Financial accounting a critical approach canadian canadian 4th edition john friedlan solutions manua

Financial Accounting A Critical Approach CANADIAN Canadian 4th Edition John Friedlan Solutions Manual Visit to download the full and correct content document: https://testbankdeal.com/dow nload/financial-accounting-a-critical-approach-canadian-canadian-4th-edition-john-frie dlan-solutions-manual/

CHAPTER 6 Cash, Receivables, and the Time Value of Money QUESTIONS Q6-1.

Internal controls are the policies and procedures that management implements to protect an entity’s assets and ensure the integrity of the accounting information system. Strong internal controls provide assurance to stakeholders that the entity’s assets can’t be stolen, used inappropriately, or used without proper authorization, and that the information produced by the accounting system can be relied on. Strong internal controls are extremely important because without them actions that could be very detrimental to the profitability and survival of the entity could occur. For example, theft by employees and customers can cost a company a large amount of money.

Q6-2.

Segregation of duties means that people who handle an asset shouldn’t also be responsible for record keeping for that asset. If duties aren’t segregated, an employee may be able to steal cash and cover up the theft by making fictitious entries to the accounting records. The idea is that an employee shouldn’t be in a position to steal or misuse an asset and be able to cover up the theft or misuse through access to the accounting records. If the same employee maintains custody of an asset and maintains the accounting records, that person can steal assets and modify the records such that the theft can’t easily be discovered.

Q6-3.

Cash is an unproductive asset because the return earned on cash by depositing it in the bank is much less than the cost of financing cash. That is particularly so for businesses that receive little or no interest on cash balances in chequing accounts but must pay at least 3% to 4% interest on borrowed funds. People invest cash in businesses to earn a return that is larger than what they would receive from a bank investment. However, an adequate reserve of cash is crucial to provide liquidity.

Q6-4.

If an entity has more cash than is required either for operating purposes or for planned investments in productive assets then the owners would be better off if the cash was returned to them so that they could invest it in productive assets. The reason is that cash is an unproductive asset because it doesn’t earn a reasonable return to the investor. A crucial decision for management is determining what the appropriate amount of cash the entity should have.

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Q6-5.

Unless there has been a period of zero or negative inflation, you are worse off now in the sense that you have less purchasing power than when the money was misplaced. Also, you have foregone the interest that you would have earned had you invested all or part of the $500 during the four-year period. You also delayed enjoying the $500 for four years.

Q6-6.

A nominal dollar is a dollar that isn’t adjusted for changes in the purchasing power. The use of the nominal dollar ignores purchasing power gains and losses. That means that while the absolute (nominal) number of dollars stays the same, the quantity of goods a dollar will purchase changes over time. If there is inflation and an entity has a liability that must be paid in money, it costs the entity less to repay the debt in terms of the purchasing power that is sacrificed. The fact that less is sacrificed in terms of purchasing power isn’t captured by IFRS/ASPE accounting.

Q6-7.

Restricted cash is cash that is set aside for a particular purpose and not available for general use by the entity. This could be because of a legal or contractual obligation to use it in a particular way. The implication is that when assessing an entity’s liquidity it’s necessary to ignore restricted cash because it isn’t available for general use.

Q6-8.

There are several reasons for a preference for money now. There is an opportunity to earn a return on the money, there is a risk that the future payment may not occur, and there is a loss of purchasing power unless there is zero inflation or deflation. Also, having money now allows you to spend it sooner, which means that you get satisfaction of some form sooner (a vacation today is probably more attractive than the same one a year later).

Q6-9.

Simple interest is paid only on the principal while compound interest is paid on the principal and interest earned in previous periods. Given the same interest rate, you earn more interest with compound interest, because with compound interest the interest is calculated on a larger amount.

Q6-10.

The present value of future cash flows is the value today of amounts that will be received in the future. Future value is the amount that will be received in the future by investing today. When estimating the value of a lottery that will pay $25,000 each year for 10 years, present value is appropriate. Future value is the amount we will have in the bank at retirement if we deposit $10,000 in the bank today at 6% per year until retirement. (Other examples are appropriate as well.)

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Q6-11.

A receivable is an amount owed to the entity. Receivables can be classified as current or noncurrent assets, depending on when they are expected to be collected (current if they will be collected within one year or one operating cycle). Receivables are valued at NRV (net realizable value)—the estimated amount that will be collected. Common types of receivables are accounts receivable (amounts due from customers), notes receivable (a more formal receivable, often from customers), interest receivable, and receivables from shareholders (amounts due from shareholders).

Q6-12.

When revenue is recognized earlier, the balance in accounts receivable is larger and the firm reports more current assets. As a result, balance sheet measures of liquidity such as the current and quick ratios indicate a more liquid entity when revenue is recognized earlier. There is no real impact on economic liquidity using different revenue recognition methods since the ability to meet obligations depends on cash availability, not the timing of revenue recognition. The same conclusion is true if cash is received before or at the same time as revenue is recognized.

Recognition of revenue improves measured liquidity in this case because current liabilities (unearned revenue) decrease.

Q6-13.

When revenue is recognized before cash is collected accounts receivable are reported on the balance sheet. Thus recognition of revenue gives rise to receivables. The revenue recognition criteria determine when receivables are reported.

Q6-14.

The benefit is that the business is able to sell merchandise to customers who don’t wish to pay cash at the time of sale, and almost certainly obtains sales that otherwise would go to competitors. The drawback is that the company must wait for the receivable to be collected and there is a risk that the money will never be collected. Indeed, it’s almost a certainty that some percentage of credit sales won’t be collected. A company would prefer to collect the cash at the time of the sale, unless there is a very high interest rate on the amount owing. For example, credit card companies earn significant amounts of money when customers don’t pay immediately. Other than for retail businesses most transactions are carried out with credit terms, with suppliers sending invoices to customers for payment.

Q6-15.

The amount reported on the balance sheet is usually less than the sum of individual receivables because the reported amount is net of an allowance for an estimated amount that won’t be collected. Accounts receivable are reported at net realizable value, which is the amount that will

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be realized in cash. If an entity sells on credit it’s highly likely that some customers won’t pay so it’s necessary to reflect the fact that all the money people promised to pay won’t be collected. In addition to uncollectable amounts, estimated returns and discounts are deducted from gross accounts receivable, which reduces the NRV and increases the difference between the gross and net amount of accounts receivable.

Q6-16.

The owner’s decision criteria for writing off receivables needs to be explained. The owner may wait too long to write off receivables (thus leaving assets and net income overstated) or that he writes off receivables in an arbitrary manner (potentially at times when it is convenient for him).

It’s possible that since the owner is seeking a loan, he may delay writing off bad debts to make his financial statements appear stronger. As a result the bank manager may not be receiving the information he needs to make a good decision (the amount of cash that will be received). As a bank manager I would ask to see an aging schedule and information on the collectability of receivables before approving the loan request.

Q6-17.

When the percentage-of-receivables or percentage-of-credit-sales method is used the expense is accrued when financial statements are prepared. The amount accrued recognizes that some receivables wouldn’t be collected, but it isn’t known which ones. The decision to write off a receivable is recognition that a specific receivable won’t be collected. So part of the estimate is converted into a known amount (the actual customer). The journal entry to record the write-off would reduce the allowance (the general recognition) and the receivable (the specific customer), which has no effect on the income statement as these are both balance sheet accounts.

Q6-18.

The direct write-off method results in both an income statement that doesn’t match expenses to related revenues and a balance sheet that reports accounts receivable at an amount that exceeds the net realizable value. In accrual accounting all costs incurred to earn revenue in a period should be expensed in that period. The direct write-off method recognizes the cost of uncollectible amounts when an amount is determined to be uncollectible, which may occur in a period other than when the related revenue was recognized.

