Chapter08 - Substantive Tests of Receivables and Sales (1).Unlocked

8 CHAPTER

SUBSTANTIVE TESTS OF RECEIVABLES AND SALES

8-1. Tests of details of financial balances are designed to determine the reasonableness

of the balances in sales, accounts receivable, and other account balances which are affected by the sales and collection cycle. Such tests include confirmation of accounts receivable, and examining documents supporting the balance in these accounts.

Tests of transactions for the sales and collection cycle are intended to determine

the effectiveness of internal control structure and to test the substance of the transactions which are produced by this cycle. Such tests would consist of examining sales invoices in support of entries in the sales journal, reconciling cash receipts, or reviewing the approval of credit.

The results of the tests of transactions will be used to affect the procedures,

sample size, timing and particular items selected for the tests of details of financial balances (i.e., an effective internal control structure will result in reduced testing when compared to the tests of details required in the case of an inadequate internal control structure).

8-2. There are two common types of confirmations used for confirming accounts

receivable: “positive” confirmations and “negative” confirmations. A positive confirmation is a communication addressed to the debtor requesting him to confirm directly whether the balance as stated on the confirmation request is correct or incorrect. A negative confirmation is also a communication addressed to the debtor, but it requests a response only when the debtor disagrees with the stated amount.

A positive confirmation is more reliable evidence because the auditor can perform

follow-up procedures if a response is not received from the debtor. With a negative confirmation, failure to reply must be regarded as a correct response even though the debtor may have ignored the confirmation request.

Offsetting the reliability disadvantage, negative confirmations are less expensive

to send than positive confirmations, and thus more of them can be distributed for the same total cost. The determination of which type of confirmation to be sent is an auditor’s decision, and it should be based on the facts in the audit. The following are the most important circumstances where positive confirmations should be used:

8-2 Solutions Manual to Accompany Applied Auditing, 2006 Edition

1. There are a small number of large accounts which account for a significant portion of total accounts receivable.

2. There are suspected conditions of dispute, inaccuracy, or irregularity. This would be the case when internal controls are considered inadequate or if prior year’s audit test results are unsatisfactory.

3. The rules of certain regulatory agencies require them. This is the case for brokers and dealers in securities.

When the above conditions do not exist, it is acceptable to use negative

confirmations, but negative confirmations should not be used if the auditor believes the customer is likely to ignore the confirmation. Typically, when negative confirmations are used, the auditor is using a reduced control risk assessment in the audit of accounts receivable. It is also common to use negative confirmations for audits of hospitals, retail stores, and other industries where the receivables are due from the general public. In these cases, far more assurance is obtained from tests of internal control than from confirmations.

It is also common to use a combination of negative and positive confirmations by

sending the positives to accounts with large balances and negatives to those with small balances.

8-3. It is acceptable to confirm accounts receivable prior to the balance sheet date if the

internal control structure is adequate and can provide reasonable assurance that sales, cash receipts and other credits are properly recorded between the date of the confirmation and the end of the accounting period. Other factors the auditor is likely to consider in making the decision are the materiality of accounts receivable and the auditor’s experience in prior years. If the decision is made to confirm accounts receivable prior to year end, it is necessary to test the transactions occurring between the confirmation date and the balance sheet date by examining internal documents and performing analytical procedures at year end.

8-4. South Technologies, Inc.

(a) When confirmation requests are mailed to debtors whose accounts were written off as uncollectible, the auditors’ purpose is to determine that the receivables were genuine when they were first recorded in the accounts. In some fraud cases, fictitious accounts receivable have been created to cover up a shortage. Eventually these fictitious receivables must be disposed of; one method is to write off the fictitious accounts as uncollectible.

(b) The South executive appears to believe the auditors are solely concerned with

the collectibility of accounts and notes receivable. In fact, the confirmation process is primarily intended to establish that the receivables are genuine and that the customers (or makers of notes) exist. Other audit procedures are followed to determine collectibility.

Substantive Tests of Receivables and Sales 8-3

8-5. The confirmation requests should go to the makers of the notes regardless of whether the notes have been discounted. The act of discounting a note receivable does not reduce the importance of the note being genuine and collectible. A company which discounts its notes receivable remains in a position of sustaining a loss if the makers of the notes fail to make payment at the maturity dates.

8-6. (a) When customers fail to respond to positive confirmation requests the CPAs

may not assume with confidence that these customers reviewed the requests and found no disagreement and therefore did not reply. Some busy customers will not take the time to review confirmation requests and will not respond; hence, obvious exceptions may exist without being reported to the CPAs.

(b) If there is no response to a second request, the CPAs may mail a third request

and possibly make telephone calls in an effort to get a reply directly from the customer. When it becomes apparent that the confirmation program will not produce further evidence, the CPAs should consider each remaining customer as to the size, nature, and age of the balance and the apparent reason for the lack of a reply before they decide what additional work is necessary in the circumstances. The CPAs should carry out the alternative audit procedures of examining customers’ purchase orders or contracts, shipping documents and sales invoices of the client, and remittances by nonconfirming customers received by the client subsequent to the balance sheet date. The auditors may also verify the existence, location, and credit standings of the nonconfirming customers by reference to credit agencies or other sources independent of the client.

