Financial Accounting 1
Module 6
Internal control and accounting for cash,
investments held for the short-term, and
receivables
Lectures and handouts by:
Jane Loftus
2007-8
Module 6 - Audio File Legend
Part
1
2
3
4
5
Content
Learning objectives & Cash
Investments held for the short-term
Accounts receivable
Other receivable issues, ratios
Summary, Review Problems
2
Part 1 – Learning Objectives
1.
State the purposes and principles of internal
control (L2)
2.
Explain the concept of liquidity and distinguish
between cash and cash equivalents (L1)
3.
Explain the operation of a petty cash fund and
prepare journal entries to record petty cash
fund transactions (L1)
4.
Explain the ethical issues related to the
operation of a petty cash fund (L1)
5.
Prepare a bank reconciliation and explain its
purpose (L1)
3
1
Part 1 – Learning Objectives
6.
Describe different types of debt and equity
investments (L1)
7.
Identify & describe classification of debt &
equity instruments (L1)
8.
Journalize entries to account for trading
investments, including purchase, income,
sale, and valuation(L1)
9.
Prepare entries for transactions with credit
customers, including accounting for bad debts
under the allowance method and direct writeoff method (L1)
4
Part 1 – Learning Objectives
10. Calculate interest on promissory notes and
prepare entries to record receipt of
promissory notes and their payment or
dishonour, along with the end-of-period
adjustments (L1)
11. Explain how receivables can be converted to
cash (L2)
12. Calculate acid-test ratio; explain how
accounts receivable turnover and days’ sales
outstanding ratios can be used to analyze a
company’s credit policy (L2)
5
Part 1 – Cash
Cash and cash equivalents
Cash - currency, petty cash, amounts on deposit
Cash equivalent - an investment readily convertible
to a known amount of cash within 3 months
•
Commercial paper - short-term notes issued by
corporations with strong credit ratings
•
Treasury bills (T-bills) - short-term government
debt
Financial Statement Presentation - cash appears
on the balance sheet at its face value. Any
foreign currency holdings are converted to
Canadian dollars using the exchange rate in effect
on the balance sheet date.
6
2
Part 1 – Cash
Internal controls
• policies and procedures that are implemented and
maintained to help ensure the orderly and efficient
conduct of the company’s business activities
and to help safeguard assets.
Purposes and Principles of internal control
• See text pages 462 & 463
• Key concept = implement policies & procedures to
safeguard assets
7
Part 1 – Cash
Internal controls for cash
- liquidity of this asset makes it most susceptible to
fraud and theft.
Safeguards include:
• Separation of duties - don’t have same person
receiving cash, recording receipt, maintaining A/R,
paying & recording bills, maintaining A/P and doing
bank reconciliations!
• Daily bank deposits
• Payments by cheque only
• Small payments should be made from petty cash,
not from cash receipts
8
Part 1 – Cash
Liquidity
• the ability to meet cash requirements as they come
due
• cash and equivalents are liquid assets
• other “quick assets” – assets that can be quickly
converted to cash are temporary investments; and
accounts receivable
• assets and liabilities are listed on the Balance Sheet
in order of liquidity.
• Order of assets: #1 Cash;# 2 Short term
investments; #3 Account receivable.
9
3
Part 1 – Cash
Petty cash fund
•
cash kept on hand to allow for cash payment of
small items (e.g. parking, postage etc.)
•
usually kept in a lock-box under the responsibility
of the custodian. The custodian is responsible for
making payments, obtaining suitable back-up for
disbursements, and keeping accurate records
•
petty cash fund must be replenished at period-end
to ensure expenses get properly recorded
•
Entry to record cheque that replenishes petty
cash: Debit Expenses (listed individually)
Credit Cash
•
Frequently asked exam question
10
Part 1 – Cash
Ethical Issues & Petty Cash
• an internal auditor needs to be aware of the signs of
fraud, theft or other unethical behavior, and have
“professional skepticism”
• the auditor is obligated to dig further if something
appears suspicious
• investigate possible causes, ask questions and look
at history
• follow the rule of “innocent until proven guilty” don’t accuse without being sure
• follow up with adequate reporting of the facts (not
speculation) and do another check soon
11
Part 1 – Cash
See Handout to Module 6
Do Problem #1(a): Petty cash
December 1996 Exam Question 2 Part (a)
Then come back and listen to the solution
Stop the presentation
Download the handout and
Complete this question !