Q6-19.

The percentage-of-credit-sales method estimates the amount of credit sales recognized in a period that isn’t collectible and recognize an expense for that amount in the period. The amount of the expense is added to the allowance account. Because the percentage-of-credit-sales method focusses on credit sales, which is an income statement account, it’s considered an income statement approach. In the percentage-of-receivables method the focus is on getting the amount of receivables reported on the balance sheet to reflect the net realizable value (NRV) of the

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receivables. Here the focus is on the balance sheet. The amount of the expense is simply the amount required to get the allowance to the desired amount. Because of the focus on amount of accounts receivable on the balance sheet it’s considered a balance sheet approach.

Q6-20.

If the percentage is too low, income will be overstated, as will the net balance in accounts receivable (because the allowance is too small). Over time net receivables could become significantly overstated if the underestimation of bad debts isn’t noticed because the underestimate each year will build up in the allowance account. If the expense is consistently too high, income will be understated, as will the net balance in accounts receivable (because the allowance is too large). Over time net receivables could become significantly understated if the overestimation of bad debts isn’t noticed because the overestimate each year will build up in the allowance account.

Q6-21.

An aging schedule classifies accounts receivable according to the time they have been outstanding. It’s useful for assessing the bad debt expense and the collectability of receivables because the longer a receivable is outstanding and overdue, the less likely it is the amount will be collected.

Q6-22.

The decision is a combination of past experience and a consideration of trends in the economy in general and the specific industry and entities who owe money. Some of the analysis is objective but the judgment of management is also informed by subjective assessments. The process is subjective because it’s a prediction. The actual outcome depends on uncertain future events that won’t be known with certainty when the estimate is made.

Q6-23.

There are a variety of circumstances that may cause a manager to write off an account receivable. The company that owes the money may have declared bankruptcy, efforts to collect the money may have been unsuccessful, or the debtor may have informed the creditor that they have no intention or ability to pay. Such decisions are often subjective with respect to the timing of the write off, but there are objective criteria such as the length of time that has passed without payment of any part of the debt. There is always some probability that a written off account receivable will be collected. The timing of write offs won’t have any immediate effect on the accrual methods because the effect of the write off is to shift the effect from the allowance account to the specific account receivable. The timing may affect future estimates of bad debts though.

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If the direct write off approach is used the timing and judgement exercised by management will have an immediate effect on the income statement and balance sheet. Deciding to write off a receivable during a period (as opposed to another) will reduce net income and the balance in accounts receivable by the amount of the write off. The decision to defer a write off would increase net income and receivables in the period relative to if a receivable was written off.

Q6-24.

The amount of the revenue should be reported at the present value of the future payment or at the fair value of the merchandise (the cash selling price). This is the effect of the time value of money—a dollar today is worth more than one received two years in the future. By deferring collection two years the amount of revenue is less than if it were collected immediately. The difference between the amount collected in two years and the amount recognized as revenue today should be treated as interest revenue over the two years. By recognizing the full $100,000 as revenue upon delivery, Verlo has overstated revenue in the current period as the interest revenue hasn’t yet been earned.

Q6-25 Allowing customers to return product indicates that at company stands behind their merchandise giving their customers confidence in purchases. As a result sales may be higher. However, allowing returns comes at a cost to the company including the cost of restocking, record keeping and the reselling of items (perhaps at a discount). Returns should be accrued at the end of a period by estimating the amount that will be returned. Returns are reflected on the income statement as a contra revenue account with a corresponding entry on the balance sheet as a contra asset account (contra accounts receivable—allowance for returns (if a credit sale)) or an accrued liability (if a cash sale).

Q6-26 The benefits of giving a discount to customers are to give the customer an incentive to pay earlier rather than later. This may reduce the risk of default and give the company providing the discount quicker access to cash it can use to meet its obligations. The challenge accountants face with respect to discounts is estimating the amount that will be taken by customers (the proportion of receivables eligible for discounts at the end of the period that will be claimed). Practically this isn’t a big problem because the actual amount will usually be known within a few days of the end of the period (the discount period is usually short).

Q6-27.

Hidden reserves are accounting estimates that management uses to manage earnings. A hidden reserve allows management to increase or decrease revenues or expenses in a period and thereby shift income among periods to achieve a reporting objective. Hidden reserves are made possible by inadequate accounting disclosure—entities don’t disclose all the estimates they make or the

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underlying assumptions. Hidden reserves create a problem for users of financial statements because they distort income and related measures and they aren’t observable or identifiable by stakeholders. As a result the measures affected by hidden reserves can’t be interpreted effectively.

Q6-28.

The quick ratio is cash, cash equivalents, temporary investments, and receivables (really assets that will or can be converted to cash quickly) divided by current liabilities. The ratio provides an indication of liquidity by using only current assets that are cash or will be realized in cash very soon. The ratio excludes inventory, prepaid assets and other current assets from the numerator of the current ratio because generally these assets are less liquid. The inventory of a jewellery store can’t be sold quickly—it’s not very liquid—so the current ratio may not be as good an indication of liquidity. For the gold mine, inventory is very liquid because gold bullion can be sold at any time on the open market, so the current ratio provides a very good indication of the mine’s ability to meet its financial obligations.

Q6-29.

The accounts receivable turnover ratio is useful for evaluating liquidity because it provides insight into how quickly receivables are converted into cash. The higher the ratio, the faster receivables are being collected and the more quickly the entity collects cash from its customers, which shortens the cash lag.

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EXERCISES E6-1.

Cash is money on hand and cash equivalents are short-term investments easily and quickly converted into a known amount of cash. a.

Cash in the office should be included in cash and cash equivalents because it’s money on hand.

b.

Cash in a bank savings account should be included in cash and cash equivalents because it’s money on hand and readily available for use.

c.

Uncashed cheques should be classified as cash because a cheque is equivalent to cash (although there is some uncertainty since the debtor might not have the funds to cover the cheque).

d.

The amount owed by an executive is a receivable, not cash. The amount isn’t money on hand or available and it isn’t a short-term investment easily and quickly converted into a known amount of cash (it’s not even clear if or when the amount will be repaid).

e.

The investment certificate should be classified as cash and cash equivalents because it’s easily convertible to a known amount of cash. The certificate can be cashed at any time for its face value plus interest so the amount of cash is known.

f.

The amount borrowed is cash (only borrowed amount). The unborrowed portion of the line isn’t included in cash and cash equivalents.

g.

This item shouldn’t be considered as cash and cash equivalents because it’s being held by a foreign government and not available for use. The amount is similar to restricted cash.

h.

The post-dated cheques shouldn’t be included in cash and cash equivalents because they can’t be converted to cash until February 21. On the balance sheet date (December 31, 2017) they don’t represent cash that’s available or an investment. If the cheques represent payments from the customers they would be classified as receivables until they are cashed or become cashable.

i.

The amount held by the lawyer shouldn’t be included in cash and cash equivalents. Since the cash is held by the lawyer for a specific and restricted purpose it should be classified as restricted cash. Restricted cash isn’t readily available for use. The restricted cash would be disclosed separately on the financial statements.

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j.

The British pounds should be included in cash and cash equivalents. While the pounds can’t be converted into a known amount of Canadian cash, they can be converted quickly and easily and are readily available for use. Also, if the pounds are used to pay obligations denominated in pounds, exchange isn’t an issue.

k.

These items shouldn’t be included in cash and cash equivalents because the value of publicly traded shares fluctuates daily. It’s uncertain how much cash would be received for the shares until they were sold.

