ACCT 1209 Chapter Notes - Chapter 6: Accounts Receivable, Bank Statement, Bank Reconciliation

Upscale Toddlers, Inc., manufactures children’s clothing,including such accessories as socks and belts. The company has beenin business since 1955, mainly supplying private label merchandiseto large department stores. In 1990, however, the company startedproducing its own line of children’s clothing under the brandname“Yuppiewear.” An increasing number of two-income families has beenaccompanied by an increasing demand for high-status children’sclothing, and Toddlers was the first in its field to recognize thistrend.
When Toddlers’ sales were primarily for private labels, the firm’sfinancial manager did not have to worry much about its overallcredit policy. Most of its sales were negotiated directly withdepartment store buyers, and the resulting contracts containedspecific credit terms. The new line, however, represents asignificant change. It is sold through numerous wholesalers understandard credit terms, so credit policy per se has becomeimportant. Elizabeth Hardin, the assistant treasurer, has beenassigned the task of reviewing the company’s current credit policyand recommending any desirable changes.
Toddlers’ current credit terms are 2/10, net 30. Thus, wholesalersbuying from Toddlers receive a 2 percent discount off the grosspurchase price if they pay within ten days, while customers who donot take the discount must pay the full amount within thirty days.The company does check the financial strength of potentialcustomers, but its standards for granting credit are not high.Similarly, it does have procedures for collecting past-dueaccounts, but its collections policy could best be described aspassive. Gross sales to wholesalers average about $15 million ayear, and 50 percent of the paying wholesalers take the discountand pay, on average, on Day 10. Another 30 percent of the payersgenerally pay the full amount on Day 30, while 20 percent tend tostretch Toddlers’ terms and do not actually pay, on average, untilDay 40. Two percent of Toddlers’ gross sales to wholesalers end upas bad debt losses.
Nathan Langly, the treasurer and Hardin’s boss, is convinced thatthe firm should tighten up its credit policy. According to Langly,good customers will pay on time regardless of the terms, and theones who would complain about a tighter policy are probably notgood customers. Hardin must make an analysis and then recommend acourse of action. For political reasons, she has decided to focuson a tighter policy, under which a 4 percent discount would beoffered to customers who pay cash on delivery (COD) and twenty daysof credit would be offered to customers who elect not to take thediscount. Also, under the new policy stricter credit standardswould be applied, and a tougher collection policy would beenforced. This policy has been dubbed 4/COD, net 20.
Langly likes this policy. He believes that increasing the discountwould both bring in new customers and also encourage more ofToddlers’ existing customers to take the discount. As a result, hebelieves that sales to wholesalers would increase from $15 millionto $16.5 million annually, that 60 percent of the paying customerswould take the discount, that 30 percent of the payers would pay onDay 20, that 10 percent would pay late on Day 30, and that bad debtlosses