12
4
Part 1 – Cash
December 1996 Exam Question 2 (a)(i) solution
i) Journal entries for petty cash transactions:
Nov 1
Established a $300 petty cash fund;
Nov 1
Petty cash
300
Cash
300
To establish the petty cash fund
13
Part 1 – Cash
December 1996 Exam Question 2 continued
i) Journal entries for petty cash transactions:
Paid $35 to replenish office supplies, $40 for postage;
$55 in COD charges; $50 for janitorial; had $110 in
cash at month end and want to reduce fund to $200
Nov 30 Office supplies
35
Postage expense
40
Inventory
55
Janitorial expense
50
Cash over & short
10
Petty cash
100
Cash
90
To record petty cash transactions for November
14
Part 1 – Cash
December 1996 Exam Question 2 continued
ii) Why was the fund replenished on Nov 30th?
The fund was replenished in order to recognize in
the accounts the expenses represented by the
petty cash receipts. The expenses were incurred
in November and in accordance with the
matching principle are recognized in the period in
which the resulting revenues were realized.
15
5
Part 1 – Cash
Bank reconciliation
•
an excellent internal control over cash
•
reconciles the bank statement (received from the
company’s bank each month) to the company’s
own records – its cash balance according to its
general ledger. Any differences will need to be
followed up
•
the balance per the bank statement is rarely the
same as the balance per the general ledger due to:
–
Timing differences; and
–
Unrecorded transactions and errors
16
Part 1 – Cash
Reasons for discrepancies:
1. Timing differences
– outstanding cheques
– outstanding deposits
– bank errors
• These items do NOT require an
adjustment in the accounts
17
Part 1 – Cash
Reasons for discrepancies:
2. Unrecorded transactions & errors
– unrecorded deposits and withdrawals
– service and interest charges
– NSF cheques
– errors made by the company
• These items REQUIRE an adjusting
journal entry to correct cash per the
general ledger
18
6
Part 1 – Cash
Timing
AJE’s
XYZ Company Ltd
Bank Reconciliation
Month, Year
Balance per bank
$
Add: Outstanding deposits
Deduct:Outstanding cheques
+/-:
Bank errors
= Adjusted Balance per bank $
Balance per books
$
Add:
Unrecorded deposits
Deduct: Service charges & interest
Unrecorded withdrawals
NSF cheques
+/-:
Accounting errors
= Adjusted Balance per books $
Must
Equal
19
Part 1 – Cash
See Handout to Module 6
Do Problem #1(b): Bank reconciliation
December 1996 Exam Question 2 Part (b)
Then come back and listen to the solution
Stop
presentation
and complete!
20
Part 1 – Cash
Gallo Company Ltd
Bank Reconciliation
November 30th
Balance per bank
$5,450
Add: Outstanding deposits
470
Deduct:Outstanding cheques
(1,340)
+/-:
Bank errors
420
= Adjusted Balance per bank $5,000
Solution, Dec 1996 b(i)
Timing
AJE’s
Balance per books
$
Add:
Unrecorded deposits
Deduct: NSF cheques
Service charges
+/-:
Accounting errors
= Adjusted Balance per books $
Must
Equal
21
7
Part 1 – Cash
Gallo Company Ltd
Bank Reconciliation
November 30th
Balance per bank
$5,450
Add: Outstanding deposits
470
Deduct:Outstanding cheques
(1,340)
+/-:
Bank errors
420
= Adjusted Balance per bank $5,000
Solution, Dec 1996
b(i)
Timing
AJE’s
Balance per books
$4,382
Add:
Unrecorded deposits
660
Deduct: NSF cheque
( 170)
Service & NSF charges
( 16)
+/-:
Accounting errors(160-16)
144
= Adjusted Balance per books $5,000
22
Part 1 – Cash
b(ii) November 30th Adjusting Journal entries:
1.
Cash
660
Interest income
30
Notes receivable
630
To record collection of notes receivable and interest
2.
