Module 6: Internal control and accounting for cash, investments held for the short term, and receivables

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1 Page 1 of 40 Module 6: Internal control and accounting for cash, investments held for the short term, and receivables Overview In previous modules, you studied the steps in the accounting cycle of service enterprises and merchandising companies, including how to account for inventory a current asset. This module explains how to account for other major categories of current assets cash, accounts receivable, and investments held for the short term. Cash is the easiest asset to account for but it is also the most easily stolen. You will study the internal control procedures used to safeguard this asset. Test your knowledge Begin your work on this module with a set of test-your-knowledge questions designed to help you gauge the depth of study required. Learning objectives 6.1 State the purposes and broad principles of internal control. (Level 2) 6.2 Explain the concept of liquidity and distinguish between cash and cash equivalents. (Level 1) 6.3 Explain the operation of a petty cash fund and prepare journal entries to record petty cash fund transactions. (Level 1) 6.4 Explain the ethical issues related to the operation of a petty cash fund. (Level 1) 6.5 Prepare a bank reconciliation and explain its purpose. (Level 1) 6.6 Calculate the acid-test ratio. (Level 2) 6.7 Describe and identify debt and equity investments and their classification. (Level 1) 6.8 Journalize entries to account for trading investments, including their purchase, the collection of interest and/or dividends, the sale and resulting gain/loss, and appropriate valuation adjustment on the balance sheet date. (Level 1) 6.9 Prepare entries to account for transactions with credit customers, including accounting for bad debts under the allowance method and the direct write-off method. (Level 1) 6.10 Calculate the interest on promissory notes and prepare entries to record the receipt of promissory notes and their payment or dishonour, along with the end-of-period adjustments. (Level 1) 6.11 Explain how receivables can be converted to cash before maturity. (Level 2)

2 Page 2 of Explain how the accounts receivable turnover and days' sales outstanding ratios can be used to analyze a company's credit policy. (Level 2) Module 6: Internal control and accounting for cash, investments held for the short term, and receivables - Content Links Module 6 Test your knowledge a. Which of the following options include only passive investments? 1. Trading investments, held-to-maturity investments, significant influence investments 2. Trading investments, held-to-maturity investments, available-for-sale investments 3. Trading investments, significant influence investments, control investments 4. Trading investments, control investments, joint-venture investments b. On the bank reconciliation, which of the following adjustments will cause the general ledger cash account balance to increase? 1. Outstanding deposits, collection of note receivable by the bank, and an NSF cheque 2. Outstanding deposits, bank errors, and interest revenue recorded on the bank statement 3. Electronic fund transfer (EFT) deposits, collection of note receivable by the bank, interest revenue recorded on the bank statement 4. Electronic fund transfer (EFT) deposits, bookkeeper errors, and bank service charges c. If the allowance for doubtful accounts is estimated as 2% of outstanding accounts receivable, what is the amount of the adjusting entry, given the following information? 1. $2, $3, $5, $8,000

3 Page 3 of 40 d. Which of the following methods of accounting for bad debts does not satisfy the GAAP of conservatism and matching? 1. Income statement approach 2. Simplified balance sheet approach 3. Aging analysis balance sheet approach 4. Direct write-off method e. At the end of an accounting period, how are unrealized gains and losses on trading investments resulting from the comparison of book value to market value recorded? Solutions 1. Unrealized gains and losses are not recorded. 2. Unrealized losses are recognized directly against income; unrealized gains are not recorded to conform with GAAP. 3. Unrealized gains and losses are recognized directly against income. 4. Unrealized gains are recognized directly against income; unrealized losses are not recorded to conform with GAAP. Module 6 Test Your Knowledge solutions a. b. c. 1. Incorrect. Significant influence investments are not passive; they are strategic investments. 2. Correct. Trading investments, held-to-maturity investments, available-for-sale investments are all passive investments. 3. Incorrect. Significant influence and control investments are strategic investments; they are not passive investments. 4. Incorrect. Control and joint-venture investments are strategic investments; they are not passive investments. 1. Incorrect. Outstanding deposits will be an adjustment that causes the bank balance to increase; an NSF cheque would involve an adjustment that causes the general ledger cash account to decrease. 2. Incorrect. Outstanding deposits will be an adjustment that causes the bank balance to increase; bank errors would involve an adjustment to the bank balance. 3. Correct. Electronic fund transfer (EFT) deposits, collection of note receivable by the bank, and interest revenue recorded on the bank statement would require adjustments that increase the general ledger cash account. 4. Incorrect. Bank service charges would cause the general ledger cash account balance to decrease; depending on the error, a bookkeeper error will cause the general ledger cash account balance to either increase or decrease. 1. Incorrect. Since AFDA has an unadjusted debit balance of $3,000, the required balance of $5,000 ($250,000 2%) must be added, not subtracted, to get the $8,000 amount of the adjusting entry. 2. Incorrect. The unadjusted debit balance of $3,000 must be added to the required balance of $5,000 ($250,000 2%) to get the correct $8,000 amount of the adjusting entry. 3. Incorrect. The unadjusted debit balance of $3,000 must be added to the required balance of

