Solution manual intermediate accounting 9e by nicolai ch06

When the customer pays, if the allowable cash discount is taken the company records the difference between the cash received and the original amount of accounts receivable as a debit to

CHAPTER 6

CASH AND RECEIVABLES

CONTENT ANALYSIS OF EXERCISES AND PROBLEMS

E6-1 Cash Determination of items to be included as cash on the

E6-2 Cash Balance Computing amount to be reported on balance

E6-3 Petty Cash Journal entries to record establishment, expenses,

E6-4 Unknown Cash Balance Determine cash balance and

adjusted cash balance through use of bank reconciliation

Journal entries to update cash account balance

5-15

E6-5 Bank Reconciliation Prepare reconciliation from account

balances Record journal entries to adjust the books 10-15 E6-6 Bank Reconciliation Prepare reconciliation from various

transactions Record journal entries to adjust the books 10-15 E6-7 Bank Statement Balance Determine cash balance from prior

journal entries, no bank statement available Discrepancy analysis

10-20

E6-8 Classification of Receivables Journal entries to properly record

receivables Balance sheet disclosure 5-10 E6-9 Sales Discounts Journal entries to record the sale,

collection, and year-end adjustment under the gross price and net price methods

10-15

E6-10 Discount Methods Comparison of gross price and net price

E6-11 Returns and Allowances Record as actual, record as estimate

Journal entries, financial statement disclosure 10-15 E6-12 Bad Debts Estimation versus direct write-off Journal entries 10-15

Number Content Time Range (minutes) E6-13 Bad Debts Estimating from receivable balances Journal

entries Balance sheet disclosure Computation of receivables turnover

5-15

E6-14 Aging Analysis Estimation of uncollectible receivables Journal

entries with various balances in the allowance account 10-20 E6-15 Bad Debts Comparison of different estimation methods

Journal entries for estimates based on total sales, credit sales, and accounts receivable

10-20

E6-16 (AICPA adapted) Receivables-Bad Debts Percentage of net

sales method Schedule computing balance in the allowance account

10-20

E6-17 Assigning Accounts Receivable Sales return, collections,

repayment Journal entries Balance sheet disclosure 15-20 E6-18 Factoring Accounts Receivable Sales returns and allowances

on factored accounts Journal entries 10-15 E6-19 Credit Card Sales Sales, sales return Journal entries 5-10 E6-20 (AICPA adapted) Factoring and Assigning Accounts

Receivable Income statement disclosure 15-20 E6-21 Notes Receivable Interest-bearing, noninterest-bearing

E6-22 Notes Receivable Discounted Interest-bearing,

E6-23 Notes Receivable Discounted Journal entries for issuance,

P6-1 Cash and Other Items Determination of cash account

balance, balance sheet disclosure of other items 10-20 P6-2 Bank Reconciliation Preparation from various transactions

Record journal entries to adjust the books 20-30 P6-3 Unknown Book Balance Determination of unadjusted and

adjusted cash balances Journal entries to update account balances

20-30

P6-4 Bank Reconciliation Preparation from bank statement.

Record journal entries to adjust the books 20-40 P6-5 (AICPA adapted) Comprehensive Reconciliation

Bank reconciliation from various transactions Prepare journal entries to adjust book balance

60-75

Number Content Time Range (minutes) P6-6 Bad Debts Change from direct write-off method to

estimation of bad debts Percentage of credit sales, percentage of outstanding accounts receivable

Analysis

30-40

P6-7 Accounts Receivable Various transactions affecting

receivables Journal entries Balance sheet disclosure 30-40 P6-8 Notes Receivable Interest-bearing Discounted Default

P6-9 Reconstructing Entries Changes in accounts receivable,

allowance for doubtful accounts, allowance for sales returns and allowances, and allowance for sales discount

Ending balance and financial statement disclosure

30-45

P6-10 Cash Discounts Gross price and net price methods Journal

entries to record sale, collections, and returns Reversing entries

30-40

P6-11 Accounts Receivable Aging analysis Journal entries to record

sale, collection, write-off of accounts receivable, and bad debts expense Balance sheet disclosure Calculation and discussion of receivables turnover

35-45

P6-12 Bad Debts Estimation as a percent of total sales, net credit

sales, and gross accounts receivable Aging analysis Income statement vs balance sheet approach

30-40

P6-13 Notes Receivable Interest-bearing, discounted Journal

P6-14 Assigning Accounts Receivable Journal entries for various

transactions Balance sheet disclosure 20-30 P6-15 Factoring Accounts Receivable Sales on account, sales

returns and allowances, and sales discounts Factored and unfactored accounts receivable Journal entries

20-30

P6-16 Factoring and Assigning Accounts Receivable Journal entries

for various transactions Financial statement disclosure 20-30 P6-17 (AICPA adapted) Accounts Receivable Reclassification of

accounts Journal entries to write-off uncollectible accounts and adjust allowance for doubtful accounts

