Problem 23 - Accounting

Question

Journalize the following transactions of Funhouse Productions: July 8. Received a \(\$ 120,000,90\)-day, \(8 \%\) note dated July 8 from Mystic Mermaid Company on account. Oct. 6. The note is dishonored by Mystic Mermaid Company. Nov. 5. Received the amount due on the dishonored note plus interest for 30 days at \(10 \%\) on the total amount charged to Mystic Mermaid Company on October \(6 .\)

Step-by-Step Solution

Answer

Accounts were settled on Nov 5 with $123,420 received, including interest.

Step 1: Journalize the Receipt of the Note

On July 8, Funhouse Productions receives a 90-day, 8% note from Mystic Mermaid Company for $120,000. The entry to record this transaction is a debit to Notes Receivable and a credit to Accounts Receivable. This reflects that a note has been received on account, replacing the existing account receivable. **Journal Entry:** - Debit: Notes Receivable - $120,000 - Credit: Accounts Receivable - $120,000

Step 2: Journalize the Dishonoring of the Note

On October 6, the note is dishonored, meaning that Mystic Mermaid Company fails to pay the note on its due date. For accounting purposes, Funhouse Productions calculates interest up to the maturity date and moves the full amount including accrued interest to Accounts Receivable. First, calculate the interest due: Interest = Principal x Rate x Time = $120,000 x 8% x (90/360) = $2,400. **Journal Entry:** - Debit: Accounts Receivable - $122,400 ($120,000 principal + $2,400 interest) - Credit: Notes Receivable - $120,000 - Credit: Interest Revenue - $2,400

Step 3: Journalize Receiving the Amount Due Plus Additional Interest

On November 5, Mystic Mermaid Company pays the amount due from the dishonored note plus additional interest for 30 days at 10%. First, calculate the additional interest: Interest = Amount Due x Rate x Time = $122,400 x 10% x (30/360) = $1,020. The total received will be the principal plus accrued interest from October 6. **Journal Entry:** - Debit: Cash - $123,420 ($122,400 principal + $1,020 interest) - Credit: Accounts Receivable - $122,400 - Credit: Interest Revenue - $1,020

Key Concepts

Notes Receivable

In accounting, notes receivable is an asset account that represents a written promise for amounts to be received. It is like a contract between a borrower and a lender. The note specifies the amount to be paid in the future and may also include interest to be paid.

When Funhouse Productions received a note from Mystic Mermaid Company, it shifted the amount from "Accounts Receivable" to "Notes Receivable." This reflects that instead of merely owing money from a sale, there is now a formal agreement to pay. This record is essential for keeping track of debts owed and ensuring that financial statements are accurate.

• The principal amount is the original sum of money lent or invested. In this case, $120,000.
• Notes Receivable are often used when settling an account receivable, as it formalizes the debt and often includes an interest agreement.

Interest Calculation

Interest calculation is crucial when dealing with notes as it measures the cost of using borrowed money. The formula for calculating interest is:

\[\text{Interest} = \text{Principal} \times \text{Rate} \times \text{Time}\]
When Mystic Mermaid Company's note was dishonored, Funhouse Productions calculated the interest that had accrued during the note's period. For the 90-day period with an 8% interest rate, they calculated as follows:

- The time the note was held was converted into a fraction of a year: \(\frac{90}{360}\).- Therefore, the interest on \(120,000 with an 8% annual rate was \)2,400.

• Understanding the time factor, the 360-day year is commonly used in financial calculations to simplify interest calculations.
• Interest serves as compensation for lending the money and is a crucial income stream for the lender.

Accounts Receivable

Accounts Receivable (AR) is an asset account that represents money owed to a company by its customers for goods or services already delivered. This account is crucial because it reflects the income that the business can expect to receive shortly.

In this exercise, when the note is dishonored, Funhouse Productions moves the full amount back to Accounts Receivable. This indicates that the payment expected from the note is unpaid.

• AR is often monitored closely as it directly impacts a company's cash flow.
• Delays or dishonored payments can affect financial planning and operations due to the deferred inflow of cash.

Dishonored Note

A dishonored note occurs when the borrower fails to pay the note by its due date. It is not something a lender likes to see because it means payment was not received as the agreement stipulated.

For Funhouse Productions, the note from Mystic Mermaid Company was dishonored on October 6. At this point, the company calculates any interest up until this date and moves the debt back into Accounts Receivable.

• A dishonored note can signify cash flow issues for the borrower or potential credit risk.
• It's important for the lender to have a system for tracking dishonored notes to protect financial interests.

Interest Revenue

Interest revenue is the income earned by a company from lending its money or allowing its funds to be used by others. Money earned from interest is recorded as revenue and is an important source of income for lenders.

After the dishonored note, Funhouse Productions additionally earns interest revenue by charging Mystic Mermaid Company for the extended period without payment. This ensures they are compensated for the time value of their money.

• Interest revenue reflects the earning capacity of a lender’s funds and should be managed to ensure profitability.
• Keeping track of interest revenue helps in understanding the returns generated from financing activities.