Simplified notes on accounting treatment PDF

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Discount Received Discounts may be offered by suppliers on sales of goods to attract buyers. Accounting for discount received depends on the nature of discount. Discounts may be classified into two types: Trade Discounts: offered at the time of purchase for example when goods are purchased in bulk or to retain loyal customers. Cash Discount: offered to customers as an incentive for timely payment of their liabilities in respect of credit purchases.

Trade Discount Trade discounts are generally ignored for accounting purposes in that they are omitted from accounting records. Therefore, purchases, along with any payables in the case of a credit purchase, are recorded net of any trade discounts offered.

Example BMX LTD as part of its purchases promotion campaign has offered to sell their bikes at a 10% discount on their listed price of $100. Purchases and payables in respect of BMX LTD will be recorded net of trade discount, i.e. $90 per bike.

Cash Discount Cash discounts result in the reduction of purchase costs during the period and the amount payable in respect of those purchases. However, not all purchases may qualify for the cash discount. It is therefore necessary to record the initial purchase and accounts payable at the gross amount (after deducting any trade discounts though!) and subsequently decreasing purchases and payables by the amount of discount that is actually received. Following double entry is required to record the cash discount: Debit

Payable

Discount Received (Income Statement)

Credit

Crediting discount received has the effect of reducing gross purchases by the amount of cash discount received. Consequently, payables are debited to reduce their balance to the amount that is expected to be paid to them, i.e. net of cash discount.

Example BMX LTD as part of its purchases promotion campaign has offered to sell their bikes at a 10% discount on their listed price of $100. If customers pay within 10 days from the date of purchase, they get a further $5 cash discount. Bike LTD purchases a bike from BMX LTD and pays within 10 days of the date of purchase. Before we proceed with the accounting entries, it is necessary to first distinguish between the two types of discounts being offered by BMX LTD. The 10% discount is a trade discount and should therefore not appear in Bike LTD's accounting records. The $5 discount is a cash discount and must be dealt with accordingly. The initial purchase of the bike will be recorded as follows: Debit Credit

Purchases (net of trade discount) BMX LTD (Payable) (net of trade discount)

$90 $90

As Bike LTD qualifies for the cash discount, the following double entry will be required to record the discount received: Debit Credit

BMX LTD (Payable) Discount Received (income statement)

$5 $5

The above entries have resulted in purchases of Bike LTD being reduced to $85 (100-90-5). The payable to BMX LTD has also been reduced to this amount effectively.

Purchases Returns

Purchases returns, or returns outwards, are a normal part of business. Goods may be returned to supplier if they carry defects or if they are not according to the specifications of the buyer. There is need to account for purchase returns as though no purchase had occurred in the first place. Hence, the value of goods returned to the supplier must be deducted from purchases. Where purchase was initially made on credit, the payable recognized must also be reversed by the amount of purchases returned. The following double entry must be made upon purchases returns: Payable (decrease in liability) Purchases Returns (decrease in expense)

Debit Credit

Example Bike LTD purchases a mountain bike from BMX LTD for $100 on credit. Bike LTD later returns the bike to BMX LTD due to a serious defect in the design of the bike. The initial purchase will be recorded as follows: Debit Credit

Purchases BMX LTD (Payable)

$100 $100

Upon the return of bike, the following double entry will be passed: Debit Credit

BMX LTD (Payable) Purchases Return

$100 $100

No further entry will be required as the payable due to BMX LTD has been reversed.

Discount Allowed Discounts may be offered on sales of goods to attract buyers. Discounts may be classified into two types:

Trade Discounts: offered at the time of purchase for example when goods are purchased in bulk or to retain loyal customers. Cash Discount: offered to customers as an incentive for timely payment of their liabilities in respect of credit purchases.

Trade Discount Trade discounts are generally ignored for accounting purposes in that they are omitted from accounting records. Therefore, sales, along with any receivables in the case of a credit sale, are recorded net of any trade discounts offered.

Example Bike LTD as part of its sales promotion campaign has offered to sell their bikes at a 10% discount on their listed price of $100. Sale revenue and any accounts receivable will be recorded net of trade discount, i.e. $90 per bike.

