CHAPTER 6

The Current Asset Classification, Cash, and Accounts Receivable

SYNOPSIS

In this chapter, the author discusses the uses and limitations of the current asset classification,
the measurement and recording of cash and accounts receivables, and the major concerns of
financial statement users in accounting for these items. The specific topics covered include the
nature of cash, cash controls, cash discounts, and bad debts using the allowance method. The
international perspective segment discusses accounting for receivables and payables
expressed in foreign currencies, and hedging.

The ethics vignette presents the case of a regional bank with admittedly overstated bad debt
expense in good periods and understated bad debt expense in poor periods. In this manner, the
bank can achieve consistent increases in reported net income across time. The ethical conduct
of both the bank executives and the outside auditors is considered.

The Internet research exercise directs the student to access and analyze the activity in the
allowance for credit losses account for a major bank, JPMorgan Chase.

The following key points are emphasized in Chapter 6:

1. Current assets, working capital, current ratio, and quick ratio, and how these measures can
be used to assess the solvency position of a company.

2. "Window dressing" and the reporting of current assets, working capital, and the current
ratio.

3. Techniques used to account for and control cash.

4. Accounts receivable and how they are valued on the balance sheet.

5. The allowance method for uncollectible receivables.

6. Major concerns of financial statement users in the area of receivables reporting.

TEXT/LECTURE OUTLINE

The current asset classification, cash, and accounts receivable.

I. Current assets.

A. A current asset is any asset that is intended to be converted into cash within one
year or the company's operating cycle, whichever is longer. An operating cycle is
the time that it takes a company to begin with cash, convert the cash to inventory,
sell the inventory, and collect the cash from the sale.
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B. The relative size of current assets across industries.

C. Measures using current assets: working capital, current ratio and quick ratio.

D. The economic consequences of working capital, the current ratio and the quick
ratio.

E. Limitations of the current asset classification

F. A movement toward cash flow accounting.

II. Cash

A. Cash is defined as coin, currency, checking accounts, and negotiable instruments

such as personal checks, money orders, certified checks, cashiers' checks, and
bank drafts.

B. Restrictions on the use of cash.

C. Proper management of cash.

D. Control of cash.

III. Accounts receivable.

A. An account receivable is an amount owed to a company from selling goods or

services to customers on account. The agreement between the company and the
customer is usually informal.

B. Importance of accounts receivable

C. Net realizable value: The valuation base for accounts receivable

1. Net realizable value is the net expected future benefit arising from accounts
receivable. NRV represents the amount of cash the company expects to
realize from accounts receivable.

2. NRV equals the face value of the receivable less adjustments for the following
items:

a) Cash discounts.

b) Bad debts.

c) Sales returns.

D. Cash discounts

1. A discount offered by a company to provide incentives to its customers to pay

their open accounts promptly.
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2. Methods to account for cash discounts.

(A) Gross method.

(i) The sale and related receivable are recorded at the gross
amount of the transaction.

(ii) Recognition is given to the discount only if the customer takes

the discount. If the customer takes the discount, Cash Discount
is debited for the amount of the discount. This account is a
contra revenue account to Sales.

(iii) The gross method is the most common method because it is

the easiest to use.

E. The allowance method of accounting for bad debts (uncollectibles)

1. Bad debts are amounts sold to customers on account that the company does
not expect to convert into cash.

2. Companies would prefer to have no bad debts, but it would be extremely

costly to eliminate all bad debts. Hence, from a cost/benefit perspective, some
bad debts are inevitable.

3. Bad debts should be recognized in accordance with both the revenue

recognition principle (i.e., bad debts provide after-the-fact evidence that cash
collection was not reasonably assured) and the matching principle.

4. Allowance method.

(a) Bad debts are estimated and recognized in the period in which the
underlying credit sale took place. That is, the allowance method results in
an amount being estimated and recognized for both Bad Debt Charge
(which is offset against the company's sales) and Allowance for Doubtful
Accounts (which is offset against the balance in accounts receivable in
the period the underlying credit sale took place).

