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No-Tell Nortel
Recently, Nortel announced that its net income for 2003 was really half what it originally reported. In addition, the company had understated net income for 2002. How could this happen? One reason: It appears that Nortel set up cookie jar reserves, using the allowance for doubtful accounts as the cookie jar. As the following chart shows, in 2002 Nortel overestimated the amount of bad debt expense (with a sizable allowance for doubtful accounts). Then, in 2003 Nortel slashed the amount of bad debt expense, even though the total money owed by customers remained nearly unchanged. In 2002, its allowance was 19 percent of receivables compared to 10 percent in 2003quite a difference.
2003 Amount customers owe, gross Allowance for doubtful accounts Allowance as % of gross
2002 $2.62 billion $2.68 billion
$256 million $517 million 10% 19% Source: Company reports
It is difficult to determine if the allowance was too high in 2002 or too low in 2003, or both. Whatever the case, the use of the allowance cookie jar permitted Nortel to report higher operating margins and net income in 2003. This analysis suggests the importance of looking carefully at the amount of bad debt expense reported in annual reports. Sometimes companies use it to artificially decrease income. Others understate bad debt expense to increase income. For example, analysts have noted that many large hospitals, such as Tenet Healthcare and HCA, may be facing increasing uncollectible accounts that are presently not fully reflected in their balance sheets.
Adapted from J. Weil, At Nortel, Warning Signs Existed Months Ago, Wall Street Journal (May 18, 2004), p. C3; and B. McLean, Reality Checkup, Fortune (January 12, 2004), p. 140.
Learning Objectives
After studying this chapter, you should be able to: 1 2 3 4 5 6 7 8 9 Identify items considered as cash. Indicate how to report cash and related items. Define receivables and identify the different types of receivables. Explain accounting issues related to recognition of accounts receivable. Explain accounting issues related to valuation of accounts receivable. Explain accounting issues related to recognition of notes receivable. Explain accounting issues related to valuation of notes receivable. Explain accounting issues related to disposition of accounts and notes receivable. Describe how to report and analyze receivables.
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PREVIEW OF CHAPTER 7
As our opening story indicates, estimating the collectibility of accounts receivable has important implications for accurate reporting of operating profits, net income, and assets. In this chapter we discuss cash and receivablestwo assets that are important to companies as diverse as Nortel and Tenet Healthcare. The content and organization of the chapter are as follows.
C A S H A N D R E C E I VA B L E S
CASH
What is cash? Management and control of cash Reporting cash Summary of cash-related items
R E C E I VA B L E S
Recognition of accounts receivable Valuation of a ccounts receivable Recognition of notes receivable Valuation of notes receivable Disposition of accounts and notes receivable Presentation and analysis
SECTION 1
CASH
WHAT IS CASH?
OBJECTIVE 1
Identify items considered cash.
Cash, the most liquid of assets, is the standard medium of exchange and the basis for measuring and accounting for all other items. Companies generally classify cash as a current asset. Cash consists of coin, currency, and available funds on deposit at the bank. Negotiable instruments such as money orders, certified checks, cashiers checks, personal checks, and bank drafts are also viewed as cash. What about savings accounts? Banks do have the legal right to demand notice before withdrawal. But, because banks rarely demand prior notice, savings accounts nevertheless are considered cash. Some negotiable instruments provide small investors with an opportunity to earn interest. These items, more appropriately classified as temporary investments than as cash, include money market funds, money market savings certificates, certificates of
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Management and Control of Cash deposit (CDs), and similar types of deposits and short-term paper.1 These securities usually contain restrictions or penalties on their conversion to cash. Money market funds that provide checking account privileges, however, are usually classified as cash. Certain items present classification problems: Companies treat postdated checks and I.O.U.s as receivables. They also treat travel advances as receivables if collected from employees or deducted from their salaries. Otherwise, companies classify the travel advance as a prepaid expense. Postage stamps on hand are classified as part of office supplies inventory or as a prepaid expense. Because petty cash funds and change funds are used to meet current operating expenses and liquidate current liabilities, companies include these funds in current assets as cash.
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MANAGEMENT AND CONTROL OF CASH
Cash is the asset most susceptible to improper diversion and use. Management faces two problems in accounting for cash transactions: (1) to establish proper controls to prevent any unauthorized transactions by officers or employees, and (2) to provide information necessary to properly manage cash on hand and cash transactions. Yet even with sophisticated control devices, errors can and do happen. For example, the Wall Street Journal ran a story entitled A $7.8 Million Error Has a Happy Ending for a Horrified Bank. The story described how Manufacturers Hanover Trust Co. mistakenly overpaid about $7.8 million in cash dividends to its stockholders. (As implied in the headline, most stockholders returned the monies.) To safeguard cash and to ensure the accuracy of the accounting records for cash, companies need effective internal control over cash. Provisions of the Sarbanes-Oxley Act of 2002 call for enhanced efforts to increase the quality of internal control (for cash and other assets). Such efforts are expected to result in improved financial reporting. However, the increasing volume of transactions conducted with the swipe of a debit or credit card presents new challenges to the effort to maintain control over liquid assets. As one writer noted, In 5,000 years there have been only four times that we have changed the way we paythere was barter to coinage; coins to paper; paper to checks; and then cards. Just since 1995, the amount of stuff that American consumers buy using plastic has increased 430 percent.2 In 2003, for the first time, Americans bought more using cards than cash.3 In addition, electronic commerce conducted over the Internet continues to grow.
A variety of short-term paper is available for investment. For example, certificates of deposit (CDs) represent formal evidence of indebtedness, issued by a bank, subject to withdrawal under the specific terms of the instrument. Issued in $1,000 to $100,000 denominations, they have maturities anywhere from 7 days to 10 years and generally pay interest at the short-term interest rate in effect at the date of issuance. Banks and savings and loan associations issue money-market savings certificates in denominations of $10,000 or more for 6-month periods (6 to 48 months). The interest rate is tied to the 26-week Treasury bill rate. In money-market funds, a variation of the mutual fund, the mix of Treasury bills and commercial paper making up the funds portfolio determines the yield. Most money-market funds require an initial minimum investment of $1,000; many allow withdrawal by check or wire transfer. Treasury bills are U.S. government obligations generally issued with 4-, 13-, and 26-week maturities; they are sold in $10,000 denominations at weekly government auctions. Commercial paper is a short-term note issued by corporations with good credit ratings. Often issued in $5,000 and $10,000 denominations, these notes generally yield a higher rate than Treasury bills.
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K. Brooker, Just One Word: Plastic, Fortune (February 23, 2004), p. 130.
Ibid, p. 132. Non-U.S. consumers are even bigger users of digital cash than U.S. consumers. For example, non-check payments in Japan and Europe comprise over 70 percent of all payment transactions. U.S. consumers continued use of checks and cash for payment raises fraud concerns, though, as duplication technology makes it easier to forge checks and currency.
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Chapter 7 Cash and Receivables Each of these trends contributes to the shift from cold cash to digital cash, and poses new challenges for the control of cash. In the appendix to this chapter, we discuss some of the basic control procedures used to ensure the correct reporting of cash.
REPORTING CASH
OBJECTIVE 2
Indicate how to report cash and related items.
Although the reporting of cash is relatively straightforward, a number of issues merit special attention. These issues relate to the reporting of:
1 2 3
Restricted cash. Bank overdrafts. Cash equivalents.
Restricted Cash
Petty cash, payroll, and dividend funds are examples of cash set aside for a particular purpose. In most situations, these fund balances are not material. Therefore, companies do not segregate them from cash in the financial statements. When material in amount, companies segregate restricted cash from regular cash for reporting purposes. Companies classify restricted cash either in the current assets or in the long-term assets section, depending on the date of availability or disbursement. Classification in the current section is appropriate if using the cash for payment of existing or maturing obligations (within a year or the operating cycle, whichever is longer). On the other hand, companies show the restricted cash in the long-term section of the balance sheet if holding the cash for a longer period of time. Cash classified in the long-term section is frequently set aside for plant expansion, retirement of long-term debt or, in the case of International Thoroughbred Breeders, for entry fee deposits.
ILLUSTRATION 7-1 Disclosure of Restricted Cash
International Thoroughbred Breeders
Restricted cash and investments (See Note) $3,730,000 Note: Restricted Cash. At year-end, the Company had approximately $3,730,000, which was classified as restricted cash and investments. These funds are primarily cash received from horsemen for nomination and entry fees to be applied to upcoming racing meets, purse winnings held in trust for horsemen, and amounts held for unclaimed ticketholder winnings.
Banks and other lending institutions often require customers to maintain minimum cash balances in checking or savings accounts. The SEC defines these minimum balances, called compensating balances, as that portion of any demand deposit (or any time deposit or certificate of deposit) maintained by a corporation which constitutes support for existing borrowing arrangements of the corporation with a lending institution. Such arrangements would include both outstanding borrowings and the assurance of future credit availability.4
4 Accounting Series Release No. 148, Amendments to Regulations S-X and Related Interpretations and Guidelines Regarding the Disclosure of Compensating Balances and Short-Term Borrowing Arrangements, Securities and Exchange Commission (November 13, 1973). The SEC defines 15 percent of liquid assets (current cash balances, whether restricted or not, plus marketable securities) as being material, thereby requiring additional reporting.
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Summary of Cash-Related Items To avoid misleading investors about the amount of cash available to meet recurring obligations, the SEC recommends that companies state separately legally restricted deposits held as compensating balances against short-term borrowing arrangements among the Cash and cash equivalent items in current assets. Companies should classify separately restricted deposits held as compensating balances against long-term borrowing arrangements as noncurrent assets in either the investments or other assets sections, using a caption such as Cash on deposit maintained as compensating balance. In cases where compensating balance arrangements exist without agreements that restrict the use of cash amounts shown on the balance sheet, companies should describe the arrangements and the amounts involved in the notes.
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International Insight Among other potential restrictions, companies need to determine whether any of the cash in accounts outside the U.S. is restricted by regulations against exportation of currency.
Bank Overdrafts
Bank overdrafts occur when a company writes a check for more than the amount in its cash account. Companies should report bank overdrafts in the current liabilities section, adding them to the amount reported as accounts payable. If material, companies should disclose these items separately, either on the face of the balance sheet or in the related notes.5 Bank overdrafts are generally not offset against the cash account. A major exception is when available cash is present in another account in the same bank on which the overdraft occurred. Offsetting in this case is required.
Cash Equivalents
A current classification that has become popular is Cash and cash equivalents.6 Cash equivalents are short-term, highly liquid investments that are both (a) readily convertible to known amounts of cash, and (b) so near their maturity that they present insignificant risk of changes in interest rates. Generally, only investments with original maturities of three months or less qualify under these definitions. Examples of cash equivalents are Treasury bills, commercial paper, and money market funds. Some companies combine cash with temporary investments on the balance sheet. In these cases, they describe the amount of the temporary investments either parenthetically or in the notes.
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Additional Disclosures of Restricted Cash
SUMMARY OF CASH-RELATED ITEMS
Cash and cash equivalents include the medium of exchange and most negotiable instruments. If the item cannot be quickly converted to coin or currency, a company separately classifies it as an investment, receivable, or prepaid expense. Companies segregate and classify cash that is unavailable for payment of currently maturing liabilities in the long-term assets section. Illustration 7-2 (page 318) summarizes the classification of cash-related items.
Bank overdrafts usually occur because of a simple oversight by the company writing the check. Banks often expect companies to have overdrafts from time to time and therefore negotiate a fee as payment for this possible occurrence. However, at one time, E. F. Hutton (a large brokerage firm) began intentionally overdrawing its accounts by astronomical amountson some days exceeding $1 billionthus obtaining interest-free loans that it could invest. Because the amounts were so large and fees were not negotiated in advance, E. F. Hutton came under criminal investigation for its actions. Accounting Trends and Techniques2004, indicates that approximately 6 percent of the companies surveyed use the caption Cash, 83 percent use Cash and cash equivalents, and 4 percent use a caption such as Cash and marketable securities or similar terminology.
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Chapter 7 Cash and Receivables
Classification of Cash, Cash Equivalents, and Noncash Items Item Cash Cash Classification Comment If unrestricted, report as cash. If restricted, identify and classify as current and noncurrent assets. Report as cash. Investments with maturity of less than 3 months, often combined with cash. Investments with maturity of 3 to 12 months. Assumed to be collectible. Assumed to be collected from employees or deducted from their salaries. May also be classified as office supplies inventory. If right of offset exists, reduce cash. Classify as current or noncurrent in the balance sheet. Disclose separately in notes details of the arrangement.
ILLUSTRATION 7-2 Classification of CashRelated Items
Petty cash and change funds Short-term paper
Cash Cash equivalents
Short-term paper Postdated checks and IOUs Travel advances
Temporary investments Receivables Receivables
Postage on hand (as stamps or in postage meters) Bank overdrafts Compensating balances
Prepaid expenses
Current liability Cash separately classified as a deposit maintained as compensating balance
Too much of a good thing?
Can it ever be a bad thing to have too much cash on hand? Maybe so. As the data in the following table indicate, General Motors and some other major companies have been stockpiling cash at levels not recently seen.
Company General Motors Berkshire Hathaway Ford Motor Company Hewlett-Packard Intel Total Cash (in billions) $54.8 $36.0 $33.6 $13.9 $13.5
What do the numbers mean?
Given the low returns on cash, investors may ask why companies maintain such large cash balances. Some companies with good growth prospects plan to use these resources to fuel growth. They intend to step up spending on property, plant, and equipment or on research and development. Or they may hold cash in order to acquire other companies that have growth prospects. However, without good use for stockpiled cash, stockholders would be better served by a payout in the form of a cash dividend.
SECTION 2
RECEIVABLES
Receivables are claims held against customers and others for money, goods, or services. For financial statement purposes, companies classify receivables as either current (short-term) or noncurrent (long-term). Companies expect to collect current receivables within a year or during the current operating cycle, whichever is longer. They classify
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Receivables all other receivables as noncurrent. Receivables are further classified in the balance sheet as either trade or nontrade receivables. Customers often owe a company amounts for goods bought or services rendered. A company may subclassify these trade receivables, usually the most significant item it possesses, into accounts receivable and notes receivable. Accounts receivable are oral promises of the purchaser to pay for goods and services sold. They represent open accounts resulting from short-term extensions of credit. A company normally collects them within 30 to 60 days. Notes receivable are written promises to pay a certain sum of money on a specified future date. They may arise from sales, financing, or other transactions. Notes may be short-term or long-term. Nontrade receivables arise from a variety of transactions. Some examples of nontrade receivables are:
1 2 3 4 5 6
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OBJECTIVE 3
Define receivables and identify the different types of receivables.
Advances to officers and employees. Advances to subsidiaries. Deposits paid to cover potential damages or losses. Deposits paid as a guarantee of performance or payment. Dividends and interest receivable. Claims against: (a) Insurance companies for casualties sustained. (b) Defendants under suit. (c) Governmental bodies for tax refunds. (d) Common carriers for damaged or lost goods. (e) Creditors for returned, damaged, or lost goods. (f) Customers for returnable items (crates, containers, etc.).
Because of the peculiar nature of nontrade receivables, companies generally report them as separate items in the balance sheet. Illustration 7-3 shows the reporting of trade and non-trade receivables in the balance sheets of Adolph Coors Company and Seaboard Corporation.
ILLUSTRATION 7-3 Receivables Balance Sheet Presentations
Adolph Coors Company
(in thousands) Current assets Cash and cash equivalents Short-term investments Accounts and notes receivable Trade, less allowance for doubtful accounts of $299 Subsidiaries Other, less allowance for certain claims of $584 Inventories Other supplies, less allowance for obsolete supplies of $3,968 Prepaid expenses and other assets Deferred tax asset Total current assets $160,038 96,190
Seaboard Corporation
(in thousands) Current assets Cash and cash equivalents Short-term investments Receivables Trade Due from foreign affiliates Other Allowance for doubtful receivables Net receivables Inventories Deferred income taxes Prepaid expenses and deposits Total current assets $ 19,760 91,375 $194,966 36,662 41,816 273,444 (29,801) 243,643 218,030 14,132 23,760 $610,700
106,962 11,896 7,751 102,660 27,729 12,848 22,917 $548,991
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Chapter 7 Cash and Receivables The basic issues in accounting for accounts and notes receivable are the same: recognition, valuation, and disposition. We discuss these basic issues for accounts and notes receivable next.
RECOGNITION OF ACCOUNTS RECEIVABLE
OBJECTIVE 4
Explain accounting issues related to recognition of accounts receivable.
In most receivables transactions, the amount to be recognized is the exchange price between the two parties. The exchange price is the amount due from the debtor (a customer or a borrower). Some type of business document, often an invoice, serves as evidence of the exchange price. Two factors may complicate the measurement of the exchange price: (1) the availability of discounts (trade and cash discounts), and (2) the length of time between the sale and the due date of payments (the interest element).
Trade Discounts
Prices may be subject to a trade or quantity discount. Companies use such trade discounts to avoid frequent changes in catalogs, to alter prices for different quantities purchased, or to hide the true invoice price from competitors. Trade discounts are commonly quoted in percentages. For example, say your textbook has a list price of $90, and the publisher sells it to college bookstores for list less a 30 percent trade discount. The publisher then records the receivable at $63 per textbook. The publisher, per normal practice, simply deducts the trade discount from the list price and bills the customer net. As another example, Maxwell House at one time sold a 10-ounce jar of its instant coffee listing at $5.85 to supermarkets for $5.05, a trade discount of approximately 14 percent. The supermarkets in turn sold the instant coffee for $5.20 per jar. Maxwell House records the receivable and related sales revenue at $5.05 per jar, not $5.85.
Cash Discounts (Sales Discounts)
Companies offer cash discounts (sales discounts) to induce prompt payment. Cash discounts generally read in terms such as 2/10, n/30 (2 percent if paid within 10 days, gross amount due in 30 days), or 2/10, E.O.M., net 30, E.O.M. (2 percent if paid any time before the tenth day of the following month, with full payment received by the thirtieth of the following month). Companies usually take sales discounts unless their cash is severely limited. Why? A company that receives a 1 percent reduction in the sales price for payment within 10 days, total payment due within 30 days, effectively earns 18.25 percent (.01 [20/365]), or at least avoids that rate of interest cost. Companies usually record sales and related sales discount transactions by entering the receivable and sale at the gross amount. Under this method, companies recognize sales discounts only when they receive payment within the discount period. The income statement shows sales discounts as a deduction from sales to arrive at net sales. Some contend that sales discounts not taken reflect penalties added to an established price to encourage prompt payment. That is, the seller offers sales on account at a slightly higher price than if selling for cash. The cash discount offered offsets the increase. Thus, customers who pay within the discount period actually purchase at the cash price. Those who pay after expiration of the discount period pay a penalty for the delayan amount in excess of the cash price. Per this reasoning, companies record sales and receivables net. They subsequently debit any discounts not taken to Accounts Receivable and credit to Sales Discounts Forfeited. The entries in Illustration 7-4 show the difference between the gross and net methods.
