Solution manual intermediate accounting 15e by stice ch07

Chapter CHAPTER QUESTIONS (a) A receivable evidenced by a formal, written promise to pay is classified as a note receivable; an informal, unsecured promise to pay is classified as an account receivable or other appropriate title (e.g., advances to officers) (b) Receivables arising from the normal operating activities of a business are classified as trade receivables; those from all other sources are nontrade receivables (c) All trade receivables and those nontrade receivables expected to be collected within year (or the normal operating cycle, whichever is longer) are reported as Current Assets; all other receivables are noncurrent and are reported under the Investments or Other Noncurrent Assets caption, whichever is appropriate (a) Methods for establishing and maintaining an allowance for bad debts account are as follows: (1) Allowance for Bad Debts is increased by a certain percentage of total sales or credit sales (2) Allowance for Bad Debts is adjusted to a certain percentage of receivables (3) Allowance for Bad Debts is adjusted to an amount determined by aging the accounts (b) The percentages to use in estimating uncollectible accounts should be based on the collection experience of each individual company Analysis of the past records can be made to determine the relationships between write-offs and sales or receivables If there has been no recognizable change in the economic conditions or in the credit policy of the company, these historical percentages may be used as the best estimate of future uncollectibles To the extent that these conditions are changing, the percentages will require appropriate adjustment GAAP requires the allowance method because it provides for a matching of current revenues with related expenses, and it reports the receivables at their net realizable value The direct write-off method is easy to apply and is objective but does not provide for proper matching of revenues and expenses nor appropriate valuation of receivables (a) Adjustments to be made: Age the receivables (including the dishonored notes) in order to determine the amount by which to increase Allowance for Bad Debts or to create an allowance balance if none exists Write off worthless accounts of $320 as follows: Allowance for Bad Debts 320 Accounts Receivable 320 (b) Accounts Receivable should appear on the balance sheet under Current Assets at $9,572 This balance consists of the following: Accounts from sales of the last three months $7,460 Accounts from sales prior to October 1,312 Dishonored notes charged back to customers’ accounts 800 $9,572 The balance of Allowance for Bad Debts should be deducted from Accounts Receivable The credit balances in customers’ accounts, $1,190, should be reported as a current liability Product warranties are obligations that clearly exist at a balance sheet date, but the amount to be paid cannot be definitely determined The amount of the claim is therefore estimated This estimated liability should normally be recorded on an accrual basis because the obligation created upon the sale of a product should be matched with the revenue received from the sale (a) Accounts receivable turnover is computed by dividing net sales by the average accounts receivable outstanding for the year (b) Average collection period is computed by dividing average daily sales (net sales ÷ 365) into the average receivables for the year This measurement can also be obtained by dividing the number of days in a year by the accounts receivable turnover (c) The accounts receivable turnover represents the average number of sales or collection cycles completed by a firm during a particular year The average collection period shows the average time required to collect receivables Cash, because it is the standard medium of exchange, is required to complete almost all business transactions Therefore, a certain amount of cash must be kept immediately available for daily transactions It is management’s responsibility to see that sufficient cash, but not an excessive amount, is available for current operating purposes To be productive, any excess of “idle cash” should be invested in temporary or longterm investments (a) Cash (b) Investments, noncurrent receivables, or other assets (not currently available) (c) Cash (d) Other noncurrent assets (will be used to acquire a noncurrent asset) (e) Accounts receivable (f) Accounts receivable (g) Employees’ accounts or notes receivable (h) Office supplies (i) Cash (j) Notes receivable (k) Cash (l) Cash The balance with Bank A should be reported as cash The overdraft with Bank B should be reported as a current liability Even if the overdraft arose from deposited checks that did not clear, it would represent a liability to the bank The fact that the overdraft is canceled promptly is not Chapter * Relates to Expanded Material Chapter relevant; as of December 31, it would still have to be regarded as a liability 10 Because the compensating balance is legally restricted, the balance should be segregated and reported separately among the Cash Items in the current or noncurrent asset section of the balance sheet, depending on the nature of the restrictions This will protect financial statement readers from assuming that the total cash balance is available to pay current obligations 11 (a) Differences between depositor and bank balances typically arise from the following: (1) Deposits in transit (2) Outstanding checks (3) Bank service charges (4) Not-sufficient-funds checks (5) Direct collection by bank of amounts owed to depositor (6) Recording errors by the depositor or the bank (b) Items (3), (4), and (5) require entries on the depositor’s books, as well as item (6) if the error was made by the depositor 12.* The practice of financing accounts receivable has become very popular In the past this form of financing was viewed as a last resort for obtaining funds Now it is often seen as a wise and legitimate business tool that can be used to put the assets of a company to work This change in attitude results from the realization that an available, easy-to-obtain form of financing was not being used 13.