10-20

P6-18 (AICPA adapted) Bad Accounts Percentage of sales, original

set up of the allowance account Adjusting journal entries 40-60

Number Content Time Range (minutes) P6-19 (AICPA adapted) Allowance for Doubtful Accounts Prepare

schedule analyzing changes in allowance account Prepare related adjusting journal entry

40-60

P6-20 (AICPA adapted) Correction of Allowance Account Prepare

schedules to analyze initial and subsequent balance in allowance account, based on historical data

30-40

P6-21 Comprehensive Receivable Problem Sales, collections,

write-off, bad debts, assignment, returns and allowances, notes receivable discounted, default Calculation and discussion of receivables turnover

45-60

P6-22 (Appendix) Proof of Cash Preparation of four-column proof

of cash from a list of account balances and transactions 45-60 P6-23 (Appendix) Proof of Cash Preparation of four-column proof

of cash from a list of account balances and transactions 45-60

ANSWERS TO QUESTIONS

Q6-1 Cash consists of coins, currency, unrestricted funds on deposit with a bank (either

checking accounts or savings accounts), negotiable checks, and bank drafts Certificates of deposit, bank overdrafts, postdated checks, travel advances, and postage stamps may be confused with cash, but these items normally are

categorized under other balance sheet captions Items that are available

immediately to pay current debts and are not bound by any contractual or legal restrictions are classified under the "current asset cash" caption on the balance sheet, and those that do not meet these criteria are reported elsewhere within the assets (or liabilities, in the case of a bank overdraft) section on the balance sheet Cash equivalents are short-term, highly liquid investments (e.g., commercial paper, treasury bills, money market securities) that are readily convertible into known

amounts of cash and so near their maturity that there is little risk of changes in value because of changes in interest rates

Q6-2 Internal control is the process (policies and procedures) a company uses to enhance

the reliability of its financial reports, promote the effectiveness and efficiency of its operations (including safeguarding its assets), and ensure its compliance with

applicable laws and regulations Two important elements of internal control over cash are a petty cash system and a bank reconciliation

Q6-3 The purpose of a petty cash system is to allow a company to pay small amounts that

might be impractical or impossible to pay by check

Q6-4 The actual expenses rather than the Petty Cash account are debited when the fund

is replenished because the petty cash fund is always carried in the company's

accounting records at its original amount This entry has the effect of recording the expenses incurred for the period at the time the amount of cash expended is given

to the custodian of the fund to replenish the petty cash fund

Q6-5 A bank reconciliation is a schedule prepared by a company to analyze the

difference between the ending cash balance in the company's accounting records and the ending cash balance reported by its bank in a bank statement in order to determine the correct ending cash balance The causes of the difference between the cash balance listed on a company's bank statement and the balance shown in the company's cash account include outstanding checks, deposits in transit, charges made directly by the bank, deposits made directly by the bank, and errors

Q6-6 After the bank reconciliation is completed, adjusting entries are made to bring the

company records up to date The adjustments to the company records on the bank reconciliation have not been previously recorded by the company, so journal entries must be prepared by the company for these items An example of an item on a bank reconciliation requiring an adjusting entry would be a bank service charge of

$10 deducted on the bank statement but not yet recognized on the company books The adjusting entry would be a debit to Bank Service Charge Expense for $10 and a credit of $10 to Cash

Q6-7 The two revenue recognition criteria are that (1) realization must have occurred and

(2) the revenue must be earned (the earning process must be complete or virtually complete) In the case of some industries (e.g., book publishing), sometimes a company cannot make a reliable estimate of the collectibility of receivables (so realization has not occurred) or the risks and benefits of ownership have not been transferred (so that the earning process is not complete) In these cases, the

company must defer revenue recognition

Q6-8 The first method of recording accounts receivable (gross price method) when cash

discounts are involved is to record accounts receivable and sales at the gross price

In using this method, a company records both accounts at the total invoice price as

if no cash discount were involved When the customer pays, if the allowable cash discount is taken the company records the difference between the cash received and the original amount of accounts receivable as a debit to Sales Discounts Taken

If the cash discount is not taken, the amount of cash remitted by the customer will be equal to the original balance in the Accounts Receivable account and no further adjustment is necessary

A second method (net price method) is to record accounts receivable and sales at the net invoice price When the customer pays, if the allowable cash discount is taken by the customer no adjustment is necessary because the amount of cash received is equal to the recorded amount of the receivable However, if the

customer chooses not to take the cash discount, the amount of cash received is greater than the recorded Accounts Receivable balance The company credits this excess to an account entitled Sales Discounts Not Taken

Q6-9 A sales return occurs when a customer returns goods to the seller A sales allowance

occurs when a customer retains defective goods and is allowed a reduction in the purchase price Conceptually, a company should estimate and record sales returns and allowances in the period of sale so as to properly report net sales revenue and correctly value its ending accounts receivable