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Valuation of Accounts Receivable
Gross Method Sales of $10,000, terms 2/10, n/30 Accounts Receivable Sales Cash Sales Discounts Accounts Receivable Cash Accounts Receivable 10,000 10,000 3,920 80 4,000 Payment of $6,000 received after discount period 6,000 6,000 Accounts Receivable Sales Discounts Forfeited Cash Accounts Receivable 120 120 6,000 6,000 Accounts Receivable Sales Cash Accounts Receivable 9,800 9,800 3,920 3,920 Net Method
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ILLUSTRATION 7-4 Entries under Gross and Net Methods of Recording Cash (Sales) Discounts
Payment of $4,000 received within discount period
If using the gross method, a company reports sales discounts as a deduction from sales in the income statement. Proper matching dictates that the company also reasonably estimates the expected discounts to be taken and charge that amount against sales. If using the net method, a company considers Sales Discounts Forfeited as an Other revenue item.7 Theoretically, the recognition of Sales Discounts Forfeited is correct. The receivable is stated closer to its realizable value, and the net sales figure measures the revenue earned from the sale. As a practical matter, however, companies seldom use the net method because it requires additional analysis and bookkeeping. For example, the net method requires adjusting entries to record sales discounts forfeited on accounts receivable that have passed the discount period.
Nonrecognition of Interest Element
Ideally, a company should measure receivables in terms of their present value, that is, the discounted value of the cash to be received in the future. When expected cash receipts require a waiting period, the receivable face amount is not worth the amount that the company ultimately receives. To illustrate, assume that Best Buy makes a sale on account for $1,000 with payment due in four months. The applicable annual rate of interest is 12 percent, and payment is made at the end of four months. The present value of that receivable is not $1,000 but $961.54 ($1,000 .96154). In other words, the $1,000 Best Buy receives four months from now is not the same as the $1,000 received today. Theoretically, any revenue after the period of sale is interest revenue. In practice, companies ignore interest revenue related to accounts receivable because the amount of the discount is not usually material in relation to the net income for the period. The profession specifically excludes from present value considerations receivables arising from transactions with customers in the normal course of business which are due in customary trade terms not exceeding approximately one year.8
Underlying Concepts
Materiality means it must make a difference to a decision maker. The FASB believes that present value concepts can be ignored for short-term receivables.
VALUATION OF ACCOUNTS RECEIVABLE
Reporting of receivables involves (1) classification and (2) valuation on the balance sheet. Classification involves determining the length of time each receivable will be outstanding. Companies classify receivables intended to be collected within a year or the operating cycle, whichever is longer, as current. All other receivables are classified as long-term.
7 To the extent that discounts not taken reflect a short-term financing, some argue that companies could use an interest revenue account to record these amounts.
Interest on Receivables and Payables, Opinions of the Accounting Principles Board No. 21 (New York: AICPA, 1971), par. 3(a).
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Chapter 7 Cash and Receivables Companies value and report short-term receivables at net realizable valuethe net amount they expect to receive in cash. Determining net realizable value requires estimating both uncollectible receivables and any returns or allowances to be granted.
OBJECTIVE 5
Explain accounting issues related to valuation of accounts receivable.
Uncollectible Accounts Receivable
As one revered accountant aptly noted, the credit managers idea of heaven probably would be a place where everyone (eventually) paid his or her debts.9 The recent experiences of Circuit City, Sears (now Sears Holdings), Target, and Kohls, as shown in Illustration 7-5, indicate the importance of credit sales for many companies. Note that for Sears, increased bad debt expense led to a lower stock price, which prompted Sears to sell its credit card portfolio to Citigroup in 2003.
ILLUSTRATION 7-5 Credit and Its Costs
COUNTING ON CREDIT
Percentage of profits derived from credit cards
100%
54%
15%
5%
Circuit City
Sears
Target
Kohls
AT SEARS
As card problems mount... Bad Debt Expense
$2,000 million
...the stock is slumping Stock Price per Share
$60
$40 $1,000 $20 0 1996 0 1996
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2002
98
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2002
Source: Sears financial data.
Sales on any basis other than cash make uncertain the possibility of collecting the account. An uncollectible account receivable is a loss of revenue that requires, through proper entry in the accounts, a decrease in the asset accounts receivable and a related decrease in income and stockholders equity. Companies recognize the loss in revenue and the decrease in income by recording bad debt expense. Companies use two procedures to record uncollectible accounts:
METHODS FOR RECORDING UNCOLLECTIBLES
1 DIRECT WRITE-OFF METHOD. No entry is made until a specific account
has definitely been established as uncollectible. Then the loss is recorded by crediting Accounts Receivable and debiting Bad Debt Expense. 2 ALLOWANCE METHOD. An estimate is made of the expected uncollectible accounts from all sales made on account or from the total of outstanding receivables. This estimate is entered as an expense and an indirect reduction in accounts receivable (via an increase in the allowance account) in the period in which the sale is recorded.
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William J. Vatter, Managerial Accounting (Englewood Cliffs, N.J.: Prentice-Hall, 1950), p. 60.
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Valuation of Accounts Receivable The direct write-off method records the bad debt in the period in which a company determines that it cannot collect a specific receivable. In contrast, the allowance method enters the expense on an estimated basis in the accounting period in which the sales on account occur. Supporters of the direct write-off method (which is used for tax purposes) contend that it records facts, not estimates. It assumes that a good account receivable resulted from each sale, and that later events revealed certain accounts to be uncollectible and worthless. From a practical standpoint this method is simple and convenient to apply. But the direct write-off method is theoretically deficient: It usually fails to match costs with revenues of the period. Nor does it result in receivables being stated at estimated realizable value on the balance sheet. As a result, using the direct write-off method is not considered appropriate, except when the amount uncollectible is immaterial. Advocates of the allowance method believe that companies should record bad debt expense in the same period as the sale, to properly match expenses and revenues and to achieve a proper carrying value for accounts receivable. They contend that although estimates are involved, companies can predict the percentage of uncollectible receivables from past experiences, present market conditions, and an analysis of the outstanding balances. Many companies set their credit policies to provide for a certain percentage of uncollectible accounts. (In fact, many feel that failure to reach that percentage means that they are losing sales due to overly restrictive credit policies.) The FASB considers the collectibility of receivables a loss contingency. Thus, the allowance method is appropriate in situations where it is probable that an asset has been impaired and that the amount of the loss can be reasonably estimated.10 A receivable is a prospective cash inflow. The probability of its collection must be considered in valuing cash flows. These estimates normally are based either on (1) percentage of sales or (2) outstanding receivables. Percentage-of-Sales (Income Statement) Approach If there is a fairly stable relationship between previous years credit sales and bad debts, then a company can convert that relationship into a percentage and use it to determine this years bad debt expense. The percentage-of-sales approach matches costs with revenues because it relates the charge to the period in which a company records the sale. To illustrate, assume that Chad Shumway Corp. estimates from past experience that about 2 percent of credit sales become uncollectible. If Chad Shumway has credit sales of $400,000 in 2007, it records bad debt expense using the percentage-of-sales method as follows.
Bad Debt Expense Allowance for Doubtful Accounts 8,000 8,000
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Underlying Concepts
The percentage-of-sales method illustrates the matching principle, which relates expenses to revenues earned.
The Allowance for Doubtful Accounts is a valuation account (i.e., a contra asset), subtracted from trade receivables on the balance sheet.11 The amount of bad debt expense and the related credit to the allowance account are unaffected by any balance currently existing in the allowance account. Because the bad debt expense estimate is related to a nominal account (Sales), any balance in the allowance is ignored. Therefore, the percentage of sales method achieves a proper matching of cost and revenues. This method is frequently referred to as the income statement approach. Percentage-of-Receivables (Balance Sheet) Approach Using past experience, a company can estimate the percentage of its outstanding receivables that will become uncollectible, without identifying specific accounts. This procedure provides a reasonably accurate estimate of the receivables realizable value. But,
10 Accounting for Contingencies, Statement of Financial Accounting Standards No. 5 (Stamford, Conn.: FASB, 1975), par. 8.
The account description employed for the allowance account is usually Allowance for Doubtful Accounts or simply Allowance. Accounting Trends and Techniques2004, for example, indicates that approximately 86 percent of the companies surveyed used allowance in their description.
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Chapter 7 Cash and Receivables it does not fit the concept of matching cost and revenues. Rather, it simply reports receivables in the balance sheet at net realizable value. Hence it is referred to as the percentage-of-receivables (or balance sheet) approach. Companies may apply this method using one composite rate that reflects an estimate of the uncollectible receivables. Or, companies may set up an aging schedule of accounts receivable, which applies a different percentage based on past experience to the various age categories. An aging schedule also identifies which accounts require special attention by indicating the extent to which certain accounts are past due. The following schedule of Wilson & Co. is an example.
ILLUSTRATION 7-6 Accounts Receivable Aging Schedule
Name of Customer Western Stainless Steel Corp. Brockway Steel Company Freeport Sheet & Tube Co. Allegheny Iron Works
WILSON & CO. AGING SCHEDULE Balance Dec. 31 $ 98,000 320,000 55,000 74,000 $547,000 Under 60 days $ 80,000 320,000 60,000 $460,000 Summary Percentage Estimated to be Uncollectible 4% 15% 20% 25% Required Balance in Allowance $18,400 2,700 2,800 13,750 $37,650 $18,000 6190 days $18,000 $55,000 $14,000 $14,000 $55,000 91120 days Over 120 days
Age Under 60 days old 6190 days old 91120 days old Over 120 days
Amount $460,000 18,000 14,000 55,000
Year-end balance of allowance for doubtful accounts
Wilson reports bad debt expense of $37,650 for this year, assuming that no balance existed in the allowance account. To change the illustration slightly, assume that the allowance account had a credit balance of $800 before adjustment. In this case, Wilson adds $36,850 ($37,650 $800) to the allowance account, and makes the following entry.
Bad Debt Expense Allowance for Doubtful Accounts 36,850 36,850
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Tutorial on Recording Uncollectible Accounts
Wilson therefore states the balance in the Allowance account at $37,650. If the Allowance balance before adjustment had a debit balance of $200, then Wilson records bad debt expense of $37,850 ($37,650 desired balance $200 debit balance). In the percentage-of-receivables method, Wilson cannot ignore the balance in the allowance account, because the percentage is related to a real account (Accounts Receivable). Companies usually do not prepare an aging schedule to determine bad debt expense. Rather, they prepare it as a control device to determine the composition of receivables and to identify delinquent accounts. Companies base the estimated loss percentage developed for each category on previous loss experience and the advice of credit department personnel. Whether using a composite rate or an aging schedule, the primary objective of the percentage of outstanding receivables method for financial statement purposes is to report receivables in the balance sheet at net realizable value. However, it is deficient in that it may not match the bad debt expense to the period in which the sale takes place. The allowance for doubtful accounts as a percentage of receivables will vary, depending on the industry and the economic climate. Companies such as Eastman Kodak, General Electric, and Monsanto have recorded allowances ranging from $3 to $6 per
co
llege/k
i
w
ile
y. c o m /
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Valuation of Accounts Receivable $100 of accounts receivable. Other large companies, such as CPC International ($1.48), Texaco ($1.23), and USX Corp. ($0.78), have had bad debt allowances of less than $1.50 per $100. At the other extreme are hospitals that allow for $15 to $20 per $100 of accounts receivable.12
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Going for broke
The start of the new millennium has been a tough one for companies and their investors, creditors, and employees. Enron, Kmart, and WorldCom all declared bankruptcywith WorldCom representing the largest bankruptcy ever. The trend seems to be continuing. It is not surprising that banks and other creditors are raising their lending standards to guard against future loan defaults. Even so, some question whether creditors have set up reasonable bad debt allowances to ensure that financial performance is reported accurately. Indeed, one recent analysis for hospitals (mentioned in our opening story) indicates that additional bad debt expense needed to properly reflect future write-offs could result in an earnings hit of as much as 18 percent for some hospitals. That will be tough medicine for these companies to swallow.
Source: Adapted from: Julie Creswell, First Going for Broke, Fortune (February 18, 2002), pp. 2425; Bethany McLean, Reality Check-up, Fortune (January 12, 2004), pp. 140.
What do the numbers mean?
In summary, the percentage-of-receivables method results in a more accurate valuation of receivables on the balance sheet. From a matching viewpoint, the percentageof-sales approach provides the better results. Illustration 7-7 relates these methods to the basic theory.
Percentage-of-Sales Matching Sales Bad Debts Expense
Percentage-of-Receivables Net Realizable Value Accounts Receivable Allowance for Doubtful Accounts
ILLUSTRATION 7-7 Comparison of Methods for Estimating Uncollectibles
Income Statement Approach
Balance Sheet Approach
The account title employed for the allowance account is usually Allowance for Doubtful Accounts or simply Allowance.
A U.S. Department of Commerce study indicated, as a general rule, the following relationships between the age of accounts receivable and their uncollectibility.
30 days or less 3160 days 6190 days 91120 days 4% uncollectible 10% uncollectible 17% uncollectible 26% uncollectible
12
After 120 days, an approximate 34 percent increase in uncollectibles for every 30 days outstanding occurs for the remainder of the first year.
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Chapter 7 Cash and Receivables Regardless of the method chosen, determining the expense associated with uncollectible accounts requires a large degree of judgment. Recent concern exists that, similar to Nortel in our opening story, some banks use this judgment to manage earnings. By overestimating the amounts of uncollectible loans in a good earnings year, the bank can save for a rainy day in a future period. In future (less-profitable) periods, banks can reduce the overly conservative allowance for loan loss account to increase earnings. In this regard, the SEC brought action against Suntrust Banks, requiring a reversal of $100 million of bad debt expense. This reversal increased aftertax profit by $61 million.13 Collection of Accounts Receivable Written Off When a company determines a particular account receivable to be uncollectible, it removes the balance from the books by debiting Allowance for Doubtful Accounts and crediting Accounts Receivable. If it eventually collects on a receivable that it previously wrote off, it first reestablishes the receivable by debiting Accounts Receivable and crediting Allowance for Doubtful Accounts. The company then debits Cash and credits the customers account for the amount received. If using the direct write-off approach, the company debits the amount collected to Cash and credits a revenue account entitled Uncollectible Amounts Recovered, with proper notation in the customers account.
International Insight The U.S. has criticized some countries use of excess reserves to manage income. These same countries would argue that Suntrust Banks accounting for loan losses is a similar practice.
Collection is a click away
What do lenders do with uncollectible receivables? After they record bad debts on their books, they next to try to collect what they can from the deadbeat customers. Some lenders auction their bad loans in the market for distressed debt, usually paying a fee of 515 percent to a distressed debt broker, who arranges the sale. Recently, several Web sites have sprung up to provide a meeting place between lenders with bad loans and collectors. These sites are sort of an eBay of deadbeats. For example, Bank One Corp. listed $211 million of unpaid credit card receivables on DebtforSale.com. While the lendors generally recover less than 10 percent of the face value of the receivables in an auction, by going online they can reduce the costs of their bad debts. Online services charge just 0.51 percent for their auction services.
Source: Adapted from P. Gogoi, An eBay of Deadbeats, Business Week (September 18, 2000), p. 124.
What do the numbers mean?
RECOGNITION OF NOTES RECEIVABLE
A note receivable is supported by a formal promissory note, a written promise to pay a certain sum of money at a specific future date. Such a note is a negotiable instrument that a maker signs in favor of a designated payee who may legally and readily sell or otherwise transfer the note to others. Although notes contain an interest element because of the time value of money, companies classify them as interest-bearing or noninterestbearing. Interest-bearing notes have a stated rate of interest. Zero-interest-bearing notes (noninterest-bearing) include interest as part of their face amount. Notes receivable are considered fairly liquid, even if long-term, because companies may easily convert them to cash (although they might pay a fee to do so).
Recall from our earnings management discussion in Chapter 4 that increasing or decreasing income through management manipulation can reduce the quality of financial reports.
13
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Recognition of Notes Receivable Companies frequently accept notes receivable from customers who need to extend the payment period of an outstanding receivable. Or they require notes from high-risk or new customers. In addition, companies often use notes in loans to employees and subsidiaries, and in the sales of property, plant, and equipment. In some industries (e.g., the pleasure and sport boat industry) notes support all credit sales. The majority of notes, however, originate from lending transactions. The basic issues in accounting for notes receivable are the same as those for accounts receivable: recognition, valuation, and disposition. Companies generally record short-term notes at face value (less allowances) because the interest implicit in the maturity value is immaterial. A general rule is that notes treated as cash equivalents (maturities of three months or less and easily converted to cash) are not subject to premium or discount amortization. However, companies should record and report long-term notes receivable at the present value of the cash they expect to collect. When the interest stated on an interestbearing note equals the effective (market) rate of interest, the note sells at face value.14 When the stated rate differs from the market rate, the cash exchanged (present value) differs from the face value of the note. Companies then record this difference, either a discount or a premium, and amortize it over the life of a note to approximate the effective (market) interest rate. This illustrates one of the many situations in which time value of money concepts are applied to accounting measurement.
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OBJECTIVE 6
Explain accounting issues related to recognition of notes receivable.
Note Issued at Face Value
To illustrate the discounting of a note issued at face value, assume that Bigelow Corp. lends Scandinavian Imports $10,000 in exchange for a $10,000, three-year note bearing interest at 10 percent annually. The market rate of interest for a note of similar risk is also 10 percent. We show the time diagram depicting both cash flows in Illustration 7-8.
Present Value PV PV PV OA PVOA i = 10% $1,000 $1,000
$10,000 Principal $1,000 Interest
ILLUSTRATION 7-8 Time Diagram for Note Issued at Face Value
0
1
n=3
2
3
Bigelow computes the present value or exchange price of the note as follows.
Face value of the note Present value of the principal: $10,000 (PVF3,10%) $10,000 .75132 Present value of the interest: $1,000 (PVF-OA3,10%) $1,000 2.48685 Present value of the note Difference
$10,000 $7,513 2,487 10,000 $ 0
ILLUSTRATION 7-9 Present Value of Note Stated and Market Rates the Same
The stated interest rate, also referred to as the face rate or the coupon rate, is the rate contracted as part of the note. The effective-interest rate, also referred to as the market rate or the effective yield, is the rate used in the market to determine the value of the note that is, the discount rate used to determine present value.
14
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Chapter 7 Cash and Receivables In this case, the present value of the note equals its face value, because the effective and stated rates of interest are also the same. Bigelow records the receipt of the note as follows.
