CHAPTER 7 (WILLIAMS) Accountants define cash as money on deposit in banks

and any items that banks will accept for deposit

FINANCIAL ASSETS
- These items include not only coins and paper
Financial Assets – are a company’s most liquid (or cash-
money, but also checks, money orders, and
like) resources
travelers’ checks, drafts signed by customers
- the ability of a company to service its debt, using bank credit cards
purchase inventory, pay taxes, and cover payroll  sales to customers using bank cards are
obligations hinges on the availability of these considered cash sales, not credit sales, to the
highly liquid assets enterprise that makes the sale
 Most companies maintain several bank
How much cash should a business have? accounts as well as keep a small amount of cash
If the daily receipts exceed routine cash outlays, the on hand. Therefore, the Cash account in the
company can meet its obligations while maintaining general ledger is often a control account
relatively low balances in its bank accounts  A cash subsidiary ledger includes separate
accounts corresponding to each bank account
Cash that will not be needed in the immediate future and each supply of cash on hand within the
often is invested in highly liquid, short-term securities organization
- they earn revenue in the forms of interest and Reporting Cash in the Balance Sheet
dividends
- if the business should need more cash than it Cash is listed first in the balance sheet because it is the
has in its bank accounts, it can easily convert most liquid of all assets; the balance in the Cash control
some of its investments back into cash account is combined with that of the control account
for cash equivalents
Financial Assets – describes not just cash but also those
assets easily and directly convertible into known Cash Equivalents – some short-term investments that
amounts of cash; include cash, short-term investments are so liquid
(also called marketable securities), and receivables - include money market funds, U.S. Treasury bills,
- all of these assets represent forms of money; and high-grade commercial paper (very short-
financial resources flow quickly among these term notes payable that are issued by large,
asset categories creditworthy corporations)

The Valuation of Financial Assets To qualify as a cash equivalents: an investment must be

very safe, have a very stable market value, and mature
Financial Assets – are shown at their current values; and within 90 days of the date of acquisition
is measured differently for each type of financial asset
 Short-term investments that do not qualify as
Current Value of: (1) cash and AR – is simply its face cash equivalents are listed in the balance sheet
amount, (2) marketable securities – may change daily, as Marketable Securities
based on fluctuations in stock prices, interest rates, and
other factors, (3) short-term investments – current Restricted Cash – they are not available to meet the
market values normal operating needs of the company; should be
presented in the balance sheet as part of the section
 Notice that the valuation of these investments entitled “Investments and Restricted Funds”
represents an exception to the cost principle
Compensating Balance - As a condition for granting a
Net Realizable Value – receivables appear in the balance loan, banks often require the borrower to maintain this
sheet at the estimated collectible amount on deposit in a non-interest-bearing checking account

- this agreement does not actually prevent the

borrower from using the cash, but it does mean
 the company must quickly replenish this bank  Require that all cash receipts be deposited daily
account in the bank
 Make all payments by check. The only exception
Lines of Credit – the bank has agreed in advance to lend
should be for small payments to be made in
the company any amount of money up to a specified
cash from a petty cash fund
limit; it increases the company’s liquidity
 Require that every expenditure be verified
- the company can borrow this money at any before a check is issued in payment; separate
time simply by drawing checks on a special bank the function of approving expenditures from
account; a liability to the bank arises as soon as the function of signing checks
a portion of the credit line is used  Promptly reconcile bank statements with the
- the unused portion of a line of credit is neither accounting records; the person who reconciles
an asset nor a liability; it represents only the the bank statements should not have any
ability to borrow money quickly and easily opportunities to physically handle cash

