FAR SEC 6

Question 1

In terms of liquidity, how do accounts and notes receivable compare to available-for-sale securities and inventories?

Answer 1

Liquidity ranked from greatest to least:

Cash > Available-for-sale securities > accounts and notes receivable > Inventory

Question 2

What are accounts receivable?

Answer 2

Accounts receivable often are short-term, unsecured, and informal credit arrangements (open accounts).

Question 3

What are notes receivable?

Answer 3

Notes receivable are evidenced by a formal instrument, such as a promissory note. A formal document provides its holder with a stronger legal status than does an account receivable.

Question 4

What distinguishes accounts receivable from notes receivable?

Answer 4

Notes receivable have a formal contract or promissory note and are therefore more legally enforceable than accounts receivable (which lack a formal contract document).

Question 5

What is a receivable?

Answer 5

A receivable is an asset recognized to reflect a claim against another party for the receipt of money, goods, or services. For most accounting purposes, the claim is expected to be settled in cash.

Question 6

How do receivables relate to accrual accounting?

Answer 6

The recording of a receivable, which often coincides with revenue recognition, is consistent with accrual accounting.

Question 7

When is a receivable current?

Answer 7

A receivable is a current asset if it is reasonably expected to be collected within the longer of 1 year or the entity’s normal operating cycle.
-Otherwise, it should be classified as noncurrent. Noncurrent receivables are measured at the present value of expected cash flows.

Question 8

What are trade receivables? (3 elements)?

Answer 8

1) Trade receivables, the majority of receivables, are current assets resulting from credit sales to customers in the normal course of business and due in customary trade terms.
2) They are normally unsecured and noninterest-bearing.
3) They represent unconditional rights to consideration from contracts with customers.

Question 9

What are nontrade receivables? (3 elements)

Answer 9

1) Nontrade receivables are all other receivables than trade receivables.
They include among others
2) Lease receivables
3) Interest, dividends, rent, or royalties accrued

Question 10

What are trade discounts? (3 elements)

Answer 10

1) Trade discounts adjust the gross (list) price for different buyers, quantities, and costs. Net price after the trade discount is the basis for recognition.
2) Some sellers offer chain-trade discounts such as 40%, 10%, which means certain buyers receive both a 40% discount and a 10% discount.
3) Trade discounts are solely a means of calculating the sales price. They are not recorded.

Question 11

What is the basis for recognizing trade discounts?

Answer 11

Trade discounts adjust the gross (list) price for different buyers, quantities, and costs. Net price after the trade discount is the basis for recognition.

Question 12

Are trade discounts recorded?

Answer 12

No. Trade discounts are solely a means of calculating the sales price. They are not recorded.

Question 13

What are cash discounts? (4 elements)

Answer 13

1) Cash discounts (prompt payment discounts) accelerate cash collection by rewarding customers for early payment.
2) A common example of prompt payment discount is 2/10, n/30. It means a 2% discount if the invoice is paid within 10 days, or the entire balance is due in 30 days.
3) Because of the uncertainty as to whether customers will pay during the discount period and receive the discount, the consideration in this type of contract is variable.
4) At contract inception, an entity should estimate the number of customers that are expected to receive the discount and recognize revenue based on the expected amount of consideration to which it will be entitled.

Question 14

How are accounts receivable measured? (5 elements)

Answer 14

1) Accounts receivable are presented at the net amount expected to be collected. They are measured using the amortized cost basis and reported minus the allowance for credit losses (previously called the allowance for uncollectible accounts).
2) The amortized cost basis is the amount at which an account receivable is originated or acquired, adjusted for applicable accrued interest and amortization of premium or discount (in the case of noncurrent receivables), cash and trade discounts, collection of cash, and write-offs.
3) The allowance for credit losses on accounts receivable must be recorded at the reporting date. It represents the portion of accounts receivable that the entity does not expect to collect.
-The allowance for credit losses is a valuation account that is deducted from the accounts receivable balance.
4) Initial recognition of the allowance for credit losses and subsequent changes in the allowance balance are recognized immediately in the income statement in the credit loss expense (previously called bad debt expense) account.
-An increase in the balance of the allowance for credit losses is recognized as a credit loss expense.
Credit loss expense $XXX
Allowance for credit losses $XXX
-A decrease in the balance of the allowance for credit losses is recognized as a reversal of credit loss expense.
Allowance for credit losses $XXX
Credit loss expense $XXX
5) The allowance for credit losses should be estimated based on entity’s past experience taking into account current and forecasted economic conditions.