8-7. North, Inc. No, the matter remains unresolved. First, oral evidence from the client is never in

itself sufficient; the auditors must follow up to determine the reliability of the oral evidence. Second, payment of an account receivable is not confirmation; the account might be fictitious, and the “payment” could have been made by a dishonest employee who had created the fictitious account to conceal a cash shortage. The auditors must examine the customer purchase order or contract, and copies of the sales invoice and shipping document, in support of the unconfirmed receivable. They should also determine the genuineness of the customer by reference to the telephone directory or to credit agency reports.

8-8. Monty’s Meat, Inc.

a. The workpaper does not include a description of the auditing procedures

performed in confirming the accounts. The workpaper is also incomplete in the following respects:

1) The workpaper does not state whether the auditor traced the ABC Grocery remittance of P3,000 to November cash receipts.


2) The workpaper does not state whether the auditor examined the November 2 credit memo issued to Sari-Sari Store.

3) The workpaper does not state whether the auditor traced the Lucena’s Meat Market remittance to November cash receipts.

4) The workpaper does not state whether and how the auditor obtained satisfaction regarding confirmation requests not returned.

5) The workpaper does not state whether the auditor examined documentation for the Diana’s Supper Club order returned and received on October 31.

6) Rather than summarizing the confirmations returned without exception, as was done at the bottom of Working Paper 1, these confirmations should have been listed separately.

b. 1) Sales P11,100 Accounts receivable P11,100 Inventory 8,600 Cost of goods sold 8,600

To reverse 2007 sale recorded in 2006. 2) Allowance for uncollectible accounts 1,277 Accounts receivable 1,277

To write off uncollectible account. 3) Sales returns and allowances 3,634 Accounts receivable 3,634

To record return of spoiled meat and recognize loss in period in which incurred. Meat not restored to inventory, inasmuch as it was spoiled. 4) Sales 13,000 Accounts receivable 13,000

To correct error in recording customer remittance as a sale. 5) Sales Returns 334 Accounts receivable 334 Inventory 250 Cost of goods sold 250

To record return and restore meat to inventory because meat returned in good condition.


c. (See completed Exhibits 1.1 and 1.2 reproduced below and on the following page.)

Exhibit 1.1 Monty’s Meat, Inc. Accounts Receivable - Trade Aging Analysis October 31, 2006

Conf. Past Due (Days) No. Customer Balance Current 1-30 31-60 Over 60

1060 Culley’s Meats P 1,330 P 1,330 1061 Jolly Roger Restaurant 466 P 466 1064 ABC Grocery 4,256 3,000 1,256

(Other) 329,433 280,763 33,467 P12,324 P 2,879 1602 Rudy’s Deli 378 378 1603 General Foods Grocers 13,468 13,000 468 1607 Kim’s Fresh Meats 2,334 1,074 1,260 1608 Dill’s Discount Grocery 12,469 12,469 1612 Diana’s Supper Club 866 334 532 10/31 Balance per ledger P365,000 P 311,970 P 36,449 P13,234 P 3,347

Audit Adjustments P (29,345) P (28,068) P(1,277)

10/31 Audited balance P335,655 P 283,902 P 36,449 P13,234 P 2,070 # Cash receipts 11/1 – 11/27 P(210,113) P (13,353) P 0 P 0 &

11/27 Outstanding P 73,789 P 23,096 P13,234 P 2,070 Estimated percent uncollectible 10% 25% 70% 100%

10/31 Estimated uncollectible P 24,487 P 7,379 P 5,774 P 9,264 P 2,070

& Traced subsequent collections to November remittance advices. # Obtained balances from subsidiary ledger after agreeing to general ledger control account.

Prepared by: Reviewed by: Initial Date Initial Date


Exhibit 1.2 Monty’s Meat, Inc. Accounts Receivable - Trade Allowance for Doubtful Accounts October 31, 2006 11/1/05 Balance per general ledger P28,000 # 11/1 - 10/31 Monthly provision 24,000 & 11/1 - 10/31 Write-offs (37,000) @

10/31/06 Balance per general ledger P15,000 AJE 2 (1,277) P13,723 AJE 6 P10,777

10/31/06 Audited balance P24,500 ^

AJE 6 Bad debts expense P10,777 Allowance for doubtful accounts P10,777

To adjust allowance for doubtful accounts to amount

considered reasonable in the circumstances. # Traced to last year’s WTB - audited balance & Traced to standard journal entries @ Examined documentation and discussed with credit manager and legal counsel ^ In light of aging analysis, the above balance, as adjusted, appears to be adequate.

Prepared by: Reviewed by:

Initial Date Initial Date


8-9. Makati Company For all of the exceptions, the auditor is concerned about four principal things.

(a) Whether there is a client error. Many times the confirmation response differences are due to timing differences for deposits in the mail and inventory in transit to the customer. Sometimes customers misunderstand the confirmation or the information requested. The auditor must distinguish between those and client errors.

