Financial accounting in an economic context 8e chapter 06

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1 Chapter 6: The Current Asset Classification, Cash and Accounts Receivable Current Asset Classification A current asset is defined as any asset that is intended to be converted into cash within one year or the company’s operating cycle, whichever is longer Figure 6-2 Current Assets / Current Liabilities Limitations of the Current Asset Classification As noted by Leopold A Bernstein, “The current ratio is not fully up to the task [of assessing short-term liquidity] because it is a static or “stock” concept of what resources are available at a given moment to meet the obligations at that moment.” Cash Proper Management of Cash Restrictions placed on a company’s access to its cash are typically imposed by creditors to help ensure future interest and principal payments Compensating balances are sometimes required Record Control over cash Physical Control over cash Accounts Receivable     Accounts receivable arise from selling goods or services to customers on account Recorded at face amount to be collected However, we must also reflect the fact that a portion of A/R may not be collected – Net Realizable Value Reasons for lack of collection: sales discounts (cash discounts) sales returns sales allowances uncollectible A/R (bad debts) Cash Discounts    Offered to encourage early payment Examples • 2/10, net 30 • 2/10, EOM Accounting approaches • Gross Method - records discounts when taken by customers • Net Method - records discounts not taken by customers 10 Estimation of Uncollectibles    Note that we not know in 2008 which A/Rs will not be collected in 2009 Therefore, we must estimate uncollectibles There are two methods: Percentage of sales Percentage of accounts receivable Both methods are used to estimate uncollectibles for the AJE The percentage of sales method is simpler, but the percentage of A/R method is more accurate Under IFRS, the methods used to estimate and account for uncollectible are very similar to those under US GAAP 24 Percentage of Sales Method    Usually based on credit sales, but may use total sales or net sales as basis Calculation: Sales x % = Bad Debt Expense (focus on the debit side of the AJE) Called the Income Statement approach, because: revenues x % = expense 25 Percentage of A/R Method (using Aging Schedule)      Based on ending A/R and ending Allowance account Calculation: Ending A/R x % = Ending Allowance (focus on the credit side of the AJE) Called Balance Sheet approach, because: ending asset x % = ending contra asset Requires the analysis of the Allowance account before preparing the AJE An aging schedule of A/R is the most accurate way to estimate uncollectibles (see Figure 626 11) T-Account Approach for Percentage of A/R Method    Based on the analysis of the Allowance account Calculate the “desired ending balance” based on an aging of A/R Now, given the Beginning, Ending and Writeoff amounts, calculate the amount of the current estimate that must be added to the Allowance account to achieve the “desired ending balance.” 27 Allowance for Doubtful Accts (T-account) Allowance for Doubtful Accts Beginning Balance The allowance established in the prior period carries forward for current period write-offs 28 Allowance for Doubtful Accts (T-account) Allowance for Doubtful Accts Write-off of specific accounts receivable Beginning Balance Accounts Receivable Write-off of specific accounts receivable As specific accounts are determined uncollectible during the year, they are written-off to the allowance account as shown These write-offs may cause the allowance account to have a debit balance before the AJE if the prior year’s expense was underestimated 29 Allowance for Doubtful Accts (T-account) Allowance for Doubtful Accts Beginning Balance Write-off of accounts receivable Ending Balance Accounts Receivable Write-off of accounts receivable The “desired ending balance” in the allowance account is estimated using the percentage calculation or the aging schedule 30 Allowance for Doubtful Accts (T-account) Allowance for Doubtful Accts Beginning Balance Write-off of accounts receivable Recovery of write-offs Ending Balance Accounts Receivable Recovery of write-offs Write-off of accounts receivable The recovery of an account receivable that has been written off must first be reversed back into A/R and the Allowance account Then the collection is like the collection of any other A/R 31 Allowance for Doubtful Accts (T-account) Allowance for Doubtful Accts Write-off of accounts receivable Beginning Recognition of Balance bad debt expense Write-off recovery Recognition of bad debt expense Ending Balance Accounts Receivable Write off recovery Bad Debts Expense (RE) Write-off of accounts receivable The AJE to record the estimate of uncollectibles is calculated based on the amount necessary to achieve the “desired ending balance” in the allowance account The focus is on the Allowance account 32 Class Problem Given the following information: At December 31, 2009, Company Z prepared an aging schedule to determine that the uncollectible accounts receivable at that date were $18,000 The balance in the Allowance for Doubtful Accounts at 1/1/09 was a $3,000 credit During 2004, the company wrote off $5,000 of specific accounts receivable that were deemed to be uncollectible Required: prepare the AJE to record the estimated uncollectibles