E6-2.

Future Value

amount invested

a. FV = (1.04)6 × $100,000 = $126,531.90 b. FV= (1.02)12 × $100,000 = $126,824.18 c. FV= (1.01)24 × $100,000 = $126,973.46 d. FV= (1.0033333)72 × $100,000 = $127,074.19 E6-3.

Future Value

amount invested

a. FV = (1.03)8 × $5,000 = $6,333.85 b. FV= (1.025)24 × $70,000 = $126,610.82 c. FV= (1.08)4 × $100,000 = $136,048.90 d. FV= (1.00)6 × $25,000 = $25,000 E6-4.

PV= a. PV = $200,000/(1.14)10 = $53,949 b. PV = [$50,000/(1.06)1] + [$25,000/(1.06)3] + [$10,000/(1.06)5] = $47,169.81 + $20,990.48 + $7,472.58 = $75,632.88 c. PV = [$10,000/(1.06)1] + [$25,000/(1.06)3] + [$50,000/(1.06)5] = $9433.96 + $20,990.48 + $37,362.91 = $67,787.35

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E6-5.

PV= a.

PV = $20,000/(1.08)3 = $15,876.64.

If $20,000 is to be paid in the future revenue should be $15,877 with 8% recorded as interest revenue each year.

b.

PV

c.

PV= $5,000/(1.10)20 = $743.22 You should pay no more than $743.22 for the bond because that’s what $5,000 to be received in twenty years is equivalent to.

d.

PV

e.

PV =$15,000/(1.10)5 =$9,313.82 Choosing $10,000 today is a better option since $15,000 in five years is only worth $9,313.82 today.

= $4,000/(1.12) + $3,000/(1.12)2 + $2,000/(1.12)3 = $3,571.43 + $2,391.58 + $1,423.56 = $7,386.57 Yes, the present value of the future cash flows is higher than the $7,000 investment.

= $6,000/(1.08) + $4,000/(1.08)2 + $8,000/(1.08)3 = $5,555.56 + $3,429.36 + $6,350.66 = $15,335.57 You should pay no more than $15,335.57 for the investment as that the present value of the amount that will be received.

E6-6.

The solutions are calculated using the equation from the text:

a.

1/.08*[1 – 1/(1 + .08)25] x $40,000= $426,991.05.

The real value of the prize is $426,991 given the present value of the annuity.

b.

1/.12*[1 – 1/(1 + .12)15] x $250,000 = $1,702,716.12 Since the $250,000 annuity is worth only $1,702,716.12 today, you would prefer to receive $2,000,000 now.

c.

1/.01*[1 – 1/(1 + .01)36] x $50 + $200

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=$1,505 + $200 =$1,705 would be the equivalent cash prize today d.

1/.10*[1 – 1/(1 + .10)10] x $200 + $2500/(1.10)10= $2,192.77 The present value of the annuity and lump sum is $2,192.77 today. This is the maximum amount you would pay for the investment.

E6-7. a.

Future Value: $5,000 X (1.04)10 = $7,401.22 will be the maturity value. b.

Comparing Present values to $1000: Option 1: PV = $2,500/(1.10)5 = $1,552.30 Option 2: PV = $500/(1.10)1 + $650/1.102 +$800/1.103 +$200/1.104 +$100/1.105 = $1,791.48 Option 3: PVannuity = 1/.10*[1 – 1/(1 + .10)5] x $400 = $1,516.31 Option 2 has the highest present value and would be the best investment.

c.

PVannuity = 1/.07*[1 – 1/(1 + .07)20] x $10,000 = $105,940.14 She would pay $105,940.14 for the annuity.

d.

Future Value = $50,000(1.09)3 = $64,751.45 will be the amount owing on the loan.

e.

Students may approach from PV or FV in their solution: Using PV : (i) PV = $1500/(1.10)3 = $1,126.97 (ii) PV = $1500/(1.15)3 = $986.27 Using FV: (i) FV = $1000 x (1.10)3 = $1,331.00 (ii) FV = $1000 x (1.15)3 = $1,520.88 Both methods yield the same choice, at 10% it is a better option to take the $1,500 in the future while at 15% it is better to take the $1000 now.

f.

Present value of an annuity: 1/.08*[1 – 1/(1 + .08)25] x $2,000,000 = $21,349,552 The real value of the prize is $21,349,552.38

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E6-8. a.

b.

c.

d.

Dr. Cash Dr. Accounts receivable Cr. Sales

175,000 625,000

Dr. Cash Cr. Accounts receivable

405,000

Dr. Bad debt expense Cr. Allowance for bad debts

31,250

Dr. Allowance for bad debts Cr. Accounts receivable

34,000

Dr. Cash Dr. Accounts receivable Cr. Sales

2,500 7,000

Dr. Allowance for bad debts Cr. Accounts receivable

7,000

Dr. Cash Cr. Allowance for bad debts

7,000

Dr. Bad debt expense Cr. Accounts receivable

50,000

800,000

405,000

31,250

34,000

E6-9. a.

b.

c.

9,500

7,000

7,000

E6-10. a.

50,000

The effect of this entry on net income would be to decrease it by $50,000. b.

Dr. Allowance for bad debts Cr. Accounts receivable

50,000 50,000

This entry has no effect on net income. The effect on net income occurs when the bad debt expense is recorded at the end of the period, based on the amount of credit sales made during the period. c.

Allowance for bad debts Accounts receivable

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50,000 50,000

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This entry has no effect on net income. The effect on net income occurs when the bad debt expense is recorded at the end of the period, based on the amount of ending accounts receivable that is estimated not to be collectable. d.

Malagash decided to write off the account receivable because collectability was no longer reasonably assured. The company exercised judgment by deciding to write off the amount immediately. This is a conservative approach, avoiding overstating assets. From an objectives standpoint the writedown could have served to lower income currently, thereby avoiding a reduction in the future.

E6-11 a. $4,000,000 + $4,000,000(1.14)-1 + $4,000,000 (1.14)-2 + $4,000,000 (1.14)-3 = $13,286,528.11 Or use the PV of an annuity:  1  PVn, r =    Amount to be received or paid in each period n  (1 + r )  1  1  =  1 −   Amount to be received or paid in each period r  (1 + r ) n 

= $4,000,000 + (1/.14*[1 – 1/(1 + .14)3] x $4,000,000) = $13,286,528.11

Dr. Cash Dr. Long-term Receivables Cr. Revenue

4,000,000.00 9,286,528.11 13,286,528.11

b.

Debden Ltd. Long-term Receivable Schedule 2018-2020

2018 2019 2020

Beginning balance in long-term receivable account $9,286,528.11 6,586,642.04 3,508,771 .93

Cash Payment $4,000,000 4,000,000 4,000,000

Interest revenue (Bal. X 14%) $1,300,113.94 922,129.89 491,228.07

Reduction in long-term receivable (Pmt-Interest) $2,699,886.06 3,077,870.11 3,508,771.93

Ending balance in long-term receivable account $6,586,642.04 3,508,771.93 0

*numbers may vary due to rounding 2018 Cash

4,000,000.00 Long-term receivable Interest revenue

2019 Cash

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2,699,886.06 1,300,113.94 4,000,000.00

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Long-term receivable Interest revenue

3,077,870.11 922,129.89

2020 Cash

4,000,000.00 Long-term receivable Interest revenue

3,508,771.93 491,228.07

c.

