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CHAPTER 5

Accounting for and Presentation of Current Assets

McGraw-Hill/Irwin

2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

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What Should You Learn in Chapter 5?

1. What is included in the cash and cash equivalents amount reported on the balance sheet? 2. The features of a system of internal control and why internal controls are important. 3. The bank reconciliation procedure. 4. How short-term marketable securities are reported on the balance sheet.

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What Should You Learn in Chapter 5?

5. How accounts receivable are reported on the balance sheet, including the valuation allowances for estimated uncollectible accounts and estimated cash discounts. 6. How notes receivable and related accrued interest are reported on the balance sheet. 7. How inventories are reported on the balance sheet.

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What Should You Learn in Chapter 5?

8. The alternative inventory cost-flow assumptions and their respective effects on the income statement and balance sheet when price levels are changing. 9. The impact of inventory errors on the balance sheet and income statement. 10.What prepaid expenses are and how they are reported on the balance sheet.

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Operating Cycle
An operating cycle is the average time it takes to convert an investment in inventory back into cash. Cash Sale
Purchases

Credit Sale
Cash collection Purchases

Cash sales

Account receivable

Merchandise inventory

Merchandise inventory Credit sales

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What are Current Assets?

Current assets include cash and those assets that are expected to be converted to cash or used up within one year, or an operating cycle, whichever is longer. Cash Current Assets include Inventories (Stock)

Short-term Securities

Prepaid Expenses

Accounts and Notes Receivable

Deferred Tax Assets

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LO1

Cash
Coins and paper money Checking and Savings accounts

Cash includes
Petty cash funds Money orders

Undeposited receipts

Cash Equivalents Are Readily LO1 Convertible Into Cash with a Minimal Risk
Commercial Paper Money Market Mutual Funds

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Cash Equivalents includes

Government Securities

Bank Certificates of Deposit

Foreign Currency Accounts

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LO1

Cash Management Goals

Invest excess cash with minimal risk. Assure the availability of adequate amounts of cash. Avoid unnecessarily large amounts of idle cash. Prevent theft and fraud.

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LO2

The Internal Control System

Internal control objectives are to ensure:

1. Effective and efficient operations. 2. Reliable financial reporting. 3. Compliance with applicable laws and regulations.

Internal Control Over Cash

Require daily deposits. Make all payments by check.

Promptly reconcile bank statements.

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LO3

Bank Statements

Bank Statement
Beginning Bank Balance

+
Deposits processed by the Bank

Checks which have cleared the account +/Other adjustments made by the Bank = Ending Balance

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LO3

Bank Reconciliation - Objective

Identify Differences Between
Ending cash balance reported on bank statement

Compared to
Ending cash balance in depositors accounting records.

Provides information for reconciling journal entries.

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LO3

Bank Reconciliation Process

Balance per Bank Balance per Depositor

+ Deposits in Transit

End Result: + Deposits by Bank Adjusted Bank Balance

=
- Outstanding Checks - Bank Adjustments Adjusted Book Balance Bank Errors Book Errors

Adjusted Balance

Adjusted Balance

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LO3

Bank Reconciliation
Balance per Depositor
+ Deposits by Bank (credit memos) - Service Charge - NSF Checks Book Errors = Adjusted Balance

All reconciling items on the book side require an adjusting entry to the cash account.

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LO3

Bank Reconciliation
Prepare a July 31 bank reconciliation statement and the resulting journal entries for the Simmons Company.

The July 31 bank statement indicates a cash balance of $9,610.

Difference must be reconciled

The cash ledger account balance is $7,430.

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LO3

Bank Reconciliation

Outstanding checks totaled $2,417. A $500 check mailed to the bank for deposit had not reached the bank at the statement date. The bank returned a customers NSF check for $225 received as payment of an account receivable. The bank statement showed $30 interest earned on the bank balance for the month of July. Check 781 for supplies cleared the bank for $268 but was erroneously recorded in our books as $240. A $486 deposit by Acme Company was erroneously credited to our account by the bank.

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LO3

Bank Reconciliation
Balance per bank statement, July 31 Additions: Deposit in transit Deductions: Bank error $ 486 Outstanding checks 2,417 Adjusted cash balance $ 9,610 500

2,903 $ 7,207

Balance per depositor's records, July 31 $ 7,430 Additions: Interest 30 Deductions: Recording error $ 28 NSF check 225 253 Adjusted cash balance $ 7,207

Bank Records = Depositor records

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LO3

Bank Reconciliation
GENERAL JOURNAL

Date

Account Titles and Explanation

Debit 30

Credit

Jul 31 Cash Interest Revenue 31 Supplies Inventory Accounts Receivable Cash

30 28 225 253

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LO4

Short-Term Marketable Securities

Bond Investments Capital Shares Investments

Readily Marketable

Marketable Securities are . . .