4 Page 4 of 40 d. e. $5,000 ($250,000 2%) to get the correct $8,000 amount of the adjusting entry. 4. Correct. The unadjusted debit balance of $3,000 must be added to the required balance of $5,000 ($250,000 2%) to get the correct $8,000 amount of the adjusting entry. 1. Incorrect. The income statement approach satisfies both conservatism and matching. 2. Incorrect. The simplified balance sheet approach satisfies both conservatism and matching. 3. Incorrect. The aging analysis balance sheet approach satisfies both conservatism and matching. 4. Correct. The direct write-off method does not satisfy GAAP. 1. Incorrect. Unrealized gains and losses are recognized directly in income. 2. Incorrect. Both unrealized gains and losses are recognized directly in income. 3. Correct. Both unrealized gains and losses are recognized directly against income. 4. Incorrect. Unrealized gains and losses are recognized against income. 6.1 Internal control Learning objective State the purposes and broad principles of internal control. (Level 2) Required reading Chapter 9, pages LEVEL 2 In accounting for cash and other assets, and in all phases of business operations, procedures that help control business activities are very important. These procedures are called internal controls. Purposes and broad principles of internal control procedures The text explains the four broad purposes and the seven fundamental principles of internal control on pages It then explores the positive and negative impacts of technology on internal control systems and review some inherent limitations of monitoring techniques. Exercise 9-1 on page 476 demonstrates how internal control principles can be applied to a small business. Think about the answer, then click on the solution to check. Textbook activities Judgement Call on page 451 (Solution on page 468) Checkpoint questions 1 and 2 on page 451 (Solutions on page 469) Quick Study 9-1 on page 475 (Solution)

5 Page 5 of Internal control - Content Links Solution to Lombard Company This example shows that Lombard Company s internal control system failed to require a separation of asset custody and recordkeeping. The bookkeeper should not have been allowed to sign the company s cheques. In addition, since a loss was incurred, the company apparently had not bonded its employee. Otherwise, the loss would have been insured by the bonding company. Finally, if regular, independent reviews of the accounting records had been done, the payments of salary cheques to a nonemployee may have been discovered sooner. 6.2 Cash defined and internal control for cash Learning objective Explain the concept of liquidity and distinguish between cash and cash equivalents. (Level 1) Required reading Chapter 9, pages Extend your knowledge 9-2: Voucher Systems of Control LEVEL 1 You should distinguish between cash and cash equivalents, and notice how they are closely related to the concept of liquidity. Cash equivalents are held for the purpose of meeting short-term cash commitments rather than for investing or other purposes. For an investment to qualify as a cash equivalent, it must be readily convertible to a known amount of cash and be subject to an insignificant risk of a change in value. An investment normally qualifies as a cash equivalent only when it has a short maturity of three months or less from the date of acquisition (CICA Handbook, paragraph ). Examples of cash equivalents include temporary investments in commercial paper, treasury bills, and money market funds with three months or less remaining to maturity. Commercial paper is a short-term note issued by corporations with strong credit ratings. Treasury bills (T-bills) are short-term government obligations. Canadian cash is reported on the balance sheet at its face value. Foreign currency holdings are translated into Canadian dollars using the exchange rate in effect at the balance sheet date. Internal control for cash Cash is the most desirable asset to thieves because, if held in sufficient quantities, it can be used to purchase any other asset that they desire. Moreover, cash is easily transported. Cash is therefore the most likely target

