6 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.”
8 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
9 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)
10 1. Cash Discounts Offered to encourage early payment Examples 2/10, net 30 2/10, EOM Accounting approaches Gross Method - records discounts when taken by customers Net Method - records discounts not taken by customers
11 Recording sales discounts The gross method Assume a $100 sale, terms 2/10, n/30 The sale is recorded: DebitCredit Accounts Receivable 100 Sales 100
12 Recording sales discounts The gross method If paid within 10 days: DebitCredit Cash 98 Accounts Receivable 100 Sales Discounts 2 A contra-account to Sales Revenue
13 Recording sales discounts The gross method If paid after 10 days: DebitCredit Cash 100 Accounts Receivable 100 Will not disclose that discount was not taken
14 Gross Method Make year end estimate of amount of discounts expected to be taken Adjusting entry: SALES DISCOUNTS ALLOWANCE FOR SALES DISCOUNTS
15 Recording sales discounts The net method Assume a $100 sale, terms 2/10, n/30 The sale is recorded: DebitCredit Accounts Receivable 98 Sales 98
16 Recording sales discounts The net method If paid within 10 days: DebitCredit Cash 98 Accounts Receivable 98 Will not disclose that discount was taken
17 Recording sales discounts The net method If paid after 10 days: DebitCredit Cash 100 Accounts Receivable 98 Sales Discounts Forfeited 2 Report as miscellaneous revenue
18 Net Method Record sale net of cash discounts Record discounts not taken (similar to interest income) Make year end adjustment for accounts that are past the discount period Adjusting entry: ACCOUNTS RECEIVABLE SALES
19 Theory Discounts are more like interest If so, the Gross Method Overstates Sales Understates Interest Income Defense for use of the Gross Method? Materiality
20 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 Allowancexx Sales Returnsxx A/Rxx 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 Returnsxx
21 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. Record sale in 2008: A/R1,000 Sales Revenue 1,000 Record default in 2009: Bad Debt Expense 1,000 A/R 1,000 Note: this is called the direct method, and is not GAAP, for the reasons listed on the next page.
22 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.
23 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 Expense4,000 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): Allowance1,000 A/R 1,000 When are the income statement and balance sheet affected? At the 2008 estimate.
24 Estimation of Uncollectibles Note that we do not know in 2008 which A/Rs will not be collected in 2009. Therefore, we must estimate uncollectibles. There are two methods: 1. Percentage of sales 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.
25 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.
26 2. Percentage of A/R Method (using Aging Schedule) Based on ending A/R and ending Allowance account. Calculation: Ending A/R x % = Ending Allowance (focus on the credit side of the AJE) Called Balance Sheet approach, because: ending asset x % = ending contra asset. Requires the analysis of the Allowance account before preparing the AJE. An aging schedule of A/R is the most accurate way to estimate uncollectibles (see Figure 6-11).
27 T-Account Approach for Percentage of A/R Method Based on the analysis of the Allowance account. Calculate the “desired ending balance” based on an aging of A/R. 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.”
28 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.
29 Allowance for Doubtful Accts. (T-account) Allowance for Doubtful Accts. Beginning Balance Accounts Receivable 2. Write-off of specific accounts receivable 2. Write-off of specific accounts receivable 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.
30 Allowance for Doubtful Accts. (T-account) Allowance for Doubtful Accts. Beginning Balance Accounts Receivable Write-off of accounts receivable 3. Ending Balance Write-off of accounts receivable 3. The “desired ending balance” in the allowance account is estimated using the percentage calculation or the aging schedule.
31 Allowance for Doubtful Accts. (T-account) Allowance for Doubtful Accts. Beginning Balance 4. Recovery of write-offs 4. Recovery of write-offs Accounts Receivable Write-off of accounts receivable Ending Balance Write-off of accounts receivable 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.
32 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 Accounts Receivable Write-off of accounts receivable Ending Balance Write-off of accounts receivable 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 Allowance account. Write-off recovery Write off recovery
33 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.
34 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 Allowance for D.A.20,000
35 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: Bad debt expense49,500 Allow. for D.A. 49,500
36 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.
37 % 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 Calculated as % of Receivables Calculated as % of Sales