Chapter wise question collection of financial accounting

CHAPTER 6

                INTERNAL CONTROL SYSTEMS, CASH, AND RECEIVABLES

Questions

 1. It is true that cash is often a small item in the balance sheets of most organisations. The reason control of cash is regarded as an important part of an internal control system is that being the most liquid asset, cash is more prone to embezzlements, thefts, frauds and defalcations than other assets.

 2. Certificates of deposits are not classified as cash because they are not accepted by banks for deposit into the account of a customer as cash.

 3. Accounting controls are designed to provide reasonable assurance that all transactions are authorised by management and promptly and properly recorded and that access to assets is permitted in accordance with management's authorisation. Administrative controls are concerned mainly with operational efficiency and adherence to management policies.

 4. A feature of a good internal control system is that record‑keeping duties are separated from custody of assets. This reduces the chances of frauds. If the cashier is allowed to maintain the customers ledger, it is possible that any embezzlements of receipts from customers do not come to the notice of anyone in the organisation.

 5. No internal control system is completely safe. Human failures will exist regardless of how good a system is. Carelessness, collusion among employees, and deliberate by‑passing by senior officials can weaken any system. Therefore, the statement is not correct.

 6. Computers can perform complex operations at great speed with an extremely high degree of accuracy. However, controls can be breached in a computer environment, perhaps more easily than in a manual environment. Frauds that would have necessitated the collusion of several employees can be perpetrated in a computer environment by a couple of employees without much difficulty. There are numerous horror stories of computer frauds.

 7. A voucher is a set of all the relevant documents evidencing the validity and amount of a claim supporting an authorisation to disburse cash. A voucher for purchase of goods would typically have the following documents: purchase order, invoice, receiving report.

 8. The balance shown on the monthly bank statement will rarely agree with the balance of cash shown by a company's Cash account. A bank reconciliation is prepared to explain the difference between the cash balance appearing on the bank statement and the balance according to the depositor's records.

   

9.	Petty Cash	3,000
	Cash		3,000

10. Credit is granted for purchases as a matter of industry practice in many cases. Extending credit can increase revenue and net profit significantly for many businesses. So long as the additional profit generated from credit sales exceeds the additional expenses incurred in extending credit (including the amount of uncollectible accounts), it is profitable to extend credit.

11. The entry does not affect the estimated realisable amount of trade debtors.

12. The percentage‑sales‑method estimates uncollectible accounts as a percentage of the net credit sales of an accounting period. The percentage‑of‑sales method takes a profit and loss account approach to the problem of estimation of uncollectible accounts. The percentage‑of‑receivables method estimates uncollectible accounts as a percentage of debtors appearing on a firm's balance sheet. The estimate may be prepared based on a flat percentage of debtors at the year‑end. The percentage‑of‑receivables method takes a balance sheet approach to the problem of estimation of uncollectible accounts.

13. When sales are made on bank credit cards, the amount of sales net of service charge levied by the credit card company is debited to Cash. When sales are made on a non‑bank credit card, the amount of sales is initially debited to Trade Debtors. When cash is received from the credit card company, the amount received net of service charge is debited to Cash.

14. When the drawee conveys his assent to the order in writing, he becomes the acceptor.

15. The endorser of a discounted bill receivable is contingently liable for payment of the bill until it matures. That is, the endorsee can require the endorser to pay the bill should it be dishonoured by the acceptor on maturity.

16. The completed contract method should be preferred to the percentage‑of‑completion method when there is considerable uncertainty over completion of the contract or regarding the cost of completion or receipt of contract price (whole or part) by the contractor.

17. A factor is a financier as well insurer in a transaction involving of receivables without recourse. In a with recourse transaction a factor is merely a financier.

18. An important principle of control is that physical custody of assets should be separated from other functions. If the purchase manager looks after the receiving function as well, there would be no independent verification of actual quantities and specifications of goods received. This is potentially dangerous and may lead to frauds. In principle, combining of the two roles should be avoided.

