-It.

1. On Oct. 1, 2004 Cell-It borrowed $8,000 cash by issuing a note payable with a one-year term and an 8% stated interest rate. All interest will be paid at maturity. This is an “interest bearing” note.

2. On Oct. 1, 2004 Cell-It issued an $8,000 face value, discounted note payable with a one-year term and an 8% stated discount rate. This is called a “Discounted” or “Non-interest bearing” note.

3. On Dec. 31, 2004 recorded interest related to the 8% interest-bearing note issued on Oct. 1st (see #1).

4. On Dec. 31, 2004 recorded interest related to the 8% discounted (non-interest bearing) note issued on Oct. 1st (see #2).

5. On Sept. 30, 2005 repaid the 8% non-discounted note payable (#1), plus all interest.

6. On Sept. 30, 2005 repaid the 8% discounted note payable (#2).

59

Horizontal Model Transaction Analysis Horizontal Model Transaction Analysis

Assets = Liabilities + Equity Inc. State. Cashflow

Cash = I/P + N/P(1) + N/P(2) - Disc.+C.Stk+R.E. Rev.- Exp.= N. I. OA,IA,FA

1

Balance Sheet

60

T1: On Oct. 1, 2004 Cell-it borrowed $8,000 at 8% for 1 year on an interest bearing note. All interest to be paid at maturity.

T1: On Oct. 1, 2004 Cell-it borrowed $8,000 at 8% for 1 year on an interest bearing note. All interest to be paid at maturity.



1

Balance Sheet

8000 8000 8000 FA

61

T2: On Oct. 1, 2004 Cell-it issued an $8,000 face value, one year note payable discounted at

8%. (A noninterest bearing note.)





1

Balance Sheet

8000 8000 8000 FA2 7360 8000 640 7360 FA

The interest is INCLUDED in the Note Payable. The interest must be subtracted to calculate the amount of cash the borrower receives on the issue date.

Note Payable (Face Value) $8000Interest ($8000 x .08 x 12/12) (640) Cash to borrower $7360 (Carrying value)

62







1

Balance Sheet

8000 8000 8000 FA2 7360 8000 640 7360 FA

The interest is INCLUDED in the Note Payable. The interest must be subtracted to calculate the amount of cash the borrower receives on the issue date.

Note Payable (Face Value) $8000Interest ($8000 x .08 x 12/12) (640) Cash to borrower $7360 (Carrying value)

Since no time has past, the $640 is NOT an EXPENSE yet.

63







1

Balance Sheet

8000 8000 8000 FA2 7360 8000 640 7360 FA

Discount on Note Payable is a contra liability account.Its balance is SUBTRACTED from the Note Payable account to obtain the total liability for the Note.

Note Payable 8000Less: Discount on N/P (640) Total Note Liability 7360

64

T3: On Dec. 31, 2004 recorded interest related to the note in #1.

Oct. 1-Dec. 31 = 3 mo. (8000 x .08 x 3/12=160)

T3: On Dec. 31, 2004 recorded interest related to the note in #1.

Oct. 1-Dec. 31 = 3 mo. (8000 x .08 x 3/12=160)



1

Balance Sheet

8000 8000 8000 FA2 7360 8000 640 7360 FA

3 160 (160) 160 (160) n.a.

65

T4: On Dec. 31, 2004 recorded interest related to the discounted (noninterest bearing) note in #2.T4: On Dec. 31, 2004 recorded interest related to the discounted (noninterest bearing) note in #2.



1

Balance Sheet

8000 8000 8000 FA2 7360 8000 640 7360 FA

3 160 (160) 160 (160) n.a.

4 (160) (160) 160 (160) n.a.

66

T4: On Dec. 31, 2004 recorded interest related to the discounted (noninterest bearing) note in #2.T4: On Dec. 31, 2004 recorded interest related to the discounted (noninterest bearing) note in #2.



1

Balance Sheet

8000 8000 8000 FA2 7360 8000 640 7360 FA

3 160 (160) 160 (160) n.a.

4 (160) (160) 160 (160) n.a.

Discount on Note Payable is a contra liability account.Its balance is SUBTRACTED from the Note Payable account to calculate the current liability for the Note.

Note Payable 8000Less: Discount on N/P (480) (640 – 160)

Current Note Liability 7520

67

T5: On Sept. 30, 2005 repaid the 8% note from Transaction #1 and all its interest.

a= accrue the remaining interest. b= payment. (Jan. 1-Sept. 30 = 9 mo. (8000 x .08 x 9/12= $480)

T5: On Sept. 30, 2005 repaid the 8% note from Transaction #1 and all its interest.

a= accrue the remaining interest. b= payment. (Jan. 1-Sept. 30 = 9 mo. (8000 x .08 x 9/12= $480)



1

Balance Sheet

8000 8000 8000 FA2 7360 8000 640 7360 FA

3 160 (160) 160 (160) n.a.

