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Credit card sales are almost like cash to a business. The credit card company reimburses the firm and is paid a fee for the service. The risk is much less than that of extending the firm s own credit to its customers. For example, if you use a Macy s charge account, the risk is greater to Macy s than if you had used your MasterCard to make a purchase at the department store. Notes are amounts owed to the firm, often by customers who have been slow in paying their accounts and have negotiated new payment terms that include interest. Firms use accounts to help evaluate a firm s liquidity. The accounts turnover ratio (net sales or net credit sales divided by average accounts ) measures how quickly the firm is collecting its accounts. Controls are especially important with respect to cash. Three of them are (1) clear assignment of responsibility, (2) specific procedures for documentation, and (3) independent internal verification of the data. Chapter Summary Problem The following transactions took place during Choco Drops fiscal year ended December 31, 2011: a. Sold $900,000 of merchandise on account. Related cost of goods sold was $270,000. b. Collected payment for 80% of the sales. c. Accepted a three-month note from Nature s Grocery Store Chain for $8,000 on October 1, 2011 (due on January 1, 2012), with an interest rate of 6%, in payment of its $8,000 outstanding balance in accounts. d. Had $98,000 of cash sales. Related cost of goods sold was $29,400. e. Wrote off a bad account for $4,000 after the bankruptcy court approved a reorganization plan for one of its struggling customers. f. Incurred operating expenses $75,600, paid in cash. Instructions 1. Enter each of the transactions in an accounting equation worksheet. The firm started the year with a balance of $150,000 in accounts and a balance of $4,500 in the allowance for uncollectible accounts. The balance in the inventory account was $500,000. The other beginning balances are not given and not required for the problem. (These came from the December 31, 2010, balance sheet.) 2. Make the adjustment to record bad debts expense. Choco Drops uses the allowance method of accounting for uncollectible accounts, based on a percentage of the ending balance in accounts. (Use the same percentage 3% the firm used to calculate the bad debts expense for 2010. Also, be sure to accrue interest on the note in Transaction (c).) 3. Prepare an income statement for the year ended December 31, 2011. 179
Solution Assets = Liabilities + Shareholders Equity Contributed Capital Retained Earnings Selected Beginning Balances $150,000 (4,500) 500,000 Allowance for bad debts Inventory Transaction Cash All other assets (Account) All liabilities (Account) (Account) a. 900,000 900,000 Sales (270,000) Inventory (270,000) Cost of goods sold b. 720,000 (720,000) c. (8,000) 8,000 Notes d. 98,000 (29,400) Inventory 98,000 (29,400) Sales Cost of goods sold e. (4,000) 4,000 Allowance for bad debts f. (75,600) (75,600) Operating expenses A-1 (9,040) Allowance for bad debts (9,040) Bad debts expense A-2 120 Interest 120 Interest revenue Income Statement Statement of Changes in Shareholders Equity Balance Sheet Statement of Cash Flows Calculations for bad debt expense: 1 - What is the balance in AR? Beginning AR... + Sales... Collections... to Notes... Write-offs... Ending AR... 2 - What is the balance in the allowance? Beginning allowance... Write-offs... + Bad debt expense... Desired allowance balance... Balance in allowance before adjustment: = $500 $ 150,000 900,000 (720,000) (8,000) (4,000) $ 318,000 Needed to bring allowance to desired $9,540 = $9,040 $ 4,500 (4,000) x $ 9,540 (318,000 3 0.03) Choco Drops Income Statement For the Year Ended December 31, 2011 Revenues Sales Interest revenue Total revenue Expenses Costs of goods sold Bad debts expense Operating expenses Total expenses Net income $998,000 120 $299,400 9,040 75,600 $998,120 384,040 $614,080 180
Key Terms for this Chapter (AR) turnover ratio Aging schedule Allowance for uncollectible accounts Allowance method Bad debts expense Bank reconciliation Bank statement Cash equivalents Deposit in transit Direct write-off method Maker Net realizable value Outstanding check Payee Promissory note Segregation of duties Answers to YOUR TURN Questions Your Turn 1 The purpose of a bank reconciliation is to provide a control to protect cash. The amount of cash reported on the bank statement (an independently calculated balance) must be reconciled to the cash reported in the accounting records. A firm would prepare a bank reconciliation as often as the bank provided a statement, usually once each month. Your Turn 2 To find the solution, you need to know the following information: Balance per books $2,400 Deduct service charges 100 Add collection 300 Add interest revenue 100 True cash balance $2,700 Outstanding checks are ignored because we are working with only the balance per books side of the reconciliation. Your Turn 3 1. $400 ($500 desired balance $100 remaining balance before adjustments) 2. $9,500 ($10,000 $500) Your Turn 4 Magic Milk will record revenue of $5,000. Cash collected will be 97% of $5,000 $4,850. The remaining 3%, or $150, will be recorded as credit card expense. Your Turn 5 Current assets: Notes $3,000 Current assets: Interest $80 [$3,000 0.08 4/12] Your Turn 6 1. Sales of $120,000 divided by average AR [$11,500 ($10,500 $12,500) 2] 10.43 times. 2. Days to collect: 365 days 10.43 35 days Your Turn 7 To get the receipt to print, the transaction must be entered into the cash register or computer. If cash collected is reconciled to the records (from the register or computer), any missing amounts would be apparent. Questions 1. What is a bank reconciliation and what does it determine? 2. What are two common adjustments made to the balance per bank on the bank reconciliation? 3. Describe two common adjustments made to the balance per books on the bank reconciliation. 181