Exercises

Exercise 6‑1. Missing Items in Bank Reconciliation

a. Rs 5,800

b. Rs 8,5001

c. - Rs 1,700

d. Rs 2,100

Exercise 6‑2. Preparing Bank Reconciliation

Balance per bank statement, November 30		Rs 12,700
Add Cheques under collection		1,100
		13,800
Deduct Outstanding cheques		6,800
Adjusted balance per bank		7,000
Balance per books, November 30		Rs 5,920
Add Bill receivable collected by bank, including interest of Rs 100		2,100
		8,020
Deduct Service charge		120
Dishonoured cheque		900
Adjusted balance per books		7,000

Journal entries:

Nov.	30	Cash		2,100
		Bills Receivable			2,000
		Interest Receivable			100
	30	Debtors		900
		Cash			900
	30	Bank Charges		120
		Cash			120

Exercise 6.3: Preparing Bank Reconciliation

Balance per bank statement, August 31		Rs 12,100
Add Cheques under collection		1,030
		13,130
Deduct Outstanding cheques		3,900
Adjusted balance per bank		9,230
Balance per books, August 31		Rs 8,265
Add Bill receivable collected by bank, including interest of Rs 50		1,050
		9,315
Deduct Service charge		85
Adjusted balance per books		9,230

The cash balance to be reported on Shiny Company's August 31 balance sheet is Rs 9,230.

Journal entries:

Aug.	31	Cash		1,050
		Bills Receivable			1,000
		Interest Receivable			50
	31	Bank Charges		85
		Cash			85

Exercise 6.4: Petty Cash System

Sep.	1	Petty Cash		1,000.00
		Cash			1,000.00
	30	Office Supplies		143.60
		Local Travel Expense		85.00
		Postage		415.00
		Miscellaneous Expense		38.20
		Cash			681.80

Exercise 6.5: Computing Trade Debtors under Direct Write‑off Method

Trade Debtors, April 1, 19X1		Rs  49,000
Add Credit sales, April 1, 19X1 to March 31, 19X2		6,12,000
		6,61,000
Deduct Collections from customers on account	Rs 5,96,000
Write‑offs of uncollectible customer accounts	2,000	5,98,000
Trade Debtors, March 31, 19X2		63,000

Exercise 6.6: Recording Write‑off and Recovery

Mar.	31	Bad Debts Expense		2,000
		Provision for Doubtful Debts			2,000
June	18	Provision for Doubtful Debts
		Trade Debtors, Ramesh Company		970	970
Oct.	25	Trade Debtors, Ramesh Company		970
		Provision for Doubtful Debts			970
	25	Cash		970
		Trade Debtors, Ramesh Company			970

Exercise 6.7: Adjusting Entries: Percentage‑of‑Sales Method and Percentage‑of‑Receivables Method

a.		Bad Debts Expense		2,800
		Provision for Doubtful Debts			2,800
b.	(1)	Bad Debts Expense		200
		Provision for Doubtful Debts			200
		(Rs 1,000 ‑ Rs 800)
	(2)	Bad Debts Expense		1,950
		Provision for Doubtful Debts			1,950
		(Rs 1,000 + Rs 950)

Exercise 6.8: Preparing Ageing Analysis

                                                                                                               

			Number of days past due
Customer	Amount	Not yet due	1-30 days	31-60 days	61-90 days	91-120 days	Over 120 days
R. Anand	Rs 11,070			Rs 11,070
J. Bhowmick	3,570						Rs  3,570
K. Chandra	9,250	Rs  9,250
E. Dawood	5,980				Rs 5,980
A. Eknath	7,190			7,190
N. Govind	1,480		Rs  1,480
V. Hariharan	6,310						6,310
B. Kamal	980		980
M. Lakshman	10,720	10,720
C. Pankaj	2,310					Rs 2,310
S. Uday	3,210					3,210
D. Wilson	1,120		1,120
Total	63,190	19,970	3,580	18,260	5,980	5,520	9,880

Exercise 6.9: Determining Maturity Dates and Maturity Values for Bills

a. May 14: Rs 2,040.

b. September 3: Rs 6,225.

c. February 17: Rs 10,150.

d. November 29: Rs 5,200.