Cash Management – refers to planning, controlling, and Cash Over and Short
accounting for cash transactions and cash balances; the
- errors may cause a cash shortage or overage at
management of all financial resources
the end of the day when the cash is counted
- Efficient management of these resources is and compared with the reading on the cash
essential to the success—even to the survival— registers
of every business organization
Journal Entry for Cash Over and Short (for Shortages)
Objectives of Cash Management Cash Over and Short xxx
Cash xxx
 Provide accurate accounting for cash receipts,
cash disbursements, and cash balances The account entitled Cash Over and Short is debited for
 Prevent or minimize losses from theft or fraud shortages and credited with overages. If the account
 Anticipate the need for borrowing and assure has a debit balance, it appears in the income statement
the availability of adequate amounts of cash for as a miscellaneous expense; if it has a credit balance, it
conducting business operations is shown as a miscellaneous revenue
 Prevent unnecessarily large amounts of cash
Bank Statements
from sitting idle in bank accounts that produce
no revenue Each month the bank provides the depositor with a
statement of the depositor’s account; a bank statement
Internal Control over Cash
shows the account balance at the beginning of the
- is sometimes regarded merely as a means of month, the deposits, the checks paid, any other
preventing fraud and theft additions and subtractions during the month, and the
- a good system of internal control will also aid in new balance at the end of the month
achieving the other objectives of efficient cash
Reconciling the Bank Statement
management
Bank Reconciliation – is a schedule explaining any
Major Steps in Achieving Internal Control over Cash
differences between the balance shown in the bank
Transactions and Cash Balances:
statement and the balance shown in the depositor’s
 Separate the function of handling cash from the accounting records
maintenance of accounting records
 the bank and the depositor maintain
 Prepare cash budgets (or forecasts) of planned
independent records of the deposits, the
cash receipts, cash payments, and cash
checks, and the current balance of the bank
balances, scheduled month-by-month for the
account
coming year
 Each month, the depositor should prepare a
 Prepare a control listing of cash receipts at the
bank reconciliation to verify that these
time and place the money is received
 independent sets of records are in agreement. account receivable from the customer, not as
This reconciliation may disclose internal control cash
failures, such as unauthorized cash  Credits for Interest Earned – the checking
disbursements or failures to deposit cash accounts of unincorporated businesses often
receipts, as well as errors in either the bank earn interest; this interest is credited to the
statement or the depositor’s accounting records depositor’s account and reported in the bank
 the reconciliation identifies certain transactions statement; inaadd sa depositor
that must be recorded in the depositor’s  Miscellaneous Bank Charges and Credits – the
accounting records and helps to determine the bank deducts these charges from the
actual amount of cash on deposit depositor’s account and notifies the depositor
by including a debit memorandum in the
Normal Differences bet. Bank Records and Accounting
monthly bank statement; dinededuct sa
Records
depositor
The balance shown in a monthly bank statement  If the bank collects a note receivable on behalf
seldom equals the balance appearing in the depositor’s of the depositor, it credits the depositor’s
accounting records account and issues a credit memorandum
(inaadd sa depositor)
Certain transactions recorded by the depositor may not  Banks charge for services — such as printing
have been recorded by the bank: checks, handling collections of notes receivable,
 Outstanding Checks – checks issued and and processing NSF checks
recorded by the company but not yet presented In a bank reconciliation, the balances shown in the bank
to the bank for payment; dinededuct sa bank statement and in the accounting records are both
statement adjusted for any unrecorded transactions
 Deposit in Transit – cash receipts recorded by
the depositor that reached the bank too late to Steps in Preparing a Bank Reconciliation
be included in the bank statement for the
1. Compare deposits listed in the bank statement
current month; inaadd sa bank statement
with the deposits shown in the accounting
Certain transactions appearing in the bank statement records
may not have been recorded by the depositor: - Any deposit na hindi pa narerecord ng bank is
called deposit in transit, and it should be added
 Service Charges – banks often charge a fee for sa bank statement
handling small accounts; the amount of this 2. Compare checks paid by the bank with the
charge usually depends on both the average corresponding entries in the accounting records
balance of the account and the number of - Any checks na inissue pero hindi pa binayadan
checks paid during the month; dinededuct sa ni bank should be listed as outstanding check,
depositor and should be deducted sa bank statement
 NSF (not sufficient funds) Checks – the bank will 3. Add to the balance per the depositor’s
reduce the depositor’s account by the amount accounting records any credit memoranda
of this uncollectible item and return the check issued by the bank that have not been recorded
to the depositor marked “NSF” ;dinededuct sa by the depositor
depositor - mag aadd ka sa depositor’s account kapag may
 When checks from customers are deposited, credit memo na inissue yung bank at hindi pa
the bank generally gives the depositor ito narerecord ng depositor
immediate credit. On occasion, one of these 4. Deduct from the balance per the depositor’s
checks may prove to be uncollectible, because records any debit memoranda issued by the
the customer who wrote the check did not have bank that have not been recorded by the
sufficient funds in his or her account; ” The depositor
depositor should view an NSF check as an
 - magde deduct ka sa depositor’s account kapag  Due to their liquidity, investments in
may debit memo na inissue yung bank at hindi marketable securities usually are listed
pa ito narerecord ng depositor immediately after Cash in the balance sheet and
5. Make appropriate adjustments to correct any are most often classified as available for sale
errors in either the bank statement or the securities
depositor’s accounting records
6. Determine that the adjusted balance of the
bank statement is equal to the adjusted balance Accounting for Marketable Securities
in the depositor’s records
7. Prepare journal entries to record any items in Four Basic Events Relating to Investment in Marketable
the bank reconciliation listed as adjustments to Securities
the balance per the depositor’s records 1. the purchase of investments
- ang may journal entry lang is depositor’s 2. the receipt of dividends or interest revenue
account; wala yung bank statement 3. the sale of investments, and
Updating the Accounting Records 4. end-of-period adjustments

In the bank reconciliation, every adjustment to the Purchase of Marketable Securities

