Financial accounting in an economic context 8e chapter 06

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Chapter 6:
The Current Asset Classification,
Cash and Accounts Receivable

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Current Asset Classification
A current asset is defined as any asset that is intended to be
converted into cash within one year or the company’s
operating cycle, whichever is longer.

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Figure 6-2

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Current Assets / Current Liabilities

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Limitations of the Current Asset Classification
As

noted by Leopold A. Bernstein,
“The current ratio is not fully up to the task
[of assessing short-term liquidity] because it
is a static or “stock” concept of what
resources are available at a given moment
to meet the obligations at that moment.”

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Cash

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Proper Management of Cash
Restrictions

placed on a company’s
access to its cash are typically imposed
by creditors to help ensure future
interest and principal payments.
Compensating balances are
sometimes required
Record Control over cash
Physical Control over cash
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Accounts Receivable







Accounts receivable arise from selling goods
or services to customers on account.
Recorded at face amount to be collected.
However, we must also reflect the fact that a
portion of A/R may not be collected.
– Net Realizable Value
Reasons for lack of collection:

1. sales discounts (cash discounts)
2. sales returns
3. sales allowances
4. uncollectible A/R (bad debts)
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1. Cash Discounts





Offered to encourage early payment
Examples
• 2/10, net 30

• 2/10, EOM
Accounting approaches
• Gross Method - records discounts when taken
by customers
• Net Method - records discounts not taken by
customers
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Recording sales discounts
The gross method


Assume a $100 sale, terms 2/10, n/30



The sale is recorded:

Debit

Accounts Receivable
Sales

Credit

100
100
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Recording sales discounts
The gross method
If

paid within 10 days:
Debit

Cash
Sales Discounts
Accounts Receivable

Credit

98
2
100

A contra-account to Sales Revenue

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Recording sales discounts
The gross method
If

paid after 10 days:
Debit

Cash
Accounts Receivable

Credit

100
100

Will not disclose that discount was not taken
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Gross Method


Make year end estimate of amount of
discounts expected to be taken
Adjusting entry:
SALES DISCOUNTS
ALLOWANCE FOR SALES DISCOUNTS

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Recording sales discounts
The net method


Assume a $100 sale, terms 2/10, n/30



The sale is recorded:

Debit

Accounts Receivable
Sales

Credit

98
98
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Recording sales discounts
The net method
If

paid within 10 days:
Debit

Cash
Accounts Receivable

Credit

98
98

Will not disclose that discount was taken

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Recording sales discounts
The net method
If

paid after 10 days:
Debit

Cash

Credit

100

Sales Discounts
Forfeited
Accounts Receivable

Report as miscellaneous revenue

2
98
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Net Method




Record sale net of cash discounts
Record discounts not taken (similar to
interest income)
Make year end adjustment for accounts that
are past the discount period
Adjusting entry:
ACCOUNTS RECEIVABLE
SALES
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Theory





Discounts are more like interest
If so, the Gross Method
• Overstates Sales
• Understates Interest Income
Defense for use of the Gross Method?
• Materiality

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2. Sales Returns and Allowances




If sales returns are small in amount, adjust A/R and
create a contra to Sales called Sales Returns when
the merchandise is returned. Sales allowances are
negotiated reductions in sales price after the sale.
Sales Allowance xx
Sales Returnsxx
A/R
xx
If sales returns are significant (e.g., bookstore),
company must estimate the amount of sales
returns expected, and adjust A/R (with a contra
account similar to Allowance for Bad Debts) at the
end of the period.
Estimated Sales Returns
xx
Allowance for Returns xx
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3. Allowance for Doubtful Accounts
Created as a contra account to A/R to indicate the
portion of A/R that will not be collected due to
defaults on payments by customers.

Reason for Allowance account: Assume $1,000
sale in 2008 and default on collection in 2009.
Record sale in 2008:
A/R
1,000
Sales Revenue
1,000
Record default in 2009:
Bad Debt Expense 1,000
A/R
1,000
Note: this is called the direct method, and is not
GAAP, for the reasons listed on the next page.
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Problems with Direct Method




Problem: the direct method, on the previous
slide, does not achieve matching (revenues
recognized in 2008, but a related expense was
recognized in 2009).
Problem: the direct method does not correctly
value the asset, A/R. The assets are overvalued
until 2009, when the receivable is written off.

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Solution: the Allowance Method
Solution: create a contra to A/R, and estimate
the A/R that will not be collected.
The AJE to record an estimate for
uncollectibles in 2008 (for all uncollectibles):
Bad Debt Expense 4,000
Allowance
4,000
The GJE during 2009, when a specific A/R is
deemed uncollectible (this is called the writeoff of a specific A/R):
Allowance
1,000
A/R
1,000
When are the income statement and balance
At the 2008 estimate.
sheet affected?
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Estimation of Uncollectibles






Note that we do not know in 2008 which A/Rs will

not be collected in 2009. Therefore, we must
estimate uncollectibles. There are two methods:
1. Percentage of sales
2. Percentage of accounts receivable
Both methods are used to estimate
uncollectibles for the AJE. The percentage of
sales method is simpler, but the percentage of
A/R method is more accurate.
Under IFRS, the methods used to estimate and
account for uncollectible are very similar to
those under US GAAP.

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1. Percentage of Sales Method





Usually based on credit sales, but may use
total sales or net sales as basis.
Calculation:
Sales x % = Bad Debt Expense
(focus on the debit side of the AJE)
Called the Income Statement approach,
because: revenues x % = expense.

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