7 Cash and Receivables CONCEPTS FOR ANALYSIS 7
CONCEPTS FOR ANALYSIS
CA7-1 (Bad-Debt Accounting) Simms Company has significant amounts of trade accounts receivable. Simms uses the allowance method to estimate bad debts instead of the direct write-off method. During the year, some specific accounts were written off as uncollectible, and some that were previously written off as uncollectible were collected.
Instructions
(a) What are the deficiencies of the direct write-off method?
(b) Briefly describe the allowance method to estimate bad debts and the theoretical justification for its use?
(c) How should Simms account for the collection of the specific accounts previously written off as uncollectible?
CA7-2 (Various Receivable Accounting Issues) Kimmel Company uses the net method of accounting for sales discounts. Kimmel also offers trade discounts to various groups of buyers.
On August 1, 2017, Kimmel sold some accounts receivable on a without recourse basis. Kimmel incurred a finance charge.
Kimmel also has some notes receivable bearing an appropriate rate of interest. The principal and total interest are due at maturity. The notes were received on October 1, 2017, and mature on September 30, 2019. Kimmel’s operating cycle is less than one year.
Instructions
(a) (1) Using the net method, how should Kimmel account for the sales discounts at the date of sale? What is the rationale for the amount recorded as sales under the net method?
(2) Using the net method, what is the effect on Kimmel’s sales revenues and net income when customers do not take the sales discounts?
(b) What is the effect of trade discounts on sales revenues and accounts receivable? Why?
(c) How should Kimmel account for the accounts receivable factored on August 1, 2017? Why?
(d) How should Kimmel account for the note receivable and the related interest on December 31, 2017? Why?
CA7-3 WRITING (Bad-Debt Reporting Issues) Clark Pierce conducts a wholesale merchandising business that sells approximately
5,000 items per month with a total monthly average sales value of $250,000. Its annual bad debt rate has been approximately
1½% of sales. In recent discussions with his bookkeeper, Mr. Pierce has become confused by all the alternatives apparently available in handling the Allowance for Doubtful Accounts balance. The following information has been presented to Pierce.
1. An allowance can be set up (a) on the basis of a percentage of receivables or (b) on the basis of a valuation of all past due or otherwise questionable accounts receivable. Those considered uncollectible can be charged to such allowance at the close of the accounting period, or specific items can be charged off directly against (1) Gross Sales or to (2) Bad Debt Expense in the year in which they are determined to be uncollectible.
2. Collection agency and legal fees, and so on, incurred in connection with the attempted recovery of bad debts can be charged to (a) Bad Debt Expense, (b) Allowance for Doubtful Accounts, (c) Legal Expense, or (d) Administrative Expense.
3. Debts previously written off in whole or in part but currently recovered can be credited to (a) Other Revenue, (b) Bad Debt
Expense, or (c) Allowance for Doubtful Accounts.
Instructions
Which of the foregoing methods would you recommend to Mr. Pierce in regard to (1) allowances and charge-offs, (2) collection expenses, and (3) recoveries? State briefly and clearly the reasons supporting your recommendations.
CA7-4 WRITING (Basic Note and Accounts Receivable Transactions)
Part 1: On July 1, 2017, Wallace Company, a calendar-year company, sold special-order merchandise on credit and received in return an interest-bearing note receivable from the customer. Wallace Company will receive interest at the prevailing rate for a note of this type. Both the principal and interest are due in one lump sum on June 30, 2018.
Instructions
When should Wallace Company report interest revenue from the note receivable? Discuss the rationale for your answer.
Part 2: On December 31, 2017, Wallace Company had significant amounts of accounts receivable as a result of credit sales to its customers. Wallace uses the allowance method based on credit sales to estimate bad debts. Past experience indicates a reliable estimate of uncollectible accounts can be developed based on an aging analysis of receivable balances. This pattern is expected to continue.