* (a) (1) When receivables are sold, they are removed from the books of the seller and a gain or loss is recognized for the difference between the net proceeds received and the carrying value of the receivables (2) When receivables are used as collateral to secure loans, the receivables remain on the books and a loan is recorded The amount of receivables assigned should be disclosed in the notes to the financial statements (b) (1) The entry to record the sale of receivables without recourse involves a debit to Cash for the sales price (less the amount, if any, withheld by the factor), a debit to Loss from Factoring for the charge made by the factor, a debit to Allowance for Bad Debts, and a credit to Accounts Receivable for the accounts sold If the factor withholds a portion of the sales price pending final settlement, the amount withheld is recorded as a debit to Receivable from Factor If the receivables are sold with recourse, the value of the recourse obligation must be estimated, and the loss on the sale is increased accordingly (2) Accounting for receivables involved in a secured borrowing involves making memorandum entries for data concerning the pledge 14.* According to FASB Statement No 140, the following three conditions must be met in order to record the transfer of accounts receivable with recourse as a sale: (1) The transferred assets must be beyond the reach of the transferor and its creditors (2) The transferees have the right to pledge or exchange the transferred assets (3) The transferor does not maintain effective control over the assets through an agreement to repurchase them before their maturity or the ability to cause the transferee to return specific assets 15.* (a) A note receivable should be recorded at an amount different from its face amount when face amount differs from present value Such a difference arises Chapter when a note is noninterest bearing or when the face amount of an interestbearing note is more or less than the fair market value of the consideration exchanged However, short-term trade notes may be recorded at face amount even when the face amount is not equal to its present value (b) The difference between a note’s face amount and its present value is initially recorded as a premium or discount and amortized over the life of the note The amortization procedure is a systematic allocation of the premium or discount to Interest Revenue on the books of the holder of the note and to Interest Expense on the books of the issuer of the note 16.* An assignment is disclosed in a parenthetical comment or note to the balance sheet, stating the nature and amount of the pledged receivables The receivables continue to be reported as an asset in the balance sheet, and the associated loan is reported as a liability 17.* Imputing a rate of interest is the process of selecting and applying an interest rate deemed appropriate under the circumstances An imputed rate must be determined when no interest rate is stated or when the stated rate is unreasonable, and the present value of a note cannot be determined by reference to the note itself or to the consideration exchanged for the note The selection of an appropriate rate is based on factors such as the credit standing of the issuer of the note, prevailing interest rates for notes with similar terms, and the rate at which the debtor could obtain financing from other sources at the time of the transaction Chapter 7 PRACTICE EXERCISES PRACTICE 7−1 SIMPLE CREDIT SALE JOURNAL ENTRIES Accounts Receivable Sales 100,000 100,000 Cash Accounts Receivable PRACTICE 7−2 88,000 88,000 SALES DISCOUNTS: GROSS METHOD Accounts Receivable Sales 500 Cash ($200 × 0.97) Sales Discounts Accounts Receivable 194 500 200 Cash Accounts Receivable PRACTICE 7−3 300 300 SALES DISCOUNTS: NET METHOD Accounts Receivable ($500 × 0.97) Sales 485 485 Cash Accounts Receivable ($200 × 0.97) 194 Cash Sales Discounts Not Taken Accounts Receivable ($300 × 0.97) 300 PRACTICE 7−4 194 291 SALES RETURNS AND ALLOWANCES Sales Returns and Allowances Accounts Receivable 10,000 Inventory Cost of Goods Sold 7,000 PRACTICE 7−5 10,000 7,000 BASIC BAD DEBT JOURNAL ENTRIES Bad Debt Expense Allowance for Bad Debts 8,000 8,000 Chapter Allowance for Bad Debts 7,300 Accounts Receivable 7,300 PRACTICE 7−6 RECOVERY OF AN ACCOUNT PREVIOUSLY WRITTEN OFF July 23 Allowance for Bad Debts Accounts Receivable 7,500 Nov Accounts Receivable Allowance for Bad Debts 7,500 7,500 7,500 Cash Accounts Receivable PRACTICE 7−7 7,500 7,500 BAD DEBTS: PERCENTAGE OF SALES METHOD Bad Debt Expense ($500,000 × 0.03) Allowance for Bad Debts 15,000 Allowance for Bad Debts Accounts Receivable 13,700 PRACTICE 7−8 15,000 13,700 BAD DEBTS: PERCENTAGE OF ACCOUNTS RECEIVABLE METHOD Bad Debt Expense Allowance for Bad Debts 11,300 11,300 $100,000 × 0.12 = $12,000; $12,000 – $700 = $11,300 Allowance for Bad Debts Accounts Receivable PRACTICE 7−9 14,700 14,700 AGING ACCOUNTS RECEIVABLE Category Amount Less than 30 days 31−60 days 61−90 days Over 90 days $122,000 24,000 8,000 9,000 Percentage 0.02 0.10 0.30 0.75 $ 2,440 2,400 2,400 6,750 Total Allowance for Bad Debts PRACTICE 7−10 Total $13,990 ESTIMATION AND RECOGNITION OF WARRANTY EXPENSE Warranty Expense ($500,000 × 0.06) Estimated Warranty Liability 30,000 Estimated Warranty Liability Cash 32,000 30,000 32,000 Chapter PRACTICE 7−11 COMPARISON OF ACTUAL AND EXPECTED WARRANTY EXPENSE Warranty Liability BeginningY1 Actual repairs Actual repairs 3,000 6,500 4,000 Estimated expense 1,000 EndingY1 6,000 Estimated expense 500 Ending1/2 Compare existing balance with estimated future repairs: $150,000 × 0.04 = $6,000; $6,000 × 6/12 remaining = $3,000 Ending balance of $500 is much less than the estimated remaining repairs of $3,000 Compare past estimates with actual experience: Year Estimated repairs—$100,000 × 0.04 × 6/12 = $2,000 Actual repairs—$3,000 Actual repairs were greater than estimated repairs Year Estimated repairs($100,000 × 0.04 × 6/12) + ($150,000 × 0.04 × 6/12) = $5,000 Actual repairs$6,500 Again, actual repairs were greater than estimated repairs The balance in the warranty liability account at the end of Year appears to be much too low Using the company’s own estimates, the balance should be $3,000 instead of $500 In addition, in the past two years the company has significantly underestimated the amount of repairs PRACTICE 7−12 AVERAGE COLLECTION PERIOD Average collection period: [($50,000 + $65,000)/2]/($400,000/365) = 52.5 days Average collection period: $65,000/($400,000/365) = 59.3 days PRACTICE 7−13 COMPUTATION OF CASH BALANCE Savings account balance Coin and currency Cash balance Restricted deposits in foreign bank accounts $10,000 2,300 $12,300 Receivable 10 Chapter Cash overdraft Post-dated customer checks PRACTICE 7−14 BANK RECONCILIATION Payable Receivable Balance per bank statement Add: Deposits in transit $ 8,000 3,600 $11,600 6,500 $ 5,100 Deduct: Outstanding checks Correct balance Balance per books Add: Interest earned Deduct: Bank service charge Correct balance PRACTICE 7−15 SALE OF RECEIVABLES WITHOUT RECOURSE Cash Receivable from Factor Allowance for Bad Debts Loss from Factoring Receivables Accounts Receivable PRACTICE 7−16 50,000 3,000 2,500 4,500 60,000 SALE OF RECEIVABLES WITH RECOURSE Cash Receivable from Factor Allowance for Bad Debts Loss from Factoring Receivables Accounts Receivable Recourse Obligation PRACTICE 7−17 $ 5,125 30 $ 5,155 55 $ 5,100 50,000 3,000 2,500 5,800 60,000 1,300 ACCOUNTING FOR A SECURED BORROWING If the transfer does not satisfy the three conditions contained in SFAS No 140, then it is not accounted for as a sale but is instead recorded as a secured borrowing, as follows: Cash Loan Payable 53,000 53,000 Chapter 11 PRACTICE 7−18 JOURNAL ENTRIES FOR INTEREST-BEARING NOTE Year Notes Receivable Jan Service Revenue Year Interest Receivable Dec 31 Interest Revenue ($1,000 × 0.08 × 12/12) 1,000 1,000 80 80 Year Cash June 30 Notes Receivable Interest Receivable Interest Revenue ($1,080 × 0.08 × 6/12) PRACTICE 7−19 1,123 1,000 80 43 JOURNAL ENTRIES FOR NONINTEREST-BEARING NOTE Year Notes Receivable Jan Discount on Notes Receivable Service Revenue 1,000 Year Discount on Notes Receivable Dec 31 Interest Revenue ($857 × 0.08 × 12/12) 69 143 857 69 Year Cash 1,000 Dec 31 Discount on Notes Receivable 74 Notes Receivable 1,000 Interest Revenue [($857 + 69) × 0.08 × 12/12] PRACTICE 7−20 NOTE EXCHANGED FOR GOODS OR SERVICES Jan Notes Receivable Loss on Sale of Land Land Dec 31 74 Cash Notes Receivable Interest Revenue ($1,000 × 0.13 × 12/12) 1,000 260 1,260 1,130 1,000 130 12 Chapter PRACTICE 7−21 EFFECTIVE INTEREST AMORTIZATION METHOD Year Notes Receivable 1,000 Jan Discount on Notes Receivable Service Revenue 249 751 To compute the present value of the note: FV = $1,000; N = 3; I = 10% → PV = $751 Year Discount on Notes Receivable Dec 31 Interest Revenue (see following table) 75 Year Discount on Notes Receivable Dec 31 Interest Revenue (see following table) 83 Year Cash Dec 31 Discount on Notes Receivable Notes Receivable Interest Revenue (see following table) Net Amount (1) – (2) Dec 31, Dec 31, Dec 31, (1) Face Amount Discount Before Current Amortization Installment 10% × (3) Year 1$1,000 Year 1,000 Year 1,000 PRACTICE 7−22 75 83 1,000 91 1,000 91 (2) (3) (4) $249 174 91 $751 826 909 $75 83 91 $249    $1,000 BAD DEBTS AND THE DIRECT METHOD Change in net accounts receivable balance: Beginning of year ($12,000 − $2,500) End of year ($10,000 − $2,900) Decrease Cash Flows Income StatementAdjustmentsfrom Operations Sales $ 50,000 $2,400 $ 52,400 Bad debt expense (1,000) (1,000) Cash expenses (44,000) (44,000) Net income $ 5,000 $2,400 $ 7,400 BAD DEBTS AND THE INDIRECT METHOD See the solution to Practice 7−22 $9,500 7,100 $2,400 Cash collected from customers Cash collected from customers ($52,400 − $1,000) $ Cash paid for expenses (44,000) Cash flows from operating activities $ 7,400 PRACTICE 7−23 (5) Cash paid for expenses Cash from operations 51,400 Chapter 37 7–60.‡ (Concluded) Journal Entries Required: 2005 Jan Notes Receivable Discount on Notes Receivable Gain on Sale of Land Land 600,000 96,910* 103,090† 400,000 * ($600,000 – $503,090 = $96,910) † Gain on sale = Net present value ($503,090) – Cost ($400,000) = $103,090 Dec 31 Cash Discount on Notes Receivable Interest Revenue Notes Receivable 224,000 46,433 70,433* 200,000 *Net notes receivable: $600,000 – $96,910 = $503,090 Interest revenue: $503,090 × 0.14 = $70,433 2006 Dec 31 Cash Discount on Notes Receivable Interest Revenue Notes Receivable 216,000 32,933 48,933* 200,000 *Net notes receivable: ($600,000 – $200,000) – ($96,910 – $46,433) = $349,523 Interest revenue: $349,523 × 0.14 = $48,933 2007 Dec 31 Cash Discount on Notes Receivable Interest Revenue Notes Receivable 208,000 17,544 25,544* 200,000 *Net notes receivable: ($600,000 – $200,000 – $200,000) – ($96,910 – $46,433 – $32,933) = $182,456 Interest revenue: $182,456 × 0.14 = $25,544 38 Chapter 7–61.‡ This problem can be solved using either the gross or the net method We offer both solutions Gross Method: Income Statement (Partial) Sales $1,700,000 Bad debt expense (34,000) Cash collected from customers Adjustments $(45,000) 6,000 Cash Flows from Operating Activities $1,655,000 (28,000) $1,627,000 Adjustments $(39,000) Cash Flows from Operating Activities $1,661,000 (34,000) $1,627,000 Net Method: Income Statement (Partial) Sales $1,700,000 Bad debt expense (34,000) Cash collected from customers Although not required, the following T-accounts help explain the preceding solution Jan Sales Dec 31 Write-Offs Accounts Receivable 300,000 Write-Offs 1,700,000 Cash Collected 345,000 28,000 1,627,000 Allowance for Bad Debts Jan 28,000 Bad Debt Expense Dec 31 36,000 34,000 42,000 Chapter 39 DISCUSSION CASES Discussion Case 7–62 Olin should consider the following factors in deciding whether to allow credit sales: • Total sales increase The fundamental reason for selling on credit is to increase total sales Olin must estimate how much this increase will be It must be remembered that some customers currently paying cash will buy on credit if it is allowed The relevant portion of the sales increase is the increase in contribution margin (sales – variable expenses) • Cost of managing the accounts receivable system When all sales are for cash, no file need be kept of accounts receivable, no monthly bills are sent, and no clerk is hired to track the accounts For some businesses, especially those with a large number of customers each purchasing a small amount, the cost of managing an accounts receivable system far outweighs the potential benefit in increased sales An attractive feature of credit card sales is that the individual merchant need not establish an entire accounts receivable system in order to be able to sell on credit Of course, merchants pay a fee on credit card sales • Bad debt expense One nice thing about cash sales is that there are fewer bad debts than with credit sales (Because payments by check are usually considered cash sales, the possibility of bad debts in the form of bounced checks exists with cash sales as well as credit sales.) • Implicit interest costs Allowing customers to buy on credit increases the amount of working capital a company needs in order to business Bills that formerly were paid for with the proceeds from cash sales must be paid for with funds from some other source If short-term interest rates are