Week 5| Cash, Bank reconciliation, revenue recognition and receivables

Question 1

Why is cash the most desirable asset?

Answer 1

Cash is the most desirable asset because it is readily convertible into any other asset.

Cash consists of:

• cash on hand (notes and coins)
• cash at bank (savings accounts and everyday transaction accounts)
• cash equivalents (bank overdrafts, deposits on money market, 90-day bank acceptance bills)

Question 2

How does the use of a bank contribute significantly to good internal control over cash?

Answer 2

It does this through:

• minimising the amount of cash that must be kept on hand
• providing a double record of al bank transactions:
  1. one by the business
  2. one by the bank
• helping a company safeguard its cash by using a bank as a depository and clearinghouse for EFTS received and written

Question 3

Reconciling the bank account involves comparing the bank’s records and the firm’s bank ledger account. What are the two main reasons for lack of agreement between firm’s books and bank statement?

Answer 3

1. Timing differences occurs when the parties record the same transaction in different periods:
   - Outstanding EFTs - lag between when the EFT is requested and recorded by the business and is paid by the bank
   - Outstanding deposits - lag between when receipts are recorded by the business and when recorded by the bank
2. Errors by either party in recording transactions (introduction to auditing)

Question 4

A firm’s bank balance (receipts minus payments) is $5620. BUT….. the bank statement shows the balance is $5600.
A reconciliation reveals the bank has deducted $20 as a bank fee. So the bank fee must be added to the firm’s records

Why should we compare balance in the accounting periods to the bank statement?

Who should prepare the reconciliation?

Answer 4

We should compare in the accounting records (cash receipts and cash payments) to the bank statement balance to reconcile and make adjustments to correct balances.

For internal control purposes the reconciliation should be prepared by an employee who has no other responsibilities pertaining to cash

Question 5

What are the steps in the reconciliation procedure?

Answer 5

1. Compare current bank statement to:
   a) Previous month’s bank reconciliation and
   b) Current month’s cash receipts and cash payments journal

tick items that match
correct errors in cash books
bank statement errors added to bank reconciliation’

2. a. Identify ‘unticked’ items on bank statement:
   - Adjust cashbook for direct deposits and own errors

b. Examine cash journals and unticked items (outstanding deposits and EFTs)
- List in bank reconciliation

c. Unticked items from opening reconciliation are carried forward to current bank reconciliation
3. Total cash journals and post to Cash at Bank ledger

4. Complete bank reconciliation:
   - Outstanding deposits increase the bank account
   - Outstanding EFTs decrease the bank account

(Adjusting bank balance should equal the balance of the Cash at Bank account)

Question 6

What is the definition of revenue? What is the definition in the conceptual framework for it?

Answer 6

Revenue is the Income arising in the course of an entity’s ordinary activities

Conceptual framework: Income is the increase in economic benefits during the accounting period in the form of inflows or increases in assets or decreases in liabilities that result in increases in equity - other than those relating to the contributions from equity participations.

Question 7

How to recognise revenue using the recognition criteria?

Answer 7

Revenue recognition: Revenue is recognised when it is probable that future economic benefits will flow to the entity and these benefits can be measured reliably

On many occasions firms have been too keen to recognize revenue too early

Note: Revenue (and expenses) are distinct from gains (and losses) from the sale of assets

Question 8

List the five steps in the framework to identify when revenue should be recognized - applies to both goods and services

Answer 8

1. Identify the contract with a customer - both agree
2. Identify the performance obligation - cleaning contract
3. Determine the transaction price and terms - part payment
4. Allocate the transaction price to the performance obligation in the contract
5. Recognise revenue when entity satisfies the performance obligation (the G&S have been exchanged) and high probability of payment

Question 9

Revenue should be recognized when the performance obligation has been completed, but in what instances may that be be violated?