(b) The allowance account is a contra asset account that offsets Accounts
Receivable.

(c) The balance in the allowance account represents the amount reported in
Accounts Receivable that the company does not expect to eventually
collect.

(d) The balance in Bad Debt Charge represents the amount reported in that
period's sales that the company does not expect to eventually collect.

(e) Percentage-of-credit-sales approach—bad debt charge is estimated as a

percentage of the accounting period's credit sales. This approach takes
an income statement approach.
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(f) Aging approach.

i) A company decomposes its accounts receivable balance into

different ages and uses this aging to compute the balance
necessary in Allowance for Doubtful Accounts.

ii) Bad Debt Charge represents the change from the unadjusted to
the necessarily adjusted balance in the allowance account. This
approach takes a balance sheet valuation focus.

iii) Companies will often use the aging approach to verify the
accuracy of the balance in the allowance account computed
using the percentage-of-credit-sales approach.

(g) Regardless of the approach used, the balances in both Allowance for
Doubtful Accounts and Bad Debt Charge are based on estimates.

i) With the percentage-of-credit-sales approach, the ending balance

for Bad Debt Charge is estimated directly and the ending balance
for Allowance for Doubtful Accounts is estimated indirectly.

ii) With the aging method, the ending balance for Allowance for
Doubtful Accounts is estimated directly and the ending balance
for Bad Debt Charge is estimated indirectly.

5. Accounting for sales returns.

6. Accounts receivable from a user’s perspective.

a) Discretion in recognizing receivables and related revenues can result in

manipulation of the financial statements.

b) Judgment in estimating bad debts and sales returns can result in

manipulation of the financial statements.

c) Balance sheet valuation of receivables.

d) Financial institutions and uncollectible loans.

IV. International perspective: receivables, foreign currencies, and hedging.

V. Review problem

VI. Ethics in the real world.

VII. Internet research exercise.

LECTURE TIPS

1. Students are often puzzled by the computational difference in estimating bad debt expense
between the percentage-of-sales and the aging approach. The numerical example below uses
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the same data set as a basis to demonstrate the alternative approaches. he example can be
expanded (Case II) to illustrate the effect of a debit balance in the allowance account before
adjustment. The data was constructed so as to produce results that are different but
reasonable, reflecting the inherent subjectivity in the estimation process and the
appropriateness of alternative approaches. The example emphasizes that the primary
difference between the two methods is which balance is being estimated directly and which
balance is being estimated indirectly.

Data
Sales $1,050,000
Estimated % of sales uncollectible 1/2 %
Accounts receivable balance $ 75,000
Estimated % of accounts receivable uncollectible
based on an aging analysis 71/2 %

Case I—Allowance for doubtful accounts $250 (Cr.)

Case II—Allowance for doubtful accounts $250 (Dr.)

Demonstration Examples
Using the percentage-of-sales approach and, alternatively, the aging
approach, prepare the entry to record bad debt expense and compute the final
balance in Allowance for Doubtful Accounts for each case. Treat each
case independently and compare the results.

Check Numbers
Bad Debt Allowance
Expense Balance

Case I—Percentage-of-sales approach $5,250 $5,500

Case I—Aging approach $5,375 $5,625

Case II—Percentage-of-sales approach $5,250 $5,000

Case II—Aging approach $5,875 $5,625

OUTSIDE ASSIGNMENT OPPORTUNITIES

Group study of current assets, cash, and receivables both across time and within and across
industries (continuing assignment for Chapters 6–14)

1. Form groups (3–5 students) and obtain the most recent annual report of a major public
company in one of the four general industry groupings (manufacturing, retailing, general
services, and financial services). This report will be used for this assignment and for similar
assignments for each succeeding chapter. Depending on class size, each industry group
will be represented by several companies. Research the economic characteristics of and
current conditions in the industry (e.g., competitive market; capital and labor intensity and
other production characteristics; regulatory status; growth profile; and sensitivity to
technological, demographic, and macroeconomic trends) and the company’s strategy for
competing. Prepare a written summary of those background factors. This summary will be
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used as a framework for understanding and interpreting financial statement information to

be studied in these assignments.