high, the cost of carrying accounts receivable can be sizable Discussion Case 7–63 Ultimate expects products costing $90 ($600 × 0.15) to be returned in exchange for credit on account of $150 ($1,000 × 0.15) A variety of treatments would be possible One approach is as follows: Sales Returns and Allowances Allowance for Sales Returns 150 150 Allowance for Estimated Returned Inventory 90 Cost of Sales Returns 90 Sales Returns and Allowances is a reduction in net sales; Allowance for Sales Returns is a reduction in net accounts receivable; Allowance for Estimated Returned Inventory is an increase in inventory; Cost of Sales Returns is a decrease in cost of goods sold Typically, adjustments like those made here are not disclosed because for most firms, the amounts are not material However, in an extreme case like that described above, the financial statements would be materially misleading without the adjustments If, when products are shipped to dealers, the possibility of sales returns is great enough, the appropriate accounting treatment might be not to record the sales revenue in the first place Revenue (and the corresponding receivable) should not be recognized until the collectibility of any receivable is reasonably assured The topic of revenue recognition is discussed in detail in Chapter 40 Chapter Discussion Case 7–64 This case should lead to a discussion of the differences in accounting for receivables under the direct write-off method and the allowance method The accounting principles to be discussed include realization and matching The receivables of Montana Company have been accounted for correctly The CEO’s idea to recognize uncollectibles in the period of their discovery is simple and convenient However, this direct write-off method does not provide for the proper matching of current revenues with related expenses and does not report receivables at their net realizable value Therefore, use of the direct write-off method is not considered to be in conformity with generally accepted accounting principles This case may be expanded to discuss the various methods of applying the allowance method of estimating uncollectibles Discussion Case 7–65 One cause for the delay in recording payments may actually be the mail system; holidays and increases in volume often slow down mail service, or perhaps clients are writing out their checks but forgetting to mail them on time Jackie may have too many duties and is getting behind in posting the payments to the accounts or is making errors (e.g., posting incorrect amounts or posting payments to the wrong accounts) Another reason may be that Jackie is “lapping” the accounts (stealing cash from receipts from one customer and covering the theft with cash subsequently received from another customer) Covering the theft of a small sum of money would not cause a big delay, but as the amount increased, so would the lag time required to bring a balance to the correct amount Cash shortages might begin to occur in the company bank accounts If the company has accounts at more than one bank, Jackie could hide the problem by transferring amounts between banks at the end of the period Also, individual accounts receivable balances may not reconcile with the control accounts receivable balance Several measures can be taken to correct the problem Jackie’s responsibilities should be separated; she should not be in charge of collecting, reporting, and reconciling the cash accounts An assistant could be hired to relieve Jackie of some of her duties An assistant could detect whether Jackie is stealing, and the division of responsibilities would increase control of the accounts In the future, internal audits should be performed at irregular intervals, complaints of incorrect balances should be investigated immediately, and appropriate internal controls should be installed in the accounting system Also, employees should be required to take a yearly vacation Discussion Case 7–66 Reducing the collection period from days to days would result in an increase in the average balance in the checking account equaling days’ worth of collections, or $40,000 Over the course of a year, this increase would add $2,400 ($40,000 × 0.06) to net interest income Increasing the average check-clearing time from days to days would increase the average amount in the checking account by days’ worth of payments, or $30,000 This would increase net interest income by $1,800 ($30,000 × 0.06) The total increase in net interest income resulting from both actions would be $4,200 The lockbox system adds $2,400 to net interest income per year However, if it costs $4,000 to implement, income before taxes would decrease by $1,600 The lockbox system should not be implemented This illustrates that both the cost and the benefit of a proposed action must be considered Cash and float management plans always have positive benefits, but their costs in terms of out-of-pocket expenses and employee time must also be calculated Chapter 41 Discussion Case 7–67 Bruno should consider the following factors: Relative interest rates: If the additional interest to be earned by placing funds in a certificate of deposit or treasury notes is small relative to what can be earned on the checking account, Bruno might keep most of the $35 million in the checking account The larger the interest differential, the more funds should be allocated to the CDs and the treasury notes Transactions costs: The cost of converting the CDs and the treasury notes into cash must be considered If there is a large penalty for early conversion of CDs, Bruno should allocate a smaller amount to the CDs Similarly, the larger the brokerage costs of selling the treasury notes, the smaller the amount Bruno should allocate Bank relations: Banks often provide many services to firms in addition to maintaining checking accounts Examples are loans; revolving credit agreements; business, financial, and investment advice; and networking with potential customers and investors Firms well to maintain good relations with their banks, and Bruno would want to consider this before reducing the checking account too far Discussion Case 7–68 The purpose of a bank reconciliation is to isolate any differences between the receipts, disbursements, and balances of the books and the bank statement One way Jonathan may have manipulated outstanding checks to cover a shortage is either to leave some outstanding checks out of the reconciliation or to underfoot the listed outstanding checks Jonathan could then withdraw