Chapter 6
The Current Asset Classification, Cash, and Accounts Receivable
Multiple Choice Questions
1. Current assets are assets which
a. can be used immediately to retire liabilities.
b. are newly acquired.
c. have been converted into cash in the previous year.
d. are intended to be converted into cash within one year.
Answer: D
2. A company’s operating cycle may be described as
a. the period of time that is typically required for a company to convert cash into inventory
and inventory into cash.
b. the period of time from the beginning of operations until a company liquidates all of its
assets.
c. always a one-year time period.
d. a cycle that is distinguished at the discretion of the Board of Directors on a daily basis.
Answer: A
3. Cash may consist of
a. coin and currency, loans to employees, and money orders.
b. petty cash, officer imprest accounts, and employee savings accounts.
c. money orders, postage stamps, and currency.
d. checking accounts, savings accounts, and bank drafts.
Answer: D
4. A compensating balance is
a. cash held by a foreign government.
b. a balance maintained by the company to pay the employees’ payroll.
c. a minimum cash balance that must be maintained on deposit.
d. items which are not cash, but equivalent to cash.
Answer: C
5. Which of the following are components of the quick ratio?
a. Cash and notes payable
b. Cash and accounts receivable
c. Accounts receivable and inventory
d. All current assets except accounts receivable
Answer: B
6. Which of the following are components of the current ratio?
a. Accounts receivable and short term investments
b. Inventory, retained earnings, and accounts payable
c. Accounts payable, dividends, and cash
d. Short term investments, equipment, and land
Answer: A
7. ‘Earnings management’ is described as deliberate managerial decisions and choices that are
solely designed to
a. increase selling prices of a company’s products.
b. reduce repair costs on the company’s equipment.
c. manipulate net income from one period to the next to boost the company’s stock price.
d. increase working capital.
Answer: C
8. If a company with a current ratio of 2.0 pays $2,000 of its salaries payable, then its current
ratio will
a. change, but not enough information is provided to determine if it will increase or decrease.
b. decrease.
c. remain the same.
d. increase.
Answer: D
9. On August 1, Compass Co. made a $10,000 credit sale under the terms 2/10, n/30. If
Compass receives full payment of the account on August 8, how much cash will it receive?
a. $9,700
b. $9,800
c. $9,000
d. $10,000
Answer: B
10. If a company with working capital of $210,000 pays $4,000 of bonds payable, then its
working capital will
a. increase.
b. decrease.
c. remain the same.
d. Not enough information to determine
Answer: B
11. The allowance for doubtful accounts is
a. an ‘other revenue’ account.
b. a contra accounts receivable account.
c. an ‘other expense’ account.
d. a contra expense.
Answer: B
12. On November 3, Carol Company made a $2,000 credit sale under the terms 3/10, n/60. If
Carol receives full payment of the account on November 14, how much cash will it receive?
a. $1,400
b. $1,900
c. $1,940
d. $2,000
Answer: D
13. On January 2, Favre Co. made a $2,000 credit sale under the terms 3/10, n/30. If Favre
uses the gross method of accounting for cash discounts, the proper entry on January 2
includes
a. a debit to Accounts Receivable for $2,000, and a credit to Sales for $2,000.
b. a debit to Accounts Receivable for $2,000, a credit to Cash Discounts for $1,940, and a
credit to Sales for $60.
c. a debit to Accounts Receivable for $1,940, and a credit to Sales for $1,940.
d. a debit to Accounts Receivable for $1,940, a debit to Cash Discounts for $60, and a credit
to Sales for $2,000.
Answer: A
14. The net realizable value of receivables is calculated as the face value of the receivables
less adjustments for
a. sales returns and sales discounts.
b. actual uncollected amounts adjusted for purchase discounts.
c. bad debts already written off.
d. sales returns, cash discounts, and estimated uncollectible accounts.
Answer: D
15. Montego Bay Resort Club offers a cash discount of 3% if its customers pay within 15
days after the customer eats dinner. Otherwise, the customer must pay within 30 days. If a
customer does not take advantage of the cash discount, then he/she is paying an annual
interest rate for not delaying payment for 15 days of
a. 3%.
b. 6%.
c. 36%.
d. 72%.
Answer: D
16. The face amount of accounts receivable for Rio Inc. is $20,000. It was estimated that 5%
of the accounts will not be collected, cash discounts of $500 will be exercised, and $200 of
sales returns will be experienced. The net realizable value of accounts receivable is
a. $19,500
b. $19,300
c. $20,000
d. $18,300
Answer: D
17. Under the allowance method of accounting for bad debts, the recognition of bad debts
expense
a. increases current assets and decreases net income.
b. decreases current assets and increases net income.
c. increases current assets and net income.
d. decreases current assets and net income.
Answer: D
18. Under the direct write-off method of accounting for bad debts, the recognition of bad
debts expense
a. decreases current assets and net income.
b. decreases current assets and increases net income.
c. increases current assets and net income.
d. increases current assets and decreases retained earnings.
Answer: A
19. Under the allowance method of accounting for bad debts, the write-off of an account
receivable determined to be uncollectible
a. decreases the current ratio.
b. increases the current ratio.
c. has no effect on the current ratio.
d. decreases working capital.