Exercise 6.10: Accounting for Transactions in Bills Receivable

Mar.	11	Bills Receivable		10,000
		Sales			10,000
a.
May	10	Cash		10,200
		Bills Receivable			10,000
		Interest Revenue			200
b.
Apr.	3	Cash		10,042.75
		Bills Receivable			10,000.00
		Interest Revenue			42.75
		Discount = Rs 10,200x.15x37/360 = 157.25
		Proceeds = Rs 10,200 – 157.25 = Rs 10,042.75
May	10	No entry in Vignan Company’s books for Pradeep Company’s payment of the bill on its maturity.
c.
Apr.	3	Cash		10,042.75
		Bills Receivable			10,000.00
		Interest Revenue			42.75
		(10,200x.15x37/360 = 157.25)
		Discount = Rs 10,200x.15x37/360 = 157.25
		Proceeds = Rs 10,200 – 157.25 = Rs 10,042.75
May	10	Trade Debtors		10,225
		Cash			10,225

Exercise 6.11: Internal Control Evaluation

The major weaknesses of the restaurant's internal control system are as follows:

a.       Customers' invoices are prepared by the waiters who service the customers. This can lead to situations where the waiters omit to include items ordered by the customers or misprice the items or by collusion with customers. Since the bills are not checked by anyone, errors and omissions will not be detected, except possibly by the customers themselves.

b.       Cash memos are filed by the cashier who also receives the cash from customers. There is a risk of cash loss due to the cashier's negligence or embezzlement since no independent record of cash collections exists.

c.        There is no mechanism to detect non‑paying customers. This is apparently done by the personal observation of the cashier.

d.       The cashier is allowed to make payments from cash collections. This often results in difficulties in reconciling cash receipts with cash balance at the end of the day.

Problem Set A

Problem A‑1. Bank Reconciliation

1.

Balance per bank statement		Rs 6,311.50
Add Cheques under collection	Rs 1,910.80
Error in recording deposit by the bank on November 11	72.00
Error in recording cheque by the bank on November 18	27.00	2,009.80
		8,321.30
Deduct Outstanding cheques		784.20
Adjusted balance per bank		7,537.10
Balance per books		Rs 3,962.10
Add Bill receivable collected by bank, including interest of Rs 200		4,200.00
		8,162.10
Deduct Service charge	Rs 135
Dishonoured cheque	490	625.00
Adjusted balance per books		7,537.10

2.

Nov.	30	Cash		4,200
		Bills Receivable			4,000
		Interest Revenue			200
	30	Debtors		490
		Cash			490
	30	Bank Charges		135
		Cash			135

3. Cash balance that would appear on the November balance sheet, Rs 7,537.10.

Problem A‑2. Bank Reconciliation

1. Bank reconciliation:

Arun Company
Bank Reconciliation
April 30
Balance per bank, April 30		Rs 10,126
Add Cheque under collection (April 30)		384
		10,510
Deduct Outstanding cheque No. 597		315
Adjusted cash balance, April 30		10,195
Balance per books, April 30		Rs 10,817
Add Bill receivable collected by bank, including interest of Rs 18		618
		11,435
Deduct Service charge	Rs       60
Dishonoured cheque	1,180	1,240
Adjusted cash balance		10,195

2. Journal entries:

Apr. 30	Cash	618
	Bills Receivable		600
	Interest Revenue		18
	Bank Charges	60
	Cash		60
	Debtors	1,180
	Cash		1,180

3. The amount of cash that should appear on the April 30 balance sheet of Arun Company is Rs 10,195.

Problem A-3. Percentage of Net Sales Method

1. Journal entries to record the transactions:

Mar. 31
Item   a.	Debtors	3,28,000
	Sales		3,28,000
b.	Sales and Returns and Allowances	4,300
	Debtors		4,300
c.	Cash	372,900
	Debtors		372,900
d.	Provision for Doubtful Debts	9,720
	Debtors		9,720
d.	Debtors	1,870
	Provision for Doubtful Debts		1,870
e.	Cash	1,870
	Debtors		1,870

2. Adjusting entry:

Mar. 31	Bad Debts Expense	6,474
	Provision for Doubtful Debts		6,474

3. Posting the journal entries:

Debtors
Mar. 31	Balance	4,78,900	Mar. 31	Sales Returns and Allowances	4,300
	Sales	3,28,000		Cash	3,72,900
	Provision for Doubtful Debts	1,870		Provision for Doubtful Debts	9,720
				Cash	1,870
		8,08,770			3,88,790
Mar. 31	Balance	4,19,980

Provision for Doubtful Debts
Mar. 31	Debtors	9,720	Mar. 31	Balance	12,710
				Debtors	1,870
				Bad Debts Expense	6,474
		9,720			21,054
			Mar. 31	Balance	11,334

4. Presentation on Balance Sheet:

Balance Sheet as at March 31
Debtors	Rs  4,21,850
Less Provision for Doubtful Debts	11,334	Rs 4,10,516

Problem A-4. Percentage of Receivables Method.