cash from the deposits equal to the error in listing outstanding checks while still recording the correct deposits on the books The reconciliation would show more cash than really exists, but it would agree with the balance reported on the books A thorough bank reconciliation would detect this error The deposits according to the bank records would be less than the total receipts in the books, and the disbursements according to the bank records would be less than the book disbursements by the same amount Even though the ending cash balances would appear to reconcile, the receipts and disbursements would not balance and the defalcation would be detected Discussion Case 7–69 ‡ This case should generate a discussion of receivables as a possible source of immediate cash Normally, the operating cycle takes several months to complete However, receivables may be converted to cash immediately by pledge or sale to a bank or finance company In this context receivables become a source of financing Major points to be covered in discussing this case include the following: The circumstances that might lead a company to use its receivables as a source of financing (i.e., the situation in the case where immediate cash is needed to take advantage of cash discounts on purchases) Financial stress in the form of liquidity problems or the desire to shift the risks and efforts of collection to someone else are other examples The alternatives available in converting receivables to immediate cash are secured borrowing and sale of receivables on a recourse or nonrecourse basis Emphasis should be placed on the different accounting treatments involved and the advantages and disadvantages of each alternative The discussion should identify the conditions that must be met if transfer of receivables with recourse is to be accounted for as a sale The treasurer’s consideration of the savings to be earned by taking the cash discounts versus the costs involved in using receivables as a source of financing A point to be stressed is the significant cost of receivable financing (i.e., the large discount generally involved in the sale of receivables) However, the effective interest on cash discounts is generally very high, which might more than offset the high cost of receivable financing ‡ Relates to Expanded Material 42 Chapter Discussion Case 7–70 ‡ FASB Statement No 140 indicates that a transfer of receivables with recourse should be handled as a sale if the following three conditions are present in the arrangement: The transferred assets have been isolated from the transferor That is, the transferor and its creditors cannot access the assets The transferee has the right to pledge or exchange the transferred assets The transferor does not maintain effective control over the assets through an agreement to repurchase them before their maturity or the ability to cause the transferee to return specific assets In this case, the arrangement clearly meets all three conditions Based on this analysis, the arrangement should be reported as a sale The major difference between the applications of these two methods on the financial statements would be on the balance sheet A sale would reduce the receivable balance and record a loss equal to the difference between the carrying value of the receivables and the amount of cash paid by Larsen Financial for the receivables Any probable contingent liability under the recourse provisions would be recorded and an additional loss recognized A borrowing would leave the receivables on the books reduced by an allowance for bad debts A liability for the amount of the cash received would be reported Chapter 43 SOLUTIONS TO STOP & THINK Stop & Think (p 358): Why would a company consider selling on account in the first place? Why not just have a policy of "all sales are for cash"? The use of credit allows businesses to attract customers A policy of "cash only" may cause customers to shop elsewhere, especially if all your competitors are offering credit terms Stop & Think (p 375): Suppose that after employing the procedures outlined here, your bank and book balances are not the same What types of errors might prevent the bank and book balances from being equal? The most common reason for bank and book balances not being equal would be when checks and/or deposits were recorded incorrectly by the company This would be detected by comparing the amounts on the bank statements with the amounts in the check register and identifying any differences Stop & Think (p 381): Why would a company ever factor receivables with recourse when it could factor those same receivables without recourse? What might cause the company selling the receivables to allow the factor to have recourse? The factor would charge a fee based on the risk he or she is assuming Factoring without recourse involves the factor assuming all the risk associated with collections To assume that risk, the factor will charge a higher fee If the risk of collection remains with the company (with recourse), then the factor would be willing to charge a lower fee Stop & Think (p 383): In light of the statement that all arm's-length transactions that extend over time have elements of interest, what you think about advertising slogans such as "Buy now, no interest and no payments for six months"? In situations like this, interest is factored into the selling price Why would companies make these deals? Marketing They are willing to lower their margin on each individual item in hopes of making up for it in volume 44 Chapter SOLUTIONS TO STOP & RESEARCH Stop & Research (p 363): As you can imagine, discussion of bad debts is an important part of the financial statements of a bank Find a copy of Bank of America’s most recent annual report, and locate Management’s Discussion and Analysis Determine what average rate of interest Bank of America earned on its consumer loan portfolio Also determine which category of the bank’s consumer loan operations generated the highest average rate of interest (for 2001, in millions) Average Interest Interest Balance Income Rate $ 81,472 $ 5,920 Home equity lines 22,013 1,625 7.38 Direct/Indirect consumer 39,528 3,025 7.65 Consumer finance 18,555 1,683 9.07 Bankcard 16,641 1,879 11.29 2,222 127 5.72 $180,431 $14,259 Residential mortgage Foreign consumer Total consumer 7.27% 7.90% In 2001, the average rate of interest on Bank of America’s consumer loan portfolio was 7.90% The highest returns where earned on outstanding credit card balances (bankcard); the bank earned an average