CHAPTER 1

CASH AND CASH EQUIVALENTS

TOPIC OVERVIEW:
This chapter discusses the concept of cash and cash equivalents, its characteristics and
components, preparation of bank reconciliation and proof of cash.

LEARNING OBJECTIVES:
After studying this chapter, the students should be able to:
1. Identify what items are included as cash and cash equivalents.
2. Account for the cash shortage or overage.
3. Calculate the correct balance of petty cash fund.
4. Determine bank and book reconciling items.
5. Prepare bank reconciliation and proof of cash.

DEFINITION OF CASH
Cash includes money and other negotiable instrument that is payable in money and acceptable by
the bank for deposit and immediate credit.

SUMMARY OF GENERALLY ACCEPTED ACCOUNTING PRINCIPLES FOR CASH

CASH ITEMS

Unrestricted and For use other than current

immediately available for operations
use in current operations

Other noncurrent financial

Cash in the current section
assets

The following cash items are included in cash:

1. Cash on Hand (CUTCPoBa)
C Customer’s checks awaiting deposit
U Undeposited cash collections (bills and coins)
T Traveler’s checks
C Cashier’s/Official/Treasurer’s/Manager’s checks
Po Postal money orders (a demand credit instrument issued and payable by a post office)
 Ba Bank drafts (a written order addressed to the bank to pay an amount of money to the
order of the maker)
2. Cash in Bank
a. Current account/checking account/demand deposit/commercial deposit
-generally non-interest bearing
-withdrawable by checks against bank

b. Savings deposit
-generally non-interest bearing
-depositor is issued an ATM card or passbook
-withdrawable in ATM station or within the bank

3. Cash fund for current operations (TPaPRIntPeCDiT)

T Travel fund
Pa Payroll fund
P Purchasing fund (for purchasing of inventories)
R Revolving fund
Int Interest fund
Pe Petty cash fund
C Change fund
Di Dividend fund
T Tax fund

FUND FOR NONCURRENT OPERATIONS

Fund for noncurrent operations are part of noncurrent assets and should not be included as part of
cash. Examples are as follows: (𝑷𝟐 ACIS)
P Pension fund Generally noncurrent investment but if the
related liability is current, the fund is included
as cash
P Preferred redemption fund Noncurrent investment unless the preferred
share has a mandatory redemption and if
redeemable
- Within one year from the reporting
period (part of current investment)
- Within three months from the reporting
period (part of current investment)
A Acquisition of property, plant and Always noncurrent even if expected to be
equipment disbursed next year
C Contingent fund Noncurrent investment
I Insurance fund Noncurrent investment
S Sinking fund Noncurrent investment, if the related bonds
payable is current, the fund is included as cash
Note: Classification of cash fund as current or noncurrent should be aligned to the classification
applied to related liability. Thus, an entity should reclassify such noncurrent asset if the related
liability becomes current.

CASH EQUIVALENTS
Cash equivalents are short-term and highly liquid investments that are readily convertible into cash
and so near their maturity that they present insignificant risk of changes in value because of
changes in interest rates. (PAS 7, paragraph 6)
Items that may qualify as cash equivalents include the following:
1. Time deposit
2. Money market instrument or commercial paper
3. Treasury bills, treasury notes and treasury bonds
4. Redeemable preference shares with mandatory redemption period

If the items stated are: Treatment

1. Originally invested/acquired for more than three months
before maturity date
a. Remaining term is three months or less from the Short-term investment
reporting date
b. Remaining term is more than three months but within Short-term investment
one year
c. Remaining term is more than one year Long-term investment
2. Originally invested/acquired for three months or less
before maturity date Cash equivalents
Note: If the problem is silent
1. Treasury note and bonds – assumed noncurrent investment
2. Cash in money market account – cash equivalent
3. Time deposit – cash equivalent

Some Measurement Issues and Frequent Encountered Tricks in Cash and Cash Equivalents
Computation

ITEMS REMARKS
Cash Measured at face value
Cash in foreign currency Should be translated to Philippine Peso using the
closing rate or spot rate at the reporting date
Deposits in foreign bank a. Unrestricted – part of cash
b. Restricted – if material, classified separately among
noncurrent assets as receivables
Cash in closed bank / banks in Measured at estimated realizable value and be included
bankruptcy among noncurrent assets if the amount recoverable is
lower than face value
Bank overdraft Definition: Negative balance in the cash in bank
account
Treatment: If the company is maintaining two
accounts in
a. Different banks
- current liability or may be netted against other bank if
immaterial
- netted against other account of it is part of cash
management
b. Same banks
- maybe netted against the account with positive amount
but cannot be offset against restricted account
Compensating balance Definition: Compensating balance is the minimum
checking account balance that must be maintained in
connection with a borrowing agreement with a bank
Treatment:
a. Not legally restricted – part of cash
b. Legally restricted – if the related loan is
1. Short-term – presented as “cash held as
compensating balance” (current receivable)
2. Long-term – presented as “cash held as
compensating balance” (noncurrent receivable)
Note: If silent, it is assumed as not legally restricted
Undelivered/Unreleased check Reverted back to cash (Dr. Cash, Cr. A/P)
Stale checks Definition: Checks not encashed with a relatively long
period of time. Under current banking practice, checks
 are considered stale if not encashed within six (6)
months from its date.
Treatment: Reverted to cash (Dr. Cash, Cr. A/P-if
material or Cr. Misc. Income-if not material)
Postdated checks Definition: Checks dated after the reporting period
Treatment:
a. For company’s PDC – reverted to cash (Dr. Cash, Cr.
A/P)
b. Customer’s check – will still remain as receivable
IOUs (I owe you) Included as part of receivable
Equity securities Generally cannot be classified as cash equivalents
because they do not have a maturity date except
redeemable preference shares
Redeemable preference shares Read the previous discussion
Callable preference shares Not classified as cash equivalents. It is part of
shareholders’ equity on the part of the issuer and part of
long-term investment of the holder.
NSF/DAUD/DAIF Definition:
NSF – no sufficient fund
DAUD – drawn against uncleared deposits
DAIF – drawn against insufficient funds
Treatment: Reverted back as part of receivables
Expense advances (travel advances) Receivable or prepaid expenses
Temporary investments in shares of Either FVTPL or FVTOCI but never to be included as
stocks part of cash and cash equivalents
Unused credit line Definition: Difference between the amount of line of
credit applied for and approved by a bank and the
amount actually borrowed
Treatment: Disclosed in the notes
Treasury warrants Definition: A warrant for the payment of money into or
from public treasury
Treatment: Included as part of cash
Escrow deposit Definition: Restricted amount held in trust for another
party (ex. Deposit required by a court of law for a
pending case)
Treatment: Part of other current/noncurrent asset and
reported as liability
Unrecorded cash disbursements Record the disbursements by Dr. A/P or other
appropriate account, Cr. Cash
Unrecorded cash collections/receipts Record the collection by Dr. Cash, Cr. A/R or other
appropriate account
Certificate of deposit (CD) for time Definition: A savings certificate entitling the bearer to
deposits receive interest. A CD bears a maturity date, a specified
fixed interest rate and can be issued by any
denomination. CDs are generally issued by commercial
banks and are insured by PDIC. The term of a CD
generally ranges from one month to five years.
Treatment: a. Invested three months before maturity –
cash equivalents
b. Invested for more than three months – investment
(short or long-term)
Postage stamps on hand Should be reported as office supplies or as a prepaid
expense
Bank overdraft netted from cash in Bank overdraft that was netted or deducted from cash in
bank bank but should be presented as current liability should
 be added back to compute for the correct balance of
cash in bank

Illustration 1: Cash Composition

On December 31, 2019, Hayahay Company’s cash and cash equivalents account balance per ledger
of P5,700,000 includes:

Manager’s check P 70,000

Traveler’s check 100,000
Treasury note 50,000
Treasury shares, purchased on 12/1/2019, to be reissued on 3/1/2020 150,000
Escrow deposit 200,000
Bank drafts 20,000
Postal money orders 20,000
Demand deposit 100,000
Treasury bills, purchased 12/16/2019, due 3/15/2020 50,000
160-day treasury bill 30,000
Time deposit, PCIB, one year, due 3/31/2020 180,000
Time deposit – PNB, 90 days 170,000
Time deposit – BPI, 120 days 45,000
Money market instrument, due 2/28/2020 40,000
Money market instrument, due 6/1/2020 70,000
Cash in bank –Metrobank, includes a compensating balance of P50,000 for short- 1,050,000
term borrowing arrangement. (not legally restricted)
Cash in bank, Metrobank (100,000)
Cash in bank - Firstbank, includes a compensating balance of P50,000 for long- 450,000
term borrowing arrangement (legally restricted)
Cash in bank – Secondbank (60,000)
Cash in bank – Seatbank, includes a compensating balance of P40,000 for short- 150,000
term borrowing arrangement (legally restricted)
Cash in bank – Seabank, includes a compensating balance of P40,000 for short- 250,000
term borrowing arrangement
Petty cash fund, includes an unreplenished voucher for P4,000 10,000
Payroll fund 100,000
Travel fund 20,000
Interest fund 40,000
Tax fund 30,000
Sinking fund 420,000
Preferred redemption fund 100,000
Contingent fund 200,000
Insurance fund 500,000
Fund for acquisition of PPE 800,000
IOU from officers 20,000
Customers’ post-dated checks 70,000
Customers’ checks returned by bank marked NSF 20,000
Redeemable preference shares – acquired three (3) months before maturity date 15,000
Unused credit line 200,000
Revolving fund 100,000
Visa card credit limit 20,000
Total P 5,700,000
Required: Compute the correct amount of cash and cash equivalents that should be shown in the
statement of financial position.
Solution:
Manager’s check P 70,000
Traveler’s check 100,000
Bank drafts 20,000
Postal money orders 20,000
Demand deposit 100,000
Treasury bills, purchased 12/16/2019, due 3/15/2020 50,000
Time deposit – PNB, 90 days 170,000
Money market instrument, due 2/28/2020 40,000
Cash in bank –Metrobank, includes a compensating balance of P50,000 for short- 1,050,000
term borrowing arrangement. (not legally restricted)
Cash in bank, Metrobank (100,000)
Cash in bank - Firstbank, net 400,000
Cash in bank – Seatbank, net 110,000
Cash in bank – Seabank, includes a compensating balance of P40,000 for short- 250,000
term borrowing arrangement
Petty cash fund, net 6,000
Payroll fund 100,000
Travel fund 20,000
Interest fund 40,000
Tax fund 30,000
Redeemable preference shares – acquired three (3) months before maturity date 15,000
Revolving fund 100,000
Total cash and cash equivalents P 2,591,000

WINDOW DRESSING
The books of an entity should be closed at the end of every reporting period in order that financial
statements will show fairly the financial position and performance of the entity.

Window dressing is a practice of opening the books of accounts beyond the close of the reporting
period for the purpose of showing a better financial position and performance. It is usually
accomplished as follows:

a. By recording as of the last day of the reporting period collections made subsequent to the close
the period.

b. By recording as of the last day of the reporting period payments of accounts made subsequent
to the close of the period.

The entries made to window dress must be reversed to correct the statements.

LAPPING
Lapping is a practice used for concealing a cash shortage. It consists of misappropriating a
collection from one customer and concealing this defalcation by applying a subsequent collection
made from another customer. It involves series of postponements of the entries for the collection
of receivables.

KITING
Kiting is another device used to conceal a cash shortage. It is possible when a company maintains
current accounts in different banks. Kiting is usually employed at the end of the month. It occurs
when a check is drawn against a first bank and depositing the same check in a second bank to cover
the shortage in the latter bank. No entry is made for both the drawing and deposit of a check.

ACCOUNTING FOR CASH SHORTAGE

If the cash count shows cash which is less than the balance per book, there is a cash shortage to be
recorded as follows:
Cash short or over xx
Cash xx

The cash short or over account is only a temporary or suspense account. When financial statements
are prepared, the same should be adjusted.

Hence, if the cashier or cash custodian is held responsible for the cash shortage, the adjustment
should be:
Due from cashier xx
Cash short or over xx

However, if reasonable efforts fail to disclose the cause of the shortage, the adjustment is
Loss from cash shortage xx
Cash short or over xx
If the amount of cash shortage is not material, it can be debited to miscellaneous expense.

ACCOUNTING FOR CASH OVERAGE

If the cash count shows cash which is more than the balance per book, there is a cash overage to
be recorded as follows:
Cash xx
Cash short or over xx

The cash overage is treated as miscellaneous income if there is no claim on the same. The journal
entry is
Cash short or over xx
Miscellaneous income xx

But if the cash overage is properly found to be the money of the cashier, the journal entry is
Cash short or over xx
Payable to cashier xx

PETTY CASH FUND

Imprest system is a system of control of cash which requires that all cash receipts should be
deposited intact and all cash disbursements should be made by means of check. However, it is
impractical for the company to make all payments thru check. Therefore, a petty cash fund is
established to cover small and miscellaneous expenditures. Petty cash fund may be accounted for
using the following two methods:
1. Imprest fund system
2. Fluctuating fund system

COMPARISON OF JOURNAL ENTRIES:

Imprest Fund System Fluctuating System
a. To establish the fund
Dr. Petty Cash Fund Dr. Petty Cash Fund
Cr. Cash in Bank Cr. Cash in Bank
b. Payment of expenses
Memo entry in the petty cash journal Dr. Expenses
 Cr. Petty Cash Fund
c. Replenishment of petty cash payments
Dr. Expenses Dr. Petty Cash Fund
Cr. Cash in Bank Cr. Cash in Bank
d. To adjust the unreplenished expenses
Dr. Expenses No adjusting entry
Cr. Petty cash fund
e. Increase in the fund
Dr. Petty Cash Fund Dr. Petty Cash Fund
Cr. Cash in Bank Cr. Cash in Bank
f. Decrease in the fund
Dr. Cash in Bank Dr. Cash in Bank
Cr. Petty Cash Fund Cr. Petty Cash Fund

ILLUSTRATION: (Imprest Fund System)

Prepare the necessary journal entries for the following transactions:

2019
Nov 10 The entity established a fund of P10,000.
29 Replenished the fund. The petty cash items include the following:
Currency and coin – P2,000
Supplies – P5,000
Telephone – P1,800
Postage – P1,200
31 The fund was not replenished. The fund is composed of the following:
Currency and coin – P7,000
Supplies – P1,500
Postage – P500
Miscellaneous expense – P1,000

2020
Feb 1 Replenished the fund and increased to P15,000. The petty cash items include the
following:
Currency and coin – P1,000
Supplies – P4,500
Postage – P3,000
Miscellaneous expense – P1,500

