chapter 7 current assets- mba 2006

Chapter 7

Current Assets- MBA 2006

Chapter 7 Mugan-Akman 2005 2-51

Economic Consequences of Accounting

• on wealth or behavior of– lenders and investors– reporting entities, their management and users of

financial statements– reporting entities and standard setters

• Sources of impact– Effect of financial results reported in the financial

statements– Effect of firm’s choice of accounting principles– Effect on reporting entities of standard setters’

decisions– Effect on standard setters of their decisions


Quality of Earnings• Business: having stable and recurring basic revenue

generating activities• Accounting: 1) using consistent estimates and rules

High: same methods of estimation and rules 2) proximity of revenue recognition and cash

collectionHigh: when revenue recognition and cash collection are

close• High quality earnings are presumed to be fair

representations of the economic performance of the firm• Low quality earnings overstate fair earnings


What will affect Quality of Earnings?

• Managers’ discretion in measuring and reporting earnings in:– Choosing among alternative accounting

principles

– Making estimates

– Timing transactions in order to control recognition


Current assets

• assets that are expected to be converted into cash within one year or within the operating cycle of an entity


Anadolu Efes


Why is Current Asset Management Important?

• solvency

• profitability

• profitable but insolvent

• quality of receivables

• credit policies

• idle cash


Cash and Cash Equivalents

• Cash– Coins, banknotes deposits at banks, checks received

from customers– Restricted Cash or Blocked Cash and the related

amounts should not be included in the cash amount – Petty Cash

• Cash Equivalents– Investments that are readily convertible to cash with

insignificant risk and with a maturity less than 90 days- e.g. Treasury Bills, term-deposits with less than 90 days maturity


Checks Received From Customers

• by law, checks are payable at sight, so they are deemed as liquid and should be included as cash in the balance sheets of the entities

• although the concept of post dated checks is not within the context of the legislation, in practice checks with future payment dates are issued in Turkey

• due-dated checks should not be included as cash but treated as notes receivable in the balance sheet.


Control Over Cash

• easily transportable • large number of transactions involving cash • Establish Responsibilities• Segregation of Duties• Documentation Controls• Physical Controls• Independent Internal Verification• Use of Bank Accounts


Bank ReconciliationWhy are there differences between the Cash (bank balance of checking

account) per bank statement and ledger accounts ?

• Unknown items or forgotten items: - direct debits; - standing orders; - credit transfers;

• Bank charges or bank interest:

• Errors - calculations: - overs; - unders;

• Timing differences: - unpresented checks; - outstanding checks

All reconciling items on the book side require an adjusting entry to the cash account.


BANK RECONCILIATIONHere are step-by-step instructions for preparing a bank reconciliation.

• Prepare a list of deposits in transit. Compare the deposits listed on your bank statement with the bank deposits shown in your cash receipts journal. On your bank reconciliation, list any deposits that have not yet cleared the bank statement. Also, take a look at the bank reconciliation you prepared last month. Did all of last month's deposits in transit clear on this month's bank statement? If not, you should find out what happened to them.

• Prepare a list of outstanding checks. In your cash disbursements journal, mark each check that cleared the bank statement this month. On your bank reconciliation, list all the checks from the cash disbursements journal that did not clear. Also, take a look at the bank reconciliation you prepared last month. Are there any checks that were outstanding last month that still have not cleared the bank? If so, be sure they are on your list of outstanding checks this month. If a check is several months old and still has not cleared the bank, you may want to investigate further.

• Record any bank charges or credits. Take a close look at your bank statement. Are there any special charges made by the bank that you have not recorded in your books? If so, record them now just as you would have if you had written a check for that amount. By the same token, if there are any credits made to your account by the bank, those should be recorded as well. Post the entries to your general ledger.

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BANK RECONCILIATION• Compute the cash balance per your books. Foot the general

ledger cash account to arrive at your ending cash balance.