of 11.29% on these loans Stop & Research (p 381): SFAS No 140 had a significant impact on the financial statements of Sears Find a copy of Sears’ most recent annual report and determine what the company has to say about SFAS No 140 In its 2001 annual report, Sears disclosed the following with respect to SFAS No 140: During the second quarter of 2001, the Company recorded a non-cash, pretax charge of $522 million ($331 million after-tax) to establish an allowance for uncollectible accounts related to $12 billion of securitized credit card receivables reinstated on the Company's balance sheet as a result of the Company's adoption of Statement of Financial Accounting Standards No 140 in April 2001 (see Note of the Notes to Consolidated Financial Statements) In addition, effective in the second quarter of 2001, the Company's securitization transactions are accounted for as secured borrowings and the Company ceased recording securitization income As such, securitization income reported in prior periods is noncomparable subsequent to March 2001 Accounting for SecuritizationsSFAS No 140 In September 2000, the FASB issued SFAS No 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” The guidance in SFAS No 140 superseded SFAS No 125 Under SFAS No 125, the Company's securitization transactions were accounted for as sales of receivables SFAS No 140 established new conditions for a securitization to be accounted for as a sale of receivables Specifically, SFAS No 140 changed the requirements for an entity to be a qualifying special purpose entity and modified under what conditions a transferor has retained effective control over transferred assets The new standard was effective for transfers occurring after March 31, 2001 Chapter 45 The addition of previously uncommitted assets to the securitization trust in April 2001 required the Company to consolidate the securitization structure for financial reporting purposes on a prospective basis Accordingly, the Company recognized approximately $8.1 billion of previously unconsolidated securitized credit card receivables and related securitization borrowings in the second quarter of 2001 In addition, approximately $3.9 billion of assets were reclassified to credit card receivables from retained interest in transferred credit card receivables The Company now accounts for securitizations as secured borrowings 46 Chapter SOLUTIONS TO BOXED ITEMS ZZZZ Best (p 359) Assume for a moment that all sales are bogus, and then sales and accounts receivable would be equal—a situation that would attract the attention of any financial statement reader The higher the amount of fictitious sales being recorded, the more out of line accounts receivable would be An aging of receivables would indicate that collections are not being made In addition, an increase in sales could be expected to be accompanied by an increase in accounts payable (after all, whatever we are selling must have been purchased) If sales are fraudulent, then there would be little relationship between payables and sales Interpreting financial results with a degree of healthy skepticism alerts the reader to abnormal relationships between accounts Instead of asking ZZZZ Best to take him to some restoration sites, the auditor could have made surprise visits to the sites Also, an awareness of the restoration industry would have alerted the auditor to the unusual size of these contracts Most restoration contracts are not anywhere near as large as those being claimed by ZZZZ Best A Classic Bank Account Manipulation (p 373) Utilizing checking account float is good business practice and is not inherently unethical Hutton went beyond generally accepted ethical standards by manufacturing float Two aspects of this scheme are particularly unsavory: (a) Hutton blatantly overdrew its accounts knowing that the small banks would be hesitant to question Hutton about it for fear of losing an important account Exploitation because of superior market position or economic power may be common but it is still not ethical (b) In manufacturing float, Hutton clearly went beyond what was expected by the banks when Hutton opened its accounts In practice, bank account manipulation like that performed by E F Hutton can be eliminated only if the costs associated with such manipulation are perceived to exceed the benefits One positive aspect of the Hutton case is that firms are now more aware of the costs that can be imposed—in the form of fines, court costs, and negative publicity One side benefit of transferring funds electronically is that float schemes like this are no longer possible when transactions are posted immediately Chapter 47 COMPETENCY ENHANCEMENT OPPORTUNITIES Deciphering 7–1 (The Walt Disney Company) The following excerpt is taken from Disney’s significant accounting policies note on revenue recognition: Revenues from the theatrical distribution of motion pictures are recognized when motion pictures are exhibited Revenues from video sales are recognized on the date that video units are made widely available for sale by retailers Revenues from the licensing of feature films and television programming are recorded when the material is available for telecasting by the licensee and when certain other conditions are met Broadcast advertising revenues are recognized when commercials are aired Revenues from television subscription services related to the Company's primary cable programming services are recognized as services are provided Internet advertising revenues are recognized on the basis of impression views in the period the advertising is displayed, provided that no significant obligations remain and collection of the resulting receivable is probable Direct marketing and Internet-based merchandise revenues are recognized upon shipment to customers Merchandise licensing advance and guarantee payments are recognized when the underlying royalties are earned Revenues from advance theme park ticket sales are recognized when the tickets are used Revenues from participants at the theme parks are generally recorded over the period of the applicable agreements commencing with the opening of the related attraction For the fiscal year ended September 30, 2001, Disney’s average collection period is 50.1 days, computed as follows: $25,269/[($3,599 + $3,343)/2] = 7.28 accounts receivable (A/R) turnover 365 days/7.28 = 50.1 days As seen in Note 11, Disney’s Media Networks segment has consistently generated the most revenue The same is true of segment operating income Media