6 Page 6 of 40 for theft and fraud. An important managerial role is to ensure that a strong system of internal controls is in place to safeguard this asset from theft and embezzlement. Important controls to safeguard cash are covered on pages Textbook activities Checkpoint question 3 on page 454 (Solution on page 469) Quick Study 9-2 on page 475 (Solution) 6.3 The petty cash fund Learning objective Explain the operation of a petty cash fund and prepare journal entries to record petty cash fund transactions. (Level 1) Required reading Chapter 9, pages LEVEL 1 The single exception to the control procedure requiring that all disbursements be made by cheque is the use of a petty cash fund. This fund is established to pay for small purchases (such as postage and lunch room supplies) in order to avoid issuing cheques. It is done for convenience and to save cost. For example, coffee supplies for small offices are normally paid for out of petty cash. Imagine running down to the corner store to get some cream and asking them to send you an invoice for the total cost of $1.03! Even if the store agrees to bill you (which is doubtful), think of the associated costs of completing a purchase order, processing the resultant statement, and issuing and mailing the cheque! Petty cash fund transactions and records are explained on pages An ethical issue Learning objective Explain the ethical issues related to the operation of a petty cash fund. (Level 1) Required reading Chapter 9, page 456 (Judgement Call)

7 Page 7 of 40 LEVEL 1 Accountants have an ethical obligation to exercise integrity and behave in a competent and trustworthy manner. Read the Judgement Call on page 456. Think about the answer, then click on the link to view an analysis of the case. Textbook activities Checkpoint questions 4, 5, and 6 on page 456 (Solutions on page 469) Quick Study 9-3, 9-4, and 9-5 on page 475 (Solutions) Mid-Chapter Demonstration Problem on pages An ethical issue - Content Links Analysis of "Internal auditor" The problem that you face is whether to simply accept the present situation or to investigate further to determine whether the petty cashier is abusing the petty cash system. Since she asked you to postpone the count and the money in the fund consists of new $20 bills, you might conclude that she was borrowing the money for personal use. However, that may or may not be true. It may be that the cashier has been "borrowing" money from the account, which would be a real reason for concern. Or it may simply be that the recent reimbursement was for $180, which was received in sequentially numbered bills from the bank. You should therefore conduct an investigation into these occurrences. Then, according to what the investigation reveals, you may or may not comment on the potential problem in your report. Your investigation should go beyond a count of the cash on hand to determine what has occurred in the past. Has the petty cashier been providing suitable documents in support of their reimbursement requests? If the answer is "yes," there is probably no problem. On the other hand, if the answer to the question is "no," then you certainly have a reportable case that the cashier s supervisor should know about. If the cashier has borrowed the cash for personal use and reimbursed it only when a count was to take place, she may do it again. An important point is that while unethical behaviour is usually disguised, the cover-up may be very thin. An auditor should be aware of potential problem areas and how they might be disguised. However, you should not conclude that a person has been unethical without adequate evidence. To comment on the events in a report to management is to act only on suspicion; only facts based on objective evidence should be part of a report. There may be a plausible explanation for the sequential bills. Remember that you must assume others are innocent until proven guilty! However, to disregard the matter might be considered irresponsible. The situation should be investigated further by scrutinizing past petty cash reports, questioning the cashier about the current state of affairs, and performing a surprise review of the petty cash box in the near future.

8 Page 8 of 40 As an internal audit trainee, there is a lesson that can be learned. Your supervisor s instructions were to conduct surprise audits. Unfortunately, in agreeing to return at a later time, the element of surprise was removed from the audit. Did this provide the cashier with the opportunity to replace any missing cash? Or were there nine sequentially numbered $20 bills in the petty cash box when you first arrived? You may never know. 6.5 Reconciling the bank balance Learning objective Prepare a bank reconciliation and explain its purpose. (Level 1) Required reading Chapter 9, pages LEVEL 1 Good internal control practice requires that cash be deposited daily and payments be made by cheque. Banks produce chequing account statements, which provide a separate and external record of all cash transactions. These statements can be used to prove the cash balance in the company s own records. Bank statement At least once a month, banks provide a statement to each client. Refer to Exhibit 9.5 on page 461, which shows the cash withdrawals, cash deposits, and their effects on the balance of VideoBuster s cash account as recorded by the bank. A bank statement is comparable to a ledger account that shows a beginning balance, debits, credits, and an ending balance. Cheques and other deductions are shown as debits; deposits and other additions are reported as credits. When you deposit money with a bank, the bank credits your account because the bank s liability has increased. The increase side for a liability is the credit side. Cancelled cheques and debit or credit memoranda that have affected the account are included with the bank statement.