Cash Discount Cash discounts result in the reduction of sales revenue earned during the period. However, not all customers may qualify for the cash discount. It is therefore necessary to record the initial sale and receivables at the gross amount (after deducting any trade discounts!) and subsequently decreasing the sale revenue and accounts receivable by the amount of discount that is actually allowed. Following double entry is required to record the cash discount: Debit Credit

Discount Allowed (Income Statement) Receivable

Debiting discount allowed ledger has the effect of reducing gross sales revenue by the amount of cash discount allowed. Consequently, receivables are credited to reduce their balance to the amount that is expected to be recovered from them, i.e. net of cash discount.

Example

Bike LTD as part of its sales promotion campaign has offered to sell their bikes at a 10% discount on their listed price of $100. If customers pay within 10 days from the date of purchase, they get a further $5 cash discount. Bike LTD sells a bike to XYZ who pays within 10 days. Before we proceed with the accounting entries, it is necessary to first distinguish between the two types of discounts being offered by Bike LTD. The 10% discount is a trade discount and should therefore not appear in Bike LTD's accounting records. The $5 discount is a cash discount and must be dealt with accordingly. The initial sale of the bike will be recorded as follows: Debit Credit

XYZ (Receivable) Sales

$90 $90

As XYZ qualifies for the cash discount, the following double entry will be required to record the discount allowed: Debit Credit

Discount Allowed (Income Statement) XYZ (Receivable)

$5 $5

The above entries have resulted in sales of Bike LTD being reduced to $85 (100-90-5). The receivable from XYZ has also been reduced to this amount effectively.

Bad Debts / Irrecoverable Debts An entity may not be able to recover its balances outstanding in respect of certain receivables. In accountancy we refer to such receivables as Irrecoverable Debts or Bad Debts. Bad debts could arise for a number of reasons such as customer going bankrupt, trade dispute or fraud. Every time an entity realizes that it unlikely to recover its debt from a receivable, it must 'write off' the bad debt from its books. This ensures that the entity's assets (i.e. receivables) are not stated above the amount it can reasonably expect to recover which is in line with the concept of prudence. Accounting entry required to write off a bad debt is as follows:

Bad Debt Expense Receivable

Debit Credit

The credit entry reduces the receivable balance to nil as no amount is expected to be recovered from the receivable. The debit entry has the effect of cancelling the impact on profit of the sales that were previously recognized in the income statement.

Example ABC LTD sells goods to DEF LTD for $500 on credit. ABC LTD subsequently finds out that DEF LTD is being liquidated and therefore the prospects of recovering its dues are very low. ABC LTD should write off the receivable from DEF LTD in view of the circumstances. The double entry will be recorded as follows: Debit Credit

Bad Debt Expense DEF LTD (Receivable)

$500 $500

Bad Debt Recovered Occasionally, a bad debt previously written off may subsequently settle its debt in full or in part. In such case, it will be necessary to cancel the effect of bad debt expense previously recognized up to the amount settlement.

Example ABC LTD sells goods to DEF LTD for $500 on credit. ABC LTD subsequently finds out that DEF LTD is being liquidated and therefore the prospects of recovering its dues are very low. ABC LTD therefore writes off the receivable from its books. However, the administrator appointed to oversee the liquidation of DEF LTD instructs the company to pay $300 to ABC LTD in full settlement of its dues. As $300 of the bad debt has been recovered, it is necessary to cancel the effect of previously recognized bad debt expense up to this amount. The accounting entry will therefore be as follows: Debit Credit

Cash/Bank Bad Debt Recovered (Income)

$300 $300

Provision / Allowance for doubtful debts

Recoverability of some receivables may be doubtful although not definitely irrecoverable. Such receivables are known as doubtful debts. Prudence requires that an allowance be created to recognize the potential loss arising from the possibility of incurring bad debts. The allowance for doubtful debts is created by forming a credit balance which is deducted from the total receivables balance in the statement of financial position. This works in the same way as accumulated depreciation is deducted from the fixed asset cost account. The allowance for doubtful debts reduces the receivable balance to the amount that the entity prudently estimates to recover in the future. Allowance for doubtful debts consist of two types:  Specific Allowance  General Allowance