1. Calculation of the Provision for Doubtful Debts on December 31 balance sheet:

Age category	Amount	Percentage Estimated Uncollectible	Provision for Doubtful Debts
Not yet due	Rs 3,95,900	2	Rs   7,918
1-30 days past due	1,60,500	5	8,025
31-60 days past due	1,20,400	8	9,632
61-90 days past due	1,10,200	10	11,020
90-120 days past due	79,500	15	11,925
Over 120 days past due	35,300	25	8,825
Total	9,01,800		57,345

2. General journal entry to record the bad debts expense for the year:

Dec. 31	Bad Debts Expense	69,827
	Provision for Doubtful Debts		69,827
	To record the bad debts expense for the year: Required balance in the Provision account, Rs 57,345 + Debit balance in the Provision account on December 31, Rs 12,482 = Rs 69,827

3. Provision for Doubtful Debts account:

Provision for Doubtful Debts
Dec.  31	Balance (before adj. entry)	12,482	Dec. 31	Bad Debts Expense	69,827
			Dec. 31	Balance	57,345

4. The write-off of Rs 4,200 will not have any effect on the following year’s net profit and the estimated net realisable value of its debtors because the journal entry to record the write-off  reduces both debtors and provision for doubtful debts.

Problem A-5. Comprehensive Problem on Debtors and Bills Receivable

Journal entries:

19X1
Apr. 12	Bills Receivable	10,000
	Sales		10,000
	Sold merchandise on credit terms 12%, 90-day bill to Navin Gupta
May  18	Bills Receivable	20,000
	Debtors		20,000
	12%,  90-day bill accepted in place of past-due account receivable of Ganesh Apte
23	Provision for Doubtful Debts	2,100
	Debtors		2,100
	Uncollectible account of Rs 2,100 written off
June 17	Cash	20,085
	Bills Receivable		20,000
	Interest Revenue		85
	Discounted Ganesh Apte’s bill at the bank at 15%:      Face value                                                Rs 20,000      Interest 20,000 x 12% x 90/360                         600      Maturity value                                               20,600      Less discount 20,600 x 15% x 60/360                 515      Proceeds                                                        20,085
July  11	Cash	10,300
	Bills Receivable		10,000
	Interest Revenue		300
	Collected Navin Gupta’s bill on maturity:       Interest revenue Rs 10,000 x 12% x 90/360
Aug. 16	Debtors	20,650
	Cash		20,650
	To record dishonour of bill by Ganesh Apte:       Maturity value                                          Rs 20,600       Protest fee                                                            50       Total receivable                                             20,650
Sep.  15	Cash	20,857
	Debtors		20,650
	Interest Revenue		207
	To record receipt of amount receivable on the bill dishonoured on August 16:       Interest Rs 20,650 x 12% x 30/360
Oct.    8	Bills Receivable	15,000
	Sales		15,000
	Sold merchandise on 14%, 90-day bill to Mahesh
Nov.   7	Cash	15,111
	Bills Receivable		15,000
	Interest Revenue		111
	Discounted Mahesh’s bill at the bank at 16%:      Face value                                                Rs 15,000      Interest 15,000 x 14% x 90/360                         525      Maturity value                                               15,525      Less discount 15,525 x 16% x 60/360                414      Proceeds                                                        15,111
23	Bills Receivable	30,000
	Debtors		30,000
	14%,  90-day bill accepted in place of past-due account receivable of Vidya Mohan
19X2
Jan.    6	No entry
Feb.  21	Debtors	31,100
	Bills Receivable		30,000
	Interest Revenue		1,050
	Cash		50
	To record dishonour of bill by Vidya Mohan:       Face value                                                Rs 30,000       Interest 30,000 x 14% x 90/360                       1,050       Protest fee                                                            50       Total receivable                                             31,100
23	Cash	31,100
	Debtors		31,100
	To record receipt of amount receivable on the bill dishonoured on February 21

Problem Set B

Problem B‑1. Bank Reconciliation

1.