Question 15

On the balance sheet, how is the carrying amount of accounts receivable presented? (2 elements)

Answer 15

1) On the face of the balance sheet, the carrying amount of accounts receivable is presented net of any allowance for credit losses.
2) The allowance for credit losses must be separately presented as a deduction from the balance of accounts receivable.
Balance sheet:
Accounts receivable $X,XXX
Less: (Allowance for credit losses) (X,XXX)
Equals final total: Accounts receivable, net $X,XXX

Question 16

On the balance sheet, how are material receivables treated? (4 elements)

Answer 16

1) Material receivables should be segregated. Among the usual categories are
2) Notes receivable (with disclosure of the effective interest rates)
3) Trade receivables
4) Nontrade receivables

Question 17

On the balance sheet, how are receivables presented on the balance sheet in terms of current/noncurrent?

Answer 17

Receivables should be separated into current and noncurrent portions.

Question 18

On the balance sheet, how does time value of money affect reporting?

Answer 18

Discount or premium resulting from a present value measurement directly decreases or increases the face amount of a note.

Question 19

On the balance sheet, what disclosures are required for receivables? (3 elements)

Answer 19

Disclosure should be made of
1) Related party receivables, e.g., those arising from loans to employees or affiliates
2) Pledged or assigned receivables
3) Concentrations of credit risk (described in Study Unit 4, Subunit 6)

Question 20

What is the definition of trade receivables in section 6.2?

Answer 20

Trade receivables are current, noninterest-bearing accounts receivable that are reported at the net amount expected to be collected, i.e., net of an allowance for credit losses.

Question 21

How does reporting of trade receivables relate to interest and time value of money?

Answer 21

For trade receivables, interest recognition (except for late payment) and present value calculations are not relevant.

Question 22

What are the two primary measurement issues for accounts receivable?

Answer 22

The principal measurement issue for accounts receivable is the estimation of the allowance for credit losses and calculation of credit loss expenses for the period.

Question 23

What is the direct write-off method? (4 elements)?

Answer 23

1) The direct write-off method expenses bad debts when they are determined to be uncollectible. It is not acceptable under GAAP because
2) It does not match revenue and expense when the receivable and the write-off are recorded in different periods.
3) It does not state receivables at the net amount expected to be collected.
4) This method is acceptable for tax purposes.

Question 24

Is the direct write-off method for credit losses acceptable for tax purposes?

Answer 24

Yes.

Question 25

What is the direct write-off method used for?

Answer 25

Measuring credit losses.

Question 26

What are the two methods for accounting for credit losses?

Answer 26

The two approaches to accounting for credit losses are the direct write-off method and the allowance method. However, only the allowance method is acceptable under GAAP.

Question 27

What is the allowance method for credit losses? (5 elements)

Answer 27

1) The allowance method attempts to match credit loss expense with the related revenue. This method is required under GAAP.
2) The periodic journal entry to record credit loss expense is
Credit loss expense $XXX
Allowance for credit losses $XXX
3) As specific accounts receivable are written off, they are charged to the allowance account.
Allowance for credit losses $XXX
Accounts receivable $XXX
3) Thus, the write-off of a particular account has no effect on expenses.
-Write-offs do not affect the carrying amount of the net accounts receivable balance because the reductions of gross accounts receivable and the allowance are the same.
4) In the balance sheet, the carrying amount of accounts receivable is reported at the net amount expected to be collected.
Gross accounts – Allowance for credit losses = Carrying amount of accounts receivable

Question 28

Why don’t write-offs (allowance method) affect the carrying amount of net accounts receivable?