Specific Allowance This is allowance created in respect of specific receivables which are known to be facing serious financial problems or have a trade dispute with the entity. Such balances may be identified by examining an aged receivable analysis which details the time lapsed since the creation of a receivable. Long outstanding balances identified from such analyses could be considered for inclusion in the allowance for doubtful debts. The difference between the treatment of a bad debt and a specific allowance for doubtful debt is that in the latter case, the receivable ledger of the specific debt is not removed in case the debtor actually pays whereas in the case of bad debts, the receivable ledger is reduced to nil. Also, specific allowance may not be created for the entire amount of the doubtful receivable but only a portion of it. For instance, if there is a 50% chance of recovering a doubtful debt in respect of a certain receivable, a specific allowance of only 50% may be required. On the contrary, bad debt is normally recognized in full.

General Allowance Past history of a business may show that a portion of receivable balances is not recovered due to unforeseen circumstances. Therefore, it may be prudent to create a general allowance for doubtful debts in addition to the specific

allowance. The general allowance may be calculated on the basis of past experience concerning recoverability of debts. The practice of creating general provisions is on the decline after revisions in the International Financial Reporting Standards (IFRS). Specifically, IAS 39 prohibits creation of general provisions on the basis of past experience due to the subjectivity involved in creating such an estimate. Instead, reporting entity is required to carry out impairment review to determine the recoverability of the receivables and any associated allowance. Next page contains detail on the accounting of provision for doubtful debts.

Accounting for Doubtful Debts Allowance for doubtful debts is created by forming a credit balance which is netted off against the total receivables appearing in the balance sheet. A corresponding debit entry is recorded to account for the expense of the potential loss. Accounting entry to record the allowance for receivable is as follows: Debit Credit

Allowance for Doubtful Debts (Expense) Allowance for Doubtful Debts (Balance Sheet)

Once an allowance for doubtful debts has been created, only the movement in the allowance will need to be charged to the income statement in future accounting period. So if estimated allowance for doubtful debt is same as last accounting period, no accounting entry will be required in the current period as the total receivables will be reduced by the amount of allowance which has already been created.

Example ABC LTD has trade receivable of worth $50,000 as at 31 December 2010. XYZ LTD, a receivable owing $10,000 to ABC LTD at the year end, has been recently been wound up. Consequently, ABC LTD does not expect to recover the amount due from XYZ LTD. Based on past experience, ABC LTD estimates that 5% of its receivables will default. Allowance for doubtful debts on 31 December 2009 was $1500. ABC LTD must write off the $10,000 receivable from XYZ LTD as bad debt. Accounting entry to record the bad debt will be as follows:

Debit Credit

Bad Debt Expense XYZ LTD (Receivable)

$10,000 $10,000

A general allowance of $2,000 [( 50,000-10,000) x 5%] must be made. As a general allowance of $1500 has already been created, only $500 additional allowance must be charged to the income statement: Debit Credit

Allowance for Doubtful Debts (Expense) Allowance for Doubtful Debts (Balance Sheet)

$500 $500

Note that $10,000 in respect of receivable from XYZ LTD has been excluded from the calculation of the general allowance as it has already been written off in full. Bad Debt Expense $ Credit

Debit XYZ LTD (Receivable)

10,000

Income Statement

10,000

Sales

10,000

Bad Debt Expense

10,000

Debit

2,000

Balance c/d Income Statement

2,000

ccounts Payable

What is accounts payable?

$ 10,000 10,000

Allowance for Doubtful Debts $ Credit

Balance c/d

10,000 10,000

XYZ LTD Receivable $ Credit

Debit

$

$ 1,500 500 2,000

Accounts payable is the balance owed by the entity to its suppliers in respect of purchase of goods and services on credit.