Q6-10 Under the estimation methods of recording bad debts, a company studies the

historical data about the actual bad debts it has incurred on credit sales or credit accounts receivable as a result of a particular credit policy This information is then compared with current sales or accounts receivable to determine relationships upon which to base estimates of current uncollectible accounts These relationships

provide the information the company needs to prepare the adjusting entry to record the estimated bad debt expense for the period When the estimate of bad debts is recorded, the journal entry involves a debit to Bad Debt Expense and a credit to Allowance for Doubtful Accounts (or, alternatively, Allowance for Bad Debts)

Estimation methods enable a company to match its expenses with revenues in the current period Bad debt expense is normally reported on the company's current year income statement as an operating expense However, some companies offset the account against gross sales, or disclose it as a financial expense in the other items section of the income statement

The direct write-off method has the advantages of simplicity and of reporting actual losses rather than estimates When the direct write-off method is used, a company records bad debt expense when it determines a specific customer account is

uncollectible At that time, the account is written off by debiting Bad Debt Expense and crediting Accounts Receivable However, this determination and write-off may not occur until a period later than the period of sale The use of the direct write-off method has the disadvantage of matching expenses associated with previous sales with current revenues, and of overstating accounts receivable associated with previous sales Furthermore, it allows the manipulation of income because

management selects the period of write-off (and expense)

Q6-11 Under the sales or income statement approach, a company estimates bad debts

based on the historical relationship to sales This approach matches current revenues and anticipated current expenses It is income statement oriented because it is based upon the matching principle and results in recording bad debt expense in the period during which credit sales occur A percentage of total sales may be used as the basis for the estimate when there is a stable relationship between cash and credit sales However, if the proportion of credit to total sales varies from period to period,

a percentage of total sales is not appropriate to use in any one period and net credit sales should be used Since this method focuses upon an expense account, any existing balance in the allowance account is ignored Also, if a company sells many products in different locations, it may choose to extend this analysis and estimate bad debts based on the historical net credit sales of particular products or in specific locations

Q6-11 (continued)

Under the accounts receivable or balance sheet approach, a company estimates bad debts based on the historical relationship between actual losses and accounts receivable This approach is balance sheet oriented in that the resulting accounts receivable balance is properly reported on the balance sheet at its net realizable value A relatively simple balance sheet approach is to base the estimated expense

on the relationship between the actual bad debts and the outstanding receivable balance at the end of the year However, a more sophisticated method is to

categorize the outstanding receivables by the length of time they have been

outstanding and then apply a different uncollectible percentage to each category This method is termed "aging."

Q6-12 The net realizable value of a company's accounts receivable is the amount

expected to be collected in the future The company reports the net realizable value of its accounts receivable on its balance sheet by deducting the balance of a contra account, entitled Allowance for Doubtful Accounts, from the balance of the Accounts Receivable account (If a company has other accounts such as

Allowance for Sales Returns and Allowances, Allowance for Sales Discounts, and Deferred Gross Profit, it would also deduct these accounts from Accounts Receivable

to determine the net realizable value.)

Q6-13 The aging of accounts receivable method categorizes individual accounts based on

the length of time they are outstanding The length of time an account is

outstanding is an important factor in estimating the probability that it will be

collected A company is much more likely to collect an open account that is 30 days old than one that is 360 days old

Q6-14 If bad debt expense is recorded based on an estimate, an individual account is

written off the accounting records when it is determined to be uncollectible by debiting Allowance for Doubtful Accounts and crediting Accounts Receivable This write-off is simply an adjustment required to recognize that previously anticipated losses are now realized It has no effect on the net realizable accounts receivable on the balance sheet because both the asset and contra-asset accounts are reduced

by the same amount There is no impact on the income statement as a result of this write-off because it does not involve a revenue or expense account

Q6-15 When a company pledges its accounts receivable, it is using these only as collateral

for a loan, and the servicing activities generally remain the responsibility of the

borrower The borrower records the loan in the usual manner and then uses the cash collected from the receivables to repay the loan plus any interest charges Upon full payment, the pledge is canceled When a company assigns its accounts receivable

to a finance institution (or bank), it enters into a lending agreement with the institution

to receive cash on specific customer accounts Usually the borrowing company (assignor) retains ownership of the assigned accounts, incurs bad debts, collects the amounts due from customers, and then uses these funds to repay the loan When a company factors its accounts receivable, it sells individual accounts to a finance institution or bank, called a factor The accounts receivable are sold without

recourse so the collection activities and the risk of ownership are assumed by the factor Also, any related collection costs and bad debt expenses are incurred by the factor

Q6-16 A company (transferor) records the transfer of accounts receivable to a transferee as

a sale when all of the following conditions are met:

(1) The transferred assets have been isolated from the transferor (i.e., put beyond the reach of the transferor)

(2) The transferee obtains the right to exchange (e.g., sell) the transferred assets (3) The transferor does not maintain effective control over the transferred assets through an agreement that entitles and obligates the transferor to repurchase the transferred assets before their maturity