balance per depositor’s records is a cash receipt or a Investments in marketable securities are originally
cash payment that has not been recorded in the recorded at cost, which includes any brokerage
depositor’s accounts. Therefore, each of these items commissions (add)
should be recorded
For example: Foster Corporation purchases as a short-
- every adjustment sa depositor’s account is term investment 4,000 shares of The Coca-Cola
either cash receipt or cash payment na hindi pa Company on December 1. Foster paid $48.98 per share,
narerecord ng depositor sa account nya, plus a brokerage commission of $80
therefore dapat nya itong irecord
 We follow a policy of making one journal entry Journal Entry for Purchase of Marketable Securities
to record the unrecorded cash receipts and Marketable Securities 196K
another to record the unrecorded cash Cash 196K
reductions The total cost will be 196K, and the cost per share is
Short-Term Investments $49 which is computed by 196K/4K (these share per
cost basis will be used in computing any gains or losses
Companies with large amounts of liquid resources often when Foster Corporation sells these securities)
hold most of these resources in the form of marketable
securities rather than cash Marketable Securities – is a control account used to
report all of a company’s short-term investments
Marketable Securities – consist primarily of investments
in bonds and in the capital stocks of publicly owned - if an entity invest in other companies, they will
corporations make similar entry at the above, however, it will
also create a marketable securities subsidiary
- are traded (bought and sold) daily on organized ledger to maintain a separate record of each
securities exchanges security owned
- they are readily marketable —meaning that
they can be purchased or sold quickly and easily Recognition of Investment Revenue
at quoted market prices Journal Entry to Recognize Interest/Dividends Revenue
 Investments in marketable securities earn a Cash xxx
return for the investor in the form of interest, Interest/Dividends Revenue xxx
dividends, and—if all goes well—an increase in
market value. Meanwhile, these investments Dividend and interest revenue is reported in the income
are almost as liquid as cash itself statement as a component of a company’s net income.
It most often appears near the bottom of the income Summary account at the end of the period,
statement in the computation of income before taxes along with the debit balances of the other
expense accounts
Sale of Investments
ADJUSTING MARKETABLE SECURITIES TO MARKET
If an investment is sold for more than its cost basis a
VALUE
gain is recorded, whereas selling an investment for an
amount less than its cost basis results in a loss. These Securities – classified as available for sale; are presented
items appear in the “Other Income/Expense” section of in the balance sheet at their current market value as of
the income statement the balance sheet date

Investment Sold at a Gain Fair Value Accounting – is a valuation principle where

securities are presented in balance sheet at their
For example: Foster Corporation sells 500 shares of its
current market value
Coca-Cola stock on December 18 for $50.04 per share,
less a $20 brokerage commission. Recall that Foster’s Unrealized Holding Gain (or Loss) on Investments – an
cost basis, as computed on December 1, is $49 per account that is used for adjustment of marketable
share securities to their current market value

Journal Entry for Gain on Sale of Investment - This appears in owner’s equity at the balance
Cash 25K sheet
Marketable Securities 24500
For example: Foster Corporation’s 1,000 remaining
Gain on Sales of Investment 500
shares of Coca-Cola capital stock have a current market
Sold 500 shares of Coca-Cola stock at a gain: value of $47,000 ($1000 x 47 shares). Prior to any
Sales Proceeds (50.04 x 500 - 20commission) = 25K adjustment, the company’s Marketable Securities
Cost Basis (49 x 500) =24500 account has a balance of $49,000 (1,000 shares at $49
Gain on Sale (25K – 24500) = 500 per share)

 yung amount nung cash is kulang ilan yung Adjusting Entry for Unrealized Holding LOSS on
nabenta which is computation ng sales Investments
proceeds Unrealized Holding Loss on Investment 2K
 gain is recorded in the income statement, Marketable Securities 2K
together with other revenues like the interest
and dividends; it is also closed to income
summary along with other revenues For Example: Foster’s 1,000 shares of Coca-Cola had a
market value on December 31 of $51 per share, the
Investment Sold at a Loss
investment would have been reported in the asset
For example: Foster Corporation sells an additional section of the balance sheet at $51,000
2,500 shares of its Coca-Cola stock on December 27 for
Adjusting Entry for Unrealized Holding GAIN on
$48.01 per share, less a $25 brokerage commission
Investments
Journal Entry for Loss on Sale of Investment Unrealized Holding Gain on Investment 2K
Cash 120K Marketable Securities 2K
Loss on Sales of Investment 2500
 The difference between the cost and market
Marketable Securities 122,500
value also appears as an element of
Sold 2,500 shares of Coca-Cola stock at a loss: stockholders’ equity, entitled Unrealized
Sales Proceeds (48.01 x 2500 – 25commission) = 120K Holding Loss (or Gain) on Investment
Cost Basis (49 x 2500) = 122,500  Unrealized holding gains and losses are not
Loss on Sale (120K – 122,500) = 2500 subject to income taxes; Income taxes are
levied only upon realized gains and losses
 The debit balance in the Loss on Sale of
recognized when investments are sold
Investments account is closed to the Income
  Unrealized holding gains and losses are actually  an account receivable that originates from a
reported in the balance sheet net of expected credit sale in January and is determined to be
future income tax effects uncollectible in June represents an expense in
January
 Fair value accounting is not always used
For example: At January 31, accounts receivable
internationally for valuing short-term
amount to $250,000. On this date, the credit manager
investments. Some countries continue to use
reviews the accounts receivable and estimates that
the lower of cost or market valuation
approximately $10,000 of these accounts will prove to
techniques because their accounting standards
be uncollectible.
setters believe the techniques are more
conservative Adjusting Entry for Uncollectible Accounts Receivable
 IFRS account for available-for-sale marketable Bad Debt Expense 10K
securities in similar fashion to U.S. GAAP Allowance for Doubtful Accounts 10K