Accounts receivable 180
Cash
180
To record NSF cheque, including $10 bank NSF fee
3.
Bank service charges
6
Cash
6
To record bank service charges for November
4.
Cash
144
Insurance expense
144
To correct error in recording insurance payment
23
Part 2 – Investments held for short-term
New level 1 material effective 2006; text outdated
Types of Investments
A. Debt instruments:
•
•
•
investments in government or corporate debt;
earn interest on investment
potential gain through price appreciation
B. Equity instruments:
•
•
•
investments in shares of a corporation
earn dividends
potential gain through price appreciation
24
8
Part 2 – Investments held for short-term
ACCOUNTING TREATMENT
•
depends on category of investment
Broad categories of investments:
1. Passive investments:
 investor can not influence or control
operations
 aim is to earn dividend or interest income
plus gain through price appreciation
2. Strategic investments:
 investor controls investee
25
Part 2 – Investments held for short-term
Classification of Passive Investments:
1.
•
•
•
Held for Trading – equity & debt instruments
purchased as a short-term investment
includes actively traded shares & debt instruments
company holds investment primarily to realize a profit
from price fluctuations, plus to earn interest or
dividends
2.
•
Held to maturity – debt instruments only
bonds with specified interest & principal payments,
and maturity date
3.
•
Available for sale – equity & debt instruments
other equity & debt instruments not included in held
for trading & held to maturity categories
26
Part 2 – Investments held for short-term
Classification of Strategic Investments:
1. Significant influence investment
• Own 20 to 50% of outstanding shares
• Can affect strategic operating, investing, or financing
policies of investee
2. Control investment
• Own greater than 50% of outstanding shares
• Can determine policies of investee
3. Joint venture investment
• Two or more venturers jointly control the economic
activity
27
9
Part 2 – Investments held for short-term
Expected knowledge - SUMMARY:
1. Explain difference between debt & equity investments
2. Explain difference between passive and strategic
investments
3. Know the different types of passive investments:
1. Held for Trading
2. Held To maturity
3. Available for sale
4. Know the different types of strategic investments:
1. Significant influence investment
2. Control investment
3. Joint venture investment
5. Know accounting treatment of trading investments
28
Part 2 – Investments held for short-term
Held for Trading – Accounting treatment (level1)
• investments recorded using the fair value method
•
•
•
•
purchase recorded at cost
transaction(brokerage) costs are recorded as an expense
record investment at market value at period-end
recognize any unrealized losses/gains at period end as
income
• when sell investment, record realized gain/loss
• current asset on balance sheet
NOT responsible for accounting treatment of other types of
passive investments or strategic investments
29
Part 2 – Investments held for short-term
Classification – Trading Investments
Current Assets (right after cash)
Valuation
At market (fair value method)
Income/Expenses
Dividends on stocks, Interest on bonds
Brokerage costs expensed;
Unrealized holding gains/losses to record
investment at market at period end;
Realized gains/losses on sale of investment
30
10
Part 2 – Investments held for short-term
Journal entries:
1.
2.
3.
At date of purchase:
Trading investment – Co Y
Brokerage expense
Cash
xx
xx
When income received
Cash
Dividend/Interest income
xx
xx
xx
At period-end, if decrease in market value:
Unrealized holding loss
xx
Trading investment – Co Y
xx
31
Part 2 – Investments held for short-term
Journal entries:
4.
At period-end, if increase in market value
Trading investment – Co Y
xx
Unrealized holding gain
xx
5.
When sell trading investment at a profit
Cash
xx
Brokerage expense
xx
Gain on sale of investment
xx
Trading Investment – Co Y
xx
6.
When sell trading investment at
Cash
Brokerage expense
Loss on sale of investment
Trading Investment – Co Y
a loss
xx
xx
xx
xx
32
Part 2 – Investments held for short-term
See Handout to Module 6
Do Problem #2: Investments held for Short Term
Problem - Trading Investment Transactions
Then come back and listen to the solution
Stop
presentation
and complete!