(b) The amount of the client error if any. (c) The cause of the error. It would be intentional, a misunderstanding of the

proper way to record a transaction, or a breakdown of internal control. (d) Potential errors in the sample not tested. The auditor must estimate the error

in the untested population, based on the results of the tests of the sample.

Suggested steps to clear each of the comments satisfactorily are:

1. (a) Examine supporting documents, including the sales invoices and applicable sales and shipping orders, for propriety and valuation of the sales.

(b) Review the cash receipts books for the period after December 31, 2005, and note any collections from the PDQ Company. The degree of internal control over cash receipts should be an important consideration in determining the reliance that can be placed on the cash receipts entries. In addition, as there is no assurance that collections after December 31 represent the payment of invoices supporting the December 31 trial balance, consideration should be given to requesting a confirmation from the PDQ Company of the invoices paid by their checks.

2. (a) The cause should be investigated thoroughly. If the credit was posted to the wrong account, it may indicate merely a clerical error. On the other hand, posting to the wrong account may indicate lapping.

(b) Such a comment may also indicate a delay in posting and depositing of receipts. If upon investigation such is the case, the company should be informed immediately so that it can take corrective steps.

3. This is a confirmation of the balance with an additional comment. Since the customer has given us the data, it is preferable to check to see that the information agrees with the company’s records. Such a procedure may disclose misposting or delay in recording receipts.

4. This incomplete comment should raise an immediate question: does the customer mean paid before or paid after December 31? Because the customer’s intent is unknown, this account should be reconfirmed and the customer asked to state the exact date. Upon receipt of the second confirmation, the information thereon should be traced to the cash receipts book.


5. The auditor should first evaluate how long it takes to ship goods to the customer in question. If it ordinarily takes more than five days, there is no indication of error.

A comment of this type may indicate that the company may be recording sales before an actual sale has taken place. The auditor should examine the invoice and review with the appropriate officials the company’s policies. Sales, cost of sales, inventories and accounts receivable may have to be adjusted if title has not passed to the buyer as of December 31, 2005.

6. (a) Determine if such advance payment has been received and that it has been properly recorded. A review should be made of other advance payments to ascertain that charges against such advances have been properly handled.

(b) If the advance payment was to cover these invoices, the auditor should propose a reclassification of the P1,350, debiting the advance payment account and crediting accounts receivable--trade.

7. (a) Examine the shipping order for indications that the goods were shipped and, if available, carrier’s invoice and/or bill of lading for receipt of the goods.

(b) If it appears that goods were shipped, send all available information to the customer and ask the customer to reconfirm. If the customer still insists that goods were never received, all data should be presented to an appropriate company official for a complete explanation. This may indicate that accounting for shipments is inadequate and consideration should be given to reviewing the procedures to determine if improvements can be made.

(c) If the goods were not shipped, the auditor should recommend an adjustment reducing sales, cost of sales, and accounts receivable, and increasing inventories.

8. This should be discussed with the appropriate officials and correspondence with the customer should be reviewed to allow determination whether an adjustment should be made in the amount receivable or if an allowance for doubtful accounts should be set up.

9. As title on any goods shipped on consignment does not pass until those goods are sold, the sales entry should be reversed, inventory charged, and cost of sales credited if it is actually a consignment sale. Other so-called sales should be reviewed and company officials queried to determine if other sales actual represent consignment shipments; if so, the adjustment set forth in the preceding sentence should be made for all consignment shipments.

10. This is a noncurrent asset and should be reclassified to either deposit or prepaid rent. A review of other accounts, especially those with round numbers, may disclose other accounts that should be so reclassified.

11. This may indicate a misposting of the credit or a delay in posting the credit. Comments under 2 above would also apply to credits.


8-10. Ken Company

Requirement (a) Ken Company

Accounts Receivable Aging Schedule May 31, 2006

Age Category

Proportion of

Total

Amount in

Category

Probability of

Non-Collection

Estimated Uncollectible

Amount

Not yet due .680 P 816,000 .010 P 8,160 Less than 30 days past due .150 180,000 .035 6,300 30 to 60 days past due .080 96,000 .050 4,800 61 to 120 days past due .050 60,000 .090 5,400 121 to 180 days past due .025 30,000 .400 12,000 Over 180 days past due .015 18,000 .900 16,200

1.000 P1,200,000 P52,860

Requirement (b) Ken Company

Analysis of Allowance for Doubtful Accounts May 31, 2006

June 1, 2005 balance P 30,250 Bad debt expense accrual (3,000,000 x .04) 120,000

Balance before write-offs of bad accounts P150,250 Write-offs of bad accounts 108,750

Balance before year-end adjustment P 41,500 Estimated uncollectible amount 52,860

Additional allowance needed P 11,360

Debit Credit

Bad Debts Expense 11,360 Allowance for Doubtful Accounts 11,360

Requirement (c)

1. Steps to Improve the Accounts Receivable Situation

2. Risks and Costs Involved

Establish more selective credit-granting policies, such as more restrictive credit requirements or more thorough credit rating investigation.

This policy could result in lost sales and increased costs of credit evaluation. Ken may be all but forced to adhere to the prevailing credit-granting policies of the office equipment and supplies industry.

Establish a more rigorous collection policy either through external collection agencies or by Ken’s own personal.

