ACCT 335 Chapter 7 Pre-Assigned Problems Suggested Solutions

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1 ACCT 335 Chapter 7 Pre-Assigned Problems Suggested Solutions PROBLEM 7-2 (a) Sales $1,980,000 Sales discounts 4,400 Sales returns and allowances 60,000 Net sales 1,915,600 Percentage 1 1/2% Bad debt expense $ 28,734 (b) Accounts receivable $1,790,000 Amounts estimated to be uncollectible (160,000) Net realizable value $1,630,000 (c) Allowance for doubtful accounts 1/1/10 $37,000 Establishment of accounts written off in prior years (recovery) 18,000 Customer accounts written off in 2010 (36,000) Bad debt expense for 2010 ($3,200,000 X 4.5%) 144,000 Allowance for doubtful accounts 12/31/10 $163,000 (d) Bad debt expense for 2010 $92,000 Customer accounts written off as uncollectible during 2010 (24,000) Allowance for doubtful accounts balance 12/31/10 $68,000 Accounts receivable, net of allowance for doubtful accounts $ 950,000 Allowance for doubtful accounts balance 12/31/10 68,000 Accounts receivable, before deducting allowance for doubtful accounts $1,018,000 (e) Accounts receivable $610,000 Percentage 7% Allowance for doubtful accounts (ending bal.) 42,700 Allowance for doubtful accounts (debit bal.) 34,000 Bad debt expense $ 76,700

2 PROBLEM Cash 137,200 Sales Discounts 800 Accounts Receivable 138, Accounts Receivable 6,700 Allowance for Doubtful Accounts 6,700 Cash 6,700 Accounts Receivable 6, Allowance for Doubtful Accounts 19,500 Accounts Receivable 19, Bad Debt Expense 16,500 Allowance for Doubtful Accounts 16,500 ($17,300 + $6,700 $19,500 = $4,500; $21,000 $4,500 = $16,500) PROBLEM 7-10 Part I (a) Cash 250,000 Accounts Receivable 215,000 Sales 465,000 Note Receivable 50,000 Accounts Receivable 50,000 Cash 160,000 Accounts Receivable 160,000 12/31 Interest Receivable 2,750 Interest Revenue 2,750 ($50,000 X 11% X 6/12)

3 (b) Current Ratio Dec. 31, 2010 = Current Assets Current Liabilities = ($15,000+$45,000+$2,750+$50,00 0+$80,000) $70,000+$16,000 = Current Ratio Dec. 31, 2009 = $20,000+$40,000+$85,000 $65,000+$15,000 = Accounts Receivable Turnover = Credit Sales Average Receivables = $215,000 ($45,000 + $40,000)/2 = 5.06 times (or about 72 days) Current Ratio of in 2010 is much higher than last year at Accounts Receivable turnover of 5.06 times is slightly higher than last year s While the current ratio is considerably higher, Logo is collecting receivables at close to the same pace, showing a slight improvement. Part 2 (c) Cash 50,904 Loss on Sale of Note Receivable 1,846 Note Receivable 50,000 Interest Receivable 2,750 ($50,000 X 11% X 6/12) = $2,750 ($50,000 + $2,750) X 3.5% = $1,846 $52,750 - $1,846 = $50,904 (d) Cash 36,000 Due from Factor 2,400 Loss on Sale of Accounts Receivable 5,600 Accounts Receivable 40,000 Recourse Liability 4,000 (e) Current Ratio = Current Assets Current Liabilities = $15,000+$50,904+$36,000 +$5,000+$80,000+$2,400 $70,000+$16,000+$4,000 = $189,400 $90,000 = 2.1

4 Accounts Receivable Turnover = Credit Sales Average Receivables = $215,000 ($5,000 + $40,000)/2 = 9.56 times (or about 38 days) Logo has been able to speed up collection of receivables by transferring the note to the bank and selling accounts receivable to First Factors and has improved the current ratio from to 2.1. (f) With a secured borrowing, the receivables stay on Logo s books and Logo records a Note Payable. This would reduce the current ratio and leave the receivable turnover ratio at approximately the same level as in Part I.

5 PROBLEM 7-17 Calculation of Cash Balance per Books General Chequing Account Cash balance, June 1, 2010 $30, Receipts for June: Deposit on 6/12 $1, Deposit on 6/23 1, Deposit on 6/28 4, Deposit in transit 4, , Cash available 41, Deduct disbursements per cheque register 11, Cash balance June 30, 2010 $30, Quartz Industries Ltd. Bank Reconciliation General Chequing Account June 30, 2010 Balance per bank statement June 30, 2010 $28, Add: Deposit in transit (June receipts not deposited by June 30) 4, , Deduct: Outstanding cheques #6139 $ # # # # , Correct cash balance $30, Balance per books, June 30, 2010 $30, Deduct: Bank charge not yet recorded in books Correct cash balance $30,162.45

