Financial accounting in an economic context 8e chapter 06

Recording sales discountsThe gross method If paid within 10 days:... Recording sales discountsThe gross method If paid after 10 days:... Recording sales discountsThe net method If pai

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:

1 sales discounts (cash discounts)

2 sales returns

3 sales allowances

4 uncollectible A/R (bad debts)

Recording sales discounts

The gross method

 Assume a $100 sale, terms 2/10, n/30

 The sale is recorded:

Debit Credit

Accounts Receivable 100

Recording sales discounts

The gross method

If paid within 10 days:

Recording sales discounts

The gross method

If paid after 10 days:

Gross Method

 Make year end estimate of amount of

discounts expected to be taken

Adjusting entry:

SALES DISCOUNTS

ALLOWANCE FOR SALES DISCOUNTS

Recording sales discounts

The net method

 Assume a $100 sale, terms 2/10, n/30

 The sale is recorded:

Debit Credit

Accounts Receivable 98

Recording sales discounts

The net method

If paid within 10 days:

Recording sales discounts

The net method

If paid after 10 days:

Net Method

 Record sale net of cash discounts

 Record discounts not taken (similar to

 Discounts are more like interest

 If so, the Gross Method

• Overstates Sales

• Understates Interest Income

 Defense for use of the Gross Method?

• Materiality

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 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 (with a contra

account similar to Allowance for Bad Debts) at the end of the period.

Estimated Sales Returns xx

Allowance for Returns xx

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.

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

Solution: the 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

write-off of a specific A/R):

When are the income statement and balance sheet affected? At the 2008 estimate.

2 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.

1 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.

2 Percentage of A/R Method (using Aging Schedule)

account.

Ending A/R x % = Ending Allowance

(focus on the credit side of the AJE)

ending asset x % = ending contra asset.

account before preparing the AJE.

way to estimate uncollectibles (see Figure

6-T-Account Approach for Percentage

 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.”

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

Allowance for Doubtful Accts

(T-account)

Allowance for Doubtful Accts.

Beginning Balance

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.

Allowance for Doubtful Accts.

(T-account)

Allowance for Doubtful Accts.

Beginning Balance

Write-off of accounts

3 The “desired ending balance”

in the allowance account is estimated using the percentage calculation or the aging schedule.

Allowance for Doubtful Accts

(T-account)

Allowance for Doubtful Accts.

Beginning Balance

4 Recovery of write-offs

Write-off of

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.

Allowance for Doubtful Accts

(T-account)

Allowance for Doubtful Accts.

Beginning Balance

5 Recognition of bad debt expense

Bad Debts Expense (RE)

5 Recognition of bad debt expense

Write-off of accounts

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

Write-off recovery

Write off

recovery

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.

Solution 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

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:

Allow for D.A 49,500

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.

% Sales vs % Receivables

What is the Difference?

Allowance for Doubtful Accts.

Beginning Balance

Recognition of bad debt expense

Write-off of accounts receivable

Ending Balance % of Receivables Calculated as

Calculated as

% of Sales

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