This policy may offend current customers and thus risk future sales. Increased collection costs could result from this policy.


Charge interest on overdue accounts. This policy may offend current customers and thus risk future sales.

Insist on cash on delivery (COD) or cash on order (COO) for new customers or poorer credit risks.

This policy could result in lost sales and increased administrative costs.

8-11. Demo Inc. Requirement (a)

DEMO INC. Accounts Receivable

12-31-05

Balance A G I N G D I S T R I B U T I O N Per General Per M o n t h s O u t s t a n d i n g Ledger Subsidiary 0 - 1 1 - 3 3 - 6 over 6 Unadjusted Balances P197,000 P198,240 P93,240 P76,820 P22,180 P6,000 Add (Deduct) Adjustments: AJE (2) to correct

understatement of accounts written off on October 31.

(200)

(3) to write off definitely uncollectible accounts

(1,000)

(1,000)

(1,000)

(4) to reclassify advances from customers

2,000

2,000

2,000

(5) to reclassify accounts with credit balances

500

500

500

(6) to adjust general ledger balance to agree with subsidiary balance

1,440

_______

_______

_______

_______

______

Balances as adjusted P199,740 P199,740 P95,240 P77,320 P22,180 P5,000

DEMO INC. Allowance for Doubtful Accounts

12-31-05 Balance per Ledger P12,000.00 Add (Deduct) Adjustments: AJE (1) to correct error in recording bad debts recovery 324.00 (2) to correct understatement of accounts written off ( 200.00) (3) to write off definitely uncollectible accounts ( 1,000.00) (4) to adjust allowance to required balance (Schedule 1) ( 6,359.80)

Balance as adjusted P 4,764.20


Schedule 1: Computation of Required Allowance

Adjusted Required Allowance Account Classification Total % Amount

0-1 month outstanding P 95,240 1 P 952.40 1-3 months outstanding 77,320 2 1,546.40 3-6 months outstanding 22,180 3 665.40 over 6 months outstanding 5,000 P2,000-50% 1,000.00 _______ P3,000-20% 600.00

Totals P199,740 P4,764.20

Requirement (b) Adjusting Journal Entries 12-31-05 (1) Bad Debts 324.00 Allowance for Doubtful Accounts 324.00

(2) Allowance for Doubtful Accounts 200.00 Accounts Receivable 200.00

(3) Allowance for Doubtful Accounts 1,000.00 Accounts Receivable 1,000.00

(4) Accounts Receivable 2,000.00 Advances from Customers 2,000.00

(5) Accounts Receivable 500.00 Customers’ accounts with credit balances 500.00

(6) Accounts Receivable 1,440.00 Sales 1,440.00

(7) Allowance for Doubtful Accounts 6,359.80 Bad Debts Expense 6,359.80

8-12. Tripoli Company Requirement (1)

Accounts receivable, trade ............................................. 40,000 Advances to suppliers..................................................... 450 Due from officers ........................................................... 2,500 Subscriptions receivable – share capital......................... 4,600 Expense advances to salespeople ................................... 1,000 Accounts payable, trade (P19,250 – P450)* ........... 19,250 Advances from customers on sales contracts .......... 450 Salaries payable....................................................... 3,300 Allowance for doubtful accounts ............................ 500 Receivables (to close permanently)......................... 23,050 Customers’ credit balances...................................... 2,000


Requirement (2)

Current assets: Accounts receivable, trade ...................................... 40,000 Less allowance for doubtful accounts ..................... 500 P39,500 Creditors’ debit balances......................................... 450 Due from officers** ................................................ 2,500 Subscriptions receivable – ordinary shares** ......... 4,600 Expense advances to salespeople ............................ 1,000 Current liabilities: Accounts payable, trade .......................................... 19,250 Customers’ credit balances...................................... 2,000 Cash advances from customers on sales (not yet shipped)...................................................

450

Salaries payable....................................................... 3,300

* These amounts are netted against normal balances to reflect control balances; but if material in amount, they should be reported separately on the balance sheet as indicated in Requirement 2.

** Considered as current assets only if currently collectible. All items are assumed to be material in amount.

8-13. Pearl Corporation 1. Estimated bad debt percentage based on year-end accounts receivable: 28.5%#

2003 2004 2005 2006

Actual bad debts P 3,300a P 5,700c P 7,800e P 16,800 Credit Sales P90,000 P158,000 P210,000 P459,000 Outstanding receivables

(year-end)

P 9,500b

P 19,900d

P 29,500f

P 58,900 Percentage of

outstanding receivables

0.347

0.286

0.264 0.285#

a P2,500 + P500 + P300 = P3,300 b 0 + P90,000 - P78,000 - P2,500 = P9,500 c P4,600 + P700 + P400 = P5,700 d P9,500 + P158,000 - P8,500 - P134,000 - P500 - P4,600 = P19,900 e Estimated. The bad debts written off in the third year following the sale have

averaged about 7.8% [(P300 + P400) ÷ (P3,300 + P5,700)] of the total actual bad debts in the previous 2 years. Therefore, the bad debts on 2005 sales of P6,200 and P1,000 are about 92.2% of the total bad debts expected on 2005 sales.

f P19,900 + P210,000 - P200 - P14,200 - P178,800 - P300 - P700 - P6,200 = P29,500


2. Bad debts estimated as a percentage of year-end accounts receivable P29,500 + P235,000 - P300 - P19,500 - P400 - P1,000 - P200,000 = P43,300

P43,300 x 0.285 = P12,340.50, or approximately P12,300. Criteria for recognition of bad debts or impairment of receivables under PAS 39 should be applied.