May 31,2017 May 31,2018 May 31,2019 May 31,2020

Total receivable $ 9,286,528.11 $ 6,586,642.04 $ 3,508,771.93 $ -

Long-term $ 5,777,756 $ 3,077,870 $ $ -

Current portion $ 3,508,772 $ 3,508,772 $ 3,508,772 $

-

For each year, the amount of the long-term receivable reported on the balance sheet is the present value of the remaining payments. Since $4,000,000 is paid each year the amount reported as current on the May 31, balance sheet each year is the present value of $4,000,000. The remainder is long-term. d.

It would be misleading to users of the financial statements if Debden recognized the full $16,000,000 immediately since income is overstated. If the time value of money is ignored, stakeholders might get the impression that the sale was more profitable than it actually was. In addition, stakeholders wouldn’t realize that Debden isn’t only selling land, but is also financing the purchase, which has cash flow implications. Debden’s management would favour this approach if it wanted to increase income in the current period, perhaps because of a bonus plan or an interest in impressing external stakeholders with higher income.

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E6-12.

Cash

Beginnin g balances 7/31/17

Accounts receivable

75,800

Allowance for uncollectable accounts (3,000)

350,000 375,000

Ending balances 7/31/18

375,000

Revenu e

Bad debt expense

350,000

(375,000) (3,200) 47,600

(3,500) 3,200 (3,300)

(3,500) 350,000

(3,500)

Note: The ending balance in accounts receivable on July 31, 2018 was $47,600. During 2018 $3,200 was written off from accounts receivable.

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E6-13.

Cash

Beginning balances 12/31/2016

Accounts receivable

Allowance for uncollectable accounts

Unearned revenue

134,750

(7,062)

56,100

902,000

(47,300)

31,240 847,000

Revenue

949,300

31,240 (847,000) (9,130)

Ending balances 12/31/2017

878,240

Bad debt expense

(7,480)

7,480

182,270

(8,712)

(9,130)

40,040

949,300

(9,130)

Amounts that have to be calculated are shown in grey. It’s necessary to calculate the amount of the unearned revenue that was recognized in 2017 (this is done by calculating that amount from the other three pieces of information about the unearned revenue account. With the amount of unearned revenue recognized it’s then possible to calculate the increase in accounts receivable for the period (the information gives revenue for the period so the increase in accounts receivable is revenue – the decrease in unearned revenue. The other amounts then flow from there.

E6-14.

Allowance for doubtful accounts December 31, 2016 Less: Accounts written of during 2017 Pre-closing allowance for doubtful accounts December 31, 2017

$38,150 (39,600)

Credit sales during 2017 Average percentage of credit sales uncollectible Bad debts expense for 2017 Pre-closing allowance for doubtful accounts December 31, 2017

2,262,500 2% 45,250

Allowance for doubtful accounts December 31, 2017

Bad debt expense Allowance for bad debts John Friedlan, Financial Accounting: A Critical Approach, 4th edition Solutions Manual

(1,450)

(1,450) $43,800

45,250 45,250 Page 6-16 Copyright © 2013 McGraw-Hill Ryerson Ltd.

To record bad debt expense for 2017 E6-15. a.

Year 2014 2015 2016 2017 2018

b.

Credit Percent Sales Uncollected $500,000 2% 500,000 2% 500,000 2% 500,000 2% 500,000 2.3%

Bad Debt Expense $10,000 10,000 10,000 10,000 11,500

By only recording a bad debt expense of $10,000 when in fact bad debts were $11,500, net income was overstated by $1,500 for each of the years 2014 to 2017. The company corrected addressed the issue in 2018 so it recorded an appropriate expense in 2018, in addition to correcting the error.

c.

Credited To Allowance

Debited To Allowance

Allowance Year Balance Open $(11,500) 2014 $(10,000) $11,500 $(10,000) 2015 (10,000) 11,500 (8,500) 2016 (10,000) 11,500 (7,000) 2017 (10,000) 11,500 (5,500) 2018 (11,500) 11,500 (5,500) 2018 (6,000)* (11,500) *Adjustment to correct understatement from 2014-2017 (part e)

The impact is that net accounts receivable are overstated because the allowance is understated. d.

The correction is needed to “catch up” with the expense understatement made in 2014 through 2017. The result is that the allowance and the bad debt expense will be “correct” at the end of 2018. From 2014 through 2017 the bad debt expense was understated by $1,500 each year so the correction would require an additional bad debt expense of $6,000 ($1,500 4).

e.

Bad debt expense Allowance for doubtful accounts

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6,000 6,000

Page 6-17 Copyright © 2013 McGraw-Hill Ryerson Ltd.

E6-16.

a.

Bad debt expense = $94, 500 ($1,575,000

6%) – $11,250 = $83,250

Allowance for doubtful accounts = $1,575,000 Bad debt expense (94,500 – 11,250) Allowance for doubtful accounts b.

Bad debt expense = $9,361,500

6% = $94,500 83,250 83,250

1.5%) = $140,422.50

Allowance for doubtful accounts = $140,422.50 + $11,250 = $151,672.50

c.

Bad debt expense Allowance for doubtful accounts

140,422.50 140,422.50

Bad debt expense = $94, 500 ($1,575,000

6%) + $11,250 = $105,750

Allowance for doubtful accounts = $1,575,000 Bad debt expense (94,500 + 11,250) Allowance for doubtful accounts Bad debt expense = $9,361,500

6% = $94,500 105,750 105,750

1.5% = $140,422.50

Allowance for doubtful accounts = $140,422.50 – $11,250 = $129,172.50 Bad debt expense Allowance for doubtful accounts

140,422.50 140,422.50

A debit balance in allowance for doubtful accounts indicates that the estimate of bad debts was too low. Under the percentage of receivables method, the focus is on reporting receivables at their net realizable value. This means that the allowance must reflect the amount of receivables estimated to be uncollectible. Therefore the bad debt expense must be debited an additional $11,250, resulting in a higher bad debts expense.

Under the percentage of credit sales method, the focus is to report an accurate bad debt expense. It follows that the bad debt expense for the period won’t be changed because of the balance in the allowance account. However, the allowance for doubtful accounts will be $11,250 lower, and accounts receivable won’t be stated at their estimated net realizable value on the balance sheet. With the percentage credit sales method it’s possible for the allowance balance to become unrepresentative of the amount

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of receivables that won’t be collected if there is an error that persists in one direction (i.e. the bad debt expense is continually overstated or understated).

E6-17.

Account Age Current 1-30 days

Percent Amount Balance Uncollectible Uncollectible $700,000 2.50% $17,500 288,000 10% 28,800

31-90 days

128,400

25%

32,100

> 90 days

58,800

60%

35,280

Total

$1,175,200

$113,680

Allowance Account Pre-closing balance $10,800 Required balance (113,680) Required adjustment ($124,480)

a.

The amount of closing accounts receivable that is estimated to be uncollectible is $113,680.

b.

Bad debt expense Allowance for doubtful accounts To record bad debt expense for the period

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124,480 124,480

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E6-18. a.

Average accounts receivable

Accounts receivable turnover ratio

=

(520,000 + 475,000) 2

=

497,500

=

Credit sales Average accounts receivable

=

4,150,000 497,500

=

8.34

b.

Average collection period of accounts receivable =

365 8.34

= 43.76 days

c.

The reasonableness of the collection period can’t be determined with the information provided. Benchmarks are required, such as the collection period in prior years, credit terms offered to customers, economic conditions, amount for comparable firms, etc.

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E6-19. a.

Allowance for doubtful accounts Bad debt expense

53,000 53,000

b.

The effect of making estimates of bad debts that were higher than the actual amount was to understate net income in each year by the excess of the estimate over the actual amount. The adjusting entry increases net income by $53,000 in the year of the correction, which reverses the cumulative effect of the high estimates over the past three years. In other words, net income in the current year will be $53,000 higher after the adjustment than it otherwise would have been, but in the previous three years (taken together) net income would have been $53,000 lower than it should have been.

c.