Answers:
2019
Nov 10 Petty Cash Fund 10,000
Cash in Bank 10,000
29 Supplies 5,000
Telephone 1,800
Postage 1,200
Cash in Bank 8,000
31 Supplies 1,500
Postage 500
Miscellaneous expense 1,000
Petty Cash Fund 3,000
2020
Jan 1 Petty Cash Fund 3,000
Supplies 1,500
Postage 500
Miscellaneous expense 1,000
Feb 1 Petty Cash Fund 5,000
 Supplies 4,500
Postage 3,000
Miscellaneous expense 1,500
Cash in Bank 14,000

ILLUSTRATION: (Fluctuating Fund System)

2019
Nov 10 The entity established a fund of P10,000.
11 Petty cash disbursements amounted to P8,000
29 Issued a check for P10,000 to replenish the fund
Dec 30 Petty cash expenses amounted to P9,000
31 Issued a check for P15,000 to replenish the fund

Journal entries:
Nov 10 Petty Cash Fund 10,000
Cash in Bank 10,000
11 Expenses 8,000
Petty Cash Fund 8,000
29 Petty Cash Fund 10,000
Cash in Bank 10,000
Dec 30 Expenses 9,000
Petty Cash Fund 9,000
31 Petty Cash Fund 15,000
Cash in Bank 15,000

BANK RECONCILIATION
Bank reconciliation is a schedule prepared to account for the differences between cash balances
per book and per bank statement. It is prepared only for checking account/demand deposit and is
prepared monthly because the bank provides the depositor with the bank statement at the beginning
of the following month.
Reconciling Items:
1. Book reconciling items
a. Credit Memos
b. Debit Memos
c. Errors

2. Bank reconciling items:

a. Deposits in transit
b. Outstanding checks
c. Errors

Credit Memos. These are collections or deposits made by the bank to the account of the company
but not yet recorded by the entity. Examples are:
a. Collections made by the bank on behalf of the entity
b. Proceeds of bank loan credited to the account of the entity
c. Matured time deposits transferred by the bank to the current account of the depositor.
d. Interest income credited to the account
Debit Memos. These are charges and deductions made by the bank to the account of the entity but
not yet recorded by the latter. Examples are:
a. Bank service charges. These include bank charges for interest, collection, checkbook, and
penalty.
b. NSF/DAIF/DAUD checks. These are checks deposited and already recorded by the bank but
subsequently returned by the bank to the entity because of insufficiency of fund.
c. Payment of loan. This pertains to amount deducted from the current account of the depositor in
payment for loan which the depositor owes to the bank and which has already matured.
d. Final withholding tax on interest income.

Deposits in Transit. These are deposits already recorded in the cash books in one period but were
taken up by the bank only in the next period. Examples are:
a. Collections already forwarded to the bank for deposit but too late to appear in the bank statement.
b. Undeposited collections awaiting delivery to the bank for deposit.

Outstanding Checks. These are checks written and released to payees and are already recorded in
the cash books but are not yet presented for encashment or deposit to the bank.

Certified Checks. These are checks that the bank already certified as having sufficiency of funds
and thus technically are no longer outstanding checks.

Errors. Errors made by the bank or the company that must be corrected for the reconciliation to
balance.

Forms of Bank Reconciliation

1. Adjusted balance method
2. Book to bank method
3. Bank to book method

Proforma Reconciliation
Adjusted Balance Method
Unadjusted balance per book xx
Add: Credit Memos xx
Total xx
Less: Debit Memos xx
Adjusted balance per book xx

Unadjusted balance per bank xx

Add: Deposits in Transit xx
Total xx
Less: Outstanding Checks xx
Adjusted balance per bank xx

The following are the rules for errors assuming the company is using the adjusted balance method
of presenting bank reconciliation:
Effect of the errors Treatment
1 Understatement of cash receipts Add on the unadjusted cash in bank balance
2 Overstatement of cash receipts Deduct from the unadjusted cash in bank
balance
3 Understatement of cash disbursements Deduct from the unadjusted cash in bank
balance
4 Overstatement of cash disbursements Add on the unadjusted cash in bank balance
Book to Bank Method
Balance per book xx
Add: Credit Memos xx
Outstanding checks xx
Total xx
Less: Debit Memos xx
Deposits in Transit xx
Balance per bank xx

Bank to Book Method

Balance per bank xx
Add: Deposits in Transit xx
Debit Memos xx
Total xx
Less: Outstanding checks xx
Credit Memos xx
Balance per book xx

ILLUSTRATION:
The cash records of Company A show the following for the month of January:
CASH RECEIPTS CASH DISBURSEMENTS
Jan 5 60,000 Jan 6 Check No. 721 5,000
13 20,000 7 Check No. 722 10,000
25 30,000 10 Check No. 723 18,000
31 40,000 14 Check No. 724 2,000
150,000 28 Check No. 725 37,000
31 Check No. 726 28,000
100,000
Bank Statement
Below is the bank statement of Company A for the month of January.
FIRST BANK
Manila, Philippines
Date Check No. Withdrawals Deposits Balance
Jan 6 60,000 60,000
8 721 5,000 55,000
11 722 10,000 45,000
12 723 18,000 27,000
14 20,000 47,000
17 724 2,000 45,000
26 30,000 75,000
26 15,000 CM 90,000
30 5,000 RT 85,000
30 1,000 SC 84,000
Code: CM – Credit Memo ; DM – Debit Memo ; RT – Returned Check ; SC – Service Charge

The following data are gathered in connection with the CM and DM appearing on the bank
statement:

a. The CM of P15,000 on January 26 represents proceeds of note collected by the bank on favor
of the company.

b. The RT of P5,000 represents check of customer deposited previously but returned by the bank
because of “no sufficient fund” or NSF.
ADJUSTED BALANCE METHOD
Unadjusted balance per book P 50,000
Add: Credit Memos 15,000
Total 65,000
Less: Debit Memos 6,000
Adjusted balance per book P 59,000

Unadjusted balance per bank P 84,000

Add: Deposits in Transit 40,000
Total 124,000
Less: Outstanding Checks 65,000
Adjusted balance per bank P 59,000

BOOK TO BANK METHOD

Balance per book P 50,000
Add: Credit Memos 15,000
Outstanding checks 65,000
Total 130,000
Less: Debit Memos 6,000
Deposits in Transit 40,000
Balance per bank P 84,000

BANK TO BOOK METHOD

Balance per bank P 84,000
Add: Deposits in Transit 40,000
Debit Memos 6,000
Total 130,000
Less: Outstanding checks 65,000
Credit Memos 15,000
Balance per book P 50,000

Preparation of Adjusting Entries

Only the book reconciling items require adjusting entries on the book of depositor.

a. To record the note collected by the bank

Cash in bank 15,000
Notes receivable 15,000

b. To record the return of NSF check

Notes receivable 5,000
Cash in bank 5,000

c. To record the bank service charge

Bank service charge 1,000
Cash in bank 1,000
PROOF OF CASH (Two-date Bank Reconciliation)
The bank reconciliation is so called two-date because it literally involves two dates.

Formulas:
Deposits in transit, beginning xx
Add: Deposits made by the company this month xx
Total deposits to be acknowledged by the bank xx
Less: Deposits acknowledged by the bank this month xx
Deposits in transit, ending xx

Outstanding checks, beginning xx

Add: Checks issued by the company this month xx
Total checks to be paid by the bank xx
Less: Checks paid by the bank this month xx
Outstanding checks, ending xx

Computation of Deposits Made by the Company and Deposits Acknowledged by the Bank

Book receipts (Debits) xx Bank receipts (Credits) xx

Less: Less:
Credit Memo last month xx Credit Memo this month xx
Book errors last month corrected this Bank errors last month corrected this
month month
Understatement of CR xx Understatement of CR xx
Overstatement of CD xx Overstatement of CD xx
Book errors this month Bank errors this month
Overstatement of CR xx Overstatement of CR xx
Add: Understatement of CR xx Add: Understatement of CR xx
Deposits made by the company this Deposits acknowledged by the bank
month xx this month xx

Computation of Checks Issued by Company and Checks paid by the bank

Book disbursements (Credits) xx Bank disbursements (Debits) xx

Less: Less:
Debit Memo last month xx Debit Memo this month xx
Book errors last month corrected this Bank errors last month corrected this
month month
Overstatement of CR xx Overstatement of CR xx
Understatement of CD xx Understatement of CD xx
Book errors this month Bank errors this month
Overstatement of CD xx Overstatement of CD xx
Add: Understatement of CD xx Add: Understatement of CD xx
Checks issued by the company this
month xx Checks paid by the bank this month xx
Computation of Book and Bank Balances
Balance per book, beg xx Balance per bank, beg xx
Add: Book debits xx Add: Bank credits xx
Total xx Total xx
Less: Book credits xx Less: Bank debits xx
Balance per book, end xx Balance per bank, end xx

Book debits. Cash receipts or all items debited to the cash in bank account
Book credits. Cash disbursements or all items credited to the cash in bank account
Bank credits. All items credited to the account of the depositor which include deposits
acknowledged by the bank and credit memos
Bank debits. All items debited to the account of the depositor which include checks paid by the
bank and debit memos.

ILLUSTRATION

Cash in bank per ledger

Balance, January 31 P 50,000
Book debits for February, including January CM of P15,000 200,000
Book credits for February including NSF check of P5,000 and 180,000
service charge of P1,000 for January

Bank Statement for February

Balance, January 31 P 84,000
Bank credits for February, including CM of P20,000 and 170,000
January DIT of P40,000
Bank debits for February including NSF check of P10,000 130,000
and January OC of P65,000

Required:
1. Prepare the bank reconciliation for the month of January using the adjusted balance method.
2. Compute the book and bank balances on February 28.
3. Calculate the deposits in transit and outstanding checks on February 28.
4. Prepare a proof of cash using adjusted balance method, book to bank method, and bank to book
method.

Solution:
1.
Company A
Bank Reconciliation
January 31

Unadjusted balance per book P 50,000

Add: Credit Memos 15,000
Total 65,000
Less: Debit Memos 6,000
Adjusted balance per book P 59,000

Unadjusted balance per bank P 84,000

Add: Deposits in Transit 40,000
Total 124,000
Less: Outstanding Checks 65,000
Adjusted balance per bank P 59,000
2.
Balance per book, Jan 31 P 50,000 Balance per bank, Jan 31 P 84,000
Add: Book debits 200,000 Add: Bank credits 170,000
Total 250,000 Total 254,000
Less: Book credits 180,000 Less: Bank debits 130,000
Balance per book, Feb 28 P 70,000 Balance per bank, Feb 28 P 124,000

3.
Book receipts (Debits) P 200,000 Bank receipts (Credits) P 170,000
Less: Less:
Credit Memo last month 15,000 Credit Memo this month 20,000
Deposits made by the company Deposits acknowledged by the
this month P 185,000 bank this month P 150,000

Book disbursements (Credits) P 180,000 Bank disbursements (Debits) P 130,000

Less: Less:
Debit Memo last month 6,000 Debit Memo this month 10,000
Checks issued by the company Checks paid by the bank this
this month P 174,000 month P 120,000

Deposits in transit, January 31 P 40,000

Add: Deposits made by the company this month 185,000
Total deposits to be acknowledged by the bank 225,000
Less: Deposits acknowledged by the bank this month 150,000
Deposits in transit, February 28 P 75,000

Outstanding checks, January 31 P 65,000

Add: Checks issued by the company this month 174,000
Total checks to be paid by the bank 239,000
Less: Checks paid by the bank this month 120,000
Outstanding checks, February 28 P 119,000

4. Adjusted Balance Method

COMPANY A
PROOF OF CASH
For the month of February

January 31 Receipts Disbursements February 28

Balance per book P 50,000 200,000 180,000 70,000
Note collected by bank
January 15,000 (15,000)
February 20,000 20,000
NSF check
January (5,000) (5,000)
February 10,000 (10,000)
Service charge
January (1,000) (1,000)
Adjusted book balance P 59,000 P 205,000 P 184,000 P 80,000
Balance per bank P 84,000 P 170,000 P 130,000 P 124,000
Deposits in Transit
January 40,000 (40,000)
February 75,000 75,000
Outstanding Checks
January (65,000) (65,000)
February 119,000 (119,000)
Adjusted bank balance P 59,000 P 205,000 P 184,000 P 80,000

Book to Bank Method

COMPANY A
PROOF OF CASH
For the month of February

January 31 Receipts Disbursements February 28

Balance per book P 50,000 200,000 180,000 70,000
Note collected by bank
January 15,000 (15,000)
February 20,000 20,000
NSF check
January (5,000) (5,000)
February 10,000 (10,000)
Service charge
January (1,000) (1,000)
Deposits in Transit
January (40,000) 40,000
February (75,000) (75,000)
Outstanding Checks
January 65,000 65,000
February (119,000) 119,000
Balance per bank P 84,000 P 170,000 P 130,000 P 124,000

Bank to Book Method

COMPANY A
PROOF OF CASH
For the month of February

January 31 Receipts Disbursements February 28

Balance per bank P 84,000 P 170,000 P 130,000 P 124,000
Deposits in Transit
January 40,000 (40,000)
February 75,000 75,000
Outstanding Checks
January (65,000) (65,000)
February 119,000 (119,000)
Note collected by bank
January (15,000) 15,000
February (20,000) (20,000)
NSF check
January 5,000 5,000
February (10,000) 10,000
Service charge
January 1,000 1,000
Balance per book P 50,000 200,000 180,000 70,000
References:

Asuncion, et. al. (2018). Applied Auditing Book 1 of 2, Baguio City: Real Excellence Publishing
Valix, et. al. (2016). Financial Accounting Volume 1, Manila Philippines

Assessments:
1. On December 31, 2018, GG Company’s cash and cash equivalents account balance per ledger
of P4,000,000 includes:
Demand deposit P 2,200,000
Undeposited collection 300,000
Time deposit – 30 days 500,000
NSF check of customer 20,000
35-day money market placement due 1/28/2019 300,000
45-day commercial papers due 2/4/2019 80,000
Savings deposit in closed bank 50,000
IOU from an employee 150,000
Preferred redemption fund 400,000
Total P 4,000,000

Additional information:
a) Included in the demand deposit of P2,200,000 was a customer check amounting to P50,000
dated January 25, 2019.
b) Also included in the demand deposit is a customer check amounting to P90,000 dated
December 31, 2017. GG neglected to encash the check. On December 31, 2018, the
customer was informed and he was willing to replace this with a new one. New check is
yet to be received from the customer.
c) Check of P60,000 dated January 31, 2019 in payment of accounts payable was recorded
and mailed December 31, 2018.
d) Check of P70,000 in payment of accounts payable was recorded on December 31, 2018
but mailed to creditors on January 15, 2019.
e) The company uses the calendar year. The cash receipts journal was held open until January
15, 2019, during which time P80,000 was collected and recorded on December 31, 2018.