8-14. Flores Corporation Requirement (1)

Flores Corporation Analysis of Changes in the

Allowance for Doubtful Accounts For the Year Ended December 31, 2006

Balance at January 1, 2006 P130,000Provision for doubtful accounts (P9,000,000 x 2%) 180,000Recovery in 2006 of bad debts written off previously 15,000

P325,000Deduct write-offs for (P90,000 + P60,000) 150,000

Balance at December 31, 2006, before additional impairment loss P175,000Increase in estimated uncollectible accounts during 2006 (P235,300 - P175,000) 60,300

Balance at December 31, 2006, adjusted (Schedule 1) P235,300 Schedule 1:

Computation of Allowance for Doubtful Accounts at December 31, 2006

Aging category Balance Percent Doubtful accounts

November-December 2006 P1,140,000 2 P 22,800 July-October 600,000 10 60,000 January-June 400,000 25 100,000 Prior to 1/1/06 70,000 a 75 52,500

P235,300 a P130,000 - P60,000 Requirement (2)

Flores Corporation Journal Entry

December 31, 2006

Bad Debt Expense 60,300 Allowance for Doubtful Accounts 60,300

To increase the allowance for doubtful accounts at December 31, 2006, resulting from evaluation of collectibility of remaining receivables.


8-15. Visayas Company

Requirement (a) Visayas Company

Accounts Receivable 12.31.06

Balance, 12.31.05 P 546,400 Add: Sales on account for the year 2,622,832

Total P3,169,232 Less: Collections during the year - with discount (1) P2,050,859 - without discount (2) 848,118 Accounts written off 18,700 Credit memo for sales returns & allowances 37,000 2,954,677

Balance, 12.31.06 P 214,555 Total collections P2,857,960 Less: Accts paid w/ discount 2,009,842 (÷ 98% = P2,050,859) (1) Accts paid by customers w/o

discount

P 848,118 (2)

Requirement (b) AJE (1) Doubtful accounts expense 6,599 Allowance for doubtful accounts 6,599 Supporting Analysis: % allowance to AR 12.31.05 P 16,392 = 3 %

P546,400 Required % allowance to AR 12.31.06 2/3 x 3% = 2 % Required allowance 12.31.06 2% x P214,555 P4,291 Allowance for doubtful accounts balance, 12.31.05 P 16,392 Less: Accounts written off 18,700 P( 2,308)

Required balance, 12.31.06 4,291

Estimated bad debts expense for 12.31.06 P 6,599


8-16. Charry Company Requirement (a) Adjusting Journal Entries

(1) Accounts Receivable 5,500 Customers’ accounts with credit balances 5,500 (P500 + P5,000) (2) Sales 5,000 Accounts Receivable 5,000 (3) Subscriptions Receivable 15,000 Accounts Receivable 15,000 (4) Deposit on Contract 15,000 Accounts Receivable 15,000 (5) Claims Receivable 500 Accounts Receivable 500 (6) Advances to Employees 500 Accounts Receivable 500 (7) Advances to Affiliated Company 10,000 Accounts Receivable 10,000 (8) Advances to Supplier 5,000 Accounts Receivable 5,000

Requirement (b) Balance Sheet Presentation 12-31-06 Current Assets Accounts Receivable - Trade P59,500 Claims Receivable 500 Advances to Employees 500 Advances to Supplier 5,000

Investments Advances to Affiliated Company 10,000

Other Assets Deposit on Contract 15,000

Shareholders’ Equity Subscribed Share Capital (net of subscriptions receivable of P15,000) xxx


Supporting Analysis:

Charry Company Accounts Receivable -Trade

12-31-06

Balance per ledger P105,000

Add (Deduct) Adjustments: AJE (1) To reclassify accounts with credit balances 5,500 (2) To reverse entry for consignment deliveries ( 5,000) (3) To reclassify subscriptions receivable ( 15,000) (4) To reclassify deposit on contract ( 15,000) (5) To reclassify balance of claims from carrier for

shipping damages

( 500) (6) To reclassify employee’s IOU’s ( 500) (7) To reclassify advances to affiliate ( 10,000) (8) To reclassify advances to supplier ( 5,000)

Net adjustments ( 45,500)

Balance as adjusted P 59,500

If correct entries were made for the transactions given, the Accounts Receivable account would show the following postings:

Accounts Receivable

Jan. 1 Balance P 56,000 Collections P615,000 Charge Sales 625,000 Write offs 3,500 Recoveries of Merchandise returns 2,500 accounts written off 1,000 Allowance for shipping ________ damages 1,500

P682,000 P622,500 ________ Balance Dec. 31 59,500

P682,000 P682,000 8-17. The Preston Companies

(amounts in P millions) Requirement (1) (a) Preston’s earnings would have increased (1 – 0.40) P105 million or P63

million in 2006. Net accounts receivable and total assets would have been P105 million higher than actually reported in 2006. Ignoring differences between tax and financial reporting, income tax payable would have increased by P0.40 (P105 million) or P42 million, and retained earnings


would be greater by P63 million. This example illustrates the material effect estimated bad debts can have on reported earnings and total assets.