ACCOUNTS RECEIVABLE Uncollectible Accounts Expense – is closed in the

Income Summary with other expense account
Accounts Receivable – comprise the largest financial
asset of many merchandising companies Allowance for Doubtful Account – appears in the
balance sheet as a deduction from the face amount of
- are relatively liquid assets, usually converting accounts receivable; it reduces the accounts receivable
into cash within a period of 30 to 60 days to their net realizable value in the balance sheet
 All accounts receivable arising from normal
sales activity are generally classified as current THE ALLOWANCE FOR DOUBTFUL ACCOUNTS
assets, even if the credit terms extend beyond Allowance for Doubtful Account – is used to estimate
one year the amount of uncollectible
 Accounts receivable are shown in the balance
sheet at the estimated collectible amount— - a contra-asset or valuation account; has a credit
called net realizable value balance which offsets the AR control account to
produce a more useful and reliable measure of
Uncollectible Accounts a company’s liquidity
If a company makes credit sales to some customers, - is merely an estimate and not a precise
some accounts inevitably will turn out to be calculation, professional judgment plays a
uncollectible. A limited amount of uncollectible considerable role in determining the size of this
accounts is not only expected—it is evidence of a sound valuation account
credit policy  You cannot determine in advance which AR will
prove to be uncollectible. It is therefore not
Reflecting Uncollectible Accounts in the Financial possible to credit the accounts of specific
Statements customers for our estimate of probable
uncollectible accounts
An account receivable that has been determined to be
uncollectible is no longer an asset; the loss of this asset Monthly Adjustments of the Allowance Account
represents an expense, termed Bad Debt (Uncollectible
Accounts) Expense At January 31, the amount of the adjustment ($10,000)
was equal to the estimated amount of uncollectible
Bad Debt (Uncollectible Accounts) Expense – is caused accounts. This is true only because January was the first
by selling goods on credit to customers who fail to pay month of operations and this was the company’s first
their bills; is estimated and recorded in the time period estimate of its uncollectible accounts
in which the related sales are made, even though
specific accounts receivable may not be determined to In future months, the amount of the adjusting entry will
be uncollectible until a later accounting period depend on two factors: (1) the estimate of uncollectible
accounts and (2) the current balance in the Allowance
for Doubtful Accounts
Writing Off an Uncollectible Accounts Receivable balance, which will be eliminated by the adjustment at
the end of the period
Whenever an account receivable from a specific
customer is determined to be uncollectible, it no longer Monthly Estimates of Credit Losses
qualifies as an asset and should be written off
For Example: At the end of February, the credit
- Kapag nadetermine mo na may uncollectible manager of World Famous Toy Co. analyzes the
ang isang customer, hindi na yun qualified as accounts receivable and estimates that approximately
asset at kailangan na ding iwritten off $11,000 of these accounts will prove uncollectible.
 To write off an accounts receivable is to reduce Currently, the Allowance for Doubtful Accounts has a
the balance of the customer’s account to zero credit balance of only $6,000

For example: World Famous Toy Co. learns that

Discount Stores has gone out of business and that the
$4,000 account receivable from this customer is now
worthless

Journal Entry for Writing off an AR as Uncollectible For Example: To increase the balance in the allowance
Allowance for Doubtful Accounts 4K account to $11,000 at February 28, the month-end
Accounts Receivable 4K adjusting entry must add $5,000 to the allowance.
Note: The debit is made to the Allowance for Doubtful Adjusting Entry for Additional Uncollectible AR
Accounts and not to the Uncollectible Accounts Expense Bad Debt Expense 5K
account Allowance for Doubtful Account 5K
The estimated expense of credit losses is charged to the
Bad Debt Expense account at the end of each
accounting period. When a specific account receivable is
later determined to be worthless and is written off, this
action does not represent an additional expense but
merely confirms our previous estimate of the expense Two general approaches to estimating credit losses

 writing off an uncollectible account does not 1. a balance sheet approach

change the net realizable value of accounts 2. an income statement approach
receivable in the balance sheet Estimating Credit Losses – The Balance Sheet Approach
 Credit losses are recognized as an expense in
the period in which the sale occurs, not the Aging the accounts receivable (Balance Sheet Approach)
period in which the account is determined to be – widely used method of estimating the probable
uncollectible amount of uncollectible accounts

Write-offs Seldom Agree with Previous Estimates - the method emphasizes the proper balance
sheet valuation of accounts receivable
The total amount of accounts receivable actually written - “Aging” accounts receivable means classifying
off will seldom, if ever, be exactly equal to the each receivable according to its age
estimated amount previously credited to the Allowance
for Doubtful Accounts Aging schedule – is useful to management in reviewing
the status of individual accounts receivable and in
If the amounts written off as uncollectible turn out to be evaluating the overall effectiveness of credit and
less than the estimated amount, the Allowance for collection policies
Doubtful Accounts will continue to show a credit
balance. If the amounts written off as uncollectible are - is used as the basis for estimating the amount
greater than the estimated amount, the Allowance for of uncollectible accounts
Doubtful Accounts will acquire a temporary debit  The longer an account is past due, the greater
the likelihood that it will not be collected in full
  the credit manager estimates the percentage of Recovery of an Accounts Receivable Previously Written
credit losses likely to occur in each age group of Off
accounts receivable
A receivable that has been written off as worthless will
 by adding together the estimated uncollectible
later be collected in full or in part; collections are often
portions for all age groups, the required balance
referred to as recoveries of bad debts
in the Allowance for Doubtful Accounts is
determined  Collection of an account receivable previously
 if AR written off during the period exceed the written off is evidence that the write-off was an
ADA at the last adjustment date, the allowance error; the receivable should therefore be
account temporarily acquires a debit balance; reinstated as an asset
this situation rarely occurs if the allowance is
adjusted each month but often occurs if For example: A company wrote off a $500 account
adjusting entries are made only at year-end receivable from Brad Wilson on February 16