9 Page 9 of 40 Debit memoranda represent deductions for service charges, uncollectible deposits (NSF cheques), errors, withdrawals through automatic teller machines (ATM withdrawals), and periodic payments arranged in advance by the depositor. Credit memoranda are used for correction of errors and collections for the depositor, such as notes receivable and interest earned. Pages of the text provide an in-depth, illustrated explanation of the steps required to properly reconcile the bank balance. Textbook activities Checkpoint question 7 on page 460 and questions 8 to 12 on page 467 (Solutions on page 469) Quick Study 9-6 to 9-9 on pages (Solutions) Demonstration Problem on pages Before you attempt to solve the question, carefully review the "Planning the Solution" section on page 471. Also, follow the steps set out on page Using the information Acid-test ratio Learning objective Calculate the acid-test ratio. (Level 2) Required reading Appendix 9A, page 472 LEVEL 2 The acid-test (quick) ratio, like the current ratio, assesses a company s liquidity. The current ratio attempts to capture a company s ability to pay its obligations when due, through comparing its current assets to its current liabilities. The quick ratio is a more stringent evaluative tool, however, because it excludes both inventory and prepaid expenses from the numerator. These assets are omitted because the acid-test recognizes that 1. prepaid expenses represent assets that will be used up during the year rather than be converted to cash, and 2. converting inventory to cash may be a lengthy process because it frequently involves a two-stage process first it must be sold, and then the resultant receivable must be collected. Exercise 9-13 on page 480 illustrates how the current ratio and acid-test ratio are applied. The Exercise asks

10 Page 10 of 40 you to calculate the acid-test ratio. Calculate the current ratio as well. Click on the solution to check your answer. Textbook activities Checkpoint question 13 on page 473 (Solution on page 473) Quick Study 9-10 on page 476 (Solution) 6.6 Using the information - Acid-test ratio - Content Links Solution to acid-test ratio and current ratio The current ratio and acid-test ratio are calculated as follows (rounded to two decimal places): Both the current ratio and the acid-test ratio indicate that of the three cases, Case Y is best able to meet current debt with existing assets. 6.7 Investments held for the short term Learning objective Describe and identify debt and equity investments and their classification. (Level 1) Required reading Chapter 18, pages

11 Page 11 of 40 LEVEL 1 Introduction to investments Management has a responsibility to ensure that the business has an appropriate amount of cash on hand. Too much idle cash on hand is a waste of the company's resources because money on deposit in a chequing account typically earns little or no interest. Too little cash at hand can have severe repercussions if, for example, employees walk off the job when they are not paid on time. To ensure that "the right amount" of cash is at hand, companies use a budgeting process to estimate their cash inflows and outflows during each period. (You will study budgeting in the management accounting and finance courses in the CGA program of professional studies.) One way of employing idle cash is to put the cash in investments. Corporations frequently purchase debt and shares of other corporations. These are called intercorporate investments. A debt investment (or debt security) such as a bond represents an amount owed and arises when one company lends money to another. A share investment (or equity security) represents one company's purchase of the shares in another company. The company that purchases as an investment the debt or shares of another is called the investor, and the company whose debt (that is, bonds) or shares (common or preferred) are being purchased is called the investee. For instance, if you own shares in WestJet, then you are the investor and WestJet is the investee. Investments can be held by the investor for the short term (less than one year), or for the long term (more than one year). The focus of this topic is on investments held for the short term. To understand which investments fall into this category, you must review the various types of investments. There are two broad categories of investments: passive and strategic. A passive investment is one where the investor cannot significantly influence or control the operations of the investee company. The primary objective of these investments is to earn a return on price fluctuations of the debt or equity securities and the secondary objective is to collect interest or dividends. A strategic investment has occurred when the investee is controlled by, significantly influenced by, or in a joint venture with, the investor. The investor's goal with these investments is to absorb a major competitor or major customer, or realize efficiencies by investing in a supplier, or participate in new markets or technologies, along with other reasons of a strategic nature. Classification of investments is based on whether they are passive or strategic. Passive investments can be classified into three types: Held-for-trading investments or trading investments are the shares or debt of another corporation purchased by the investor for the short term. This group of securities is traded actively, which means there is frequent buying and selling. Profits may be realized from trading investments primarily because of short-term changes in price 1 and secondarily through receipt of dividend or interest revenue. Held-to-maturity investments are debt securities such as bonds, where interest and principal payments are specified along with the maturity date. The investor's intent is to hold these investments until maturity. An investment in shares cannot be a held-to-maturity investment because shares do not have a maturity date. Available-for-sale investments, according to the CICA Handbook, are investments in the shares or debt of another corporation but are not trading investments or held-to-maturity investments. Strategic investments include the following three categories:

12 Page 12 of 40 Significant influence investments occur when the investor can affect the strategic operating, investing, and/or financing policies of the investee. The general rule for determining significant influence is that it exists if 20% to 50% of the investee's shares are held by the investor. 2 This is a general rule because an owner with 40% ownership could have no influence if all of the other shares are held by one owner. A control investment exists when the investor owns sufficient shares to determine the investee's strategic operating, investing, and financing policies without the cooperation of others. 3 Again, the general rule is that control exists when greater than 50% of the shares are owned by a single investor. A joint venture investment is where two or more venturers jointly control the resulting economic activity. For example, the Syncrude Project is a joint venture producing crude oil within the Athabasca Oil Sands Region. Its venturers include those shown in Exhibit 18.1 on page 897 with corresponding co-ownership interests. During 2004, Syncrude generated revenues of $4.57 billion. The focus of FA1 will be on trading investments, listed on the balance sheet as a current asset. Held-tomaturity and available-for-sale investments could also be current assets depending on the circumstances, but the accounting for these, as well as for strategic investments, will be covered in intermediate and advanced Financial Accounting courses. Textbook activities Checkpoint questions 1, 2, and 3 on page 897 (Solutions on page 911) Quick Study 18-1 and 18-2 on page 919 (Solutions) 1 CICA Handbook, paragraph , effective October Ditto. 3 Ditto. 6.8 Accounting for trading investments Learning objective Journalize entries to account for trading investments, including their purchase, the collection of interest and/or dividends, the sale and resulting gain/loss, and appropriate valuation adjustment on the balance sheet date. (Level 1) Required reading Chapter 18, pages LEVEL 1 Purchase of equity investments Review the example on page 898 regarding the purchase of the Cameco Corporation equity investment. Then try the following textbook activities.

13 Page 13 of 40 Textbook activities Checkpoint question 4 on page 901 (Solution on page 911) Quick Study 18-4 on page 919 (Solution) Purchase of debt investments Review the example on pages regarding the purchase of the Power Corp. debt investment. Then try the following textbook activity. Textbook activity Quick Study 18-3 on page 919 (Solution) Balance sheet presentation of trading investments Review the example on pages regarding the valuation adjustment and subsequent balance sheet presentation of the Cameco equity investment and Power Corp. debt investment. Then try the following textbook activities. Textbook activities Checkpoint question 5 on page 901 (Solution on page 912) Quick Study 18-5, 18-6, and 18-7 on page 920 (Solutions) Sale of trading investments Review the example on pages regarding the sale of 200 shares of the Cameco equity investment. Then try the following reinforcement activity. Textbook activity Exercises 18-1 and 18-2 on pages (Solutions) Note: In Exercise 18-1, assume Aryee Corporation has a December 31 year end; prepare all related journal entries for Accounting for trading investments - Content Links

14 Page 14 of 40 Exercise 18-1 solution

15 Page 15 of 40 Calculations for Dec. 31/11 valuation adjustment: Trading investments Analysis component: Unadjusted balance at Dec. 31/11 Market values at Dec. 31/11 Difference Bates (40, % = 39,800) $ 38,968 $ 39,800 $ 832 Delta (25,000 $3.50 = 87,500) 80,000 87,500 7,500 Unrealized holding gain(loss) $118,968 $127,300 $ 8,332 If the adjusting entry on December 31, 2011 was not recorded, net income and assets would have been understated on the income statement and balance sheet, respectively. It would be worse to not record an Unrealized holding loss than an Unrealized holding gain because the Conservatism Principle states that net income and assets should never be overstated; it is better to understate than overstate, given that users of financial statement information are relying on them.