Notes Receivable Cash 10,000 10,000
As indicated in Appendix 6A, you can use a financial calculator to solve this problem. Calculator Solution for Present Value of Note Receivable Inputs Answer
Bigelow recognizes the interest earned each year as follows.
Cash Interest Revenue 1,000 1,000
N I PV PMT FV
3
10
Note Not Issued at Face Value
10,000
?
1,000
10,000
Zero-Interest-Bearing Notes If a company receives a zero-interest-bearing note, its present value is the cash paid to the issuer. Because the company knows both the future amount and the present value of the note, it can compute the interest rate. This rate is often referred to as the implicit interest rate. Companies record the difference between the future (face) amount and the present value (cash paid) as a discount and amortize it to interest revenue over the life of the note. To illustrate, Jeremiah Company receives a three-year, $10,000 zero-interest-bearing note, the present value of which is $7,721.80. The implicit rate that equates the total cash to be received ($10,000 at maturity) to the present value of the future cash flows ($7,721.80) is 9 percent (the present value of 1 for three periods at 9 percent is .77218). We show the time diagram depicting the one cash flow in Illustration 7-10.
ILLUSTRATION 7-10 Time Diagram for ZeroInterest-Bearing Note
Present Value PV PV PV OA PVOA i = 9% $0 $0
$10,000 Principal $0 Interest
0
Calculator Solution for Effective-Interest Rate on Note Inputs Answer
1
n=3
2
3
Jeremiah records the transaction as follows:
Notes Receivable Discount on Notes Receivable ($10,000 Cash 10,000.00 $7,721.80) 2,278.20 7,721.80
N I PV PMT FV
3
?
9
7,721.80
0
The Discount on Notes Receivable is a valuation account. Companies report it on the balance sheet as a contra-asset account to notes receivable. They then amortize the discount, and recognize interest revenue annually using the effective-interest method. Illustration 7-11 (page 329) shows the three-year discount amortization and interest revenue schedule. Jeremiah records interest revenue at the end of the first year using the effectiveinterest method as follows.
Discount on Notes Receivable Interest Revenue ($7,721.80 694.96 9%) 694.96
10,000
The amount of the discount, $2,278.20 in this case, represents the interest revenue Jeremiah will receive from the note over the three years. Interest-Bearing Notes Often the stated rate and the effective rate differ. The zero-interest-bearing note is one example.
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Recognition of Notes Receivable
SCHEDULE OF NOTE DISCOUNT AMORTIZATION EFFECTIVE-INTEREST METHOD 0% NOTE DISCOUNTED AT 9% Cash Received Date of issue End of year 1 End of year 2 End of year 3 $ 0 0 0 $ 0
a b
329
ILLUSTRATION 7-11 Discount Amortization ScheduleEffectiveInterest Method
Carrying Amount of Note $7,721.80 8,416.76c 9,174.27 10,000.00
Interest Revenue $ 694.96a 757.51 825.73d $2,278.20
c
Discount Amortized $ 694.96b 757.51 825.73 $2,278.20
$7,721.80 .09 $694.96 $694.96 0 $694.96
d
$7,721.80 $694.96 $8,416.76 5 adjustment to compensate for rounding
To illustrate a more common situation, assume that Morgan Corp. makes a loan to Marie Co. and receives in exchange a three-year, $10,000 note bearing interest at 10 percent annually. The market rate of interest for a note of similar risk is 12 percent. We show the time diagram depicting both cash flows in Illustration 7-12.
Present Value PV PV PV OA PVOA i = 12% $1,000 $1,000
$10,000 Principal $1,000 Interest
ILLUSTRATION 7-12 Time Diagram for Interest-Bearing Note
0
1
n=3
2
3
Morgan computes the present value of the two cash flows as follows.
Face value of the note Present value of the principal: $10,000 (PVF3,12%) $10,000 .71178 Present value of the interest: $1,000 (PVF-OA3,12%) $1,000 2.40183 Present value of the note Difference (Discount)
$10,000 $7,118 2,402 9,520 $ 480
ILLUSTRATION 7-13 Computation of Present ValueEffective Rate Different from Stated Rate
In this case, because the effective rate of interest (12 percent) exceeds the stated rate (10 percent), the present value of the note is less than the face value. That is, Morgan exchanged the note at a discount. Morgan records the receipt of the note at a discount as follows.
Notes Receivable Discount on Notes Receivable Cash 10,000 480 9,520
Morgan then amortizes the discount and recognizes interest revenue annually using the effective-interest method. Illustration 7-14 (page 330) shows the three-year discount amortization and interest revenue schedule.
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Chapter 7 Cash and Receivables
SCHEDULE OF NOTE DISCOUNT AMORTIZATION EFFECTIVE-INTEREST METHOD 10% NOTE DISCOUNTED AT 12% Cash Received Date of issue End of year 1 End of year 2 End of year 3 $1,000a 1,000 1,000 $3,000
a b
ILLUSTRATION 7-14 Discount Amortization ScheduleEffectiveInterest Method
Interest Revenue $1,142b 1,159 1,179 $3,480
c
Discount Amortized $142c 159 179 $480
Carrying Amount of Note $ 9,520 9,662d 9,821 10,000
$10,000 10% $1,000 $9,520 12% $1,142
d
$1,142 $9,520
$1,000 $142 $142 $9,662
On the date of issue, the note has a present value of $9,520. Its unamortized discount additional interest revenue spread over the three-year life of the noteis $480. At the end of year 1, Morgan receives $1,000 in cash. But its interest revenue is $1,142 ($9,520 12%). The difference between $1,000 and $1,142 is the amortized discount, $142. Morgan records receipt of the annual interest and amortization of the discount for the first year as follows (amounts per amortization schedule).
Cash Discount on Notes Receivable Interest Revenue 1,000 142 1,142
The carrying amount of the note is now $9,662 ($9,520 $142). Morgan repeats this process until the end of year 3. When the present value exceeds the face value, the note is exchanged at a premium. Companies record the premium on a note receivable as a debit and amortize it using the effective-interest method over the life of the note as annual reductions in the amount of interest revenue recognized. Notes Received for Property, Goods, or Services When a note is received in exchange for property, goods, or services in a bargained transaction entered into at arms length, the stated interest rate is presumed to be fair unless:
1 2 3
Calculator Solution for Effective-Interest Rate on Note Inputs Answer
No interest rate is stated, or The stated interest rate is unreasonable, or The face amount of the note is materially different from the current cash sales price for the same or similar items or from the current market value of the debt instrument.15
N I PV PMT FV
5
?
12
20,000
In these circumstances, the company measures the present value of the note by the fair value of the property, goods, or services or by an amount that reasonably approximates the market value of the note. To illustrate, Oasis Development Co. sold a corner lot to Rusty Pelican as a restaurant site. Oasis accepted in exchange a five-year note having a maturity value of $35,247 and no stated interest rate. The land originally cost Oasis $14,000. At the date of sale the land had a fair market value of $20,000. Given the criterion above, Oasis uses the fair market value of the land, $20,000, as the present value of the note. Oasis therefore records the sale as:
Notes Receivable Discount on Notes Receivable ($35,247 $20,000) Land Gain on Sale of Land ($20,000 $14,000) 35,247 15,247 14,000 6,000
0
35,247
15 Interest on Receivables and Payables, Opinions of the Accounting Principles Board No. 21 (New York: AICPA, 1971), par. 12.
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Valuation of Notes Receivable Oasis amortizes the discount to interest revenue over the five-year life of the note using the effective-interest method.
331
Choice of Interest Rate
In note transactions, other factors involved in the exchange, such as the fair market value of the property, goods, or services, determine the effective or real interest rate. But, if a company cannot determine that fair value, and if the note has no ready market, determining the present value of the note is more difficult. To estimate the present value of a note under such circumstances, the company must approximate an applicable interest rate that may differ from the stated interest rate. This process of interest-rate approximation is called imputation. The resulting interest rate is called an imputed interest rate. The prevailing rates for similar instruments, from issuers with similar credit ratings, affect the choice of a rate. Restrictive covenants, collateral, payment schedule, and the existing prime interest rate also impact the choice. A company determines the imputed interest rate when it receives the note. It ignores any subsequent changes in prevailing interest rates.
VALUATION OF NOTES RECEIVABLE
Like accounts receivable, companies record and report short-term notes receivable at their net realizable valuethat is, at their face amount less all necessary allowances. The primary notes receivable allowance account is Allowance for Doubtful Accounts. The computations and estimations involved in valuing short-term notes receivable and in recording bad debt expense and the related allowance exactly parallel that for trade accounts receivable. Companies estimate the amount of uncollectibles by using either a percentage of sales revenue or an analysis of the receivables. Long-term notes receivable, however, pose additional estimation problems. For evidence, we need only look at the problems that financial institutions, most notably money-center banks, have had in collecting receivables from energy loans, real estate loans, and loans to less-developed countries.16 A company considers a note receivable impaired when collecting all amounts due (both principal and interest) will likely not occur. We discuss impairments, as well as restructurings, of receivables and debts in detail in Appendix 14A. OBJECTIVE 7
Explain accounting issues related to valuation of notes receivable.
Putting the squeeze on
When the economy slows, lenders such as J.P. Morgan and First Chicago get stingier in granting new loans or renewing loans to existing customers. This tightening of loans is referred to as a credit squeeze. However, it is sometimes difficult for banks to cut back on lending when the economy goes from good times to bad. When times are good and banks are competing for lending business, lenders often grant business customers lines of credit as a sweetener to close a loan. In contrast to a term loan that is supported by a note, a line of credit allows borrowing on a day-to-day basis. When times turn bad, the bank can cut back on loans via notes receivable, but it still must honor the lines of credit, even to weak customers. For example, Xerox Inc. got a $7 billion line of credit before it hit the skids. Although denied by the traditional loan markets, Xerox has been able to draw on its line of credit to make ends meet. Thus, what seemed like of good competitive tool in good times has put the squeeze on lenders when times have turned bad.
Source: Adapted from H. Timmons and D. Sparks, Feeling a Credit Squeeze, Business Week (December 4, 2000), pp. 148149.
What do the numbers mean?
A wise person once said that a bank lending money to a Third World country is like lending money to ones children: You should never expect to get the interest, let alone the principal.
16
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Chapter 7 Cash and Receivables
DISPOSITION OF ACCOUNTS AND NOTES RECEIVABLE
OBJECTIVE 8
Explain accounting issues related to disposition of accounts and notes receivable.
In the normal course of events, companies collect accounts and notes receivable when due and then remove them from the books. However, the growing size and significance of credit sales and receivables has led to changes in this normal course of events. In order to accelerate the receipt of cash from receivables, the owner may transfer accounts or notes receivables to another company for cash. There are various reasons for this early transfer. First, for competitive reasons, providing sales financing for customers is virtually mandatory in many industries. In the sale of durable goods, such as automobiles, trucks, industrial and farm equipment, computers, and appliances, most sales are on an installment contract basis. Many major companies in these industries have created wholly-owned subsidiaries specializing in receivables financing. For example, General Motors Corp. has General Motors Acceptance Corp. (GMAC), and John Deere has John Deere Credit. Second, the holder may sell receivables because money is tight and access to normal credit is unavailable or too expensive. Also, a firm may sell its receivables, instead of borrowing, to avoid violating existing lending agreements. Finally, billing and collection of receivables are often time-consuming and costly. Credit card companies such as MasterCard, VISA, American Express, Diners Club, Discover, and others take over the collection process and provide merchants with immediate cash. Conversely, some purchasers of receivables buy them to obtain the legal protection of ownership rights afforded a purchaser of assets versus the lesser rights afforded a secured creditor. In addition, banks and other lending institutions may need to purchase receivables because of legal lending limits. That is, they cannot make any additional loans but they can buy receivables and charge a fee for this service. The transfer of receivables to a third party for cash happens in one of two ways:
1 2
Secured borrowing. Sales of receivables.
Secured Borrowing
A company often uses receivables as collateral in a borrowing transaction. In fact, a creditor often requires that the debtor designate (assign) or pledge17 receivables as security for the loan. If the loan is not paid when due, the creditor can convert the collateral to cash that is, to collect the receivables. To illustrate, on March 1, 2007, Howat Mills, Inc. provides (assigns) $700,000 of its accounts receivable to Citizens Bank as collateral for a $500,000 note. Howat Mills continues to collect the accounts receivable; the account debtors are not notified of the arrangement. Citizens Bank assesses a finance charge of 1 percent of the accounts receivable and interest on the note of 12 percent. Howat Mills makes monthly payments to the bank for all cash it collects on the receivables. Illustration 7-15 (page 333) shows the entries for the secured borrowing for Howatt Mills and Citizens Bank. In addition to recording the collection of receivables, Howat Mills must recognize all discounts, returns and allowances, and bad debts. Each month Howat Mills uses the proceeds from the collection of the accounts receivable to retire the note obligation. In addition, it pays interest on the note.18
If a company transfers the receivables for custodial purposes, the custodial arrangement is often referred to as a pledge. What happens if Citizens Bank collected the transferred accounts receivable rather than Howat Mills? Citizens Bank would simply remit the cash proceeds to Howat Mills, and Howat Mills would make the same entries shown in Illustration 7-15. As a result, Howat Mills reports these collaterized receivables as an asset on the balance sheet.
18
17
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Disposition of Accounts and Notes Receivable
Howat Mills, Inc. Citizens Bank
333
Transfer of accounts receivable and issuance of note on March 1, 2007 Cash Finance Charge Notes Payable *(1% $700,000) 493,000 7,000* 500,000 Notes Receivable Finance Revenue Cash 500,000 7,000* 493,000
Collection in March of $440,000 of accounts less cash discounts of $6,000 plus receipt of $14,000 sales returns Cash Sales Discounts Sales Returns Accounts Receivable ($440,000 $14,000 434,000 6,000 14,000 454,000 $454,000)
(No entry)
Remitted March collections plus accrued interest to the bank on April 1 Interest Expense Notes Payable Cash *($500,000 .12 5,000* 434,000 439,000 1/12) Collection in April of the balance of accounts less $2,000 written off as uncollectible Cash Allowance for Doubtful Accounts Accounts Receivable *($700,000 $454,000) 244,000 2,000 246,000* $434,000) on the note plus interest on May 1 Cash Interest Revenue Notes Receivable 66,660 660* 66,000 (No entry) Cash Interest Revenue Notes Receivable 439,000 5,000* 434,000
Remitted the balance due of $66,000 ($500,000 Interest Expense Notes Payable Cash *($66,000 .12 660* 66,000
66,660 1/12)
Sales of Receivables
Sales of receivables have increased substantially in recent years. A common type is a sale to a factor. Factors are finance companies or banks that buy receivables from businesses for a fee and then collect the remittances directly from the customers. Factoring receivables is traditionally associated with the textile, apparel, footwear, furniture, and home furnishing industries.19 Illustration 7-16 shows a typical factoring arrangement.
ILLUSTRATION 7-15 Entries for Transfer of ReceivablesSecured Borrowing
FACTOR (6) Makes payment (3) Approves credit
(2) Requests credit review
ILLUSTRATION 7-16 Basic Procedures in Factoring
(4) Advances cash
CUSTOMER Retailer or Wholesaler
(1) Places order
COMPANY Manufacturer or Distributor
(5) Ships goods
Credit cards like MasterCard and VISA are a type of factoring arrangement. Typically the purchaser of the receivable charges a 34112 percent commission of the receivables purchased (the commission is 45 percent for credit card factoring).
19
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Chapter 7 Cash and Receivables A recent phenomenon in the sale (transfer) of receivables is securitization. Securitization takes a pool of assets such as credit card receivables, mortgage receivables, or car loan receivables, and sells shares in these pools of interest and principal payments. This, in effect, creates securities backed by these pools of assets. Virtually every asset with a payment stream and a long-term payment history is a candidate for securitization. What are the differences between factoring and securitization? Factoring usually involves sale to only one company, fees are high, the quality of the receivables is low, and the seller afterward does not service the receivables. In a securitization, many investors are involved, margins are tight, the receivables are of higher quality, and the seller usually continues to service the receivables. In either a factoring or a securitization transaction, a company sells receivables on either a without recourse or a with recourse basis.20 Sale without Recourse When buying receivables without recourse, the purchaser assumes the risk of collectibility and absorbs any credit losses. The transfer of accounts receivable in a nonrecourse transaction is an outright sale of the receivables both in form (transfer of title) and substance (transfer of control). In nonrecourse transactions, as in any sale of assets, the seller debits Cash for the proceeds and credits Accounts Receivable for the face value of the receivables. The seller recognizes the difference, reduced by any provision for probable adjustments (discounts, returns, allowances, etc.), as a Loss on the Sale of Receivables. The seller uses a Due from Factor account (reported as a receivable) to account for the proceeds retained by the factor to cover probable sales discounts, sales returns, and sales allowances. To illustrate, Crest Textiles, Inc. factors $500,000 of accounts receivable with Commercial Factors, Inc., on a without recourse basis. Crest Textiles transfers the receivable records to Commercial Factors, which will receive the collections. Commercial Factors assesses a finance charge of 3 percent of the amount of accounts receivable and retains an amount equal to 5 percent of the accounts receivable (for probable adjustments). Crest Textiles and Commercial Factors make the following journal entries for the receivables transferred without recourse.
es
o
co
llege/k
i
w
Comprehensive Illustration of Sale Without Recourse
ILLUSTRATION 7-17 Entries for Sale of Receivables Without Recourse
Cash Due from Factor Loss on Sale of Receivables Accounts (Notes) Receivable *(5% $500,000) **(3% $500,000)
ile
y. c o m /
Crest Textiles, Inc. 460,000 25,000* 15,000** 500,000
Commercial Factors, Inc. Accounts (Notes) Receivable Due to Crest Textiles Financing Revenue Cash 500,000 25,000 15,000 460,000
In recognition of the sale of receivables, Crest Textiles records a loss of $15,000. The factors net income will be the difference between the financing revenue of $15,000 and the amount of any uncollectible receivables.
20 Recourse is the right of a transferee of receivables to receive payment from the transferor of those receivables for (1) failure of the debtors to pay when due, (2) the effects of prepayments, or (3) adjustments resulting from defects in the eligibility of the transferred receivables. See Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, Statement of Financial Accounting Standards No. 140 (Stamford, Conn.: FASB, 2000), p. 155.
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Disposition of Accounts and Notes Receivable Sale with Recourse For receivables sold with recourse, the seller guarantees payment to the purchaser in the event the debtor fails to pay. To record this type of transaction, the seller uses a financial components approach, because the seller has a continuing involvement with the receivable.21 In this approach, each party to the sale only recognizes the assets and liabilities that it controls after the sale. To illustrate, assume the same information as in Illustration 7-17 for Crest Textiles and for Commercial Factors, except that Crest Textiles sold the receivables on a withrecourse basis. Crest Textiles determines that this recourse obligation has a fair value of $6,000. To determine the loss on the sale of the receivables, Crest Textiles computes the net proceeds from the sale as follows.