33
11
Part 2 – Investments held for short-term
Trading Investments: SOLUTION
Jan 15 Trading Investments – TBills
100,000
Cash
100,000
To record purchase of 6 month, 8% T-Bills
Feb 7 T/I – Royal Bank (2,200 * $26.50) 58,300
Brokerage expense
500
Cash
58,800
To record purchase of 2,200 Royal Bank shares
Feb 19 T/I – Imperial Oil (1,200 * $51.75) 62,100
Brokerage expense
600
Cash
62,700
To record purchase of 1,200 Imperial shares
34
Part 2 – Investments held for short-term
Trading Investments: SOLUTION
June 1 Cash (2,200 * $.25)
Dividend income
To record Royal Bank dividend
550
550
June 17 Cash(1,200 * $27- $300)
32,100
Brokerage expense
300
T/I – Royal Bank (1,200 * $26.50) 31,800
Gain on sale of investment
600
To record sale of Royal Bank shares
July 17 Cash
104,000
Interest income (100,000*8%*1/2) 4,000
T/I – T-Bills
100,000
To record proceeds from matured T-Bill
35
Part 2 – Investments held for short-term
Trading Investments: SOLUTION
Aug 5
Cash(1,200 * $.50)
600
Dividend income
To record Imperial Oil dividend
Sept 1
Cash(600 * $51- $250)
30,350
Brokerage expense
250
Loss on sale of investment
450
T/I – Imperial Oil(600 * $51.75) 31,050
To record sale of Imperial Oil shares
600
36
12
Part 2 – Investments held for short-term
Trading Investments: SOLUTION
Adjusting Journal Entry – December 31st
•
Need to adjust trading investments from book value
to market value
Market values/unadjusted book values at Dec 31st:
Royal Bank Market: $27.50; Book: $26.50
Imperial Oil Market: $50.25; Book: $51.75
Trading Investment- Royal Bank
# Shares outstanding: 2,200 – 1,200 = 1,000 shares
Market value (Dec 31st) $27.50 x 1,000
Book value
$26.50 x 1,000
Unrealized gain
$27,500
26,500
1,000
37
Part 2 – Investments held for short-term
Trading Investments: SOLUTION
Trading Investment- Imperial Oil
# Shares outstanding: 1,200 – 600 = 600 shares
Market value (Dec 31st)
Book value
Unrealized loss
$50.25 x 600
$51.75 x 600
Summary:
Unadjusted Bal
Market Value
Royal($26.50) $26,500 ($27.50) $27,500
Imp Oil(51.75) 31,050 (50.25) 30,150
Net unrealized holding gain
$30,150
31,050
(900)
Difference
$1,000
(900)
$ 100
38
Part 2 – Investments held for short-term
Trading Investments: SOLUTION
Trading Investment – Royal Bank
1,000
Trading Investment – Imperial Oil
900
Unrealized holding gain
100
To adjust trading investments to fair value at December 31
Financial Statement Presentation
Balance Sheet
Current Assets
Trading Investments, at market value $57,650*
*Royal Bank $ 27,500
Imperial Oil
30,150
$ 57,650
39
13
Part 3 – Accounts Receivable
Issue?
Sales on credit give rise to a business receiving
an asset called Accounts Receivable in
exchange for goods/services. Not all credit
customers will end up paying off their accounts
receivable, which gives rise to a bad debt.
Principle? Matching principle requires the cost of
granting credit – i.e the bad debt – be matched
with the period the related revenue was earned
Valuation? Accounts Receivable must be valued at its Net
Realizable Value – the net amount of cash
expected to be collected for the accounts
receivable. Principle? Conservatism
40
Part 3 – Accounts Receivable
Recording Bad Debt transactions – Allowance Method
• Record bad debt expense at period-end to comply with
matching principle.