Answer 9

Sale of goods:
Case study 2:
Goods shipped subject to conditions of installation and inspection
Response:
Revenue is normally recognized when the buyer accepts delivery, and installation and inspection are complete. For example, installation of ducted heating.
Performance obligation is for delivery; installation and inspection…… Delivery alone is not sufficient

Question 10

Case study 2:
Goods shipped subject to conditions of installation and inspection
Response:
Revenue is normally recognized when the buyer accepts delivery, and installation and inspection are complete. For example, installation of ducted heating.
For the case study above, list the corresponding five steps of the revenue recognition criteria

Answer 10

1. Identify contract with customer:
   Contract exists- as per invoice
2. Identify the performance obligation (s):
   Seller to deliver, install and to be inspected afterwards
3. Determine price and terms:
   Agreement to price and conditions
4. Allocate price to performance obligation:
   Price allocated to each performance obligation
5. Performance obligation(s) satisfied:
   Entity to collect consideration on completion of contract- control passes to buyer… payment to be made

Question 11

What happens to step 3 of the revenue recognition criteria when goods have been supplied to a buyer but subject to a right of return? AASB 15 Para B20-27

Answer 11

step 3: the terms of the contract specify a right of return so, until the right of return expires the revenue from the sale cannot be recorded

Record two entries:

1. An Account receivable and cost of sales; AND
2. A refund liability for the amount expected to be refunded

Question 12

When goods have been supplied to a buyer but subject to a right of return. $1000 sales; cost $500; estimated 10% likely return

Answer 12

At the time of sale
1. Dr Cash/Acc Rec $1000 Credit Sales $1000
Dr Cost of sales $500 Cr Inventory $500

2. Dr Sales $100 Cr liability-Customer refund $100
   Dr Asset-est.
   Inventory returns $50 Cr. Cost of Sales $50

Question 13

When goods have been supplied to a buyer but subject to right of return, $1000 sales; cost $500; estimated 10% likely return.

Answer 13

The general journal entries are:

On return of the goods:
Dr Liability- Customer refund $100 Cr Cash $100
Dr Inventory $50 Cr Asset- Est
Inventory returns $50

Note: Under the perpetual inventory method the sale price and the cost price must be recorded for every transaction as well as the anticipated return.

Question 14

Orders when payment (or partial payment) is recieved in advance of delivery for goods (or services) not presently held in inventory, for example the goods are still to be manufactured (or performed) or will be delivered directly to the customers from a third party (e.g. gym equipment)
How is revenue recognised from this?

Answer 14

Revenue is recognised when the goods (or services) are delivered to the buyer…. i.e. satisfying the performance obligation

Question 15

Bob’s Billiards Ltd sells a pool table to Spike’s Bar on December 31
for $5,000. The pool table was not paid for until January 15 and it
was not delivered to Spike’s Bar until January 31.
According to the 5 step revenue recognition principle, Bob’s Billiards
should not record the sale in December.

Should revenue be recognized?

Answer 15

Even though the cash payment of $5,000 was made on January 15,
the performance obligation was not completed, so revenue was not
earned until January 31 when the pool table was delivered.

Question 16

Case study: Contract is for item and service- example mobile phone contract

Answer 16

Response:
Revenue is recognized in 2 parts:
a) the value of the item (mobile phone); and
b) on a periodic basis when service is delivered to the customer

Question 17

Contract is for good and service - mobile phone contract

Answer 17

1. Identify the contract(s): Contract for sales item and service exists- 2 separate contracts
2. Identify the performance obligation(s): seller to supply a mobile phone
   seller to provide contract for service
3. Determine price and terms: Price to be broken into separate parts - one for supply of good and one for service
4. Allocate price to performance obligation(s): Price allocated to each performance obligation
5. Performance obligation satisfied:
   Entity to record revenue on satisfaction of separate performance obligations

Question 18

Long terms contracts, AASB 15 Revenue recognition-an example: consider long term contract such as ship or tollway construction.
How is revenue recognised? How is the stage of completion measured and the costs incurred

Answer 18

Revenue is recognised by reference to the 5 steps which may identified via the stages of completion of the transaction at reporting dates and the performance obligations can be identified reliably

Determine the amount of revenue that can be measured reliably…. Separate the parts of the contract

The stages of completion (eg. Work in progress or percentage estimate) of the transaction can be measured reliably at reporting date; and if have they met specific performance obligations

The costs incurred for the transaction and costs to complete the transaction can be measured reliably according to the separate performance obligations.

Question 19

What are the advantages and disadvantages of offering credit terms?