Required:
1. Prepare the adjusting entries to correct the cash account.
2. Compute the cash and cash equivalents to be shown on December 31, 2018 statement of
financial position.

2. On October 31, 2018, the bank statement for the checking account of EZ Company shows a
balance of P126,300, while the company’s record shows a balance of P123,310. The data that
might be useful in preparing a bank reconciliation are as follows:
a) Outstanding checks are P14,300 which includes a certified check for P2,000.
b) The October 31 cash receipts of P7,850 are not deposited in the bank until November 2.
c) One check written in payment of utilities for P1,370 is correctly recorded by the bank but
is recorded by EZ as a disbursement of P1,730.
 d) In accordance with prior authorization, the bank debited P6,500 directly from the checking
account as payment of interest amounting to P500 and the principal amounting to P6,000.
EZ has not yet recorded the direct withdrawal.
e) Bank service charges of P240 are listed on the bank statement.
f) A deposit of P5,670 is recorded by the bank on October 31, but it did not belong to EZ.
The deposit should have been made to the checking account of EC Company.
g) The bank statement includes a charge of P750 for an NSF check. The check is returned
with the bank statement and the company will seek payment from the customer.
Required:
1) Prepare a bank reconciliation using the adjusted balance method for the month of October.
2) Prepare the necessary journal entries.

3. The following data are available for Cash in bank of QWERTY Company for the month of
February:
a) Deposit made by the company this February, P120,000
b) Deposit in transit, January 31, P200,000
c) Customer’s check representing receipts in January amounting to P21,000 was erroneously
recorded by the company as P12,000
d) Check of the company representing disbursements in January amounting to P2,000 was
erroneously recorded by the company as P20,000
e) Deposit acknowledged by the bank in February, P150,000
f) Erroneous bank charge in January, P13,000
g) Erroneous bank credit in February, P14,000
h) Customer’s note collected, January 31, P10,000
i) Customer’s note collected, February 28, P12,000

Required: Compute for the following:

1) Deposit in transit, February 28
2) Unadjusted book receipts in February
3) Unadjusted bank receipts in February

4. The following data are available for Cash in bank of ASDFG Company for the month of
February:

a) Checks issued by the company during February, P150,000

b) Outstanding checks, January 31, P52,000
c) Customer’s check representing receipts in January amounting to P12,000 was erroneously
recorded by the company as P21,000
d) Check of the company in January amounting to P20,000 was erroneously recorded by the
company as P2,000
e) Checks paid by the bank in February, P130,000
f) Erroneous bank credit in January, P10,000
g) Erroneous bank charge in February, P12,000
h) Bank service charge, January, P2,000
i) Bank service charge, February, P3,000
Required: Compute for the following:
1) Outstanding checks on February 28
2) Unadjusted book disbursements in February
3) Unadjusted bank disbursements in February

5. Data concerning the cash records of Lyndon Company for the months of September and October
2018:
a) Unadjusted book balance on September 30 amounted to P2,258,000
b) Total receipts per book in October, P1,400,000
c) Total disbursements per book in October, P2,400,000
d) Unadjusted bank balance on September 30 amounted to P2,100,000
e) Total credits per bank in October amounted to P1,200,000
f) Total debits per bank in October amounted to P2,500,000
g) NSF checks on September 30 amounted to P60,000 while on October 31 amounted to
P40,000
h) Collection of accounts receivable not recorded by the company on September 30, P30,000
and P50,000 on October 31
i) Erroneous bank charge on September 30, P10,000 and P18,000 on October 31
j) Erroneous bank credit on September 30, P7,000 and P9,000 on October 31
k) Understatement of check in payment of rent payable on September 30, P90,000 and
P120,000 on October 31
l) Deposit in transit on September 30, P130,000
m) Outstanding checks on October 31, P30,000

Required: Based on the above data, answer the following questions:

1) How much is the deposit in transit on October 31?
2) How much is the outstanding checks on September 30?
3) How much is the adjusted cash in bank balance on September 30?
4) How much is the adjusted cash receipts during October?
5) How much is the adjusted cash in bank balance on October 31?
6) Prepare the necessary adjusting journal entries.
 CHAPTER 2
LOANS AND RECEIVABLES

TOPIC OVERVIEW:
This chapter discusses loans and receivables, their characteristics and classifications, initial and
subsequent measurement of each type of receivable and provision for bad debts.

LEARNING OBJECTIVES:
After studying this chapter, the students should be able to:
1. Define and identify the different classification of receivables.
2. Explain the initial recognition, initial measurement, subsequent measurement, financial
statement presentation and derecognition of receivables.
3. Explain the accounting of discounts and freight and how will it affect receivables account.
4. Apply the different methods of accounting for bad debts.
5. Explain and identify the different methods of receivable financing.
6. Calculate the correct balances of receivables and related accounts.

RECEIVABLES
Receivable is a financial asset that represents a contractual right to receive cash or another financial
asset from another entity. It represents the amount collectible from customers and others, most
frequently arising from sale of merchandise, claims for money lent, or the performance of services.
Under PFRS 15 paragraph 108, a receivable is an entity’s right to consideration that is
unconditional. A right to consideration is unconditional if only the passage of time is required
before payment of that consideration is due.

CLASSIFICATION OF RECEIVABLES

A. As to source
1. Trade receivables – refer to claims arising from sale of merchandise or services in the
ordinary course of the business operations. This includes:

a) Accounts Receivable / Customers’ accounts / trade debtors – these are open

accounts not supported by promissory note arising from sale of merchandise or
services in the ordinary course of business

b) Notes Receivable – is a formal claim against another that is evidenced by a written

promise called promissory note, or a written order to pay at a later time called time
draft. Negotiable promissory note is an unconditional written agreement to pay a
certain sum of money on a specific or determinable date to order of the payee or to
bearer.
NOTE: Only negotiable promissory note is included as part of notes receivable.
Dishonored notes receivable do not qualify as note receivable in the statement of
financial position as well as overdue notes. They are reclassified as accounts
receivable together with the accrued interest.

2. Nontrade receivables – these are receivables that arise from sources other than from sale
of goods or services in the normal course of business.
 Examples of Nontrade Receivables

1 Loans to officers, shareholders, directors, and Noncurrent if due more than

employees 12 months from the
reporting date
2 Advances to affiliates Long term investment unless
collectible within one year
(short term investment)
3 Advances to supplier for acquisition of merchandise Current Asset
4 Accrued income receivables such as dividends Current Asset
receivable, accrued rent income, accrued royalties
income and accrued interest on bonds investments
5 Deposits to guarantee performance or payment or to Current Asset
cover possible damages or losses
6 Deposit with creditors, claims for losses and Current Asset
damages
7 Claims receivables from common carriers for Current Asset
damaged or lost goods; claims against creditors for
returned, damaged, or lost goods
8 Claims for tax refunds or rebates Current Asset
9 Special deposit on contract bids Normally classified as other
noncurrent assets unless
collectible within one year
(current asset)
10 Debit balance of creditors account that may arise Current asset if material,
from overpayments or returns and allowance otherwise it may be netted
against account payable with
credit balance.

Issue on Subscription Receivable

Under the Securities and Exchange Commission of the United States of America (USA)
and Section 22.7.c of the PFRS for SME, subscriptions receivable must be netted against
the Subscribed Share Capital. However, under the old Statement of Financial Standards of
the Philippines (SFAS), it is presented as current asset if collectible currently, otherwise it
is deducted from subscribed share capital.
The authors still believe the latter treatment under SFAS will be used until the Financial
Reporting Standards Council addresses this matter.

B. As to Statement of Financial Position Classification

1. Current
a) Trade receivables – generally classified as current because of the concept of
normal operating cycle notwithstanding the period from the reporting date
b) Nontrade receivables – classified as current only if they are reasonably expected
to be realized in cash within 12 months after the reporting date

Normal operating cycle is the period between the acquisition of materials entering
into a process (or the purchase of goods for resale) and its realization in cash or an
instrument that is readily convertible to cash.

2. Noncurrent – nontrade receivables that are not reasonably expected to be realized in cash
within 12 months after the reporting date.
INITIAL RECOGNITION
Receivables are recognized simultaneously with the recognition of revenue under PFRS 15. An
entity shall recognize revenue to depict the transfer of promised goods or services to customers in
an amount that reflects the consideration to which the entity expects to be entitled in exchange for
those goods or services (PFRS 15.2)

OTHER REVENUE RECOGNITION ISSUES

Bill and hold sales

A bill-and-hold arrangement is a contract under which an entity bills a customer for a product but
the entity retains physical possession of the product until it is transferred to the customer at a point
in time in the future. For example, a customer may request an entity to enter into such a contract
because of the customer’s lack of available space for the product or because of delays in the
customer’s production schedule.

Revenue is recognized when the customer have obtained control of a product. A customer has
obtained control when all of the following criteria are met:
a) The reason for the bill-and-hold arrangement must be substantive (for example, the
customer has requested the arrangement)
b) The product must be identified separately as belonging to the customer
c) The product currently must be ready for physical transfer to the customer
d) The entity cannot have the ability to use the product or to direct it to another customer

Revenue is not recognized when there is simply an intention to acquire or manufacture the goods
in time for delivery.

Goods shipped subject to conditions

1. Installation and inspection conditions
Revenue is normally recognized when the buyer accepts delivery, and installation and
inspection are complete. However, revenue is recognized immediately upon the buyer’s
acceptance of delivery when:
i. The installation process is simple in nature, for example, the installation of a factory
tested television receiver which only requires unpacking and connection of power
and antennae, or
ii. The inspection is performed only for purposes of final determination of contract
prices, for example, shipments of iron ore, sugar or soya beans
2. On approval when the buyer has negotiated a limited right of return
If there is uncertainty about the possibility of return, revenue is recognized when the
shipment has been formally accepted by the buyer or the goods have been delivered and
the time period for rejection has elapsed.

Layaway sales
Layaway sales are sales where the goods are delivered only when the buyer has paid a final
installment in a series of payments.

Revenue from such sales is recognized when the goods are delivered. However, when experience
indicates that most of such sales are consummated, revenue may be recognized when a significant
deposit is received provided the goods are on hand, identified and ready for delivery to the buyer.

Sales to distributors or other intermediate parties

Revenue from such sales is generally recognized when the control has been transferred. However,
when the buyer is acting in substance as an agent, the sale is treated as a consignment sale.
Orders when payment (or partial payment) is received in advance
Orders when payment (or partial payment) is received in advance of delivery for goods not
presently held in inventory, for example, the goods are still to be manufactured or will be delivered
directly to the customer from a third party.
Revenue is recognized when the control of goods are transferred to the buyer. Normally, control
is transferred when delivery takes place.

Subscriptions to publications and similar items

When the items involved are of similar value in each time period, revenue is recognized on a
straight-line basis over the period in which the items are dispatched. When the items vary in value
from period to period, revenue is recognized on the basis of the sales value of the item dispatched
in relation to the total estimated sales value of all items covered by the subscription.

Installment Sales
Installment sales are sales under which the consideration is receivable in installments.
Revenue attributable to the sales price, exclusive of interest, is recognized at the date of sale. The
sale price is the present value of the consideration, determined by discounting the installments
receivable at the imputed rate of interest. The interest element is recognized as revenue as it is
earned using the effective interest method.

Credit card sales

Credit card is a plastic card which enables the holder to obtain credit up to a predetermined limit
from the issuer of the card for the purchase of goods and services. Service is usually charged
ranging from 1% to 5%.

SUBSEQUENT MEASUREMENT
Receivables are subsequently measured at amortized cost (net realizable value) using the effective
interest method.

Amortized cost is the amount at which the receivable is measured initially minus principal
repayments, plus or minus the cumulative amortization of any difference between the initial
amount recognized and the principal maturity minus reduction for impairment or uncollectibility.

SHORT-TERM RECEIVABLES
Initial Measurement
Short term receivables with no stated interest rates can be measured initially at transaction price
(ex. Invoice price) when the effect of discounting is immaterial.

Trade discount/volume discount/quantity discount

Trade discounts are given to encourage prospective customers to buy the goods in large quantities.
These discounts are deducted from the list price to arrive at the invoice price and are never
recognized in the accounting record since the journal entry is based on the amount on the sales
invoice.

NOTE: Sales and related receivables are always recorded net of trade discounts, which is the same
with the transaction price.

Cash discount/Settlement discount

Cash discounts are reductions from invoice price as an inducement for prompt payment of an
account within the discount period (e.g. 2/10, n/30). This is also called sales discount from the
point of view of the seller, while it is termed as purchase discount from the point of view of the
buyer.
 1. Gross price method – sales and receivables are recorded at the gross amount. Sales
discounts taken by customers are debited to the Sales Discount account which is reported
as a reduction of sales. This is considered to be more practical than the net method.
NOTE: Discount is computed based on invoice price, not including the freight paid by the
seller.

2. Net price method – sales and receivables are recorded at the net amount. Sales discount
not taken by customers are credited to the Sales Discount Forfeited account which is
reported in the Other Income line item of the Statement of Comprehensive Income. This
method is considered to be theoretically correct since the receivable and sales ae recorded
using the cash price equivalent.

3. Allowance method – accounts receivable and sales are recorded at gross amount and a
corresponding allowance for sales discount is recorded

ILLUSTRATION: Gross vs. Net Method

Si Cand Company entered into the following during the year:
Jan 2 Sold 10,000 units of merchandise to Rex Company at a selling price of P100 with
terms of 2/10, 1/20, n/30.
4 Sold 15,000 units of merchandise to Zeus Company at a selling price of P100 with
terms of 2/10, 1/20, n/30.
6 Rex returned 2,000 units of goods to the company.
10 Rex paid his account availing of the cash discount.
Feb 2 Zeus Company paid his account.