335
Cash received Due from factor Less: Recourse obligation Net proceeds
$460,000 25,000
$485,000 6,000 $479,000
ILLUSTRATION 7-18 Net Proceeds Computation
Net proceeds are cash or other assets received in a sale less any liabilities incurred. Crest Textiles then computes the loss as follows.
Carrying (book) value Net proceeds Loss on sale of receivables
$500,000 479,000 $ 21,000
ILLUSTRATION 7-19 Loss on Sale Computation
Illustration 7-20 shows the journal entries for both Crest Textiles and Commercial Factors for the receivables sold with recourse.
Crest Textiles, Inc. Cash Due from Factor Loss on Sale of Receivables Accounts (Notes) Receivable Recourse Liability 460,000 25,000 21,000 500,000 6,000
Commercial Factors, Inc. Accounts Receivable Due to Crest Textiles Financing Revenue Cash 500,000 25,000 15,000 460,000
ILLUSTRATION 7-20 Entries for Sale of Receivables with Recourse
21 Accounting standards before SFAS No. 140 generally required that the transferor account for financial assets transferred as an inseparable unit that had been entirely sold or entirely retained. Those standards were difficult to apply and produced inconsistent and arbitrary results. Values are now assigned to such components as the recourse provision, servicing rights, and agreement to reacquire.
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Tutorial on the Disposition of Receivables
In this case, Crest Textiles recognizes a loss of $21,000. In addition, it records a liability of $6,000 to indicate the probable payment to Commercial Factors for uncollectible receivables. If Commercial Factors collects all the receivables, Crest Textiles eliminates its recourse liability and increases income. Commercial Factors net income is the financing revenue of $15,000. It will have no bad debts related to these receivables.
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What do the numbers mean?
International Insight The IASB has a similar conceptual approach to the sale of receivables, although it provides more flexibility in implementation.
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Ugly ducklings
Ugly Duckling is a used-car dealer that has carved out a niche by selling cars to customers with questionable credit histories. Ugly Duckling and other sub-prime lenders earn a profit by loaning money to riskier borrowers so they can purchase automobiles or homes. To compensate for the higher probability of default of these customers, subprime lenders charge higher rates of interest on these high-risk loans. In many instances these companies package their sub-prime loans and sell them as securities. However, recognition of gains on these transfers of receivables is appropriate only if Ugly Duckling can reasonably estimate the proportion of the loans that borrowers will not repay (the receivables are sold with recourse). However, estimating loan defaults is difficult. If sub-prime lenders fail to set rates high enough to cover unexpected higher rates of default, a severe cash squeeze will result. In addition, if too many of the loans that it sells then default, Ugly Duckling will have to take them back, thereby eliminating any gain it recorded on the original sale. Indeed, in one year alone, ContiFinancial had to write off over $654 million in subprime loans. Similarly, bank regulators had to step in and take over Superior Bank FSB, which specialized in sub-prime loans, because it overestimated the value of its subprime loans. Thus, the sub-prime lending business is a risky one. Depending on default and interest rate assumptions on these receivables, companies like Ugly Duckling may not survive to grow into lending swans.
Secured Borrowing versus Sale
The FASB concluded that a sale occurs only if the seller surrenders control of the receivables to the buyer. The following three conditions must be met before a company can record a sale:
1 2 3
The transferred asset has been isolated from the transferor (put beyond reach of the transferor and its creditors). The transferees have obtained the right to pledge or exchange either the transferred assets or beneficial interests in the transferred assets. The transferor does not maintain effective control over the transferred assets through an agreement to repurchase or redeem them before their maturity.
If the three conditions are met, a sale occurs. Otherwise, the transferor should record the transfer as a secured borrowing. If sale accounting is appropriate, a company must still consider assets obtained and liabilities incurred in the transaction. Illustration 7-21 (page 337) shows the rules of accounting for transfers of receivables. As it shows, if there is continuing involvement in a sale transaction, a company must record the assets obtained and liabilities incurred.
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Presentation and Analysis
337
Transfer of Receivables
ILLUSTRATION 7-21 Accounting for Transfers of Receivables
Does it meet three conditions? 1. Transferred assets isolated from transferor. 2. Transferee has right to pledge or sell assets. 3. Transferor does not maintain control through repurchase agreement.
Yes Is there continuing involvement? Yes Record as a sale: Use financial components approach: 1. Reduce receivables. 2. Recognize assets obtained and liabilities incurred. 3. Record gain or loss. No Record as a sale: 1. Reduce receivables. 2. Record gain or loss.
No Record as secured borrowing: 1. Record liability. 2. Record interest expense.
PRESENTATION AND ANALYSIS
Presentation of Receivables
The general rules in classifying receivables are:
1 2 3 4 5 6
OBJECTIVE 9
Describe how to report and analyze receivables.
Segregate the different types of receivables that a company possesses, if material. Appropriately offset the valuation accounts against the proper receivable accounts. Determine that receivables classified in the current assets section will be converted into cash within the year or the operating cycle, whichever is longer. Disclose any loss contingencies that exist on the receivables. Disclose any receivables designated or pledged as collateral. Disclose all significant concentrations of credit risk arising from receivables.22
The assets sections of Colton Corporations balance sheet in Illustration 7-22 (page 338) show many of the disclosures required for receivables.
Concentrations of credit risk exist when receivables have common characteristics that may affect their collection. These common characteristics might be companies in the same industry or same region of the country. For example, Quantum Corporation reported that sales of its disk drives to its top five customers (including Hewlett-Packard) represented nearly 40 percent of its revenues in 2003. Financial statements users want to know if a substantial amount of receivables from such sales are to customers facing uncertain economic conditions. No numerical guidelines are provided as to what is meant by a concentration of credit risk. Three items should be disclosed with an identified concentration: (1) information on the characteristic that determines the concentration, (2) the amount of loss that could occur upon nonperformance, and (3) information on any collateral related to the receivable. Disclosures about Fair Value of Financial Instruments, Statement of Financial Accounting Standards No. 107 (Norwalk, Conn.: FASB, 1991), par. 15.
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COLTON CORPORATION BALANCE SHEET (PARTIAL) AS OF DECEMBER 31, 2007 Current assets Cash and cash equivalents Accounts receivable (Note 2) Less: Allowance for doubtful accounts
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ILLUSTRATION 7-22 Disclosure of Receivables
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$ 1,870,250 $8,977,673 500,226 8,477,447 2,090,000 1,532,000 146,704 75,500 174,620 12,496,271 14,366,521 376,090 585,000
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Additional Disclosures of Receivables
Advances to subsidiaries due 9/30/08 Notes receivabletrade (Note 2) Federal income taxes refundable Dividends and interest receivable Other receivables and claims (including debit balances in accounts payable) Total current assets Noncurrent receivables Notes receivable from officers and key employees Claims receivable (litigation settlement to be collected over four years)
International Insight Holding receivables that it will pay in a foreign currency represents risk that the exchange rate may move against the company. This results in a decrease in the amount collected in terms of U.S. dollars. Companies engaged in crossborder transactions often hedge these receivables by buying contracts to exchange currencies at specified amounts at future dates.
ILLUSTRATION 7-23 Computation of Accounts Receivable Turnover
Underlying Concepts
Providing information that will help users assess a companys current liquidity and prospective cash flows is a primary objective of accounting.
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Note 2: Accounts and Notes Receivable. In November 2007, the Company arranged with a finance company to refinance a part of its indebtedness. The loan is evidenced by a 12% note payable. The note is payable on demand and is secured by substantially all the accounts receivable.
Analysis of Receivables
Receivables Turnover Ratio Analysts frequently compute financial ratios to evaluate the liquidity of a companys accounts receivable. To assess the liquidity of the receivables, they use the receivables turnover ratio. This ratio measures the number of times, on average, a company collects receivables during the period. The ratio is computed by dividing net sales by average (net) receivables outstanding during the year. Theoretically, the numerator should include only net credit sales, but this information is frequently unavailable. However, if the relative amounts of credit and cash sales remain fairly constant, the trend indicated by the ratio will still be valid. Barring significant seasonal factors, average receivables outstanding can be computed from the beginning and ending balances of net trade receivables. To illustrate, Circuit City reported 2004 net sales of $9,745 million, its beginning and ending accounts receivable balances were $380 million and $580 million, respectively. Illustration 7-23 shows the computation of its accounts receivables turnover ratio.
Net Sales Average Trade Receivables (net) $9,745 ($580 $380)/2 Accounts Receivable Turnover 20.3 times, or every 18 days (365 20.3)
This information23 shows how successful the company is in collecting its outstanding receivables. If possible, an aging schedule should also be prepared to help determine how long receivables have been outstanding. A satisfactory receivables turnover may have resulted because certain receivables were collected quickly though others have been outstanding for a relatively long period. An aging schedule would reveal such patterns.
Often the receivables turnover is transformed to days to collect accounts receivable or days outstandingan average collection period. In this case, 20.3 is divided into 365 days, resulting in 18 days. Several figures other than 365 could be used. A common alternative is 360 days because it is divisible by 30 (days) and 12 (months). Use 365 days in any homework computations.
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Summary of Learning Objectives
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SUMMARY OF LEARNING OBJECTIVES
1. Identify items considered cash. To be reported as cash, an asset must be readily available for the payment of current obligations and free from contractual restrictions that limit its use in satisfying debts. Cash consists of coin, currency, and available funds on deposit at the bank. Negotiable instruments such as money orders, certified checks, cashiers checks, personal checks, and bank drafts are also viewed as cash. Savings accounts are usually classified as cash. 2. Indicate how to report cash and related items. Companies report cash as a current asset in the balance sheet. The reporting of other related items are: (1) Restricted cash: The SEC recommends that companies state separately legally restricted deposits held as compensating balances against short-term borrowing among the Cash and cash equivalent items in current assets. Restricted deposits held against long-term borrowing arrangements should be separately classified as noncurrent assets in either the investments or other assets sections. (2) Bank overdrafts: Companies should report overdrafts in the current liabilities section and usually add them to the amount reported as accounts payable. If material, these items should be separately disclosed either on the face of the balance sheet or in the related notes. (3) Cash equivalents: Companies often report this item together with cash as Cash and cash equivalents. 3. Define receivables and identify the different types of receivables. Receivables are claims held against customers and others for money, goods, or services. The receivables are classified into three types: (1) current or noncurrent, (2) trade or nontrade, (3) accounts receivable or notes receivable. 4. Explain accounting issues related to recognition of accounts receivable. Two issues that may complicate the measurement of accounts receivable are: (1) The availability of discounts (trade and cash discounts), and (2) the length of time between the sale and the payment due dates (the interest element). Ideally, companies should measure receivables in terms of their present valuethat is, the discounted value of the cash to be received in the future. The profession specifically excludes from the present-value considerations receivables arising from normal business transactions that are due in customary trade terms within approximately one year. 5. Explain accounting issues related to valuation of accounts receivable. Companies value and report short-term receivables at net realizable valuethe net amount expected to be received in cash, which is not necessarily the amount legally receivable. Determining net realizable value requires estimating uncollectible receivables. 6. Explain accounting issues related to recognition of notes receivable. Companies record short-term notes at face value and long-term notes receivable at the present value of the cash they expect to collect. When the interest stated on an interest-bearing note equals the effective (market) rate of interest, the note sells at face value. When the stated rate differs from the effective rate, a company records either a discount or premium. 7. Explain accounting issues related to valuation of notes receivable. Like accounts receivable, companies record and report short-term notes receivable at their net realizable value. The same is also true of long-term receivables. Special issues relate to uncollectibles and impairments. 8. Explain accounting issues related to disposition of accounts and notes receivable. To accelerate the receipt of cash from receivables, the owner may transfer the receivables to another company for cash in one of two ways: (1) Secured borrowing: A creditor often requires that the debtor designate or pledge receivables as security for the loan. (2) Sales (factoring) of receivables: Factors are finance companies or banks that buy receivables from businesses and then collect the remittances directly from the customers. In many cases, transferors may have some continuing involvement with the receivable sold. Companies use a financial components approach to record this type of transaction.
KEY TERMS
accounts receivable, 319 aging schedule, 324 allowance method, 323 bank overdrafts, 317 cash, 314 cash discounts, 320 cash equivalents, 317 compensating balances, 316 direct write-off method, 323 factoring receivables, 333 financial components approach, 335 imputed interest rate, 331 net realizable value, 322 nontrade receivables, 319 notes receivable, 319 percentage-of-receivables approach, 324 percentage-of-sales approach, 323 promissory note, 326 receivables, 318 receivables turnover ratio, 338 restricted cash, 316 sales discounts, 320 securitization, 334 trade discounts, 320 trade receivables, 319 with recourse, 335 without recourse, 334 zero-interest-bearing notes, 326
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Chapter 7 Cash and Receivables 9. Describe how to report and analyze receivables. Companies should report receivables with appropriate offset of valuation accounts against receivables, classify receivables as current or noncurrent, identify pledged or designated receivables, and identify concentrations of risks arising from receivables. Analysts assess receivables based on turnover and the days outstanding.
APPENDIX
7A
OBJECTIVE 10
Explain common techniques employed to control cash.
Cash Controls
As we indicated in Chapter 7, cash creates many management and control problems. In this appendix, we discuss some of the basic control issues related to cash.
USING BANK ACCOUNTS
To obtain desired control objectives, a company can vary the number and location of banks and the types of bank accounts. For large companies operating in multiple locations, the location of bank accounts can be important. Establishing collection accounts in strategic locations can accelerate the flow of cash into the company by shortening the time between a customers mailing of a payment and the companys use of the cash. Multiple collection centers generally reduce the size of a companys collection float. This is the difference between the amount on deposit according to the companys records and the amount of collected cash according to the bank record. Large, multilocation companies frequently use lockbox accounts to collect in cities with heavy customer billing. The company rents a local post office box and authorizes a local bank to pick up the remittances mailed to that box number. The bank empties the box at least once a day and immediately credits the companys account for collections. The greatest advantage of a lockbox is that it accelerates the availability of collected cash. Generally, in a lockbox arrangement the bank microfilms the checks for record purposes and provides the company with a deposit slip, a list of collections, and any customer correspondence. Thus, a lockbox system improves the control over cash and accelerates collection of cash. If the income generated from accelerating the receipt of funds exceeds the cost of the lockbox system, then it is a worthwhile undertaking. The general checking account is the principal bank account in most companies and frequently the only bank account in small businesses. A company deposits in and disburses cash from this account. A company cycles all transactions through it. For example, a company deposits from and disburses to all other bank accounts through the general checking account. Companies use imprest bank accounts to make a specific amount of cash available for a limited purpose. The account acts as a clearing account for a large volume of checks or for a specific type of check. To clear a specific and intended amount through the imprest account, a company transfers that amount from the general checking account or other source. Companies often use imprest bank accounts for disbursing payroll checks, dividends, commissions, bonuses, confidential expenses (e.g., officers salaries), and travel expenses.
International Insight Multinational corporations often have cash accounts in more than one currency. For financial statement purposes, these corporations typically translate these currencies into U.S. dollars, using the exchange rate in effect at the balance sheet date.
THE IMPREST PETTY CASH SYSTEM
Almost every company finds it necessary to pay small amounts for miscellaneous expenses such as taxi fares, minor office supplies, and employees lunches. Disbursements by check for such items is often impractical, yet some control over them is important.
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Physical Protection of Cash Balances A simple method of obtaining reasonable control, while adhering to the rule of disbursement by check, is the imprest system for petty cash disbursements. This is how the system works:
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The company designates a petty cash custodian, and gives the custodian a small amount of currency from which to make payments. It records transfer of funds to petty cash as:
Petty Cash Cash 300 300
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The petty cash custodian obtains signed receipts from each individual to whom he or she pays cash, attaching evidence of the disbursement to the petty cash receipt. Petty cash transactions are not recorded until the fund is reimbursed; someone other than the petty cash custodian records those entries. When the supply of cash runs low, the custodian presents to the general cashier a request for reimbursement supported by the petty cash receipts and other disbursement evidence. The custodian receives a company check to replenish the fund. At this point, the company records transactions based on petty cash receipts.
Office Supplies Expense Postage Expense Entertainment Expense Cash Over and Short Cash 42 53 76 2 173
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If the company decides that the amount of cash in the petty cash fund is excessive, it lowers the fund balance as follows.
Cash Petty Cash 50 50
A company makes entries to the Petty Cash account only to increase or decrease the size of the fund. A company uses a Cash Over and Short account when the petty cash fund fails to prove out. That is, an error occurs such as incorrect change, overpayment of expense, or lost receipt. If cash proves out short (i.e., the of sum the receipts and cash in the fund is less than the imprest amount), the company debits the shortage to the Cash Over and Short account. If cash proves out over, it credits the overage to Cash Over and Short. The company closes Cash Over and Short only at the end of the year. It generally shows Cash Over and Short on the income statement as an Other expense or revenue. There are usually expense items in the fund except immediately after reimbursement. Therefore, to maintain accurate financial statements, a company must reimburse the funds at the end of each accounting period and also when nearly depleted. Under the imprest system the petty cash custodian is responsible at all times for the amount of the fund on hand either as cash or in the form of signed receipts. These receipts provide the evidence required by the disbursing officer to issue a reimbursement check. Further, a company follows two additional procedures to obtain more complete control over the petty cash fund:
1 2
A superior of the petty cash custodian makes surprise counts of the fund from time to time to determine that a satisfactory accounting of the fund has occurred. The company cancels or mutilates petty cash receipts after they have been submitted for reimbursement, so that they cannot be used to secure a second reimbursement.
PHYSICAL PROTECTION OF CASH BALANCES
Not only must a company safeguard cash receipts and cash disbursements through internal control measures, but it must also protect the cash on hand and in banks. Because receipts become cash on hand and disbursements are made from cash in banks, adequate control of receipts and disbursements is part of the protection of cash balances, along with certain other procedures.
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Chapter 7 Cash and Receivables Physical protection of cash is so elementary a necessity that it requires little discussion. A company should make every effort to minimize the cash on hand in the office. It should only have on hand a petty cash fund, the current days receipts, and perhaps funds for making change. Insofar as possible, it should keep these funds in a vault, safe, or locked cash drawer. The company should transmit intact each days receipts to the bank as soon as practicable. Accurately stating the amount of available cash both in internal management reports and in external financial statements is also extremely important. Every company has a record of cash received, disbursed, and the balance. Because of the many cash transactions, however, errors or omissions may occur in keeping this record. Therefore, a company must periodically prove the balance shown in the general ledger. It can count cash actually present in the officepetty cash, change funds, and undeposited receiptsfor comparison with the company records. For cash on deposit, a company prepares a bank reconciliationa reconciliation of the companys record and the banks record of the companys cash.