Adjusting Entry to Increase the ADA Journal Entry to Write-off an AR as Uncollectible

Uncollectible Accounts Expense 1680 Allowance for Doubtful Accounts 500
Allowance for Doubtful Account 1680 Accounts Receivable 500

Estimating the Credit Losses – The Income Statement Journal Entry to Reinstate the AR that was previously
Approach written off
Accounts Receivable 500
Income Statement Approach - an alternative method of Allowance for Doubtful Accounts 500
estimating and recording credit losses; focuses on
estimating the uncollectible accounts expense to be A separate entry will be made to record the cash
reported in the income statement for the period collected from Brad Wilson and to remove his
reinstated account from the system
- the uncollectible accounts expense is estimated
at some percentage of net credit sales Journal Entry for Collecting the AR
- adjusting entry is made in the full amount of the Cash 500
estimated expense, without regard for the AR 500
current balance in the Allowance for Doubtful Direct Write-Off Method
Accounts
Some companies recognize no uncollectible accounts
For example: A company’s past experience indicates expense until specific receivables are determined to be
that about 2 percent of its credit sales will prove to be worthless; this method makes no attempt to match
uncollectible and credit sales for September amount to revenue with the expense of uncollectible accounts
$150,000
 When a particular customer’s account is
Adjusting Entry to Record Uncollectible Account determined to be uncollectible, it is written off
Expense directly to Uncollectible Accounts Expense
Uncollectible Accounts Expense 3K
Allowance for Doubtful Account 3K Journal Entry to Write-off an AR as Uncollectible
(Direct)
 This approach is fast and simple—no aging Bad Debt Expense 250
schedule is required and no consideration is Accounts Receivable 250
given to the existing balance in the Allowance
for Doubtful Accounts If direct write-off method yung ginamit, yung AR is
 The aging of accounts receivable provides a malilist sa balance sheet at their gross amount and
more reliable estimate of uncollectible accounts walang valuation allowance ang magagamit; the
because of the consideration given to the age receivables are not stated at estimated net realizable
and collectibility of specific accounts receivable value
at the balance sheet date
The allowance method is preferable to the direct write- Accounts Receivable – usually do not bear interest
off method because the allowance method does a
When interest will be charged, creditors usually require
better job of matching revenues and expenses
the debtor to sign a formal promissory note
 the direct write-off method is acceptable
Promissory Note – is an unconditional promise in
because its use does not have a material effect
writing to pay on demand or at a future date a definite
on the reported net income – if sales are not on
sum of money
credit but rather than cash
 current income tax regulations require Maker – person who signs/ made the note; the one who
taxpayers to use the direct write-off method in promises to pay
determining the uncollectible accounts expense
used in computing taxable income Payee – the person whom payment is to be made
 it enables expenses to be matched with the  The maker of a note expects to pay cash at the
related revenue and thus provides a more maturity date (or due date); the payee expects
logical measurement of net income to receive cash at that date
Factoring Accounts Receivable Nature of Interest
Factoring – transactions in which a business sells its Interest – is a charge made for the use of money
accounts receivable to a financial institution (often
called a factor) A borrower incurs interest expense; interest payable din
since sya yung umutang kaya may payable sya
- enable a business to obtain cash immediately
instead of having to wait until the receivables A lender earns interest revenue; interest receivable din
can be collected since sya yung nagpa-utang kaya makakareceive sya

Credit Card Sales Computing Interest

By making sales through credit card companies, Interest = Principal x Rate of Interest x Time (I = P x R x
merchants receive cash more quickly from credit sales T)
and avoid uncollectible accounts expense For example: The total interest charge on a $200,000,
Bank Credit Cards – when the credit card company is a one-year, 6% note receivable
bank, the retailing business may deposit the signed I = P x R x T = 200K x 0.06 x 1= 12K
credit card drafts directly in its bank account; recorded
as cash sales For example: If the term of the note were only four
months instead of one year, the total interest revenue
Other Credit Cards – when customers use nonbank earned in the life of the note would be
credit cards, the retailing business cannot deposit the
credit card drafts directly in its bank account; record AR I = P x R x T = 200K x 0.06 x 4/12 = 4K
instead of cash
 It should be noted that these computations
 Businesses, however, are not reimbursed for illustrate simple interest, meaning no interest
the full amount of the outstanding receivable accrues on the unpaid interest amounts each
month
To record sale from customer using credit card
Accounts Receivable 1200 Accounting for Notes Receivable
Sales 1200
For example: Assume that on December 1, a 3-month, 6
To record the collection of AR less 5% discount percent note receivable is acquired from a customer,
Cash 1140 Marvin White, in settlement of an existing account
Credit Card Discount Expense 60 receivable of $60,000
Accounts Receivable 1200
Notes Receivable 60K
Notes Receivable and Interest Revenue Accounts Receivable 60K
For example: At December 31, the end of the  The higher the turnover rate, the more liquid
company’s fiscal year, the interest earned to date on the company’s receivables; result in shorter
notes receivable should be accrued by an adjusting collection periods than low turnover rates
entry  Dividing 365 days by the turnover rate provides
an estimate of the average number of days an
Interest Receivable 300
account receivable remains outstanding before
Interest Revenue 300
it is collected
For example: On March 1 (3 months after the date of
the note), the note matures. The entry to record
collection of the note will be