Required: Prepare all the necessary journal entries assuming the company used:
a. Gross Method b. Net Method

Solution:
GROSS METHOD NET METHOD
Date Account Title Debit Credit Account Title Debit Credit
Jan Accounts 1,000,000 Accounts 980,000
2 Receivable Receivable
Sales 1,000,000 Sales 980,000

4 Accounts 1,500,000 Accounts 1,470,000

Receivable Receivable
Sales 1,500,000 Sales 1,470,000

6 Sales Return 200,000 Sales Return 196,000

Accounts Receivable 200,000 Accounts Receivable 196,000

10 Cash 784,000 Cash 784,000

Sales Discount 16,000
Accounts Receivable 800,000 Accounts Receivable 784,000

Feb
2 Cash 1,500,000 Cash 1,500,000
Accounts Receivable 1,500,000 Sales Discount Forfeited 30,000
Accounts Receivable 1,470,000
FREIGHT CHARGE
Terms related to freight charge:
1. FOB – means either Free on Board or Freight on Board
2. FOB Destination – means ownership of the goods will be transferred to the buyer only
upon the receipt of goods at the point of destination
3. FOB Shipping Point - means ownership of the goods will be transferred to the buyer upon
shipment of the goods
4. Freight Collect – means that freight charge on the goods shipped is not yet paid by the
seller and the common carrier shall collect the same from the buyer
5. Freight Prepaid – means that the freight charge on the goods shipped was already paid by
the seller

SUMMARY TABLE FOR FREIGHT

Freight Terms Buyer Seller
Freight collect Reduction of A/P Reduction to A/R
FOB Destination
Freight prepaid No effect No effect
Freight collect No effect No effect
FOB Shipping Point
Freight prepaid Addition to A/P Addition to A/R

ILLUSTRATION: Freight Terms

Assume the following data for BNM Company:
List price of the merchandise sold P 200,000
Trade discount 10, 20
Sales discount 3/10, 2/15, n/30
Invoice price of the merchandise returned on January 8 P 10,000
Date of sale January 5, 2018
Date of collection January 20, 2018
Freight cost P 2,000

Assume the following freight terms:

Case 1: FOB Destination, freight prepaid
Case 2: FOB Destination, freight collect
Case 3: FOB Shipping Point, freight collect
Case 4: FOB Shipping Point, freight prepaid

Required: Using the above independent cases:

1. Prepare the journal entries for the freight both on the part of the buyer and seller.
2. Compute for the net cash collection on January 20, 2018.

Solution:
Case 1: FOB Destination, freight prepaid
SELLER BUYER
Freight out 2,000
No entry
Cash 2,000

Requirement 2:
Invoice price of the merchandise sold
(P 200,000 * 90% * 80%) P 144,000
Less: Invoice price of the merchandise returned 10,000
Net invoice price 134,000
Less: Sales discount (P134,000 * 2%) 2,680
Total cash collection P 131,320
Case 2: FOB Destination, freight collect

SELLER BUYER
Freight out 2,000 Accounts Payable 2,000
Accounts Receivable 2,000 Cash 2,000

Requirement 2:
Invoice price of the merchandise sold
(P 200,000 * 90% * 80%) P 144,000
Less: Invoice price of the merchandise returned 10,000
Net invoice price 134,000
Less: Sales discount (P134,000 * 2%) 2,680
Collection before freight P 131,320
Less: Freight paid by buyer 2,000
Total net cash collection P 129,320

Case 3: FOB Shipping Point, freight collect

SELLER BUYER
Freight in 2,000
No entry
Cash 2,000

Requirement 2:
Invoice price of the merchandise sold
(P 200,000 * 90% * 80%) P 144,000
Less: Invoice price of the merchandise returned 10,000
Net invoice price 134,000
Less: Sales discount (P134,000 * 2%) 2,680
Total cash collection P 131,320

Case 4: FOB Shipping Point, freight prepaid

SELLER BUYER
Accounts Receivable 2,000 Freight in 2,000
Cash 2,000 Accounts Payable 2,000

Requirement 2:
Invoice price of the merchandise sold
(P 200,000 * 90% * 80%) P 144,000
Less: Invoice price of the merchandise returned 10,000
Net invoice price 134,000
Less: Sales discount (P134,000 * 2%) 2,680
Collection before freight P 131,320
Add: Freight paid by buyer 2,000
Total net cash collection P 133,320

METHODS OF ACCOUNTING FOR BAD DEBTS

1. Direct write-off (tax): When a specific account is ascertained or proven to be uncollectible, Bad
Debt Expense is debited and Accounts Receivable is credited. This method is theoretically
undesirable because it makes no attempt to match revenues and expenses, and does not result in
receivables being stated at net realizable value in the statement of financial position.

2. Allowance Method (GAAP): At the end of each accounting period, an estimate is made of
expected losses from uncollectible accounts. This estimate is debited to Bad Debt Expense and
credited to Allowance for Doubtful Accounts. This method is justified because a company has
incurred a loss the moment customers receive goods or services that they will never pay for.

METHODS OF ESTIMATING BAD DEBT EXPENSE UNDER ALLOWANCE METHOD

1. Percentage of Sales (Income Statement Approach): Bad debt expense is estimated directly by
multiplying a percentage to sales account.
2. Percentage of A/R (Balance Sheet Approach)
a. First, the required ending balance in the Allowance for Doubtful Accounts is estimated by
multiplying a percentage to the ending outstanding receivables.
b. Then, bad debt expense is equal to the difference between the required ending balance and the
existing balance in the Allowance account.
3. Aging the A/R (Balance Sheet Approach)
This has the same procedure with the percentage of receivables; the only difference is the
percentage use for each term in the aging schedule.

Accounts Receivable
Beginning balance xx xx Sales Return and Allowances
Sales on account xx xx Sales Discounts
Recoveries xx xx Collections including recoveries
xx Accounts written off
xx Ending balance

Allowance for Doubtful Accounts

Accounts written off xx xx Beginning balance
Ending balance xx xx Doubtful accounts expense
xx Recoveries

The items in the T-accounts are derived from the following journal entries:
1. To record sales on account
Accounts Receivable xxx
Sales xxx

2. To record sales return by the customer

Sales return and allowances xxx
Accounts Receivable xxx

3. To record collection within the discount period

Cash xxx
Sales Discounts xxx
Accounts Receivable xxx

4. To record accounts written-off

Allowance for doubtful accounts xxx
Accounts Receivable xxx

5. To record re-establishment of accounts previously written-off

Accounts Receivable xxx
Allowance for doubtful accounts xxx

6. To record collection of accounts previously written off

Cash xxx
Accounts Receivable xxx
7. To record the provision for bad debts during the year
Bad debts expense/Doubtful accounts expense xxx
Allowance for doubtful accounts xxx

ILLUSTRATION: Different Methods of Accounting for Bad Debts

CC Company’s unadjusted trial balance at December 31 included the following accounts:
Debit Credit
Accounts Receivable P 1,500,000
Allowance for Doubtful Accounts P 40,000
Sales 10,000,000
Sales returns and allowances 700,000

The following analysis pertains to the accounts receivable reported in the trial balance:
Classification Balance of A/R Percentage
Collectible
0-1 month category P 500,000 98%
1-6 months category 800,000 95%
Over 6 months 200,000 80%
P 1,500,000

Required:
1. CC Company estimates its bad debt expense to be 2% of net sales. Determine its bad debt
expense for the year.
2. Assuming the same method of estimating bad debts in number 1, compute for the allowance for
doubtful account at the end of the year.
3. CC Company estimates its bad debt expense to be 5% of accounts receivable. Compute for the
allowance for doubtful account at the end of the year.
4. Assuming the same method of estimating bad debts in number 3, determine its bad debt expense
for the year.
5. Assuming the same method of estimating bad debts in number 3, compute for the net realizable
value of accounts receivable.
6. CC Company estimates its bad debt expense based on aging. Compute for the allowance for
doubtful account at the end of the year.
7. Assuming the same method of estimating bad debts in number 6, compute for the net realizable
value of accounts receivable.

Solution:
1.
Net Sales (P10,000,000-700,000) P 9,300,000
Multiply by: Percentage of uncollectible accounts 2%
Bad debts expense P 186,000

2.
Allowance for bad debt expense, beg P 40,000
Add: Bad debts expense 186,000
Allowance for bad debts expense, end P 226,000

3.
Accounts Receivable, end P 1,500,000
Multiply by: Percentage of uncollectible accounts 5%
Allowance for bad debts expense, end P 75,000
4.
Allowance for bad debt expense, beg P 40,000
Add: Bad debts expense (squeeze) 35,000
Allowance for bad debts expense, end P 75,000

5.
Accounts Receivable, end P 1,500,000
Less: Allowance for bad debts expense, end 75,000
Net realizable value P 1,425,000

6.
Classification Balance of A/R Percentage Required
Uncollectible Balance
0-1 month category P 500,000 2% P 10,000
1-6 months category 800,000 5% 40,000
Over 6 months 200,000 20% 40,000
Allowance for bad debts, end P 90,000

7.
Accounts Receivable, end P 1,500,000
Less: Allowance for bad debts expense, end 90,000
Net realizable value P 1,410,000

NOTES RECEIVABLES
Notes receivable are claims supported by formal promises to pay usually in the form of notes. A
negotiable promissory note is an unconditional promise in writing made by one person to another,
signed by the maker, engaging to pay on demand or at a fixed determinable future time a sum
certain in money to order or to bearer.

Dishonored Notes
When a promissory note matures and is not paid, it is said to be dishonored. Theoretically,
dishonored notes shall be removed from the notes receivable account and transferred to accounts
receivable at an amount to include, if any, interest and other charges.

Dishonored notes should be recorded as follows:

Accounts Receivable xx
Notes Receivable xx
Interest Income xx

LONG-TERM NOTES RECEIVABLES

Long term notes receivable may be classified as interest bearing and non-interest bearing. Interest
bearing note may be further classified into two, with realistic interest rates and unrealistic rates.

Initial Measurement: Long-term Notes Receivable

a. Interest bearing notes receivable – With realistic interest rate

Interest bearing notes with realistic or reasonable interest rate is initially measured at its fair value,
which is equal to its face value.

b. Interest bearing notes receivable – With unrealistic interest rate

Interest bearing notes with unrealistic rates are discounted using the imputed interest rate that
approximates the market rate of interest for the same note.

Unrealistic interest rates – interest bearing note with a nominal rate which is significantly different
from prevailing interest rate for similar notes or when the notes face value is significantly different
from market value of the consideration given on exchange for the note.

c. Non-interest bearing notes receivable/zero interest bearing

Non-interest bearing note is discounted to arrive at the fair value or the present value of future cash
flows using the prevailing market rate of interest for the similar receivables. In determining the
fair value of non-interest bearing notes, the following rules should be applied:
1. Periodic payment (with available cash price). The present value of the note is equal to the
cash price.
2. One-time collection of principal (no available cash price). The present value of the note is
equal to face value multiplied by present value of 1.
3. Uniform collection of principal annually (no available cash price). The present value of the
note is equal to periodic payment multiplied by present value of ordinary annuity of 1.

Subsequent Measurement: Long-Term Notes Receivable

Long-term notes receivable is subsequently measured at amortized cost using effective interest
method.

a. Interest bearing notes receivable – with realistic interest rate

Interest bearing notes with realistic or reasonable interest rate is subsequently measured at
amortized cost. Its amortized cost is its face value.

b. Interest bearing notes receivable – with unrealistic interest rate

Interest bearing notes with unrealistic rates are subsequently measured at amortized cost using the
imputed interest rate that approximates the market rate of interest for the same variables.

c. Non-interest bearing notes receivable/zero-interest bearing

Non-interest bearing notes are measured subsequently at amortized cost using the prevailing
market rate of interest for the similar receivables. The amortized cost for interest bearing note with
unrealistic interest rate or non-interest bearing note is computed as follows:

Face amount xx
Add: Premium on notes receivable xx
Or Less: Discount on notes receivable xx
Loss Allowance xx
Amortized cost xx

ILLUSTRATION: Interest-Bearing Note with Realistic Interest Rate

On January 1, 2018, VV Company sold a machine to BB Company. In lieu of cash payment, BB
gave VV a 4-year P100,000, 10% note. The note requires interest to be paid annually on December
31. The machinery has a cost of P500,000 and accumulated depreciation as of January 1, 2018 of
P350,000.
The 10% interest rate is a realistic rate of interest for a note of this type.

Required:
a. Compute for the following as of December 31, 2018:
1. Gain or loss on sale of machinery
2. Interest income
3. Current portion of the notes receivable
4. Noncurrent portion of the notes receivable

b. Prepare all the necessary entries in 2018.

Solution:
Requirement 1.
Net selling price P 100,000
Less: Carrying amount of machinery
Cost P 500,000
Accumulated Depreciation 350,000 150,000
Loss on sale (P 50,000)

Requirement 2
Interest income = 100,000 * 10% = P10,000

Requirement 3
Zero. No principal amount is collectible within one year from the reporting date.

Requirement 4
P100,000

b. Journal entries for 2018 are as follows:

Jan 1
Notes Receivable 100,000
Accumulated depreciation 350,000
Loss on sale 50,000
Machinery 500,000

Dec 31
Cash 10,000
Interest Income 10,000

ILLUSTRATION: Interest Bearing Note with Unrealistic Interest Rate, One-Time

Collection of Principal

On January 1, 2018, VV Company sold a machine to BB Company. In lieu of cash payment, BB

gave VV a 4-year P100,000, 10% note. The note requires interest to be paid annually on December
31. The machinery has a cost of P500,000 and accumulated depreciation as of January 1, 2018 of
P350,000. The prevailing interest rate for this type of note is 16%.

Required:
a. Compute for the following as of December 31, 2018:
1. Gain or loss on sale of machinery
2. Interest income
3. Current portion of the notes receivable
4. Noncurrent portion of the notes receivable

b. Prepare all the necessary entries in 2018.

Solution:
Requirement 1.
 Net selling price
Present value of principal (P100,000 * 0.5523) P 55,230
Add: Present value of interest (P10,000 * 2.7982) 27,982 P 83,212
Less: Carrying amount of machinery
Cost P 500,000
Accumulated Depreciation 350,000 150,000
Loss on sale (P 66,788)

Amortization Table
Interest Discount
Date Interest Income Present Value
Collection Amortization
01/01/18 P 83,212
12/31/18 P 10,000 P 13,314 P 3,314 86,526
12/31/19 10,000 13,844 3,844 90,370
12/31/20 10,000 14,459 4,459 94,829
12/31/21 10,000 15,173 5,171 100,000

Requirement 2.
P 13,314

Requirement 3
Zero. No principal amount is collectible within one year from the reporting date.