Identify or compute the items listed below for the two most recent years. Compare the items
across time. Relate your findings to the industry and company background factors. Report
findings in a class discussion session in which comparisons will be made both across time
and within and across industries.
Current assets as a percentage of total assets
Current ratio
Quick ratio
Balance sheet caption for cash and equivalents
Cash as a percentage of total assets and current assets
Balance sheet caption for receivables and the related allowance for uncollectibles
Receivables as a percentage of total assets and current assets
Bad debts as a percentage of outstanding receivables
Average accounts receivable collection period

Inferring bad debt reporting strategies for a commercial bank

2. Obtain the most recent annual report for a commercial bank. Identify the trend in net
income for as many periods as possible. (The 10-year summary may provide enough
information for a long-term analysis.) Identify any strategy the bank may be using to report
bad debts and support your position with appropriate computations. Explain why the bank’s
management may be using the strategy you identified.

ANSWERS TO IN-TEXT DISCUSSION QUESTIONS

227. Tommy Hilfiger, a clothing manufacturer, designs and markets fashion clothing ultimately
sold by retailers. It buys raw materials and converts them to finished products and/or
outsources production of its merchandise. Finished goods are then sold to retailers on
open account. The operating cycle–the time it takes the company to convert cash to
inventory, sell the inventory, and collect cash from the sale–would likely be fairly long,
but certainly less than a year.

Toyota, an automobile manufacturer, designs and manufactures automobiles. It buys

raw materials and converts them to finished products. Finished goods are then sold to
dealers on open account. The operating cycle–the time it takes the company to convert
cash to inventory, sell the inventory, and collect cash from the sale–would likely be fairly
long, but probably less than a year.

Young & Rubicam, an advertising agency, does not manufacture or sell goods, but
rather provides services to its clients. The operating cycle consists of paying salaries to
employees who render the services followed by billing and cash collections. The time it
takes the company to convert the services rendered by its employees into cash is
probably a month or two.
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Yahoo!, an internet portal, does not manufacture or sell goods, but rather provides
services to its customers. The operating cycle here is probably a monthly cycle where
customers pay for monthly service.

229. RadioShack’s primary revenue producing asset is inventory, compared to Simon

Property Group which generates revenue primarily from its mall properties. Accordingly,
the major asset category on RadioShack’s balance sheet is inventory, a current asset,
while Simon’s major asset is property, plant and equipment, a non-current asset
category.

230. Recognizing revenue before the sale was complete would create an overstatement of
assets, probably in accounts receivable. The overstatement of accounts receivable
enhances the appearance of working capital, thus it fits the description of “window
dressing.”

231. Current and quick ratios are two simple measures of liquidity, neither of which reflects
Kroger’s true liquidity position. Kroger’s has relatively little in the way of current assets
because of the nature of its operations. Kroger’s buys it and sells it and collects for it all
very quickly. Inventories are kept low and turn over quickly. Kroger’s has a short
operating cycle. Current and quick ratios are static measures. Kroger’s liquidity is better
assessed with a dynamic measure, such as cash flow from operations (CFFO)
compared to current liabilities.

232. The correct amount of Cash that a company should keep is a function of its needs, its
future plans for the usage of cash (cash budget), and its risk appetite. The company will
also react to the needs and expectations of its shareholders who are the owners of the
company. Holding excessive cash carries the opportunity costs of all of the other
options that are available to the organization in terms of investing the money including
putting money back into growing the business. Carrying excessive cash is not an
effective use of assets of from the investors’ perspective. If they wanted an investment
in cash, they would not have bought stock in the company to begin with. If a company
does not have plans for excess cash, then it should be returned to investors who can
invest in other opportunities, or the company can increase value to shareholders by
reducing the number of shares outstanding by buying treasury stock.