(b) Under the allowance method, failure to write off an account has no effect on

earnings (assuming a sufficient balance exists in the allowance account), or any net balances in the balance sheet. Only the components of net accounts receivable would be affected. Both gross accounts receivable and the allowance for doubtful accounts would be overstated P0.6 million.

Requirement (2)

1998 Beginning allowance balance P183 Bad debt expense 105 Ending allowance balance (212) Write-offs of accounts P 76

Requirement (3) (a) The ratio of bad debt expense to operating revenue for the two years is: 2006,

P105/P3,729 = 2.8%; 2005, P81/P3,534 = 2.3%. This ratio appears relatively stable although is increasing.

(b) The composite rate of uncollectible accounts as a percentage of gross

accounts receivable = ending allowance balance/ending accounts receivable. The ratio for 2006 is P212 / (P951 + P212) = 18.2%, and for 2005 is P183 / (P972 + P183) = 15.8%. This ratio is less stable and also is increasing.

(c) Bad debt expense is considerably higher than the write-offs in 2006. The

firm has experienced an increase in expected write-offs. Apparently the firm expects an increase in bad debts, which is partially an estimate of future write-offs.

8-18. Rain Company Requirement (1) Present value of the note:

P150,000 x (PV1, 12%, 3) (0.71178) = P106,767


Requirement (2)

Correction and Collection Schedule:

Note Receivable Date Explanation and Interest Revenue Change Balance

1-1-2005 Recorded originally at face amount P150,000 12-31-2005 Correction to restate to present value – P 43,233 106,767 12-31-2005 To accrue interest, P106,767 x 12% = P12,812 + 12,812 119,579 12-31-2006 To accrue interest, P119,579 x 12% = P14,349 + 14,349 133,928 12-31-2007 To accrue interest, P133,928 x 12% = P16,072* + 16,072 150,000 12-31-2007 Collection on face amount, debit Cash – 150,000 0

* Rounded. 8-19. 1. d. The Josefina note is a short-term note and is reported at face value

although the note can be recorded at present value. The Nicole note is reported at present value: [(P20,000 + 5(0.3) (P20,000)] (PV1, 8%, 5) = P23,000 (0.68058) = P15,653

2. c. The annual payment is computed as: P10,000 (PVA, 8%, 5) = P10,000 / 3.99271 = P2,505.

Discounting this stream of payments at 9% yields cash proceeds of: P2,505 (PVA, 9%, 5) = P2,505 (3.88965) = P9,744.

Total interest equals total payments less proceeds = 5 (P2,505) – P9,744 = P2,781.

3. b. Interest receivable is recorded for one month.

4. c. Maturity value..................................................................... P100,000 Discount P100,000 (0.10) (6/12)......................................... (5,000) Proceeds .............................................................................. P 95,000 8-20. Luce Company

(1) AJE: Sales returns and allowances 30,000 Inventory 12.31.06 24,000 Accounts receivable 30,000 Cost of sales 24,000 Income will decrease by P6,000 if

the above AJE is made.

Ans. (c)

(2) AJE: Sales 10,000 Accounts receivable 10,000 Income was overstated by P10,000

Ans. (a)


(3) Actual number of units sold to Mr. Lazo was 320. P48,000 P150

Ans. (b)

(4) Correct receivable from Mr. Lazo : 320 x P100 P 32,000 Per client 48,000 Overstatement P 16,000 Ans. (d)

(5) Accounts receivable from Mr. Sia is correctly stated because the goods are considered sold in 2006.

Ans. (a)

(6) Ans. (d) 8-21. ETC Co.

Adjusting Journal Entries

AJE 1. Cash 225,000 Other Current Liabilities (UCPB Overdraft) 225,000

2. Accounts Receivable 37,500 Cash 37,500

3. Cash 28,709 Accounts Payable 28,709

4. Notes Payable 67,500 Interest Expense 16,200 Cash 83,700

5. Cash – BPI 25,000 Other Current Liabilities (UCPB Overdraft) 25,000

6. Cash – SBTC 73,690 Accounts Receivable 73,690

Cash 5.31.06

Per books P 15,825,000 AJE 1. 225,000 2. (37,500) 3. 28,709 4. (83,700) 5. 25,000 6. 73,690 Adjusted balance P16,056,199 (1) (c)


Accounts Receivable 5.31.06

Subsidiary Ledger General Ledger P8,047,054 P7,868,029

AJE 2. 37,500 37,500 6. (73,690)

(375,215) 122,500 P7,831,839 P7,831,839 (2) (b)

