FINANCIAL ACCOUNTING Week 5 Current Asset Classification, Cash, and Accounts Receivable. I. Overview of First Half and Second Half of Course

Transcription

1 FINANCIAL ACCOUNTING Week 5 Current Asset Classification, Cash, and Accounts Receivable I. Overview of First Half and Second Half of Course A. Part I - Foundation in Financial Accounting ( Ratio Analysis and Transaction Focus) B. Part II - Review of Financial Statements (Statement Focus) 1. Effect of this item on Balance Sheet, Income Statement, and Cash Flow. 2. Management Choices available and their effect upon the statements. II. Learning Objectives A. Understand what are current assets, working capital, current ratio, and quick ratio, and explain how these measures can be used to assess the solvency position of a company. B. Recognize how and why managers use Αwindow dressing techniques to affect the reporting of current assets, working capital, and the current ratio. C. Understand what is included in the Αcash account. D. Understand what the account Αaccounts receivable means and explain how they are valued on the balance sheet. E. Explain how the allowance method accounts for uncollectible receivables. F. Explain the major concerns of financial statement users in the area of receivables reporting. G. Understand the meaning of accounts receivable turnover and its implications for decision makers. III. Current Assets (CA) A. Definition: Any asset that is intended to be converted into cash or used up within one year or the company's operating cycle, whichever is longer. An operating cycle is the time it takes a company to begin with cash, convert the cash to inventory, and collect cash from the sale. 1

2 B. Uses of the classification 1. Current assets provide a low-cost measure of a company's ability to generate cash in the short run. 2. Comparing CA with current liabilities (CL) provides a measure of solvency. a. Working capital b. Current Ratio c. Quick Ratio C. Limitations of CA classification 1. Liquidity of current assets 2. Not all CA provide future cash inflows, for example - prepaid expenses 3. Managers may "window dress" financial statements to make CA look "good" D. Importance of Liquidity - Who is interested in liquidity? E. ID6-3. IV. Cash A. Definition: Coin, currency, checking accounts, and negotiable instruments such as checks, money orders, certified checks, cashiers checks, and bank drafts. Postdated checks and I.O.U.s are not considered cash. 2

3 B. Reporting issues 1. Reported on the balance sheet (BS) at face value or Fair Market Value. 2. Restricted cash a. Definition: Access or use is restricted for some special purpose. b. Usually arises through borrowing arrangements. Entity loaning money may require cash to be set aside in escrow or as a compensating balance. c. Reporting 3. Lawson (1) Separately from unrestricted cash (2) Classified as CA if obligation is a CL (3) Classified as NCA if obligation is a NCL (ADC Balance Sheet, if available) C. Managers must make sure enough cash is on hand to meet company's day-to-day cash needs, but not have idle cash sitting around not earning anything. D. Control of Cash 1. Record control 2. Physical control E. Homework: (1) E6-1. (2) ID6-1. V. Accounts Receivable A. Definition: Amounts owed to a company from selling goods or services to customers on account, agreement is usually informal. B. Presentation on Balance Sheet 1. Valuation - Fair Market Value (FMV) or Net Realizable Value (NRV) a. Definition: The amount of cash the company expects to realize from accounts receivable. b. NRV equals the face value of the receivable less allowance for uncollectibles, adjustments for cash discounts, and sales 3

4 returns. 2. Statement Presentation a. Accounts Receivable (net of allowance for uncollectibles OR less reserves) - see p. 37 in the text. b. Lawson 3. BE6-1. C. Accounting for Accounts Receivable 1. When to record an account receivable - use the same criteria for recording a sale, the revenue recognition principle. 2. Bad Debts - amounts sold to customers that the company does not expect to convert into cash a. Because customers like to pay after the date of sale, there is the chance that not all will pay. b. Bad debts should be recognized in accordance with the revenue recognition principle (cash collection was not reasonably assured) and the matching principle. 3. Allowance Method a. Steps to take (1) Estimate Bad Debt Expense at the end of the period. (2) Prepare an adjusting entry at end of period + Bad Debt Expense + Allowance for Uncollectibles (Reserve for Bad Debts) (3) During the period, write off specific accounts when they are considered uncollectible - Accounts Receivable - Allowance for Uncollectibles (Reserve for Bad Debts) b. Two methods of estimating bad debts 4. Estimate Bad Debts a. Percentage of sales on account (1) Bad Debt expense is estimated as a 4

5 percentage of a period's sales on account. This is referred to as an Income Statement approach. (2) Homework b. Aging approach Metro 5A (Look on the Acct 210 website) (1) Arranges a company's A/R into different ages and uses this aging to compute the balance necessary in the Allowance for Doubtful Accounts. (2) Bad debt expense represents the change from the unadjusted balance to the adjusted ("correct") balance in the allowance account. This approach takes a Balance Sheet valuation focus. (3) Companies will often use the aging approach to verify the accuracy of the balance in the allowance account. (4) E6-10. c. Regardless of which method used, the balances in the allowance account and the bad debt expense are based on estimates (1) With the percentage of sales on account approach, the ending balance in bad debt expense is estimated directly and the ending balance for the allowance for uncollectibles is estimated indirectly. (2) With the aging approach, the ending balance in bad debt expense is estimated indirectly and the ending balance for the allowance for uncollectibles is estimated directly. (3) Which one does the better job of matching? d. Write-offs and recoveries of accounts (1) Effect on Current Assets (2) Total Assets (3) Net Income e. Reporting Issues f. Homework - P6-3. 5

6 5. Cash discounts a. Definition: A discount offered by a company to give incentives to its customers to pay their accounts promptly b. Methods to account for cash discounts (1) Gross Method (Most commonly used method) (2) Net Method 6. Sales Returns - previously sold merchandise expected to be returned by the customer a. Text says to estimate this amount from past experience b. Some companies wait until item returned 7. Economic consequences of accounting for Accounts Receivable a. Discretion in recognizing a receivable and related revenue can result in manipulation of Financial Statements b. Judgment in estimating bad debts can result in manipulation of Financial Statements c. Income Statement Goal - Performance Measurement d. Balance Sheet Goal - Measurement of assets capable of becoming cash 8. Collection period of Accounts Receivable a. Accounts Receivable Turnover (1) Formula: Net Credit Sales / Average Net Accounts Receivable (2) Meaning - How many times during the year were the receivables recorded and then collected. b. Collection period (1) Formula: 6

7 365 or 360 / Accounts Receivable Turnover (2) Meaning - How many days, on average, does it take the firm to collect its receivables. VI. Review of Learning Objectives 7