If the conditions for a sale are not met, the company records the proceeds from the transfer of accounts receivable as a secured borrowing with a pledge of collateral Q6-17 A note receivable is an unconditional written agreement to receive a certain sum of

money on a specific date Notes receivable have two attributes not found in

accounts receivable: (1) They are negotiable instruments, which means that they are legally and readily transferable among parties and may be used to satisfy debts

by the holders of these instruments, and (2) They usually involve interest

Q6-18 A non-interest-bearing note is a note that does not specify an interest rate For a

short-term non-interest-bearing note, the maturity value is listed as the face value, and includes both principal and implicit interest Therefore, the note is initially

recorded at its maturity value, the total interest to be earned over the life of the note

is recorded as Interest Revenue, and Sales is credited for the difference If the fiscal period ends prior to collection of the note an adjusting entry must be made to

reduce the interest revenue and establish a contra-asset account for any unearned interest In contrast, for a short-term interest bearing note, the Notes Receivable account is recorded at the face value of the note After issuance, interest revenue is recorded as earned and is determined by multiplying the principal by the stated interest rate for the time the note has been outstanding

Q6-19 Notes receivable discounted are customer notes receivable that a company has

transferred to a bank with recourse in exchange for cash The customer is notified to pay the bank directly at the maturity date and the company guarantees payment of the note if the customer defaults During the interim period between the discount date and the maturity date, the note represents a contingent liability to the

company This contingent liability is disclosed in a separate contra account entitled Notes Receivable Discounted This account is offset against Notes Receivable on any balance sheet prepared prior to the note's maturity date

Q6-20 When a note receivable is discounted, the cash proceeds are determined by

multiplying the discount rate times the maturity value of the note (face value of the note plus total interest) for the discount period, and then deducting the resulting discount from the maturity value

Q6-21 The proof of cash reconciliation provides the following four separate reconciliations:

(a) the reconciliation of the bank and book balance for the previous month; (2) the reconciliation of the receipts recorded by the bank with the receipts recorded on the

ANSWERS TO CASES

C6-1

The two main aspects of cash management are cash planning systems and cash control systems Cash planning systems consist of those methods and procedures adopted to ensure that a company has adequate cash available to meet maturing obligations and that it invests any unused or excess cash Cash control systems are the methods and procedures adopted to ensure the safeguarding of the company's funds

The major component of a cash planning system is the cash budget A cash budget is a plan of cash activity that forecasts cash inflows and outflows, and identifies the timing of potential cash surpluses and shortages The cash budget is primarily a managerial

accounting technique

The second aspect of cash management, cash control systems, requires adequate

internal control procedures Internal control consists of the policies and procedures a company uses to enhance the reliability of its financial reports, promote the effectiveness and efficiency of its operations, (including safeguarding its assets), and ensure its

compliance with applicable laws and regulations

Internal control procedures are designed to reduce the possibility of errors or omissions Whenever a company adopts internal control procedures, the cost associated with the use of the measure should not exceed the value of the derived benefits Cash control systems can be divided into main functions: (1) control over receipts and (2) control over disbursements Two important elements of internal control over cash are a petty cash system and a bank reconciliation

C6-2

The two-column and the four-column (known as a Proof of Cash) reconciliations each start with two different amounts: the balance of the cash account in the company's records and the bank statement balance, and each adjusts both balances to one common amount, which is the corrected cash balance Both types of reconciliation make

adjustments to the bank balance and the book balance in the same manner (i.e

outstanding checks are deducted from the bank balance)

The difference between the two types of reconciliations is based on format and purpose The two-column reconciliation only reconciles the bank balance and the book balance for the current month The proof of cash incorporates the monthly cash receipts and payments to test the internal control over cash and provide additional evidence of the accuracy of the cash balance In essence, the proof of cash provides four separate reconciliations The four reconciliations are: (1) the reconciliation of the bank and book balance for the previous month; (2) the reconciliation of the receipts recorded by the bank with the receipts recorded on the books for the current month; (3) the reconciliation

of the payments recorded by the bank with the payments recorded on the books for the current month; and (4) the reconciliation of the bank and book balances for the current month

C6-3 (AICPA adapted solution)

1 There are basically two methods of recognizing bad debt expense: (1) direct write-off and (2) allowance

The direct write-off method requires the identification of specific balances that are

deemed to be uncollectible before any bad debt expense is recognized At the time that

a specific account is deemed uncollectible, the account is removed from accounts receivable and a corresponding amount of bad debt expense is recognized

The allowance method requires an estimate of bad debt expense for a period of time by reference to the composition of the accounts receivable balance at a specific point in time (aging) or to the overall experience with credit sales over a period of time Thus, total bad debt expense expected to arise as a result of operations for a specific period is

estimated, the valuation account (allowance for doubtful accounts) is appropriately adjusted, and a corresponding amount of bad debt expense is recognized As specific accounts are identified as uncollectible, the account is written off; that is, it is removed from accounts receivable and a corresponding amount is removed from the valuation account (allowance for doubtful accounts) Net accounts receivable do not change, and there is no charge to bad debt expense when specific accounts are identified as uncollectible and written off using the allowance method