Answer 28

Write-offs do not affect the carrying amount of the net accounts receivable balance because the reductions of gross accounts receivable and the allowance are the same.

Question 29

Under the allowance method for credit losses, how is the amount of accounts receivable reported?

Answer 29

In the balance sheet, the carrying amount of accounts receivable is reported at the net amount expected to be collected.
Gross accounts – Allowance for credit losses = Carrying amount of accounts receivable

Question 30

Under the allowance method for credit losses, what is the equation for the carrying amount of accounts receivable?

Answer 30

Gross accounts – Allowance for credit losses = Carrying amount of accounts receivable

Question 31

What is the method for the measurement of the allowance for credit losses? (3 elements)

Answer 31

1) The ending balance of the allowance for credit losses is a percentage of the ending balance of accounts receivable.
2) Credit loss expense reflects the adjustment of the allowance to its correct ending balance.
3) An entity rarely experiences a single rate of uncollectibility on all its accounts. For this reason, entities generally prepare an aging schedule for accounts receivable.

Question 32

Why do entities prepare an aging schedule for accounts receivable?

Answer 32

An entity rarely experiences a single rate of uncollectibility on all its accounts. For this reason, entities generally prepare an aging schedule for accounts receivable.

Question 33

What happens when a customer pays on an account that was previously written-off as uncollectible?

Answer 33

Occasionally, a customer pays an account that was previously written off and was not expected to be recovered. The journal entry is
Cash $XXX
Allowance for credit losses $XXX

Question 34

What is factoring?

Answer 34

Factoring is a transfer of receivables to a third party (a factor) who assumes the responsibility of collection.

Question 35

How does factoring work? (5 elements)

Answer 35

1) Factoring discounts receivables on a nonrecourse, notification basis. Thus, payments by the debtors on the transferred assets are made to the factor. If the transferor (seller) surrenders control, the transaction is a sale of accounts receivable.
2) If a sale is with recourse, the transferor (seller) may be required to make payments to the transferee or to buy back receivables in specified circumstances. For example, the seller may become liable for defaults up to a given percentage of the transferred receivables.
3) The sale proceeds are reduced by the fair value of the recourse obligation.
4) If the transfer with recourse does not qualify as a sale, the parties account for the transaction as a secured borrowing with a pledge of noncash collateral.
5) If a sale is without recourse, the transferee (credit agency) assumes the risks and receives the rewards of collection. This sale is final, and the seller has no further liabilities to the transferee.

Question 36

What are two attributes of factors?

Answer 36

1) A factor usually receives a high financing fee plus a fee for collection.
2) Furthermore, the factor often operates more efficiently than its clients because of the specialized nature of its services.

Question 37

How are credit card sales factored? (3 elements)

Answer 37

1) Credit card sales are a common form of factoring. The retailer benefits by prompt receipt of cash and avoidance of credit losses and other costs. In return, the credit card company charges a fee.
-Two methods of accounting for credit card sales may be necessary depending upon the reimbursement method used.
2) If payment is after submission of credit card receipts, the retailer initially records a sale and a receivable. After payment, the entry is
Cash $XXX
Service charge expense $XXX
Receivable $XXX
3) If the retailer’s checking account is increased by the direct deposit of credit card receipts, no receivable is recognized. The entry is to credit sales instead of a receivable.
Cash $XXX
Service charge expense $XXX
Sales $XXX

Question 38

How does pledging work? (4 elements)

Answer 38

1) A pledge (a general assignment) is the use of receivables as collateral (security) for a loan. The borrower agrees to use collections of receivables to repay the loan.
2) Upon default, the lender can sell the receivables to recover the loan proceeds.
3) Because a pledge is a relatively informal arrangement, it is not reflected in the accounts. A transfer of financial assets is a sale only when the transferor relinquishes control.
4) If the transfer (e.g., a pledge) of accounts receivable is not a sale, the transaction is a secured borrowing. The transferor becomes a debtor, and the transferee becomes a creditor in possession of collateral.
-However, absent default, the collateral remains an asset of the transferor.

Question 39

What method is used for transfers of financial assets?