Answer: C
20. Hummel Inc. and Nadia Co. have experienced identical economic performances for the
last several years of growing sales. Each uses identical accounting measurement rules except
that Hummel uses the allowance method and Nadia uses the direct write-off method of
accounting for bad debts. Both companies have experienced a gradual increase in
uncollectible accounts. Which one of the following statements is True in the first year of
operations for both companies?
a. Hummel ‘s net income is less than Nadia’s net income.
b. Hummel ‘s net income is greater than Nadia’s net income.
c. Hummel ‘s current ratio is greater than Nadia’s current ratio.
d. Hummel will appear more solvent than Nadia will.
Answer: A
21. Delvin Co. uses the percentage of credit sales approach in estimating its bad debt
expense. The total estimate that is calculated by multiplying the percentage times the net
sales revenue for the period will be equal to
a. the debit balance required in the allowance for doubtful accounts after the recognition of
bad debts expense.
b. the credit balance required in the allowance for doubtful accounts after the recognition of
bad debts expense.
c. the difference between the beginning and the ending accounts receivable balance.
d. the amount of bad debt expense.
Answer: D
22. Maradonna Co. uses an aging schedule of accounts receivable in estimating its bad debt
expense. The total estimate, which appears on the aging schedule, will be equal to
a. the amount of bad debts expense on the company’s income statement.
b. the debit balance required in the allowance account prior to the recognition of bad debts
expense.
c. the increase in bad debts expense as a result of the estimate.
d. the credit balance required in the allowance account after the recognition of bad debts
expense.
Answer: D
23. On December 1, 2010, Smith Company delivered a shipment of goods to a Danish
customer for a price of 160,000 euros. If on that date 1.3 U.S. dollars could be exchanged for
1 euro. If Smith closes its books on December 31 and 1 U.S. dollar is trading for 1 euro at
that time, the adjusting entry that Smith would record would include:
a. a credit to Exchange Rate Gain for $48,000.
b. a debit to Accounts Receivable for $20,800.
c. a debit to Exchange Rate Loss for $48,000.
d. a debit to Sales for $48,000.
Answer: C
24. Under the allowance method of accounting for bad debts, the actual write-off of an
account receivable determined to be uncollectible
a. decreases current assets.
b. has no effect on current assets.
c. increases current assets.
d. occurs in the same accounting period as the sale.
Answer: B
25. Polo, Inc. uses the direct write-off method of accounting for bad debts. During July,
Torey’s account was written off as uncollectible. The write-off of Torey’s account
a. increases both the current and quick ratios.
b. decreases the current ratio and has no effect on the quick ratio.
c. decreases both the current and quick ratios.
d. increases the current ratio and has no effect on the quick ratio.
Answer: C
26. Alma Company uses the allowance method of accounting for bad debts. Alma:
a. is violating the matching principle.
b. will record bad debt expense only when an account is determined to be uncollectible.
c. will not sell to customers on account anymore.
d. will report accounts receivable in the balance sheet at their net realizable value.
Answer: D
27. If a company decreases its cash discount offer from 3/10, n/30 to 2/10, n/60, then it would
expect its accounts receivable collection period to
a. increase.
b. decrease.
c. remain the same.
d. There is not enough information to answer this question.
Answer: A
28. A company’s allowance for doubtful accounts is $4,000 and $3,000 on 1/1/11 and 1/1/10,
respectively. During 2010, bad debts expenses were estimated to be 6% on net credit sales of
$100,000. During 2010, the amount of accounts written off as uncollectible amounts to
a. $6,000.
b. $7,000.
c. $5,000.
d. $4,000.
Answer: C
29. The journal entry to record the recovery of a previously written-off $2,000 account
receivable (for customer Leno Company) under the allowance method would include:
a. a credit to Bad Debt Expense.
b. a credit to Cash.
c. a debit to Accounts Payable – Leno Company.
d. a credit to Allowance for Doubtful Accounts.
Answer: D
30. The allowance method of accounting for bad debts emphasizes the net realizable value of
accounts receivable on the balance sheet when
a. the direct write-off method is used.
b. the percentage of net credit sales approach is used to estimate uncollectibles.
c. the percentage of accounts receivable approach is used to estimate uncollectibles.
d. a company omits cash payments during the accounting period.
Answer: C
31. If a company’s collection period for accounts receivable is considered to be excessively
long, then
a. the company may want to invest excess cash from receivable collections in the stock
market.
b. the company might examine its billing procedures in order to expedite collection from
customers.
c. customer returns should be disallowed in order to increase the collection of cash.
d. cash flows from operations will probably be more than sufficient.
Answer: B
32. During the year, Caltech Inc.’s accounts receivable turnover rate increased from 10 to 12
times. The company makes credit sales only with credit terms of 3/10, n/40. The best
explanation for the increase is that
a. the company’s credit department did a better follow up with customers whose account
balances became past due.
b. the company has recently dropped its credit check policy.
c. the company makes all customers pay cash instead of allowing purchases to be charged.
d. the company has more customers at the end of the year than it had at the beginning of the
year.