Requirement 4
Principal collectible beyond one year P 100,000
Less: Unearned interest income 13,474
Carrying amount of notes receivable P 86,526

b. Journal entries for 2018 are as follows:

Jan 1
Notes Receivable 100,000
Accumulated depreciation 350,000
Loss on sale 66,788
Machinery 500,000
Unearned interest income (100,000 – 83,212) 16,788

Dec 31
Cash 10,000
Interest Income 10,000

Unearned interest income 3,314

Interest income 3,314

ILLUSTRATION: Interest Bearing Note with Unrealistic Interest Rate, Interest is Payable
Semi-annually, One-Time Collection of Principal

On January 1, 2018, VV Company sold a machine to BB Company. In lieu of cash payment, BB

gave VV a 4-year P100,000, 10% note. The note requires interest to be paid semi-annually on June
30 and December 31. The machinery has a cost of P500,000 and accumulated depreciation as of
January 1, 2018 of P350,000. The prevailing interest rate for this type of note is 16%.

Required:
a. Compute for the following as of December 31, 2018:
1. Gain or loss on sale of machinery
2. Interest income
3. Current portion of the notes receivable
4. Noncurrent portion of the notes receivable

b. Prepare all the necessary entries in 2018.

Solution:
Requirement 1.
Net selling price
Present value of principal (P100,000 * 0.5403) P 54,030
Add: Present value of interest (P5,000 * 5.7466) 28,733 P 82,763
Less: Carrying amount of machinery
Cost P 500,000
Accumulated Depreciation 350,000 150,000
Loss on sale (P 67,237)

Amortization Table
Interest Discount
Date Interest Income Present Value
Collection Amortization
01/01/18 P 82,763
06/30/18 P 5,000 P 6,621 P 1,621 84,384
12/31/18 5,000 6,751 1,751 86,135
06/30/19 5,000 6,891 1,891 88,026
12/31/19 5,000 7,042 2,042 90,068
06/30/20 5,000 7,205 2,205 92,273
12/31/20 5,000 7,382 2,382 94,655
06/30/21 5,000 7,572 2,572 97,227
12/31/21 5,000 7,778 2,773 100,000

Requirement 2.
P 6,621 + 6,751 = P 13,372

Requirement 3
Zero. No principal amount is collectible within one year from the reporting date.

Requirement 4
Principal collectible beyond one year P 100,000
Less: Unearned interest income 13,865
Carrying amount of notes receivable P 86,135

b. Journal entries for 2018 are as follows:

Jan 1
Notes Receivable 100,000
Accumulated depreciation 350,000
Loss on sale 67,237
Machinery 500,000
Unearned interest income (100,000 – 82,763) 17,237

June 30
Cash 5,000
Interest Income 5,000
 Dec 31
Cash 5,000
Interest Income 5,000

Unearned interest income 3,372

Interest income 3,372

ILLUSTRATION: Interest Bearing Note with Unrealistic Interest Rate, Uniform Collection
of Principal

On January 1, 2018, VV Company sold a machine to BB Company. In lieu of cash payment, BB

gave VV a 4-year P100,000, 10% note. The note requires interest to be paid annually on December
31. The machinery has a cost of P500,000 and accumulated depreciation as of January 1, 2018 of
P350,000. The prevailing interest rate for this type of note is 16% and the principal amount of the
note is to be paid in four equal annual installments of P25,000 every December 31.

Required:
a. Compute for the following as of December 31, 2018:
1. Gain or loss on sale of machinery
2. Interest income
3. Current portion of the notes receivable
4. Noncurrent portion of the notes receivable

b. Prepare all the necessary entries in 2018.

Solution:
Requirement 1.
Net selling price P 88,733
Less: Carrying amount of machinery
Cost P 500,000
Accumulated Depreciation 350,000 150,000
Loss on sale (P 61,267)

Present value of notes receivable:

Interest Total Present
Principal PV of 1
Date Collection Collection Value
(A) (D)
(B) (A+B) C*D
12/31/18 P 25,000 P 10,000 P 35,000 0.8621 P 30,172
12/31/19 25,000 7,500 32,500 0.7432 24,153
12/31/20 25,000 5,000 30,000 0.6407 19,220
12/31/21 25,000 2,500 27,500 0.5523 15,188
Total P 88,733

Amortization Table
Interest Interest Principal Present
Date Amortization
Collection Income Collection Value
01/01/18 P 88,733
12/31/18 P 10,000 P 14,197 P 4,197 P 25,000 67,930
12/31/19 7,500 10,869 3,369 25,000 46,299
12/31/20 5,000 7,408 2,408 25,000 23,707
12/31/21 2,500 3,793 1,293 25,000 -

Requirement 2.
P 14,197. See amortization table above.
Requirement 3
P 21,631 (P 25,000 – 3,369)

Requirement 4
Principal collectible beyond one year P 50,000
Less: Discount Amortization (2,408+1,293) 3,701
Carrying amount of notes receivable P 46,499

b. Journal entries for 2018 are as follows:

Jan 1
Notes Receivable 100,000
Accumulated depreciation 350,000
Loss on sale 61,267
Machinery 500,000
Unearned interest income (100,000 – 88,733) 11,267

Dec 31
Cash 35,000
Notes Receivable 25,000
Interest Income 10,000

Unearned interest income 4,197

Interest income 4,197

ILLUSTRATION: Non-interest Bearing Note, One-Time Collection of Principal

On January 1, 2018, VV Company sold a machine to BB Company. In lieu of cash payment, BB
gave VV a 5-year, P500,000 note. The machinery has a cost of P500,000 and accumulated
depreciation as of January 1, 2018 of P150,000. The note is a non-interest bearing note and the
prevailing rate of interest for a note of this type is 10%.

Required:
a. Compute for the following as of December 31, 2018:
1. Gain or loss on sale of machinery
2. Interest income
3. Current portion of the notes receivable
4. Noncurrent portion of the notes receivable

b. Prepare all the necessary entries in 2018.

Solution:
Requirement 1.
Net selling price P 310,450
Less: Carrying amount of machinery
Cost P 500,000
Accumulated Depreciation 150,000 350,000
Loss on sale (P 39,550)

Date Interest Income Present value

01/01/18 P 310,450
12/31/18 P 31,045 341,495
12/31/19 34,150 375,645
Requirement 2
P31,045. See amortization table above.

Requirement 3
Zero. No principal amount is collectible within one year from the reporting date.

Requirement 4
Principal collectible beyond one year P 500,000
Less: Unearned interest income 158,505
Carrying amount of notes receivable P 341,495

b. Journal entries for 2018 are as follows:

Jan 1
Notes Receivable 500,000
Accumulated depreciation 150,000
Loss on sale 39,550
Machinery 500,000
Unearned interest income 189,550

Dec 31
Unearned interest income 31,045
Interest Income 31,045

ILLUSTRATION: Non-interest Bearing Note, Uniform Collection of Principal

On January 1, 2018, VV Company sold a machine to BB Company. In lieu of cash payment, BB
gave VV a 3-year, P600,000 note. The machinery has a cost of P500,000 and accumulated
depreciation as of January 1, 2018 of P150,000. The note is a non-interest bearing note and the
prevailing rate of interest for a note of this type is 14% and the principal amount of the note is to
be paid in three equal annual installments of P200,000 every December 31.

Required:
a. Compute for the following as of December 31, 2018:
1. Gain or loss on sale of machinery
2. Interest income
3. Current portion of the notes receivable
4. Noncurrent portion of the notes receivable

b. Prepare all the necessary entries in 2018.

Solution:
Requirement 1.
Net selling price P 464,320
Less: Carrying amount of machinery
Cost P 500,000
Accumulated Depreciation 150,000 350,000
Gain on sale P 114,320

Date Annual Interest Income Amortization Present value

Collection
01/01/18 P 464,320
12/31/18 P 200,000 P 65,005 P 134,995 329,325
12/31/19 200,000 46,105 153,895 175,430
12/31/20 200,000 24,570 175,430 -
Requirement 2
P65,005. See amortization table above.

Requirement 3
Principal collectible next year P 200,000
Less: Unearned interest income 46,105
Carrying amount of notes receivable P 153,895

Requirement 4
Principal collectible beyond one year P 200,000
Less: Unearned interest income 24,570
Carrying amount of notes receivable P 175,430

b. Journal entries for 2018 are as follows:

Jan 1
Notes Receivable 600,000
Accumulated depreciation 150,000
Gain on sale 114,320
Machinery 500,000
Unearned interest income 135,680

Dec 31
Cash 200,000
Notes Receivable 200,000

Unearned interest income 65,005

Interest Income 65,005

ILLUSTRATION: Non-interest Bearing Note, Periodic Payment with Available Cash Price
On January 1, 2018, VV Company sold a machine to BB Company. In lieu of cash payment, BB
gave VV a 3-year, P300,000 note. The machinery has a cost of P500,000 and accumulated
depreciation as of January 1, 2018 of P200,000. The machinery has a cash price of P288,000. The
note is a non-interest bearing and payable in three equal annual installments of P100,000 every
December 31 beginning December 31, 2018.

Required:
a. Compute for the following as of December 31, 2018:
1. Gain or loss on sale of machinery
2. Interest income
3. Current portion of the notes receivable
4. Noncurrent portion of the notes receivable

b. Prepare all the necessary entries in 2018.

Solution:
Requirement 1.
Net selling price P 288,000
Less: Carrying amount of machinery
Cost P 500,000
Accumulated Depreciation 200,000 300,000
Loss on sale (P 12,000)
 Year Notes Outstanding Fraction Allocated interest
income
1/1/18-12/31/18 P 300,000 3/6 P 6,000
1/1/19-12/31/19 200,000 2/6 4,000
1/1/20-12/31/20 100,000 1/6 2,000
Total P 600,000 P 12,000

Requirement 2
P 6,000. See table above.

Requirement 3
Principal collectible next year P 100,000
Less: Unearned interest income 4,000
Carrying amount of notes receivable P 96,000

Requirement 4
Principal collectible beyond one year P 100,000
Less: Unearned interest income 2,000
Carrying amount of notes receivable P 98,000

b. Journal entries for 2018 are as follows:

Jan 1
Notes Receivable 300,000
Accumulated depreciation 200,000
Loss on sale 12,000
Machinery 500,000
Unearned interest income 12,000

Dec 31
Cash 100,000
Notes Receivable 100,000

Unearned interest income 6,000

Interest Income 6,000

LOAN RECEIVABLE
A loan receivable is a financial asset arising from a loan granted by bank or other financial
institution to a borrower or client. The term of the loan may be short-term but in most cases the
repayment periods cover several years.

Initial Measurement
Loans receivable should be initially measured at fair value plus transaction cost. In other words,
the following items should be considered in the initial measurement of loans receivable which is
directly related in granting a loan to a customer or borrower:
1. Origination fees include compensation for activities such as evaluating the borrower’s financial
condition, evaluating guarantees, collateral and other security, negotiating the terms of the loan,
preparing and processing documents and closing the loan transaction. Origination fees received
from the borrower is recorded as unearned interest income.
2. Direct origination costs refer to origination costs or transaction costs not directly chargeable to
customers.
3. Indirect origination costs shall be treated as expense.

Therefore, the initial carrying amount of the loans receivable may be computed as follows:
Principal amount xx
Less: Origination fee received xx
Add: Direct origination costs xx
Initial present value or carrying amount xx

Journal entries:
1. To record the loan
Loan receivable xxx
Cash xxx

2. To record the receipt of origination fees

Cash xxx
Unearned interest income xxx

3. To record the payment of direct origination cost

Unearned interest income xxx
Cash xxx

4. To record the collection of loan receivable

Cash xxx
Loan Receivable xxx

5. To record the amortization of unearned interest income

Loan receivable xxx
Cash xxx

Subsequent Measurement
Loan receivable is subsequently measured at amortized cost using effective interest method. Since
loans receivable frequently involves transaction costs, a new effective rate should be computed
through interpolation. When computing the effective interest rate, always remember the rule on
present value, that the higher the interest rate, the lower the present value”.

Illustration: Computation of Effective Interest Rate through Interpolation

On January 1, 2018, Happier granted a 4-year loan to a borrower in the amount of P5,000,000. The
company incurs P200,000 of direct loan origination cost and receives nonrefundable origination
fee amounting to P500,000. The stated interest is 10% payable annually every December 31.

Required:
A. Compute for the following:
1. Effective interest rate
2. Interest income on December 31, 2018
3. Carrying amount of loan receivable, December 31, 2018
4. Current portion of loan receivable, December 31, 2018
5. Noncurrent portion of loan receivable, December 31, 2018
B. Prepare the necessary journal entries.

Solution:
Requirement No. 1 – Steps:
1. Compute for the initial present value of the loan receivable.
Principal amount P 5,000,000
Less: Origination fee received 500,000
Add: Direct origination costs 200,000
Initial present value or carrying amount P 4,700,000

2. Get the present value using a higher rate. Use 11%.

Present value of principal (P5,000,000 * 0.6587) P 3,293,500
Add: Present value of interest (P500,000 * 3.1024) 1,551,200
Total present value P 4,844,700

3. Compute the present value using 12%.

Present value of principal (P5,000,000 * 0.6355) P 3,177,500
Add: Present value of interest (P500,000 * 3.0373) 1,518,650
Total present value P 4,696,150

4. Use the following formula in computing the effective interest rate.

(𝑃𝑉 𝑜𝑓 𝐿𝑅−𝑃𝑉 𝑜𝑓 𝑋)
X = Lower rate + [(Higher rate – lower rate) x ]
(𝑃𝑉 𝑜𝑓 𝐿𝑅−𝑃𝑉 𝑜𝑓 𝐻𝑅)
(4,844,700−4,700,000)
X = 11% + [(12% - 11%) x(4,844,700−4,696,150)]
144,700
X = 11% + (1% x148,550)
X = 11% + (1% x 0.97)
X = 11% + 0.0097
X = 11.97%
Amortization Table (Using 11.97%)
Interest Discount
Date Interest Income Present Value
Collection Amortization
01/01/18 P 4,700,000
12/31/18 P 500,000 P 562,590 P 62,590 4,762,590
12/31/19 500,000 570,082 70,082 4,832,672
12/31/20 500,000 578,471 78,471 4,911,143
12/31/21 500,000 587,864 87,864 5,000,000

Requirement No. 2
Interest income = P 562,590

Requirement No. 3
Principal amount collectible beyond one year P 5,000,000
Less: Unearned interest income 237,410
Carrying amount of notes receivable P 4,762,590

Requirement No. 4
Zero, the entire receivable is collectible beyond one year.

