Lecture Accounting: What the numbers mean (5/e) - Chapter 5: Accounting for and presentation of current assets

After reading this chapter, you should be able to answer the following questions: What is included in the cash amount reported on the balance sheet? What are the features of an internal control system, and why are internal controls important? What is the bank reconciliation procedure?...

CHAPTER 5

ACCOUNTING FOR AND

PRESENTATION OF CURRENT ASSETS

Learning Objectives

1 What is included in the cash amount

reported on the balance sheet?

2 What are the features of an internal control

system, and why are internal controls

important?

3 What is the bank reconciliation procedure?

4 How are short-term marketable securities

reported on the balance sheet?

Learning Objectives

5 How are accounts receivable reported

on the balance sheet, including the

valuation allowances for estimated

uncollectible accounts and estimated

cash discounts?

6 How are notes receivable and related

accrued interest reported on the

balance sheet?

7 How are inventories reported on the

Learning Objectives

8 What are the alternative inventory

cost flow assumptions, and what are

their respective effects on the income statement and balance sheet when

price levels are changing?

9 What are the effects of inventory

errors on the balance sheet and

income statement?

10.What are prepaid expenses, and how

are they reported on the balance

Learning Objective 1

• What is included in the cash

amount reported on the balance

sheet?

Cash and Cash Equivalents

• Cash includes money on hand in change

funds, petty cash, undeposited receipts, and

checking and savings accounts

• Cash equivalents are short-term investments

easily convertible to cash

• Cash management is concerned with

maximizing earnings by having as much cash

as feasible invested for the longest possible

time

Learning Objective 2

• What are the features of an internal control system, and why are internal controls important?

Internal Control System

• A process designed to provide

reasonable assurance that objects are achieved with respect to:

– The effectiveness and efficiency of the operations

– The reliability of the organization’s financial reporting

– The organization’s compliance with applicable laws and regulations

• Includes financial and administrative controls

• Example: individual preparing checks does not sign the checks

Administrative Controls

• Frequently included in policy and

procedures manuals

• Reflected in management reviews of

operations and activities

• Example: evaluating a customer’s credit history before approving a credit sale

Learning Objective 3

• What is the bank reconciliation

procedure?

Bank Reconciliation

• Used to determine that the amount of

cash shown in the general ledger is the

same as the cash reported by the bank

• Differences may result due to:

– Timing differences

– Errors

Timing Differences

• Deposits in transit – included in firm’s cash

account, but not yet recorded by the bank

• Outstanding checks – deducted from firm’s

cash account, but not yet deducted by the

bank

• Bank service charges – deducted by the

bank, but not yet deducted from firm’s cash

account

• NSF checks – not sufficient funds- checks

that have bounced from a customer’s account

• Can be made by either the firm or the

bank

• If the error is in the recording of cash

transactions on the firm’s books, an

adjusting entry must be made to

correct it

• Often a very time-consuming process

to find errors

Bank Reconciliation Example

Bank Records

Indicated balance $5,233.21

Add: Deposits in transit 859.10

Less: Outstanding checks (1,526.58)

Reconciled balance $4,565.73

=============

Company Books

Indicated balance $4,614.58

Less: Service charge (43.76) NSF Check (35.00) Reconciled balance $4,565.73

============

Learning Objective 4

• How are short-term marketable

securities reported on the balance

sheet?

Short-Term Marketable

Securities

• Part of a firm’s cash management strategy

• Prudent use of short-term marketable

securities as investments can improve ROI

• Examples: U.S treasury securities,

commercial paper, and bank certificates of

deposit

Reporting of Short-Term Marketable Securities

• Short-term marketable debt securities that are classified as held-to-maturity are reported at

cost

• Debt and equity securities that are classified

as trading or available-for-sale securities are

reported at market value

• Interest on these securities is accrued as it is

earned

Learning Objective 5

• How are accounts receivable reported on the balance sheet, including the

valuation allowances for estimated

uncollectible accounts and estimated

cash discounts?

Accounts Receivable

• Are reported on the Balance Sheet at

net realizable value – the amount

expected to be received from

customers

• The amount initially recorded may be

different from net realizable due to:

– Bad debts

– Cash discounts

Bad Debts

• Bad debts are inevitable when sales are made

on credit

• Credit managers are able to estimate the

amount of bad debts fairly accurately

• Two methods are used to estimate bad debts:

– Percentage of credit sales

– Aging of accounts receivable

Percentage of Credit Sales

• An estimated percentage of credit sales

losses is multiplied by the total credit

sales

• An entry is made in the firm’s records

increasing bad debt expense and

increasing a valuation adjustment

account

Aging of Accounts Receivable

• Involves a detailed analysis of age of accounts receivable

• The longer an account is past due, the less

likely the firm is to collect the amount owed

• An entry is made in the firm’s records

increasing bad debt expense and

increasing a valuation adjustment

account

Entries Related to Bad Debts

• Recording the estimated amount:

Bad Debt Expense XX

Allowance for Bad Debts XX

• Writing off an uncollectible account:

Allowance for Bad Debts XX

Accounts Receivable XX

Cash Discounts

• Are used to encourage prompt payment

• Credit terms often abbreviated as 2/10,

n30, meaning a 2 percent discount may be taken if the account is paid within 10 days, and the net amount is due in 30 days

• The estimation of cash discounts is similar

to the estimation of bad debts

Learning Objective 6

• How are notes receivable and

related accrued interest reported on the balance sheet?