Allowance for Doubtful Accounts

Aging

Distribution

Subsidiary Ledger

%

Amount Estimated to be Uncollectible

Current P1,737,690.00 + P122,500 = P1,860,190.00 x 2 = P 37,203.80 Past due: 1 – 30 P1,617,340.00 = 1,617,340.00 x 5 = 80,867.00 31 – 60 P1,437,706.50 = 1,437,706.50 x 10 = 143,770.70 61 – 90 P1,474,450.00 = 1,474,450.00 x 15 = 221,167.50 Over 90 P1,779,867.50 + P37,500

___________ – P375,215 = 1,442,152.50

x 20

= 288,430.50

(3) (a) P8,047,054.00 P7,831,839.00 P771,439.50 8-22. Ling, Inc. Requirement (1)

LING, INC. Long-term Receivables Section of Balance Sheet

December 31, 2005 9% note receivable from sale of division, due in annual

installments of P500,000 to May 1, 2007, less current installment

P 500,000 [1]

8% note receivable from officer, due December 31, 2007, collaterized by 10,000 shares of Ling, Inc., ordinary shares with a fair value of P450,000

400,000

Non-interest-bearing note from sale of patent, net of 15% imputed interest, due April 1, 2007

84,105 [2]

Installment contract receivable, due in annual installments of P50,000 to July 1, 2009, less current installment

112,400 [3]

Total long-term receivables P1,096,505


Requirement (2)

LING, INC. Selected Balance Sheet Balances

December 31, 2005 Current portion of long-term receivables: Note receivable from sale of division P500,000 [1] Installment contract receivable 27,600 [3] Total P527,600 Accrued interest receivable: Note receivable from sale of division P 60,000 [4] Installment contract receivable 11,200 [5] Total P 71,200

Requirement (3)

LING, INC. Interest Income from Long-Term Receivables

and Gains Recognized on Sale of Assets For the Year Ended December 31, 2005

Interest income: Note receivable from sale of division P105,000 [6] Note receivable from sale of patent 8,505 [2] Note receivable from officer 32,000 [7] Installment contract receivable from sale of land 11,200 [5] Total interest income for year ended 12/31/05 P156,705 Gains recognized on sale of assets: Patent P 37,600 [8] Land 50,000 [9] Total gains recognized for year ended 12/31/05 P 87,600

Explanation of amounts:

[1] Long-term Portion of 9% Note Receivable at 12/31/05 Face amount, 5/1/00 P1,500,000 Less: installment received 5/1/05 (500,000) Balance, 12/31/05 P1,000,000 Less: installment due 5/1/06 (500,000) Long-term portion, 12/31/05 P 500,000


[2] Non-interest-bearing Note, Net of Imputed Interest at 12/31/05 Face amount, 4/1/05 P 100,000 Less: imputed interest [P100,000 – (P100,0000 x 0.756)]

(24,400)

Balance, 4/1/05 P 75,600 Add: interest earned to 12/31/05 (P75,600 x 15% x 9/12)

8,505

Balance, 12/31/05 P 84,105

[3] Long-term Portion of Installment Contract Receivable at 12/31/05 Contract selling price, 7/1/05 P 200,000 Less: down payment, 7/1/05 (60,000) Balance, 12/31/05 P 140,000 Less: installment due 7/1/06 [P50,000 – (P140,000 x 16%)]

(27,600)

Long-term portion, 12/31/05 P 112,400

[4] Accrued Interest – Note Receivable, Sale of Division, at 12/31/05 Interest accrued from 5/1 to 12/31/05 (P1,000,000 x 9% x 8/12)

P 60,000

[5] Accrued Interest – Installment Contract at 12/31/05

Interest accrued from 7/1 to 12/31/05 (P140,000 x 16% x ½)

P 11,200

[6] Interest Income – Note Receivable, Sale of Division, for 2005

Interest earned from 1/1 to 5/1/05 (P1,500,000 x 9% x 4/12)

P 45,000

Interest earned from 5/1 to 12/31/05 (P1,000,000 x 9% x 8/12)

60,000

Interest income P 105,000

[7] Interest Income – Note Receivable, Officer, for 2005 Interest earned 1/1 to 12/31/05 (P400,000 x 8%) P 32,000

[8] Gain Recognized on Sale of Patent Stated selling price P 100,000 Less: imputed interest (24,400)[2] Actual selling price (P100,000 x 0.756) P 75,600 Less: cost of patent (net) Carrying value 1/1/05 P40,000 Less amortization 1/1 to 4/1/06 (P8,000 x ¼) (2,000)

(38,000)

Gain recognized P 37,600


[9] Gain Recognized on Sale of Land Sale of price P 200,000 Less: cost (150,000) Gain recognized P 50,000

8-23. Grande Company

Requirement 1 PAS 39, paragraph 63 will be applied in this case. On December 31, 2006,

Grande Company should record the 2006 accrued interest and the impairment:

Notes / Interest Receivable (0.06) (100,000) 6,000 Interest Income 6,000

Bad Debts Expense 55,537 * Allowance for decline in note value 55,537

* Carrying value of note and interest (100,000 + 6,000) P106,000 Present value / New carrying value of note (discount rate – 6%) Principal: Due on 12.31.08 (P30,000 x 0.89000) P26,700 Due on 12.31.10 (P30,000 x 0.79209) 23,763 50,463 Impairment write-down P 55,537