233. The restricted cash would not be included with the other current assets in the calculation
of working capital because it is not available to pay current liabilities.

233. Cash management requires managers to maintain enough cash to ensure that the
business remains liquid and is able to meet payment obligations, and to invest cash in
excess of those needs in assets that produce a higher return. Identifying and estimating
cash inflows and cash needs, and determining the amount and where to invest excess
cash, are important concerns to company managers.

234. Company managers desire to keep cash balances at a minimum, and therefore the
absolute amount of cash at any one point in time is minimal compared to other assets.
Yet, cash transactions are very voluminous and are central to every accounting system.
Most liabilities, revenues, expenses, and other assets flow through the cash account.
The mere number of transactions leads to a higher likelihood of errors. Also, cash is the
most liquid of assets and the most susceptible to theft, embezzlement, and
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misappropriation. Accordingly, record and physical controls of cash are critical to the
accountant.

235. Paying attention to the relationship between sales and accounts receivable might alert
an analyst to a problem. Accounts receivable turnover is a ratio based on this
relationship. An unexplained increase or decrease in receivables turnover may be an
indication of an accounting problem.

236. Large companies generally have more economic power than smaller companies and are
better able to control the terms of contracts with both their vendors and their customers
than are smaller companies. For this reason, smaller companies will usually have more
difficulty collecting their receivables and extending the time they have to pay their
vendors than the larger companies, especially in an economic downturn.

236. Accounts receivable management and control is likely most important to General
Electric. Wal-Mart is a cash and carry business without significant accounts receivable.
Walgreens has few receivables. General Electric is a large diversified manufacturer,
which also has a finance operation. Receivables are very material to its operations and
financial statements.

237. The net realizable value of the 11.02 billion in accounts receivable was only $10.93
billion. The difference is the allowance for doubtful accounts.

240. A company must evaluate the creditworthiness of potential customers before making
sales on account to them. This is a costly, and necessarily subjective (and therefore
risky) undertaking, especially when it involves a new customer-base in a new market.
Managers must balance the profit from the incremental sales gained from credit sales,
against a realistic estimate of the bad debt losses that are inevitable if credit is granted.

241. Because Citigroup’s core business is financial services (lending) it may be better at
managing the credit card business than Sears was. The “increasingly large reserves”
were allowances for doubtful accounts, which are often referred to as “reserves.”

243. The $.1 million charged to expense was the amount of bad debt expense for the year.
The $.3 million of uncollectible receivables written off were written off under Radio
Shack’s policy because of doubts as to collectability. Because the write-offs exceeded
the expense, the allowance decreased.

244. Collection of the receivables appeared unlikely since no payments had been made. An
allowance should have been established for those amounts that would not be collected
and a large bad debt expense should have affected the income statement. Users of the
financial statements might have detected the problem by comparing the amount in the
allowance account to such numbers as sales and accounts receivable across time. A/R
ratios such as A/R turnover would have reflected these issues. Unsatisfactory
explanations for unusual deviations may have revealed a problem.

245. There is a trend in American business to outsource functions to others that can perform
them more effectively and efficiently, and collection of delinquent receivables is no
exception. Companies are willing to sell delinquent receivables for an assured smaller
amount now, rather than wait to possibly receive a larger amount later. Mr. Passen is so
confident in his new firm’s collection skills, that he believes he can achieve higher
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returns by actually buying the delinquent receivables and keeping the full amount
recovered, than by simply taking a percentage of amounts recovered.

246. The indictment alleges that certain (named) executives kept Computer Associate's
books open at the end of fiscal periods. In the week following the end of fiscal periods,
while the books were held open, they directed sales managers and salespeople to
finalize and backdate license agreements. Revenue from those falsely dated license
agreements was then improperly recognized in the quarter just ended. The executives
met routinely and conferred with each other during the week following the end of fiscal
periods to determine whether Computer Associate's had generated sufficient revenue to
meet the quarterly projections, and closed Computer Associate's books only after they
determined that Computer Associate's had generated enough revenue to meet the
quarterly projections.