RECONCILIATION OF BANK BALANCES
At the end of each calendar month the bank supplies each customer with a bank statement (a copy of the banks account with the customer) together with the customers checks that the bank paid during the month.1 If neither the bank nor the customer made any errors, if all deposits made and all checks drawn by the customer reached the bank within the same month, and if no unusual transactions occurred that affected either the companys or the banks record of cash, the balance of cash reported by the bank to the customer equals that shown in the customers own records. This condition seldom occurs for one or more of the reconciling items presented below. Hence, a company expects differences between its record of cash and the banks record. Therefore, it must reconcile the two to determine the nature of the differences between the two amounts.
RECONCILING ITEMS
1 DEPOSITS IN TRANSIT. End-of-month deposits of cash recorded on the de-
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positors books in one month are received and recorded by the bank in the following month. OUTSTANDING CHECKS. Checks written by the depositor are recorded when written but may not be recorded by (may not clear) the bank until the next month. BANK CHARGES. Charges recorded by the bank against the depositors balance for such items as bank services, printing checks, not-sufficient-funds (NSF) checks, and safe-deposit box rentals. The depositor may not be aware of these charges until the receipt of the bank statement. BANK CREDITS. Collections or deposits by the bank for the benefit of the depositor that may be unknown to the depositor until receipt of the bank statement. Examples are note collection for the depositor and interest earned on interest-bearing checking accounts. BANK OR DEPOSITOR ERRORS. Errors on either the part of the bank or the part of the depositor cause the bank balance to disagree with the depositors book balance.
As we mentioned in Chapter 7, paper checks continue to be used as a means of payment. However, ready availability of desktop publishing software and hardware has created new opportunities for check fraud in the form of duplicate, altered, and forged checks. At the same time, new fraud-fighting technologies, such as ultraviolet imaging, high-capacity barcodes, and biometrics, are being developed. These technologies convert paper documents into electronically processed document files, thereby reducing the risk of fraud.
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Reconciliation of Bank Balances A bank reconciliation is a schedule explaining any differences between the banks and the companys records of cash. If the difference results only from transactions not yet recorded by the bank, the companys record of cash is considered correct. But, if some part of the difference arises from other items, either the bank or the company must adjust its records. A company may prepare two forms of a bank reconciliation. One form reconciles from the bank statement balance to the book balance or vice versa. The other form reconciles both the bank balance and the book balance to a correct cash balance. Most companies use this latter form. Illustration 7A-1 shows a sample of that form and its common reconciling items.
Balance per bank statement (end of period) Add: Deposits in transit Undeposited receipts (cash on hand) Bank errors that understate the bank statement balance Deduct: Outstanding checks Bank errors that overstate the bank statement balance Correct cash balance Balance per depositors books Add: Bank credits and collections not yet recorded in the books Book errors that understate the book balance Deduct: Bank charges not yet recorded in the books Book errors that overstate the book balance Correct cash balance $$$ $$ $$ $$ $$ $$
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ILLUSTRATION 7A-1 Bank Reconciliation Form and Content
$$ $$$ $$ $$$ $$$
$$ $$ $$ $$
$$ $$$ $$ $$$
This form of reconciliation consists of two sections: (1) Balance per bank statement and (2) Balance per depositors books. Both sections end with the same Correct cash balance. The correct cash balance is the amount to which the books must be adjusted and is the amount reported on the balance sheet. Companies prepare adjusting journal entries for all the addition and deduction items appearing in the Balance per depositors books section. Companies should immediately call to the banks attention any errors attributable to it. To illustrate, Nugget Mining Companys books show a cash balance at the Denver National Bank on November 30, 2007, of $20,502. The bank statement covering the month of November shows an ending balance of $22,190. An examination of Nuggets accounting records and November bank statement identified the following reconciling items.
1 2
A deposit of $3,680 that Nugget mailed November 30 does not appear on the bank statement. Checks written in November but not charged to the November bank statement are:
Check #7327 #7348 #7349 $ 150 4,820 31
3 4 5 6 7
Nugget has not yet recorded the $600 of interest collected by the bank November 20 on Sequoia Co. bonds held by the bank for Nugget. Bank service charges of $18 are not yet recorded on Nuggets books. The bank returned one of Nuggets customers checks for $220 with the bank statement, marked NSF. The bank treated this bad check as a disbursement. Nugget discovered that it incorrectly recorded check #7322, written in November for $131 in payment of an account payable, as $311. A check for Nugent Oil Co. in the amount of $175 that the bank incorrectly charged to Nugget accompanied the statement.
Nugget reconciled the bank and book balances to the correct cash balance of $21,044 as shown in Illustration 7A-2 (page 344).
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NUGGET MINING COMPANY BANK RECONCILIATION DENVER NATIONAL BANK, NOVEMBER 30, 2007 Balance per bank statement (end of period) Add: Deposit in transit Bank errorincorrect check charged to account by bank Deduct: Outstanding checks Correct cash balance Balance per books Add: Interest collected by the bank Error in recording check #7322 Deduct: Bank service charges NSF check returned Correct cash balance $22,190 (1) (7) (2) $3,680 175 3,855 26,045 5,001 $21,044 $20,502 (3) (6) (4) (5) $ 600 180 18 220 780 21,282 238 $21,044
ILLUSTRATION 7A-2 Sample Bank Reconciliation
The journal entries required to adjust and correct Nuggets books in early December 2007 are taken from the items in the Balance per books section and are as follows.
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Cash Interest Revenue (To record interest on Sequoia Co. bonds, collected by bank) Cash Accounts Payable (To correct error in recording amount of check #7322) Office ExpenseBank Charges Cash (To record bank service charges for November) Accounts Receivable Cash (To record customers check returned NSF)
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600 600 180 180 18 18 220 220
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E xpanded Discussion of a Four-Column Bank Reconciliation
What do the numbers mean?
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After posting the entries, Nuggets cash account will have a balance of $21,044. Nugget should return the Nugent Oil Co. check to Denver National Bank, informing the bank of the error.
Bounce a check, get banned
Rebecca Cobos overdrew her checking account at a Bank of America branch in Los Angeles. When she could not immediately repay the bank, it not only closed her account but also had her, in effect, banned for five years from opening a checking account at most other banks. Bank of America did so by reporting the 23-year-old university secretary to ChexSystems, a national database to which 80 percent of banks in the country subscribe. Once lodged in ChexSystems, your name automatically stays there for five years, whether your offense was bouncing a check or two or committing serious fraud. The large majority of banks using ChexSystems reject any checking-account applicant they find in the database. Maintained by a unit of the check-printing company Deluxe Corp., ChexSystems currently has about seven million names on file. Bank officials and executives of the unit, called eFund, defend the database as a valuable weapon in the battle against fraud and high-risk customers. And there is no denying that many of those who end up in the database have been financially careless, or worse.
Source: Paul Beckett, Its Not in the Mail, Wall Street Journal (August 1, 2000), p. A1.
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Questions
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SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 7A
10. Explain common techniques employed to control cash. The common techniques employed to control cash are: (1) Using bank accounts: A company can vary the number and location of banks and the types of accounts to obtain desired control objectives. (2) The imprest petty cash system: It may be impractical to require small amounts of various expenses be paid by check, yet some control over them is important. (3) Physical protection of cash balances: Adequate control of receipts and disbursements is a part of the protection of cash balances. Every effort should be made to minimize the cash on hand in the office. (4) Reconciliation of bank balances: Cash on deposit is not available for count and is proved by preparing a bank reconciliation. Note: All asterisked Questions, Brief Exercises, Exercises, Problems, and Concepts for Analysis relate to material covered in the appendix to the chapter.
KEY TERMS
bank reconciliation, 343 imprest system for petty cash, 341 not-sufficient-funds (NSF) checks, 342
QUESTIONS
1. What may be included under the heading of cash? 2. In what accounts should the following items be classified? (a) Coins and currency. (b) U.S. Treasury (government) bonds. (c) Certificate of deposit. (d) Cash in a bank that is in receivership. (e) NSF check (returned with bank statement). (f) Deposit in foreign bank (exchangeability limited). (g) Postdated checks. (h) Cash to be used for retirement of long-term bonds. (i) Deposits in transit. (j) 100 shares of Dell stock (intention is to sell in one year or less). (k) Savings and checking accounts. (l) Petty cash. (m) Stamps. (n) Travel advances. 3. Define a compensating balance. How should a compensating balance be reported? 4. Michael Tilsen Thomas Inc. reported in a recent annual report Restricted cash for debt redemption. What section of the balance sheet would report this item? 5. What are the reasons that a company gives trade discounts? Why are trade discounts not recorded in the accounts like cash discounts? 6. What are two methods of recording accounts receivable transactions when a cash discount situation is involved? Which is more theoretically correct? Which is used in practice more of the time? Why? 7. What are the basic problems that occur in the valuation of accounts receivable? 8. What is the theoretical justification of the allowance method as contrasted with the direct write-off method of accounting for bad debts? 9. Indicate how well the percentage-of-sales method and the aging method accomplish the objectives of the allowance method of accounting for bad debts. 10. Of what merit is the contention that the allowance method lacks the objectivity of the direct write-off method? Discuss in terms of accountings measurement function. 11. Explain how the accounting for bad debts can be used for earnings management. 12. Because of calamitous earthquake losses, Kishwaukee Company, one of your clients oldest and largest customers, suddenly and unexpectedly became bankrupt. Approximately 30% of your clients total sales have been made to Kishwaukee Company during each of the past several years. The amount due from Kishwaukee Companynone of which is collectibleequals 22% of total accounts receivable, an amount that is considerably in excess of what was determined to be an adequate provision for doubtful accounts at the close of the preceding year. How would your client record the write-off of the Kishwaukee Company receivable if it is using the allowance method of accounting for bad debts? Justify your suggested treatment. 13. What is the normal procedure for handling the collection of accounts receivable previously written off using the direct write-off method? The allowance method? 14. On January 1, 2007, John Singer Co. sells property for which it had paid $690,000 to Sargent Company, receiving in return Sargents zero-interest-bearing note for $1,000,000 payable in 5 years. What entry would John Singer make to record the sale, assuming that John Singer frequently sells similar items of property for a cash sales price of $620,000?
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Travel advance to employees Loan to wholly owned subsidiary Advances to creditors for goods ordered Accounts receivable assigned as security for loans payable Notes receivable past due plus interest on these notes Total 22,000 45,500 61,000 75,000 27,000 $769,000
15. What is imputed interest? In what situations is it necessary to impute an interest rate for notes receivable? What are the considerations in imputing an appropriate interest rate? 16. Indicate three reasons why a company might sell its receivables to another company. 17. When is the financial components approach to recording the transfers of receivables used? When should a transfer of receivables be recorded as a sale? 18. Hale Hardware is planning to factor some of its receivables. The cash received will be used to pay for inventory purchases. The factor has indicated that it will require recourse on the sold receivables. Explain to the controller of Hale Hardware what recourse is and how the recourse will be reflected in Hales financial statements after the sale of the receivables. 19. Outkast Outfitters Company includes in its trial balance for December 31 an item for Accounts Receivable $769,000. This balance consists of the following items:
Due from regular customers Refund receivable on prior years income taxes (an established claim) $523,000
Illustrate how these items should be shown in the balance sheet as of December 31. 20. What is the accounts receivable turnover ratio, and what type of information does it provide? 21. You are evaluating Hawthorn Downs Racetrack for a potential loan. An examination of the notes to the financial statements indicates restricted cash at year-end amounts to $100,000. Explain how you would use this information in evaluating Hawthorns liquidity.
*22. Distinguish among the following: (1) a general checking account, (2) an imprest bank account, and (3) a lockbox ac15,500 count.
BRIEF EXERCISES
(L0 1)
BE7-1
Stowe Enterprises owns the following assets at December 31, 2007.
Cash in banksavings account Cash on hand Cash refund due from IRS 63,000 9,300 31,400 Checking account balance Postdated checks Certificates of deposit (180-day) 17,000 750 90,000
What amount should be reported as cash?
(L0 4)
BE7-2 Montoya Co. uses the gross method to record sales made on credit. On June 1, 2007, it made sales of $40,000 with terms 3/15, n/45. On June 12, 2007, Montoya received full payment for the June 1 sale. Prepare the required journal entries for Montoya Co. BE7-3 Use the information from BE7-2, assuming Montoya Co. uses the net method to account for cash discounts. Prepare the required journal entries for Montoya Co. BE7-4 Battle Tank, Inc. had net sales in 2007 of $1,200,000. At December 31, 2007, before adjusting entries, the balances in selected accounts were: Accounts Receivable $250,000 debit, and Allowance for Doubtful Accounts $2,100 credit. If Battle Tank estimates that 2% of its net sales will prove to be uncollectible, prepare the December 31, 2007, journal entry to record bad debt expense. BE7-5 (a) Use the information presented in BE7-4 for Battle Tank, Inc. Instead of estimating the uncollectibles at 2% of net sales, assume that 10% of accounts receivable will prove to be uncollectible. Prepare the entry to record bad debts expense. (b) Instead of estimating uncollectibles at 2% of net sales, assume Battle Tank prepares an aging schedule that estimates total uncollectible accounts at $24,600. Prepare the entry to record bad debts expense.
(L0 4)
(L0 5)
(L0 5)
(L0 6)
BE7-6 Addams Family Importers sold goods to Acme Decorators for $20,000 on November 1, 2007, accepting Acmes $20,000, 6-month, 6% note. Prepare Addamss November 1 entry, December 31 annual adjusting entry, and May 1 entry for the collection of the note and interest. BE7-7 Aero Acrobats lent $15,944 to Afterburner, Inc., accepting Afterburners 2-year, $20,000, zerointerest-bearing note. The implied interest rate is 12%. Prepare Aeros journal entries for the initial transaction, recognition of interest each year, and the collection of $20,000 at maturity. BE7-8 On October 1, 2007, Akira, Inc. assigns $1,000,000 of its accounts receivable to Alisia National Bank as collateral for a $700,000 note. The bank assesses a finance charge of 2% of the receivables assigned and interest on the note of 9%. Prepare the October 1 journal entries for both Akira and Alisia.
(L0 6)
(L0 8)
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(L0 8)
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BE7-9 CRC Incorporated factored $100,000 of accounts receivable with Fredrick Factors Inc. on a without recourse basis. Fredrick assesses a 2% finance charge of the amount of accounts receivable and retains an amount equal to 6% of accounts receivable for possible adjustments. Prepare the journal entry for CRC Incorporated and Fredrick Factors to record the factoring of the accounts receivable to Fredrick. BE7-10 Use the information in BE7-9 for CRC. Assume that the receivables are sold with recourse. Prepare the journal entry for CRC to record the sale, assuming that the recourse obligation has a fair value of $7,500. BE7-11 Keyser Woodcrafters sells $200,000 of receivables to Commercial Factors, Inc. on a with recourse basis. Commercial assesses a finance charge of 5% and retains an amount equal to 4% of accounts receivable. Keyser estimates the fair value of the recourse obligation to be $8,000. Prepare the journal entry for Keyser to record the sale. BE7-12 Use the information presented in BE7-11 for Keyser Woodcrafters but assume that the recourse obligation has a fair value of $4,000, instead of $8,000. Prepare the journal entry and discuss the effects of this change in the value of the recourse obligation on Keysers financial statements. BE7-13 The financial statements of General Mills, Inc. report net sales of $5,416,000,000. Accounts receivable are $277,300,000 at the beginning of the year and $337,800,000 at the end of the year. Compute General Millss accounts receivable turnover ratio. Compute General Millss average collection period for accounts receivable in days.
(L0 8)
(L0 8)
(L0 8)
(L0 9)
(L0 10)
*BE7-14 Genesis Company designated Alex Kidd as petty cash custodian and established a petty cash
fund of $200. The fund is reimbursed when the cash in the fund is at $17. Petty cash receipts indicate funds were disbursed for office supplies $94 and miscellaneous expense $87. Prepare journal entries for the establishment of the fund and the reimbursement.
(L0 10)
*BE7-15 Jaguar Corporation is preparing a bank reconciliation and has identified the following potential
reconciling items. For each item, indicate if it is (1) added to balance per bank statement, (2) deducted from balance per bank statement, (3) added to balance per books, or (4) deducted from balance per books. (a) Deposit in transit $5,500. (b) Interest credited to Jaguars account $31. (c) Bank service charges $25. (d) (e) Outstanding checks $7,422. NSF check returned $377.
(L0 10)
*BE7-16 Use the information presented in BE7-15 for Jaguar Corporation. Prepare any entries necessary
to make Jaguars accounting records correct and complete.
EXERCISES
(L0 1)
E7-1 (Determining Cash Balance) The controller for Clint Eastwood Co. is attempting to determine the amount of cash to be reported on its December 31, 2007, balance sheet. The following information is provided. 1. Commercial savings account of $600,000 and a commercial checking account balance of $900,000 are held at First National Bank of Yojimbo. 2. Money market fund account held at Volonte Co. (a mutual fund organization) permits Eastwood to write checks on this balance, $5,000,000. 3. Travel advances of $180,000 for executive travel for the first quarter of next year (employee to reimburse through salary reduction). 4. A separate cash fund in the amount of $1,500,000 is restricted for the retirement of long-term debt. 5. Petty cash fund of $1,000. 6. An I.O.U. from Marianne Koch, a company customer, in the amount of $190,000. 7. A bank overdraft of $110,000 has occurred at one of the banks the company uses to deposit its cash receipts. At the present time, the company has no deposits at this bank. 8. The company has two certificates of deposit, each totaling $500,000. These CDs have a maturity of 120 days. 9. Eastwood has received a check that is dated January 12, 2008, in the amount of $125,000. 10. Eastwood has agreed to maintain a cash balance of $500,000 at all times at First National Bank of Yojimbo to ensure future credit availability. 11. Eastwood has purchased $2,100,000 of commercial paper of Sergio Leone Co. which is due in 60 days. 12. Currency and coin on hand amounted to $7,700.
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Instructions (a) Compute the amount of cash to be reported on Eastwood Co.s balance sheet at December 31, 2007. (b) Indicate the proper reporting for items that are not reported as cash on the December 31, 2007, balance sheet.
(L0 1)
E7-2
(Determine Cash Balance) Presented below are a number of independent situations.