Notes Receivable

• A firm may convert and account receivable

into a note receivable if a customer has

developed difficulties paying the amount due

• A note receivable is a formal document that

includes maturity date, collateral, and

penalties

• Notes receivable are also used when lending

funds to another entity

Interest Accrual

• If interest is to be paid on a note

receivable at the maturity of the note,

the holder accrues interest on a

Learning Objective 7

• How are inventories reported

on the balance sheet?

• For merchandising and manufacturing firms,

the sale of inventory is the major, ongoing

source of revenue

• Accounting for inventory is basically the same for all firms

• As inventory is sold, it is moved from an asset

to an expense – Cost of Goods Sold

• Amount of cost of goods sold depends on the

cost flow assumption used by the firm

Inventory Cost Flow

– First-in, First-out (FIFO)

– Last-in, First-out (LIFO)

• Only cost flow assumptions, not

Learning Objective 8

• What are the alternative inventory cost flow assumptions, and what

are their respective effects on the

income statement and balance

sheet when price levels are

changing?

• Not practical for firms with a large

number of inventory items

• Applied to individual items of inventory

• Is not a simple average of the costs of the

inventory items; the average is weighted by

the number of units purchased at a specific

price

• The weighted average cost is then multiplied

by the number of units sold to determine cost

of goods sold, and by the number of units in

ending inventory to determine the balance

First-In, First-Out (FIFO)

• The first costs in to inventory are the first

costs out to cost of goods sold

• The oldest costs are transferred to cost of goods sold

• The balance sheet reports the most current costs of inventory

Last-In, First-Out (LIFO)

• The most recent costs of inventory are

transferred to the income statement -

cost of goods sold – when items are

sold

• The oldest costs are reported on the

balance sheet

Impact of Changing Costs

• In times of rising costs, LIFO results in

lower ending inventory amounts and

higher cost of goods sold than FIFO

• When inventory purchase costs are

decreasing, FIFO results in lower ending inventory amounts and higher cost of

goods sold than LIFO

Selecting an Inventory

Cost-Flow Assumption

• When rates of inflation are low, most financial managers choose FIFO

• In periods of high inflation, managers choose

LIFO to avoid high taxes

• However, consistency requires the use of a

single cost-flow assumption

• If a change in methods is made, the effect of

the change on both the balance sheet and the

Inventory Accounting System

Alternatives

• Accounting for inventory is very complex

• There are two principal inventory

accounting systems:

– Perpetual inventory systems

– Periodic inventory systems

Perpetual Inventory Accounting Systems

• A record is made of every purchase

and sale

• A continuous record of the quantity

and cost of each inventory item is

maintained

• Computers and bar codes scanning

have aided in the development and

use of this system

Periodic Inventory Accounting Systems

• A count of the inventory on hand is made periodically

• The cost of the inventory on hand, based

on the cost-flow assumption being used,

is reported on the balance sheet

• The remainder of the beginning inventory and the purchases are reported on the

income statement as cost of goods sold

Inventory Terms

• In a merchandising operation, inventory is

referred to as “merchandise inventory”

• In a manufacturing operation, there are three

categories of inventory:

– Raw materials inventory – raw material

used in the manufacturing process

– Work in process inventory – items currently being worked on

– Finished goods inventory – ready to be sold

Learning Objective 9

• What are the effects of inventory

errors on the balance sheet and

income statement?

Inventory Errors

• Errors in the amount of ending

inventory have a direct

dollar-for-dollar effect on cost of goods sold and

net income

• If ending inventory is understated,

cost of goods sold will be overstated,

and net income will be understated

• The effect in the subsequent period

will be reversed

Balance Sheet Valuation at

the Lower of Cost or Market

• This reporting is an application of

conservatism

• Market is generally the replacement value

• If market is lower than cost, then a loss is

recognized

• The determination may be done on an

individual item basis or on the inventory

as a whole

Learning Objective 10

• What are prepaid expenses,

and how are they reported on

the balance sheet?

Prepaid Expenses and Other

Current Assets

• Prepaid expenses are expenses that

have been paid in the current fiscal

period but will not be subtracted from

revenue until a subsequent fiscal period

• Often referred to as a deferral or deferred charge

• Examples are prepaid insurance,

prepaid rent, and office supplies

Deferred Tax Assets

• Arise from differences in the fiscal year

in which revenues and expenses are

recognized for financial accounting

purposes and when they are recognized for income tax determination

• Can have deferred tax assets (expenses recognized for financial purposes before they are recognized for tax purposes)

and/or deferred tax liabilities (just the

opposite)