Instructions
(a) Discuss the rationale for using the allowance method based on the balance in the trade receivables accounts.
(b) How should Wallace Company report the allowance for doubtful accounts on its balance sheet at December 31, 2017?
Also, describe the alternatives, if any, for presentation of bad debt expense in Wallace Company’s 2017 income statement.
(AICPA adapted)
CA7-5 (Sale of Notes Receivable) Corrs Wholesalers Co. sells industrial equipment for a standard 3-year note receivable. Revenue is recognized at time of sale. Each note is secured by a lien on the equipment and has a face amount equal to the equipment’s list price. Each note’s stated interest rate is below the customer’s market rate at date of sale. All notes are to be collected in three equal annual installments beginning one year after sale. Some of the notes are subsequently sold to a bank with recourse, some are subsequently sold without recourse, and some are retained by Corrs. At year end, Corrs evaluates all outstanding notes receivable and provides for estimated losses arising from defaults.
Instructions
(a) What is the appropriate valuation basis for Corrs’s notes receivable at the date it sells equipment?
(b) How should Corrs account for the sale, without recourse, of a February 1, 2017, note receivable sold on May 1, 2017? Why is it appropriate to account for it in this way?
(c) At December 31, 2017, how should Corrs measure and account for the impact of estimated losses resulting from notes receivable that it
(1) Retained and did not sell?
(2) Sold to bank with recourse?
(AICPA adapted)
CA7-6 (Zero-Interest-Bearing Note Receivable) On September 30, 2016, Rolen Machinery Co. sold a machine and accepted the customer’s zero-interest-bearing note. Rolen normally makes sales on a cash basis. Since the machine was unique, its sales price was not determinable using Rolen’s normal pricing practices.
After receiving the first of two equal annual installments on September 30, 2017, Rolen immediately sold the note with recourse.
On October 9, 2018, Rolen received notice that the note was dishonored, and it paid all amounts due. At all times prior to default, the note was reasonably expected to be paid in full.
Instructions
(a) (1) How should Rolen determine the sales price of the machine?
(2) How should Rolen report the effects of the zero-interest-bearing note on its income statement for the year ended December 31, 2016? Why is this accounting presentation appropriate?
(b) What are the effects of the sale of the note receivable with recourse on Rolen’s income statement for the year ended December 31, 2017, and its balance sheet at December 31, 2017?
(c) How should Rolen account for the effects of the note being dishonored?
CA7-7 GROUPWORK (Reporting of Notes Receivable, Interest, and Sale of Receivables) On July 1, 2017, Moresan Company sold special-order merchandise on credit and received in return an interest-bearing note receivable from the customer. Moresan will receive interest at the prevailing rate for a note of this type. Both the principal and interest are due in one lump sum on June 30, 2018.
On September 1, 2017, Moresan sold special-order merchandise on credit and received in return a zero-interest-bearing note receivable from the customer. The prevailing rate of interest for a note of this type is determinable. The note receivable is due in one lump sum on August 31, 2019.
Moresan also has significant amounts of trade accounts receivable as a result of credit sales to its customers. On October 1, 2017, some trade accounts receivable were assigned to Indigo Finance Company on a non-notification (Moresan handles collections) basis for an advance of 75% of their amount at an interest charge of 8% on the balance outstanding.
On November 1, 2017, other trade accounts receivable were sold on a without recourse basis. The factor withheld 5% of the trade accounts receivable factored as protection against sales returns and allowances and charged a finance charge of 3%.
Instructions
(a) How should Moresan determine the interest revenue for 2017 on the:
(1) Interest-bearing note receivable? Why?
(2) Zero-interest-bearing note receivable? Why?
(b) How should Moresan report the interest-bearing note receivable and the zero-interest-bearing note receivable on its balance sheet at December 31, 2017?
(c) How should Moresan account for subsequent collections on the trade accounts receivable assigned on October 1, 2017, and the payments to Indigo Finance? Why?