Balance per bank statement		Rs 6,873.40
Add Cheques under collection	Rs 298.70
Error in recording deposit	720.00	1,018.70
		7,892.10
Deduct Outstanding cheques		1,718.00
Adjusted balance per bank		6,174.10
Balance per books		Rs 2,994.70
Add Bill receivable collected by bank, including interest of Rs 200		5,300.00
		8,294.70
Deduct Service charge	Rs   90.00
Insurance premium paid	1,300.00
Dishonoured cheque	730.60	2,120.60
Adjusted balance per books		6,174.10

2.

Apr.    30	Cash	5,300.00
	Bills Receivable		5,000.00
	Interest Revenue		300.00
30	Debtors	730.60
	Cash		730.60
30	Bank Charges	90.00
	Cash		90.00
30	Insurance Expense	1,300.00
	Cash		1,300.00

3. Cash balance that would appear on the April balance sheet, Rs 6,174.10.

Problem B‑2. Bank Reconciliation

1. Bank reconciliation:

Bala Company
Bank Reconciliation
December 31
Balance per bank, December 31		Rs 26,679
Add Cheque under collection (December 31)		270
		26,949
Deduct Outstanding cheques Cheque No. 316	Rs 749
329	431	1,180
Adjusted cash balance, December 31		25,769
Balance per books, December 31		Rs 25,134
Add Bill receivable collected by bank, including interest of Rs 21	Rs 721
Difference in amount in cheque 326	9	730
		25864
Less Service charge		95
Adjusted cash balance		25,769

2. Adjusting entries:

Dec. 31	Cash	721
	Bills Receivable		700
	Interest Revenue		21
	Bank Charges	95
	Cash		95
	Cash	9
	Creditors		9

                                               

3. The amount of cash that should appear on the December 31 balance sheet of Bala Company is Rs 25,769.

Problem B-3. Percentage of Net Sales Method

1. Journal entries to record the transactions:

Sep. 30
Item   1	Debtors	6,97,200
	Sales		6,97,200
2	Sales and Returns and Allowances	9,700
	Debtors		9,700
3	Cash	4,12,200
	Debtors		4,12,200
4	Provision for Doubtful Debts	8,280
	Debtors		8,280
5	Debtors	930
	Provision for Doubtful Debts		930
5	Cash	930
	Debtors		930

2. Adjusting entry:

Sep.  30	Bad Debts Expense	20,625
	Provision for Doubtful Debts		20,625

3. Posting the journal entries:

Debtors
Sep. 1	Balance	2,12,400	Sep. 30	Sales Returns and Allowances	9,700
	Sales	6,97,000		Cash	4,12,200
	Provision for Doubtful Debts	930		Provision for Doubtful Debts	8,280
				Cash	930
		9,10,330			4,31,110
Sep. 30	Balance	4,79,220

Provision for Doubtful Debts
Sep. 30	Debtors	8,280	Sep. 30	Balance	10,450
				Debtors	930
				Bad Debts Expense	20,625
		8,280			32,005
			Sep. 30	Balance	23,725

4. Presentation on Balance Sheet:

Balance Sheet as at September 30
Debtors	Rs  4,79,220
Less Provision for Doubtful Debts	23,725	Rs 4,55,495

Problem B-4. Percentage of Receivables Method

1. Calculation of the Provision for Doubtful Debts on March 31 balance sheet:

Age category	Amount	Percentage Estimated Uncollectible	Provision for Doubtful Debts
Not yet due	Rs 2,75,400	3	Rs 8,262
1-30 days past due	1,10,900	6	6,654
31-60 days past due	87,500	10	8,750
61-90 days past due	65,100	15	9,765
91-120 days past due	27,800	25	6,950
Over 120 days past due	15,300	50	7,650
Total	5,82,000		48,031

2. General journal entry to record the bad debts expense for the year:

Mar. 31	Bad Debts Expense	38,651
	Provision for Doubtful Debts		38,651
	To record the bad debts expense for the year: Required balance in the Provision account, Rs 48,031 - Credit balance in the Provision account on March 31, Rs 9,380 = Rs 38,651

3. Provision for Doubtful Debts account:

Provision for Doubtful Debts
			Mar. 31	Balance	9,380
				Bad Debts Expense	38,651
			Mar. 31	Balance	48,031

4. The write-off of Rs 3,290 will not have any effect on the following year’s net profit and the estimated net realisable value of its debtors because the journal entry to record the write-off  reduces both debtors and provision for doubtful debts.