16 Page 16 of 40 Exercise 18-2 solution Calculations for Dec. 31/11 valuation adjustment:

17 Page 17 of 40 Unadjusted Trading investments balance at Dec. 31/11 Market values at Dec. 31/11 Difference Regina (25,000 $0.95) $ 21,250 $ 23,750 $ 2,500 Yates (136, %) 139, ,040 (960) Tech (75,000 $5.50) 450, ,500 (37,500) Unrealized holding gain(loss) $610,250 $ 574,290 $(35,960) Analysis component: The dividends would have been credited to the investment account instead of being recognized in net income. The net effect on the balance sheet regarding this single transaction would have been zero had the investment been classified as a significant influence investment (cash would have increased and investments would have decreased = net effect of 0). Net income is higher with the investment classified as a trading investment (cash would have increased and equity would have increased because of an increase in net income). 6.9 Credit customers and bad debts Learning objective Prepare entries to account for transactions with credit customers, including accounting for bad debts under the allowance method and the direct write-off method. (Level 1) Required reading Chapter 10, pages LEVEL 1 Many businesses extend credit terms to their customers for a short period to facilitate the purchase of their goods or services. Goods and services sold under this type of arrangement are sold on account and give rise to a current asset called accounts receivable. Accounts receivable represent the purchaser s promise to pay for the goods or services at a later date. The value of accounts receivables is uncertain, though, because some customers do not pay what they owe. The uncollectible accounts are known as bad debts; the cost of selling to these customers is called bad debt expense. From an accounting perspective, bad debt expense must be properly matched to the period in which the related revenue was recognized. The text sets out the methodology for estimating and recording bad debt expense on pages Supplemental information follows. Maintaining a separate account for each credit customer The Accounts receivable account in the general ledger provides a running total of the amount due, in

18 Page 18 of 40 aggregate from all customers. It is known as the accounts receivable control account. A supplementary record, called the accounts receivable subsidiary ledger, is typically established to keep track of the separate amounts due from each credit customer. Every time an entry is posted to the Accounts receivable account in the general ledger, it must also be posted to the underlying subsidiary account. This process is illustrated in Exhibits 10.2 to 10.4 on page 505. Before making a decision whether or not to extend a line of credit to customers, the credit worthiness of customers should be evaluated based on discussions with the company's management. The following can be done: review the customer s financial statements make enquiries with other creditors review credit reports issued by companies who provide credit-rating services Once a credit limit has been established, the customer s credit worthiness should be reviewed on an ongoing basis. Maintaining a separate record for each customer that you have extended credit to is an essential step in ensuring that tight control is kept over the accounts receivable portfolio. These documents would typically include information such as name, address, and phone number of the customer, including a contact name the maximum amount of credit to be extended to the firm and the terms of repayment a record of all transactions, including purchases, returns, payments, and the outstanding balance owed on account Remember that a subsidiary ledger is not part of the general ledger; rather, it represents the details of one account within the general ledger account. Subsidiary ledgers may be set up for other general ledger accounts as well, such as accounts payable, merchandise inventory, and capital assets. Allowance method of accounting for bad debts The allowance method estimates the total bad debts that are expected to result from the current period's sales and records the expense during the same period as the related sale (matching principle). Also, the accounts receivable appear on the balance sheet at the amount of cash proceeds that are expected from their collection, which is known as their realizable value (conservatism principle). This balance sheet presentation is illustrated in Exhibit 10.8 on page 508. The Allowance for doubtful accounts (AFDA) is a contra asset account. AFDA is credited, rather than Accounts receivable, because at this point, you do not yet know which customers will not pay. Recall that the accounts receivable subsidiary records must agree to the control account. Hence, you cannot arbitrarily reduce the control account balance because you do not yet know which customer account(s) to write off. Writing off a bad debt Under the allowance method, the bad debt expense is recorded in the year of sale. A contra asset account is used because the specific accounts that will be uncollectible are not yet known. When the specific account that is uncollectible is determined, it must be removed from Accounts receivable (by crediting Accounts receivable). In addition, because the allowance account represents estimated uncollectible accounts receivable, the known uncollectible account must be removed from AFDA (by debiting AFDA). This process and the resultant impact on the related balance sheet accounts are illustrated in Exhibits and on page 509. Note how writing off an account against AFDA does not affect the total estimated