Answer: A
33. Summers, Inc. uses the allowance method to account for bad debts. The entry to record
the write-off of a customer’s account balance decreases
a. assets and owners’ equity.
b. assets and decreases liabilities.
c. owners’ equity and revenues.
d. none of these answers is correct.
Answer: D
34. If a company uses the allowance method to account for bad debts, the company’s owners’
equity will decrease
a. at the end of the accounting period when an adjusting entry to estimate bad debts is
recorded.
b. on the date a customer’s account is determined to be uncollectible.
c. when the accounts receivable amount becomes past due.
d. on the date a customer’s account is written off.
Answer: A
35. Managers must understand how transactions affect working capital
a. because GAAP does not allow companies with weak working capital to obtain loans.
b. because lenders often use this to assess a company’s ability to meet current obligations.
c. so that management can avoid transactions that increase working capital.
d. in anticipation of meeting creditors guidelines before issuing new stock.
Answer: B
36. Which of the following would be separately reported as restricted cash in the balance
sheet or footnotes to the financial statement?
a. $8,000 in the savings account at First Bank
b. $200 in a petty cash drawer
c. $10,000 cash in an escrow account at Guarantee Bank
d. $4,000 in a checking account at Second Rate Bank
Answer: C
37. On March 1, 2010, Silver Corp. sold goods to a Chinese company for 10,000 Chinese
yuan (10,000 RMB) to be paid on April 1, 2010. The exchange rates on March 1 and April 1,
2010 are US$8.0 = 1 RMB and US$8.5 = 1 RMB, respectively. What is Silver’s revenue in
US dollars and its 2009 exchange gain or loss?
a. Sales revenue =US $80,000; Exchange gain US $5,000
b. Sales revenue = US $85,000; Exchange loss US $5,000
c. Sales revenue = US $80,000; Exchange loss US $5,000
d. Sales revenue = US $85,000; Exchange gain US $5,000
Answer: A KP4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic
38. The current ratio fails to accurately reflect
a. the ability of a company to pay its current debts as they come due.
b. amounts that will come due within the next accounting period.
c. amounts due within the next operating cycle as of the end of the accounting period.
d. cash flows anticipated in future accounting periods.
Answer: D
39. Most companies
a. use working capital and current and quick ratios as low-cost surrogates for cash flow
measures.
b. place little importance on managing current assets.
c. have large amounts of current assets comprised of cash only.
d. are moving away from cash flow accounting.
Answer: A
40. The procedures designed to ensure that the cash account on the balance sheet reflects the
actual amount of cash in the company’s possession are referred to as
a. compensating balances.
b. record controls.
c. physical controls.
d. cash budgeting.
Answer: B
41. A company that maintains a cash balance of more than is necessary for its day-to-day
needs
a. is likely to have cash flow problems.
b. is not using working capital to its ideal advantage.
c. is likely to have a very low solvency.
d. has a problem with physical controls.
Answer: B
42. Accounts used to cover day-to-day office expenses are referred to as
a. petty cash.
b. bad debts.
c. cash restrictions.
d. compensating balances.
Answer: A
43. A cash discount differs from a trade discount in that the cash discount is
a. a reduction in the per unit price of an item if a certain quantity is purchased.
b. received in currency instead of by a check from the customer.
c. typically associated with consumers and a trade discount associated with commercial
vendors or suppliers.
d. the same as a mark down.
Answer: C
44. The gross method refers to
a. a method of accounting for uncollectible accounts.
b. the expectation that the customer will not take advantage of a cash discount.
c. a method of reporting cash on the balance sheet.
d. the restriction placed on the company’s bank account by the bank.
Answer: B
45. An exchange rate
a. is the cash amount received from a customer who takes advantage of a cash discount.
b. is the value of one currency in terms of another currency.
c. seldom varies from one accounting period to the next.
d. is ignored by multinational companies.
Answer: B
46. Hedging is used to
a. reduce risks associated with holding receivables denominated in foreign currencies.
b. calculate the current ratio for multinational companies.
c. translate foreign currency into U.S. dollars.
d. ‘window dress’ uncollectible accounts.
Answer: A
47. Tyson Corp. uses the aging method to estimate bad debts. The bookkeeper provided the
following schedule as of March 30th, 2010:
What is the amount of receivables deemed uncollectible?
a. $1,650
b. $4,650
c. $3,400
d. $105,000
Answer: B
48. At the beginning of 2010, Cyrus Corp.’s allowance for doubtful accounts is $12,500.
During 2010, $4,250 was written off as uncollectible. At December 31, the company used an
aging schedule of accounts receivable and determined that $10,530 of the accounts receivable
would probably be uncollectible. What would be the bad debts expense that should be
reported on Cyrus’s 2010 income statement?
a. $5,720
b. $26,780
c. $2,280
d.$18,280
Answer: $12,500 – $4,250 + X = $10,530 X = $2,280
Answer: C
49. Before adjusting entries, Kilby Corp’s accounts receivable and allowance for doubtful
accounts are $745,000 and $7,000 (credit balance), respectively. Using an aging schedule of
accounts receivable, it is determined that $60,000 of the accounts receivable would probably
be uncollectible. Calculate the net realizable value of Truman’s receivables at year end.
a. $681,000
b. $695,000
c. $809,000
d. $685,000
Answer: D
$745,000 - $60,000 = $685,000
50. The following information concerning the current assets and current liabilities of
Mason Company at December 31, 2010, is presented below.