• Entries to record bad debt transactions:
Journal entry #1: To estimate bad debt expense
– Adjusting journal entry at period-end
Entry:
Bad debt expense (BDE)
xx
Allowance for Doubtful Accounts (ADA) xx
– Done ONLY at period end
41
Part 3 – Accounts Receivable
Recording Bad Debt transactions – Allowance Method
Journal entry #2:
To write-off ACTUAL bad debts as they arise
– Record journal entry when company knows that
accounts receivable is not collectible
Entry:
Allowance for Doubtful Accounts
Accounts Receivable
xx
xx
NEVER Debit Bad debt expense
42
14
Part 3 – Accounts Receivable
Recording bad debt transactions – Allowance Method
Journal entry #3:
To record RECOVERY of bad debts previously
written off
Entries:
1. Accounts Receivable
xx
Allowance for Doubtful Accounts xx
To set written-off accounts receivable back up
2. Cash
xx
Accounts Receivable
xx
To record collection of accounts receivable
43
Part 3 – Accounts Receivable
Recording bad debt transactions – Allowance Method
1. To estimate bad debt expense at period end
Bad debt expense (BDE)
xx
Allowance for Doubtful Accounts (ADA) xx
2. To write-off ACTUAL bad debts as they arise
Allowance for Doubtful Accounts
xx
Accounts Receivable
NEVER Dr. Bad debt expense!
xx
3. To record RECOVERY of bad debts previously written off
Accounts Receivable
xx
Allowance for Doubtful Accounts
xx
Cash
xx
Accounts Receivable
xx
44
Part 3 – Accounts Receivable
Recording bad debt transactions – Direct Write-off
• Direct write-off method expenses bad debts as they
arise by: Dr. Bad debt expense
Cr. Accounts receivable
• NOT GAAP – matching principle requires the
allowance method;
• However, materiality principle may apply. If bad
debts are immaterial, don’t need to follow GAAP –
can use the direct write-off method and expense
bad debts as they arise.
45
15
Part 3 – Accounts Receivable
Methods of estimating bad debt expense
How do you decide how much the debit to bad debt
expense should be at the end of the accounting
period?
Method #1: Income statement method
•
•
•
•
Estimate bad debt expense based on % of current
year’s credit sales.
Focuses on the income statement item sales and
calculates bad debt expense directly
% uncollectible is based on historical data
Bad debt expense = credit sales x % uncollectible
46
Part 3 – Accounts Receivable
Methods of estimating bad debt expense
Method #1: Income statement method
Example: Credit sales $200,000;1.5% of sales estimated
to be uncollectible; opening balance of ADA is $1,500;
A/R is $50,000 of which 10% are uncollectible
AJE at year end – I/S Approach:
Bad debt expense (200,000 x 1.5%) 3,000
Allowance for doubtful accounts
3,000
ADA
1,500 OB
3,000 AJE – BDE
(calculated)
4,500 CB (plug)
47
Part 3 – Accounts Receivable
Methods of estimating bad debt expense
Method #2: Balance Sheet method
• Focuses on the balance sheet item accounts
receivable
• Determines the net realizable value (NRV) of the
Accounts receivable
• NRV = amount of A/R that will be collected in
cash
• Required allowance for doubtful accounts =
Estimate amount of A/R that will NOT be collected
• Required ADA = A/R x % uncollectible;
• BDE = plug ( Required ADA less actual ADA)
48
16
Part 3 – Accounts Receivable
Methods of estimating bad debt expense
Method #2: Balance Sheet method
Example: Credit sales $200,000;1.5% of sales estimated
to be uncollectible; opening balance of ADA is $1,500;
A/R is $50,000 of which 10% are uncollectible
AJE at year end – B/S Approach:
Bad debt expense
3,500
Allowance for doubtful accounts
3,500
Required ADA = $50,000 x 10% = $5,000 = CB, ADA
ADA
1,500 OB
3,500 AJE – BDE
(plug)
5,000 CB (calculated)
49
Part 3 – Accounts Receivable
Methods of estimating bad debt expense
Balance Sheet method – additional considerations
2 variants of the Balance Sheet method:
1. Simplified method:
– ADA = % uncollectible A/R x A/R balance
2. Aging of accounts receivable method
(preferred):
– ADA is based on % aged accounts receivable
– A/R are first separated by age, then a
percentage is applied to each age category
(higher % for older accounts due to increased
risk of uncollectibility)
50
Part 3 – Accounts Receivable
Methods of estimating bad debt expense
1. Income statement method – Estimate Bad Debt expense
Balance Sheet
Accounts Receivable$50,000
Less: ADA
4,500
Net A/R
45,500
Income Statement
Bad debt expense $3,000
2. Balance Sheet Method – Estimate NRV of A/R
Balance Sheet
Accounts Receivable$50,000
Less: ADA
5,000
Net A/R
45,000
Income Statement
Bad debt expense $3,500
51
17
Part 3 – Accounts Receivable
See Handout to Module 6
Do Problem #3: Accounts Receivable
Exercise – Bad debt expense
Then come back and listen to the solution
Stop
presentation
and complete!