Answer 19

advantages:
- increase sales
- streamline the sales process (greater convenience)

Disadvantages:
- risk of non-payment - over valuation of assets

Question 20

Why are sales discount offered? What does sales discounts reduce? What may it be classified as?

Answer 20

Sales discounts are offered as incentives to customers to pay before the typical 30 day term

Sales discount reduces the actual price for inventory, hence reducing the eventual net sales revenue

May be classified as a contra revenue (or sometimes as a selling expense)

Question 21

What are the definitions for accounts receivable, notes receivable and other receivables?

Answer 21

Accounts receivable (Trade receivables): are amounts owed by customers on account/invoice

Notes receivable/Promissory notes: are claims for which formal instruments of credit are issued evidencing the debt

Other receivables: include non-trade receivables such as interest receivable, loans, advances and GST receivable.

The Balance sheet may group all types of receivables under the one heading - disaggregated in the Notes

Question 22

What are the three accounting problems associated with accounts receivable?

Answer 22

1. Recognising account receivable (related to recognition of revenue issues)
2. Valuing accounts receivable at balance date
3. Accelerating cash receipts from receivables (i.e. collecting the cash)

Question 23

At the end of an accounting period, entities are required to estimate amount of accounts receivable that is not likely to be collected . What do they estimate from there on? (what time should account receivables be recorded?)

Answer 23

The entity shall recognise an allowance or provision for a lower amount if it is below its original recorded value

If so, then the entity shall estimate the amount of allowance or provision for the uncollectable value of the asset.

Hence, Receivables are required to be assessed at the end of an accounting period for any possible loss in value

Question 24

What are the two ways of accounting for uncollectible receivables/debts? (What accounts would we debit and credit?)

Answer 24

There are 2 methods for accounting for uncollectible debts:
1. The Direct Write Off Method- write off bad debts as they occur… Ok so sole traders or partnerships
Bad debts expense is recognised when the uncollectible account is specifically identified and written off against the Account receivable

Receivables are reported at gross amount in the Balance Sheet
Dec 12 Bad Debts Expense 200
Accounts Receivable 200
(To record write-off of account not going to be paid)

2. The allowance method- make an adjustment in anticipation of future bad debts (preferred) … AASB requirement for companies
   - Receivables reported at their “recoverable amount”
   - Accounts Receivable are reduced by estimated loss in value (i.e. the amount of the estimated uncollectable loss of value)

• Example- extract from Balance Sheet

Accounts receivable 3,000000
Less Allowance for Doubtful Debts 10000
Net Accounts receivable 2990000

Question 25

Regarding allowance method, what does it use to offset Accounts Receivable? What is recorded in the income statement?

Answer 25

The method uses a contra asset to offset accounts receivable

This contra item is subtracted from the Accounts Receivable account in the Balance Sheet to show ‘Net Receivables’

An expense (relating to the estimation of the allowance) is disclosed in the Income statement as Bad or Doubtful Debts Expense

In the subsequent period when bad debts occur they are written off against the allowance and the accounts receivable

The allowance method attempts to match the revenue and the expense whereas the direct method does not.

Question 26

Example of recording doubtful debts from accounts receivable

Answer 26

Recording an estimated uncollectable amount by the allowance method - statement of financial position at the end of December.
Example:
Hampson furniture LTD
Statement of Financial position (partial)
Current Assets
Cash $14800
Accounts receivable $200000
Less: Allowance for doubtful debts $12000 $188000
Inventory $310000
Prepaid expenses 25000
Total current assets 537800

Question 27

Over the first year of his business Todd sold many of his goods on credit and at the year’s end customers owed $240000. (Accounts receivable at year end $240000). How will this be recorded?

Answer 27

Dec 31 Doubtful Debts Expense 12000
Allowance for doubtful debts 12000

(To record estimate of uncollectable accounts)

Question 28

During August in Year 2 Todd realised bad debts of $10,000. The
journal entry is to credit Accounts receivable and debit the Allowance
account. The debit to the Allowance account is a recognition that the
an estimated bad debt did, in reality, turn out to be uncollectable, so
it is no longer an estimated doubtful debt.