• Enter bank balance on the reconciliation. At the top of the bank reconciliation, enter the ending balance from the bank statement.

• Total the deposits in transit. Add up the deposits in transit, and enter the total on the reconciliation. Add the total deposits in transit to the bank balance to arrive at a subtotal.

• Total the outstanding checks. Add up the outstanding checks, and enter the total on the reconciliation.

• Compute book balance per the reconciliation. Subtract the total outstanding checks from the subtotal in step 6 above. The result should equal the balance shown in your general ledger.


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Bank Reconciliation Example

• Prepare a 31 July 2005 bank reconciliation statement for Sinan A.S. The 31July bank statement indicated a cash balance of TL 9,610, while the cash ledger account on that date shows a balance of TL 7,430

Adapted from Williams, etal, 2003


Bank Reconciliation Example

• Outstanding checks totaled TL 2,417.• A TL 500 check mailed to the bank for deposit had not

reached the bank at the statement date.• The bank returned a customer’s NSF check for TL 225

received as payment of an account receivable.• The bank statement showed TL30 interest earned on the

bank balance for the month of July.• Check #781 for supplies cleared the bank for TL 268 but

was erroneously recorded in our books as TL 240.• A TL 486 deposit by X A.S. was erroneously credited to

our account by the bank.


Balance per bank statement,31 July 2005 9,610 TL

Add: NSF check 225 TL

Recording error 28

Deposit in transit 500

Additions 753 TL

Deduct Outstanding checks 2,417

Interest 30

Bank error 486

Deductions 2,933 TL

Balance per company's records,31 July 2005 7,430 TL

Reconciling the Bank StatementExample



Reconciling the Bank Statement Example

Reconciling the Bank Statement Example



Balance per bank statement, 31 July 9,610 TLAdditions: Deposit in transit 500 Deductions: Bank error 486 TL Outstanding checks 2,417 2,903 Adjusted cash balance 7,207 TL

Balance per company's records, 31 July 7,430 TLAdditions: Interest 30 Deductions: Recording error 28 TL NSF check 225 253 Adjusted cash balance in the balance sheet 7,207 TL


Receivables

• Accounts Receivable

• Notes Receivable

• Other Receivables


Anadolu Efes


Recognition of Accounts Receivable

• accrual basis of accounting- sales revenue is recognized at the time a sale is made and the title of ownership of the items under the sale passes to the buyer regardless of the cash payment date

• when sales are made on credit the accounts receivable is recognized and recorded at the invoice amount when a sale is realized


Valuation of Receivables-IFRS• Receivables are carried at amortized cost (financial assets)

– Amortised cost = approximate the original invoice amount for short-term receivables with no stated interest rate if the impact of discounting would not be significant

• a risk that a customer will not pay or will not be able to pay its debt

• IFRS -accounts receivable should be valued at their net realizable value (or net recoverable amount)

• Net Realizable Value (amortized cost) represents the amount of cash expected to be collected from the receivables

Net Realizable Value =Invoice amount (original amount)

- cash received at the time of sale - collections from customers (during the period) - Unamortized discounts- impairment

• net recoverable amount of accounts receivable (or trade receivables) is equal to their original values unless there is an indication of impairment

• Entities should assess at each balance sheet date whether there is objective evidence that an account receivable may be impaired, and determine the amount of allowance that should be estimated based on the net realizable value or the discounted cash flow from such receivable

• TAX- when it is certain that a customer is not going to pay write-off the account *i.e. erase from the accounts and record it as a loss


Receivables are Carried at Amortized Cost

• When sales are made on credit, the interest imputed in the transaction is not recognized as sales revenue but as INTEREST INCOME

• By using the Effective Interest Method


Illustration• The sales price of TL 58.000 was charged to customer

for a sale on credit (n/90) on 1 November. If the same goods were sold at cash, the price would have been TL 50.000

• The effective interest rate for the transaction is:

1/FV

i = 1PV

Future value

PV = Present Value

n = days to maturity

i = effective interest rate

n

FV

1(90/360)58,000

i = 1 = %81.0650,000


At 31 of December30/360

58,000PV = 55,200 TL

(1+0,8106)

Account Name Debit CreditAccounts Receivable 58000

Unearned financial income 8000Sales Revenue 50000

Account Name Debit CreditUnearned financial income 5200

Interest Income 5200


Impairment of Accounts Receivable-IFRS

• Matching principle and losses estimated from selling on credit

• Some possible indications of impairment are as follows: – If there is a sign that the customer has financial difficulty,– If there is a high probability of bankruptcy of the customer,– If the customer delays its payments,– If the customer asks for extension of the payment period, and– If the economy in general or the industry the customer operates

in suffers from financial difficulties

• under IAS 39, general provisions are not permitted and all impairment of trade receivables must be measured using a discounted cash flow methodology


Impairment Loss

• measured as the difference between the original or the carrying value of the receivable and the present value of estimated cash flows discounted at the original effective interest rate of the receivable

• effective interest rate is the rate that exactly discounts estimated future cash receipts through the expected collection date of the receivable to the net carrying amount of the receivable

• Allowance for Uncollectible Accounts account accumulates the estimated losses – a contra-asset account – deducted from Accounts Receivable in order to determine the

net realizable value of receivables


Adjusting Entry-IFRS

Date Account Title and Description Debit Credit

Impairment Loss on Accounts Receivable

Allowance for Uncollectible Accounts 10.000To record impairment loss on accounts receivable

31-Dec-03 10.000

Dekorasyon A.Ş. has outstanding receivables of TL120.000 as of 31 December 2003, and its management estimated that

there is impairment of TL10.000

Cash and Cash Equivalents TL 11.000

Accounts Receivable TL 120.000

Less: Allowance for Uncollectible Accounts

-10.000 110.000

Inventories 129.000

Total Current Assets TL 250.000

Dekorasyon A.Ş.

Partial Balance Sheet

31-Dec-03


Determining the Impairment Loss

• examine each receivable or customer carefully and assess whether there is an indication of impairment

• prepare a chart showing all trade receivables and whether there is an indication of impairment


Illustration of Impairment-IFRSSağlam Yapı Market is in the process of preparing the financial statements for the

year 2004. The credit department examined all outstanding receivables and determined that the following accounts may be impaired as of 31 December 2004. Total accounts receivable as of 31 December 2004 is TL 59.750

Invoice Net

Recoverable Amount Amount

Altay A.Ş. TL 5.000 TL 4.800

Güçlü A.Ş. 4.000 3.820

Mir A.Ş. 9.800 9.322

Risk A.Ş. 5.450 2.905

OTM A.Ş. 9.000 8.220

TL 33.250 TL 29.067

Customer

Difference= impairment loss of TL 4.183


How much is the expense?

• difference between total of net recoverable amount of accounts receivable and the total invoice amount represents the targeted balance for the Allowance for Uncollectible Accounts

• adjusting entry to record the impairment loss on accounts receivable should bring the balance of the Allowance for Uncollectible Accounts to the amount estimated from the impairment of accounts receivable


Adjusting Entries – target impairment loss known- Case 1

Allowance for Uncollectible Account Balance is a credit of TL 2.950Estimated (target) Allowance for Uncollectible Accounts TL 4.183CR

Balance of Allowance for Uncollectible Accounts Before Adjustment 2.950CR

Estimated Impairment Loss TL 1.233


Impairment Loss on Accounts Receivable Allowance for Uncollectible Accounts 1.233To record impairment loss of accounts receivable

31-Dec-04 1.233

Balance Sheet RepresentationAccounts Receivable TL 59.750Allowance for Uncollectible Accounts 4.183Net Realizable Value of Accounts Receivable TL 55.567