Based on this information, how would the current ratio be affected if Mason collects the
accounts receivable and then uses some of the cash to pay off the accounts payable?
a. The current ratio would increase from 1.30 to 1.93.
b. The current ratio would increase from 0.74 to 4.02.
c. The current ratio would decrease from 1.30 to 0.62.
d. The current ratio would increase from 1.09 to 1.61.
Answer: A
Before: $17,300/$13,300 = 1.30; After: $8,300/$4,300 = 1.93
The current ratio would increase.
51. The following information concerning the current assets and current liabilities of
Mason Company at December 31, 2010, is presented below.
Based on this information, how would the quick ratio be affected if Mason purchased $1,300
of inventory on account?
a. The quick ratio would decrease from 1.30 to 1.21.
b. The quick ratio would not change.
c. The quick ratio would decrease from 1.09 to 1.00.
d. The quick ratio would decrease from 1.09 to 1.21.
Answer: C
Before: ($6,700 + $7,830)/$13,300 = 1.09
After: ($6,700 + $7,830)/($13,300 + $1,300) = 1.00
The quick ratio would decrease. Note that inventory is not a quick asset.
52. The following information concerning the current assets and current liabilities of
Mason Company at December 31, 2010, is presented below.
Based on this information, what would the quick ratio be if Mason sold all of its inventory for
$6,000 cash?
a. The quick ratio would decrease from 1.09 to 0.19.
b. The quick ratio would decrease from 1.30 to 0.85.
c. The quick ratio would increase from 1.30 to 1.54.
d. The quick ratio would increase from 1.09 to 1.54.
Answer: D
Before: ($6,700 + $7,830)/$13,300 = 1.09
After: ($6,700 + $7,830 + $6,000)/$13,300 = 1.54
The quick ratio would increase.
53. Sanchez Inc. sells to customers only on credit. For the year ended December 31, 2010, the
following information is provided:
What is the balance of the Accounts Receivable account at December 31, 2010?
a. $1,525,000
b. $590,000
c. $205,000
d. $135,000
Answer: B
$230,000 + $850,000 – $470,000 – $7,000 – $13,000 = $590,000
54. Sanchez Inc. sells to customers only on credit. For the year ended December 31, 2010, the
following information is provided:
If Sanchez estimates bad debts at 5% of net credit sales, how much is bad debt expense?
a. $34,000
b. $15,200
c. $23,400
d. $42,150
Answer: D
5% x ($850,000 – $7,000) = $42,150
55. The balances of the allowance for doubtful accounts on the balance sheets dated
December 31 of 2010 and 2009 were $2,000 and $7,000, respectively. During 2010, bad
debts expense was $12,000. What is the amount of accounts receivable that were written off
as uncollectible during 2010?
a. $22,000
b. $8,000
c. $17,000
d. $2,000
Answer: C
$7,000 + $12,000 - $2,000 = $17,000
56. The following information is provided for Atlanta, Inc..
How much is the balance in the Accounts Receivable account at December 31, 2010?
a. $193,600
b. $158,600
c. $202,600
d. $203,600
Answer: C
$198,000 + $4,600 = $202,600
57. The following information is provided for Atlanta Inc.
What is the amount of the Net Realizable Value of the receivables at December 31, 2010?
a. $198,000
b. $154,000
c. $193,600
d. $190,400
Answer: A
$198,000
58. The following information was taken from the unadjusted trial balance and aging
schedule of Diane Company on December 31, 2010. All sales are on account.
If Diane uses the aging schedule of accounts receivable to determine bad debts, what is the
bad debts expense for the year ending December 31, 2010?
a. $4,280
b. $3,600
c. $3,680
d. $3,060
Answer: D
59. The following information was taken from the unadjusted trial balance and aging
schedule of Diane Company on December 31, 2010. All sales are on account.
If Diane uses the aging schedule of accounts receivable to determine bad debts, what is the
Allowance for Doubtful Accounts balance at December 31, 2010?
a. $3,000
b. $4,280
c. $2,920
d. $3,740
Answer: D
60. The following information was taken from the unadjusted trial balance and aging
schedule of Diane Company on December 31, 2010. All sales are on account.
If Diane uses the aging schedule of accounts receivable to determine bad debts, what is the
net realizable value of accounts receivable on the 2010 financial statements?
a. $46,000
b. $42,260
c. $42,320
d. $30,400
Answer: B
Net realizable value = $46,000 – $3,740 = $42,260
61. The following information was taken from the unadjusted trial balance and aging
schedule of Diane Company on December 31, 2010. All sales are on account.