Answer 39

The accounting for transfers of financial assets is based on a financial-components approach focused on control.

Question 40

What are the three objectives of the financial-components approach to transfers of financial assets?

Answer 40

The objective is for each party to
1) Recognize the assets it controls and the liabilities it has incurred,
2) Derecognize assets when control has been given up, and
3) Derecognize liabilities when they have been extinguished.

Question 41

For transfers of financial assets, when does control exist?

Answer 41

Whether control exists depends, among other things, on the transferor’s continuing involvement. Continuing involvement is the right to receive benefits from the assets or an obligation to provide additional assets to a party related to the transfer.

Question 42

For transfers of financial assets, what is continued involvement?

Answer 42

Continuing involvement is the right to receive benefits from the assets or an obligation to provide additional assets to a party related to the transfer.

Question 43

What are the three types of transfers of financial assets?

Answer 43

Transfers of financial assets include transfers of
(1) an entire financial asset,
(2) a group of entire financial assets, and
(3) a participating interest in an entire financial asset.

Question 44

For transfers of financial assets, how is the holder of a participating interest treated?

Answer 44

The holder of a participating interest receives cash in proportion to the share of ownership, and all holders have the same priority.

Question 45

For transfers of financial assets, when is a sale recognized? (4 elements)

Answer 45

1) A transfer of financial assets is a sale when the transferor relinquishes control. The transferor relinquishes control only if certain conditions are met:
2) The transferred assets are beyond the reach of the transferor and its creditors;
3) Transferees may pledge or exchange the assets or interests received; and
4) The transferor does not maintain effective control through, for example,
-An agreement to reacquire the assets before maturity or
-An agreement making it probable that the transferee will require repurchase.

Question 46

For transfers of financial assets qualifying as sales, what method is applied?

Answer 46

If the transfer of an entire financial asset (or a group) qualifies as a sale, the financial components approach is applied.

Question 47

For sales of financial assets under the financial components method, what three activities occur?

Answer 47

If the transfer of an entire financial asset (or a group) qualifies as a sale, the financial components approach is applied. The transferor
1) Derecognizes the financial assets transferred
2) Recognizes and initially measures at fair value the assets obtained and liabilities incurred
3) Recognizes any gain or loss in earnings

Question 48

If the transfer of financial assets is not a sale but the transfer occurs, what is it?

Answer 48

If the transfer is not a sale, the transaction is a secured borrowing. The transferor becomes a debtor, and the transferee becomes a creditor in possession of collateral.

Question 49

For transfers of financial assets, how is collateral related to the secured borrowing? (4 elements)

Answer 49

1) A secured borrowing is a formal borrowing arrangement. The borrower signs a promissory note and financing agreement, and specific receivables are pledged as collateral.
2) The loan is at a specified percentage of the face amount of the collateral, and interest and service fees are charged to the borrower.
3) The collateral may be segregated from other receivables on the balance sheet.
Accounts receivable assigned $XXX
Accounts receivable $XXX
4) The note payable is reported as a liability.
Cash $XXX
Notes payable $XXX

Question 50

What is the definition of notes receivable? (6 elements)

Answer 50

1) A note receivable is a debt evidenced by a two-party writing (a promissory note). Notes are more formal promises to pay than accounts receivable.
2) Most notes bear interest (explicitly or implicitly) because they represent longer-term borrowings than accounts receivable.
3) Notes with original maturities to the holder of 3 months or less are treated as cash equivalents and accounted for at net realizable value.
-Because the interest implicit in the maturity amount is immaterial, no interest revenue is recognized.
4) Notes classified as current assets are usually recorded at face amount and reported minus an allowance for credit losses.
5) Notes classified as noncurrent assets are recorded at the present value of the expected future cash flows and reported minus an allowance for credit losses.
-Any difference between the proceeds and the face amount must be recognized as a premium or discount and amortized.
6) When the note’s stated interest rate is a reasonable rate (e.g., the market rate), the note is issued at its face amount, and no discount or premium is recognized.

Question 51

What must be done when notes are issued with no stated interest rate? In this case, what is the interest called?