52
Part 3 – Accounts Receivable
Exercise – Bad debt expense, solution
1. Entry to write off the uncollectible accounts;
Allowance for doubtful accounts 2,100
Accounts Receivable
2,100
2. Adjusting entry to record bad debt expense:
a. On credit sales, 1.5%
Credit sales = $360,000 / 6 = $60,000
Bad debt expense = $60,000 x 1.5% = $900
AJE @ Y/E: Bad Debt Expense 900
ADA
900
ADA
1,800 OB
w/o 2,100 900 AJE
600 CB
53
Part 3 – Accounts Receivable
Exercise – Bad debt expense, continued
2. Adjusting entry to record bad debt expense:
b. On total receivables at year end, 2.5%;
A/R = $34,000 x 2.5% = $850 = Required ADA
Bad debt expense = $1,800 – 2,100 – 850 =$1,150
AJE @ Y/E:
Bad Debt Expense 1,150
ADA
1,150
A/R
ADA
OB 36,100 2,100 w/o
1,800 OB
w/o 2,100 1,150 BDE
CB 34,000
850 CB
54
18
Part 3 – Accounts Receivable
Exercise – Bad debt expense, continued
c. On aging schedule:
– Not past due
$20,000 x .5%
– Past due 1- 60 days 8,000 x 1%
– Past due over 60 days 6,000 x 8%
Required ADA
100
80
480
660
Bad debt expense = $1,800 – 2,100 – 660 = $960
AJE @ Y/E: Bad Debt Expense 960
ADA
960
A/R
ADA
1,800 OB
OB 36,100 2,100 w/o
w/o 2,100
960 BDE
CB 34,000
660 CB
55
Part 3 – Accounts Receivable
Exercise – Bad debt expense, continued
3. Show the financial statement presentation for each
assumption
Balance Sheet
Current Assets
Accounts Receivable
Less: ADA
Net A/R
(a)
$34,000
600
33,400
Income Statement
Bad debt expense
$ 900
(b)
(c)
$34,000 $34,000
850
660
33,150 33,340
$ 1,150
$ 960
Note: When doing accounts receivable problems,
remember to use T-accounts
56
Part 4 - Promissory notes
Promissory Note
•
A notes receivable, which is a written promise to
pay an amount due. It specifies: amount,
interest rate and payment date
•
either
1. a sale is made directly by notes receivable;
or
2. an accounts receivable is converted into a
notes receivable because customer can’t
pay within normal credit terms.
57
19
Part 4 - Promissory notes
Journal Entries:
1. (a) On receipt of a note as payment for
revenues:
Notes receivable - ABC Ltd. 1,000
Revenue (fees or sales)
1,000
(b) On receipt of a note to extend a past-due
receivable:
Notes receivable - ABC Ltd. 1,000
A/R - ABC Co. Ltd.
1,000
58
Part 4 - Promissory notes
2. At the end of the period
• Need to accrue interest earned on notes receivable
but not yet received
Example:
The company received a $1,000 12-month note dated
June 30th. Its interest rate is 10%. The company
has a December 31st year end.
Required AJE to accrue interest earned at Dec 31st :
Interest receivable
50
Interest income
50
Interest = $1,000 x 10% x 6/12 months = $50
59
Part 4 - Promissory notes
3. When cash is received on maturity date
Journal entry to record collection of note at June 30th
Company would have received the $1,000 face value
of the note, plus $100 interest.
Journal entry on June 30th:
Cash
1,100
Interest income
50
Interest receivable
50
Notes receivable - ABC Ltd.