Almost As Liquid As Cash

Current Assets

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LO4

Short-Term Marketable Securities

Held To Maturity Trading
Debt & Equity securities actively traded Reported at market value

Available for Sale

Debt & Equity securities not in the other two categories Reported at market value

Debt securities held to maturity

Reported at cost

Amount paid at time of purchase

Market = Current Value of Investment

(May be higher or lower than original cost)

At the end of the period, remember to record interest earned but not yet received related to short-term marketable securities.

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LO5

Accounts Receivable
Lets turn our attention to accounts receivable.

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LO5

Uncollectible Accounts

If a company makes credit sales to customers, some accounts inevitably will turn out to be uncollectible.

PAST DUE

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LO5

Bad Debts/Uncollectible Accounts

At the end of each period, record an estimate of the uncollectible accounts.
GENERAL JOURNAL

Date Dec. 31

Account Titles and Explanation Bad Debts Expense Allowance for Bad Debts

Debit $$$$

Credit

$$$$

Selling expense

Contra-asset account

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When and Why Do We Create A Bad Debt Expense Account?

Bad debt expense is recognized in the same accounting period as the revenue that is related to the receivable because all costs incurred in the current period should be subtracted from current period revenues.

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PAST DUE

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LO5

Bad Debts/Uncollectible Accounts

GENERAL JOURNAL Account Titles and Explanation Bad Debts Expense Allowance for Bad Debts Debit $$$$ $$$$ Credit

Date Dec. 31

There are two methods available for estimating bad debt expense:

1. Percentage of sales method (based on the collectibility of all credit sales for the period); or
2. Aging of receivables method (based on an estimate of the accounts receivable to be collected).

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LO5

Balance Sheet Presentation

Accounts receivable Less: Allowance for bad debts Net realizable value of accounts receivable

The net realizable value is the amount of accounts receivable that the business expects to collect.

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LO5

Writing Off an Uncollectible Account Receivable

When an account is determined to be uncollectible, it no longer qualifies as an asset and should be written off.

GENERAL JOURNAL
Date Account Titles and Explanation Accounts Receivable (X Customer) Debit $$$$ $$$$ Credit

XXX XX Allowance for Bad Debts

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LO5

Writing Off an Uncollectible Account Receivable

Assume that on January 5, K-Max determined that Jason Clark would not pay the $500 he owes. What is the entry that K-Max would make?.

GENERAL JOURNAL Date Account Titles and Explanation Debit 500 500 Credit

Jan. 5 Allowance for Bad Debts Accounts Receivable (J. Clark)

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LO5

Writing Off an Uncollectible Account Receivable

Assume that before this entry, the Accounts Receivable balance was $10,000 and the Allowance for Bad Debts balance was $2,500.

Lets see what effect the write-off had on these accounts.

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LO5

Writing Off an Uncollectible Account Receivable

Before Write-Off $ 10,000 2,500 $ 7,500 After Write-Off $ 9,500 2,000 $ 7,500

Accounts receivable Less: Allow. for bad debts Net realizable value

Notice that the $500 write-off did not change the net realizable value nor did it affect any income statement accounts.

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LO5

What Approvals Should be Required for Writing Off an Uncollectible Account Receivable?

The elimination of an account receivable balance through a write-off is an activity that creates a risk of fraud or theft of company assets. A strong internal control system would require that the ability to write-off an accounts receivable balance should be tightly controlled and require approval from at least two employees above the level of the person who is responsible for creating the actual entry into the companys records.

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LO5

Cash Discounts
A deduction from the invoice price granted to induce early payment of the amount due.

Terms
Discount Period Credit Period

Time
Due
Invoice total less discount Invoice total due
Discount Period Otherwise, Net (or invoice total) is Due

Purchase or Sale
Discount Percent

2/10,n/30

Credit Period

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LO6

Notes Receivable

Notes typically A note is a include an written interest charge promise to pay a specific for use of the amount at a money during specific future the time period date. of the note.

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LO6

Adjusting Entry for Accrued Interest

An adjusting entry is required at the end of the accounting period for any unpaid interest.
GENERAL JOURNAL
Date Account Titles and Explanation Interest Income Debit $$$$ $$$$ Credit

XXX XX Interest Receivable

Use the Interest Formula: I = P x R x T where I = Interest Amount; P = Principal Amount R = Annual Interest Rate T = Time Period (as a % of a year)

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LO7

Inventories

Inventory (Stock)
Goods owned and held for sale to customers Current asset

LO5

Two Methods for Maintaining Inventory

Periodic Method
Companies only take an inventory account before financial accounting reporting periods end. Estimates are used otherwise during the year.

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Perpetual Method
Companies maintain a continuous record of inventory additions and deletions so that accurate counts of inventory items are available at all times.