Answer 51

Sometimes notes are issued with no stated rate and an unknown effective rate. In these cases, the rate must be imputed from other facts surrounding the transaction. Such facts include the marketability of the note and the debtor’s creditworthiness.
-Thus, the interest is implicit.

Question 52

What is the accounting treatment when the note is not interest bearing because the interest is included in the amount paid at maturity? (4 elements)

Answer 52

1) A note may bear no explicit interest because interest is included in the amount to be paid at maturity. The accounting treatment is to debit notes receivable for its face (maturity) amount, credit cash (or other appropriate account), and credit discount. The discount is amortized to interest revenue.
2) The entry for initial recognition is
Notes receivable $XXX
Cash $XXX
Discount on note $XXX
-Notes receivable are reported in the financial statements at their face amount minus any unamortized discount.
3) At the end of the period, the discount is amortized to interest revenue using the effective-interest method explained in Study Unit 5, Subunit 6.
The entry for recognition of interest is
Discount on note $XXX
Interest revenue $XXX
4) When the note arises in the ordinary course of business and is “due in customary trade terms not exceeding approximately 1 year,” the interest element need not be recognized.

Question 53

What are the two subcategories of non-interest bearing notes?

Answer 53

1) The term “noninterest-bearing” is confusing. It is used not only (1) when a note bears implicit interest but also (2) when no actual interest is charged (the cash proceeds equal the face amount).
2) When a note is noninterest-bearing in the second scenario above or bears interest at a rate that is unreasonable in the circumstances, interest must be imputed (estimated). A note with imputed interest also results in amortization of discount or premium.

Question 54

For unreasonable interest, how is the interest rate imputed when a note is exchanged solely for cash?

Answer 54

When a note is exchanged solely for cash, and no other right or privilege is exchanged, the proceeds are assumed to reflect the present value of the note. The effective interest rate is therefore the interest rate implicit in that present value.

Question 55

For unreasonable interest, what conditions would determine whether the interest rate agreed upon between two parties is fair? (4 elements)

Answer 55

1) When a note is exchanged for property, goods, or services, the interest rate determined by the parties in an arm’s-length transaction is presumed to be fair.
2) That presumption is overcome when (a) no interest is stated, (b) the stated rate is unreasonable, or (c) the nominal amount of the note materially differs from the cash sales price of the item or the market value of the note.
3) In these circumstances, the transaction should be recorded at the more clearly determinable of
i) The fair value of the property, goods, or services or
ii) The market value of the note.
4) Absent established exchange prices or evidence of the note’s market value, the present value of a note with no stated rate or an unreasonable rate should be determined by discounting future payments using an imputed rate. The prevailing rate for similar instruments of issuers with similar credit ratings normally helps determine the appropriate rate.

Question 56

What three conditions overcome the presumption that the interest rate agreed upon between two parties is fair?

Answer 56

That presumption is overcome when
(a) no interest is stated,
(b) the stated rate is unreasonable, or
(c) the nominal amount of the note materially differs from the cash sales price of the item or the market value of the note.

Question 57

If an interest rate is determined to be unfair (unreasonable interest), how is the transaction recorded? (2 elements)

Answer 57

In these circumstances, the transaction should be recorded at the more clearly determinable of
i) The fair value of the property, goods, or services or
ii) The market value of the note.

Question 58

What happens when the stated interest rate is less than the effective rate applicable in the circumstances? (2 elements)

Answer 58

1) The stated interest rate may be less than the effective rate applicable in the circumstances because the lender has received other stated (or unstated) rights and privileges as part of the bargain.
2) The difference between the respective present values of the note computed at the stated rate and at the effective rate should be accounted for as the cost of the rights or privileges obtained.

Question 59

How is discounting of notes receivable done? (2 elements)

Answer 59

1) When a note receivable is discounted (sold, usually at a bank), the gain or loss on disposition of the note must be calculated.
2) The holder of the note receives the maturity amount (Principal + Interest at maturity) of the note minus the bank’s discount. The bank usually collects the maturity amount from the maker of the note.