Requirement No. 5
Principal amount collectible beyond one year P 5,000,000
Less: Unearned interest income 237,410
Carrying amount of notes receivable P 4,762,590

B. Journal entries
2018
Jan 1
Loan receivable 5,000,000
 Cash 5,000,000

Unearned interest income 200,000

Cash 200,000

Cash 500,000
Unearned interest income 500,000

Dec 31
Cash 500,000
Interest income 500,000

Unearned interest income 62,590

Interest income 62,590

RECEIVABLE FINANCING
Sufficient cash is an essential part of running the operations of a business. However, there are some
instances where an entity may have insufficient funds to use for its operations. An entity may
generate cash from various source of financing. One form of raising fund is through receivable
financing which is the capability or financial flexibility of the company to generate cash out of its
receivables.

The most common forms of receivable financing are as follows:

1. Pledging of receivable
2. Assignment of receivable
3. Factoring of receivable
4. Discounting of receivable

Pledging / Hypothecating
Pledging or hypothecating of receivables refers to borrowing of money from the bank or any
financial institution in which receivables in general are used as collateral or security for a loan.
Since receivables, in general, are used as collateral, pledging is sometimes called general
assignment.

Illustration: Pledging of Accounts Receivable

On October 1 of the current year, JK Company borrowed P1,000,000 for one year from KL Bank
with a stated interest rate of 12%. As a security for the loan, JK Company hypothecated its accounts
receivable amounting to P1,500,000. KL Bank deducted the one year interest in advance.

Required: Prepare the entries in relation to the pledging of accounts receivables, assuming
amortization of interest deducted in advance is to be made equally for the entire loan term.

Solution:
Oct 1
Cash 880,000
Discount on Notes Payable 120,000
Notes payable - bank 1,000,000

Dec 31
Interest Expense 30,000
Discount on notes payable 30,000
120,000 * 3/12

Assignment
Assignment is a more formal borrowing arrangement in which the specific receivables are
identified and used as security. The assignor or borrower transfers its rights in some of its accounts
receivables to a lender or assignee inconsideration for a loan. The following are some of the
characteristics of an assignment:
a. The loan is at a specified percentage of the face value of the collateral and interest and service
fees are charged to the assignor or borrower.
b. The debtors are occasionally notified to make payments to the assignee (lender) but most
assignments are not on a notification basis.
c. Assigned accounts are segregated from other accounts. The notes payable should be deducted
from the balance of Accounts Receivable assigned to determine the equity in assigned accounts
receivable.

Assignments may either be:

1. Non-notification basis – buyer is not informed of the assignment arrangement and will continue
to remit its payment to the seller (assignor)

2. Notification basis – buyer is informed of the assignment arrangement and will remit payment
directly to the assignee (e.g. bank)

NON-NOTIFICATION NOTIFICATION
To separate the assigned accounts
Accounts Receivable – assigned xx Accounts Receivable – assigned xx
Accounts Receivable xx Accounts Receivable xx
To record the loan
Cash xx Cash xx
Service charge xx Service charge xx
Notes payable - bank xx Notes payable - bank xx
Issued credit memo (sales return)
Sales return xx Sales return xx
Accounts receivable – assigned xx Accounts receivable – assigned xx
To record collection
Cash xx Notes payable - bank xx
Sales discount xx Sales discount xx
Accounts receivable – assigned xx Accounts receivable – assigned xx
To record remittance
Notes payable – bank xx
Interest expense xx Interest expense xx
Cash xx Cash xx
To record write-off of accounts assigned
Allowance for bad debt xx Allowance for bad debt xx
Accounts receivable - assigned xx Accounts receivable - assigned xx
To transfer the remaining balance of Accounts Receivable – assigned to Accounts
Receivable (unassigned)
Accounts receivable xx Accounts receivable xx
Accounts receivable - assigned xx Accounts receivable - assigned xx

Illustration: Assignment – Non-notification Basis

On November 1 of the current year, HJ Company assigned customers’ accounts in the amount of
P1,000,000 to NM Company as a security for a loan in the amount of P750,000 and a stated interest
rate of 10%. NM Company charges 5% in relation to the amount borrowed. HJ Company will
continue to collect the accounts from customers and will remit payment to NM Company.
On December 30 of the current year, cash collections on the assigned accounts amounted to
P450,000.
On December 31, HJ Company remitted in full the amount collected plus interest due on the
outstanding balance of the loan.

Required:
1. Compute the cash received from assignment.
2. Prepare the journal entries in relation to the assignment of the accounts receivables.
3. Compute for the amount of equity over the assigned accounts to be disclosed on December 31.

Solution:
Requirement No. 1
Notes payable P 750,000
Less: Service charge (5% * P750,000) 37,500
Cash received P 712,500

Requirement No. 2
To separate the assigned accounts
Accounts Receivable – assigned 1,000,000
Accounts Receivable 1,000,000
To record the loan
Cash 712,500
Service charge 37,500
Notes payable - bank 750,000
To record collection
Cash 450,000
Accounts receivable – assigned 450,000
To record remittance
Notes payable – bank 450,000
Interest expense 12,500
Cash 462,500

Requirement No. 3
Accounts receivable – assigned (1,000,000 – 450,000) P 550,000
Less: Notes Payable (750,000 – 450,000) 300,000
Equity in assigned accounts to be disclosed in the notes P 250,000

Illustration: Assignment – Notification Basis

Canon Company finances some of its current operations by assigning accounts receivable on a
notification basis to Josiah Finance. On July 1 of the current year, it assigned under guarantee
specific accounts amounting to P2,000,000. Josiah Finance shall advance to Canon Company 80%
of the accounts assigned, less a finance charge of 1% of the total accounts assigned.
On August 1, Canon Company received a statement that Josiah had collected P1,100,000 of these
accounts and had made an additional charge of 1% of the total outstanding payable as of July 31.
This charge is to be deducted at the time of the first remittance due to Canon Company from the
Josiah Finance.
On September 1, Canon Company received a second statement from Josiah Finance together with
a check for the amount due. The statement indicated that the Josiah Finance had collected an
additional of P600,000 and had made a further charge of 1% of the balance outstanding as of
August 31.

Required:
1. Compute for the cash received from assignment.
2. Prepare the entries in relation to the assignment of the accounts receivable.

Solution:
1.
Notes payable (2,000,000 * 80%) P 1,600,000
Less: Finance charge (1% * P2,000,000) 20,000
Cash received P 1,580,000

Requirement No. 2
Jul 7
Accounts Receivable – assigned 2,000,000
Accounts Receivable 2,000,000

Cash 1,580,000
Service charge 20,000
Notes payable - bank 1,600,000

Aug 1
Notes payable - bank 1,084,000
Service charge 16,000
Accounts receivable – assigned 1,100,000

Sept 1
Notes payable - bank 516,000
Service charge 5,160
Cash 78,840
Accounts receivable – assigned 600,000

Accounts receivable 300,000

Accounts receivable - assigned 300,000

Factoring
Factoring involves the sale of receivables to a finance company which is called the factor. The
factor or buyer assumes the risk of collectivity and generally handles the billing and collection
function.

Factoring may either be:

1. Casual factoring – this is treated as an outright sale of receivable. A gain or loss is recognized
for the difference between the proceeds received and the net carrying amount of the receivables
factored. Casual factoring may either be with or without recourse basis.
2. Regular factoring – the cost of factoring is debited to appropriate expense account. Just like in
casual factoring, factoring of this kind may either be with or without recourse basis.

Factors holdback
Factors holdback is the portion retained for a purchase price to cover probable sales return,
discount and allowance. Receivable from factor is presented as current asset.

Gross amount of receivable xx

Less: Factoring fee xx
Finance charge and interest expense xx
Net Selling Price xx
Less: Factors holdback xx
 Net cash received xx

Gross amount of receivable xx

Less: Factoring fee xx
Finance charge and interest expense xx
Net Selling Price xx
Less: Recourse obligation (if any) xx
Net Proceeds xx
Less: Book value of Accounts Receivable xx
Gain (loss) on sale xx

Illustration: Factoring of Accounts Receivable

Corny Company factored P100,000 of its accounts receivable to Maisy Company for P85,000. An
allowance for bad debts equal to P3,000 was previously established for the account factored. Maisy
Company withheld 5% of the purchase price as protection against sales returns and allowance.

Case 1: Sale of receivable is without recourse

Case 2: Sale of receivable is with recourse and the recourse obligation has an estimated fair value
of P5,000.

Required:
For each of the above cases, determine the following:
1. Cash received
2. Cost of factoring
3. Journal entry to record the transaction

Solution:
Case 1:
Requirement 1
Net Selling Price P 85,000
Less: Factors holdback 4,250
Net cash received P 80,750

Requirement 2
Net Selling Price P 85,000
Less: Recourse obligation (if any) 0
Net Proceeds 85,000
Less: Book value of Accounts Receivable 97,000
Gain (loss) on sale (P 12,000)

Cost of factoring is equal to loss on factoring of P12,000.

Requirement 3
Cash 80,750
Allowance for doubtful accounts 3,000
Loss on factoring 12,000
Receivable - factor 4,250
Accounts receivable 100,000

Case 2:
Requirement 1
Net Selling Price P 85,000
Less: Factors holdback 4,250
Net cash received P 80,750
Requirement 2
Net Selling Price P 85,000
Less: Recourse obligation (if any) 5,000
Net Proceeds 80,000
Less: Book value of Accounts Receivable 97,000
Gain (loss) on sale (P 17,000)

Cash 80,750
Allowance for doubtful accounts 3,000
Loss on factoring 17,000
Receivable - factor 4,250
Accounts receivable 100,000
Estimated recourse obligation 5,000

Illustration: Factoring of Accounts Receivable

AA Company factored P600,000 of its accounts receivable to SS Company on October 1. Control
was surrendered by AA Company. The factor assessed a fee of 3% and retained a holdback equal
to 5% of the accounts receivable. In addition, the factor charged 15% interest computed on a
weighted average time to maturity of the accounts receivable of 54 days. (Use 365 days in the
computation of the interest.)

Required:
1. What is the amount of cash initially received by AA Company from the factoring?
2. If all accounts are collected, what is the cost of factoring the accounts receivable?

Solution:
1.
Gross amount of receivable P 600,000
Less: Factoring fee 18,000
Finance charge and interest expense 13,315
Net Selling Price P 568,685
Less: Factors holdback 30,000
Net cash received P 538,685

2.
Factoring fee P 18,000
Interest expense 13,315
Cost of factoring P 31,315

Net Selling Price P 568,685

Less: Recourse obligation (if any) 0
Net Proceeds 568,685
Less: Book value of Accounts Receivable 600,000
Gain (loss) on sale (P 31,315)

Discounting of Notes
Discounting of notes is a sale of the note to a third party, usually a bank. The sale is usually on a
with recourse basis which means that upon the default of the debtor, the seller of the note becomes
liable for its maturity value.

Discounting may either be:

1. Without recourse – endorser avoids future liability even if the maker refuses to pay the endorsee
on the date of maturity
2. With recourse – the endorser shall pay the endorsee if the maker dishonors the note. This is the
contingent or secondary liability of the endorsee. Discounting with the recourse may be accounted
as either:
a) Conditional sale recognizing contingent liability
b) Secured borrowing

Illustration: Notes Receivable Discounting

On January 16, Gerry Co. accepted a P600,000, 10%, 90-day note from a customer. On February
15, the note was discounted at 12%.
At maturity date, the note was dishonored and the bank charged a P2,500 protest fee.

Required: Prepare all the necessary entries assuming the notes receivable was
1. Discounted without recourse
2. Discounted with recourse
a) Conditional sale recognizing contingent liability
b) Secured borrowing

Solution:
1. Maturity value = Principal + Interest
= P 600,000 + (P600,000 * 10% * 90/360)
= P615,000

Net Proceeds = P 615,000 – (P 615,000 * 12% * 60/360)

= P 602,700

Net Proceeds P 602,700

Less: Carrying amount of notes receivable
Principal P 600,000
Add: Accrued interest (600k * 10% * 30/360 5,000 605,000
Loss on notes receivable discounting ( P2,300)

Requirement No. 1
1. Discounted without recourse
Cash 602,700
Loss on notes receivable discounting 2,300
Notes receivable 600,000
Interest income 5,000

Requirement No. 2
2.a.
Cash 602,700
Loss on notes receivable discounting 2,300
Notes receivable discounted 600,000
Interest income 5,000

Notes receivable dishonored 617,500

Cash 617,500
Notes receivable discounted 600,000
Notes Receivable 600,000

2.b.
Cash 602,700
Interest expense 2,300
 Liability for notes receivable discounted 600,000
Interest income 5,000

Notes receivable dishonored 617,500

Cash 617,500
Notes receivable discounted 600,000
Notes Receivable 600,000

Discounting Own Note

Discounting own note is accounted for as a regular loan. Discounting simply means that the interest
is deducted in advance. The pertinent journal entry to record discounting of company’s own note
would be:
Cash xx
Discount on notes payable xx
Notes payable - bank xx

Illustration: Discounting Own Note

On July 1, 2018, GG Co. discounted its own P500,000, 1-year note at a bank, at a discount rate of
12% when the prime rate is 10%.

Required:
1. Determine the following:
a) Net proceeds from discounting
b) Effective rate
2. Prepare all the necessary entries for 2018.

Solution:
Requirement No. 1
Note payable P 500,000
Less: Discount on note payable (60,000)
Net proceeds P 440,000

Effective interest rate = Discount / Net proceeds

= P60,000 / 440,000
= 13.6%

Requirement No. 2
Jul 1
Cash 440,000
Discount on notes payable 60,000
Notes payable - bank 500,000

Dec 31
Interest expense 30,000
Discount on notes payable 30,000

References:

Asuncion, et. al. (2018). Applied Auditing Book 1 of 2, Baguio City: Real Excellence Publishing
Valix, et. al. (2016). Financial Accounting Volume 1, Manila Philippines
 CHAPTER 3
INVENTORIES

TOPIC OVERVIEW:
This chapter explains inventory, its characteristics, components and valuation, initial and
subsequent measurement as well as the periodic and perpetual inventory systems.

LEARNING OBJECTIVES:
After studying this chapter, the students should be able to:
1. Describe inventories of manufacturing and merchandising companies.
2. Explain the initial recognition, initial measurement, subsequent measurement, derecognition,
and financial statement presentation of inventories.
3. Identify the situations in which periodic or perpetual system is appropriate.
4. Compare and contrast perpetual and periodic inventory system.
5. Account properly changes in inventory method and inventory error.
6. Calculate the correct balance of inventory and related accounts.

INVENTORIES

Inventories (PAS 2) are assets:

1. held for sale in the ordinary course of business
2. in the process of production for such sale
3. in the form of materials or supplies to be consumed in the production process or in the rendering
of services

Initial Recognition
An entity should recognize an inventory when:
a. the entity controls the asset as a result of past events, and
b. it is probable that future economic benefits will flow to the entity

Initial Measurement: Cost of Inventories

The cost of inventories shall comprise all cost of purchase, costs of conversion and other costs
incurred in bringing the inventories to their present location and condition.

