5-1

CHAPTER 5

Accounting for and Presentation of Current Assets

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

5-2

Operating Cycle

An operating cycle is the average time it takes to convert an investment in inventory back into cash.

Merchandiseinventory

Purchases

Merchandiseinventory

Credit sales

Accountreceivable

CashcollectionPurchases

Cashsales

Cash SaleCash Sale Credit SaleCredit Sale

5-3

Inventories

Short-term Securities

Current assets include cash and those assets that are expected to be converted to cash or used up within one

year, or an operating cycle, whichever is longer.

What are Current Assets?

Cash Current Assetsinclude

Deferred Tax Assets

Accounts and Notes Receivable

Prepaid Expenses

5-4

Cash

Coins and paper money

Checking accounts

Money orders

Undeposited receipts

Petty cash funds

L O 1

Cash

includes. . .

5-5

Commercial paper

Cash Equivalents

U.S. Treasury securities

Bank certificates of deposit

Money market mutual funds

Cash Equivalents include. . .

L O 1

5-6

Cash Management Goals

Invest excess cash with minimal risk.

Assure the availability of adequate amounts of cash.

Avoid unnecessarily large amounts of idle cash.

Prevent theft and fraud.

Invest excess cash with minimal risk.

Assure the availability of adequate amounts of cash.

Avoid unnecessarily large amounts of idle cash.

Prevent theft and fraud.

L O 1

5-7

The Internal Control System

Internal Control Over Cash Require daily deposits.

Make all payments by check.

Promptly reconcile bank statements.

Internal Control Over Cash Require daily deposits.

Make all payments by check.

Promptly reconcile bank statements.

Internal control objectives are to ensure:

1. Effective and efficient operations.

2. Reliable financial reporting.

3. Compliance with applicable laws and regulations.

L O 2

5-8

Bank Statements

Beginning Bank Balance+

Deposits processed by the Bank-

Checks which have cleared the account+/-

Other adjustments made by the Bank=

Ending Balance

Bank Statement

L O 3

5-9

Bank Reconciliation - Objective

Identify Differences BetweenEnding cash balance reported on bank

statement

Compared toEnding cash balance in depositor’s

accounting records.

Provides information for reconciling journal entries.

L O 3

5-10

Bank Reconciliation Process

Balance per Bank

+ Deposits in Transit

- Outstanding Checks

± Bank Errors

Adjusted Balance

Balance per Depositor

+ Deposits by Bank

- Bank Adjustments

± Book Errors

Adjusted Balance

L O 3

End Result:Adjusted Bank Balance

=Adjusted Book Balance

=

5-11

Bank Reconciliation

All reconciling items on the

book side require an adjusting

entry to the cash account.

Balance per Depositor

+ Deposits by Bank (credit memos)

- Service Charge - NSF Checks

± Book Errors

= Adjusted Balance

L O 3

5-12

Bank Reconciliation

Prepare a July 31 bank reconciliation statement and the resulting journal entries

for the Simmons Company.

The July 31 bank statement indicates a cash balance of $9,610.

The cash ledger account balance is $7,430.

L O 3

Difference must be reconciled

5-13

Outstanding checks totaled $2,417. A $500 check mailed to the bank for deposit had not

reached the bank at the statement date. The bank returned a customer’s NSF check for $225

received as payment of an account receivable. The bank statement showed $30 interest earned on

the bank balance for the month of July. Check 781 for supplies cleared the bank for $268

but was erroneously recorded in our books as $240. A $486 deposit by Acme Company was erroneously

credited to our account by the bank.

Outstanding checks totaled $2,417. A $500 check mailed to the bank for deposit had not

reached the bank at the statement date. The bank returned a customer’s NSF check for $225

received as payment of an account receivable. The bank statement showed $30 interest earned on

the bank balance for the month of July. Check 781 for supplies cleared the bank for $268

but was erroneously recorded in our books as $240. A $486 deposit by Acme Company was erroneously

credited to our account by the bank.

Bank ReconciliationL O 3

5-14

Bank ReconciliationBalance per bank statement, July 31 9,610$ Additions: Deposit in transit 500 Deductions: Bank error 486$ Outstanding checks 2,417 2,903 Adjusted cash balance 7,207$

Balance per depositor's records, July 31 7,430$ Additions: Interest 30 Deductions: Recording error 28$ NSF check 225 253 Adjusted cash balance 7,207$

L O 3

Bank Records

=

Depositor records

5-15

Bank Reconciliation

GENERAL JOURNAL

Date Account Titles and ExplanationPR

Debit Credit

Jul 31 Cash 30

Interest Revenue 30

31 Supplies Inventory 28

Accounts Receivable 225

Cash 253

L O 3

5-16

Short-Term Marketable Securities

Bond Investments

Capital Stock

Investments

Current Assets

Almost As Liquid As

Cash

Readily Marketable

Marketable Securities

are . . .

