Reimers finacct 03 sm04 PDF

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Chapter 4

Payment for Goods and Services: Cash and Accounts Receivable LEARNING OBJECTIVES 1. Explain how a firm controls cash and prepares a bank reconciliation. 2. Describe how cash is reported on the financial statements. 3. Calculate bad debts expense and explain how a firm evaluates and reports accounts receivable. 4. Explain the difference between sales on credit and credit card sales. 5. Account for and report notes receivable. 6. Prepare financial statements that include bad debts. 7. Analyze a firm’s accounts receivable with ratio analysis. 8. Identify the risks and controls associated with cash and receivables.

Questions 1. What is a bank reconciliation and what does it determine? Solution: A bank reconciliation is a comparison between the bank statement balance and the general ledger’s Cash account balance to identify the reasons for any differences between the two. The purpose of the bank reconciliation is to determine the true cash balance. 2. What are two common adjustments made to the balance per bank on the bank reconciliation? Solution: Two common adjustments made to the balance per bank are outstanding checks and deposits in transit. 3. Describe two common adjustments made to the balance per books on the bank reconciliation. Solution: Two common adjustments made to the general ledger’s Cash balance, “the books,” include service charges by the bank and interest earned on the checking account balance. 4. After the bank reconciliation is complete, which adjustments are recorded in the accounting records? Solution: Adjustments are recorded for each of the reconciling items to the company’s Cash account balance. 5. What does true cash balance refer to? Solution: The phrase “true cash balance” refers to the actual amount of cash that the firm has on hand as of the bank statement date, after the reconciling items are journalized and posted to the accounts. 6. Identify and explain the financial statements on which cash is reported. Solution: The amount of cash the company has on hand is reported on the balance sheet and the statement of cash flows. The statement of cash flows also describes all of the cash inflows and outflows for the period. 7. Describe how accounts receivable arise. What does the balance in accounts receivable represent? 162

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Solution: Accounts receivable arise when a company makes a sale on account. The balance represents an amount owed to the company. 8. How do accounts (trade) receivables differ from other receivables? Solution: Trade receivables are amounts owed by customers. Other receivables are amounts owed by parties other than customers, such as employees or subsidiaries. 9. Define net realizable value, book value, and carrying value as they relate to accounts receivable. Solution: Net realizable value, book value and carrying value of the Accounts Receivable is the balance in Accounts Receivable reduced by the balance in its contra account, Allowance for Uncollectible Accounts. 10. Explain the difference between the direct write-off method and the allowance method of accounting for bad debts. Which method is preferred and why? Solution: The direct write-off method of accounting for bad debts records Bad Debts Expense and reduces Accounts Receivable when an account is determined to be uncollectible and is written off. The allowance method estimates bad debts expense each accounting period and maintains an allowance account, the Allowance for Uncollectible Accounts, a contra-asset account. When specific customers’ accounts are determined to be uncollectible, they are written off against the Allowance for Uncollectible Accounts. The allowance method is the preferred method of accounting for bad debts because it better matches the cost of sales against sales revenue (income statement) and values Accounts Receivable at net realizable value (balance sheet). 11. If a company uses the allowance method of accounting for bad debts, what effect does writing off a specific account have on income? Solution: When the company uses the allowance method to account for bad debts, writing off an account has no effect on income. The expense was recognized when the company made the adjusting entry to the Allowance for Uncollectible Accounts. 12. Describe the two allowance methods used to estimate the amount of bad debts expense that appears on the income statement. Solution: Bad debts expense in the allowance method can be estimated two different ways. The percentage of sales method estimates the period’s bad debts expense by taking a percentage of the period’s net credit sales. The accounts receivable method requires the company to estimate the amount of the year end balance of accounts receivable it believes will not be collected. This estimate should be the year end balance in the allowance account. The difference between the balance in the Allowance account prior to adjustment (if positive) and the estimate is the current period’s bad debts expense. 13. Which method of calculating the allowance for uncollectible accounts focuses on the income statement? Explain. Solution: The percent of sales method focuses on the income statement because the focus is on getting the expense just right for the income statement. The estimate is based on the sales figure from the income statement. 14. Which method of calculating the allowance for uncollectible accounts focuses on the balance sheet? Explain. Solution: The accounts receivable method focuses on the balance sheet and getting the correct net realizable value on the balance sheet. The estimate of bad debts is based on the Accounts Receivable balance from the balance sheet. 15. What are the advantages and disadvantages of allowing customers to make purchases with credit cards? Solution: The advantages of allowing customers to make purchases with credit cards include increasing the number of customers and eliminating the risks associated with extending credit to customers. In addition, the company doesn’t have to keep track of customers’ credit, payments, and outstanding balances; and will not face any problems with late or uncollectible accounts. The biggest disadvantage is the cost charged by credit card companies (credit card expense).