Cost of Purchase
The standard lists the following as comprising the costs of purchase of inventories:
1. Purchase price plus
2. Import duties and other irrevocable taxes plus transport, handling and any other cost directly
attributable to the acquisition of finished goods, services and materials less trade discounts,
rebates, and other similar amounts

Costs of Conversion
Costs of conversion of inventories consist of two main parts:
1. Costs directly related to the units of production
2. Fixed and variable production overheads that are incurred in converting materials into finished
goods, allocated on a systematic basis.

Fixed production overheads are those indirect costs of production that remain relatively constant
regardless of the volume of production, (e.g. the cost of factory management and administration)
Variable production overheads are those indirect costs of production that vary directly, or nearly
directly, with the volume of production. (e.g., indirect materials and labor)

Other Costs
Other costs are included in the cost of inventories only to the extent that they are incurred in
bringing the inventories to their present location and condition. Examples of other costs are as
follows:
a. Borrowing costs – PAS 23 requires capitalizing interest on inventories which take a substantial
amount of time to create. However, an entity should not capitalize borrowing costs for inventories
that are manufactured in large quantities on a repetitive basis.
b. Storage Costs – this can be included for products that require a maturation process or substantial
amount of time to create.
c. Non-production overheads or costs of designing products for specific customer – this can be
included in cost if they contribute in bringing the inventories to their present condition and
location.

Excluded from Cost of Inventories

The standard lists types of cost which would not be included in cost of inventories. Instead, they
should be recognized as an expense in the period they are incurred.
1. Abnormal amounts of wasted materials, labor or other production costs.
2. Storage costs (except costs which are necessary in the production process before a further
production stage.)
3. Administrative overheads not incurred to bring inventories to their location and condition
4. Selling Costs
5. Foreign exchange differences arising directly on the recent acquisition of inventories invoiced
in a foreign currency
6. Interest cost when inventories are purchased with deferred settlement terms

ILLUSTRATION: Cost of Inventories

The costs set out below are those typically incurred by manufacturing businesses.
ITEMS
1 Supplier’s gross price for raw materials, P 150,000
2 Materials purchased from another supplier on extended credit amounting to P 570,000.
The price to be paid under normal credit term is P 550,000.
3 Invoice price of raw materials purchased amounting to P 180,000, quantity discounts of
10, 5 are followed by supplier.
4 Materials purchased from a supplier amounting to P616,000, inclusive of 12% VAT. The
company is VAT registered and can claim this as an input VAT.
5 Materials purchased from a supplier amounting to P515,000, inclusive of nonrecoverable
purchase tax of P15,000
6 Costs of transporting raw materials to the business premises, P5,000
7 Import duties paid to authorities on import of raw materials to be used in the
manufacturing process, P25,000
8 Labor costs directly incurred in the processing of raw materials, P420,000
9 Normal amount of wasted labor, P57,000
10 Abnormal amount of wasted labor, P69,000
11 Variable costs incurred in the processing of raw materials, P10,000

Required: Identify the cost as either inventoriable or not and determine the amount to be included
as part of inventory.
Solution:
Inventoriable? Amount Explanations
1 YES P 150,000
2 YES 550,000 The amount to be recorded is based on the price under
normal credit term. The difference between the price
under normal credit and extended credit term is recorded
as interest expense over the credit term.
3 YES 180,000 Invoice price means the quantity or trade discount was
already deducted.
4 YES 550,000 This is an example of recoverable purchase tax.
5 YES 515,000
6 YES 5,000
7 YES 25,000
8 YES 420,000
9 YES 57,000
10 NO - Abnormal waste is not inventoriable.
11 YES 10,000

Items to be included in inventory

Goods in transit from supplier
a. FOB Shipping Point Buyer
b. FOB Destination Seller
Consigned goods Consignor (Seller)
Sales out on approval Seller
Sales with buyback agreement Seller
Sales with right of return Buyer
Sales on installments Buyer
Segregated goods in the warehouse
a. Special-order goods Buyer upon completion
b. Hold for shipping instructions Seller

Accounting for Inventories

Two systems are offered in accounting for inventories, namely periodic system and perpetual
system.
The periodic system calls for the physical counting of goods on hand at the end of the accounting
period to determine quantities. It is generally used when the individual inventory items have small
peso investment, such as groceries, hardware and auto parts.
On the other hand, perpetual inventory system requires the maintenance of records called stock
cards that usually offer a running summary of the inventory inflow and outflow. It is commonly
used when the inventory items treated individually represent a relatively large peso investment
such as jewelry and cars.
ILLUSTRATION:
At the beginning of January 1, CV Company has 2,000 inventories costing P20 per unit. The
following transactions transpired during the year:
1. Purchased on account 3,000 units of inventory at P20 per unit
2. Sold on account 2,500 units of inventory for P50 per unit
3. Purchased on account 4,000 units of inventory at P20 per unit
4. Sold on account 3,000 units of inventory for P50 per unit
5. On December 31, physical count revealed that 3,500 units were on hand

Required: Prepare all the necessary journal entries using:

a. Periodic inventory system
b. Perpetual inventory system

Periodic Inventory System Perpetual Inventory System

Purchases 60,000 Inventory 60,000
Accounts Payable 60,000 Accounts Payable 60,000

Accounts Receivable 125,000 Accounts Receivable 125,000

Sales 125,000 Sales 125,000

Cost of goods sold 50,000

Inventory 50,000

Purchases 80,000 Inventory 80,000

Accounts Payable 80,000 Accounts Payable 80,000

Accounts Receivable 150,000 Accounts Receivable 150,000

Sales 150,000 Sales 150,000

Cost of goods sold 60,000

Inventory 60,000

Inventory, end 70,000

Cost of goods sold 110,000
Purchases 140,000 No closing entry
Inventory, beg 40,000

Trade discount/volume discount/quantity discount

Trade discounts are given to encourage orders in large quantities. These discounts are deducted
from the list price to arrive at the invoice price and are never recognized in the accounting record
since the journal entry is based on the amount on the sales invoice.

Cash discount/Settlement discount

Cash discounts are reductions from invoice price as an inducement for prompt payment of an
account within the discount period (e.g. 2/10, n/30). This is also called sales discount from the
point of view of the seller, while it is termed as purchase discount from the point of view of the
buyer.

1. Gross method – purchases are recorded at the gross amount. Purchase discounts taken are
recorded under Purchase Discount account which is reported as a reduction of purchases.

2. Net method – purchases are recorded at the net amount. Purchase discounts not taken are
recorded to the Purchase Discount Lost account.
ILLUSTRATION:
Prepare the necessary journal entries for the following transactions:
a. Purchases on account, P200,000, 2/10, n/30.
b. Assume payment is made within the discount period
c. Assume payment is made beyond the discount period

GROSS METHOD NET METHOD

Account Title Debit Credit Account Title Debit Credit
Purchases 200,000 Purchases 196,000
Accounts Payable 200,000 Accounts Payable 196,000

Accounts Payable 200,000 Accounts Payable 196,000

Cash 196,000 Cash 196,000
Purchase Discount 4,000

Accounts Payable 200,000 Accounts Payable 196,000

Cash 200,000 Purchase Discount 4,000
Lost
Cash 200,000

SUBSEQUENT MEASUREMENT OF INVENTORIES

Inventories are required to be stated at the lower of cost and net realizable value (NRV).
Inventories are usually written down to net realizable value item by item. In some circumstances,
however, it may be appropriate to group similar or related items.

Net Realizable Value

NRV is the estimated selling price in the ordinary course of business, less the estimated cost of
completion and the estimated costs necessary to make the sale.

Two Methods of Accounting for the Lower of Cost or Net Realizable Value
1. Direct Method.
Merchandise inventory, beg (at LCNRV) xxx
Add: Net purchases xxx
Total goods available for sale xxx
Less: Merchandise inventory, end (at LCNRV) xxx
Cost of Goods Sold after Inventory Write-down xxx

2. Allowance Method.
Merchandise inventory, beg (at cost) xxx
Add: Net purchases xxx
Total goods available for sale xxx
Less: Merchandise inventory, end (at cost) xxx
Cost of Goods Sold before Inventory Write-down xxx
Add: Loss on inventory write-down xxx
Less: Gain on inventory write-down xxx
Cost of Goods Sold after Inventory Write-down xxx

Gain or loss may be computed as follows:

Merchandise inventory, end (at cost) xxx
Less: Merchandise inventory, end (at LCNRV) xxx
Required allowance xxx
Less: Allowance for inventory write-down, beg xxx
Loss (gain) on inventory write-down xxx
To illustrate how this valuation technique is applied, assume the following data for 2017, the first
year of operations and 2018:
December 31, 2017 December 31, 2018
Inventory at Cost, per Materials Ledger Card P360,000 P420,000
Inventory at Net Realizable Value 348,000 416,000

On December 31, 2017, an adjusting entry is made to set up the valuation account for P12,000, the
difference between the inventory cost and NRV as follows:
Loss on Inventory Write-down 12,000
Allowance for Inventory Write-down 12,000

NOTE: The Loss on Inventory Write-down is treated as an addition to Cost of Goods Sold in the
Income Statement while the Allowance for Inventory Write-down is a deduction from the
Inventory account in the Balance Sheet.
At the end of the later periods, the allowance account will again be adjusted to reflect the inventory
value at that time. Continuing our illustration, at the end of 2017, the allowance account of P
12,000 should be reduced to P4,000, which is the difference between the cost of P420,000 and the
NRV of P416,000. To reduce the balance of the allowance account from P 12,000 to P4,000, the
allowance account is debited by P8,000, the difference between these amounts. This adjustment is
recorded as follows:
Allowance for Inventory Write-down 8,000
Recovery from Inventory Write-down 8,000

NOTE: The Recovery from Inventory Write-down is a deduction from Cost of Goods Sold.
The allowance account balance of P4,000 at the end of 2018 will again be treated as a deduction
from the inventory at cost on the balance sheet.
If the net realizable value exceed the cost of the inventory, the valuation account is no longer
necessary. An entry would be made to close the Allowance for Inventory Write-down by debiting
the account for its current balance and crediting Recovery from Inventory Write-down. The
inventory would be shown in the statement of financial position at cost.

COST FORMULA
To determine the amount of cost to be compared to the net realizable value (NRV), the following
may be used:
1. Specific identification of cost. When the inventory items are few and are not ordinarily
interchangeable, specification identification technique may be used. It involves tracing an item
sold, or an item remaining in inventory to the specific item that was purchased. It is inappropriate
to use this method when there are large number of items in inventory that are ordinarily
interchangeable because selecting those items that remain in inventory could be used to obtain
predetermined effects on profit or loss. In this case, PAS 2 allows either FIFO or Weighted
Average.
2. FIFO. The first-in-first-out (FIFO) technique states that the first materials purchased (the oldest
or earliest) are the first materials to be used. The materials on hand are therefore assumed to be the
last one purchased.

3. Weighted average. It allows you to mingle the costs of similar items purchased and use weighted
averages to measure inventories held, either on a periodic basis or as each shipment is received.

ILLUSTRATION: Cost Formula

RR Company sells blankets for P30 each. The following was taken from the inventory records
during July:
Date Product Units Cost
July 3 Purchase 500 P15
July 10 Sale 300
July 17 Purchase 1,000 P17
July 20 Sale 600
July 23 Sale 300
July 30 Purchase 1,000 P20

Required: Determine the cost of sales and cost of ending inventory under each of the following
independent assumptions:
1. FIFO (periodic)
2. FIFO (perpetual)
3. Weighted average method
4. Moving average method

Solution:
1. First-In-First-Out Method (periodic)
Units sold = 1,200

Date Quantity Unit Cost Total Cost

July 10 Sale (from July 3) 300 P15 P 4,500
July 20 Sale (from July 3) 200 15 3,000
July 20 Sale (from July 17) 400 17 6,800
July 23 Sale (from July 17) 300 17 5,100
Total Cost of Sales 1,200 P 19,400

Cost of ending inventory

Units in ending inventory = 1,300
Date Quantity Unit Cost Total Cost
July 17 300 P17 P 5,100
July 30 1,000 20 20,000
Total Cost of Ending Inventory 1,300 P 25,100

2. First-In-First-Out Method (Perpetual)

Cost of Merchandise
Purchases Inventory
Sold
Unit Total Unit Total Unit Total
Date Qty Qty Qty
Cost Cost Cost Cost Cost Cost
July 3 500 P15 P7,500 500 P15 P7,500
July 10 300 P15 P4,500 (300) 15 (4,500)
Balance 200 15 3,000
July 17 1,000 17 P17,000 1,000 17 17,000
Balance 1,200 20,000
July 20 200 15 3,000 (200) 15 (3,000)
 400 17 6,800 (400) 17 (6,800)
July 23 300 17 5,100 (300) 17 (5,100)
Balance 300 17 P5,100
July 30 1,000 20 P20,000 1,000 20 20,000
Total 2,500 P44,500 1,200 P19,400 1,300 P25,100

3. Weighted Average Method

Quantity Unit Cost Total Cost
Beginning inventory -
Purchases
July 3 500 P15 P 7,500
July 17 1,000 17 17,000
July 30 1,000 20 20,000
Total Goods Available for Sale 2,500 P 17.80 P 44,500

Cost of Sale = P17.80 x 1,200

P21,360

4. Moving Average Method

Cost of Merchandise
Purchases Inventory
Sold
Unit Total Unit Total Unit Total
Date Qty Qty Qty
Cost Cost Cost Cost Cost Cost
July 3 500 P15 P7,500 500 P15 P7,500
July 10 300 P15 P4,500 (300) 15 (4,500)
Balance 200 15 3,000
July 17 1,000 17 P17,000 1,000 17 17,000
Balance 1,200 16.67 20,000
July 20 600 16.67 10,000 (600) 16.67 (10,000)
Balance 600 16.67 10,000
July 23 300 16.67 5,000 (300) 16.67 (5,000)
Balance 300 16.67 P5,000
July 30 1,000 20 P20,000 1,000 20 20,000
Total 1,200 P19,500 1,300 P25,000

INVENTORY ESTIMATION
Use of Estimate in Inventory Estimation
1. The inventory is destroyed by fire and another catastrophe, or theft of the merchandise has
occurred and the amount of inventory is required for insurance purposes.
2. A physical count of the goods on hand is made and it is necessary to prove the correctness or
reasonableness of such count by making an estimate.
3. Interim financial statements are prepared and a physical count of the goods on hand is not
necessary either because it may take time to do the same or because only an estimate thereof is
required to fairly present the financial position and performance of the entity.