would be reduced to 1 percent of gross sales. Langly’s is notthe only position, though. Arnold Quayle, the sales manager, hasargued for an easier credit policy. Quayle thinks that the proposedchange would result in a drastic loss of sales and profits.
Toddlers’ variable cost-to-sales ratio is 80 percent; its pre-taxcost of carrying receivables is 12 percent; and the company canexpand without any problems (or any cost increases) because it cansubcontract production that it cannot handle in-house. Further,Langly is convinced that neither the variable cost ratio nor thecost of capital would change as a result of a credit policy change.Arnold Quayle, however, thinks that the variable cost ratio mightincrease significantly if sales rise so much that the company isforced to use outside suppliers. Also, after discussions with thecost accounting staff, Quayle thinks that the variable cost ratiomight rise as high as 90 percent this coming year, even without anincrease in sales, due to higher labor costs under a contract nowbeing negotiated. Everyone agrees that there is little chance thatcosts will decline, regardless of the credit policy decision.Toddlers’ federal-plus-state tax rate is 40 percent.
Now Hardin must conduct an analysis to estimate the effect of theproposed credit policy change on Toddlers’ profitability. She andLangly are very much concerned about the analysis, both because ofits importance to the company and also because of its “politicalimplications”. The sales and production people have been lobbyingagainst any credit tightening because they do not want to take achance on losing sales and having to cut production, and alsobecause they question the assumptions Langly wants to use.Therefore, Hardin knows that her report will be critically reviewedand a thorough analysis is required. She is especially concernedabout being prepared for follow-up questions that other people,such as those in sales and production, might ask when the report isbeing reviewed. The report should consider all relevant factors,including an analysis of both the current and proposed creditpolicies and a recommendation as to what Toddlers should do.
Hardin has requested that you assist with the report. She is notcertain what risks are involved with a credit policy change or ifsuch risks can even be assessed and incorporated in the analysis.Meanwhile, Langly has expressed concern that if the firm changesits credit policy, Toddlers’ competitors may react by makingsimilar changes in their terms. Thus, Toddlers would have a newcredit policy without any change in sales.
As with every report presented to management, there probably willbe a number of questions regarding the assumptions used in theanalysis. Specifically, Hardin expects both the sales andproduction managers to question the assumptions, so she would liketo know which variables are most critical in the sense thatprofitability is very sensitive to them. No one has yet determinedjust how far off the assumptions could be before the change to atighter credit policy would be incorrect. Also, if she could,Hardin would like to have a better basis for the assumptions usedin her report - as it stands, all she has to rely on is Langly'sjudgment, which is contrary to that of two other senior executives.However, she is not sure whether any additional actions could betaken to improve the accuracy of the forecasts.
Langly gave you a portion of a letter he recently received fromIvana Tinkle, a member of Toddler's board of directors. Ivana whoalso sits on the Board of Face Cosmetics, Inc., has been involvedin numerous credit policy decisions. The decisions made by Facewere always successful from a profitability standpoint. Thus, Ivanasuggests that Toddlers use the same algebraic approach used byFace, in addition to constructing projected profit statements.Pages two and three of Ivana's letter are set forth in Exhibit 1.Ivana is a very influential member of the board, so be prepared toaddress her suggestion.
Working with Langly, she prepared the following set of questionsfor use as a guide in drafting her report. Put yourself in herposition and answer the following questions. As you answer eachquestion, think about follow-up questions that other people, suchas those in sales and production, might ask when the report isbeing reviewed.

s an alternative to constructing profit statements, an algebraicapproach has been developed that focuses directly on the change inprofits. To use this approach, it is first necessary to define thefollowing symbols:
S0 = SN =
V =
1 – V =
k = DSO0 = DSON =B0 = BN = P0 = PN =D0 = DN = T =
current gross sales new gross sales after the change in creditpolicy. Note that SN can be greater than or less than S0. variablecosts as a percentage of gross sales. V includes production costs,inventory carrying costs, the cost of administering the creditdepartment, and all other variable costs except bad debt losses,receivables carrying costs, and the cost of giving discounts.contribution margin, or the proportion of gross sales that goestoward covering fixed costs and increasing profits cost of financing the firm’s receivables current days sales outstanding newaverage days sales outstanding after change in credit policycurrent bad debt losses as a proportion of current gross sales newbad debt losses as a proportion of new gross sales proportion ofcurrent-collected gross sales that are discount sales proportion ofnew-collected gross sales that are discount sales current discountoffered discount offered under new policy tax rate
Calculate values for the incremental change in the firm’sinvestment in receivables, ΔI, and the incremental change inafter-tax profits, DP, as follows:
Formula for ΔI if Sales Increase: ΔI = V[(DSON - DSO0)(S0/360)] +V[(DSON)(SN - S0)/360].
Formula for ΔI if Sales Decrease: ΔI = V[(DSON - DSO0)(SN/360)] +V[(DSO0)(SN - S0)/360].
Formula for ΔP: ΔP = (1 - T)(SN - S0)(1 - V) - kΔI -(BNSN - B0S0)
- [DNSNPN(1 - BN) - D0S0P0(1 - B0)].
Note that, in the profit equation, the first term {(1 - T)(SN -S0)(1 - V)} is the incremental after-tax gross profit, the secondterm {kΔI} is the incremental cost of carrying receivables, thethird term {BNSN-B0S0} is the incremental bad debt losses, and thelast term {DNSNPN(1 - BN) - D0S0P0(1 - B0)} is the incremental costof discounts taken based on the percent of discounts taken bypaying customers.
Use the equations presented here to estimate the change i profitsassociated with the new policy. I hope this provides you withenough information. I will be out of the country on business forthree months and will not be available to answer any furtherquestions on this approach.
Sincerely, Ivana Tinkle