2 The allowance method is preferable because it matches the cost of making a credit sale with the revenues generated by the sale in the same period and achieves a proper

carrying value for accounts receivable at the end of a period Since the direct write-off method does not recognize the bad debt expense until a specific amount is deemed uncollectible, which may be in a subsequent period, it does not comply with the matching concept and does not achieve a proper carrying value for accounts receivable at the end of a period

C6-4

1 In order to obtain cash, the Moore Company could:

a pledge accounts receivable

b assign accounts receivable

c factor accounts receivable (sale without recourse)

When a company pledges its accounts receivable, it is using these only as collateral for a loan, and the servicing activities generally remain the responsibility of the borrower The borrower records the loan in the usual manner and then uses the cash collected from the receivables to repay the loan plus any interest charges Upon full payment, the pledge is

C6-4 (continued)

1 (continued)

When a company assigns its accounts receivable, a financial institution enters into a lending agreement with the company to advance cash on specific customer accounts Usually the borrowing company (assignor) retains ownership of the assigned accounts, incurs any bad debts, collects the amounts due from customers, and then uses these funds to repay the loan

When a company factors its accounts receivable, it sells individual accounts to a finance institution or bank (called a factor) The accounts receivable are sold without recourse, so the collection activities and the risk of ownership are assumed by the factor Also, any related collection costs and bad debt expense are incurred by the factor

2 The existence of pledging, assignment, or factoring agreements must be disclosed

parenthetically or in the notes to the financial statements under generally accepted accounting principles

3 The Moore Company should report the sale of receivables as a factoring agreement when all of the following conditions are met:

(a) The transferred assets have been isolated from Moore (i.e., put beyond its reach), (b) The transferee obtains the right to exchange (e.g., sell) the transferred assets,

(c) Moore does not maintain effective control over the transferred assets through an agreement that entitles and obligates it to repurchase the transferred assets before their maturity

If these conditions are not met, Moore Company should record the amount of the

proceeds from transfer of receivables as a secured borrowing (pledge agreement) C6-5 (AICPA adapted solution)

1 To account for the accounts receivable factored on April 3, 2004, Magrath should

decrease accounts receivable by the amount of accounts receivable factored, increase cash by the amount received from the factor, and record a loss equal to the difference The loss should be reported in the income statement Factoring of accounts receivable

on a without recourse basis is equivalent to a sale

2 The carrying amount of the 9-month note at August 1, 2004 is the principal The interest revenue for 2004 should be determined by multiplying the carrying amount of the note at August 1, 2004 times the rate of interest times five-ninths

The interest-bearing note receivable should be reported in the December 31, 2004

balance sheet as a current asset at its face amount plus the accrued interest

3 Magrath should account for the collection of the accounts previously written off as

uncollectible as follows:

(a) Increase both accounts receivable and the allowance for uncollectible accounts (b) Increase cash and decrease accounts receivable.

C6-5 (continued)

4 One approach estimates uncollectible accounts based on credit sales This approach focuses on income determination by attempting to match uncollectible accounts

expense with the revenues generated

The other allowance approach estimates uncollectible accounts based on the balance in

or aging of receivables The approach focuses on asset valuation by attempting to report receivables at realizable value

C6-6

Note to Instructor: This case is slightly advanced for students but provides a good basis for class discussion

1 A lockbox account might benefit a company in the following ways:

a Improve funds availability by reducing float caused by mail, processing, and check clearing delays Improved funds availability can lead to more interest or investment income and/or less interest expense

b Eliminate the function of processing cash receipts

c Improve internal controls because lockbox receipts cannot be lost or

misappropriated by company personnel

Bank Reconciliation December 31, 2004

Deduct: Balances applied to line of credit (20,000)

3 Adjusting Entries Required:

To record 12/31/04 lockbox receipts

To record collected cash balances

applied to the line of credit

C6-7 (AICPA adapted solution)

1 Cash normally consists of coins and currency on hand, bank deposits, and various kinds of orders for cash such as bank checks, money orders, traveler's checks, demand bills of exchange, bank drafts, cashier's checks, and letters of credit Balances on deposit in banks that are subject to immediate withdrawal are properly included in cash There is some question as to whether deposits not subject to immediate withdrawal are properly included

in cash or whether they should be set out separately Savings accounts, time certificates of deposit, and time deposits fall in this latter category Unless restrictions on these kinds of deposits are such that they cannot be converted (withdrawn) within one year or the

operating cycle of the entity, whichever is longer, there can be little question but that they are properly classed as current assets At the same time, they may well be presented separately from other cash and their restrictions as to convertibility reported