L O 4

5-17

TradingTrading

Debt & Equity securities actively

traded

Debt & Equity securities actively

traded

Reported at market value

Reported at market value

Short-Term Marketable Securities

At the end of the period, remember to record interest earned but not yet received related to short-term

marketable securities.

L O 4

Available for Sale

Available for Sale

Debt & Equity securities not in the other two categories

Debt & Equity securities not in the other two categories

Reported at market value

Reported at market value

Market = Current Value of Investment

(May be higher or lower than original cost)

Held To Maturity

Held To Maturity

Debt securities held to maturity

Debt securities held to maturity

Reported at costReported at cost

Amount paid at time of purchase

5-18

Let’s turn our attention to accounts

receivable.

L O 5 Accounts Receivable

5-19

Uncollectible Accounts

If a company makes credit sales to

customers, some accounts inevitably will

turn out to be uncollectible.

If a company makes credit sales to

customers, some accounts inevitably will

turn out to be uncollectible.

PAST DUE

L O 5

5-20

Bad Debts/Uncollectible Accounts

At the end of each period, record an estimate of the uncollectible

accounts.

At the end of each period, record an estimate of the uncollectible

accounts.

Contra-asset accountContra-asset accountSelling expenseSelling expense

L O 5

5-21

Bad Debts/Uncollectible Accounts

There are two methods available for estimating bad debt expense:

1. Percentage of sales method (based on the collectibility of all credit sales for the period); or

2. Aging of receivables method (based on an estimate of the accounts receivable to be collected).

L O 5

5-22

Balance Sheet Presentation

Accounts receivableLess: Allowance for bad debtsNet realizable value of accounts receivable

The net realizable value is the amount of accounts receivable that the business

expects to collect.

L O 5

5-23

Writing Off an Uncollectible Account Receivable

When an account is determined to be uncollectible, it no longer qualifies as an

asset and should be written off.

When an account is determined to be uncollectible, it no longer qualifies as an

asset and should be written off.

L O 5

5-24

Assume that on January 5, K-Max determined that Jason Clark would not pay the $500 he

owes.

K-Max would make the following entry.

L O 5 Writing Off an Uncollectible Account Receivable

5-25

Assume that before this entry, the Accounts Receivable balance was $10,000 and the

Allowance for Bad Debts balance was $2,500.

Let’s see what effect the write-off had on these accounts.

L O 5 Writing Off an Uncollectible Account Receivable

5-26

Before Write-Off

After Write-Off

Accounts receivable 10,000$ 9,500$ Less: Allow. for bad debts 2,500 2,000 Net realizable value 7,500$ 7,500$

Notice that the $500 write-off did not change the net realizable value nor did it affect any income

statement accounts.

L O 5 Writing Off an Uncollectible Account Receivable

5-27

Cash Discounts

A deduction from the invoice price granted to A deduction from the invoice price granted to induce early payment of the amount due.induce early payment of the amount due.

A deduction from the invoice price granted to A deduction from the invoice price granted to induce early payment of the amount due.induce early payment of the amount due.

Terms

Time

Due

Discount Period

Invoice totalless discount

Credit Period

Invoice total due

Purchase or SalePurchase or Sale

2/10,n/302/10,n/30

Discount Period

Discount Period

Otherwise, Net (or invoice

total) is Due

Otherwise, Net (or invoice

total) is Due

CreditPeriod

CreditPeriod

Discount Percent

Discount Percent

L O 5

5-28

A note is a written

promise to pay a specific amount at a

specific future date.

Notes Receivable

Notes typically include an

interest charge for use of the money during

the time period of the note.

L O 6

5-29

Adjusting Entry for Accrued Interest

An adjusting entry is required at the end of the accounting period for any unpaid interest.

An adjusting entry is required at the end of the accounting period for any unpaid interest.

L O 6

Use the Interest Formula

I = P x R x T

Use the Interest Formula

I = P x R x T

5-30

InventoryInventory

Goods ownedand held for sale

to customers

Goods ownedand held for sale

to customers

Current asset

Current asset

InventoriesL O 7

5-31

GENERAL JOURNAL

Date Account Titles and ExplanationPR

Debit Credit

Entry on Purchase Date

Inventory $$$$

Accounts Payable (or Cash) $$$$

Entry on Sale Date

Cost of Goods Sold $$$$

Inventory $$$$

In a perpetual inventory system, inventory entries are as follows:

InventoriesL O 7

Cost of Goods sold is an Expense

5-32

5-33

Specific identification

LIFO

Weighted-average

FIFO

We use one of these inventory valuation methods to determine cost of inventory sold.