The error and adjusting entry could mislead financial statement users if it’s material. Net income in each of the previous three years has been understated which may cause users to underestimate Trilby’s future cash flows. In addition, the large decrease in bad debt expense due to the adjusting entry will overstate the current year’s net income. This could cause users to overestimate Trilby’s future cash flows (especially if these adjustments and misestimates aren’t disclosed). Also, the balance sheets of all the affected periods wouldn’t reflect the net realizable value of accounts receivable. This could affect the decisions of creditors since decision criteria such as current assets, current ratio, quick ratio, etc., will be misleading. Stakeholders may have made decisions that weren’t optimal for them versus the ones they would have made if they had obtained more accurate information.

E6-20 a.

Sales Returns and Allowances 10,000 (contra sales) Allowance for Returns (contra accounts receivable) This assumes no beginning balances in the contra accounts.

10,000

b.

Accounts Receivable balance would be $515,000 (525,000 – 10,000) and net sales would be $4,115,000 (4,125,000 – 10,000).

c.

Allowance for Returns Accounts Receivable

2,000

Inventory

XXX

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2,000

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Cost of Sales

XXX

E6-21 a.

Sales Discounts (30% x 120,000 x 2%) (contra sales) Allowance for Trade Discount (contra accounts receivable)

720 720

b.

Accounts Receivable balance would be $274,280 (275,000 – 720) and net sales would be $1,964,280 (1,965,000 – 720).

c.

Cash Allowance for Trade Discount Accounts Receivable

980 20 1000

E6-22 Account Age Current Up to 60 days >60 days

Balance $180,000 40,000 15,000

Total

$235,000

a.

Uncollectible 2.00% 20% 50%

Uncollectible $3,600 $8,000 $7,500

Bad Debt Expense Allowance for doubtful accounts

$19,100

19,100 19,100

Sales Discounts ($120,000 x 40% x 2%) Allowance for sales discounts (A/R)

960 960

Sales Returns and Allowances Allowance for sales returns (A/R)

12,000 12,000

b.

Accounts Receivable balance would be $202,940 (235,000 – 19,100 – 960 – 12,000).

c.

The amount of net sales recorded for the year is $1,887,040 ( 1,900,000 – 960 – 12,000).

Bad debts would be reported as an expense.

d.

A stakeholder should be concerned with the estimates made by management, especially in the first year of operations as there is an absence of historical data to base the estimates.

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E6-23. a. This item shouldn’t be included when calculating the quick ratio because prepaids aren’t liquid assets (they represent cash flows that have already occurred). b. This item should be included in calculating the quick ratio because it represents the current portion of interest that is receivable within the period. Consideration should be given to when the interest is due to be paid. c.

This item should be included when calculating the quick ratio because the maturity date is very soon, one month.

d. This item shouldn’t be included when calculating the quick ratio because it is a long-term receivable that can’t be quickly converted to cash. e. This item should be included in the quick ratio because the current portion of long term receivable is collectible within the operating cycle in the form of cash. f. This item shouldn’t be included when calculating the quick ratio because long term assets can’t be quickly converted to cash. g. This item shouldn’t be included in the calculation of the quick ratio because it can’t be converted into cash to cover current liabilities prior to maturity. h. This item should be included in the calculation of the quick ratio because gold can be quickly converted into cash. i. This item shouldn’t be included when calculating the quick ratio because restricted cash isn’t available for general purpose use. j. This item shouldn’t be included in the quick ratio because it can’t be converted to cash quickly. k. This item should be included when calculating the quick ratio because post-dated cheques pertain to receivables, which are included in quick assets. l. This item should be included in the quick ratio as it will be converted to cash in a very short period of time. m. Shares in privately owned corporations are often not very liquid (there is no ready market, sales are often restricted) so these shouldn’t be considered quick assets.

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E6-24. a.

Current ratio 2017

2018

Quick ratio 2017

2018

=

Current assets Current liabilities

=

513,750 401,250

=

1.28

=

627,750 342,500

=

1.83

=

Quick assets Current liabilities

=

250,000 401,250

=

0.62

=

332,500 342,500

=

0.97

Quick Assets Cash and cash equivalents Accounts receivable Total quick assets b.

2018 2017 $ 95,000 $105,000 237,500 145,000 332,500 250,000

Both Seahorse’s current and quick ratios increased from 2017 to 2018. This indicates that Seahorse has improved its ability to meet its current obligations. Also, the current ratio of 1.83 at the end of 2018 suggests that its liquidity position is solid. It should be noted, however, that the current ratio includes current non-liquid assets (such as prepaids), which aren’t readily available to meet current obligations. Also, both the current and quick ratios include items, which may or may not convert into cash that will be available to satisfy current obligations. This includes such items as accounts receivable and

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inventory. Whether or not these items represent resources that will be available to meet current obligations depends on how quickly they get converted to cash. c.

One scenario in which a significant increase in the quick ratio could be an indicator of a deteriorating liquidity position is when there is a large increase in accounts receivable but the receivables aren’t collectable. This could indicate that the entity is having difficulty converting its accounts receivable into cash. In this situation, accounts receivable wouldn’t be as liquid as expected because their collectability is in doubt. This analysis presumes that management didn’t properly account for the collectability problem by recording an adequate allowance for doubtful accounts and bad debt expense.

E6-25.

Assume all sales are on credit: Accounts receivable turnover ratio =

Credit sales Average accounts receivable

4.92 =

1,592,000 Average accounts receivable

Average accounts receivable

Average collection period

=

1,592,000 4.92

=

$323,577

=

365 Accounts receivable turnover ratio

=

365 4.92

=

74.19

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E6-26.

Average collection period

=

47 =

365 Accounts receivable turnover ratio 365 Accounts receivable turnover ratio

Accounts receivable turnover ratio =

365 47

=

7.77

Accounts receivable turnover ratio =

Credit sales Average accounts receivable

7.77 =

125,125,000 Average accounts receivable

Average accounts receivable

=

125,125,000 7.77

=

16,111,986

Accounts receivable at the end of 2019 = (ARend 2018 + ARend 2019) =$16,111,986 2 = (ARend 2018 + 1.12*ARend 2018) =$16,111,986 2 =2.12* ARend 2018 =$2*16,111,986 = $32,223,972 ARend 2018 = $15,199,986 = ARend 2019 = 1.12*ARend 2018 = $17,023,984

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E6-27.

Assume all sales are on credit: 2017 2016 2015 Accounts receivable $275,200 $249,800 $244,900 Allowance for uncollectable amounts 8,256 8,243 7,837 Net accounts receivable 266,944 241,557 237,063 Sales 1,845,000 1,552,000

The following formulas were used to calculate answers: Accounts receivable turnover ratio = Average accounts receivable

Average collection period

Credit sales Average accounts receivable

= Opening A/R + Closing A/R 2 365 = Accounts receivable turnover ratio

2016 Accounts receivable turnover ratio

=

Credit sales Average accounts receivable

=

1,552,000 (241,557+237,063)/2

=

6.49

=

Credit sales Average accounts receivable

=

1,845,000 (266,944+241,557)/2

=

7.26

2017 Accounts receivable turnover ratio

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2016 Average collection period

=

365 Accounts receivable turnover ratio

=

365 6.49

=

56.3

2017 Average collection period

=

365 Accounts receivable turnover ratio

=

365 7.26

=

50.3

Accounts receivable turnover measures the number of times during a period an entity collects its receivable. The average collection period is the number of days it takes to collect receivables (on average). Accounts receivable turned over more often in 2017 (7.26 times) than in 2016 (6.49 times), indicating the company has improved in their collection practices year over year. This is reflected in the number of days it takes for the company to collect. It took on average 56.3 days to collect in 2016 versus 50.3 days in 2017.