6 WA 7-3 Note: This content is not examinable in ACCT 335 The controller of Arkin Corp. cannot justify the manner in which the company has accounted for the transaction in terms of sound financial accounting principles. The sale of shares appears to have been made March 1 and the company s yearend is March 31, To account for this note receivable, the company must address the following issues: Is the company a party to the contract at March 31? Yes, the deal appears to have been completed at March 1 and the company has a signed note receivable as proof. The loan receivable must be measured at its fair value initially March 1. In order to measure the loan receivable at fair value, the company must present value the expected future cash flows using a market interest rate that is appropriate for loans with a similar level of credit risk. This issue is discussed in further detail below. At each reporting date, March 31, the company will measure the loan receivable at amortized cost plus accrued interest; and At each reporting period, the company will have to test whether or not the loan receivable has been impaired and if so, an impairment loss is recognized. At March 1, the fair value of the note receivable must be determined. The note is repayable over 10 years with an annual payment of $400,000 on March 1. In looking at the market for similar credit risk investments, assume that an appropriate rate of interest would be 8%. Using the interest rate of 8%, the present value of the annuity of $400,000 for ten periods is equal to $2,684,032 ($400,000 X ). In this case, a loss of $315,968 must be recognized. There is a question about how the transaction fees should be reported. Are the transaction fees a cost of the disposal which increases the loss on disposal? Or are the transaction fees related to preparing the note receivable? In this case, to show as a possible solution, the full amount of the transaction fees was allocated to the note receivable. In addition, under IFRS, the transaction fees of $20,000 are also recorded as part of the receivable as illustrated by the following journal entry to be recorded March 1: Note Receivable 2,704,032 Loss on Disposal of Hi-Tek Shares 315,968 Investment in Hi-Tek Shares 3,000,000 Cash 20,000

7 On March 31, 2011, the company must record interest income for the period of one month. Under IFRS, the effective interest rate method must be used and the effective interest rate will have to be recalculated given that the present value is now $2,704,032. Based on this present value, and 10 annual payments of $400,000 each, the effective interest rate is 7.83%. Using this effective interest rate, the accrued interest for one month is: 2,704,032 X 7.83% X 1/12 = 17,643 Theoretically, the loan receivable should be tested for impairment at March 31. However, since the loan is only one month old, it is assumed that there is no impairment of value. Calculation of revised net income: Net income before net gain (5,200, ,000) 4,514,000 Loss on disposal assume a capital loss and no immediate tax benefit (315,968) Accrued interest income net of tax 17,643 (1-.3) 12,351 Revised net income 4,210,383 This amount is less than the net income reported in prior years of $4.8 million. Under private entity GAAP, there are two differences as follows: Transaction fees may be expensed and are not required to be capitalized The company may use a straight-line amortization method for the interest rather than the effective interest rate. Using the interest rate of 8%, the present value of the annuity of $400,000 for ten periods is equal to $2,684,032 ($400,000 X ). In this case, a loss of $315,968 must be recognized. The journal entry to record this on March 1 is: Note Receivable 2,684,032 Transaction costs 20,000 Loss on Disposal of Hi-Tek Shares 315,968 Investment in Hi-Tek Shares 3,000,000 Ca`sh 20,000

8 Using the straight-line method for the amortization of the interest, the total interest income reported over the total ten years will be: 10 X $400,000 2,684,032 = $1,315,968. The annual interest income to be recorded will be: $1,315,968/10 = $131,597. And the one month accrued interest income will be: $131,597 X 1/12 = $10,966. Calculation of revised net income: Net income before net gain (5,200, ,000) 4,514,000 Loss on disposal assume a capital loss and no immediate tax benefit (315,968) Transaction fees expensed net of tax (20,000 X (1-30%)) (14,000) Accrued interest income net of tax at 30%: 10,966 X (1-30%) 7,676 Revised net income 4,191,708 This amount is less than the net income reported in prior years of $4.8 million. IC 7-1 FRITZ S FURNITURE Overview: - Business down due to economic downturn. - Cash crunch and therefore plans to go to bank bank will assess creditworthiness and will lend based on value of inventory and receivables. The higher the inventory and receivables, the higher the loan. - As bookkeeper, you will want to provide Franklyn with the impact of choices in the financial statements. Franklyn will want to put his best foot forward to the bank to maximize his chances of getting the loan. - GAAP likely a constraint since bank will want information that is useful and relevant. The entity would generally use PE GAAP (although they have the option to choose IFRS when first adopted if that is more appropriate).

9 Analysis and Recommendations: Issue: Recognition of revenues under new sales promotion Recognize revenues when shipped - Possession and legal title pass at time of delivery therefore, risks and rewards pass. - Measurable = selling price of the inventory. - May consider discounting selling price and recognizing part of selling price as income from financing. - Other. Recognize revenues/income later - Since no cash down, no real risk to the customer. They do not have a vested interest in the merchandise. Is this a real sale? - Collectibility may be an issue since a credit check will be done a year before the customer actually starts to pay higher risk of default. - Other. In conclusion, it would seem more prudent to not recognize a sale until the revenue is earned. As an alternative, the sale might be recognized using the instalment sales method such that the sale is recognized but only as an instalment sale with profits being deferred. Discussion should be had with the bank to determine whether the instalment sale could be used as collateral for the loan. Issue: Transfer of receivables Present as a sale/disposition - FI is an arm s length party and will take legal title to the receivables therefore, a bona fide sale. - FI has the right to pledge or sell the assets and there is no repurchase agreement. This supports the fact that control has been surrendered to FI. - NB. if the credit cards are sold, the company might have to pay down some existing debt, since the debt is currently capped based on a % of credit card receivables outstanding (or may not be eligible for new financing from the bank since it is capped at 70% of credit card receivables). - Other. Present as financing - FF will retain possession of the receivables as well as service them. Therefore, the assets are not isolated from FF and control has not been surrendered. - May have recourse and therefore still has risks of ownership. - Other.

10 It would appear that this should be reported as a financing, i.e., as debt. The AR would be left on the books. The additional debt might affect the company s ability to obtain the financing from the bank. Note that this is an area of significant complexity and standard setters are currently looking to revise the standards.