1. 2 chapter 6: the current asset classification, cash and accounts receivable
TRANSCRIPT
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Chapter 6:
The Current Asset Classification, Cash and Accounts Receivable
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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.
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Figure 6-2
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Current Assets / Current Liabilities
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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.”
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Cash
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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 requiredRecord Control over cashPhysical Control over cash
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Accounts ReceivableAccounts ReceivableAccounts 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:1. sales discounts (cash discounts)2. sales returns3. sales allowances4. uncollectible A/R (bad debts)
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1. Cash Discounts1. Cash Discounts
Offered to encourage early paymentExamples
• 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
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Recording sales discountsRecording sales discountsThe gross methodThe gross method
Assume a $100 sale, terms 2/10, n/30
The sale is recorded:
Debit Credit
Accounts Receivable 100Sales 100
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Recording sales discountsRecording sales discountsThe gross methodThe gross method
If paid within 10 days:
Debit Credit
Cash 98
Accounts Receivable 100
Sales Discounts 2
A contra-account to Sales Revenue
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Recording sales discountsRecording sales discountsThe gross methodThe gross method
If paid after 10 days:
Debit Credit
Cash 100
Accounts Receivable 100
Will not disclose that discount was not taken
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Gross MethodGross Method
Make year end estimate of amount of discounts expected to be takenAdjusting entry:
SALES DISCOUNTS
ALLOWANCE FOR SALES DISCOUNTS
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Recording sales discountsRecording sales discountsThe net methodThe net method
Assume a $100 sale, terms 2/10, n/30
The sale is recorded:
Debit Credit
Accounts Receivable 98Sales 98
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Recording sales discountsRecording sales discountsThe net methodThe net method
If paid within 10 days:
Debit Credit
Cash 98
Accounts Receivable 98
Will not disclose that discount was taken
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Recording sales discountsRecording sales discountsThe net methodThe net method
If paid after 10 days:
Debit Credit
Cash 100
Accounts Receivable 98
Sales Discounts Forfeited
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Report as miscellaneous revenue
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Net MethodNet Method
Record sale net of cash discountsRecord discounts not taken (similar to
interest income)Make year end adjustment for accounts
that are past the discount periodAdjusting entry:
ACCOUNTS RECEIVABLE
SALES
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TheoryTheory
Discounts are more like interestIf so, the Gross Method
• Overstates Sales• Understates Interest Income
Defense for use of the Gross Method?• Materiality
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2. Sales Returns and Allowances 2. 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 xxSales Returns xx
A/R xx If sales returns are significant (e.g., bookstore),
company must estimate the amount of sales returns expected, and adjust A/R (with a contra account similar to Allowance for Bad Debts) at the end of the period.
Estimated Sales Returns xxAllowance for Returns xx
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3. Allowance for Doubtful Accounts 3. Allowance for Doubtful Accounts Created as a contra account to A/R to indicate the
portion of A/R that will not be collected due to defaults on payments by customers.
Reason for Allowance account: Assume $1,000 sale in 2008 and default on collection in 2009.Record sale in 2008:
A/R 1,000Sales Revenue 1,000
Record default in 2009:Bad Debt Expense 1,000
A/R 1,000Note: this is called the direct method, and is not
GAAP, for the reasons listed on the next page.
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Problems with Direct Method Problems with Direct Method Problem: the direct method, on the previous
slide, does not achieve matching (revenues recognized in 2008, but a related expense was recognized in 2009).
Problem: the direct method does not correctly value the asset, A/R. The assets are overvalued until 2009, when the receivable is written off.
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Solution: the Allowance MethodSolution: the Allowance MethodSolution: 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 4,000The GJE during 2009, when a specific A/R is
deemed uncollectible (this is called the write-off of a specific A/R):
Allowance 1,000A/R 1,000
When are the income statement and balance sheet affected? At the 2008 estimate.
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Estimation of UncollectiblesEstimation of UncollectiblesNote that we do not know in 2008 which A/Rs will
not be collected in 2009. Therefore, we must estimate uncollectibles. There are two methods:1. Percentage of sales2. 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.
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1. Percentage of Sales Method1. Percentage of Sales MethodUsually 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.
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2. Percentage of A/R Method 2. Percentage of A/R Method (using Aging Schedule) (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 6-11).
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T-Account Approach for T-Account Approach for Percentage of A/R MethodPercentage 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 Write-off amounts, calculate the amount of the current estimate that must be added to the Allowance account to achieve the “desired ending balance.”
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Allowance for Doubtful Accts. Allowance for Doubtful Accts. (T-account)(T-account)
Allowance for Doubtful Accts.
1. Beginning Balance
1. The allowance established in the prior period carries forward for current period write-offs.
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Allowance for Doubtful Accts. Allowance for Doubtful Accts. (T-account)(T-account)
Allowance for Doubtful Accts.
Beginning Balance
Accounts Receivable
2. Write-off of specific accountsreceivable
2. Write-off of specific accountsreceivable
2. 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.
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Allowance for Doubtful Accts.Allowance for Doubtful Accts.(T-account)(T-account)
Allowance for Doubtful Accts.
Beginning Balance
Accounts Receivable
Write-off ofaccountsreceivable
3. Ending Balance
Write-off ofaccountsreceivable
3. The “desired ending balance” in the allowance account is estimated using the percentage calculation or the aging schedule.
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Allowance for Doubtful Accts. Allowance for Doubtful Accts. (T-account)(T-account)
Allowance for Doubtful Accts.
Beginning Balance
4. Recovery of write-offs
4. Recovery of write-offs
Accounts Receivable
Write-off ofaccountsreceivable
Ending Balance
Write-off ofaccountsreceivable
4. 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.
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Allowance for Doubtful Accts. Allowance for Doubtful Accts. (T-account)(T-account)
Allowance for Doubtful Accts.
Beginning Balance
5. Recognition of bad debt expense
Bad Debts Expense (RE)
5. Recognition of bad debt expense
Accounts Receivable
Write-off ofaccountsreceivable
Ending Balance
Write-off ofaccountsreceivable
5. 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.
Write-offrecovery
Write off recovery
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Class ProblemClass ProblemGiven 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.
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Solution to Class ProblemsSolution to Class Problems
Allowance for Doubtful Accounts
3,000 Beginning (1)(1) W/O 5,000
20,000 AJE (3)
18,000 End. Balance (2)
(1) Post the beginning balance and write-off.
(2) Post the desired ending balance.
(3) Post the adjusting journal entry.
AJE: Bad debt expense 20,000
Allowance for D.A. 20,000
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Problem 6-4, Part (a)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
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Problem 6-4, Parts (b&c)Problem 6-4, Parts (b&c)
Allowance for Doubtful Accounts
65,000 Beginning (1)(1) W/O 70,000
49,500 AJE (2)
44,500 End. Balance (3)
Note that, for the percentage of sales method, the AJE is posted before calculating the ending balance.
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% Sales vs % Receivables% Sales vs % ReceivablesWhat is the Difference?What is the Difference?
Allowance for Doubtful Accts.Beginning Balance
Recognition of bad debt expense
Write-off ofaccountsreceivable
Ending BalanceCalculated as
% of Receivables
Calculated as % of Sales
CopyrightCopyright
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