If Diane Company estimates bad debts as 6% of net credit sales, what is the amount of bad
debts expense to be reported on the income statement for the period ending December 31,
2010?
a. $27,019
b. $29,820
c. $30,000
d. $29,779
Answer: B
Bad debts expense = ($500,000 – $3,000) X 6% = $29,820
62. On December 1, 2010, Sedona Trading Co. sold goods to a German company for 25,000
German marks (25,000 DM) to be collected on January 12, 2011. The exchange rates on
December 1 and December 31, 2010 are US$0.75 = 1 DM and US$.90 = 1 DM, respectively.
What is Sedona’s revenue in U.S. dollars?
a. $18,750
b. $22,500
c. $3,750
d. $41,250
Answer: A
Sales revenue = $0.75 x 25,000 = US$18,750
63. On December 1, 2010, Sedona Trading Co. sold goods to a German company for 25,000
German marks (25,000 DM) to be collected on January 12, 2011. The exchange rates on
December 1 and December 31, 2010 are US$0.75 = 1 DM and US$.90 = 1 DM, respectively.
What is Sedona’s exchange gain or loss for 2010?
a.$22,500 Exchange Gain
b. $3,750 Exchange Loss
c. $3,750 Exchange Gain
d. $18,750 Exchange Loss
Answer: C
Exchange gain = ($0.90 - $0.75) x 25,000 = US$3,750
Matching Questions
1. For each item listed in 1 through 5 below, place the letter of the best description
selected from a through e in the space provided. You may use each letter more than
once or not at all.
____ 1. Operating cycle
____ 2. Cash discount
____ 3. Allowance method
____ 4. Collection period
____ 5. Direct write-off method
Answer:
1. e
2. b
3. c
4. a
5. d
2. For each item numbered 1 through 5 below, identify the letter of the best description by
selecting from items a through e below. You may use each letter more than once or not at all.
____ 1. Current liabilities
____ 2. Current assets
____ 3. Quick ratio
____ 4. Working capital
____ 5. Current ratio
Answer:
1. d
2. a
3. e
4. c
5. b
3. For each item listed in 1 through 5, place the letter (a through e) of the best description in
the space provided. You may use each letter more than once or not at all.
____ 1. Sales returns
____ 2. Accounts receivable
____ 3. Sales discounts
____ 4. Net realizable value
____ 5. Quantity discounts
Answer:
1. a
2. f
3. d
4. e
5. b
Short Problems
1. At the beginning of 2010, Flagstaff Corp.’s allowance for doubtful accounts is $10,000.
During 2010, $7,000 was written off as uncollectible. At December 31, the company used an
aging schedule of accounts receivable and determined that $8,000 of the accounts receivable
would probably be uncollectible. Calculate bad debts expense to be reported on Flagstaff’s
2010 income statement.
Answer: $10,000 – $7,000 + X = $8,000
X = $5,000
2. Before adjusting entries, Dormont Corp’s accounts receivable and allowance for doubtful
accounts are $800,000 and $7,000 (credit balance), respectively. Using an aging schedule of
accounts receivable, it is determined that $44,000 of the accounts receivable would probably
be uncollectible. Calculate the net realizable value of Dormont’s receivables at year end.
Answer: $800,000 - $44,000 = $756,000
Use the information that follows concerning the current assets and current liabilities of Ryan
Company at December 31, 2010, to answer problems 3 through 8. Each problem is
independent of the others.
3. How would the current ratio be affected if Ryan collects the accounts receivable and then
uses some of the cash to pay off the accounts payable?
Answer: Before: $7,100/$6,300 = 1.13; After: $3,100/$2,300 = 1.35
The current ratio would increase.
4. Calculate Ryan’s working capital, current ratio, and quick ratio at December 31, 2010.
Answer:
5. How would the quick ratio be affected if Ryan purchased $500 of inventory on account?
Answer:
The quick ratio would decrease. Note that inventory is not a quick asset.
6. How would the current ratio be affected if Ryan collects $600 from customers for amounts
owed?
Answer: Before: $7,100/$6,300 = 1.13; After: ($7,100 – $600 + $600)/$6,300 = 1.13
The current ratio would not change. Cash and accounts receivable are both current.
7. What would the quick ratio be if Ryan sold all of its inventory for $5,000 cash?
Answer: Before: ($1,700 + $2,830)/$6,300 = 0.72
After: ($1,700 + $2,830 + $5,000)/$6,300 = 1.51
The quick ratio would increase.
8. How would the current ratio be affected if Ryan paid off its wages and taxes?
Answer: Before: $7,100/$6,300 = 1.13
After: ($7,100 – $500)/($6,300 – $200 – $300) = 1.14
The current ratio would increase slightly.
9. Brocton Inc. sells to customers only on credit. For the year ended December 31, 2010, the
following information is provided:
A. Determine the balance of the Accounts Receivable account at December 31, 2010.
B. If Brocton estimates bad debts at 3% of net credit sales, how much is bad debt expense?
Answer: A. $240,000 + $550,000 – $580,000 – $6,000 – $14,000 = $190,000
B. 3% x ($550,000 – $6,000) = $16,320
10. Before adjusting entries, Martin’s accounts receivable and allowance for doubtful
accounts are $65,000 and $1,500 (debit balance), respectively. Using an aging schedule of
accounts receivable, it is determined that $4,000 of the accounts receivable would probably
be uncollectible. Calculate bad debts expense to be reported on Martin’s current year’s
income statement?