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16. What is the difference between accounts receivable and notes receivable? Solution: Accounts receivable arise from credit sales, called sales on account, where the customer receives the goods and pays later. Notes receivable are generally interest-bearing and for longer periods of time than accounts receivable. Notes receivable are also evidenced by a written document. 17. What is the formula to calculate the accounts receivable turnover ratio, and what does the formula measure? Solution: The accounts receivables turnover ratio is measured as net sales divided by average net accounts receivable. It measures how quickly a firm is collecting its receivables, and it is a measure of liquidity. 18. How does a firm use its accounts receivable turnover ratio to determine the average number of days it takes to collect its accounts receivable? Solution: The average number of days to collect a credit sale is calculated by dividing 365 by the accounts receivable turnover. 19. Explain how the segregation of duties serves as a major control for safeguarding cash. Solution: Segregation of duties with regard to cash requires that the person who has physical custody of the cash not be the same person who does the record keeping for cash. 20. Explain why it is important to have physical control of cash. Solution: It is important to have physical control of cash because it is the most easily stolen asset.

Multiple-Choice Questions Use the following information for questions 1–4. Fred’s Supply Store just received its monthly bank statement from Local Street Bank. The bank gives a balance of $45,000. Fred’s accounting clerk has calculated that outstanding checks amount to $20,000. Fred’s Supply Store made a deposit of $5,000 on the last day of the month, and it was not included on the bank statement. Bank service fees, not yet recorded on the store’s books, were shown on the statement as $35. The bank statement also included an NSF check returned from a new customer in the amount of $250. 1. What is the store’s true cash balance at the end of the month? a. $25,000 b. $30,000 c. $29,715 d. $29,750 2. How should outstanding checks be treated on the bank reconciliation? a. They should be deducted from the balance per books. b. They should be added to the balance per books. c. They should be deducted from the balance per bank. d. They should be added to the balance per bank. 3. Which items would need to be recorded in Fred’s Supply Store’s accounting records? a. Outstanding checks and the deposit in transit b. NSF check c. Bank service fee d. Both NSF check and bank service fee 4. What was the cash balance in its accounting records before Fred’s Supply Store began the bank reconciliation? a. $30,285 b. $30,250 c. $45,250 d. $25,285

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Use the following information to answer multiple-choice questions 5 and 6. At the end of the year, before any adjustments are made, the accounting records for Sutton Company show a balance of $100,000 in accounts receivable. The allowance for uncollectible accounts has a remaining balance of $2,000. (This means last year’s estimate was too large by $2,000.) The company uses accounts receivable to estimate bad debts expense. An analysis of accounts receivable results in an estimate of $27,000 of uncollectible accounts. 5. The bad debts expense on the income statement for the year would be a. $27,000. b. $25,000. c. $23,000. d. $29,000. 6. Net realizable value of the receivables on the year-end balance sheet would be a. $100,000. b. $75,000. c. $73,000. d. $77,000. 7. Suppose a firm uses the percentage of sales method for estimating bad debts expense. The firm has credit sales for the year of $200,000 and a balance of $80,000 in accounts receivable. The firm estimates that 2% of its credit sales will never be collected. What is the bad debts expense for the year? a. $1,600 b. $2,000 c. $4,000 d. $3,600 8. Scott Company uses the allowance method of accounting for bad debts. During May, the company found out that one of its largest customers filed for bankruptcy. If Scott Company decides to write off the customer’s account, what effect will that decision have on Scott Company’s net income for the period? a. Bad debts expense will decrease income. b. Writing off the receivable will decrease income. c. Both a. and b. will happen. d. There is no effect on net income. 9. Merry Maids, Inc., sells vacuum cleaners to McKenzie-Grace Corporation for $1,000. McKenzie-Grace pays Merry Maids with the company Visa card. Visa charges Merry Maids a 3% fee for all Visa sales. What is the net effect of this transaction on the accounting equation for Merry Maids? a. Increase assets $1,000; increase retained earnings $1,000 b. Decrease assets $1,000; decrease retained earning $1,000 c. Increase assets $970; increase retained earnings $970 d. Not enough information