Cash 60,900
Notes Receivable 60K
Interest Receivable 300 Summary of Learning Objectives
Interest Revenue 600
Financial assets are cash and other assets that convert
If the Maker of the Note Defaults – A note receivable directly into known amounts of cash. The three basic
that cannot be collected at maturity is said to have been categories are cash, marketable securities, and
defaulted by the maker receivables. In the balance sheet, financial assets are
To record default by Marvin White on 3-month, 6% listed at their current value. For cash, this means the
note face amount; for marketable securities, current market
Accounts Receivable 60,900 value; and for receivables, net realizable value
Notes Receivable 60K The purpose of a bank reconciliation is to achieve the
Interest Receivable 300 control inherent in the maintenance of two
Interest Revenue 600 independent records of cash transactions: one record
Notice that the interest earned on the note is recorded maintained by the depositor and the other by the bank.
through the maturity date and is included in the When these two records are reconciled (brought into
account receivable from the maker. The interest agreement), we gain assurance of a correct accounting
receivable on a defaulted note is just as valid a claim for cash transactions
against the maker as is the principal amount of the note Short-term investments (marketable securities) are
Financial Analysis and Decision Making adjusted to their market value at each balance sheet
date (a valuation principle often referred to as fair value
Collecting accounts receivable on time is important; it accounting). If the value of a company’s marketable
spells the success or failure of a company’s credit and securities has increased above their original cost, an
collection policies. A past-due receivable is a candidate unrealized holding gain is reported as a component of
for write-off as a credit loss stockholders’ equity. If the value of its marketable
We compute the ratio of net sales to average securities has fallen below their original cost, an
receivables, to help us judge how good a job a company unrealized holding loss is reported as a component of
is doing in granting credit and collecting its receivables stockholders’ equity

Accounts Receivable Turnover Rate – tells us how many Under the allowance method, the portion of each
times the company’s average investment in receivables period’s credit sales expected to prove uncollectible is
was converted into cash during the year estimated. This estimated amount is recorded by a debit
to the Bad Debt Expense account and a credit to the
 The ratio is computed by dividing annual net contra-asset account Allowance for Doubtful Accounts.
sales by average accounts receivable When specific accounts are determined to be
uncollectible, they are written off by debiting Allowance
for Doubtful Accounts and crediting Accounts  FOB shipping point – are included in the buyer’s
Receivable. Under the direct write-off method, inventory when the items are shipped
uncollectible accounts are charged to expense in the  FOB destination – are not included in the
period that they are determined to be worthless. The buyer’s inventory until they arrive at their
allowance method is theoretically preferable because it destination
is based on the matching principle. However, only the
Goods on Consignment – are goods shipped by the
direct write-off method may be used in income tax
owner, called the consignor, to another party, the
returns
consignee
Accounts receivable usually do not bear interest. When
 Consignee – sells good for the owner
interest will be charged, creditors usually require the
 Consignor – continues to own the consigned
debtor to sign a formal, legally binding promissory note.
goods and reports them in its inventory
Promissory notes appear in the balance sheet as assets
designated as notes receivable. Interest on a note Goods Damaged or Obsolete (and deteriorated) – goods
receivable is a contractual amount that accumulates that are not counted in inventory if they cannot be sold
(accrues) over time. The amount of interest accruing
over a time period may be computed by the formula  If these goods can be sold at a reduced price,
Principal Rate Time they are included in inventory at a conservative
estimate of their net realizable value
The most liquid financial asset is cash, followed by cash
equivalents, marketable securities, and receivables. The Net Realizable Value – is sales price minus the cost of
liquidity of receivables varies depending on their making the sale
collectibility and maturity dates. The Allowance for  The period when damage or obsolescence (or
Doubtful Accounts should provide for those receivables deterioration) occurs is the period when the
that may prove to be uncollectible. However, users of loss in value is reported
financial statements may also want to evaluate the
concentrations-of-credit-risk disclosure and, perhaps, Determining Inventory Costs
the credit ratings of major debtors. The accounts Merchandise inventory includes costs of expenditures
receivable turnover rate provides insight as to how necessary, directly or indirectly, to bring an item to a
quickly receivables are being collected salable condition and location