Question 1, What are the four variables that make up a firm’scredit policy? How likely (and how quickly) are competitors torespond to a change in each variable, and is their response likelyto be the same for a change toward tightness as one towardlooseness?

2.What is Toddlers’ dollar cost of carrying receivables underthe current policy? What would be the expected cost under the newpolicy? (Use a 360 day year.)

3.Hardin expects both the sales and production managers toquestion her assumptions, so she would like to know which variablesare most critical in the sense that profitability is very sensitiveto them. Then, she would like to know just how far off herassumption could be before the change to a tighter credit policywould be incorrect. If you are using the spreadsheet model, do somesensitivity analyses, changing one variable at a time while leavingthe others at their base case values. Which variables are mostimportant in terms of their effects on profits, and how large anerror could there be in the assumptions which you regard as beingmost critical before the decision should be reversed?

Financial Accounting, 14th Edition

Carl S. Warren; Jim Reeve; Jonathan Duchac

Final_Multiple choice

1. The primary objectives of control over inventory are

a.safeguarding the inventory from damage and maintainingconstant observation of the inventory

b.reporting inventory in the financial statements

c.maintaining constant observation of the inventory andreporting inventory in the financial statements

d.safeguarding inventory from damage and reporting inventory inthe financial statements

2. When merchandise sold is assumed to be in the order in whichthe purchases were made, the company is using

a.first-in, last-out

b.first-in, first-out

c.last-in, first-out

d.average cost

3. Use the information below to answer the followingquestion.

The Boxwood Company sells blankets for $60 each. The following wastaken from the inventory records during May. The company had nobeginning inventory on May 1.

Assuming that the company uses the perpetual inventory system,determine the gross profit for the sale of May 23 using the FIFOinventory cost method.

a.$72

b.$108

c.$180

d.$120

4.If merchandise inventory is being valued at cost and thepurchase price is steadily falling, which method of costing willyield the largest net income?

a.FIFO

b.LIFO

c.average cost

d.weighted average

5.Stevens Company started the year with an inventory cost of$145,000. During the month of January, Stevens purchased inventorythat cost $53,000. January sales totaled $140,000. Estimated grossprofit is 35%. The estimated ending inventory as of January 31is

a.$58,000

b.$107,000

c.$69,300

d.$91,000

6. Which one of the following below is not anelement of internal control?

a.risk assessment

b.cost-benefit considerations

c.monitoring

d.information and communication

7. A check drawn by a company for $340 in payment of a liabilitywas recorded in the journal as $430. What entry is required in thecompany's accounts?

a.debit Cash; credit Accounts Receivable

b.debit Accounts Receivable; credit Cash

c.debit Accounts Payable; credit Cash

d.debit Cash; credit Accounts Payable

8. A bank reconciliation should be prepared

a.to explain any difference between the company's balance perbooks with the balance per bank

b.by the company's bank

c.whenever the bank refuses to lend the company money

d.by the person who is authorized to sign checks

9.

Pilger Corporation has cash on hand at year-end of $201,000 anda negative cash flow from operations of $144,000. What is the ratioof cash to monthly cash expenses?

a.1.4 months

b.7.2 months

c.12.0 months

d.16.8 months

10. When does an account become uncollectible?

a.when accounts receivable is converted into notesreceivable

b.when a discount is availed on notes receivable

c.at the end of the fiscal year

d.there is no general rule for when an account becomesuncollectible

11.On the balance sheet, the amount shown for the Allowance forDoubtful Accounts is equal to the

a.total estimated uncollectible accounts as of the end of theyear

b.sum of all accounts that are past due

c.total of the accounts receivables written-off during theyear

d.uncollectible accounts expense for the year

12. Allowance for Doubtful Accounts has a debit balance of $600at the end of the year (before adjustment), and an analysis ofaccounts in the customers ledger indicates uncollectiblereceivables of $13,000. Which of the following entries records theproper adjusting entry for bad debt expense?