2 Valuation problems can arise when cash balances are in foreign countries or when a

domestic entity holds a bill of exchange payable in foreign money All balances expressed

in foreign money must be converted into domestic dollar equivalents The conversion of cash items is fairly simple and is ordinarily done in terms of the exchange rate prevailing at the close of a fiscal period

Valuation problems can also arise where there is cash in a domestic bank that has closed or

is in receivership In such cases, an estimate must be made or obtained from the receiver that reflects the probable amount to be realized in excess of balances covered fully by deposit insurance

There is some potential for loss any time an entity accepts checks However, only those entities that handle a substantial volume of checks representing losses from insufficient funds

or forgeries would ordinarily reflect a valuation allowance in respect to bank checks that have not yet cleared payor banks

C6-8 (AICPA adapted solution)

1 The allowance method based on credit sales attempts to match bad debts with the

revenues generated by the sales in the same period Thus, it focuses on the income

statement rather than the balance sheet

On the other hand, the allowance method based on the balance in the trade receivables accounts attempts to value the accounts receivable at the end of a period at their future collectible amounts Thus, it focuses on the balance sheet rather than the income

statement

It should be noted, however, that both the allowance method based on credit sales and the allowance method based on the balance in the trade receivables accounts are

acceptable under generally accepted accounting principles

2 Carme Company should report on its balance sheet at December 31, 2004, the balance in the allowance for bad debts account as a valuation or contra asset account; that is, a subtraction from the asset accounts receivable

C6-9

1 The first method (gross price method) a company could use to record accounts receivable when cash discounts are involved is to record accounts receivable and sales at the gross price In using this method, the company records both accounts at the total invoice price

as if no cash discount were involved When the customer pays, if the allowable cash

discount is taken the company records the difference between the cash received and the original amount of accounts receivable as a debit to Sales Discounts Taken If the cash discount is not taken, the amount of cash remitted by the customer will be equal to the original balance in the Accounts Receivable account and no further adjustment is

necessary

A second method (net price method) a company could use is to record accounts

receivable and sales at the net invoice price When the customer pays, if the allowable cash discount is taken by the customer no adjustment is necessary because the amount of cash received is equal to the recorded amount of the receivable However, if the customer chooses not to take the cash discount, the amount of cash received is greater than the recorded Accounts Receivable balance The company credits this excess to an account entitled Sales Discounts Not Taken

2 The second method is theoretically sound because it values the accounts receivable at the net realizable value and states sales and financial revenue properly The first method states accounts receivable at gross amounts which simplifies communications with customers; it also enables sales returns and allowances to be recorded at gross amounts The first method tends to overstate sales and accounts receivable each period, since most customers will take advantage of cash discounts This is also the method most frequently used, because it

requires less record keeping, but if the timing of collections does not vary significantly from period to period, there will be no material difference between the two methods

C6-10 (AICPA adapted solution)

1 Because the trade accounts receivable are assigned on a with-recourse, nonnotification basis, Marie Company is responsible for collection and assumes the risks of any losses Marie should account for the subsequent collections on the assigned trade accounts receivable

by debiting cash and crediting accounts receivable assigned The cash collected should then be remitted to Daniel Finance until the amount advanced by Daniel Finance is settled The payments to Daniel Finance consist of both principal and interest with interest

computed at the rate of 20 percent on the balance outstanding

2 Because the trade accounts receivable were factored on a without-recourse basis, the factor is responsible for collection On November 3, 2004, Marie should credit accounts receivable for the amount of trade accounts receivable factored, debit cash for the

amount received from the factor, debit a receivable from the factor for 5 percent of the trade accounts receivable factored, and debit finance charges (an expense) for 3 percent

of the trade accounts receivable factored

C6-11 (AICPA adapted solution)

1 Hogan should account for the sales discounts at the date of sale using the net method by recording accounts receivable and sales revenue at the amount of sales less the sales discounts available Revenues should be recorded at the cash equivalent price at the

C6-11 (continued)

2 a There is no effect on Hogan's sales revenues when customers do not take the sales

discounts Hogan's net income is increased by the amount of interest (discount) earned when customers do not take the sales discounts

b Trade discounts are neither recorded in the accounts nor reported in the financial statements Therefore, the amount recorded as sales revenues and accounts

receivable is net of trade discounts and represents the cash equivalent price of the asset sold

c To account for the accounts receivable factored on August 1, 2004, Hogan should decrease accounts receivable by the amount of accounts receivable factored,

increase cash by the amount received from the factor, and record a loss Factoring of accounts receivable on a without recourse basis is equivalent to a sale The difference between the cash received and the carrying amount of the receivables is a loss

d Hogan should report the face amount of the interest-bearing notes receivable and the related interest receivable for the period from October 2 through December 31 on its balance sheet as current assets Both assets are due on October 1, 2005, which is less than one year from the date of the balance sheet