Short Exercises Set A SE4-1A. Analyze bank reconciliation items. (LO 1). For each of the following items, indicate whether or not the balance per books should be adjusted. For each item that affects the balance per books, indicate whether the item should be added to (⫹) or subtracted from (⫺) the balance per books. Item Outstanding checks Service charge by bank NSF check from customer Deposits in transit Error made by the bank Note receivable collected by the bank

Balance per books adjusted? No

ⴙ/ⴚ n/a

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Solution:

SE4-2A. Calculate the true cash balance. (LO 1, 2). At March 31, Ronca Company has the following information available about its cash account: Cash balance per bank Outstanding checks Deposits in transit Bank service charge

$7,500 $2,500 $1,800 $ 100

Determine the true cash balance per bank at March 31 and tell where it would be reported in the financial statements. Solution:

SE4-3A. Analyze errors in a bank reconciliation. (LO 1). Name Brand Electronics’ accountant wrote a check to a supplier for inventory in the amount of $1,600 but erroneously recorded it on the company’s books as $1,060. She discovered this when she saw the monthly bank statement and noticed that the check had cleared the bank for $1,600. How would this be handled on the bank reconciliation? Enter the transaction into the accounting equation Name Brand’s accountant needs to make to correct its accounting records. Solution:

SE4-4A. Determine bad debts expense using the percentage of sales method. (LO 3). Discount Bakery has a liberal credit policy and has been experiencing a high rate of uncollectible accounts. The company estimates that 5% of credit sales become bad debts. Due to the significance of this amount, the company uses the allowance method for accounting for bad debts. During the year, credit sales amounted to $200,000. The year-end accounts receivable balance was $117,000. What was the bad debts expense for the year? Solution:

SE4-5A. Determine bad debts expense using the accounts receivable method. (LO 3). Don’s Golf Supplies ended its first year with $50,000 of accounts receivable and estimates that 3% of that amount will never be paid. No account has been specifically identified as non-paying at the date of the year-end balance sheet. What will the income statement for the year show as the bad debts expense if Don’s uses the allowance method of accounting for bad debts?

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Solution:

SE4-6A. Write off uncollectible accounts. (LO 3). Chastain’s Upholstery has determined that Global Builders’ accounts receivable balance of $5,500 is uncollectible. Use the accounting equation to show how Chastain’s would write off the account using (a) the direct write-off method and (b) the allowance method for bad debts. Solution:

SE4-7A. Account for credit card sales. (LO 4). Jordan Beauty Supply accepts Discover® cards from its customers. Discover charges Jordan 3.5% of sales for its services. During the 2009–2010 fiscal year, Jordan’s customers used Discover cards to purchase $65,000 worth of merchandise. How much did Jordan show as sales on the income statement for the year ended June 30, 2010? How much cash did Jordan actually receive from these sales? Solution:

SE4-8A. Analyze notes receivable. (LO 5). On May 1, 2011, Bob’s Music renegotiated its overdue account balance of $2,500 with Spectrum Electronics by signing a two-month promissory note at an interest rate of 5%. What is the principal amount of the note? What is the due date of the note? How much will Bob’s Music repay on the due date of the note? Solution:

SE4-9A. Calculate accounts receivable turnover ratio. (LO 7). Candid Company had the following balances: Receivables, net Sales (all credit)

December 31, 2011 $ 325,000 $1,757,000

December 31, 2010 $ 285,000 $1,248,700

Calculate the accounts receivable turnover ratio for 2011. On average, how many days does it take Candid Company to collect its accounts receivable?