Problem B-5. Comprehensive Problem on Debtors and Bills Receivable

Journal entries:

19X4
July  13	Bills Receivable	30,000
	Debtors		30,000
	15%,  120-day bill accepted in place of past-due account receivable of Hari
19	Provision for Doubtful Debts	1,700
	Debtors		1,700
	Uncollectible account of Rs 1,700 written off
Aug. 10	Bills Receivable	20,000
	Sales		20,000
	Sold merchandise on credit terms 15%, 120-day bill to Srinivasan
12	Cash	29,925
	Interest Expense	75
	Bills Receivable		30,000
	Discounted Hari’s bill at the bank at 20%:      Face value                                                Rs 30,000      Interest 30,000 x 15% x 120/360                     1,500      Maturity value                                               31,500      Less discount 31,500 x 20% x 90/360              1,575      Proceeds                                                        29,925
Nov. 10	Debtors	31,550
	Cash		31,550
	To record dishonour of bill by Hari:       Maturity value                                          Rs 31,500       Protest fee                                                            50       Total receivable                                             31,550
Dec.   8	Cash	21,000
	Bills Receivable		20,000
	Interest Revenue		1,000
	Collected Srinivasan’s bill on maturity:       Interest Rs 20,000 x 15% x 120/360
10	Cash	31,944
	Debtors		31,550
	Interest Revenue		394
	To record receipt of amount receivable on the bill dishonoured on November 10:       Interest Rs 31,550 x 15% x 30/360
19X5
Mar.   1	Bills Receivable	25,000
	Sales		25,000
	Sold merchandise on 15%, 120-day bill to Mary Selvaraj
31	Cash	24,937
	Interest Expense	63
	Bills Receivable		25,000
	Discounted Mary Selvaraj’s bill at the bank at 20%:      Face value                                                Rs 25,000      Interest 25,000 x 15% x 120/360                     1,250      Maturity value                                               26,250      Less discount 26,250 x 20% x 90/360              1,313      Proceeds                                                        24,937
Apr. 10	Bills Receivable	10,000
	Debtors		10,000
	15%,  60-day bill accepted in place of past-due account receivable of Arun Kumar
June   9	Cash	9,975
	Interest Expense	25
	Bills Receivable		10,000
	Discounted Arun Kumar’s bill at the bank at 20%:      Face value                                                Rs 10,000      Interest 10,000 x 15% x 120/360                       500      Maturity value                                              10,500      Less discount 10,500 x 20% x 90/360                525      Proceeds                                                         9,975
June 29	No entry

Business Decision Case Studies

I. Baron Company

About the case: The case illustrates the justification for and effect of an accounting method change and associated disclosure requirements.

1. Schedule showing changes in the Provision for Doubtful Debts account:

19X3: March 31	Bad Debts Expense	Rs 11,480
	Bad Debts Written Off	(1,240)
	Balance	10,240
19X3-X4:	Bad Debts Written Off	(9,710)
	Bad Debts Recovered	710
19X4: March 31	Bad Debts Expense	17,738
	Balance	18,978
19X4-X5:	Bad Debts Written Off	(17,380)
	Bad Debts Recovered	1,370
19X5: March 31	Bad Debts Expense	24,760
	Balance	27,728
19X5-X6:	Bad Debts Written Off	(28,160)
	Bad Debts Recovered	2,720
19X6: March 31	Bad Debts Expense	35,730
	Balance	38,018

2. Journal entry:

19X7
Mar. 31	Bad Debts Expense	35,615
	Provision for Doubtful Debts		35,615

Age category	Amount	Percentage Estimated Uncollectible	Provision for Doubtful Debts
Not yet due	Rs 1,19,600	3	Rs  3,588
1-30 days past due	74,200	5	3,710
31-60 days past due	46,700	10	4,670
61-90 days past due	28,300	15	4,245
90-120 days past due	17,200	25	4,300
Over 120 days past due	6,100	50	3,050
Total	2,92,100		23,563

3. Presentation on Balance Sheet:

Balance Sheet as at 31 March 19X7
Debtors	Rs  2,92,100
Less Provision for Doubtful Debts	23,563	Rs 2,68,537

4. The case indicates that Shyam decided to change the method of providing for doubtful debts from percentage of net sales to percentage of receivables based on the ageing analysis because he believes that the latter approach would result in a “more scientific valuation of debtors”. Both the methods are acceptable under GAAP and a company may consistently follow one of them. The choice would depend on a number of factors, including what the company intends to achieve. For example, if the purpose is to produce a profit and loss account that reflects revenues and expenses pertaining to a period, the percentage of net sales method would be appropriate. If, on the other hand, the company intends to present a fair valuation of its debtors on its balance sheet, the percentage of receivables method is preferable.