(d) How should Moresan account for the trade accounts receivable factored on November 1, 2017? Why?
(AICPA adapted)
CA7-8 WRITING (Accounting for Zero-Interest-Bearing Note) Soon after beginning the year-end audit work on March 10 at Engone Company, the auditor has the following conversation with the controller.
Controller: The year ended March 31st should be our most profitable in history and, as a consequence, the board of directors has just awarded the officers generous bonuses.
Auditor: I thought profits were down this year in the industry, according to your latest interim report.
Controller: Well, they were down, but 10 days ago we closed a deal that will give us a substantial increase for the year.
Auditor: Oh, what was it?
Controller: Well, you remember a few years ago our former president bought stock in Henderson Enterprises because he had those grandiose ideas about becoming a conglomerate. For 6 years we have not been able to sell this stock, which cost us $3,000,000 and has not paid a nickel in dividends. Thursday we sold this stock to Bimini Inc. for $4,000,000. So, we will have a gain of $700,000 ($1,000,000 pretax) which will increase our net income for the year to $4,000,000, compared with last year’s $3,800,000. As far as I know, we’ll be the only company in the industry to register an increase in net income this year. That should help the market value of the stock!
Auditor: Do you expect to receive the $4,000,000 in cash by March 31st, your fiscal year-end?
Controller: No. Although Bimini Inc. is an excellent company, they are a little tight for cash because of their rapid growth.
Consequently, they are going to give us a $4,000,000 zero-interest-bearing note with payments of $400,000 per year for the next 10 years. The first payment is due on March 31 of next year.
Auditor: Why is the note zero-interest-bearing?
Controller: Because that’s what everybody agreed to. Since we don’t have any interest-bearing debt, the funds invested in the note do not cost us anything and besides, we were not getting any dividends on the Henderson Enterprises stock.
Instructions
Do you agree with the way the controller has accounted for the transaction? If not, how should the transaction be accounted for?
CA7-9 WRITING (Receivables Management) As the manager of the accounts receivable department for Beavis Leather Goods, Ltd., you recently noticed that Kelly Collins, your accounts receivable clerk who is paid $1,200 per month, has been wearing unusually tasteful and expensive clothing. (This is Beavis’s first year in business.) This morning, Collins drove up to work in a brand new Lexus.
Naturally suspicious by nature, you decide to test the accuracy of the accounts receivable balance of $192,000 as shown in the ledger. The following information is available for your first year (precisely 9 months ended September 30, 2017) in business.
(1) Collections from customers $188,000
(2) Merchandise purchased 360,000
(3) Ending merchandise inventory 90,000
(4) Goods are marked to sell at 40% above cost.
Instructions
Assuming all sales were made on account, compute the ending accounts receivable balance that should appear in the ledger, noting any apparent shortage. Then, draft a memo dated October 3, 2017, to Mark Price, the branch manager, explaining the facts in this situation. Remember that this problem is serious, and you do not want to make hasty accusations.
CA7-10 ETHICS (Bad-Debt Reporting) Marvin Company is a subsidiary of Hughes Corp. The controller believes that the yearly allowance for doubtful accounts for Marvin should be 8% of gross accounts receivable. Given the recession and the high interest rate environment, the president, nervous that the parent company might expect the subsidiary to sustain its 10% growth rate, suggests that the controller increase the allowance for doubtful accounts to 9%. The president thinks that the lower net income, which reflects a 6% growth rate, will be a more sustainable rate for Marvin Company.
Instructions
(a) In a recessionary environment with tight credit and high interest rates:
(1) Identify steps Marvin Company might consider to improve the accounts receivable situation.
(2) Then evaluate each step identified in terms of the risks and costs involved.
(b) Should the controller be concerned with Marvin Company’s growth rate in estimating the allowance? Explain your answer.
(c) Does the president’s request pose an ethical dilemma for the controller? Give your reasons.