Adjusting Entries – target impairment loss known- Case 2

Allowance for Uncollectible Account Balance is credit of TL 6.283 Balance of Allowance for Uncollectible Account Before Adjustment TL 6.283CREstimated Allowance for Uncollectible Accounts 4.183CRRecovery of Impairment Loss TL 2.100


Allowance for Uncollectible Accounts 2.100 Recovery of Impairment Loss 2.100To record the recovery of impairment loss

31-Dec-04

Balance Sheet RepresentationAccounts Receivable TL 59.750Allowance for Uncollectible Accounts 4.183Net Realizable Value of Accounts Receivable TL 55.567


Write Off of Accounts Receivable

• a specific customer is not able to pay its debt

Risk A.Ş. declared bankruptcy on 20 March 2005 Date Account Title and Description Debit Credit

Bad Debt Expense Accounts Receivable-Risk A. Ş 5.450To write off the receivable from Risk A.Ş.

20-Mar-05 5.450


Recovery of Receivables Written Off

Risk A.Ş. informed Sağlam Yapı Market that it will pay TL 3.000 of its

total debt on 3 April 2005 and the remaining amount later


Accounts Receivable- Risk A.Ş. Other Income 5.450To recover the written off receivable from Risk A.Ş.Cash 3.000 Accounts Receivable- Risk A.Ş. 3.000To record collection from Risk A.Ş.

3-Apr-05 5.450

3-Apr-05


Direct Write-off Dekorasyon A.Ş. sold furniture at TL1.000 to Mr. Aksoy in December 2004

with terms n/60. However, Mr. Aksoy was in financial difficulty and informed Dekorasyon A.Ş. that he bankrupted in May 2005. Since it became evident that this receivable cannot be collected, Dekorasyon A.Ş. decided to write off the receivable.

Date Account Title and Description Debit CreditUncollectible Account Expense Accounts Receivable-Mr. Aksoy 1,000To record receivable from Mr. Aksoy as Uncollectible Account Expense

May 31 2005 1,000


Financing with Accounts Receivable

• Pledge of Accounts Receivable - used as a guarantee in credit arrangements with financial institutions to receive loans-IFRS requires that pledge agreements should be disclosed in the notes to the financial statements

• Factoring Accounts Receivable- selling receivables to get cash before the maturity (due date) of the receivables

• Credit Card Sales


Factoring Accounts Receivable

• With recourse - factor can collect the receivable from the seller if the customer does not pay the receivable – risk with lies with the company

• Without recourse -risk of non-payment of the customer lies with the factor

• Based on the risks involved rates differ• In the case of with recourse factoring the entity

may become liable to the factor - this contingent liability should be disclosed in the notes to the financial statements


Factoring Example-without recourse

Fashion Giyim Sanayi sold its receivables of TL 3.500 to Firm Factoring on 3 March 2005 without recourse and agreed to pay 5% factoring expense- financing expense plus TL 150 for recourse liabilities and TL 50 for possible sales discounts


Cash 3.125Financing Expense* 325Due from Firm Factoring 50 Accounts Receivable 3.500To record the sale of accounts receivable to Firm Factoring

3-Mar-05

* TL 3.500 x 5% = TL 175 plus TL 150 for recourse liability

Fashion Giyim Sanayi –without recourse


Factoring Example-with recourseIf Fashion Giyim Sanayi had sold its accounts receivable with recourse; Firm

Factoring keeps TL 50 for possible sales discounts and TL 150 for recourse liabilities.