Hogan should report interest revenue from the notes receivable on its income statement for the year ended December 31, 2004 Interest revenue is equal to the amount

accrued on the notes receivable at the appropriate rate for three months

Interest revenue is realized with the passage of time Accordingly, interest revenue should be accounted for as an element of income over the life of the notes receivable C6-12 (AICPA adapted solution)

1 Tidal should account for the assignment of trade accounts receivable by debiting trade accounts receivable assigned and crediting trade accounts receivable for the amount of trade accounts receivable assigned Tidal should account for the note payable to Herb Finance by debiting cash for 70 percent, debiting finance fee expense for 5 percent, and crediting notes payable for 75 percent of the trade accounts receivable assigned

Tidal should account for the subsequent collections on the trade accounts receivable assigned by debiting cash and crediting trade accounts receivable assigned Tidal should account for the write-off as uncollectible of some specific accounts of the assigned

receivables by debiting allowance for doubtful accounts and crediting trade accounts receivable assigned

Tidal should account for the total payment to Herb Finance by debiting interest expense and notes payable, and crediting cash The amount of the cash payment consists of both principal (the amount of the note payable) and interest computed at a rate of 12 percent

on the balance outstanding

2 a Tidal should determine the amount of the discount for the note receivable as follows:

(1) Determine the maturity value of the note receivable (the face value of the note receivable plus the 15 percent interest to be earned over the 90-day life of the note receivable).

C6-12 (continued)

2.a (continued)

(2) Multiply the maturity value of the note receivable by one-sixth (the 60-day life of the discounted note receivable) of the 18 percent discount rate to arrive at the amount of the discount

b The discounting transaction should be accounted for by debiting cash and crediting notes receivable discounted Cash would be debited for the amount received from the bank, and notes receivable discounted, a contra-asset account, generally would be credited for the face value of the note receivable Also, interest expense should be debited for the difference between the amount received from the bank and the face value of the note receivable at the date of discounting plus interest income earned to the date of discounting and interest revenue should be credited for the interest income earned to the date of discounting The income and expense, however, are usually netted against each other instead of being recorded separately when the amounts involved are immaterial

C6-13

1 The cash and cash equivalents were $1,866 million at the end of 2001(balance sheet, p 58) Marketable securities that are highly liquid and have maturities of three months or less at the date of purchase are classified as cash equivalents (Note 1, p 62)

2 The trade accounts receivable (net) at the end of 2001 and 2000 were $1,882 million and

$1,757 million, respectively (balance sheet, p 58)

3 11.04 receivables turnover for 2001 [$20,092 net credit sales (p 57)/($1,882 + $1,757/2

average accounts receivable)]

11.20 receivables turnover for 2000 [$19,889 net credit sales (p 57)/($1,757 +$1,798/2

average accounts receivable)]

There is no significant difference in the receivables turnover for 2001and 2000

C6-14

Note to Instructor: This case does not have a definitive answer From a financial reporting perspective, GAAP is identified and summarized From an ethical perspective, various issues are raised for discussion purposes

From a financial reporting perspective, when a company has made sales for which a right

of return exists, all of the following criteria must be met to recognize revenue at the time of sale: (1) the sales price is known at the time of sale, (2) the payment for the inventory is not contingent upon resale of the product, (3) the buyer's obligation would not be changed by theft or damage to the product, (4) the buyer has economic substance apart from the seller, (5) the seller does not have significant obligations for future performance to help the buyer sell the product, and (6) the amount of future returns can be reasonably estimated If these conditions are not met, then the company must defer revenue (and cost of goods sold) recognition until the return privilege has expired or when all the conditions have been met, whichever comes first

C6-14 (continued)

From an ethical perspective, the issues are whether revenue on sales with the right of return should be recognized at the time of sale (1) when it is unclear that the criteria have been met, and (2) because a previous year's returns have already been recorded in the current year In either case, current earnings would be increased The stakeholders are you, the controller, and the stockholders If current earnings are increased, the controller (and you) may appear to be efficient, but the stockholders may be misled about the future earning potential of the company

A fair and unbiased judgment must be made as to whether all the criteria have been met

in regard to the textbook sales of Debitus From the information given, it appears that criteria (1), (3), (4) and (5) are satisfied However, it is unclear that (2) and (6) are met It would be unethical to simply assume that they have been met in order to boost current earnings More information is needed about the stipulations concerning payment of the inventory Furthermore, more information is needed about how "hard" is the maximum of 5 percent returns In regard to the argument that last year's returns have already decreased this year's net sales, this is inconsistent with the change in company policy and it would be unethical to use this argument to adjust earnings Since the new return policy is due to a new promotional strategy, it is fair to include the effects of this strategy (i.e., current returns)

in this year's income

repurchase them before their maturity According to par F38.113 (FAS 125, par 25A), a prohibition of the sale of the assets to the transferor's competitor would not constrain the transferee if other potential buyers exist