247. Revenue recognition on product sales prior to shipment is not appropriate because the
earnings process is not complete until the goods are shipped. Such a practice could
result in a receivables write-off if the goods were not in fact subsequently shipped or
from a change in accounting to recognize revenue in the proper period.

248. Macy’s decided that they did not want to be in the customer credit business. Rather, they
spun that part of the business off, and sold it. Because of the widespread use of credit
cards, merchants can sell on credit without carrying the risks involved in financing
consumer purchases.

249. Receivables may have increased because sales grew, collections slowed, or because of
acquisitions of other companies, or a combination of those factors. An investor’s
interpretation of the company’s current ratio and cash flow statement should include an
evaluation of the factors underlying the increase to help determine whether the
receivables are in fact realizable. A favourable current ratio does not mean much unless
the receivables are in fact collectible. Cash flow measures should be used together with
the current ratio. A large difference between net income and net cash from operations
because of an increase in receivables could be a problem, but not necessarily. If the
increase in receivables is commensurate with an increase in sales, it may not be.

250. The increases in accounts receivable of $60, $714, and $774 million represent earnings
that were not collected in the form of cash. Because the operating section of the
statement of cash flows starts with net income, the fact that accounts receivable
increased needs to be taken into consideration when computing cash provided by
operations. That much less cash was provided than would have been the case had
accounts receivable not increased.

250. Losses on receivables reduce a bank’s retained earnings, a component of their capital.
These impairments of banks’ capital pose a threat to the solvency of individual banks
and on a macro-level to our entire banking system and our economy as a whole.

CHARACTERISTICS OF END-OF-CHAPTER ASSIGNMENTS

Item Difficulty Description

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Brief exercises:
BE6–1 E Analysis of accounts receivable
BE6–2 E Uncollectible accounts
BE6–3 E Uncollectible accounts

Exercises:
E6–1 E Classifying cash on the balance sheet
E6–2 E Classifying cash on the balance sheet
E6–3 E Accounting for cash discounts
E6–4 E Accounting for cash discounts
E6–5 M Bad debts under the allowance method
E6–6 M Accounting for uncollectibles
E6–7 M Accounting for doubtful accounts: the allowance method
E6–8 H Inferring bad debt write-offs and reconstructing related journal entries
E6–9 M Accounting for uncollectibles - IFRS
E6–10 M Preparing an aging schedule
E6–11 M Exchange gains/losses on outstanding receivables
E6–12 M Hedging to reduce the risk of currency fluctuations

Problems:
P6–1 M Classifying cash on the balance sheet
P6–2 E Cash discounts
P6–3 M Bad debts over time
P6–4 M Accounting for uncollectibles over two periods
P6–5 M Accounting for uncollectibles over three periods
P6–6 M Analysing the activity in the allowance account
P6–7 H Ignoring potential bad debts--overstatements
P6–8 H Estimating uncollectibles: financial ratios and loan agreements
P6–9 M Uncollectibles: ignoring an allowance
P6–10 H Accounting for uncollectibles and the aging estimate
P6–11 H Inferring reporting strategies
P6–12 M Exchange gains and losses
P6–13 M Fluctuating exchange rates, debt covenants, and hedging

Issues for discussion:

ID6–1 M Restricted cash and solvency ratios
ID6–2 E Revenue recognition, ethics, and reputation
ID6–3 M Working capital, debt covenants, and restrictions on management decisions
ID6–4 M Analyzing the allowance account
ID6–5 M Managing reserves for uncollectible receivables
ID6–6 M Provisions for loan losses and profits
ID6–7 M Bad debts, statement of cash flows: GAAP vs. IFRS
ID6–8 M Earnings restatement due to misstated loan losses
ID6–9 E Concentrations of credit risk
ID6–10M Boosting earnings with bad debt estimates
ID6–11M Macroeconomic conditions and uncollectibles
ID6–12E Accounting for foreign currencies—an economic consequence
ID6–13M The annual report of Google