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Solution:

Set B SE4-10B. Analyze bank reconciliation items. (LO 1). For each of the following items, indicate whether or not the balance per bank should be adjusted. For each item that affects the balance per bank, indicate whether the item should be added to (⫹) or subtracted from (⫺) the balance per bank. Item Outstanding checks Service charge by bank NSF check from customer Deposits in transit Error made by the bank Note receivable collected by the bank

Balance per bank adjusted? Yes

ⴙ/ⴚ —

Solution:

SE4-11B. Calculate the true cash balance. (LO 1). Use the following information to calculate the true reconciled cash balance: Bank statement shows interest earned for month Bank statement shows service charges for month Book shows deposits in transit Book shows outstanding checks Balance per

Books $100

Interest earned for month Service charges for month Deposits in transit Outstanding checks Balance True cash balance

What is the company’s true cash balance at April 30?

$50 $10 $75 $25 Bank $90

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Solution:

SE4-12B. Analyze errors in a bank reconciliation. (LO 1). Rimes Restaurant makes large cash deposits daily. The bookkeeper recorded one of the daily deposits as $5,700 in the company’s records, but the bank statement showed that deposit as $7,500. After checking the day’s restaurant receipts and the original deposit slip, the bookkeeper realized the bank was correct and that he had transposed the digits when he recorded the transaction. How should this be handled on the bank reconciliation? Show what Rimes should record to correct its books. Solution:

SE4-13B. Determine bad debts expense using the percentage of sales method. (LO 3). Following are the 2010 year-end balances before adjustments: Accounts receivable (AR) Allowance for uncollectible accounts Net sales

$ 80,000 $ (2,000) $250,000

Using the percentage of sales method, the company estimates 3% of sales will become uncollectible. What is the bad debts expense for 2010? What will be the net realizable value of accounts receivable on the year-end balance sheet? Solution:

SE4-14B. Determine bad debts expense using the accounts receivable method. (LO 3). Carpet Emporium ended its first year with $300,000 of accounts receivable and estimates that 2% of that amount will never be paid. No account has been specifically identified as non-paying at the date of the year-end balance sheet. What will the income statement for the year show as the bad debts expense if Carpet Emporium uses the allowance method of accounting for bad debts?

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Solution:

SE4-15B. Write off uncollectible accounts. (LO 3). Building Supplies Corporation has determined that a customer’s accounts receivable balance of $35,700 is uncollectible. Use the accounting equation to show how Building Supplies Corporation would write off the account using (a) the direct write-off method and (b) the allowance method for bad debts. Solution:

SE4-16B. Account for credit card sales. (LO 4). Fried Foods Corporation accepts MasterCard® from its customers. MasterCard charges Fried Foods a fixed fee of $125 per month plus 4.25% of MasterCard sales. If Fried Foods had MasterCard sales of $600,000 during 2011, how much did Fried Foods pay MasterCard for its service? Solution:

SE4-17B. Analyze notes receivable. (LO 5). When Moss Planters Corporation was contacted by Green’s Garden Center asking for a time extension on its outstanding balance of $1,000, Moss Planters Corporation offered to convert the accounts receivable into a short-term note. Green’s agreed to the offer and, on June 1, signed a three-month promissory note at an interest rate of 4%. What is the principal amount of the note? What is the due date of the note? How much will Green’s Garden Center repay on the due date of the note? Solution:

SE4-18B. Calculate accounts receivable turnover ratio. (LO 7). Ross Company had the following balances: Receivables, net Sales (all credit)

December 31, 2010 $ 200,000 $1,600,000

December 31, 2009 $ 250,000 $1,000,000

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Calculate the accounts receivable turnover ratio for 2010. On average, how many da...