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E6-28.

Assume all sales are on credit.

The following formulas were used to calculate answers: Accounts receivable turnover ratio = Average accounts receivable

Average collection period

Credit Sales Opening Accounts Receivable Ending Accounts Receivable Average Accounts Receivable Accounts receivable turnover ratio (ARTO) Average collection period

Credit sales Average accounts receivable

= Opening A/R + Closing A/R 2 365 = Accounts receivable turnover ratio 2018 $1,922,720

2017 $1,424,250

2016 $1,076,700

165,624 261,800 213,712

122,283 165,624 143,954

93,113 122,283 107,698

9.00 40.57

9.89 36.89

10.00 36.51

As a bank manager I am a bit concerned that the ARTO is decreasing and the average collection period is increasing. The company is taking a longer period of time to collect on its receivables. In 2016 and 2017 the company was collecting on its receivables almost within their specified period of 30 days (just under 37 days) but in 2018 the collection period increased almost four days. It is important that Aggassiz maintains control over receivables by following up on overdue accounts and ensure that credit is only offered to customers with acceptable credit ratings. To properly assess Aggasiz’s situation I would require more information such as industry standards for these ratios, an aging schedule for receivables, a full balance sheet, income statement, and a cash flow statement.

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PROBLEMS P6-1.

It costs Alix 10% per year to borrow from the line of credit. Therefore if Alix borrows $1,000 from the line of credit to pay their supplier on day 10 and subsequently pays off the line of credit on day 30, the amount of interest that Alix will pay is for a 20 day period. $1,000 * (20/365) * 10% = $5.48 in interest The savings that Alix realized from paying early was $20.00 $20 – $5.48 = $14.52 net savings Alix should immediately change their policy to pay their suppliers early whenever possible even if it means using the line of credit. Another way to look at this question can be to compare the interest rates.

365/20 = 18.25 , therefore there are 18.25 cycles in a year 2% * 18.25 = 36.5% Therefore suppliers are providing an equivalent of 36.5% discount per year for early payment while it only cost 10% interest to borrow.

P6-2.

The main weakness in this scenario is the lack of physical safeguards over cash. Due to the location of the cash, and the fact that the drawer is unlocked, anyone could easily steal the cash.

The cash should be kept in a more secure location, in a locked drawer or safe. The cash should be taken to the bank on a more timely basis – could use night deposit. There is also a lack of separation of duties. The volunteer treasurer could take some of the cash and deposit the rest in the bank and no one would be aware of it. One volunteer should keep records of cash donations, and a second volunteer should have to sign for receiving the cash when he or she takes it to the bank for deposit.

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P6-3.

The weakness in this scenario is the lack of verification of expenses claimed by the trustees.

Expenses charged to the cards only require explanation if the staff person requests it, and even then if the trustee has a suitable explanation then the expense is approved. This system could easily allow trustees to charge items to the card that aren’t employment related. To improve this control, trustees should be required to submit receipts for all expenses and also provide a statement explaining what the item purchased was as well as why it was required. Additionally, there appears to be no verification regarding the amount of kilometres driven. A trustee could claim the distance travelled was for employment reasons, however without verification the trustee could easily claim distances travelled for personal reasons. A better control would be to require the trustee to note the reason for the travel, their starting point and destination as well as submit a calculation that provides the kilometres driven (for example, a print out from a mapping website such as Map Quest or Google Maps). The expenses should be approved by a manager or chair of the board. Additionally, the travel expenses should be submitted more frequently so that there are fewer expenses to verify with each submission.

P6-4.

The weakness in this scenario is the lack of separation of duties. The person hired by the park to collect the cash could steal some of it and give the rest to the park manager at the end of the day.

This kind of theft is difficult to detect. A better system is to have one person collect the cash from customers, and a separate person record the sales and issue receipts, with each person separately turning in the cash and receipts at the end of the day. This could be done by having a separate person sell tickets for the rides and have the ride operator only collect tickets from customers. In either case it would be possible to give free rides to people. In the latter case rides could be sold to people for cash on the side. This behaviour could be checked by having someone observe the operator from time to time.

P6-5.

Retail businesses have large amounts of inventory that are included in the calculation of the current ratio but not the quick ratio. For retail businesses inventory is usually by far the largest current asset and often the largest asset category on the balance sheet so the impact of leaving out inventory when calculating the quick ratio will be significant. The denominator, current liabilities, is the same for both ratios and current liabilities includes amounts owing for inventory while inventory isn’t classified as a quick asset.

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P6-6. a.

$15,000 + $22,500/(1.10)1 + $37,500/(1.10)2 = $66,446.28

b.

$50,000 (1.05)18 = $120,330.96

c.

$1/.08*[1 – 1/(1 + .08)12] $25,000 = $188,401.95 The maximum amount the investor should pay is $188,401.95

d.

The company will have to repay the original amount of the loan, $500,000 plus interest.

The amount that must be repaid is the future value of $500,000 with interest compounded at 9% per year for five years. It’s assumed that interest owing is compounded each year. $500,000 (1.09)4 = $705,790.08

e.

$30,000 today = $30,000 $50,000 (1.10)5 = $31,046.07 $1/.10

[1 – 1/(1 + .10)5] x $8,000 = $30,326.29

Of the three alternatives, the $50,000 to be received in 5 years has the highest present value and so is the preferred option.

P6-7.

The purpose of this report is to provide an analysis of the recent credit policy change at Magundy Inc. Four issues are covered in the report. These are the bad debt expense for 2017, the accounts receivable turnover ratio, the effect of the change on Magundy’s liquidity, and an assessment of the policy. Each issue is discussed below. a.

The new aggressive policy and the old conservative policy are opposite extremes. The estimated percentage-of-credit-sales uncollectible amount should be adjusted to reflect this change. Given that new customers who are granted credit will pose more risk, meaning there will likely be an increase in uncollected amounts, the rate should be modified with the new sales policy in mind. The exact new percentage that should be used will require an assessment of the customers. However, the new percentage should be higher than 2%.

b.

The new credit policies allow customers more time to pay and provides credit to more risky customers, which implies that Magundy’s accounts receivable balance will

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grow more quickly than sales. As a result the average accounts receivable balance will increase, which will cause Magundy’s accounts receivable turnover to decrease. c.

Magundy’s new credit strategy will reduce the liquidity of the company. The looser credit terms means that cash will be collected more slowly, which means more cash will be tied up. This is indicated by the decreasing accounts receivable turnover. In addition, the increased sales will likely require additional inventory and that will require more cash investment as well. On the other hand, cash flow increase because the company is selling more merchandise (this assumes that the changed credit policy is beneficial).

d.

Whether or not the policy is good or bad also depends on the outcome. The increase in sales is a good thing but costs also increase. The attractiveness of the strategy depends on whether the benefits exceed the costs. While sales are rising as a result of the new strategy there will be additional costs from bad debts, collection, and financing. The certain measures of liquidity will also likely decline with the associated consequences.

P6-8.