Answer: $1,500 + $4,000 = $5,500
11. The balances of the allowance for doubtful accounts on the balance sheets dated
December 31 of 2010 and 2009 were $1,000 and $4,000, respectively. During 2010, bad
debts expense was $9,000. What is the amount of accounts receivable that were written off as
uncollectible during 2010?
Answer: $4,000 + $9,000 - $1,000 = $12,000
12. The following information is provided for Garland Inc. Answer the questions that follow.
A. How much is the balance in the Accounts Receivable account at December 31, 2010?
B. What is the amount of the Net Realizable Value of the receivables at December 31, 2010?
Answer: A. $165,000 + $3,000 = $168,000
B. $165,000
13. The balances of the allowance for doubtful accounts on the balance sheets dated
December 31 of 2010 and 2009 were $21,000 and $14,000, respectively. During 2010,
$13,000 of accounts receivable were written off as uncollectible. How much bad debts
expense is recognized during 2010?
Answer: $14,000 – $13,000 – $21,000 = $20,000
14. Before adjusting entries, Clark’s accounts receivable and allowance for doubtful accounts
are $42,000 and $300 (credit balance), respectively. Clark determined that 0.4% of net sales
would probably be uncollectible. Sales during the year were $500,000 and sales returns
amounted to $6,000. Calculate the net realizable value of accounts receivable on Clark’s
balance sheet at year-end.
Answer: $42,000 – [$300 + ($494,000 x .004)] = $39,724
Use the information that follows taken from the unadjusted trial balance and aging schedule
of Behrend Company on December 31, 2010 to answer problems 15. All sales are on account.
15. If Behrend uses the aging schedule of accounts receivable to determine bad debts,
determine the following:
A. Bad debts expense for the year ending December 31, 2010
B. Allowance for Doubtful Accounts balance at December 31, 2010
C. Net realizable value of accounts receivable on the 2010 financial statements
Answer:
Use the information that follows from the financial statements of Pines Company at
December 31, 2010, to answer questions 16 through 20 that follow.
16. Calculate total current assets for Pines Company at December 31, 2010.
Answer: $3,000 + $5,000 + $19,000 = $27,000
17. Calculate total current liabilities for Pines Company at December 31, 2010.
Answer: $2,000 + $5,000 = $7,000
18. Calculate total working capital for Pines Company at December 31, 2010.
Answer: ($3,000 + $5,000 + $19,000) – ($2,000 + $5,000) = $20,000
19. Calculate the current ratio for Pines Company at December 31, 2010.
Answer: $27,000/$7,000 = 3.86
20. Calculate the quick ratio for Pines Company at December 31, 2010.
Answer: ($3,000 + $5,000)/$7,000 = 1.14
21. On December 1, 2010, Casio Trading Co. sold goods to a German company for 20,000
German marks (20,000 DM) to be collected on January 12, 2011. The exchange rates on
December 1 and December 31, 2010 are US$0.50 = 1 DM and US$.60 = 1 DM, respectively.
Calculate Casio’s revenue in U.S. dollars and its exchange gain or loss for 2010.
Answer: Sales revenue = $0.50 x 20,000 = US$10,000
Exchange gain = ($0.60 - $0.50) x 20,000 = US$2,000
22. On December 11, 2010, Bisbee Co. purchased capsules from a Canadian company for
10,000 Canadian dollars (10,000 C$) to be paid on January 2, 2011. The exchange rates on
December 11 and December 31, 2010 are US$0.79 = 1C$ and US$0.82 = 1C$, respectively.
What is the cost of the capsules in U.S. dollars and the 2010 exchange loss?
Answer: Cost of capsules = $0.79 x 10,000 = US$7,900
Exchange loss = ($0.82 - $0.79) x 10,000 = US$300
23. On December 1, 2009, Mason Company delivered a shipment of goods to a Swiss
customer for a price of 150,000 euros. If on that date 1.3 U.S. dollars could be exchanged for
1 euro, what entry would Mason record to convert the receivable to equivalent U.S. dollars?
Answer:
24. The following are partial balance sheets for Pedro Co, dated December 31:
During 2010, $4,000 of accounts receivable were written off as uncollectible. Calculate the
amount of bad debts expense recognized on Pedro’s 2010 income statement.
Answer: $5,000 - $4,000 - $11,000 = $10,000
25. Paxton’s aging schedule of its accounts receivable on December 31 follows:
The balance in Paxton’s allowance for doubtful accounts immediately prior to December 31
adjusting entries is $700 credit. Determine bad debts expense and the net realizable value of
the December 31 accounts receivable.
Answer: Balance in the allowance for doubtful accounts required on the balance sheet:
(.03 x $100,000) + (.07 x $70,000) + (.1 x $40,000) = $11,900.
Bad debts expense is $11,200 ($11,900 – $700).
The net realizable value of accounts receivable is $210,000 – $11,900 = $198,100.
