Financial accounting 9th jamie pratt 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.

Figure 6-1 The operating cycle

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Relative Size of Current Assets

Figure 6-2

Current assets
as a percentage
of total assets

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Measures Using Current Assets – Current Ratio

Figure 6-3
Current assets
as a
percentage
of current
liabilities

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Limitations of the Current Assets Classification
As noted by Leopold A. Bernstein:
“The current ratio is not fully up to the task [of assessing short-term liquidity]
because
given

it is a static or “stock” concept of what resources are available at a

moment to meet the obligations at that moment.”

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Cash
*Cash flows are increasingly popular in assessing solvency

Figure 6-5
Cash as a
percentage of
total assets
and current
assets

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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

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Record Control over cash

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Physical Control over cash

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Accounts Receivable

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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.

We adjust to Net Realizable Value
Reasons for lack of/partial collection:

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sales discounts (cash discounts)
sales returns
sales allowances
uncollectible A/R (bad debts)

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Cash Discounts

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Offered to encourage early payment

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Examples:

2/10, net 30
2/10, EOM

Accounting approaches

Gross Method - records discounts when taken by customers, this is more
common and is discussed in more detail
Net Method – records discounts not taken by customers

Quantity and Trade discounts are a reduction of price/revenue and aren’t
recorded separately in the financials

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Recording Sales Discounts:
The Gross Method

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•

Assume a $100 sale, terms 2/10, n/30
The sale is recorded:

Debit

Accounts Receivable
Sales

Credit

1,000
1,000

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Cont’d
If paid within 10 days:

Debit

Cash
Sales Discounts

Credit

980
20

Accounts Receivable

1,000

A contra-account to Sales Revenue
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Cont’d
If paid after 10 days:

Debit

Cash

Credit

1,000

Accounts Receivable

1,000

Will not disclose that discount was not taken
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Allowance for Doubtful Accounts
We create a contra account to A/R (called Allowance for Doubtful Accounts) to indicate the
portion of A/R that will not be collected due to defaults on payments by customers.
Direct write off is not consistent with GAAP because it does not achieve a matching of
revenues and expenses due to the time between the recording of the sale and the
decision to finally write off an asset. Assets are overvalued until the final write off.

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llowance Method

 There are three basic steps

 Bad debts are estimated
 An adjusting journal is made to recognize the expense and reduce the net balance
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in A/R
A write-off journal entry is made when the bad debt occurs (it is determined the item
is not collectable)

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Estimating the Bad Debt
 Note that we do not know in any given period which A/Rs will specific A/R balances

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will not be collected. Therefore, we must estimate uncollectibles. There are two
methods:
1. Percentage of sales (covered in the text)
2. Percentage of accounts receivable
Both methods are used to estimate for an adjusting journal entry at the end of the
period. This entry ensures that bad debt expenses are matched to the revenues
reported

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Percentage of Sales Method
 Typically based on credit sales
 Calculation:
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Sales x % = Bad Debt Expense
(focus on the debit side of the AJE)
The percentage chosen by management for this calculation is normally based on
the past experience of the company.

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Adjusting Journal Entry
 Based on the estimate, a journal entry is recorded
Debit – Bad Debt Expense XXX
Credit –
Allowance for Doubtful Accounts XXX

 Bad debt expense as a contra revenue recognizes some revenue should not be
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recorded (as it is uncollectible)
Allowance for Doubtful Accounts decreases the net realizable value of Accounts
Receivables on the Balance Sheet

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The Write – Off Journal Entry
 When a determination is made that a specific A/R is not collectable, it should be
removed from the ledger with a write-off JE

Debit-Allowance for Doubtful Accounts XXX
Credit – Accounts Receivable
XXX

 Net realizable value of the Accounts Receivable does not change because both
the A/R and the Allowance are effected.

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Bad Debt Recoveries
 If written off amounts are later collected, reverse the write-off entry for the
collected amount (this reestablishes the receivable)
Debit- Accounts Receivable
XXX
Credit – Allowance for Doubtful Accounts XXX

 Then record the cash collection
Debit- Cash
Credit –

XXX

Accounts Receivable XXX

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Inaccurate Estimates of Bad Debt
 Estimates of Bad Debt are Estimates so are rarely ‘correct’

 Over time, over estimates and under estimates should tend toward averaging
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out and may be ignored.
If there is a large debit or credit balance in the preadjustment Allowance for

Doubtful Accounts, it may indicate that estimates are poorly done or biased.
 Methodology for estimates should be reviewed
 Potential adjustment should be made

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An Aging Schedule – Used to Estimate Bad Debt
Receivables do not get better with age.
Older items are less likely to be collected.
Figure 6-11 An Aging Schedule

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An Aging Schedule – Used as a Management Tool
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Maintaining control over receivables is an important
part of effective management for companies

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Identify slow moving accounts

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Direct collection efforts

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Estimate how much a company is losing in potential
interest charges

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Sales Returns
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Sales returns can be a significant issue for some companies and industries.

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Returns are estimated similar to bad debts where they are material.

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The income statement and the accounts receivables on the balance sheet must be
adjusted.

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International Perspective: Receivables, Foreign Currencies, and
Hedging

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For multinational corporations, sales and receivables can be denominated in foreign

currency.

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This means there is a risk based on changing exchange rates

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Gain or Loss possible based on the exchange rate.

Hedging is a strategy companies use to limit the risk of foreign exchange transactions

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