4 (160) (160) 160 (160) n.a.5a 480 (480) 480 (480) n.ab (8640) (640) (8000) (8000) FA

(640) OA

68

T6: On Sept. 30, 2005 repaid the 8% discounted note payable from Trans. #2. a=

accrue the remaining interest. b= payment.

T6: On Sept. 30, 2005 repaid the 8% discounted note payable from Trans. #2. a=

accrue the remaining interest. b= payment.



1

Balance Sheet

8000 8000 8000 FA2 7360 8000 640 7360 FA

3 160 (160) 160 (160) n.a.

4 (160) (160) 160 (160) n.a.5a 480 (480) 480 (480) n.ab (8640) (640) (8000) (8000) FA

(640) OA 6a (480) (480) 480 (480) n.a.

b (8000) (8000) (7360) FA

(640) OA

69

Comparison of Journal Entries for Interest Bearing and Discounted Notes

Comparison of Journal Entries for Interest Bearing and Discounted Notes

NOTE PAYABLE (Interest bearing) DISCOUNTED NOTE PAYABLEDate Accounts Debit Credit Date Accounts Debit Credit2004 2004

Oct. 1 Cash 8000 Oct. 1 Cash 7360 Note Payable 8000 Discount on Note Payable 640Borrowed $8000 at 8% for one year Note Payable 8000

Borrowed $8000 discounted at 8% for one year

Dec. 31 Interest Expense 160 Dec. 31 Interest Expense 160 Interest Payable 160 Discount on Note Payable 160Accrued 3 mo. interest (8000x.08x3/12) Amortized 3 mo. interest from Discount to Int. Exp.

2005 2005Sept. 30 Interest Expense 480 Sept. 30 Interest Expense 480

Interest Payable 480 Discount on Note Payable 480Accrued 9 mo. interest (8000x.08x9/12) Amortized 9 mo. interest from Discount to Int. Exp.

Sept. 30 Interest Payable 640 Sept. 30 Note Payable 8000Note Payable 8000 Cash 8000 Cash 8640 Paid note (which already includes iall nterest)

Paid note and all interest

Contra-liabilities are increased by debiting.

70

Comparison of Ledger Accounts for Interest Bearing and Discounted Notes

Comparison of Ledger Accounts for Interest Bearing and Discounted Notes

INTEREST BEARING NOTE PAYABLE2004 Exp.

Cash Note Payable Interest ExpenseBeg. Bal. X 10/01/04 8000 12/31/04 16010/01/04 8000 9/30/05 8000 09/30/05 480

8640 9/30/05 02005 Exp.

Interest Payable 160 12/31/04

480 09/30/05

9/30/05 640 0

NON-INTEREST BEARING (DISCOUNTED) NOTE PAYABLE2004 Exp.

Cash Note Payable Interest ExpenseBeg. Bal. X 10/01/04 8000 12/31/04 16010/01/04 7360 9/30/05 8000 09/30/05 480

8000 9/30/05 02005 Exp.

Discount on Note Pay. 160 12/31/04

480 09/30/05

9/30/05 640 0

71


Effect on Financial Statements

Inc. State. State. of Ch. in Eq CashFlow

1. No effect No effect +8,000 FA


3. +Int. Exp, so - N.I. Decr. R/E, so Dec. Eq, n.a.

4. +Int. Exp, so - N.I. Decr. R/E, so Dec. Eq. n.a.

5. +Int. Exp, so - N.I. Decr. R/E, so Dec. Eq. -8000FA,-640 OA

Which loan was the better deal for Cell-It?

Calculate the EFFECTIVE INTEREST % of each.

Interest bearing note:

Eff. Int. % = $ Annual Interest ÷ Cash Rec’d.

= $640 ÷ $8,000

= 8.0%

Non-Interest bearing note (Discounted note):


= $640 ÷ $7,360

= 8.7%

72


Effect on Financial Statements

Inc. State. State. of Ch. in Eq CashFlow



3. +Int. Exp, so - N.I. Decr. R/E, so Dec. Eq, n.a.

4. +Int. Exp, so - N.I. Decr. R/E, so Dec. Eq. n.a.

5. +Int. Exp, so - N.I. Decr. R/E, so Dec. Eq. -8000FA,-640 OA

Which loan was the better deal for Cell-It?

Calculate the EFFECTIVE INTEREST % of each.

Interest bearing note:


= $640 ÷ $8,000

= 8.0%

Non-Interest bearing note (Discounted note):


= $640 ÷ $7,360

= 8.7%

With note #2 Cell-It only received $7,360 from the lender, but still had to pay $640 interest for the year. That’s why the effective interest rate is higher for Note #2.

Note #1 (Interest bearing) is a “better deal” in this case.

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