19 Page 19 of 40 realizable value (net book value) of Accounts receivable. It is unlikely that the accounts written off during an accounting period will equal the allowance provided for bad debts because actual results seldom match estimates. As a result, the allowance account may have a credit or debit balance prior to adjustment at year end. 1 A debit balance in the allowance would indicate that write-offs during the period were greater than what was allowed for; a credit balance would mean that writeoffs were less than that estimated. It is important that you do not go back and change your prior year s financial statements to account for this discrepancy. Rather, changes in estimates are dealt with prospectively or going forward. Bad debt recoveries Generally, accounts are not written off until all avenues of collection have been exhausted. When a subsequent collection is made, the account is reinstated by debiting Accounts receivable and crediting AFDA and the receipt is recorded by also debiting Cash and crediting Accounts receivable. Two entries are recorded rather than simply debiting Cash and crediting Allowance for doubtful accounts to ensure that the integrity of the subsidiary ledger is maintained. The Mar. 11 entries at the top of page 510 illustrate the two entries that are required. Textbook activities Checkpoint question 1 on page 507 and questions 2 to 5 on page 511 (Solutions on page 524) Quick Study 10-1 to 10-5 on pages (Solution) Estimating the amount of bad debt expense The text sets out the two prevalent methods for estimating the required balance of the Allowance for doubtful accounts: 1) the income statement method, and 2) the balance sheet method. You should be familiar with both methods and note the different approach used by each. Income statement method The income statement method, commonly referred to as the percentage of sales method or the percentage of credit sales method, calculates bad debt expense as a function of sales made in credit. The pre-existing balance in the allowance account is not directly considered in this calculation. Exhibit on page 515 presents a summary of the methods to estimate bad debts and the focus of each. Balance sheet method The text outlines two variants of the balance sheet approach: the simplified balance sheet method and the aging of accounts receivable method. The aging of accounts receivable method is the preferred variant. This involves 1) preparing an aging schedule, which classifies outstanding accounts receivable in terms of how long each has been outstanding; 2) applying a percentage to each class to estimate the amount of total receivables due that will not be collected; and 3) comparing this estimate to the pre-existing balance in the allowance account and passing a journal entry for the difference.

20 Page 20 of 40 The aging of accounts receivable method emphasizes the net realizable amount of the Accounts receivable. The amount calculated to be uncollectible is the amount needed to reduce the total accounts receivable to the estimated realizable value. The Allowance for doubtful accounts is adjusted to the desired balance. Exhibit on page 515 presents a summary of the methods to estimate bad debts and the focus of each. Textbook activities Checkpoint question 6 on page 515 (Solution on page 524) Quick Study 10-6 to 10-9 on page 534 (Solutions) Direct write-off method of accounting for bad debts An alternative to the allowance method is the direct write-off method, in which bad debt expense is recorded when an account is determined to be uncollectible. No adjusting entry is recorded at the end of the period to estimate uncollectibles. While this method contravenes the matching principle, it can be used if the amounts involved are immaterial. The materiality principle holds that strict adherence to any accounting principle, such as matching, is not required when the financial statements are not materially affected. Textbook activities Checkpoint question 7 on page 516 (Solution on page 524) Quick Study on page 534 (Solution) Judgement Call on pages 506 and 516 (Solutions on page 523) Mid-Chapter Demonstration Problem on pages The allowance account cannot have a debit balance after the adjusting entries have been made. If it did, the net book value of accounts receivable would be more than what is entitled to be collected Promissory notes Learning objective Calculate the interest on promissory notes and prepare entries to record the receipt of promissory notes and their payment or dishonour, along with the end-of-period adjustments. (Level 1) Required reading Chapter 10, pages LEVEL 1 Notes receivable are explained on pages Supplemental coverage follows. Creditors prefer notes receivable (written promise) to accounts receivable (oral promise) for the following reasons: