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CASE STUDY 7 - RECEIVABLES Max is very happy with the work you have done in tidying up his inventory recording and valuation systems and

CASE STUDY 7 - RECEIVABLES

Max is very happy with the work you have done in tidying up his inventory recording and valuation systems and is quite confident that his reports will now give him more useful information and provide him with a truer picture of the position and performance of the business.

However, Max is now concerned that some of the other areas of his business could need a review given some the problems found with the recording of inventory. Max has explained to you that he is still a little confused about the entries required when he was considering purchasing "Ray's Motors". In particular Max is still unsure about the discrepancy between the fair value of accounts receivable and their historic cost and why the fair value was not recorded in a similar way to the other assets.

Max is also concerned that his accounts receivable have become a significant proportion of his assets. Prior to expanding his business operations Max had been owed no more than a few hundred dollars. At present his accounts receivable figure totals $26,500 and this increased to $56,419 once Max purchased the group of assets and started producing his DIY Clean Air Turbo System. Max has been able to ascertain that at the beginning of the financial year the fair value of his accounts receivable was $52,205.

Required

Explain to Max why there is a difference between the amount he has recorded for his accounts receivable and the fair value of that asset. Then clarify for Max the reasons why the historic cost is used when recording the purchase of accounts receivable and the impact the fair value will have on that entry.

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Max received a letter some months ago stating that one of his debtors would not be able to pay their debts. Max filed the letter as he was unsure whether an accounting entry was required or not and as no cash was going to be received that it would have little impact on the accounting system. You have explained to Max the importance of recording all relevant information in an accrual accounting system and that bad debts should be recorded when they occur.

Taking this advice on board Max went away and reviewed some of his old accounting notes and produced the following General Journal entry, the entry date is based on the day Max received the letter.

17 AprilBad Debts Expense3,550

GST355

Accounts Receivable3,905

Required

2.Explain to Max that he has misunderstood what you meant when you told him to record bad debts "when they occur" and why his entry does not fit with the allowance method of accounting for bad debts that he is currently using. (Note - In Case Study 2 you created an Allowance for Doubtful Debts account with a $800 balance, Max has not touched this account since). In your explanation point out to Max the differences between the direct write-off and allowance methods and why the allowance method is preferred.

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Max now feels he has a better grasp of why the allowance method he is using is a good option but is still not sure how it actually works. Max recalls something about a net sales method and ageing receivables from his studies but doesn't know how to apply them.

You have been able to gather together the following information about Max Armim Torque's debtors from Max's records, The details below have already taken into account the write off in Part 2.

AGE OF ACCOUNTSAMOUNTUNCOLLECTABLE

(incl. GST)ESTIMATE %

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0 -1 month21,725.002

1 -6 months18,928.8011

6 -12 months9,880.2046

over 12 months1,980.0092

52,514.00

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You have also been able to ascertain that Max's revenues for the past year consist of

-Credit Sales and Installations $68,700

-Cash Sales and Installations $48,200

-Sales Returns $ 7,200

(returns are only available on credit sales)

-Industry data shows that 6% of credit transactions are likely to go bad.

Required

3.Max has asked you to update his accounts below to show him how he should have entered the transaction in part 2. Then show the impact on Max's general ledger and Balance Sheet if the above information was applied using:

The ageing method

The net sales method

Accounts Receivable

Date

Details

Post Ref

Debit

Credit

Balance

Allowance for Doubtful Debts

Date

Details

Post Ref

Debit

Credit

Balance

Doubtful Debts Expense

Date

Details

Post Ref

Debit

Credit

Balance

Accounts Receivable

Date

Details

Post Ref

Debit

Credit

Balance

Allowance for Doubtful Debts

Date

Details

Post Ref

Debit

Credit

Balance

Doubtful Debts Expense

Date

Details

Post Ref

Debit

Credit

Balance

Max can now see how both these systems work and can see the net sales method is much simpler to apply. He has asked you to explain why anyone would bother going to the trouble of analysing the ageing data for accounts receivable.

Required

4.Answer Max's question for him.

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Max is still a little overwhelmed by the concepts involved in dealing with accounts receivable and wants to know why they are such a big deal. "I just give my good clients credit and they pay me back as soon as they can. Occasionally some take a little bit too long or can't pay their entire bill, but that's just the way business works."

Required

5.Try and convince Max that proper management of accounts receivable is crucial to business survival.

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