Accounting for Payables Accounts payables balance is affected by the amount of credit purchase, sales tax, discount received, purchase returns and the payments to suppliers. Credit Purchase As credit purchase results in increase in the expense and liabilities of the entity, expense must be debited while accounts payable must be credited. Therefore in case of a credit purchase, the following double entry is recorded: Debit Credit

Purchases (Income Statement) Payable

When the payable is paid his due, the payable balance will be reduced to nil. The following double entry is recorded: Debit Credit

Payable Cash/Bank

Sales Tax on Payables The payable includes the amount of sales tax since it will be paid to the supplier. Purchases are recorded net of sales tax because any input tax paid on the purchases will be recovered from tax authorities and hence, does not form part of the expense. Sales Tax account is debited since this is the amount of sales tax recoverable from the tax authorities. The accounting entry to record credit purchases involving sales tax will therefore be as follows: Debit Debit Credit

Sales Tax (Receivable) (Tax Amount) Purchases (Net Amount) Payable (Gross Amount)

Subsequent payment of dues to the supplier will result in the following double entry:

Debit Credit

Payable (Gross Amount) Cash/Bank (Gross Amount)

Example Bike LTD purchases a mountain bike from BMX LTD for $115 on credit. Sales tax is 15%. As the purchase of $115 includes an element of sales tax, we need to first separate tax from the gross amount. Input tax on the transaction may be calculated as follows: Sales Tax: 115 x 15/115 = $15 Deducting sales tax from the gross purchase, we may now arrive at the tax exclusive purchase value: Tax Exclusive Purchases: 115 - 15 = $100 This is the amount to be recognized as purchases in the income statement. Payable will be recorded for the entire amount of $115 because sales tax on purchases will also be paid to supplier. The accounting entry will therefore be as follows: Debit Debit Credit

Sales Tax (Receivable) Purchases BMX LTD (Payable)

$15 $100 $115

Upon payment of the amount payable to BMX LTD, following double entry will be made: Debit Credit

BMX LTD (Payable) Cash/Bank

$115 $115

The sales tax receivable of $15 will stand till it is recovered from tax authorities.

Accounting for Loan Payable Accounting for loan payables, such as bank loans, involves taking account of receipt of loan, re-payment of loan principal and interest expense.

Receipt of Loan Liability for loan is recognized once the amount is received from the lender. Accounting entries for the receipt of loan are as follows: Debit Credit

Cash at Bank Loan Payable

Loan payables need to be classified under current or non-current liabilities depending on the maturity of loan re-payment. For example, if a loan is to be repaid in 3 years' time, the liability would be recognized under non-current liabilities. After 2 years, the liability will be re-classified under current liabilities, i.e. when the loan is due to be settled within one year. Where loan is to be repaid in several installments, the current and non-current portions of the loan would need to be calculated using the loan repayment schedule (see example).

Interest Expense Interest expense is calculated on the outstanding amount of loan during that period, i.e. the unpaid principal amount outstanding during the period. The outstanding amount of loan could change due to receipt of another loan installment or repayment of loan. Interest calculation needs to account for the changes in outstanding amount of loan during a period (see example). Accounting entry for recording interest accrued is as follows: Debit Credit

Finance Cost Interest Payable

Upon payment of interest, following accounting entry will be recorded: Debit Credit

Interest Payable Cash at Bank

Interest may be fixed for the entire period of loan or it may be variable. Floating interest, also known as variable interest, varies over the duration of the loan usually on the basis of an inter-bank borrowing rate such as LIBOR. Fixed interest rate does not vary over time but is more expensive than a floating interest rate.

Repayment of Loan Repayments reduce the amount of loan payables recognized in financial statements. Following accounting entry is used to account for the repayment of loan: Debit Credit

Loan Payable Cash at Bank

Example ABC PLC received a bank loan of $100,000 on 1 January 20X1. Terms of the loan agreement are as follows:  Loan is re-payable in 2 installments of $50,000 each on 30 June 20X2 and 30 June 20X3.  Interest is payable six-monthly in arrears at 5% plus LIBOR.  For the purpose of calculating interest, 6-month LIBOR at the start of each 6 ...