1,000
60
20
Part 4 - Promissory notes
Dishonoured notes receivable
•
If notes receivable is not collected when due,
record the interest earned and convert from a note
receivable to an accounts receivable
•
In our previous example, if the note was not paid
on June 30th, the required AJE to record the
default:
Accounts Receivable – ABC Ltd 1,100
Interest Revenue
50
Interest Receivable
50
Note Receivable – ABC Ltd
1,000
61
Part 4 - Converting receivables into cash
Converting receivables into cash - Level 2
Receivables can be sold or pledged to convert them to
cash faster
1. Selling or Factoring A/R
• can sell accounts receivable to a bank or finance
company for a fee
• the finance company collects the A/R and takes on
the risk of non-payment
2. Pledging A/R
• can use A/R as security when obtaining a bank loan
• business still owns the receivables, but bank has
right to cash received from the receivables if the
company defaults on the loan
• Pledged receivables must be disclosed in the notes
to the financial statements.
62
Part 4 – Ratios: Acid-test ratio
Acid-test Ratio:
Quick Assets: Cash + T/I + A/R
Current Liabilities
• measure of liquidity – the company’s ability to meet
its obligations as they come due
• a more stringent measure of liquidity than the
current ratio as it excludes inventory and prepaids,
which are not necessarily quickly convertible to cash
• Rule of thumb: want a ratio of 1 to 1 or greater
63
21
Part 4 – Ratios: A/R Turnover
Accounts receivable turnover ratio:
Credit sales
Average Accts Receivable balance for the year*
*Avg A/R = (OB + CB )/2
• measures how many times a year the company’s
A/R have been converted into cash
• gives an indication of the quality and liquidity of A/R
• a high ratio compared to industry average or prior
years may mean that credit terms are too strict
(may result in lost sales)
• a low ratio compared to the industry average/prior
years may mean that more attention is needed to
collect payments from customers promptly
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Part 4- Ratios - Days’ Sales Uncollected
Days’ Sales Uncollected:
Accounts Receivable
Net sales
x 365
• measure of liquidity of company’s accounts receivable
• calculates the number of days of average sales that
make up the A/R balance
• the lower the better – but want to compare to
industry average and prior years
• Rule of thumb: days’ sales uncollected should be less
than 1 1/3 times the days in its credit period
• i.e. 30 days * 1.3 = 39 days max if no discount
• i.e. 10 days * 1.3 = 13 days max if discount offered
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Part 5 - Summary
1. Internal controls are important in safeguarding assets
against theft or waste, and in promoting operational
efficiencies. Make a list of the basic internal controls,
as listed in the text. Remember segregation of
duties!
2. A key control over cash is a bank reconciliation. Make
sure you can do one, as well as the adjusting entries
3. Know the mechanics of a petty cash fund, including
entries to set it up and replenish it at period end
4. Know the difference between passive and strategic
investments, and the types of investments included in
each.
5. Know accounting treatment of trading investments
ONLY. Trading investments are valued at market.
Know how to do journal entries to record purchase,
value asset at period end, and record the sale
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Part 5 - Summary
6. Accounts receivable is valued at NRV. Know how to
estimate bad debt expense using both the Income
Statement and Balance Sheet approaches, prepare
period end entries for bad debts, and record entry
when an accounts receivable becomes uncollectible
7. Promissory notes are notes receivable. They are
interest bearing and have a specific payment date.
If they are not repaid on time, the principal and
interest is converted to an A/R. Know journal entries
and how to calculate interest
8. Accounts receivable can be converted to cash by
factoring (selling) them to a bank or finance
company, or by using the A/R as security for a loan
9. Know the hows and whys of using the acid-test
(quick) ratio, the A/R turnover ratio and Days’ sales
uncollected
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Part 5 - Summary
Make use of the additional resources
available to you:
• Textbook: Flashbacks, Judgment Calls,
Demonstration Problems
• Lesson notes questions & answers
• Web-based interactive testing
• McGraw-Hill Online Learning Centre
• CGA Canada & Regional websites
• National Tutor service
Remember…
Try to complete the Module 8 assignment ASAP….
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Part 5 - Review Questions
See Handout to Module 6
Do Problem #4: Trading Investments
March 1999 Exam Question 4 (10 marks)
Then come back and listen to the solution
Stop
presentation
and complete!
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Part 5 - Review Questions
Solution to March 1999 Exam Question 4
a. Trading investment – Co A
60,000
Trading investment – Co B
80,000
Cash
140,000
To record purchase of Company A & B
Co A: 1,000 @ $60; Co B: 2,000 @ $40
b.