4. After the bank reconciliation is complete, which adjustments are recorded in the accounting records? 5. What does true cash balance refer to? 6. Identify and explain the financial statements on which cash is reported. 7. Describe how accounts arise. What does the balance in accounts represent? 8. How do accounts (trade) s differ from other s? 9. Define net realizable value, book value, and carrying value as they relate to accounts. 10. Explain the difference between the direct write-off method and the allowance method of accounting for bad debts. Which method is preferred and why? 11. If a company uses the allowance method of accounting for bad debts, what effect does writing off a specific account have on income? 12. Describe the two allowance methods used to estimate the amount of bad debts expense that appears on the income statement. 13. Which method of calculating the allowance for uncollectible accounts focuses on the income statement? Explain. 14. Which method of calculating the allowance for uncollectible accounts focuses on the balance sheet? Explain. 15. What are the advantages and disadvantages of allowing customers to make purchases with credit cards? 16. What is the difference between accounts and notes? 17. What is the formula to calculate the accounts turnover ratio, and what does the formula measure? 18. How does a firm use its accounts turnover ratio to determine the average number of days it takes to collect its accounts? 19. Explain how the segregation of duties serves as a major control for safeguarding cash. 20. Explain why it is important to have physical control of cash. Multiple-Choice Questions 182 Use the following information for questions 1 4. Fred s Supply Store just received its monthly bank statement from Local Street Bank. The bank gives a balance of $45,000. Fred s accounting clerk has calculated that outstanding checks amount to $20,000. Fred s Supply Store made a deposit of $5,000 on the last day of the month, and it was not included on the bank statement. Bank service fees, not yet recorded on the store s books, were shown on the statement as $35. The bank statement also included an NSF check returned from a new customer in the amount of $250. 1. What is the store s true cash balance at the end of the month? a. $25,000 b. $30,000 c. $29,715 d. $29,750 2. How should outstanding checks be treated on the bank reconciliation? a. They should be deducted from the balance per books. b. They should be added to the balance per books. c. They should be deducted from the balance per bank. d. They should be added to the balance per bank. 3. Which items would need to be recorded in Fred s Supply Store s accounting records? a. Outstanding checks and the deposit in transit b. NSF check c. Bank service fee d. Both NSF check and bank service fee 4. What was the cash balance in its accounting records before Fred s Supply Store began the bank reconciliation? a. $30,285 b. $30,250 c. $45,250 d. $25,285
Use the following information to answer multiple-choice questions 5 and 6. At the end of the year, before any adjustments are made, the accounting records for Sutton Company show a balance of $100,000 in accounts. The allowance for uncollectible accounts has a remaining balance of $2,000. (This means last year s estimate was too large by $2,000.) The company uses accounts to estimate bad debts expense. An analysis of accounts results in an estimate of $27,000 of uncollectible accounts. 5. The bad debts expense on the income statement for the year would be a. $27,000. b. $25,000. c. $23,000. d. $29,000. 6. Net realizable value of the s on the year-end balance sheet would be a. $100,000. b. $75,000. c. $73,000. d. $77,000. 7. Suppose a firm uses the percentage of sales method for estimating bad debts expense. The firm has credit sales for the year of $200,000 and a balance of $80,000 in accounts. The firm estimates that 2% of its credit sales will never be collected. What is the bad debts expense for the year? a. $1,600 b. $2,000 c. $4,000 d. $3,600 8. Scott Company uses the allowance method of accounting for bad debts. During May, the company found out that one of its largest customers filed for bankruptcy. If Scott Company decides to write off the customer s account, what effect will that decision have on Scott Company s net income for the period? a. Bad debts expense will decrease income. b. Writing off the will decrease income. c. Both a. and b. will happen. d. There is no effect on net income. 9. Merry Maids, Inc., sells vacuum cleaners to McKenzie-Grace Corporation for $1,000. McKenzie-Grace pays Merry Maids with the company Visa card. Visa charges Merry Maids a 3% fee for all Visa sales. What is the net effect of this transaction on the accounting equation for Merry Maids? a. Increase assets $1,000; increase retained earnings $1,000 b. Decrease assets $1,000; decrease retained earning $1,000 c. Increase assets $970; increase retained earnings $970 d. Not enough information Short Exercises Set A SE4-1A. Analyze bank reconciliation items. (LO 1). For each of the following items, indicate whether or not the balance per books should be adjusted. For each item that affects the balance per books, indicate whether the item should be added to ( ) or subtracted from ( ) the balance per books. Balance per Item books adjusted? / Outstanding checks No n/a Service charge by bank NSF check from customer Deposits in transit Error made by the bank Note collected by the bank All of the A exercises can be found within MyAccountingLab, an online homework and practice environment. 183