Requirement 2

The entries with the corresponding computations follow:

Effective Interest Method December 31, 2007 Allowance for decline in note value 3,028 Interest income (0.06) (50,463) 3,028 December 31, 2008 Allowance for decline in note value 3,209 Interest income (0.06) (50,463 + 3,028) 3,209 Cash 30,000 Notes receivable 30,000 December 31, 2009 Allowance for decline in note value 1,602 Interest income (0.06) (50,463 + 3,208 + 3,209 – 30,000) 1,602


December 31, 2010 Allowance for decline in note value 1,698* Interest income 1,698 * 0.06 (26,700 + 1,602) Cash 30,000 Notes receivable 30,000 Allowance for decline in note value 46,000 Notes receivable 46,000 To close remaining balance in notes receivable and allowance

*

* At this point, the amortized cost of the notes receivable is zero.

Notes Receivable Allowance for Decline in Note Value 100,000 30,000 3,028 55,537

6,000 30,000 3,209 106,000 60,000 1,602

46,000 bal 1,698 9,537 55,537 46,000

8-24. Amy Corporation Requirement 1

Accounts Receivable (Trade) 15,500 Accounts Receivable (Officer) 3,600 Ordinary Shares Subscriptions Receivable 12,000 Advances to Employees 1,800 Notes Receivable (Trade) 6,000 Deposit to Guarantee Contract Performance 5,000 Utility Deposit 500 Receivables 44,400 Requirement 2

Accounts receivable (trade)--current asset, trade receivable Accounts receivable (officer)--normally current nontrade receivable Ordinary shares subscription receivable--current or noncurrent asset, depending

on due date; nontrade receivable Advances to employees--current asset, nontrade receivable Notes receivable (trade)--noncurrent asset, trade receivable Deposit to guarantee contract performance--separately classify, could be current

or noncurrent asset, depending on the length of the contract; nontrade receivable

Utility deposit--separately classify, probably noncurrent nontrade receivable


8-25. Jane’s Department Store Requirement 1

Age Balance

Estimated Percentage

Uncollectible

Estimated Amount

Uncollectible

Under 30 days P193,000 0.008 P 1,544 30- 60 days 114,000 0.020 2,280 61-120 days 73,000 0.050 3,650 121-240 days 41,000 0.200 8,200 241-360 days 25,000 0.350 8,750 Over 360 days 19,000 0.600 11,400

P465,000 P35,824 Requirement 2 a. Bad Debt Expense 35,824 Allowance for Doubtful Accounts 35,824

b. Bad Debt Expense (P35,824 + P3,000) 38,824 Allowance for Doubtful Accounts 38,824

c. Bad Debt Expense (P35,824 – P2,800) 33,024 Allowance for Doubtful Accounts 33,024

8-26. Blue Corporation Requirement 1

2005 Dec. 1 Cash [(P175,000 x 0.80) – P1,400] 138,600 Assignment Service Charge Expense (P175,000 x 0.80 x 0.01) 1,400 Notes Payable (P175,000 x 0.80) 140,000 Dec. 1 Accounts Receivable Assigned 175,000 Accounts Receivable 175,000 11 Sales Returns and Allowances 1,000 Accounts Receivable Assigned 1,000 31 Cash 86,000 Accounts Receivable Assigned 86,000 31 Notes Payable 86,000 Interest Expense (P140,000 x 0.12 x 1/12) 1,400 Cash 87,400


2006 Jan. 29 Cash 60,000 Accounts Receivable Assigned 60,000 29 Notes Payable (P140,000 – P86,000) 54,000 Interest Expense (P54,000 x 0.12 x 1/12) 540 Cash 54,540 29 Accounts Receivable 28,000 Accounts Receivable Assigned (P175,000 – P1,000 – P86,000 – P60,000) 28,000 Requirement 2

On the December 31, 2005 balance sheet of the Blue Corporation, the assigned accounts receivable and the remaining liability would be reported as follows: Current Assets: Accounts receivable assigned P88,000 Current Liabilities: Note payable P54,000

8-27. Tandy Shoes Sept. 15 Accounts Receivable 1,995

Credit Card Expense (P2,100 x 0.05) 105 Sales 2,100 21 Sales Returns and Allowances 200 Accounts Receivable 190 Credit Card Expense (P200 x 0.05) 10 29 Cash 1,805 Accounts Receivable 1,805


8-28. Gabe Company GABE COMPANY

Income Statement Effect For the Year Ended December 31, 2005

Expenses resulting from accounts receivable assigned (Schedule 1)

P15,100

Expenses resulting from accounts receivable sold (P300,000 – P260,000)

40,000

Total expenses P55,100 Schedule 1: Computation of Expenses for Accounts Receivable Assigned

Assignment expense:

Accounts receivable assigned P200,000 x 85%

Advance by Belle P170,000 x 3%

P 5,100 Interest expense 10,000

Total expenses P 15,100

Documents

Chapter08 - Substantive Tests of Receivables and Sales (1).Unlocked