Cash
32,000
Trading investments – Co A
24,000
Gain on sale of T/I
8,000
To record sale of Company A at Dec 15, 1998
Co A Proceeds: 400 shares @ $80
$32,000
Book Value: 400 shares @ $60
24,000
Gain on sale
$ 8,000
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Part 5- Review Questions
Solution to March 1999 exam Question 4, cont’d
c.
Trading investment – Co A 6,000
Unrealized holding loss
34,000
Trading investment – Co B
To adjust for fair value at Dec 31, 1998
40,000
Co A Market value: 600 shares @ $70
Book value:
600 shares @ $60
Unrealized holding gain
$ 42,000
36,000
$ 6,000
Co B Market value: 2,000 shares @ $20
Book value: 2,000 shares @ $40
Unrealized holding loss
$ 40,000
80,000
$(40,000)
Overall unrealized holding loss
$(34,000)
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Part 5- Review Questions
Solution to March 1999 exam Question 4, cont’d
d.
Cash
39,000
Loss on sale of investment 3,000
Trading investment – Co A 42,000
To record sale of Company A Dec 15, 1998
Co A Proceeds:
600 shares @ $65
Book value: 600 shares @ $70
Loss on sale
$39,000
42,000
$ 3,000
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Part 5- Review Questions
Solution to March 1999 exam Question 4, cont’d
e.
Trading investment – Co B 30,000
Unrealized holding gain
30,000
To adjust for fair value at Dec 31, 1998
Co B Market value: 2,000 shares @ $35
Book value: 2,000 shares @ $20
Unrealized holding gain
$ 70,000
40,000
$ 30,000
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Part 5 - Review Questions
See Handout to Module 6
Do Problem #5: Accounts Receivable
June 1999 Exam Question 5 (18 marks)
Then come back and listen to the solution
Stop
presentation
and complete!
74
Part 5 - Review Questions
Solution to June 1999 exam Question 5
a. 2 marks each
1.
Accounts receivable
Sales
2.
Allowance for doubtful accounts
Accounts receivable
3.
Cash
Accounts receivable
4.
Note receivable
Accounts receivable
500,000
500,000
1,500
1,500
400,000
400,000
3,000
3,000
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Part 5 - Review Questions
Solution to June 1999 exam Question 5, cont.
5.
December 31, 1998 AJE – interest earned on note
(3 marks)
Interest receivable
Interest income
30
30
Principal of Note Receivable
x annual rate
x # months interest earned
= Interest earned to Dec 31
$3,000
x 12%
x 1/12
$ 30
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Part 5 - Review Questions
Solution to June 1999 exam Question 5, cont.
6. a. December 31, 1998 AJE – bad debt expense
Required ADA = $135,500 x 5% = $6,775
Therefore, BDE = $2,000 – 1,500 – 6,775 = $6,275
Bad debt expense
6,275
Allowance for doubtful accounts
Accounts Receivable
1,500 w/o
OB
40,000
400,000 coll’ns
Sales 500,000
3,000 N/R
CB 135,500
6,275
ADA
2,000 OB
w/o 1,500
6,275 AJE
6,775 CB
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Part 5 - Review Questions
Solution to June 1999 exam Question 5, cont.
6. b.December 31, 1998 AJE – bad debt expense
Bad debt expense = Credit Sales x 1%
BDE = $500,000 x 1% = $5,000
Bad debt expense 5,000
Allowance for doubtful accounts
5,000
Accounts Receivable
OB
40,000
1,500 w/o
Sales 500,000 400,000 coll’ns
3,000 N/R
CB
135,500
ADA
w/o 1,500
2,000 OB
5,000 AJE
5,500 CB
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Part 5 - Review Questions
Solution to June 1999 exam Question 5, cont.
c.
Companies use the allowance method of
accounting for bad debts in order to ensure
expenses are charged to the period in which the
related revenue is recognized. In addition, the
method results in accounts receivable being
reported on the balance sheet at the estimated
amount of cash to be collected. It would be
acceptable for a company to use the direct writeoff method of accounting for bad debts if bad
debts were considered to be immaterial.
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