a.debit Allowance for Doubtful Accounts, $600; credit Bad DebtExpense, $600

b.debit Bad Debt Expense, $600; credit Allowance for DoubtfulAccounts, $600

c.debit Bad Debt Expense, $13,600; credit Allowance for DoubtfulAccounts, $13,600

d.debit Bad Debt Expense, $12,400; credit Allowance for DoubtfulAccounts, $12,400

13. When comparing the direct write-off method and the allowancemethod of accounting for uncollectible receivables, a majordifference is that the direct write-off method

a.is used primarily by small companies with few receivables

b.is used primarily by large companies with many receivables

c.uses an allowance account

d.uses a percentage of sales method to estimate uncollectibleaccounts

14. Accumulated Depreciation

a. is used to show the amount of cost expiration ofintangibles

b.is used to show the amount of cost expiration of naturalresources

c.is the same as Depreciation Expense

d.is a contra asset account

15. Equipment with a cost of $220,000 has an estimated residualvalue of $30,000 and an estimated life of 10 years or 19,000 hours.It is to be depreciated by the straight-line method. What is theamount of depreciation for the first full year, during which theequipment was used 2,100 hours?

a.$19,000

b.$21,000

c.$30,000

d.$22,000

16. The process of transferring the cost of metal ores and otherminerals removed from the earth to an expense account is called

a.depreciation

b.depletion

c.amortization

d.deferral

17. The Bacon Company acquired new machinery with a price of$15,200 by trading in similar old machinery and paying $12,700. Theold machinery originally cost $9,000 and had accumulateddepreciation of $5,000. In recording this transaction, BaconCompany should record

a.a loss of $1,500

b.the new machinery at $12,700

c.a gain of $1,500

d.the new machinery at $16,700

18. Assuming a 360-day year, when a $50,000, 90-day, 9%interest-bearing note payable matures, total payment will be

a.$54,500

b.$4,500

c.$1,125

d.$51,125

19. Which of the following is required to be withheld fromemployee's gross pay?

a.only federal income tax

b.both federal and state unemployment compensation taxes

c.only state unemployment compensation tax

d.only federal unemployment compensation tax

20. Hall Company sells merchandise with a one-year warranty. Inthe current year, sales consisted of 4,500 units. It is estimatedthat warranty repairs will average $10 per unit sold, and 30% ofthe repairs will be made in the current year and 70% in the nextyear. In the current year's income statement, Hall should showwarranty expense of

a.$45,000

b.$0

c.$13,500

d.$31,500

21. Which of the following below is not acharacteristic of a limited liability company?

a.limited legal liability

b.unlimited life

c.taxable

d.moderate ability to raise capital

22. Seth and Beth have original investments of $50,000 and$100,000 respectively in a partnership. The articles of partnershipinclude the following provisions regarding the division of netincome: interest on original investment at 10%; salary allowancesof $27,000 and $18,000, respectively; and the remainder to bedivided equally. How much of the net income of $42,000 is allocatedto Seth?

a.$20,000

b.$23,000

c.$32,000

d.$0

23. Which of the following is not a rightpossessed by common stockholders of a corporation?

a.the right to share in assets upon liquidation

b.the right to receive a minimum amount of dividends

c.the right to sell their stock to anyone they choose

d.the right to vote in the election of the board ofdirectors

24. The charter of a corporation provides for the issuance of100,000 shares of common stock. Assume that 45,000 shares wereoriginally issued and 5,000 were subsequently reacquired. What isthe amount of cash dividends to be paid if a $2 per share dividendis declared?

a.$80,000

b.$100,00

c.$90,000

d.$10,000

25.Which statement below is not a reason for acorporation to buy back its own stock?

a.to increase the shares outstanding

b.for supporting the market price of the stock

c.resale to employees

d.bonus to employees