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LO7

Inventories

In a perpetual inventory system, inventory entries are as follows:

Date

Entry on Purchase Date Inventory Accounts Payable (or Cash) Entry on Sale Date Cost of Goods Sold Inventory

Cost of GoodsJOURNAL GENERAL sold is an Account Titles and Explanation Expense

Debit

Credit

$$$$ $$$$

$$$$ $$$$

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LO8

Inventory Cost-Flow Assumptions

We use one of these inventory valuation methods to determine cost of inventory sold.
Specific identification

Weightedaverage

FIFO

(In US GAAP but NOT in IFRS)

LIFO

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LO8

Inventory Cost-Flow Assumptions

The Bike Company (TBC)

Cost of Goods Available for Sale Aug. 1 Beg. Inventory 10 units @ Aug. 3 Purchased 15 units @ Aug. 17 Purchased 20 units @ Aug. 28 Purchased 10 units @ 55 Retail Sales of Goods Aug. 14 Sales 20 units @ Aug. 31 Sales 23 units @ 43

$ 91 $ 106 $ 115 $ 119

= = = =

$ $ $ $

910 1,590 2,300 1,190

$ 130 $ 150

= =

$ $

2,600 3,450

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LO8

Specific Identification
When a unit is sold, the specific cost of the unit sold is added to cost of goods sold.

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LO8

Weighted-Average
Calculate the average cost of the items in beginning inventory plus purchases made during the period.

Cost of Goods Units Available Available for for Sale During Sale During the Period the Period

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LO8

Weighted-Average
Date Aug. 1 Aug. 3 Aug. 17 Aug. 28 Total Purchases 10 @ $91 = 15 @ $106 = 20 @ $115 = 10 @ $119 = 55 $910 1,590 2,300 1,190 $5,990

$5,990 55 = $108.9091
Cost of Goods Sold $108.9091 43 = $4,683.09 Ending Inventory $108.9091 12 = $1,306.91

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LO8

First-In, First-Out (FIFO)

Oldest Costs

Costs of Goods Sold

Recent Costs

Ending Inventory

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LO8

First-In, First-Out (FIFO)

Date Aug. 1 Aug. 3 Aug. 17 Aug. 28 Total
Cost of Goods Sold 10 15 18 43 91 = $ 910 106 = 1,590 115 = 2,070 $ 4,570

Purchases 10 @ $91 = 15 @ $106 = 20 @ $115 = 10 @ $119 = 55

$910 1,590 2,300 1,190 $5,990

Ending Inventory 10 $ 119 = $ 1,190 2 $ 115 = 230 12 $ 1,420

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LO8

Last-In, First-Out Method (LIFO)

Recent Costs

Costs of Goods Sold

Oldest Costs

Ending Inventory

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LO8

Last-In, First-Out Method (LIFO)

Date Aug. 1 Aug. 3 Aug. 17 Aug. 28 Total Purchases 10 @ $91 = 15 @ $106 = 20 @ $115 = 10 @ $119 = 55 $910 1,590 2,300 1,190 $5,990

Cost of Goods Sold 10 $ 119 = $ 1,190 20 $ 115 = 2,300 13 $ 106 = 1,378 43 $ 4,868

Ending Inventory 10 $ 91 = $ 910 2 $ 106 = 212 12 $ 1,122

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LO8

The Impact of Changing Costs

In periods of rising costs, LIFO results in lower ending inventory and higher cost of goods sold than FIFO.

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LO8

The Impact of Inventory Quantity Changes

Changes in the quantities of inventory will have an impact on profits that is dependent on the cost-flow assumption used and the extent of cost changes during the year.

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LO8

Inventory Accounting System Alternatives

Periodic Inventory System Perpetual Inventory System

Cost of goods sold is determined at the end of the fiscal period.

Cost of goods sold is determined each time inventory is sold.

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LO8

Inventory Accounts
Product available to Retail Firm be sold
Used to produce products

Merchandise Inventory

Manufacturing Firm Partially completed products

Finished Goods Inventory Raw Materials Inventory Work in Process Inventory

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LO9

Inventory Errors
Errors in the amount of ending inventory have a direct dollar-for-dollar effect on cost of goods sold and net income.
For this reason, independent auditors, income tax auditors, and financial analysts look closely at reported inventory amounts.

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Lower of Cost or Market

Inventory must be reported at market value when market is lower than cost.

Defined as current replacement cost (not sales price). Consistent with the conservatism principle.

Can be applied three ways:

(1)

(2)
(3)

separately to each individual item. to broad categories of inventory. to the whole inventory.

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L O 10

Prepaid Expenses and Other Current Assets

Disbursements Examples: that Prepaid Expenses have been paid in the require adjusting Insurance current fiscal period entries but will Rent not be Assets are decreased subtracted from Expenses are until increased revenue a subsequent fiscal period.

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Deferred Tax Assets

A deferred tax asset arises when an income tax expense is recognized for financial accounting purposes in a fiscal year before the fiscal year in which it is deductible in the determination of taxable income.