26. On 12/31/09, Phoebe Company’s balance sheet revealed a $7,000 balance in its allowance
for doubtful accounts. During 2010, $2,000 of accounts were written off and $500 of
accounts receivable previously written off were collected. On 12/31/10, bad debts expense
was estimated to be 5% on net credit sales, which were $400,000. Calculate the balance in the
allowance for doubtful accounts on 12/31/10.
Answer: The balance in the allowance for doubtful accounts on 12/31/10 is $7,000 – $2,000
+ $500 + $20,000 = $25,500.
Short Essay Questions
1. Briefly described hedging.
Answer: Hedging is commonly practiced to reduce the risk associated with holding
receivables and payables in foreign currencies. Companies are susceptible to losses in
situations where extreme exchange rates are constantly fluctuating. The fluctuating exchange
rates can cause losses that cause income and other reported values (receivables and payables)
to fluctuate substantially from one period to the next. Hedging involves taking a position in
foreign currency in an amount that is equal and opposite of a particular receivable or payable
expressed in the currency. Hedging can negate the effect of transaction losses much like an
insurance policy can offset a loss to plant assets.
2. The Porsha Bank has provided its auditor with the following selected financial data for
2010:
In reviewing the loans outstanding, the auditors were troubled by the fact that the
collectability of some loans to Brazil was questionable. In fact, Porsha Bank has been making
new loans to Brazil so that they can pay the interest on the loans already outstanding. The
economic situation of Brazil has forced the auditors to insist that Porsha Bank increases its
allowance for its current loans to $9,000 and for its non-current loans to $16,000. Porsha
Bank decided to adhere to their auditors’ suggestions.
Indicate the effects of adopting the auditor’s allowance requirements on Porsha Bank’s
current ratio and 2010 net income.
Answer: Increasing the allowance for doubtful accounts-current from $3,000 to $9,000
decreases current assets from $25,000 to $19,000. This decreases the current ratio from 1.32
to 1.0. Net income is decreased by $18,000 [($9,000 + $16,000) - ($4,000 + $3,000)], upon
the increase of both current and long-term allowances for doubtful accounts. The adjusted
2010 net income is $12,000 ($30,000 - $18,000). There is no change in the current ratio as a
result of the long-term increase.
3. Why might an operating cycle of one company differ from an operating cycle of another
company?
Answer: An operating cycle is the time it takes a company to convert its cash to inventory,
sell the inventory, and collect cash from the sale. A company that grows Christmas trees will
likely have a long operating cycle, because of the time it takes to grow a tree. A fast food
restaurant will have a very quick operating cycle. The nature of a company’s industry
determines its operating cycle.
4. What accounting requirements brought significant opposition from the banking industry?
Answer: FASB has ruled that banks disclose the market value of their outstanding loans and
create larger reserves (allowances) for bad debts. Banks were opposed to this rule because it
reduced the balance sheet value of most U.S. banks.
5. Identify the limitations of current asset classification.
Answer: The limitations are related to the fundamental fact that current assets and current
liabilities fail to accurately reflect future cash inflows and outflows. The ability of the
company to pay its debts as they come due is based upon whether cash flows will occur in the
future. Since financial statements are based on historical facts and are not intended to predict
information about future cash flows, this information cannot be determined solely by
examining the current sections of the balance sheet.
6. On December 31, 2010, Priya Co. has accounts receivable of $400,000. It uses the direct
write-off method of accounting for bad debts because this is what is required for determining
its U.S. taxable net income. The opinion of management is that what is acceptable to the
Internal Revenue System should be acceptable under generally accepted accounting
procedures. However, its independent auditor disagrees with this impassioned argument and
does not accept the direct write-off method of accounting for bad debts.
Present the reason(s) for the auditor’s objection to the direct write-off method, and indicate
the method that must be used under GAAP. Indicate how Priya’s 2010 net income, current
ratio, and quick ratio will be affected by following the auditor’s position.
Answer: The direct write-off method of accounting for bad debts recognizes bad debts
expense when an individual account is determined to be uncollectible. This does not achieve
matching of expenses with the revenue that it generates. Also, accounts receivable would be
measured at total face amount and not its net realizable value. Each reason makes the direct
write-off method unacceptable under generally accepted accounting procedures. Taxable
income for the IRS does not attempt to match expenses with revenues. To have a deduction
for bad debts expense, the IRS wants evidence that a particular account is uncollectible and
not a mere estimation of uncollectibility.
The allowance method will initially increase bad debts expense and therefore decrease
income. The carrying value of accounts receivable will decrease by the allowance for
doubtful accounts and therefore decrease both the current and quick ratios.
7. A company has a significant debit or credit accumulation in the preadjustment balance of
allowance for doubtful accounts over several periods.
Required:
(1) What would this indicate?
(2) How can users detect the source of this problem?
Answer: (1) This may indicate that the estimates for bad debts are inaccurate and biased.
Consistent overestimates give risk to preadjustment credit accumulations, while consistent
underestimates create preadjustment accumulations on the debit side of allowance for
doubtful accounts. Such accumulations, which often indicate that a company’s estimating
formula should be revise, can lead to balance sheet misstatements in the allowance account
because they are reflected in the year-end, post-adjustment balance.