Two Approaches in Estimating the Value of Inventory

1. Gross Profit Method
2. Retail Inventory Method

GROSS METHOD
Based on the entity’s past experience, the average gross profit rate may be used to estimate the
cost of goods sold as well as the ending inventory to be reported in the interim financial statements.

Gross profit method is useful when:

1. A periodic system is in use and inventories are required for interim statements.
2. Inventories have been destroyed or lost by fire, theft, or other casualty, and the specific data
required for inventory valuation are not available.
3. The relationship between gross profit and sales remains stable over time.

However, the gross profit method would not be useful when:

1. There is a significant change in the mix of products being sold and the gross margin percentage
changes significantly during the year.
2. Estimating inventories to be reported in the annual financial statements

Formulas:
Gross Profit based on Sales
Sales xxx 100%
Less: Cost of Goods Sold (xxx) 75%
Gross Profit xxx 25%

Gross Profit based on Cost

Sales xxx 125%
Less: Cost of Goods Sold (xxx) 100%
Gross Profit xxx 25%

Note: In the determination of sales for the purpose of using both the gross profit method and the
retail method, sales discounts and allowances are ignored since although these items reduce sales,
they do not reduce the physical quantity of inventory sold; the cost of goods sold includes the total
cost of items sold for which discounts were availed or for which allowances were set up. Only
sales returns are deducted to arrive at the amount of sales for the purpose of determining the gross
profit ratio.

Determining the Gross Profit Rate

1. Look for possible trend.
2. If the problem states that “Average Gross Profit” would be used, then
Gross Profit Rate Year 1 +Year 2 +Year n
Average Gross Profit =
Number of years

3. If the problem states that “The overall gross profit ratio for the past years was in effect during
the year of fire or theft”, then
Gross Profit Year 1 +Year 2 +Year n
Overall Gross Profit =
Sales Year 1 + Sales Year 2 + Sales Year n

Note: Use this when there is no trend on the gross profit ratios and the problem is silent as to
what gross profit will be used.

ILLUSTRATION: Gross Profit Method

On December 31, 2018, BE Company had a fire which completely destroyed the finished goods.
After the fire, a physical inventory was taken. The inventories consisted the following:
01/01/18 12/31/18
Finished goods 200,000 ?
Work in Process 300,000 280,000
Direct Materials 400,000 320,000
Data for 2018 were:
Sales P 4,500,000
Purchases 1,900,000
Freight in 200,000
Direct Labor 900,000
 Manufacturing overhead – 75% of direct labor ?

Case No. 1: Assume the following data and trend continues:

2015 2016 2017
Sales P 1,500,000 P 2,300,000 P 3,000,000
Less: Cost of Sales 1,230,000 1,840,000 2,340,000
Gross Profit P 270,000 P 460,000 P 660,000

Required:
1. How much is the cost of goods sold for the year ended December 31, 2018?
2. How much is the estimated cost of finished goods on December 31, 2018 that was completely
destroyed by fire?

Case No. 2: Assume the following data and average gross profit to be used in 2018:
2015 2016 2017
Sales P 1,500,000 P 2,300,000 P 3,000,000
Less: Cost of Sales 1,230,000 1,840,000 2,340,000
Gross Profit P 270,000 P 460,000 P 660,000

Required:
1. How much is the cost of goods sold for the year ended December 31, 2018?
2. How much is the estimated cost of finished goods on December 31, 2018 that was completely
destroyed by fire?

Case No. 3: Assume the following data and the insurance company agreed that the fire loss claim
should be based on the assumption that the overall gross profit ratio for the past two years was in
effect during the current year.
2016 2017
Sales P 2,300,000 P 3,000,000
Less: Cost of Sales 1,840,000 2,340,000
Gross Profit P 460,000 P 660,000

Required:
1. How much is the cost of goods sold for the year ended December 31, 2018?
2. How much is the estimated cost of finished goods on December 31, 2018 that was completely
destroyed by fire?

Solution:
Case No. 1
Direct Materials, beg P 400,000
Add: Purchases 1,900,000
Freight in 200,000
Less: Direct Materials, end (320,000)
Direct Materials Used 2,180,000
Direct Labor 900,000
Manufacturing Overhead 675,000
Total Manufacturing Costs 3,755,000
Add: Work in process, beg 300,000
Cost of Goods Placed in Process 4,055,000
Less: Work in process, end (280,000)
Cost of Goods Manufactured 3,775,000
Add: Finished Goods, beg 200,000
Cost of Goods Available for Sale P 3,975,000
 2015 2016 2017 2018
Gross Profit P 270,000 P 460,000 P 660,000
Divided by: Sales 1,500,000 2,300,000 3,000,000
Gross Profit Rate 18% 20% 22% 24%

Sales P 4,500,000 100%

Less: Cost of Goods Sold 1.) 3,420,000 76%
Gross Profit P 1,080,000 24%

2.)
Cost of Goods Manufactured 3,775,000
Add: Finished Goods, beg 200,000
Cost of Goods Available for Sale P 3,975,000
Less: Finished Goods, end 555,000
Cost of Goods Sold P 3,420,000

Case No. 2:
2015 2016 2017 2018
Gross Profit P 270,000 P 460,000 P 660,000
Divided by: Sales 1,500,000 2,300,000 3,000,000
Gross Profit Rate 18% 20% 22% 20%

Gross Profit Rate Year 1 +Year 2 +Year 3

Average Gross Profit =
Number of years

18% + 20% + 22%

20% =
3

Sales P 4,500,000 100%

Less: Cost of Goods Sold 1.) 3,600,000 80%
Gross Profit P 900,000 20%

2.)
Cost of Goods Manufactured 3,775,000
Add: Finished Goods, beg 200,000
Cost of Goods Available for Sale P 3,975,000
Less: Finished Goods, end 375,000
Cost of Goods Sold P 3,600,000

Case No. 3:
Gross Profit Year 1 +Year 2
Overall Gross Profit =
Sales Year 1 + Sales Year 2

460,000 + 660,000
Overall Gross Profit =
2,300,000 + 3,000,000

1,120,000
21% =
5,300,000

Sales P 4,500,000 100%

Less: Cost of Goods Sold 1.) 3,555,000 79%
Gross Profit P 945,000 21%
2.)
Cost of Goods Manufactured 3,775,000
Add: Finished Goods, beg 200,000
Cost of Goods Available for Sale P 3,975,000
Less: Finished Goods, end 420,000
Cost of Goods Sold P 3,555,000

RETAIL INVENTORY METHOD

The retail method is simply a pragmatic way of determining cost by starting with the selling price
and deducting a suitable estimate of the profit margin. The retail method is often used in the retail
industry for measuring inventories of large numbers of rapidly changing items with similar
margins for which it is impracticable to use other costing methods, for example, supermarkets,
department stores and other retail concerns where there is a wide variety of goods.

Since the inventories are recorded at retail price, the cost of inventory is determined by reducing
the sales value of the inventory by the appropriate percentage gross margin. The percentage used
takes into consideration inventory that has been marked down to below its original selling price.
An average percentage for each retail department is often used.

The ratio exploited using this method is not the gross profit ratio but rather the cost ratio.
Basic Formula
Goods available for sale at retail xxx
Less: Net Sales
Sales xxx
Less: sales return only (xxx) xxx
Ending inventory at retail xxx
Multiply: Cost ratio xxx
Ending inventory at cost xxx

Methods in Computing Cost Ratio

For the purpose of computing cost ratio, there are three methods that can be used by an entity:
Methods Beginning Markups Markdown
Inventory
Conservative/Conventional Include Include Exclude
Average Include Include Include
First-in, First-out Exclude Include Include

Note: PAS 2, paragraph 22 requires either average cost approach or the FIFO approach (but more
particularly the average cost approach). The standard requires that the percentage to be used in the
application of the retail method should be the percentage that has been marked down below its
original selling price, meaning net markdowns should be included in the determination of the cost
ratio. The conservative or lower of cost or market is not an acceptable approach under PFRS but
is used under US GAAP.

Definition of Terms:
 Initial markup – the original markup on the cost of goods or the amount added to the
original cost to get the original retail price
 Original retail – the sales price at which the goods are first offered for sale
 Additional markup – increase in the sales price above the original sales price or the
amount added to the original retail price
 Markup cancellation – a decrease in the sales price that does not reduce the sales price
below the original sales price
  Net markup – additional markup minus markup cancellation
 Markdown – a decrease in the sales price below the original price
 Markdown cancellation – an increase in sales price that does not raise the sales price
above the original sales price
 Net markdown – markdown minus markdown cancellation
 Maintained markup (mark on) – difference between cost and sales price after adjustment
for all of the above items

GAS at cost minus beginning inventory at cost

FIFO =
GAS at retail minus beginning inventory at retail

GAS at cost
Average =
GAS at retail

GAS at cost
Conservative =
GAS at retail excluding net markdowns

COST RETAIL
At cost only:
Freight in xx
Purchase allowance (xx)
Purchase discount (xx)
At retail only:
Mark-up xx
Mark-up cancellation (xx)
Markdown (xx)
Markdown cancellation xx
Normal shrinkage, wastage, etc. (see note 1) (xx)
Employee discounts (see note 1) (xx)
At cost and retail
Beginning inventory xx xx
Purchase xx xx
Purchase return (xx) (xx)
Departmental transfer in xx xx
Departmental transfer out (xx) (xx)
Abnormal losses (see note 2) (xx) (xx)

Notes:
1. This is deducted after computing the cost ratio. Alternatively, these items can be added to sales
before computing the goods available for sale at retail.
2. This is deducted in arriving at the amounts to be used in computing the cost ratio.

ILLUSTRATION:
Presented below are the date taken from XX Company for the three months ended March 31:
COST RETAIL
Inventory, Jan 1 P 179,600 P 200,000
Purchases 475,400 800,000
Purchase returns 50,000 80,000
Purchase discounts 23,000
Purchase allowance 10,000
Freight in 5,000
Markups 200,000
 Markup cancellation 40,000
Departmental transfer in 70,000 100,000
Departmental transfer out 60,000 90,000
Abnormal loss 20,000 40,000
Markdown 115,000
Markdown cancellations 10,000
Sales 800,000
Sales returns 80,000
Sales allowance and discounts 120,000
Normal shrinkage 100,000

Required: Compute for the ending inventory at cost and cost of sales using:
1. Conservative Method
2. First-in, First-out Method
3. Average Method

Solution:
COST RETAIL
Inventory, Jan 1 P 179,600 P 200,000
Purchases 475,400 800,000
Less: Purchase returns 50,000 80,000
Less: Purchase discounts 23,000
Less: Purchase allowance 10,000
Add: Freight in 5,000
Add: Markups 200,000
Less: Markup cancellation 40,000
Add: Departmental transfer in 70,000 100,000
Less: Departmental transfer out 60,000 90,000
Less: Abnormal loss 20,000 40,000
Goods available for sale - conservative P 567,000 P 1,050,000
Less: Markdown 115,000
Add: Markdown cancellations 10,000
Goods available for sale - Average P 567,000 P 945,000
Less: Net Sales
Sales 800,000
Sales returns (80,000)
Normal shrinkage 100,000
Ending inventory at retail P 125,000

1. Computation of cost ratio

567,000 – 179,600 52%
FIFO =
945,000 – 200,000

567,000 60%
Average =
945,000

567,000 54%
Conservative =
1,050,000

Conservative
Ending inventory at retail P 125,000
Multiply by: Cost Ratio 0.54
Ending inventory at cost P 67,500
 GAS at cost P 567,000
Less: Ending inventory at cost 67,500
Cost of Sales P 499,500
FIFO
Ending inventory at retail P 125,000
Multiply by: Cost Ratio 0.52
Ending inventory at cost P 65,000
GAS at cost P 567,000
Less: Ending inventory at cost 65,000
Cost of Sales P 502,000
Average
Ending inventory at retail P 125,000
Multiply by: Cost Ratio 0.60
Ending inventory at cost P 75,000
GAS at cost P 567,000
Less: Ending inventory at cost 75,000
Cost of Sales P 492,000

References:

Asuncion, et. al. (2018). Applied Auditing Book 1 of 2, Baguio City: Real Excellence Publishing
Guerrero, P. (2018) Cost Accounting Principles and Procedural Application, Manila,
Philippines: GIC Enterprises and Co., Inc.
Valix, et. al. (2016). Financial Accounting Volume 1, Manila Philippines

Assessments:
1. MA Company sells blankets for P40 each. The following was taken from the inventory records
during August:
Date Product Units Cost
August
1 Beginning 600 P 20
4 Purchase 400 24
12 Sale 200
15 Purchase 1,100 25
17 Purchase Return 100 25
22 Sale 600
23 Sale 400
25 Sales return 100
31 Purchase 1,000 30

Required: Determine the cost of sales and cost of ending inventory under each of the following
independent assumptions:
1. FIFO (perpetual)
2. Moving average method
2. At year-end, a fire completely destroyed the goods in process inventory of EE Company. A
physical inventory was taken after the fire. The raw materials were valued at P600,000, the finished
goods at P1,000,000 and factory supplies at P100,000. The beginning inventories consisted of the
following:
Finished goods 1,400,000
Goods in process 1,000,000
Raw materials 300,000
Factory supplies 400,000

Data for current year

Sales 3,000,000
Purchases 1,000,000
Freight in 100,000
Direct Labor 800,000
Manufacturing overhead – 50% of direct labor ?
Average gross profit rate on sales 30%

Required: Calculate the following:

1. Cost of goods sold
2. Cost of goods manufactured
3. Goods in process, ending

3. AA Company used the retail inventory method to approximate the ending inventory.
COST RETAIL
Inventory, Jan 1 650,000 1,200,000
Purchases 9,000,000 14,700,000
Purchase returns 300,000 500,000
Purchase allowance 150,000
Freight in 200,000
Markups
Markup cancellation
Departmental transfer in 200,000 300,000
Markup 400,000
Markup cancellation 100,000
Markdown 1,200,000
Markdown cancellations 200,000
Sales 9,500,000
Sales discounts 100,000
Employee discounts 500,000
Estimated normal shoplifting loss 600,000
Estimated normal shrinkage 400,000

Required: Compute for the following:

1. Goods available for sale – conservative
2. Goods available for sale – average
3. Cost ratio – FIFO
4. Cost ratio – conservative
5. Cost ratio – average
6. Ending inventory at cost and cost of sales using
 Conservative
 FIFO
 Average