Inventory Cost-Flow AssumptionsL O 8

5-34

The Bike Company (TBC)

Inventory Cost-Flow AssumptionsL O 8

5-35

Specific Identification

When a unit

is sold, the specific

cost of the unit sold is added to

cost of goods sold.

L O 8

5-36

Cost of Goods Available for Sale During

the Year

Units Available for Sale During

the Year

÷

Weighted-Average

Calculate the average cost of the items in beginning inventory plus purchases

made during the year.

Calculate the average cost of the items in beginning inventory plus purchases

made during the year.

L O 8

5-37

$5,990 55 = $108.9091$5,990 55 = $108.9091

Weighted-Average

Cost of Goods Sold$108.9091 × 43 =

$4,683.09

Cost of Goods Sold$108.9091 × 43 =

$4,683.09

Ending Inventory$108.9091 × 12 =

$1,306.91

Ending Inventory$108.9091 × 12 =

$1,306.91

DateAug. 1 10 @ $91 = $910Aug. 3 15 @ $106 = 1,590 Aug. 17 20 @ $115 = 2,300 Aug. 28 10 @ $119 = 1,190 Total 55 $5,990

Purchases

L O 8

5-38

Costs of Goods Sold

Costs of Goods Sold

Oldest Costs

Oldest Costs

Ending InventoryEnding

InventoryRecent Costs

Recent Costs

First-In, First-Out (FIFO)L O 8

5-39

First-In, First-Out (FIFO)

10 × 119$ = 1,190$ 2 × 115$ = 230

12 1,420$

Ending Inventory

DateAug. 1 10 @ $91 = $910Aug. 3 15 @ $106 = 1,590 Aug. 17 20 @ $115 = 2,300 Aug. 28 10 @ $119 = 1,190 Total 55 $5,990

Purchases

10 × 91 = 910$ 15 × 106 = 1,590 18 × 115 = 2,070

43 4,570$

Cost of Goods Sold

L O 8

5-40

Recent Costs

Recent Costs

Ending InventoryEnding

InventoryOldest Costs

Oldest Costs

Last-In, First-Out Method (LIFO)L O 8

Costs of Goods Sold

Costs of Goods Sold

Recent Costs

Recent Costs

5-41

Last-In, First-Out Method (LIFO)

10 × 91$ = 910$ 2 × 106$ = 212

12 1,122$

Ending Inventory10 × 119$ = 1,190$ 20 × 115$ = 2,300 13 × 106$ = 1,378 43 4,868$

Cost of Goods Sold

DateAug. 1 10 @ $91 = $910Aug. 3 15 @ $106 = 1,590 Aug. 17 20 @ $115 = 2,300 Aug. 28 10 @ $119 = 1,190 Total 55 $5,990

Purchases

L O 8

5-42

The Impact of Changing Costs

In periods of rising costs, LIFO results in lower

ending inventory and higher cost of goods sold than

FIFO.

L O 8

5-43

The Impact of Inventory Quantity Changes

Changes in the quantities of inventory will have an impact on profits that is

dependent on the cost-flow assumption used and the extent of cost changes

during the year.

L O 8

5-44

Inventory Accounting System Alternatives

Periodic Inventory System

Cost of goods sold is determined

at the end of the fiscal period.

Cost of goods sold is determined

each time inventory is sold.

Perpetual Inventory System

L O 8

5-45

Inventory Accounts

Retail Firm Merchandise Inventory

Finished Goods InventoryRaw Materials Inventory

Work in Process Inventory

Manufacturing Firm

L O 8

Product available to

be sold

Used to produce products

Partially completed products

5-46

Inventory Errors

Errors in the amount of ending inventory have a direct dollar-for-dollar

effect on cost of goods sold and net income.

For this reason, independent auditors,

income tax auditors, and financial analysts look

closely at reported inventory amounts.

L O 9

5-47

Lower of Cost or Market

Inventory must be reported at market value when market is lower than cost.

Inventory must be reported at market value when market is lower than cost.

Can be applied three ways:(1) separately to each

individual item.(2) to broad categories of inventory.(3) to the whole inventory.

Can be applied three ways:(1) separately to each

individual item.(2) to broad categories of inventory.(3) to the whole inventory.

Defined as current replacement cost (not sales price).Consistent with

the conservatismprinciple.

Defined as current replacement cost (not sales price).Consistent with

the conservatismprinciple.

5-48

Examples:

Insurance

Rent

Prepaid Expenses require adjusting

entries

Assets are decreased

Expenses are increased

Expenses that have been paid in the

current fiscal period but will not be

subtracted from revenue until a

subsequent fiscal period.

Prepaid Expenses and Other Current AssetsL O 10

5-49

Deferred Tax Assets

A deferred tax asset arises when an income

tax expense is recognized for financial accounting purposes in a fiscal year before the fiscal year in which it is

deductible in the determination of taxable income.

5-50

End of Chapter 5