Networks also grew the most (in terms of revenues) from 1999 to 2001Media Networks’ revenue grew a total of 19% over that 2year period, compared to 14% revenue growth for Parks & Resorts The other two segments, Studio Entertainment and Consumer Products, actually experienced a revenue decline over the 2year period Using information from the income statement and the balance sheet, we can approximate the amount of cash collected from customers as follows: Revenues + Beginning A/R – Ending A/R = Cash collected from customers $25,269 + $3,599 – $3,343 = $25,525 Note that on the statement of cash flows the change in receivables is listed as $279 This figure does not agree with the difference between the beginning and ending receivables balances listed on the balance sheet, $256 The $23 difference may be attributable to the receivables balances of companies acquired during the year In the significant accounting policies section of the notes to its financial statements, Disney defines cash and cash equivalents as follows: “Cash and cash equivalents consist of cash on hand and marketable securities with original maturities of three months or less.” 48 Chapter Deciphering 7–2 (Sears, Roebuck and Co.) For 2001, Sears' average collection period is 231 days (A/R Turnover of 1.58 divided into 365 days) $35,843/[($17,317 + $28,155)/2] = 1.58 accounts receivable (A/R) turnover 365 days/1.58 = 231 days This 231-day average collection period seems long when we think of credit terms like "net 30 days," but students can see from the income statement that Sears makes almost 13% of its revenue from the granting of credit ($5,235/$41,078) Bad debt expense for Sears in 2001 amounted to $1,344 million That amount is almost 26% of credit revenue ($1,344/$5,235) While 26% may seem like a large amount of bad debt expense, remember that Sears still netted 74% of that revenue Sears' president would respond that, with interest rates of 21% and higher being charged to customers, its average collection period is just about right The longer that customers take to pay for their purchases, the more Sears makes in terms of interest The risk for Sears is that if the ratio of bad debt expense to credit revenue gets too high, the costs of collections may begin to exceed the revenues collected Deciphering 7–3 (Wal-Mart Stores, Inc.) Sears—average collection period: 231 days (see Deciphering 7–2 above) Wal-Mart—average collection period: $191,329/[($1,341 + $1,768)/2] = 123.1 accounts receivable (A/R) turnover 365 days/123.1 = days Sears—A/R as a percentage of total current assets: 78.0% ($28,155/$36,105) Wal-Mart—A/R as a percentage of total current assets: 6.7% ($1,768/$26,555) Sears—Revenue from sources other than sales: 12.7% ($5,235/$41,078) Wal-Mart—Revenue from sources other than sales: 1.0% ($1,966/$193,295) Although both companies may be in the retail business, they use credit in different ways Wal-Mart does most of its business in cash (or credit sales financed by VISA or MasterCard) Sears has its own in-store credit card and finances customer purchases of high-dollar items (like appliances or home electronics) These companies illustrate two completely different strategies concerning the use of consumer credit Deciphering 7–4 (Harley-Davidson Inc.) Provisions is the same as Bad Debt Expense Charge-offs is another term for actually writing off an account as uncollectible The entry to record the period's bad debt expense would be: Bad Debt Expense 22,178 Allowance for Bad Debts 22,178 The entry to record the actual writing off of bad debts would be: Allowance for Bad Debts 4,441 Accounts Receivable 4,441 Remember that the amount expensed for the period relates to future bad debts, while the actual amount written off during a period relates to current bad debts Harley-Davidson apparently expects future bad debts to be much higher than current bad debts In addition, it is reasonable to expect that as sales and receivables increase, the amount of bad debt expense would increase as well Chapter 49 SAMPLE CPA EXAM QUESTIONS The correct answer is c Since the two checking accounts are at the same bank, the $10,000 overdraft will be deducted from the positive balance of $175,000 In addition, the money market account of $25,000 and the 90-day certificate of $50,000 would be cash equivalents for a total of $175,000 − $10,000 + $25,000 + $50,000, or $240,000 Although the 180-day certificate matures within 90 days, the original maturity exceeded months, indicating it is not a cash equivalent The correct answer is a An entry to write off a specific uncollectible account is recorded with a debit, or decrease to the allowance, and a credit, or decrease to accounts receivable The correct answer is d Factoring of accounts receivable without recourse is comparable to an outright sale in which the risk of uncollectible accounts is transferred from the seller to the buyer The seller will generally receive an amount that is lower than the carrying value of the accounts receivable and recognize a loss on sale Writing Assignment: Foreign loan write-offs Recall that a write-off is the explicit recognition of an event that was anticipated, estimated, and recognized when the Allowance for Bad Debts was created As such, a write-off has no direct impact on earnings or on net loans receivable as can be seen with the following journal entry: Allowance for Bad Debts Accounts Receivable xxx xxx The ordered write-offs might have an indirect impact on the future bank earnings if, after the writeoffs, the banks felt that their remaining loan loss allowances were too low Banks would then be required to make an addition to their allowances, debiting Bad Debt Expense and crediting the allowance account This would reduce earnings News of the ordered write-offs might cause the banks' stock prices to decline, but only if the writeoffs conveyed new information to the market Most, if not all, of the write-offs were anticipated by the banks (and by investors) when the banks established their loan loss allowances in relation to the questionable loans A negative stock price reaction might be expected in response to the establishment of the loan loss allowances as holders of the banks' stocks realized that a large portion of the banks' foreign loan portfolios might be uncollectible If the loan loss provisions fully anticipated the subsequent necessary write-offs, no subsequent stock price reaction would be expected In fact, according to The Wall Street Journal, prices of the stocks of the banks most affected