(2) Users can detect the balance sheet misstatements by comparing the amount in the
allowance account to such numbers as sales and accounts receivable across time. Unusual
deviations or well-defined trends may reveal a problem in estimating bad debts, which may
raise questions about management’s competence and/or incentives.
8. Preston Bank has $50 million of loans outstanding on December 31 of the current year, in
which it recorded net income of $770,000. Preston did not provide for any uncollectible loans
because all of its loans are collateralized by real estate. That is, if the loans were to default,
Preston would obtain the title to the real estate for which the loans were made. However,
during the audit of Preston’s financial statements, the auditing company determined that $5
million of the outstanding loans would probably be dishonored (uncollectible). Because
during the last three years real estate values have deteriorated, they also investigated the real
estate that backed these collateralized loans. The market value of that real estate is negligible.
Recalculate Preston’s loans receivable on December 31 and current net income to an amount
that would be acceptable to the auditors.
Answer: The allowance for uncollectible loans should be increased from $0 to $5,000,000.
This would decrease the carrying value of Preston’s loans receivable from $50,000,000 to
$45,000,000. Current net income would also decrease by $5 million because of bad debts
expense, from net income of $770,000 to a net loss of $4,230,000.
9. Can a company use the direct write-off method rather than the allowance method to
account for bad debts? Explain why or why not.
Answer: Two accounting methods exist—the direct write off method and the allowance
method. The direct write off method is not considered GAAP unless the dollar amount of
uncollectible accounts is so small that using the direct write off method would not impact any
users’ decisions. The allowance method is preferable since it matches a company’s expenses
against the sales revenue and values receivables on the balance sheet at the net amount
expected to be collected.
10. What effect does ‘window dressing’ have on the solvency of a company?
Answer: Managers who have discretion over the accounts in the current asset section of the
balance sheet make efforts to inflate solvency measures by selecting accounting methods and
making operating decisions that are designed solely to make the financial statements appear
more attractive. Increasing the dollar amount of current assets increases working capital, the
current ratio, and the quick ratio. This makes a company look much more solvent than it
might be in reality. In the long run, a company may suffer and actually find its ability to raise
debt and equity capital in the future hindered.
11. The following is a partial balance sheet for Quenton Company dated December 31, 2010:
During 2010, $4,000 of accounts receivable were written off as uncollectible and bad debts
expense recognized on Quenton’s 2010 net income statement was $8,000. However, the
president of the company believes that $2,500 of these receivables were written off too soon.
She believes that there is a good chance that they will be collected next year. There is some
historical evidence to back the president’s position.
A partial explanation for her position is that Quenton has a debt covenant requiring it to
maintain a current ratio of 1.5. The president believes that by reversing the write-off of
$2,500 of accounts receivable, the current assets will be $97,500 and the current ratio will be
1.5. However, the chief financial officer states that a better approach to getting the current
ratio to 1.5 is to pay off some accounts payable. If the company paid $5,000 of accounts
payable, the current ratio would become the minimum 1.5 required by the debt covenant.
Comment, with numerical illustration, on the president’s and chief financial officer’s
positions.
Answer: If the write-off of $2,500 of accounts receivable were reversed, the carrying or net
realizable value of accounts receivable will not change because a write off under the
allowance method causes a decrease in accounts receivable and an increase in the allowance
account. The new accounts receivable portion of current assets would be:
Thus, total current assets and the current ratio would not change. Under the allowance
method of accounting for bad debts, the write-off of an account decreases both accounts
receivable and allowance for doubtful accounts, leaving the carrying value of net accounts
receivable unaffected. If we follow the president’s suggestion, the current ratio is still 1.46
($95,000/$65,000), which is less than the 1.5 required by the debt covenant. The only way to
change accounting for accounts receivable so that a 1.5 current ratio can be achieved is to
consider an aging schedule of accounts receivable and estimate that only $500 of allowance is
required. This would increase the net realizable value of accounts receivable and current
assets by the required $2,500.
The position of the CFO is frequently referred to as window dressing. If $5,000 of accounts
payable were paid, the current assets would decrease by $5,000 to $90,000, and current
liabilities would also decrease by $5,000 to $60,000. The resulting current ratio meets the 1.5
minimum.
12. Why is too much cash undesirable?
Answer: Cash that is not being used for immediate needs is idle. Idle cash provides no return,
interest, or earnings power, and loses purchasing power during periods of inflation.
Maintaining a proper balance of cash is one of management’s greatest challenges.
13. Why is the timing of recording a receivable important?
Answer: The timing of recording a receivable is important because of its relationship to
revenue recognition. Note that the timing of revenue recognition can have a significant effect
on important financial statement numbers. In other words, by recognizing the sale involving a
receivable in an earlier period, the current ratio can be increased, as well as both working
capital and net income can be increased. Such effects have economic significance, because
they may influence a company’s credit rating or determine whether it violates the terms of
debt agreements. Since the timing of revenue and receivable recognition has a direct effect on
net income and current assets, financial statement users are tremendously impacted.
Test Bank for Financial Accounting: In an Economic Context
Jamie Pratt
9780470635292, 9781119537571, 9781119444367