at 12/31/09 33 Solution to Class Problems (1) Post the beginning balance and write-off (2) Post the desired ending balance (3) Post the adjusting journal entry Allowance for Doubtful Accounts 3,000 Beginning (1) (1) W/O 5,000 20,000 AJE (3) 18,000 End Balance (2) AJE: Bad debt expense 20,000 Allowance for D.A 20,000 34 Problem 6-4, Part (a) Percentage of Sales method (a) 2011 Net sales = Sales - SD - SR - SA = 1,800,000 - 130,000 - 20,000 = 1,650,000 B.D Expense = 3% of net sales = 03 (1,650,000) = $49,500 AJE at 12/31: Bad debt expense 49,500 Allow for D.A 49,500 35 Problem 6-4, Parts (b&c) Note that, for the percentage of sales method, the AJE is posted before calculating the ending balance Allowance for Doubtful Accounts 65,000 Beginning (1) 49,500 AJE (2) (1) W/O 70,000 44,500 End Balance (3) 36 % Sales vs % Receivables What is the Difference? Allowance for Doubtful Accts Beginning Balance Write-off of accounts Recognition of bad receivable debt expense Ending Balance Calculated as % of Sales Calculated as % of Receivables 37 Copyright Copyright © 2011 John Wiley & Sons, Inc All rights reserved Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc The purchaser may make back-up copies for his/her own use only and not for distribution or resale The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein 38 [...]... the Income Statement approach, because: revenues x % = expense 25 2 Percentage of A/R Method (using Aging Schedule)      Based on ending A/R and ending Allowance account Calculation: Ending A/R x % = Ending Allowance (focus on the credit side of the AJE) Called Balance Sheet approach, because: ending asset x % = ending contra asset Requires the analysis of the Allowance account before preparing... the “desired ending balance” in the allowance account The focus is on the Allowance account 32 Class Problem Given the following information: At December 31, 2009, Company Z prepared an aging schedule to determine that the uncollectible accounts receivable at that date were $18,000 The balance in the Allowance for Doubtful Accounts at 1/1/09 was a $3,000 credit During 2004, the company wrote off $5,000... 3 The “desired ending balance” in the allowance account is estimated using the percentage calculation or the aging schedule 30 Allowance for Doubtful Accts (T-account) Allowance for Doubtful Accts Beginning Balance Write-off of accounts receivable 4 Recovery of write-offs Ending Balance Accounts Receivable 4 Recovery of write-offs Write-off of accounts receivable 4 The recovery of an account receivable... account to achieve the “desired ending balance.” 27 Allowance for Doubtful Accts (T-account) Allowance for Doubtful Accts 1 Beginning Balance 1 The allowance established in the prior period carries forward for current period write-offs 28 Allowance for Doubtful Accts (T-account) Allowance for Doubtful Accts 2 Write-off of specific accounts receivable Beginning Balance Accounts Receivable 2 Write-off... AJE An aging schedule of A/R is the most accurate way to estimate uncollectibles (see Figure 626 11) T-Account Approach for Percentage of A/R Method    Based on the analysis of the Allowance account Calculate the “desired ending balance” based on an aging of A/R Now, given the Beginning, Ending and Writeoff amounts, calculate the amount of the current estimate that must be added to the Allowance... accounts are determined uncollectible during the year, they are written-off to the allowance account as shown These write-offs may cause the allowance account to have a debit balance before the AJE if the prior year’s expense was underestimated 29 Allowance for Doubtful Accts (T-account) Allowance for Doubtful Accts Beginning Balance Write-off of accounts receivable 3 Ending Balance Accounts Receivable... estimated uncollectibles at 12/31/09 33 Solution to Class Problems (1) Post the beginning balance and write-off (2) Post the desired ending balance (3) Post the adjusting journal entry Allowance for Doubtful Accounts 3,000 Beginning (1) (1) W/O 5,000 20,000 AJE (3) 18,000 End Balance (2) AJE: Bad debt expense 20,000 Allowance for D.A 20,000 34 Problem 6-4, Part (a) Percentage of Sales method (a) 2011... Sales Returns and Allowances   If sales returns are small in amount, adjust A/R and create a contra to Sales called Sales Returns when the merchandise is returned Sales allowances are negotiated reductions in sales price after the sale Sales Allowance xx Sales Returnsxx A/R xx If sales returns are significant (e.g., bookstore), company must estimate the amount of sales returns expected, and adjust A/R... been written off must first be reversed back into A/R and the Allowance account Then the collection is like the collection of any other A/R 31 Allowance for Doubtful Accts (T-account) Allowance for Doubtful Accts Write-off of accounts receivable Beginning 5 Recognition of Balance bad debt expense Write-off recovery 5 Recognition of bad debt expense Ending Balance Accounts Receivable Write off recovery... Allowance Method Solution: create a contra to A/R, and estimate the A/R that will not be collected The AJE to record an estimate for uncollectibles in 2008 (for all uncollectibles): Bad Debt Expense 4,000 Allowance 4,000 The GJE during 2009, when a specific A/R is deemed uncollectible (this is called the writeoff of a specific A/R): Allowance 1,000 A/R 1,000 When are the income statement and balance
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