- includes its invoice cost minus any discount, and

CHAPTER 6 (WILD) plus any incidental costs necessary to put it in a
place and condition for sale
INVENTORIES AND COST OF SALES  incidental costs – include import tariffs,
Determining Inventory Items freight, storage, insurance, and costs incurred in
an aging process
Merchandise inventory includes all goods that a  some companies use the materiality constraint
company owns and holds for sale – regardless of where (cost-to-benefit constraint) to avoid assigning
the goods are located when inventory is counted some incidental costs of acquiring merchandise
to inventory; they expense them to cost of
 Certain inventory items require special
goods sold when incurred – either that those
attention, including goods in transit, goods on
incidental costs are immaterial or that the effort
consignment, and goods that are damaged or
in assigning them outweighs the benefit
obsolete
Internal Controls and Taking a Physical Count
Goods in Transit – if ownership has passed to the
purchaser, the goods are included in the purchaser’s Events (such as e theft, loss, damage, and errors) can
inventory; shipping terms (FOB destination and FOB cause the Inventory account balance to differ from the
shipping point “FOB origin or supplier’s warehouse”) actual inventory available
Nearly all companies take a physical count of inventory  Cost flow assumptions can markedly impact
at least once each year—informally called taking an gross profit and inventory numbers
inventory
Inventory Costing Illustration
 often occurs at the end of a fiscal year or when
Regardless of what inventory method or system is used,
inventory amounts are low
cost of goods available for sale must be allocated
Physical Count – is used to adjust the Inventory account between cost of goods sold and ending inventory
balance to the actual inventory available
Three key variables determine the value assigned to
 A company applies internal controls when ending inventory: (1) inventory quantity, (2) unit costs
taking a physical count of inventory to minimize of inventory, and (3) cost flow assumption
fraud and to increase reliability
1. Specific Identification – when each item in
Inventory Costing Under a Perpetual System inventory can be identified with a specific
purchase and invoice
Accounting for inventory affects both the balance sheet
- also called specific invoice inventory pricing
and the income statement
- is usually practical for companies with
Goal: is to properly match costs with sales expensive or custom-made inventory
 The assignment of costs to goods sold and to
We use the expense recognition (or matching) principle inventory using specific identification is the
to decide how much of the cost of the goods available same for both the perpetual and periodic
for sale is deducted from sales and how much is carried systems
forward as inventory and matched against future sales 2. FIFO (first in, first out) method – assigning costs
 Management decisions in accounting for to both inventory and cost of goods sold
inventory involves (1) items included in assumes that inventory items are sold in the
inventory and their costs, (2) costing method, order acquired
(3) inventory system, and (4) use of market - If may sales, yung unang napurchase ang
values or other estimates napupunta sa COGS and yung mga naiwan na
recent purchases is sa ending inventory
Four Methods used to assign costs to Inventory and
COGS 3. LIFO (last in, first out) – assigning costs assumes
1. Specific Identification that the most recent purchases are sold first
2. FIFO (First In, First Out) - If may sales, yung last na napurchase ang
3. LIFO (Last In First Out) napuounta sa COGS and yung mga early (old)na
4. Weighted Average napurchase is ending inventory
 comes closest to matching current costs of
Each method assumes a particular pattern for how costs goods sold with revenues
flow through inventory; is acceptable whether or not  is acceptable even when the physical flow of
the actual physical flow of goods follows the cost flow goods does not follow a last-in, first-out pattern
assumption. With the exception of specific
identification, the physical flow and cost flow need not 4. Weighted Average method – assigning cost
be the same requires that we use the weighted average cost
per unit of inventory at the time of each sale
Inventory Cost Flow Assumptions
- Also called as average cost
1. FIFO – assumes costs flow in the order incurred - a new average cost is computed after each
2. LIFO – assumes costs flow in the reverse order purchase
incurred  Cost of goods available for sale, units available
3. Weighted Average – cost flow at an average of for sale, and units in ending inventory are
costs available identical for all methods
Financial Statements Effects to Costing Methods Since inventory costs affect net income, they have
potential tax effects. Companies can and often do use
When purchase prices do not change, each inventory
different costing methods for financial reporting and tax
costing method assigns the same cost amounts to
reporting. The only exception is when LIFO is used for
inventory and to cost of goods sold. When purchase
tax reporting; in this case, the IRS requires that it also
prices are different, however, the methods nearly
be used in financial statements—called the LIFO
always assign different cost amounts
conformity rule
When purchase cost regularly rise (inflation):
Consistency Concept – a company use the same
 FIFO – assigns the lowest amount to cost of accounting methods period after period so that financial
goods sold—yielding the highest gross profit statements are comparable across periods—the only
and net income exception is when a change from one method to
 LIFO – assigns the highest amount to cost of another will improve its financial reporting; does not
goods sold—yielding the lowest gross profit and require a company to use one method exclusively
net income, which also yields a temporary tax
Valuing Inventory at LCM and the Effects of Inventory
advantage by postponing payment of some
Errors
income tax
 Weighted average yields results between FIFO Lower of Cost or Market – accounting principles require
and LIFO that inventory be reported at the market value (cost) of
 Specific Identification – always yields results replacing inventory when market value is lower than
that depend on which units are sold cost

When purchase cost regularly decline (falling/  Merchandise inventory is then said to be
deflation): reported on the balance sheet at the lower of
cost or market (LCM)
 FIFO – assigns the highest amount to cost of
goods sold—yielding the lowest gross profit and Computing the Lower of Cost or Market
net income
Market (in term of LCM) – is defined as the current
 LIFO – assigns the lowest amount to cost of
replacement cost of purchasing the same inventory
goods sold—yielding the highest gross profit
items in the usual manner
and net income
 a company must disclose the inventory method  When the recorded cost of inventory is higher
it uses in its financial statements or notes; all than the replacement cost, a loss is recognized
method is acceptable  When the recorded cost is lower, no adjustment
is made
Certain Advantages of each method:
LCM is applied in one of three ways:
 FIFO – assigns an amount to inventory on the
balance sheet that approximates its current 1. to each individual item separately,
cost; it also mimics the actual flow of goods for 2. to major categories of items, or
most businesses 3. to the whole of inventory
 LIFO – assigns an amount to cost of goods sold  The less similar the items that make up
on the income statement that approximates its inventory, the more likely companies are to
current cost; it also better matches current apply LCM to individual items or categories
costs with revenues in computing gross profit
 Weighted Average – tends to smooth out erratic
changes in costs
 Specific Identification – exactly matches the
costs of items with the revenues they generate