According to par F38.105 (FAS 125, par 11), if the transfer is accounted for as a sale, the transferor shall remove the assets sold from its accounts, recognize the proceeds received, recognize any liabilities incurred in the sale, and recognize any gain or loss on the sale According to par F38.106 (FAS 125, par 12), if a transfer of financial assets does not meet the criteria for a sale, the transferor shall account for the transfer as a secured borrowing with a pledge of collateral

C6-15 (continued)

Based on these findings, I recommend that Hamilton record the transaction as a sale My conclusions are based on the facts that: (1) Hamilton has transferred the receivables to the bank, (2) the bank has the right to sell the receivables, and (3) Hamilton does not maintain effective control over the receivables In regard to (1), I believe the fact that the bank is servicing the receivables is evidence that they have been isolated from Hamilton In regard

to (2), I do not think the bank is constrained from selling the receivables since there are numerous competitors in Hamilton's industry In regard to (3), I do not believe the

"repurchase" agreement relating to $3,000 of receivables is material enough that Hamilton maintains control over the receivables I also believe that the fact that Hamilton is

responsible for all bad debts (which it can reasonably estimate) does not relate to

maintaining control, but rather relates to the liability it incurs as a result of the sale

I recommend the following journal entry be made by Hamilton to record the sale:

No

No

No Yes

No

No Yes Yes

Accounts Receivable Prepaid Expense Accounts Receivable Accounts Receivable Long-term Investment Prepaid Expense

Cash

600.00

250.40 165.90 119.05 7.30

600.00

542.65

E6-3 (continued)

*$ 600.00 Beginning balance $57.35 Actual amount in petty cash (535.35) Disbursements from petty cash# (64.65) Petty cash balance, 1/31/04 $ 64.65 Petty cash balance, 1/31/04 $(7.30) Cash short and over

#$250.40 + $165.90 + $119.05

E6-4

$ 1,671.92

Balance from company records

E6-5

Bank Reconciliation July 31, 2004

$ 2,227.45

E6-6

Bank Reconciliation March 31, 2004

$19,600.80 Deduct: Outstanding checks

$19,223.00

Check incorrectly recorded 45.00 (233.80)

E6-7

1 The Accounts Receivable debit of $1,520.24 is probably an NSF check

The debit to Miscellaneous Expense of $12.50 is probably a bank service charge The credits to Notes Receivable and Interest Revenue probably arose from the bank collection of a note and interest

June 30, 2004

$ 7,893.70

3 This discrepancy indicates that the amount of cash in the bank is $1,065.04 less than the balance per bank calculated in Requirement 2 ($6,607.94 - $5,542.90) This indicates an unintentional error(s) by the company or the bank, or an intentional error(s) by the cashier All checks and deposits should be investigated, and any missing items should be traced through the bank's microfilm system The payee on any unrecorded checks should be identified to determine if pilfering is taking place

E6-8

Common Stock Subscriptions Receivable 12,000

Deposit to Guarantee Contract Performance 5,000

2 Accounts receivable (trade) current asset, trade receivable

Accounts receivable (officer) normally current nontrade receivable

Common stock subscription receivable current or noncurrent asset,

depending on due date; nontrade receivable

Advances to employees current asset, nontrade receivable

Notes receivable (trade) noncurrent asset, trade receivable

Deposit to guarantee contract performance separately classify,

could be current or noncurrent asset, depending on the length

of the contract; nontrade receivable

Utility deposit separately classify, probably noncurrent nontrade

3 (a) If sales returns and allowances are recorded as they occur, sales returns and

allowances of $200 will appear on the income statement, and accounts receivable will be reduced by $200 on the balance sheet

(b) If returns are estimated in the period of sale, the $80 remaining in the

Allowance for Sales Returns and Allowances account will be deducted from accounts receivable on the balance sheet The $280 balance in the Sales Returns and Allowances account will appear on the income statement as a deduction from sales revenue

E6-12

$78,000 x 0.04 = $3,120 Bad debts estimate

$1,400 beg credit balance - $2,600 written off (debit) = $1,200

Allowance (ending debit balance)

2004

Dec 31 Bad Debt Expense ($3,120 + $1,200) 4,320

E6-13 (continued)

3 Receivables turnover = Aver net accts rec Net credit sales = [($63,000 - $1,400) + $74,880] 2 $575,000

Estimated Amount Uncollectible Under 30 days

$465,000

0.008 0.020 0.050 0.200 0.350 0.600

$ 1,544 2,280 3,650 8,200 8,750 11,400

$35,824

E6-15

Allowance for Doubtful Accounts

Allowance for Doubtful Accounts

E6-15 (continued)

Allowance for Doubtful Accounts

E6-16 (AICPA adapted solution)

MASTER COMPANY Computation of Allowance for Doubtful Accounts December 31, 2004

Current Liabilities:

E6-18

Receivable from Factor ($80,000 x 0.10) 8,000

*Assuming the company does not normally

factor its accounts receivable, as implied

in the exercise

E6-19

Credit Card Expense ($2,100 x 0.05) 105