Wooler Inc.’s profit margin to start off is low, roughly 11% of sales for years 2014 and 2015 with all sales on a cash basis. In 2016 and 2017 it declined to just over 8%. Accepting credit cards comes at a transaction cost of 3.5% of sales. Wooler accepting credit cards increased business however the result of flat profits was a result of their existing customers paying with credit cards also. From 2016 to 2017 credit sales went from 61% to 81% of total sales. Simply put, if cash sales yielded an 11% margin, then 100% credit sales would only yield a 7.5% (113.5) margin. It appears that most customers are taking advantage of using credit cards at a cost of 3.5% to Wooler. As a result of existing customers paying on credit the over margin reduced on each transaction resulting if flat profits—the gain in profits from increased sales was offset by the added cost of credit, which applied to new and existing sales.

P6-9. a. i. ii. iii.

$84,000 1.5% (8,470,000 85%) = $107,992.50 9.5% (1,220,000) = $115,900 115,900 – (96,000 – 84,000) = $103,900

i. ii. iii.

$0 (There is no allowance for doubtful accounts under the direct method) $96,000 – $84,000 + $107,992.50 = $119,992.50 $115,900

b.

c.

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i.

Bad debt expense 84,000 Accounts receivable 84,000 To record the bad debt expense under the direct-write-off method. ii.

Bad debt expense 107,992.50 Allowance for doubtful accounts 107,992.50 To record the bad debt expense under the percentage-of-credit-sales method. iii.

Bad debt expense 103,900 Allowance for doubtful accounts 103,900 To record the bad debt expense under the percentage-of-receivables method. d. i. ii. iii.

$500,000 – 84,000 = $416,000 $500,000 – 107,992.50= $392,007.50 $500,000 –103,900 = $396,100

e.

The differences arise because each method of determining bad debts has a different focus.

Under the direct method bad debts are charged to income as they occur, which means matching doesn’t occur. Under the percentage-of-credit-sales method, the focus is to report a reasonably accurate bad debt expense. Under the percentage-of-receivables method the focus is to report accounts receivable reasonably close to their net realizable value. If the estimates using the latter two methods aren’t correct year after year differences in the methods will occur because the percentage-of-receivables method adjusts the balance in the allowance account to ensure that the net accounts receivable approximates its NRV. The percentage-of-credit-sales method doesn’t consider the NRV of accounts receivable, only the expense for the period. In principle, the percentage-ofcredit sales and percentage-of-receivables should provide the same result. However, the methods will diverge, even if they are set up to yield the same result, once estimates and actuals are different in a year.

f.

Of the two accrual methods they to ways of achieving the same end. No method is inherently better or worse, each one involves a trade-off. The direct method provides accurate information about the amount of bad debts, but doesn’t match the expense to the revenue it helped generate, which is why it’s not used under accrual accounting. The percentage-of-credit-sales method matches the expense to the revenue it helped generate, but is an estimate, not an actual indication of what won’t be collected. The percentage-ofreceivables method also matches the expense to the revenue and provides an approximation of the receivables net realizable value, but the amount of bad debts may be even less accurate than the percentage-of-credit-sales method. It must be stressed that if the estimates are unbiased (over time estimation errors average to zero) the methods should yield similar results. Differences among the methods are caused by errors in estimating bad debts. These methods, it should be remembered, are means to an end; to

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provide an appropriate valuation for accounts receivable and to determine an appropriate expense for the calculation of net income.

P6-10. a. i. ii. iii.

$18,000 2.5% (750,000 85%) = $15,937.50 10% (145,000) = $14,500 14,500 – (13,500 – 18,000) = $19,000

i. ii. iii.

$0 (There is no allowance for doubtful accounts under the direct method) 13,500 – 18,000 + 15,937.5 = $11,437.5 $14,500

b.

c. i.

Bad debt expense 18,000 Accounts receivable 18,000 To record the bad debt expense under the direct-write-off method. ii.

Bad debt expense 15,937.50 Allowance for doubtful accounts 15,937.50 To record the bad debt expense under the percentage-of-credit-sales method. iii.

Bad debt expense 19,000 Allowance for doubtful accounts 19,000 To record the bad debt expense under the percentage-of-receivables method. d. i. $45,000 – 18,000 = $27,000 ii. $45,000 – 15,937.5 = $29,062.50 iii. $45,000 – 19,000 = $26,000 e.

The differences arise because each method of determining bad debts has a different focus.

Under the direct method bad debts are charged to income as they occur, which means matching doesn’t occur. Under the percentage-of-credit-sales method, the focus is to report a reasonably accurate bad debt expense. Under the percentage-of-receivables method the focus is to report accounts receivable reasonably close to their net realizable value. If the estimates using the latter two methods aren’t correct year after year differences in the methods will occur because the percentage-of-receivables method adjusts the balance in the allowance account to ensure that the net accounts receivable approximates its NRV. The percentage-of-credit-sales method doesn’t consider the NRV of accounts receivable, only the expense for the period. In principle, the percentage-of-

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credit sales and percentage-of-receivables should provide the same result. However, the methods will diverge, even if they are set up to yield the same result, once estimates and actuals are different in a year. f.

Of the two accrual methods they to ways of achieving the same end. No method is inherently better or worse, each one involves a trade-off. The direct method provides accurate information about the amount of bad debts, but doesn’t match the expense to the revenue it helped generate, which is why it’s not used under accrual accounting. The percentage-of-credit-sales method matches the expense to the revenue it helped generate, but is an estimate, not an actual indication of what won’t be collected. The percentage-ofreceivables method also matches the expense to the revenue and provides an approximation of the receivables net realizable value, but the amount of bad debts may be even less accurate than the percentage-of-credit-sales method. It must be stressed that if the estimates are unbiased (over time estimation errors average to zero) the methods should yield similar results. Differences among the methods are caused by errors in estimating bad debts. These methods, it should be remembered, are means to an end; to provide an appropriate valuation for accounts receivable and to determine an appropriate expense for the calculation of net income.

John Friedlan, Financial Accounting: A Critical Approach, 4th edition Solutions Manual

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P6-11. a.

Year 2013 2014 2015 2016 2017 2018

Credit Sales $ 3,375,000 3,712,500 4,185,000 4,725,000 5,377,500 5,850,000

% Uncollectible 3% 3% 3% 3% 3% 3%

Bad Debt Expense $ 101,250 111,375 125,550 141,750 161,325 175,500

b.

Year Opening balance Write-offs Bad debt expense Ending balance 2013 $ 90,000 $ 88,200 $101,250 $103,050 2014 103,050 101,475 111,375 112,950 2015 112,950 80,438 125,550 158,062 2016 158,062 74,016 141,750 225,796 2017 225,796 103,496 161,325 283,625 2018 283,625 107,550 175,500 351,575

c.

Year 2013 2014 2015 2016 2017 2018

Ending allowance balance $103,050 112,950 158,062 225,796 283,625 351,575

Accounts receivable $1,183,500 1,264,500 1,381,500 1,512,000 1,692,000 1,813,500

% of A/R 8.71% 8.93% 11.44% 14.93% 16.76% 19.39%

The allowance account is growing rapidly relative to gross accounts receivable. This is occurring because the bad debt expense is being consistently overstated. Since the percentage-of-creditsales method focuses on the income statement, the overstatement of the bad debt expense results in a buildup in the allowance account. The errors are accumulating and the increase in the allowance is due to the increase in sales and the error buildup. d.

In general, overestimating the bad debt expense will cause net income to be understated because “too much” of credit sales is being expensed as uncollectible. Since the expectation is that 2% of sales will go uncollected whereas 3% is being expensed, net income is, on average, being understated each year by 1% of credit sales.

John Friedlan, Financial Accounting: A Critical Approach, 4th edition Solutions Manual

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e.

The net amount of accounts receivable on Halkirk’s balance sheet on December 31, 2018 will be $1,461,925 ($1,813,500 – $351,575)). The balance doesn’t reflect the net realizable value of the accounts receivable. The amount is understated by the cumulative excess of bad debts expense from 2013 to 2018.

f.