The Effects of Costing Method

Recording the Lower of Cost or Market
For example: If LCM is applied to the individual items of Assigning Cost to Inventory – both systems allow
inventory, the Merchandise Inventory account must be companies to apply a cost flow assumption; IFRS does
adjusted from the $295,000 recorded cost down to the not (currently) allow use of LIFO
$265,000 market amount as follows
Estimating Inventory Cost – the value of inventory can
Cost of Goods Sold 30K change while it awaits sale to customers; can decrease
Merchandise Inventory 30K or increase

Accounting rules require that inventory be adjusted to  Decrease – require companies to write down
market when market is less than cost, but inventory (reduce the cost recorded for) inventory when
normally cannot be written up to market when market its value falls below the cost recorded “lower of
exceeds cost cost or market”
- U.S. GAAP prohibits any later increase in the
Companies are not allowed to record inventory up to
recorded value of that inventory even if that
market – a gain from a market increase should not be
decline in value is reversed through value
realized until a sales transaction verifies the gain
increases in later periods. However, IFRS allows
Conservatism constraint – the use of the less optimistic reversals of those write-downs up to the
amount when more than one estimate of the amount to original acquisition cost
be received or paid exists and these estimates are about - value refers to replacement cost under U.S.
equally likely GAAP, but net realizable value under IFRS
 Increase – Neither U.S. GAAP nor IFRS allow
Financial Statement Effects of Inventory Errors inventory to be adjusted upward beyond the
Income Statement Effects original cost

Inventory Turnover and Days’ Sales in Inventory

Inventory Turnover - this ratio reveals how many times

a company turns over (sells) its inventory during a
period
Year 3 - It does not affect results or any period Inventory turnover = COGS/ Average Inventory
thereafter; hindi na affected yung year 3 kasi an
inventory error is said to be self-correcting because it  to help analyze short-term liquidity and to
always yields an offsetting error in the next period assess whether management is doing a good
job controlling the amount of inventory
Balance Sheet Effects available
 low ratio suggests insufficient use of assets; can
be susceptible to losses due to obsolescence
and trend changes
 high ratio suggest inventory may be too low; is
Errors in beginning inventory do not yield
preferable provided inventory is adequate to
misstatements in the end-of-period balance sheet, but
meet demand
they do affect that current period’s income statement
Days’ Sales in Inventory (days’ stock on hand) – is a ratio
GLOBAL VIEW
that reveals how much inventory is available in terms of
Items and Costs making up Inventory – under both the number of days’ sales
accounting systems, merchandise inventory includes all
- the number of days one can sell from inventory
items that a company owns and holds for sale;
if no new items are purchased
merchandise inventory includes costs of expenditures
- is often viewed as a measure of the buffer
necessary, directly or indirectly, to bring those items to
against out-of-stock inventory and is useful in
a salable condition and location
evaluating liquidity of inventory
Days’ Sales in Inventory = (Ending Inventory/COGS) x  Estimates are usually only required for
365 companies that use the periodic system

 focuses on ending inventory and it estimates Retail Inventory Method - To avoid the time-consuming
how many days it will take to convert inventory and expensive process of taking a physical inventory
at the end of a period into accounts receivable each month or quarter
or cash
- Used for estimating COGS and ending inventory
Note: Days’ sales in inventory focuses on ending
When a retailer takes a physical inventory, it can restate
inventory whereas inventory turnover focuses on
the retail value of inventory to a cost basis by applying
average inventory
the cost-to-retail ratio. It can also estimate the amount
 We prefer inventory turnover to be high of shrinkage by comparing the inventory computed with
provided inventory is not out of stock and the the amount from a physical inventory
company is not losing customers
Retail amount of Inventory – refers to its dollar amount
Inventory Costing under a Periodic System measured using selling prices of inventory items

Merchandise Inventory account is updated at the end of If we can get a good estimate of the cost-to-retail ratio,
each period to reflect purchases and sales we can multiply ending inventory at retail by this ratio
to estimate ending inventory at cost
 Regardless of what inventory method or system
is used, cost of goods available for sale must be Gross Profit Method – estimate the cost of ending
allocated between cost of goods sold and inventory by applying the gross profit ratio to net sales
ending inventory (at retail); often is needed when inventory is destroyed,
lost, or stolen

- to see whether inventory amounts from a

physical count are reasonable
- uses the historical relation between COGS and
net sales to estimate the proportion of cost of
goods sold making up current sales
- Reliability of the gross profit method depends
on an accurate and stable estimate of the gross
1. Specific Identification – each item in inventory profit ratio
can be identified with a specific purchase and
invoice
2. FIFO (first in, first out) – assigning costs to both
inventory and cost of goods sold assumes that
inventory items are sold in the order acquired
3. LIFO (last in, first out) – assigning costs assumes
that the most recent purchases are sold first
4. Weighted Average (average cost) – assigning
cost requires that we use the average cost per
unit of inventory at the end of the period

Inventory Estimation Method

Inventory sometimes require estimation. Reason:

1. Often require interim statements

2. May require an inventory estimate if some
casualty such as fire or flood makes taking a
physical count impossible