Instructions For each individual situation, determine the amount that should be reported as cash. If the item(s) is not reported as cash, explain the rationale. 1. Checking account balance $925,000; certificate of deposit $1,400,000; cash advance to subsidiary of $980,000; utility deposit paid to gas company $180. 2. Checking account balance $600,000; an overdraft in special checking account at same bank as normal checking account of $17,000; cash held in a bond sinking fund $200,000; petty cash fund $300; coins and currency on hand $1,350. 3. Checking account balance $590,000; postdated check from customer $11,000; cash restricted due to maintaining compensating balance requirement of $100,000; certified check from customer $9,800; postage stamps on hand $620. 4. Checking account balance at bank $37,000; money market balance at mutual fund (has checking privileges) $48,000; NSF check received from customer $800. 5. Checking account balance $700,000; cash restricted for future plant expansion $500,000; short-term Treasury bills $180,000; cash advance received from customer $900 (not included in checking account balance); cash advance of $7,000 to company executive, payable on demand; refundable deposit of $26,000 paid to federal government to guarantee performance on construction contract.
(L0 3, 4)
E7-3 (Financial Statement Presentation of Receivables) Jim Carrie Company shows a balance of $181,140 in the Accounts Receivable account on December 31, 2006. The balance consists of the following.
Installment accounts due in 2007 Installment accounts due after 2007 Overpayments to creditors Due from regular customers, of which $40,000 represents accounts pledged as security for a bank loan Advances to employees Advance to subsidiary company (made in 2002) $23,000 34,000 2,640 79,000 1,500 81,000
Instructions Illustrate how the information above should be shown on the balance sheet of Jim Carrie Company on December 31, 2006.
(L0 3, 4)
E7-4 (Determine Ending Accounts Receivable) Your accounts receivable clerk, Mitra Adams, to whom you pay a salary of $1,500 per month, has just purchased a new Buick. You decided to test the accuracy of the accounts receivable balance of $82,000 as shown in the ledger. The following information is available for your first year in business.
(1) (2) (3) (4) Collections from customers Merchandise purchased Ending merchandise inventory Goods are marked to sell at 40% above cost $198,000 320,000 90,000
Instructions Compute an estimate of the ending balance of accounts receivable from customers that should appear in the ledger and any apparent shortages. Assume that all sales are made on account.
(L0 4)
E7-5 (Record Sales Gross and Net) On June 3, Arnold Company sold to Chester Company merchandise having a sale price of $3,000 with terms of 2/10, n/60, f.o.b. shipping point. An invoice totaling $90, terms n/30, was received by Chester on June 8 from John Booth Transport Service for the freight cost. On June 12, the company received a check for the balance due from Chester Company. Instructions (a) Prepare journal entries on the Arnold Company books to record all the events noted above under each of the following bases. (1) Sales and receivables are entered at gross selling price. (2) Sales and receivables are entered at net of cash discounts. (b) Prepare the journal entry under basis 2, assuming that Chester Company did not remit payment until July 29.
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(L0 4)
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E7-6 (Recording Sales Transactions) Presented below is information from Perez Computers Incorporated.
July 1 10 17 30 Sold $20,000 of computers to Robertson Company with terms 3/15, n/60. Perez uses the gross method to record cash discounts. Perez received payment from Robertson for the full amount owed from the July transactions. Sold $200,000 in computers and peripherals to The Clark Store with terms of 2/10, n/30. The Clark Store paid Perez for its purchase of July 17.
Instructions Prepare the necessary journal entries for Perez Computers.
(L0 5)
E7-7 (Recording Bad Debts) Duncan Company reports the following financial information before adjustments.
Dr. Accounts Receivable Allowance for Doubtful Accounts Sales (all on credit) Sales Returns and Allowances $100,000 $ 2,000 900,000 50,000 Cr.
Instructions Prepare the journal entry to record Bad Debt Expense assuming Duncan Company estimates bad debts at (a) 1% of net sales and (b) 5% of accounts receivable.
(L0 5)
E7-8 (Recording Bad Debts) At the end of 2007 Aramis Company has accounts receivable of $800,000 and an allowance for doubtful accounts of $40,000. On January 16, 2008, Aramis Company determined that its receivable from Ramirez Company of $6,000 will not be collected, and management authorized its write-off. Instructions (a) Prepare the journal entry for Aramis Company to write off the Ramirez receivable. (b) What is the net realizable value of Aramis Companys accounts receivable before the write-off of the Ramirez receivable? (c) What is the net realizable value of Aramis Companys accounts receivable after the write-off of the Ramirez receivable?
(L0 5)
E7-9 (Computing Bad Debts and Preparing Journal Entries) The trial balance before adjustment of Reba McIntyre Inc. shows the following balances.
Dr. Accounts Receivable Allowance for Doubtful Accounts Sales (all on credit) $90,000 1,750 $680,000 Cr.
Instructions Give the entry for estimated bad debts assuming that the allowance is to provide for doubtful accounts on the basis of (a) 4% of gross accounts receivable and (b) 1% of net sales.
(L0 5)
E7-10 (Bad-Debt Reporting) The chief accountant for Emily Dickinson Corporation provides you with the following list of accounts receivable written off in the current year.
Date March 31 June 30 September 30 December 31 Customer E. L. Masters Company Stephen Crane Associates Amy Lowells Dress Shop R. Frost, Inc. Amount $7,800 6,700 7,000 9,830
Emily Dickinson Corporation follows the policy of debiting Bad Debt Expense as accounts are written off. The chief accountant maintains that this procedure is appropriate for financial statement purposes because the Internal Revenue Service will not accept other methods for recognizing bad debts. All of Emily Dickinson Corporations sales are on a 30-day credit basis. Sales for the current year total $2,200,000, and research has determined that bad debt losses approximate 2% of sales. Instructions (a) Do you agree or disagree with Dickinsons policy concerning recognition of bad debt expense? Why or why not? (b) By what amount would net income differ if bad debt expense was computed using the percentage-of-sales approach?
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E7-11 (Bad DebtsAging) Danica Patrick, Inc. includes the following account among its trade receivables.
Hopkins Co. 1/1 1/20 3/14 4/12 9/5 10/17 11/18 12/20 Balance forward Invoice #1710 Invoice #2116 Invoice #2412 Invoice #3614 Invoice #4912 Invoice #5681 Invoice #6347 700 1,100 1,350 1,710 490 860 2,000 800 1/28 4/2 4/10 4/30 9/20 10/31 12/1 12/29 Cash (#1710) Cash (#2116) Cash (1/1 Balance) Cash (#2412) Cash (#3614 and part of #2412) Cash (#4912) Cash (#5681) Cash (#6347) 1,100 1,350 155 1,000 790 860 1,250 800
(L0 5)
Instructions Age the balance and specify any items that apparently require particular attention at year-end.
(L0 4, 5, 8)
E7-12 (Journalizing Various Receivable Transactions) Presented below is information related to James Garfield Corp.
July 1 5 James Garfield Corp. sold to Warren Harding Co. merchandise having a sales price of $8,000 with terms 2/10, net/60. Garfield records its sales and receivables net. Accounts receivable of $9,000 (gross) are factored with Andrew Jackson Credit Corp. without recourse at a financing charge of 9%. Cash is received for the proceeds; collections are handled by the finance company. (These accounts were all past the discount period.) Specific accounts receivable of $9,000 (gross) are pledged to Alf Landon Credit Corp. as security for a loan of $6,000 at a finance charge of 6% of the amount of the loan. The finance company will make the collections. (All the accounts receivable are past the discount period.) Warren Harding Co. notifies Garfield that it is bankrupt and will pay only 10% of its account. Give the entry to write off the uncollectible balance using the allowance method. (Note: First record the increase in the receivable on July 11 when the discount period passed.)
9
Dec. 29
Instructions Prepare all necessary entries in general journal form for Garfield Corp.
(L0 8)
E7-13 (Assigning Accounts Receivable) On April 1, 2007, Rasheed Company assigns $400,000 of its accounts receivable to the Third National Bank as collateral for a $200,000 loan due July 1, 2007. The assignment agreement calls for Rasheed Company to continue to collect the receivables. Third National Bank assesses a finance charge of 2% of the accounts receivable, and interest on the loan is 10% (a realistic rate of interest for a note of this type). Instructions (a) Prepare the April 1, 2007, journal entry for Rasheed Company. (b) Prepare the journal entry for Rasheeds collection of $350,000 of the accounts receivable during the period from April 1, 2007, through June 30, 2007. (c) On July 1, 2007, Rasheed paid Third National all that was due from the loan it secured on April 1, 2007. Prepare the journal entry to record this payment.
(L0 5, 8)
E7-14 (Journalizing Various Receivable Transactions) The trial balance before adjustment for Phil Collins Company shows the following balances.
Dr. Accounts Receivable Allowance for Doubtful Accounts Sales $82,000 2,120 $430,000 Cr.
Instructions Using the data above, give the journal entries required to record each of the following cases. (Each situation is independent.) 1. To obtain additional cash, Collins factors without recourse $25,000 of accounts receivable with Stills Finance. The finance charge is 10% of the amount factored. 2. To obtain a one-year loan of $55,000, Collins assigns $65,000 of specific receivable accounts to Crosby Financial. The finance charge is 8% of the loan; the cash is received and the accounts turned over to Crosby Financial. 3. The company wants to maintain the Allowance for Doubtful Accounts at 5% of gross accounts receivable. 4. The company wishes to increase the allowance account by 112% of net sales.
(L0 8)
E7-15 (Transfer of Receivables with Recourse) Ames Quartet Inc. factors receivables with a carrying amount of $200,000 to Joffrey Company for $160,000 on a with recourse basis.
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Instructions The recourse provision has a fair value of $1,000. This transaction should be recorded as a sale. Prepare the appropriate journal entry to record this transaction on the books of Ames Quartet Inc.
(L0 8)
351
E7-16 (Transfer of Receivables with Recourse) Beyonc Corporation factors $175,000 of accounts receivable with Kathleen Battle Financing, Inc. on a with recourse basis. Kathleen Battle Financing will collect the receivables. The receivables records are transferred to Kathleen Battle Financing on August 15, 2007. Kathleen Battle Financing assesses a finance charge of 2% of the amount of accounts receivable and also reserves an amount equal to 4% of accounts receivable to cover probable adjustments. Instructions (a) What conditions must be met for a transfer of receivables with recourse to be accounted for as a sale? (b) Assume the conditions from part (a) are met. Prepare the journal entry on August 15, 2007, for Beyonc to record the sale of receivables, assuming the recourse obligation has a fair value of $2,000.
(L0 8)
E7-17 (Transfer of Receivables without Recourse) JFK Corp. factors $300,000 of accounts receivable with LBJ Finance Corporation on a without recourse basis on July 1, 2007. The receivables records are transferred to LBJ Finance, which will receive the collections. LBJ Finance assesses a finance charge of 112% of the amount of accounts receivable and retains an amount equal to 4% of accounts receivable to cover sales discounts, returns, and allowances. The transaction is to be recorded as a sale. Instructions (a) Prepare the journal entry on July 1, 2007, for JFK Corp. to record the sale of receivables without recourse. (b) Prepare the journal entry on July 1, 2007, for LBJ Finance Corporation to record the purchase of receivables without recourse.
(L0 6, 7)
E7-18
(Note Transactions at Unrealistic Interest Rates) On July 1, 2007, Agincourt Inc. made two sales.
1. It sold land having a fair market value of $700,000 in exchange for a 4-year zero-interest-bearing promissory note in the face amount of $1,101,460. The land is carried on Agincourts books at a cost of $590,000. 2. It rendered services in exchange for a 3%, 8-year promissory note having a face value of $400,000 (interest payable annually). Agincourt Inc. recently had to pay 8% interest for money that it borrowed from British National Bank. The customers in these two transactions have credit ratings that require them to borrow money at 12% interest. Instructions Record the two journal entries that should be recorded by Agincourt Inc. for the sales transactions above that took place on July 1, 2007.
(L0 6, 7)
E7-19 (Notes Receivable with Unrealistic Interest Rate) On December 31, 2005, Ed Abbey Co. performed environmental consulting services for Hayduke Co. Hayduke was short of cash, and Abbey Co. agreed to accept a $200,000 zero-interest-bearing note due December 31, 2007, as payment in full. Hayduke is somewhat of a credit risk and typically borrows funds at a rate of 10%. Abbey is much more creditworthy and has various lines of credit at 6%. Instructions (a) Prepare the journal entry to record the transaction of December 31, 2005, for the Ed Abbey Co. (b) Assuming Ed Abbey Co.s fiscal year-end is December 31, prepare the journal entry for December 31, 2006. (c) Assuming Ed Abbey Co.s fiscal year-end is December 31, prepare the journal entry for December 31, 2007.
(L0 9)
E7-20
(Analysis of Receivables) Presented below is information for Jones Company.
1. Beginning-of-the-year Accounts Receivable balance was $15,000. 2. Net sales (all on account) for the year were $100,000. Jones does not offer cash discounts. 3. Collections on accounts receivable during the year were $70,000. Instructions (a) Prepare (summary) journal entries to record the items noted above. (b) Compute Joness accounts receivable turnover ratio for the year. The company does not believe it will have any bad debts. (c) Use the turnover ratio computed in (b) to analyze Joness liquidity. The turnover ratio last year was 6.0.
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E7-21 (Transfer of Receivables) Use the information for Jones Company as presented in E7-20. Jones is planning to factor some accounts receivable at the end of the year. Accounts totaling $25,000 will be transferred to Credit Factors, Inc. with recourse. Credit Factors will retain 5% of the balances for probable adjustments and assesses a finance charge of 4%. The fair value of the recourse obligation is $1,200. Instructions (a) Prepare the journal entry to record the sale of the receivables. (b) Compute Joness accounts receivables turnover ratio for the year, assuming the receivables are sold, and discuss how factoring of receivables affects the turnover ratio.
(L0 8)
(L0 10)
*E7-22 (Petty Cash) Carolyn Keene, Inc. decided to establish a petty cash fund to help ensure internal
control over its small cash expenditures. The following information is available for the month of April. 1. On April 1, it established a petty cash fund in the amount of $200. 2. A summary of the petty cash expenditures made by the petty cash custodian as of April 10 is as follows.
Delivery charges paid on merchandise purchased Supplies purchased and used Postage expense I.O.U. from employees Miscellaneous expense $60.00 25.00 33.00 17.00 36.00
3.
The petty cash fund was replenished on April 10. The balance in the fund was $27. The petty cash fund balance was increased $100 to $300 on April 20.
Instructions Prepare the journal entries to record transactions related to petty cash for the month of April.
(L0 10)
*E7-23 (Petty Cash) The petty cash fund of Fonzarellis Auto Repair Service, a sole proprietorship, contains the following.
1. Coins and currency 2. Postage stamps 3. An I.O.U. from Richie Cunningham, an employee, for cash advance 4. Check payable to Fonzarellis Auto Repair from Pottsie Weber, an employee, marked NSF 5. Vouchers for the following: Stamps Two Rose Bowl tickets for Nick Fonzarelli Printer cartridge $ 15.20 2.90 40.00 34.00 $ 20.00 170.00 14.35
204.35 $296.45
The general ledger account Petty Cash has a balance of $300. Instructions Prepare the journal entry to record the reimbursement of the petty cash fund.
(L0 10)
*E7-24 (Bank Reconciliation and Adjusting Entries) Angela Lansbury Company deposits all receipts
and makes all payments by check. The following information is available from the cash records.
June 30 Bank Reconciliation Balance per bank Add: Deposits in transit Deduct: Outstanding checks Balance per books Month of July Results Per Bank Balance July 31 July deposits July checks July note collected (not included in July deposits) July bank service charge July NSF check from a customer, returned by the bank (recorded by bank as a charge) $8,650 5,000 4,000 1,000 15 335 Per Books $9,250 5,810 3,100 $ 7,000 1,540 (2,000) $ 6,540
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Instructions (a) Prepare a bank reconciliation going from balance per bank and balance per book to correct cash balance. (b) Prepare the general journal entry or entries to correct the Cash account.
( L0 10)
353
*E7-25 (Bank Reconciliation and Adjusting Entries) Logan Bruno Company has just received the
August 31, 2007, bank statement, which is summarized below.
County National Bank Balance, August 1 Deposits during August Note collected for depositor, including $40 interest Checks cleared during August Bank service charges Balance, August 31 Disbursements Receipts $32,200 1,040 $34,500 20 Balance $ 9,369 41,569 42,609 8,109 8,089 8,089
The general ledger Cash account contained the following entries for the month of August.
Cash Balance, August 1 Receipts during August 10,050 35,000 Disbursements in August 34,903
Deposits in transit at August 31 are $3,800, and checks outstanding at August 31 total $1,050. Cash on hand at August 31 is $310. The bookkeeper improperly entered one check in the books at $146.50 which was written for $164.50 for supplies (expense); it cleared the bank during the month of August. Instructions (a) Prepare a bank reconciliation dated August 31, 2007, proceeding to a correct balance. (b) Prepare any entries necessary to make the books correct and complete. (c) What amount of cash should be reported in the August 31 balance sheet?
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See the books website, www.wiley.com/college/kieso, for Additional Exercises.
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PROBLEMS
(L0 2)
P7-1 (Determine Proper Cash Balance) Dumaine Equipment Co. closes its books regularly on December 31, but at the end of 2007 it held its cash book open so that a more favorable balance sheet could be prepared for credit purposes. Cash receipts and disbursements for the first 10 days of January were recorded as December transactions. The following information is given. 1. January cash receipts recorded in the December cash book totaled $39,640, of which $22,000 represents cash sales, and $17,640 represents collections on account for which cash discounts of $360 were given. 2. January cash disbursements recorded in the December check register liquidated accounts payable of $26,450 on which discounts of $250 were taken. 3. The ledger has not been closed for 2007. 4. The amount shown as inventory was determined by physical count on December 31, 2007. The company uses the periodic method of inventory. Instructions (a) Prepare any entries you consider necessary to correct Dumaines accounts at December 31. (b) To what extent was Dumaine Equipment Co. able to show a more favorable balance sheet at December 31 by holding its cash book open? (Compute working capital and the current ratio.) Assume that the balance sheet that was prepared by the company showed the following amounts:
Dr. Cash Receivables Inventories Accounts payable Other current liabilities $39,000 42,000 67,000 $45,000 14,200 Cr.
ile
y. c o m /
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P7-2 1. (Bad-Debt Reporting) Presented below are a series of unrelated situations. Spock Companys unadjusted trial balance at December 31, 2007, included the following accounts.
Debit Allowance for doubtful accounts Net sales $4,000 $1,500,000 Credit
(L0 5)
Spock Company estimates its bad debt expense to be 11/2% of net sales. Determine its bad debt expense for 2007. 2. An analysis and aging of Scotty Corp. accounts receivable at December 31, 2007, disclosed the following.
Amounts estimated to be uncollectible Accounts receivable Allowance for doubtful accounts (per books) $ 180,000 1,750,000 125,000
3.
What is the net realizable value of Scottys receivables at December 31, 2007? Uhura Co. provides for doubtful accounts based on 3% of credit sales. The following data are available for 2007.
Credit sales during 2007 Allowance for doubtful accounts 1/1/07 Collection of accounts written off in prior years (customer credit was reestablished) Customer accounts written off as uncollectible during 2007 $2,100,000 17,000 8,000 30,000
4.