Bad debt expense calculated as 2% of credit sales, beginning in 2015:

Year Credit Sales % Uncollectible Bad Debt Expense 2013 $ 3,375,000 3% $101,250 2014 3,712,500 3% 111,375 2015 4,185,000 2% 83,700 2016 4,725,000 2% 94,500 2017 5,377,500 2% 107,550 2018 5,850,000 2% 117,000 Total 27,225,000 615,375 Year Opening balance Write-offs Bad debt expense Ending balance 2013 $90,000 $88,200 $101,250 $103,050 2014 103,050 101,475 111,375 112,950 2015 112,950 80,438 83,700 116,212 2016 116,212 74,016 94,500 136,696 2017 136,696 103,496 107,550 140,750 2018 140,750 107,550 117,000 150,200

The allowance on December 31, 2018 would be $150,200 if the percentage had been adjusted in 2015. g.

Allowance for bad debts Bad debt expense

201,375 201,375

The entry serves to increase income in 2018 by $201,375. This would have a very significant effect on net income for that year. (If all Halkirk’s sales are on credit and the company has a profit margin of 10% the adjustment would serve to increase income by almost 34%. This entry might give the impression on the financial statements that the company’s bad debt expense is lower than it actually is. This could mislead users when they are attempting to gauge future net income (flow of wealth). The financial statements would be even more confusing if this adjustment wasn’t disclosed separately. Users might conclude that the $201,375 was part of ongoing earnings. However, users won’t be misled when determining future cash flows from accounts receivable as they are now stated at net realizable value.

John Friedlan, Financial Accounting: A Critical Approach, 4th edition Solutions Manual

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P6-12.

The following formulas were used to calculate answers: Accounts receivable turnover ratio = Average accounts receivable

Average collection period

Accounts receivable turnover Average Collection Period

Credit sales Average accounts receivable

= Opening A/R + Closing A/R 2 365 = Accounts receivable turnover ratio

Tadoussac Inc. 2018 2017

Sturgis Ltd. 2018 2017

5.85 62.37

7.59 48.07

5.74 63.64

7.63 47.84

Comparing the two companies, Sturgis has a better accounts receivable turnover ratio, which means it’s more effective at collecting its debts. Sturgis is collecting its debts 15 days faster than Tadoussac. On the surface at least Sturgis is better at managing its cash flows and has better controls in place to ensure collection. Additional useful information regarding the receivables of the companies includes the period each company allows customers to pay (the difference between the two might not be meaningful if Tadoussac offers more time), any incentives for early payment (discount for prompt payment), and information on the risk profile of the customers (are conditions each company faces different regarding its customers).

John Friedlan, Financial Accounting: A Critical Approach, 4th edition Solutions Manual

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P6-13 Current Ratio

Quick Ratio

Accounts Receivable Turnover Ratio

1

Increase

Increase

Increase

Average Collection Period of Accounts Receivable Decrease

2

No effect

No effect

No effect

No effect

3

Increase

Increase

No effect

No effect

4

Decrease

Decrease

Decrease

Increase

5

No effect

No effect

No effect

No effect

6

No effect

No effect

No effect

No effect

7* 

No effect No Effect No effect No effect The credit sale increases ARTO because the impact on the denominator is less than the effect on the numerator. In the denominator the beginning accounts receivable isn’t affected by the credit sale, only ending receivables is. The opposite logic applies to when there are decreases as in item 4.

Assumes that an accrual method for bad debts is used (write-off has no effect on net accounts receivable). If the direct write-off approach is used the answer would be decrease, decrease, increase, decrease.

*

John Friedlan, Financial Accounting: A Critical Approach, 4th edition Solutions Manual

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P6-14.

Current Ratio

Quick Ratio

Accounts Receivable Turnover Ratio

Average Collection Period of Accounts Receivable

1

Decrease

Decrease

Increase

Decrease

2

No effect

No effect

Increase

Decrease

3

Decrease

Decrease

No effect

No effect

4

Decrease

Decrease

No effect

No effect

5

Increase

Increase

No effect

No effect

6

Decrease

Decrease

Increase

Decrease

P6-15.

Note that amounts calculated by students may vary slightly depending on how much rounding they do. Items to be solved are shown in grey.

Current assets on December 31, 2017 Current ratio on December 31, 2017 Current liabilities on December 31, 2017 Quick assets on December 31, 2017 Quick ratio on December 31, 2017 Accounts receivable on December 31, 2017 Accounts receivable on December 31, 2016 Revenues (all on credit) during 2017 Average collection period of accounts receivable for 2017 Accounts receivable turnover ratio for 2017

John Friedlan, Financial Accounting: A Critical Approach, 4th edition Solutions Manual

$1,523,750 1.15 $1,325,000 $850,000 0.64 $275,192 $207,000 $2,750,000 32 days 11.41

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P6-16.

Note that amounts calculated by students may vary slightly depending on how much rounding they do. Items to be solved are shown in bold.

Current assets on December 31, 2018 Current ratio on December 31, 2018 Current liabilities on December 31, 2018 Quick assets on December 31, 2018 Quick ratio on December 31, 2018 Accounts receivable on December 31, 2018 Accounts receivable on December 31, 2017 Revenues (all on credit) during 2018 Average collection period of accounts receivable for 2018 Accounts receivable turnover ratio for 2018

$275,000 1.25 $220,000 $187,000 0.85 $55,000 $45,000 $287,500 63.48 5.75

P6-17.

Current ratio

Quick ratio

Accounts receivable turnover ratio

Average collection period of accounts receivable

Debt-toequity ratio

Profit margin ratio

Writeoff of an account No Effect No Effect No Effect No Effect No Effect No Effect receivable1 Recording the allowance Decrease Decrease Increase Decrease Increase Decrease for discounts2 Recording the bad debt Decrease Decrease Increase Decrease Increase Decrease 3 expense Sale of merchandise Decrease on credit; (less No Effect Increase Decrease Decrease Increase payment inventory) due in three years4 1 Writeoff of an account receivable reduces the allowance and a specific receivable account. There’s no effect

John Friedlan, Financial Accounting: A Critical Approach, 4th edition Solutions Manual

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on current assets or the income statement.

2 Debit Sales—allowance for discounts (contra sales), Credit Allowance for discounts (contra accounts receivable) 3 Debit Bad debt expense (expense), Credit Allowance for uncollectables (contra accounts receivable) 4 Debit Long-term accounts receivable, Credit Sales; Debit Cost of goods sold, Credit inventory * Assume that allowance for returns has been journalized.

P6-18.

Current ratio

Quick ratio

Accounts receivable turnover ratio

Average collection period of accounts receivable

Debt-toequity ratio

Profit margin ratio

Recording the allowance for Decrease Decrease Increase Decrease Increase Decrease 1 returns Collection of a previously written off No Effect No Effect Increase Decrease No Effect No Effect account receivable2 Sale of merchandise on credit; Increase Increase Increase Decrease Decrease Increase payment due in 30 days3 Collection of an account No Effect No Effect Increase Decrease No Effect No Effect 4 receivable 1 Debit Sales—allowance for return (contra sales), Credit Allowance for returns (contra accounts receivable) 2 Debit Accounts receivable, Credit Allowance for uncollectables, Debit Cash, Credit Accounts receivable 3 Debit Accounts receivable, Credit Sales; the increase in sales is greater than the increase in average accounts receivable.

4 Debit Cash, Credit Accounts receivable.

John Friedlan, Financial Accounting: A Critical Approach, 4th edition Solutions Manual

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