Fashion Giyim Sanayi –with recourse: Date Account Title and Description Debit Credit

Cash 3.125Financing Expense 175Due from Firm Factoring 200 Accounts Receivable 3.500To record the sale of accounts receivable to Firm Factoring

3-Mar-05

Yagmur Mensucat defaulted its payment of TL 100 on 5 September 2005 to Firm Factoring


Accounts Receivable- Yagmur Men.Due from Firm Factoring 100

To record the default of an accounts receivable

5-Sep-05 100


Factoring-without recourse-Factor company entries

Firm Factoring–without recourse:


Accounts Receivable 3.500 Financing Revenue 325 Due to Fashion Giyim Sanayi 50 Cash 3.125To record the sale of accounts receivable to Firm Factoring

3-Mar-05


Factoring-with recourse-Factor entries

Date Account Title and Description Debit CreditAccounts Receivable 3.500 Financing Revenue 175 Due to Fashion Giyim Sanayi 200 Cash 3.125To record the sale of accounts receivable to Firm Factoring

3-Mar-05

Firm Factoring-a customer defaulted:


Due to Fashion Giyim Sanayi Accounts Receivable- Yagmur Men. 100

To record the default of an accounts receivable

5-Sep-05 100


Factoring with recourse-payment date• Assume none of the customers take sales discount and by 15 December 2005 Firm Factoring

collects all accounts receivable and pays Fashion Giyim Sanayi the remaining amount.

Fashion Giyim Sanayi will make the following entry


Cash Due from Firm Factoring 100To record receipt of amount withheld by the factor.

15-Dec-05 100

Firm Factoring


Due to Fashion Giyim Sanayi Cash 100T o record payment of the amount withheld by the factor.

15-Dec-05 100


Credit Card SalesGourmet Restaurant served dinner to various customers on 11 May 2005 and

collected TL 750 with the credit cards. Gourmet Restaurant’s agreement with INVO Bank to collect the credit card slips is 21 days with 5% interest rate


Receivable from INVO Bank 712,5Commission Expense 37,5 Revenues 750To record the dinner served on 11 May 2005Cash Receivable from INVO Bank 712,5To record the collection from INVO Bank

11-May-05

1-Jun-05 712,5


Notes Receivable

• A promissory note is an unconditional promise to pay a certain amount of money in the future. – To borrow money – To settle an accounts receivable

• notes with maturity dates less than or equal to 12 months are classified as short-term


Amount Date

OnPlus

Animal Co. Ankara Turkey

the amount of Eight thousand three hundred Turkish Lira

120 days after dateinterest at an annual rate of 25%.

For value received, I promise to pay to the order of Health Pharmacy Ankara Turkey

PROMISSORY NOTETL 8.300 2-Jun-05

Promissory Note-(IOU)


Accounting Entries Illustrated for Notes Receivable-1

When the Note Received


Notes Receivable 8.300 Accounts Receivable 8.300To record the notes received from Animal Co.

2-Jun-05

At the end of the Fiscal Year


Interest Receivable 518,75 Interest Income(*) 518,75To accrue for the interest on notes receivable

31-Aug-05

(*) Interest: 8.300*25%*90 days/360 days = TL 518,75)


Accounting Entries Illustrated for Notes Receivable-2

When the Note is Paid


Cash 8.991,67 Notes Receivable 8.300,00 Interest Income 172,92 Interest Receivable 518,75To record the collection of the note

30 Sept. 2005

If the Note is Dishonored


Accounts Receivables 8.991,67 Notes Receivable 8.300,00 Interest Income 172,92 Interest Receivable 518,75To record the dishonored note

30 Sept. 2005


Other Current Assets

• Value Added Taxes Deductible and Carried Forward

• Advances Given

• Prepaid Taxes

• Prepaid Expenses


Common Financial Ratios Used in Management of Current Assets

Current AssetsCurrent Ratio =

Current Liabilities

sLiabilitieCurrent

sInvestmentSecurity Short term Rec. Notes and Accounts Eqvt Cash and(Cash RatioQuick

Net SalesAccounts Receivable Turnover =

Average Accounts Receivable

365Collection Period=

Accounts Receivable Turnover


BREAK- How about coffee?

chapter 7 current assets- mba 2006

Documents

bank reconciliation

bank deposits

months bank statement

cash equivalents cash

ending cash balance

total outstanding checks

list of outstanding

cash collection high