What is the balance in the Allowance for Doubtful Accounts at December 31, 2007? At the end of its first year of operations, December 31, 2007, Chekov Inc. reported the following information.
Accounts receivable, net of allowance for doubtful accounts Customer accounts written off as uncollectible during 2007 Bad debt expense for 2007 $950,000 24,000 84,000
5.
What should be the balance in accounts receivable at December 31, 2007, before subtracting the allowance for doubtful accounts? The following accounts were taken from Chappel Inc.s trial balance at December 31, 2007.
Debit Net credit sales Allowance for doubtful accounts Accounts receivable $ 14,000 410,000 Credit $750,000
If doubtful accounts are 3% of accounts receivable, determine the bad debt expense to be reported for 2007. Instructions Answer the questions relating to each of the five independent situations as requested.
(L0 5)
P7-3 (Bad-Debt ReportingAging) Mary Pierce Corporation operates in an industry that has a high rate of bad debts. Before any year-end adjustments, the balance in Pierces Accounts Receivable account was $555,000 and the Allowance for Doubtful Accounts had a credit balance of $35,000. The year-end balance reported in the balance sheet for the Allowance for Doubtful Accounts will be based on the aging schedule shown below.
Days Account Outstanding Less than 16 days Between 16 and 30 Between 31 and 45 Between 46 and 60 Between 61 and 75 Over 75 days days days days days Amount $300,000 100,000 80,000 40,000 20,000 15,000 Probability of Collection .98 .90 .85 .75 .40 .00
Instructions (a) What is the appropriate balance for the Allowance for Doubtful Accounts at year-end? (b) Show how accounts receivable would be presented on the balance sheet. (c) What is the dollar effect of the year-end bad debt adjustment on the before-tax income? (CMA adapted)
(L0 5)
P7-4 (Bad-Debt Reporting) From inception of operations to December 31, 2007, Blaise Pascal Corporation provided for uncollectible accounts receivable under the allowance method: provisions were made monthly at 2% of credit sales; bad debts written off were charged to the allowance account; recoveries of
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bad debts previously written off were credited to the allowance account; and no year-end adjustments to the allowance account were made. Pascals usual credit terms are net 30 days. The balance in the Allowance for Doubtful Accounts was $154,000 at January 1, 2007. During 2007 credit sales totaled $9,000,000, interim provisions for doubtful accounts were made at 2% of credit sales, $95,000 of bad debts were written off, and recoveries of accounts previously written off amounted to $15,000. Pascal installed a computer facility in November 2007, and an aging of accounts receivable was prepared for the first time as of December 31, 2007. A summary of the aging is as follows.
Classification by Month of Sale NovemberDecember 2007 JulyOctober JanuaryJune Prior to 1/1/07 Balance in Each Category $1,080,000 650,000 420,000 150,000 $2,300,000 Estimated % Uncollectible 2% 10% 25% 70%
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Based on the review of collectibility of the account balances in the prior to 1/1/07 aging category, additional receivables totaling $60,000 were written off as of December 31, 2007. The 70% uncollectible estimate applies to the remaining $90,000 in the category. Effective with the year ended December 31, 2007, Pascal adopted a new accounting method for estimating the allowance for doubtful accounts at the amount indicated by the year-end aging analysis of accounts receivable. Instructions (a) Prepare a schedule analyzing the changes in the Allowance for Doubtful Accounts for the year ended December 31, 2007. Show supporting computations in good form. (Hint: In computing the 12/31/07 allowance, subtract the $60,000 write-off). (b) Prepare the journal entry for the year-end adjustment to the Allowance for Doubtful Accounts balance as of December 31, 2007. (AICPA adapted)
(L0 5)
P7-5 (Bad-Debt Reporting) Presented below is information related to the Accounts Receivable accounts of Gulistan Inc. during the current year 2007. 1. An aging schedule of the accounts receivable as of December 31, 2007, is as follows.
Age Under 60 days 6190 days 91120 days Over 120 days Net Debit Balance $172,342 136,490 39,924* 23,644 $372,400 % to Be Applied after Correction Is Made 1% 3% 6% $4,200 definitely uncollectible; estimated remainder uncollectible is 25%
*The $2,740 write-off of receivables is related to the 91-to-120 day category.
2. 3.
4.
The Accounts Receivable control account has a debit balance of $372,400 on December 31, 2007. Two entries were made in the Bad Debt Expense account during the year: (1) a debit on December 31 for the amount credited to Allowance for Doubtful Accounts, and (2) a credit for $2,740 on November 3, 2007, and a debit to Allowance for Doubtful Accounts because of a bankruptcy. The Allowance for Doubtful Accounts is as follows for 2007.
Allowance for Doubtful Accounts Nov. 3 Uncollectible accounts written off 2,740 Jan. 1 Dec. 31 Beginning balance 5% of $372,400 8,750 18,620
5.
A credit balance exists in the Accounts Receivable (6190 days) of $4,840, which represents an advance on a sales contract.
Instructions Assuming that the books have not been closed for 2007, make the necessary correcting entries.
(L0 3, 4, 5)
P7-6 (Journalize Various Accounts Receivable Transactions) The balance sheet of Antonio Vivaldi Company at December 31, 2007, includes the following.
Notes receivable Accounts receivable Less: Allowance for doubtful accounts $ 36,000 182,100 17,300
200,800
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Transactions in 2007 include the following. 1. Accounts receivable of $138,000 were collected including accounts of $40,000 on which 2% sales discounts were allowed. 2. $6,300 was received in payment of an account which was written off the books as worthless in 2007. (Hint: Reestablish the receivable account.) 3. Customer accounts of $17,500 were written off during the year. 4. At year-end the Allowance for Doubtful Accounts was estimated to need a balance of $20,000. This estimate is based on an analysis of aged accounts receivable. Instructions Prepare all journal entries necessary to reflect the transactions above.
(L0 8)
P7-7 (Assigned Accounts ReceivableJournal Entries) Nikos Company finances some of its current operations by assigning accounts receivable to a finance company. On July 1, 2007, it assigned, under guarantee, specific accounts amounting to $100,000. The finance company advanced to Nikos 80% of the accounts assigned (20% of the total to be withheld until the finance company has made its full recovery), less a finance charge of 12% of the total accounts assigned. On July 31 Nikos Company received a statement that the finance company had collected $55,000 of these accounts and had made an additional charge of 12% of the total accounts outstanding as of July 31. This charge is to be deducted at the time of the first remittance due Nikos Company from the finance company. (Hint: Make entries at this time.) On August 31, 2007, Nikos Company received a second statement from the finance company, together with a check for the amount due. The statement indicated that the finance company had collected an additional $30,000 and had made a further charge of 12% of the balance outstanding as of August 31. Instructions Make all entries on the books of Nikos Company that are involved in the transactions above. (AICPA adapted)
(L0 6)
P7-8 (Notes Receivable with Realistic Interest Rate) On October 1, 2007, Jeppo Farm Equipment Company sold a pecan-harvesting machine to Lujan Brothers Farm, Inc. In lieu of a cash payment Lujan Brothers Farm gave Jeppo a 2-year, $100,000, 8% note (a realistic rate of interest for a note of this type). The note required interest to be paid annually on October 1. Jeppos financial statements are prepared on a calendar-year basis. Instructions Assuming Lujan Brothers Farm fulfills all the terms of the note, prepare the necessary journal entries for Jeppo Farm Equipment Company for the entire term of the note.
(L0 6)
P7-9 (Notes Receivable Journal Entries) On December 31, 2007, Menachem Inc. rendered services to Begin Corporation at an agreed price of $91,844.10, accepting $36,000 down and agreeing to accept the balance in four equal installments of $18,000 receivable each December 31. An assumed interest rate of 11% is imputed. Instructions Prepare the entries that would be recorded by Menachem Inc. for the sale and for the receipts and interest on the following dates. (Assume that the effective interest method is used for amortization purposes.) (a) December 31, 2007. (b) December 31, 2008. (c) (d) December 31, 2009. December 31, 2010. (e) December 31, 2011.
(L0 6, 7)
P7-10 (Comprehensive Receivables Problem) Connecticut Inc. had the following long-term receivable account balances at December 31, 2006.
Note receivable from sale of division Note receivable from officer $1,800,000 400,000
Transactions during 2007 and other information relating to Connecticuts long-term receivables were as follows. 1. The $1,800,000 note receivable is dated May 1, 2006, bears interest at 9%, and represents the balance of the consideration received from the sale of Connecticuts electronics division to New York Company. Principal payments of $600,000 plus appropriate interest are due on May 1, 2007, 2008, and 2009. The first principal and interest payment was made on May 1, 2007. Collection of the note installments is reasonably assured.
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2. The $400,000 note receivable is dated December 31, 2006, bears interest at 8%, and is due on December 31, 2009. The note is due from Sean May, president of Connecticut Inc. and is collateralized by 10,000 shares of Connecticuts common stock. Interest is payable annually on December 31, and all interest payments were paid on their due dates through December 31, 2007. The quoted market price of Connecticuts common stock was $45 per share on December 31, 2007. 3. On April 1, 2007, Connecticut sold a patent to Pennsylvania Company in exchange for a $200,000 zero-interest-bearing note due on April 1, 2009. There was no established exchange price for the patent, and the note had no ready market. The prevailing rate of interest for a note of this type at April 1, 2007, was 12%. The present value of $1 for two periods at 12% is 0.797 (use this factor). The patent had a carrying value of $40,000 at January 1, 2007, and the amortization for the year ended December 31, 2007, would have been $8,000. The collection of the note receivable from Pennsylvania is reasonably assured. 4. On July 1, 2007, Connecticut sold a parcel of land to Harrisburg Company for $200,000 under an installment sale contract. Harrisburg made a $60,000 cash down payment on July 1, 2007, and signed a 4-year 11% note for the $140,000 balance. The equal annual payments of principal and interest on the note will be $45,125 payable on July 1, 2008, through July 1, 2011. The land could have been sold at an established cash price of $200,000. The cost of the land to Connecticut was $150,000. Circumstances are such that the collection of the installments on the note is reasonably assured.
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Instructions (a) Prepare the long-term receivables section of Connecticuts balance sheet at December 31, 2007. (b) Prepare a schedule showing the current portion of the long-term receivables and accrued interest receivable that would appear in Connecticuts balance sheet at December 31, 2007. (c) Prepare a schedule showing interest revenue from the long-term receivables that would appear on Connecticuts income statement for the year ended December 31, 2007.
(L0 8, 9)
P7-11 (Income Effects of Receivables Transactions) Radisson Company requires additional cash for its business. Radisson has decided to use its accounts receivable to raise the additional cash and has asked you to determine the income statement effects of the following contemplated transactions. 1. On July 1, 2007, Radisson assigned $400,000 of accounts receivable to Stickum Finance Company. Radisson received an advance from Stickum of 85% of the assigned accounts receivable less a commission of 3% on the advance. Prior to December 31, 2007, Radisson collected $220,000 on the assigned accounts receivable, and remitted $232,720 to Stickum, $12,720 of which represented interest on the advance from Stickum. On December 1, 2007, Radisson sold $300,000 of net accounts receivable to Wunsch Company for $250,000. The receivables were sold outright on a without recourse basis. On December 31, 2007, an advance of $120,000 was received from First Bank by pledging $160,000 of Radissons accounts receivable. Radissons first payment to First Bank is due on January 30, 2008.
2. 3.
Instructions Prepare a schedule showing the income statement effects for the year ended December 31, 2007, as a result of the above facts.
(L0 10)
*P7-12 (Petty Cash, Bank Reconciliation) Bill Howe is reviewing the cash accounting for Kappeler, Inc.,
a local mailing service. Howes review will focus on the petty cash account and the bank reconciliation for the month ended May 31, 2007. He has collected the following information from Kappelers bookkeeper for this task.
Petty Cash 1. The petty cash fund was established on May 10, 2007, in the amount of $250. 2. Expenditures from the fund by the custodian as of May 31, 2007, were evidenced by approved receipts for the following. Postage expense Mailing labels and other supplies I.O.U. from employees Shipping charges Newspaper advertising Miscellaneous expense $33.00 75.00 30.00 57.45 22.80 15.35
On May 31, 2007, the petty cash fund was replenished and increased to $300; currency and coin in the fund at that time totaled $16.40.
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Bank Reconciliation
THIRD NATIONAL BANK BANK STATEMENT Disbursements Balance, May 1, 2007 Deposits Note payment direct from customer (interest of $30) Checks cleared during May Bank service charges Balance, May 31, 2007 Receipts $28,000 930 $31,150 27 6,522 Balance $8,769
Kappelers Cash Account Balance, May 1, 2007 Deposits during May 2007 Checks written during May 2007 $ 9,150 31,000 (31,835)
Deposits in transit are determined to be $3,000, and checks outstanding at May 31 total $550. Cash on hand (besides petty cash) at May 31, 2007, is $246. Instructions (a) Prepare the journal entries to record the transactions related to the petty cash fund for May. (b) Prepare a bank reconciliation dated May 31, 2007, proceeding to a correct cash balance, and prepare the journal entries necessary to make the books correct and complete. (c) What amount of cash should be reported in the May 31, 2007, balance sheet?
(L0 10)
*P7-13 (Bank Reconciliation and Adjusting Entries) The cash account of Jose Orozco Co. showed a
ledger balance of $3,969.85 on June 30, 2007. The bank statement as of that date showed a balance of $4,150. Upon comparing the statement with the cash records, the following facts were determined. 1. There were bank service charges for June of $25. 2. A bank memo stated that Bao Dais note for $900 and interest of $36 had been collected on June 29, and the bank had made a charge of $5.50 on the collection. (No entry had been made on Orozcos books when Bao Dais note was sent to the bank for collection.) 3. Receipts for June 30 for $2,890 were not deposited until July 2. 4. Checks outstanding on June 30 totaled $2,136.05. 5. The bank had charged the Orozco Co.s account for a customers uncollectible check amounting to $453.20 on June 29. 6. A customers check for $90 had been entered as $60 in the cash receipts journal by Orozco on June 15. 7. Check no. 742 in the amount of $491 had been entered in the cash journal as $419, and check no. 747 in the amount of $58.20 had been entered as $582. Both checks had been issued to pay for purchases of equipment. Instructions (a) Prepare a bank reconciliation dated June 30, 2007, proceeding to a correct cash balance. (b) Prepare any entries necessary to make the books correct and complete.
(L0 10)
*P7-14 (Bank Reconciliation and Adjusting Entries) Presented below is information related to Tanizaki
Inc. Balance per books at October 31, $41,847.85; receipts $173,523.91; disbursements $166,193.54. Balance per bank statement November 30, $56,274.20. The following checks were outstanding at November 30.
1224 1230 1232 1233 $1,635.29 2,468.30 3,625.15 482.17
Included with the November bank statement and not recorded by the company were a bank debit memo for $27.40 covering bank charges for the month, a debit memo for $572.13 for a customers check returned and marked NSF, and a credit memo for $1,400 representing bond interest collected by the bank in the name of Tanizaki Inc. Cash on hand at November 30 recorded and awaiting deposit amounted to $1,915.40.
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Instructions (a) Prepare a bank reconciliation (to the correct balance) at November 30, for Tanizaki Inc. from the information above. (b) Prepare any journal entries required to adjust the cash account at November 30.
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CONCEPTS FOR ANALYSIS
CA7-1 (Bad-Debt Accounting) Ariel Company has significant amounts of trade accounts receivable. Ariel uses the allowance method to estimate bad debts instead of the direct write-off method. During the year, some specific accounts were written off as uncollectible, and some that were previously written off as uncollectible were collected. Instructions (a) What are the deficiencies of the direct write-off method? (b) What are the two basic allowance methods used to estimate bad debts, and what is the theoretical justification for each? (c) How should Ariel account for the collection of the specific accounts previously written off as uncollectible? CA7-2 (Various Receivable Accounting Issues) Anne Archer Company uses the net method of accounting for sales discounts. Anne Archer also offers trade discounts to various groups of buyers. On August 1, 2007, Archer sold some accounts receivable on a without recourse basis. Archer incurred a finance charge. Archer also has some notes receivable bearing an appropriate rate of interest. The principal and total interest are due at maturity. The notes were received on October 1, 2007, and mature on September 30, 2009. Archers operating cycle is less than one year. Instructions (a) (1) Using the net method, how should Archer account for the sales discounts at the date of sale? What is the rationale for the amount recorded as sales under the net method? (2) Using the net method, what is the effect on Archers sales revenues and net income when customers do not take the sales discounts? (b) What is the effect of trade discounts on sales revenues and accounts receivable? Why? (c) How should Archer account for the accounts receivable factored on August 1, 2007? Why? (d) How should Archer account for the note receivable and the related interest on December 31, 2007? Why? CA7-3 (Bad-Debt Reporting Issues) Orlando Bloom conducts a wholesale merchandising business that sells approximately 5,000 items per month with a total monthly average sales value of $250,000. Its annual bad debt ratio has been approximately 11/2% of sales. In recent discussions with his bookkeeper, Mr. Bloom has become confused by all the alternatives apparently available in handling the Allowance for Doubtful Accounts balance. The following information has been shown. 1. An allowance can be set up (a) on the basis of a percentage of sales or (b) on the basis of a valuation of all past due or otherwise questionable accounts receivable. Those considered uncollectible can be charged to such allowance at the close of the accounting period, or specific items can be charged off directly against (1) Gross Sales or to (2) Bad Debt Expense in the year in which they are determined to be uncollectible. 2. Collection agency and legal fees, and so on, incurred in connection with the attempted recovery of bad debts can be charged to (a) Bad Debt Expense, (b) Allowance for Doubtful Accounts, (c) Legal Expense, or (d) General Expense. 3. Debts previously written off in whole or in part but currently recovered can be credited to (a) Other Revenue, (b) Bad Debt Expense, or (c) Allowance for Doubtful Accounts. Instructions Which of the foregoing methods would you recommend to Mr. Bloom in regard to (1) allowances and charge-offs, (2) collection expenses, and (3) recoveries? State briefly and clearly the reasons supporting your recommendations. CA7-4 (Basic Note and Accounts Receivable Transactions) Part 1 On July 1, 2007, John Depp Company, a calendar-year company, sold special-order merchandise on credit and received in return an interest-bearing note receivable from the customer. John Depp Company will receive interest at the prevailing rate for a note of this type. Both the principal and interest are due in one lump sum on June 30, 2008.