Answer 28

Aug 31 Allowance for Doubtful Debts 10 000
Accounts Receivable 10 000
(To record bad debts and reduce the allowance of
uncollectable accounts)

Question 29

At the end of Year 2 Todd must assess the balance of the Accounts
Receivable (now $300,000) and he estimates that: $20,000 are possibly
uncollectable. What is the journal entry to balance the account at the end of
year 2?

Answer 29

Dec 31 Allowance for doubtful debts closing Bal Yr 12 20000
Allowance for doubtful debts opening Bal Yr 3 20000

(To record estimate of uncollectable accounts at end of year 2)
This closing entry is made at the end of the accounting period to carry forward (as a negative asset) the estimate of the uncollectable amount of the accounts receivable AND at the same time to determine the amount to be recorded as Doubtful Debt expense for the Income statement (the balancing item)

Question 30

What is the allowance for doubtful debts method? (across year 1 and 2?)

Answer 30

1. At end of Yr 1 assess Receivables for fair value –record in Allowance account
2. During next period (Yr 2) record actual bad debts and reduce the Allowance account
3. The Allowance account will have a debit or credit balance prior to end of Yr 2
4. At end of Yr 2 assess receivables for fair value or recoverable amount – record the
   estimate uncollectable amount as closing balance Yr 2 and opening balance Yr 3
5. The balance of the Allowance account (on the credit side) is the Doubtful Debt Expense
   for Yr 2
6. The Doubtful Debt expense account is debited and cross-referenced to the
   Allowance for Doubtful Debts account.
7. The Doubtful Debt expense account is closed to the Income Summary a/c

Question 31

What are the two common ways of estimating allowance for doubtful debts?

Answer 31

Using the allowance method requires an estimate of the recoverable/ fair value and hence, the debts expected to be doubtful (uncollectible)

The 2 most common methods are:
1. The percentage of sales method
an allowance is raised as a % of a business’s credit sales or accounts receivable. Example 2% of gross or net sales or accounts receivable

A simple method which does not analyse the probability of collection of debt from accounts receivable

2. The ageing method
   An allowance is raised based on an aged analysis of the accounts receivable/debtors

A more diagnostic method of analysing the probability of collection

Question 32

If credit sales are offered, what techniques will managers use to monitor the level of risk?

Answer 32

-Perform credit checks on potential customers
-Monitor and follow up slow paying customers
offer discounts for prompt payment (or cash sales)
- withhold further credit from (and charge interest to) overdue customers

• The receivables turnover may also be calculated as a measure of managerial effectiveness

Question 33

How to manage receivables?

Answer 33

1. Determine to whom to extend credit
   A firm needs to be careful that it does not end up with risky customers as a result of extending its credit policy
2. Establish a payment period
   The payment period should be consistent with that of the firm’s competitors
3. Monitor collections
   Credit risk ratio: measure of the risk that customers may not pay their accounts

Credit risk ratio: allowance for doubtful debts/ accounts receivable

4. Evaluate the receivables balance
   a) Receivable turnover: number of times per year on average receivables are collected
   b) Average collection period:
   convert ‘times’ to days by dividing the receivable turnover into 365
   Average collection period= 365/(receivables turnover)
5. Accelerate cash receipts from receivables when necessary
   Note: An account receivable is similar to an interest free loan

a. Sale of receivables (Debt factoring)
Reasons for sale:
- size of debt
- being the only reasonable source of cash
- to reduce cost of invoicing and collection

b. Use of credit cards for sales
Translates to more sales without bad debts for the retailer - but at a small cost

Question 34

Basic principle of cash management

Answer 34

1. Increase the speed of collection of receivables
2. Keep inventory low
3. Don’t pay earlier than necessary
4. Plan timing of major expenditures
5. Invest idle cash

Question 35

What are subsidiary ledgers? What are the 2 common subsidiary ledgers?

Answer 35

Subsidiary ledgers are groups of accounts with a common characteristic
Details from subsidiary ledgers are summarised in the general ledger control account

2 common subsidiary ledgers are:

• accounts receivable (customers) which collects transaction data of individual customers
• accounts payable (suppliers) which collects transaction data of individual creditors

Question 36

What are the advantages of subsidiary ledgers?

Answer 36

1. Shows transactions in a single account providing up to date information
2. Free the general ledger of excessive details
3. Provide for segregation of duties
4. Provide effective control