Financial accounting 9th jamie pratt chapter 06

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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 6-1 The operating cycle  Relative Size of Current Assets Figure 6-2 Current assets as a percentage of total assets  Measures Using Current Assets – Current Ratio Figure 6-3 Current assets as a percentage of current liabilities  Limitations of the Current Assets Classification As noted by Leopold A Bernstein: “The current ratio is not fully up to the task [of assessing short-term liquidity] because given it is a static or “stock” concept of what resources are available at a moment to meet the obligations at that moment.”  Cash *Cash flows are increasingly popular in assessing solvency Figure 6-5 Cash as a percentage of total assets and current assets  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 We adjust to Net Realizable Value Reasons for lack of/partial 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, this is more common and is discussed in more detail Net Method – records discounts not taken by customers Quantity and Trade discounts are a reduction of price/revenue and aren’t recorded separately in the financials  10 Estimating the Bad Debt  Note that we not know in any given period which A/Rs will specific A/R balances  will not be collected Therefore, we must estimate uncollectibles There are two methods: Percentage of sales (covered in the text) Percentage of accounts receivable Both methods are used to estimate for an adjusting journal entry at the end of the period This entry ensures that bad debt expenses are matched to the revenues reported  16 Percentage of Sales Method  Typically based on credit sales  Calculation:  Sales x % = Bad Debt Expense (focus on the debit side of the AJE) The percentage chosen by management for this calculation is normally based on the past experience of the company  17 Adjusting Journal Entry  Based on the estimate, a journal entry is recorded Debit – Bad Debt Expense XXX Credit – Allowance for Doubtful Accounts XXX  Bad debt expense as a contra revenue recognizes some revenue should not be  recorded (as it is uncollectible) Allowance for Doubtful Accounts decreases the net realizable value of Accounts Receivables on the Balance Sheet  18 The Write – Off Journal Entry  When a determination is made that a specific A/R is not collectable, it should be removed from the ledger with a write-off JE Debit-Allowance for Doubtful Accounts XXX Credit – Accounts Receivable XXX  Net realizable value of the Accounts Receivable does not change because both the A/R and the Allowance are effected  19 Bad Debt Recoveries  If written off amounts are later collected, reverse the write-off entry for the collected amount (this reestablishes the receivable) Debit- Accounts Receivable XXX Credit – Allowance for Doubtful Accounts XXX  Then record the cash collection Debit- Cash Credit – XXX Accounts Receivable XXX  20 Inaccurate Estimates of Bad Debt  Estimates of Bad Debt are Estimates so are rarely ‘correct’  Over time, over estimates and under estimates should tend toward averaging  out and may be ignored If there is a large debit or credit balance in the preadjustment Allowance for Doubtful Accounts, it may indicate that estimates are poorly done or biased  Methodology for estimates should be reviewed  Potential adjustment should be made  21 An Aging Schedule – Used to Estimate Bad Debt Receivables not get better with age Older items are less likely to be collected Figure 6-11 An Aging Schedule  22 An Aging Schedule – Used as a Management Tool • Maintaining control over receivables is an important part of effective management for companies • Identify slow moving accounts • Direct collection efforts • Estimate how much a company is losing in potential interest charges  23 Sales Returns  Sales returns can be a significant issue for some companies and industries  Returns are estimated similar to bad debts where they are material  The income statement and the accounts receivables on the balance sheet must be adjusted  24 International Perspective: Receivables, Foreign Currencies, and Hedging  For multinational corporations, sales and receivables can be denominated in foreign currency   This means there is a risk based on changing exchange rates  Gain or Loss possible based on the exchange rate Hedging is a strategy companies use to limit the risk of foreign exchange transactions  25 Problem 6-4, Part a Percentage of Sales method (a) 2014 Net sales = Gross 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  26 Problem 6-4, Part b Note that, for the percentage of sales method, the AJE is posted before calculating the ending balance (this is not the case for the percentage of receivables method) Allowance for Doubtful Accounts 65,000 Beginning 49,500 AJE W/O 70,000 44,500 End Balance  27 Problem 6-4, Part c Percentage of Sales method (a) 2015 Net sales = Gross Sales - SD - SR - SA = 1,500,000 - 100,000 - 50,000 = 1,350,000 B.D Expense = 3% of net sales = 03 (1,350,000) = $40,500 AJE at 12/31: Bad debt expense 40,500 Allow for D.A 40,500  28 Problem 6-4, Part d Allowance for Doubtful Accounts 44,500 Beginning 40,500 AJE W/O 85,000 End Balance  29 Copyright © 2014 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  30 .. .Chapter 6: The Current Asset Classification, Cash, and Accounts Receivable  Current Asset Classification... 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, this is more common... Quantity and Trade discounts are a reduction of price/revenue and aren’t recorded separately in the financials  10 Recording Sales Discounts: The Gross Method • • Assume a $100 sale, terms 2/10,
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