Financial accounting 9th jamie pratt chapter 06

Chapter 6:The Current Asset Classification, Cash, and Accounts Receivable... Allowance for Doubtful Accounts We create a contra account to A/R called Allowance for Doubtful Accounts to

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

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.”

Limitations of the Current Assets Classification

Cash

*Cash flows are increasingly popular in assessing solvency

Figure 6-5 Cash as a percentage of total assets and current assets

• 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

Proper Management of 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)

• 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

Recording Sales Discounts:

The Gross Method

Allowance for Doubtful Accounts

We create a contra account to A/R (called Allowance for Doubtful Accounts) to indicate the portion of A/R that will not be collected due to defaults on payments by customers

Direct write off is not consistent with GAAP because it does not achieve a matching of

revenues and expenses due to the time between the recording of the sale and the

decision to finally write off an asset Assets are overvalued until the final write off

Allowance Method

 There are three basic steps

 Bad debts are estimated

 An adjusting journal is made to recognize the expense and reduce the net balance

in A/R

 A write-off journal entry is made when the bad debt occurs (it is determined the item

is not collectable)

Estimating the Bad Debt

 Note that we do 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:

1 Percentage of sales (covered in the text)

2 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

Percentage of Sales Method

 Typically based on credit sales

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

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 XXX Credit – Accounts Receivable XXX

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

Figure 6-11 An Aging Schedule

Receivables do not get better with age

Older items are less likely to be collected

An Aging Schedule – Used as a Management Tool

 23

• 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

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.

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 b

Allowance for Doubtful Accounts

65,000 Beginning W/O 70,000

49,500 AJE

44,500 End Balance

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).

Problem 6-4, Part d

Allowance for Doubtful Accounts

44,500 Beginning W/O 85,000

40,500 AJE

0 End Balance

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