were essentially unchanged on the day the ordered write-offs were announced Research Project: What is meant by cash and cash equivalents? This assignment will expose students to the different disclosures associated with cash and cash equivalents They will also have an opportunity to review the statement of cash flows and one of the more difficult aspects of that statement—foreign currency adjustments The following definition from Disney’s 2001 financial statements is typical: “Cash and cash equivalents consist of cash on hand and marketable securities with original maturities of three months or less.” The definition of cash and cash equivalents is usually (but not always) in the first note to the financial statements where a company summarizes its accounting policies The FASB defines cash and cash equivalents in paragraph of SFAS No 95 The definition indicates that an investment must be highly liquid, readily convertible into a known amount of cash, and very near to maturity As a practical matter, the FASB states that the original maturity (from the time the investment was first acquired by the company) must not exceed months if the investment is to be classified as a cash equivalent 50 Chapter In its 2001 cash flow statement, Coca-Cola reported a negative $45 million line item titled “effect of exchange rate changes on cash and cash equivalents.” This represents the decrease in the U.S dollar value of the cash balances Coca-Cola held in the form of foreign currencies during the year This means that these foreign currencies got weaker, relative to the U.S dollar, during 2001 Alternatively, you can think of this as indicating that the U.S dollar got stronger The foreign exchange rate effect is explained in paragraph 25 of SFAS No 95 The Debate: Estimating uncollectible accounts The purpose of this debate is to afford students the opportunity to gain an appreciation for having accounting alternatives Students will recognize that different methods are needed for different circumstances If an accounting standard-setting body were to require a certain method of accounting for uncollectible accounts, it might decrease the usefulness of the resulting information Students should realize that there is no one best method The existence of different methods allows companies to choose the method that will provide the best information for investors and creditors Points that might be made in the first debate are as follows: No multiple methods • A key characteristic of good financial accounting information is that it is comparable across companies This is the reason for having accounting standards in the first place One method of estimating bad debts should be designated and used by all companies to increase comparability • If accountants focus their efforts on making estimates with just one method, then they will develop increased proficiency in applying that one method Ultimately, this could lead to better estimates Yes multiple methods • Companies face different economic and information environments It is absurd to insist that all companies estimate bad debts in the same way Each company should be allowed to use the best information it has available to make its accounting estimates Points that might be made in the second debate are as follows: Percentage-of-sales • The most important task of an accountant is determining income for the current period Thus, the accountant’s focus should always be on the income statement The most important reason for estimating bad debt expense is to achieve a proper matching between sales revenue and the bad debt expense associated with credit sales This naturally leads to the percentage-of-sales method Percentage-of-receivables • The balance sheet is the fundamental financial statement At the end of each period, adjusting entries are made to ensure that each asset and liability on the balance sheet is reported at the proper amount This focus suggests that the existing receivables balance should be examined to determine whether it is reported at its net realizable value The method that does this is the percentage-of-receivables method Chapter 51 Ethical Dilemma The situation described in this case is common for small businesses They have developed an atmosphere of informality and trust and would perceive controls as a violation of that trust However, what small companies fail to realize is that there is a difference between trust and controls Controls are implemented to protect not only the assets of the company but the employees themselves Imagine if money did turn up missingwho would there be to blame? Without controls, it would be difficult to narrow down the possibilities The working environment could suddenly go from one where we trust everyone to one where no one is trusted If employees are educated as to the purpose of controls, then the implementation of the controls should be welcome Cumulative Spreadsheet Analysis See Cumulative Spreadsheet Analysis solutions CD-ROM, provided with this manual Internet Search In the notes to its 2001 financial statements, The Gap stated the following with respect to sales returns: “We recognize revenue for store sales at the point at which the customer pays at the register For online and catalog sales, revenue is recognized at the time goods are shipped Allowances for estimated returns are recorded for store sales as well as online and catalog sales.” In the notes to its 2001 financial statements, Citicorp reported that the amount of consumer debt written off during the year as uncollectible was $6,233 million The amount of consumer loans previously written off that were recovered during the year totaled $853 million For commercial loans, the corresponding amounts were $2,045 million and $407 million In Note 12 to its 2001 financial statements, General Motors discloses a $16.421 billion liability for “warranties, dealer and customer allowances, claims, and discounts.” ... Accounts receivable turnover is computed by dividing net sales by the average accounts receivable outstanding for the year (b) Average collection period is computed by dividing average daily sales (net... obtained by dividing the number of days in a year by the accounts receivable turnover (c) The accounts receivable turnover represents the average number of sales or collection cycles completed by a... service charges (4) Not-sufficient-funds checks (5) Direct collection by bank of amounts owed to depositor (6) Recording errors by the depositor or the bank (b) Items (3), (4), and (5) require entries