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Instructions When should John Depp Company report interest revenue from the note receivable? Discuss the rationale for your answer. Part 2 On December 31, 2007, John Depp Company had significant amounts of accounts receivable as a result of credit sales to its customers. Depp uses the allowance method based on credit sales to estimate bad debts. Past experience indicates that 2% of credit sales normally will not be collected. This pattern is expected to continue. Instructions (a) Discuss the rationale for using the allowance method based on credit sales to estimate bad debts. Contrast this method with the allowance method based on the balance in the trade receivables accounts. (b) How should John Depp Company report the allowance for doubtful accounts on its balance sheet at December 31, 2007? Also, describe the alternatives, if any, for presentation of bad debt expense in John Depp Companys 2007 income statement. (AICPA adapted) CA7-5 (Bad-Debt Reporting Issues) Rosita Arenas Company sells office equipment and supplies to many organizations in the city and surrounding area on contract terms of 2/10, n/30. In the past, over 75% of the credit customers have taken advantage of the discount by paying within 10 days of the invoice date. The number of customers taking the full 30 days to pay has increased within the last year. Current indications are that less than 60% of the customers are now taking the discount. Bad debts as a percentage of gross credit sales have risen from the 1.5% provided in past years to about 4% in the current year. The controller has responded to a request for more information on the deterioration in collections of accounts receivable with the report reproduced below.
ROSITA ARENAS COMPANY FINANCE COMMITTEE REPORTACCOUNTS RECEIVABLE COLLECTIONS MAY 31, 2007 The fact that some credit accounts will prove uncollectible is normal. Annual bad debt write-offs have been 1.5% of gross credit sales over the past five years. During the last fiscal year, this percentage increased to slightly less than 4%. The current Accounts Receivable balance is $1,600,000. The condition of this balance in terms of age and probability of collection is as follows. Proportion of Total 68% 15% 8% 5% 212% 112% Age Categories not yet due less than 30 days past due 30 to 60 days past due 61 to 120 days past due 121 to 180 days past due over 180 days past due Probability of Collection 99% 9612% 95% 91% 70% 20%
The Allowance for Doubtful Accounts had a credit balance of $43,300 on June 1, 2006. Rosita Arenas Company has provided for a monthly bad debts expense accrual during the current fiscal year based on the assumption that 4% of gross credit sales will be uncollectible. Total gross credit sales for the 20062007 fiscal year amounted to $4,000,000. Write-offs of bad accounts during the year totaled $145,000.
Instructions (a) Prepare an accounts receivable aging schedule for Rosita Arenas Company using the age categories identified in the controllers report to the finance committee showing: (1) The amount of accounts receivable outstanding for each age category and in total. (2) The estimated amount that is uncollectible for each category and in total. (b) Compute the amount of the year-end adjustment necessary to bring Allowance for Doubtful Accounts to the balance indicated by the age analysis. Then prepare the necessary journal entry to adjust the accounting records. (c) In a recessionary environment with tight credit and high interest rates: (1) Identify steps Rosita Arenas Company might consider to improve the accounts receivable situation. (2) Then evaluate each step identified in terms of the risks and costs involved. (CMA adapted)
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CA7-6 (Sale of Notes Receivable) Sergey Luzov Wholesalers Co. sells industrial equipment for a standard 3-year note receivable. Revenue is recognized at time of sale. Each note is secured by a lien on the equipment and has a face amount equal to the equipments list price. Each notes stated interest rate is below the customers market rate at date of sale. All notes are to be collected in three equal annual installments beginning one year after sale. Some of the notes are subsequently sold to a bank with recourse, some are subsequently sold without recourse, and some are retained by Luzov. At year end, Luzov evaluates all outstanding notes receivable and provides for estimated losses arising from defaults. Instructions (a) What is the appropriate valuation basis for Luzovs notes receivable at the date it sells equipment? (b) How should Luzov account for the sale, without recourse, of a February 1, 2007, note receivable sold on May 1, 2007? Why is it appropriate to account for it in this way? (c) At December 31, 2007, how should Luzov measure and account for the impact of estimated losses resulting from notes receivable that it (1) Retained and did not sell? (2) Sold to bank with recourse? (AICPA adapted) CA7-7 (Zero-Interest-Bearing Note Receivable) On September 30, 2006, Tiger Machinery Co. sold a machine and accepted the customers zero-interest-bearing note. Tiger normally makes sales on a cash basis. Since the machine was unique, its sales price was not determinable using Tigers normal pricing practices. After receiving the first of two equal annual installments on September 30, 2007, Tiger immediately sold the note with recourse. On October 9, 2008, Tiger received notice that the note was dishonored, and it paid all amounts due. At all times prior to default, the note was reasonably expected to be paid in full. Instructions (a) (1) How should Tiger determine the sales price of the machine? (2) How should Tiger report the effects of the zero-interest-bearing note on its income statement for the year ended December 31, 2006? Why is this accounting presentation appropriate? (b) What are the effects of the sale of the note receivable with recourse on Tigers income statement for the year ended December 31, 2007, and its balance sheet at December 31, 2007? (c) How should Tiger account for the effects of the note being dishonored? CA7-8 (Reporting of Notes Receivable, Interest, and Sale of Receivables) On July 1, 2007, Gale Sondergaard Company sold special-order merchandise on credit and received in return an interest-bearing note receivable from the customer. Sondergaard will receive interest at the prevailing rate for a note of this type. Both the principal and interest are due in one lump sum on June 30, 2008. On September 1, 2007, Sondergaard sold special-order merchandise on credit and received in return a zero-interest-bearing note receivable from the customer. The prevailing rate of interest for a note of this type is determinable. The note receivable is due in one lump sum on August 31, 2009. Sondergaard also has significant amounts of trade accounts receivable as a result of credit sales to its customers. On October 1, 2007, some trade accounts receivable were assigned to Irene Dunne Finance Company on a non-notification (Sondergaard handles collections) basis for an advance of 75% of their amount at an interest charge of 8% on the balance outstanding. On November 1, 2007, other trade accounts receivable were sold on a without recourse basis. The factor withheld 5% of the trade accounts receivable factored as protection against sales returns and allowances and charged a finance charge of 3%. Instructions (a) How should Sondergaard determine the interest revenue for 2007 on the: (1) Interest-bearing note receivable? Why? (2) Zero-interest-bearing note receivable? Why? (b) How should Sondergaard report the interest-bearing note receivable and the zero-interest-bearing note receivable on its balance sheet at December 31, 2007? (c) How should Sondergaard account for subsequent collections on the trade accounts receivable assigned on October 1, 2007, and the payments to Irene Dunne Finance? Why? (d) How should Sondergaard account for the trade accounts receivable factored on November 1, 2007? Why? (AICPA adapted)
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CA7-9 (Accounting for Zero-Interest-Bearing Note) Soon after beginning the year-end audit work on March 10 at Engone Company, the auditor has the following conversation with the controller. CONTROLLER: AUDITOR: CONTROLLER: AUDITOR: CONTROLLER: The year ended March 31st should be our most profitable in history and, as a consequence, the board of directors has just awarded the officers generous bonuses. I thought profits were down this year in the industry, according to your latest interim report. Well, they were down, but 10 days ago we closed a deal that will give us a substantial increase for the year. Oh, what was it? Well, you remember a few years ago our former president bought stock in Rocketeer Enterprises because he had those grandiose ideas about becoming a conglomerate. For 6 years we have not been able to sell this stock, which cost us $3,000,000 and has not paid a nickel in dividends. Thursday we sold this stock to Campbell Inc. for $4,000,000. So, we will have a gain of $700,000 ($1,000,000 pretax) which will increase our net income for the year to $4,000,000, compared with last years $3,800,000. As far as I know, well be the only company in the industry to register an increase in net income this year. That should help the market value of the stock! Do you expect to receive the $4,000,000 in cash by March 31st, your fiscal year-end? No. Although Campbell Inc. is an excellent company, they are a little tight for cash because of their rapid growth. Consequently, they are going to give us a $4,000,000 zerointerest-bearing note with payments of $400,000 per year for the next 10 years. The first payment is due on March 31 of next year. Why is the note zero-interest-bearing? Because thats what everybody agreed to. Since we dont have any interest-bearing debt, the funds invested in the note do not cost us anything and besides, we were not getting any dividends on the Rocketeer Enterprises stock.
AUDITOR: CONTROLLER:
AUDITOR: CONTROLLER:
Instructions Do you agree with the way the controller has accounted for the transaction? If not, how should the transaction be accounted for? CA7-10 (Receivables Management) As the manager of the accounts receivable department for Vicki Maher Leather Goods, Ltd., you recently noticed that Percy Shelley, your accounts receivable clerk who is paid $1,200 per month, has been wearing unusually tasteful and expensive clothing. (This is Vicki Mahers first year in business.) This morning, Shelley drove up to work in a brand new Lexus. Naturally suspicious by nature, you decide to test the accuracy of the accounts receivable balance of $132,000 as shown in the ledger. The following information is available for your first year (precisely 9 months ended September 30, 2007) in business.
(1) (2) (3) (4) Collections from customers Merchandise purchased Ending merchandise inventory Goods are marked to sell at 40% above cost. $198,000 360,000 90,000
Instructions Assuming all sales were made on account, compute the ending accounts receivable balance that should appear in the ledger, noting any apparent shortage. Then, draft a memo dated October 3, 2007, to John Castle, the branch manager, explaining the facts in this situation. Remember that this problem is serious, and you do not want to make hasty accusations. CA7-11 (Bad-Debt Reporting) Santo Company is a subsidiary of Hughes Corp. The controller believes that the yearly allowance for doubtful accounts for Santo should be 2% of net credit sales. The president, nervous that the parent company might expect the subsidiary to sustain its 10% growth rate, suggests that the controller increase the allowance for doubtful accounts to 3% yearly. The supervisor thinks that the lower net income, which reflects a 6% growth rate, will be a more sustainable rate for Santo Company. Instructions (a) Should the controller be concerned with Santo Companys growth rate in estimating the allowance? Explain your answer. (b) Does the presidents request pose an ethical dilemma for the controller? Give your reasons.
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Financial Reporting Problem
The Procter & Gamble Company (P&G)
The financial statements of P&G are presented in Appendix 5B or can be accessed on the KWW website.
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Instructions Refer to P&Gs financial statements and the accompanying notes to answer the following questions. (a) What criteria does P&G use to classify Cash and cash equivalents as reported in its balance sheet? (b) As of June 30, 2004, what balances did P&G have in cash and cash equivalents? What were the major uses of cash during the year? (c) P&G reports no allowance for doubtful accounts, suggesting that bad debt expense is not material for this company. Is it reasonable that a company like P&G would not have material bad debt expense? Explain.
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Financial Statement Analysis Cases
Case I Occidental Petroleum Corporation
Occidental Petroleum Corporation reported the following information in its 2003 Annual Report.
Occidental Petroleum Corporation
Consolidated Balance Sheets (in millions) Assets at December 31, Current assets Cash and cash equivalents Trade receivables, net of allowances Receivables from joint ventures, partnerships, and other Inventories Prepaid expenses and other Total current assets Long-term receivables, net 2003 $ 683 804 330 510 147 2,474 264 2002 $ 146 608 321 491 307 1,873 275
Notes to Consolidated Financial Statements Cash and Cash Equivalents. Cash equivalents consist of highly liquid investments. Cash equivalents totaled approximately $661 million and $116 million at December 31, 2003 and 2002, respectively. Trade Receivables. Occidental has agreement to sell, under a revolving sale program, an undivided percentage ownership interest in a designated pool of non-interest-bearing receivables. Under this program, Occidental serves as the collection agent with respect to the receivables sold. An interest in new receivables is sold as collections are made from customers. The balance sold at December 31, 2003, was $360 million.
Instructions (a) What items other than coin and currency may be included in cash? (b) What items may be included in cash equivalents? (c) What are compensating balance arrangements, and how should they be reported in financial statements? (d) What are the possible differences between cash equivalents and short-term (temporary) investments? (e) Assuming that the sale agreement meets the criteria for sale accounting, cash proceeds were $345 million, the carrying value of the receivables sold was $360 million, and the fair value of the recourse obligation was $15 million, what was the effect on income from the sale of receivables? (f) Briefly discuss the impact of the transaction in (e) on Occidentals liquidity.
Case 2
Microsoft Corporation
Microsoft is the leading developer of software in the world. To continue to be successful Microsoft must generate new products, which requires significant amounts of cash. Shown on page 364 is the current
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asset and current liability information from Microsofts June 30, 2004, balance sheet (in millions). Following the Microsoft data is the current asset and current liability information for Oracle (in millions), another major software developer.
MICROSOFT CORPORATION BALANCE SHEETS (PARTIAL) As of June 30 (in millions) Current assets Cash and equivalents Short-term investments Accounts receivable Other Total current assets Total current liabilities 2004 $15,982 44,610 5,890 4,084 $70,566 $14,969 2003 $ 6,438 42,610 5,196 4,729 $58,973 $13,974
ORACLE BALANCE SHEETS (PARTIAL) As of May 31 (in millions) Current assets Cash and equivalents Short-term investments Receivables Other current assets Total current assets Current liabilities 2004 $ 4,138 4,449 2,012 737 $11,336 $ 4,272 2003 $ 4,737 1,782 1,920 788 $9,227 $4,158
Part 1 (Cash and Cash Equivalents) Instructions (a) What is the definition of a cash equivalent? Give some examples of cash equivalents. How do cash equivalents differ from other types of short-term investments? (b) Calculate (1) the current ratio and (2) working capital for each company for 2004 and discuss your results. (c) Is it possible to have too many liquid assets? Part 2 (Accounts Receivables) Microsoft provided the following disclosure related to its accounts receivable.
Allowance for Doubtful Accounts. The allowance for doubtful accounts reflects our best estimate of probable losses inherent in the accounts receivable balance. We determine the allowance based on known troubled accounts, historical experience, and other currently available evidence. Activity in the allowance for doubtful accounts is as follows: (in millions) Balance at beginning of period $174 209 242 Charged to costs and expenses $192 118 44 Write-offs and other $(157) (85) (120) Balance at end of period $209 242 166
Year Ended June 30 2002 2003 2004
Instructions (a) Compute Microsofts receivables turnover ratio for 2004 and discuss your results. Microsoft had sales revenue of $36,835 million in 2004. (b) Reconstruct the summary journal entries for 2004 based on the information in the disclosure. (c) Briefly discuss how the accounting for bad debts affects the analysis in Part 2 (a).
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Comparative Analysis Case
The Coca-Cola Company and PepsiCo, Inc.
Instructions Go to the KWW website and use the information found there to answer the following questions related to The Coca-Cola Company and PepsiCo, Inc. (a) What were the cash and cash equivalents reported by Coca-Cola and PepsiCo at the end of 2004? What does each company classify as cash equivalents? (b) What were the accounts receivable (net) for Coca-Cola and PepsiCo at the end of 2004? Which company reports the greater allowance for doubtful accounts receivable (amount and percentage of gross receivable) at the end of 2004? (c) Assuming that all net operating revenues (Coca-Cola) and all net sales (PepsiCo) were net credit sales, compute the receivables turnover ratio for 2004 for Coca-Cola and PepsiCo; also compute the days outstanding for receivables. What is your evaluation of the difference?
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Research Cases
Case 1
Accounting Trends and Techniques, published annually by the American Institute of Certified Public Accountants, is a survey of 600 annual reports to stockholders. The survey covers selected industrial, merchandising, and service companies. Instructions Examine the section regarding the use of receivables for financing and answer the following questions. (a) For the most recent year, how many of the companies surveyed disclosed (1) receivables sold, and (2) receivables used as collateral? (b) Examine the disclosure provided by a company that sold receivables and a company that used its receivables as collateral. Summarize the major terms of the transactions.
Case 2
The January 20, 1999, edition of the Wall Street Journal contained an article by Jonathan Weil titled Americredit Accounting Practices Are Criticized by Research Firm. Instructions Read the article and answer the following questions. (a) Why is Americredits accounting for receivables criticized? (b) How does the cash-out method of accounting for loan sales respond to the criticisms from part (a)? (c) What are warning signs that investors can use to identify problems at sub-prime lenders?
Professional Research: Financial Accounting and Reporting
As the new staff person in your companys treasury department, you have been asked to conduct research related to a proposed transfer of receivables. Your supervisor wants the authoritative sources for the following items that are discussed in the securitization agreement. Instructions Using the Financial Accounting Research System (FARS), respond to the following items. (Provide text strings used in your search.) (a) List the current statement and the previous statement that addressed transfers of receivables. (b) Provide definitions for the following: (1) Transfer. (2) Recourse. (3) Collateral. (c) Provide other examples (besides recourse and collateral) that qualify as continuing involvement.
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Professional Simulation
In this simulation you are asked to address various requirements regarding the accounting for receivables. Prepare responses to all parts.
KWW_Professional _Simulation Accounting Receivables Time Remaining 2 hours 20 minutes
Measurement Financial Statement Analysis Explanation
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Directions
Situation
Resources
Mike Horn Corporation manufactures sweatshirts for sale to athletic-wear retailers. The following information was available for Horn for the years ended December 31, 2006 and 2007. December 31, 2006 Cash Trade accounts receivable Allowance for doubtful accounts Inventories Current liabilities Total credit sales Collections on trade accounts receivable During 2007, Horn had the following transactions. 1. On June 30, sales of $50,000 to a major customer were settled, with Horn accepting a 1-year $50,000 note bearing 11% interest, payable at maturity. 2. Horn factors some accounts receivable at the end of the year. Accounts totaling $40,000 are transferred to First Factors, Inc. with recourse. First Factors will receive the collections from Horns customers and retain 6% of the balances. Horn is assessed a finance charge of 4% on this transfer. The fair value of the recourse obligation is $4,000. 3. On the basis of the latest available information, the 2007 provision for bad debts is estimated to be 0.8% of credit sales. Horn charged off as uncollectible, accounts with balances of $2,300.
Directions Situation Measurement Financial Statement Analysis Explanation Resources
December 31, 2007 $ 15,000 ? ? 80,000 86,000 550,000 500,000
$ 20,000 40,000 5,500 85,000 80,000 480,000 440,000
Based on the above transactions, determine the balance for Trade Accounts Receivable and the Allowance for Doubtful Accounts at December 31, 2007.
Directions Situation Measurement Financial Statement Analysis Explanation Resources
Prepare the current assets section of Horns balance sheet at December 31, 2007. The cash balance at December 31, 2007, reflects the following items: checking account $9,600; postage stamps $100; petty cash $300; currency $3,000; customers checks (post-dated) $2,000.
Directions Situation Measurement Financial Statement Analysis Explanation Resources
Compute the current ratio and the receivables turnover ratio for Horn at December 31, 2007. Use these measures to analyze Horns liquidity. The receivables turnover ratio in 2006 was 10.37.
Directions Situation Measurement Financial Statement Analysis Explanation Resources
Discuss how the Analysis above would be affected if Horn had transferred the receivables in a secured borrowing transaction.
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Remember to check the books companion website to find additional resources for this chapter.
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