A financial manager for a jewelry distributor is analyzing the cost of offering a cash discount to its credit policy. Currently, the firm’s sales terms are net 60 and virtually all of its customers pay at the end of the 60 days. The manager estimates that if the firm offers a 2/10 net 60 discount, the average collection time on its $5,000,000 annual credit sales will drop to one month with 60% of its customers taking advantage of the discount. The distributor currently finances working capital with a revolving credit agreement at 12 . Calculate the firm’s net cost of adding the cash discount to its credit terms.
Answer (B) is correct. To calculate the firm’s net cost of adding the cash discount to its credit terms, find both the total cash lost to discounts and the offsetting savings which arise from earlier customer payments. The calculations are as follows: Cash to be discounted = $5,000,000 × 60% = $3,000,000 Cost of discount = $3,000,000 × 2% = $60,000 Average daily sales = $5,000,000 ÷ 365 days = $13,698.63 per day Cost of A/R for 60 days = $13,698.63 × 60 days × 12% = $98,630.14 Cost of A/R for 30 days = $13,698.63 × 30 days × 12 $49,315.07 Savings from discount = $98,630.14 – $49,315.07 $49,315.07 Net cost of discount = $60,000 (cost) – $49,315 (savings) = $10,685
The cash manager for a large kitchen appliance retailer has been approached by a bank representative offering to set up a lock-box collection system. Analysis of the firm’s receipts shows that, on average, the system will reduce collection time by 2 days. The firm receives approximately 2,500 checks per day with an average value of $600 per check. The bank would charge $0.28 per check for operating the system. The firm currently invests short-term funds at an average rate of 7%. How much would the firm gain or lose annually by entering the lock-box agreement?
Answer (B) is correct. The additional annual income (loss) from using the lockbox service is the excess (deficit) of interest earned on the early deposits over (under) the cost of the service. If the plan is adopted, the firm’s average cash balance will increase by $3,000,000 ($600 value per check × 2,500 checks received per day × 2 days). Benefit (loss) = Interest earned – Cost. Thus, the loss of $45,500 is calculated from the interest earned of $210,000 ($3,000,000 × 7%) minus the cost of $255,500 ($0.28 per check × 2,500 checks per day × 365 days in a year).
Frame Co. has an 8% note receivable dated June 30, year 1,
in the original amount of $150,000. Payments of $50,000 in
principal plus accrued interest are due annually on July 1, year 2,
year 3, and year 4. In its June 30, year 2 balance sheet, what
amount should Frame report as a current asset for interest on the
(c) Accrued interest receivable at 6/30/Y3 is interest
revenue which has been earned by 6/30/Y3, but has not yet been
received by that date. Interest was last received on 7/1/Y2; the
accrued interest receivable includes interest revenue earned from
7/1/Y2 through 6/30/Y3 (a full year). The original balance of
the note receivable was $150,000 but the 7/1/Y2 principal payment
of $50,000 reduced this balance to $100,000. Therefore,
the 6/30/Y3 interest receivable is $8,000 ($100,000 × 8%).
Fenn Stores, Inc. had sales of $1,000,000 during December,
year 2. Experience has shown that merchandise equaling 7% of
sales will be returned within thirty days and an additional 3% will
be returned within ninety days. Returned merchandise is readily
resalable. In addition, merchandise equaling 15% of sales will be
exchanged for merchandise of equal or greater value. What
amount should Fenn report for net sales in its income statement
for the month of December year 2?
(a) When revenue is recognized from sales and a right of
return exists, sales revenue must be reduced to reflect estimated
returns. In this case, sales of $1,000,000 must be reduced by
estimated returns of $100,000 [(7% + 3%) × $1,000,000], resulting
in net sales of $900,000. The estimated exchanges (15%)
will not result in a future reduction of sales.
A method of estimating uncollectible accounts that emphasizes
asset valuation rather than income measurement is the
allowance method based on
(a) The aging of receivables method of estimating uncollectible
accounts is based on the theory that bad debts are a
function of accounts receivable collections during the period.
The aging of receivables method emphasizes reporting accounts
receivable at their net realizable value. It is a “balance-sheet”
approach, which stresses the collectibility (valuation) of the receivable
balance. Once the balance of the allowance account
required to reduce net accounts receivable to their realizable
value has been computed, bad debts expense is merely the
amount needed to adjust the allowance account to the computed
balance. Answer (b) is incorrect because under the direct writeoff
method, bad debts are considered expenses in the period in
which they are written off; no consideration is given to the valuation
of accounts receivable. Answers (c) and (d) are incorrect
because both of these methods are based on the theory that bad
debts are a function of sales. Thus, these methods emphasize
reporting the bad debts expense amount accurately on the income
Which method of recording uncollectible accounts expense
is consistent with accrual accounting?
Allowance Direct write-off
(b) A primary objective of accrual accounting is to record
the cash consequences of events that change an entity’s financial
position in the period in which the events occur. This
means recognizing revenues when earned rather than when cash
is received, and recognizing expenses when incurred rather than
when cash is paid. Expenses are incurred when they help the firm
earn revenue. Under the allowance method, uncollectible accounts
expense is recognized in the same period as the related
revenue. The same credit decisions that enabled the entity to
earn revenue caused it to incur uncollectible accounts expense.
Therefore, under accrual accounting that expense should be recognized
in the same period. On the other hand, when the direct
write-off method is used, the uncollectible accounts expense is
generally recognized after the period in which the revenue is
recognized; after the event (credit decision) which changed financial
position. Therefore, the direct write-off method is not
consistent with accrual accounting.
When the allowance method of recognizing uncollectible accounts is used, the entry to record the write-off of a specific account
(a) When the allowance method for recognizing uncollectible
accounts is used, the entry to write off a specific account
Allowance for unc. accts. xxx
Accts. receivable xxx
Answer (a) is correct because this entry decreases both accounts.
Which of the following is a method to generate cash from
(b) An assignment of accounts receivable is a financing
arrangement whereby the owner of the receivables (assignor)
obtains a loan from the lender (assignee) by pledging the accounts
receivable as collateral. A factoring of accounts receivable
is basically a sale of, or borrowing on, the receivables. “Factors”
are intermediaries that buy receivables from companies (for
a fee) and then collect payments directly from the customers.
Thus, both of these are methods of generating cash from accounts
Gar Co. factored its receivables. Control was surrendered in
the transaction which was on a without recourse basis with Ross
Bank. Gar received cash as a result of this transaction, which is
best described as a
(d) When receivables are factored and control is surrendered
the transaction is treated as a sale. A transfer in which
control is surrendered will not be treated as a borrowing. The
risk of uncollectible accounts is not retained by the seller in a sale
Taylored Corp. factored $400,000 of accounts receivable to
Rich Corp. on July 1, year 2. Control was surrendered by Taylored.
Rich accepted the receivables subject to recourse for nonpayment.
Rich assessed a fee of 2% and retains a holdback equal
to 5% of the accounts receivable. In addition, Rich charged 15%
interest computed on a weighted-average time to maturity of the
receivables of forty-one days. The fair value of the recourse obligation
Taylored will receive and record cash of
(c) Taylored will receive the value of the receivables
($400,000), reduced by $20,000 for the amount of the holdback
($400,000 × .05), $8,000 withheld as fee income ($400,000 ×
.02), and $6,740 withheld as interest expense ($400,000 × .15 ×
41/365). Answer (c) is therefore correct ($400,000 – $8,000 –
$6,740 – $20,000).