    It seems that quite apart from these considerations, Shyam found it difficult to make a reasonable estimate of the percentage of annual credit sales that would become uncollectible. For example, write-offs during the year ending 31 March 19X7 amounted to Rs 53,720, which works out to about 6 percent of the credit sales during the year. It is not clear how much of these relate to the current year. In any case, it appears that the actual write-offs have varied from the estimate, almost every year since 19X2. One option is to increase the provision from 5 percent to say 6 or 7 percent. The other option is to change the method itself. Shyam chose the latter option. In the circumstances, the ageing analysis-based estimation may be a better approach to providing for doubtful debts.

    In case of an accounting change that is material, it is necessary to disclose the change in the accounting method, the reason for the change, and its effect on financial statement numbers. If Baron Company had continued to follow the percentage of net sales method, the bad debts expense for the year would have been Rs 46,479 (Rs 9,29,525 x 5%). As a result of the change, the bad debts expense decreased by Rs 10,864, with the reported net profit increasing by equal amount.

    The accounting change will not affect the company’s income tax expense, since provisions for losses are not tax-deductible at all.

II. Dhillon Sports Company

About the case: The case explains the accounting treatment of factoring and the considerations in evaluating a factoring proposal.

1. Journal entries in the records of Dhillon Sports:

Apr.   1	Cash	5,46,000
	Due from Factor	30,000
	Loss on Sale of Debtors	24,000
	Debtors		6,00,000
	To record the sale of trade debtors to Punjab Factors without recourse
Apr. 30	Sales Returns and Allowances	7,400
	Sales Discounts	4,300
	Due from Factor		11,700
	To record sales returns, allowances and discounts on the trade debtors sold to Punjab Factors on April 1
Apr. 30	Profit and Loss Account	35,700
	Loss on Sale of Debtors		24,000
	Sales Returns and Allowances		7,400
	Sales Discounts		4,300
	To close expense accounts (Note: This entry would be combined with the usual closing entry)
May   1	Cash	18,300
	Due from Factor		18,300
	To record the receipt of the amount due from Punjab Factors on final settlement

2. Presentation on Dhillon Sports Company’s balance sheet at April 30:

    The trade debtors of Rs 6,00,000 will not appear on Dhillon Sports’ balance sheet on April 30, as they have been sold and are no longer the assets of the company. The account `Due from Factor’ will appear as a debtor in the amount of Rs 30,000.

3. The finance charge for the offer would have been Rs 15,000, computed as Rs 6,00,000 x 30% x 30/360. However, Dhillon Sports would have to bear the cost of bad debts of Rs 7,200. The total cost would thus have been Rs 22,200. The finance charge incurred in the arrangement with Punjab Factors was Rs 24,000. In addition, Punjab Factors retained a sum of Rs 18,300 for one month and the interest loss on the amount should be considered. Perhaps, the alternative offer would have been cheaper purely in terms of finance charge. However, the unpredictable factor in these calculations is the amount of bad debts. The Punjab Factors offer protected the company against bad debt losses, and relieved the company of the efforts needed to collect its debtors. While the cost of collection can be estimated with near-total accuracy (for example, consider the fees of professional collection agencies), it is not possible to estimate bad debt losses with a high degree of accuracy in advance. Note that the calculation of the comparative costs of the two offers is based on the actual bad debts, a piece of information that was not available when the decision was to be made.

    In sum, the following considerations are relevant in comparing the two offers:

    a. Finance charge;

    b. Interest loss on the amount retained by the factor;

    c. Collection and bookkeeping expenses;

    d. Estimated bad debt losses.

Interpreting Financial Reports

I. Barings Bank

About the case: Internal control systems are not easy to teach. At one extreme, the student might be treated to a set of do's and don'ts and at the end the discussion might end up as an explanation of some rules followed in organisations. The case of Barings Bank seeks to strike a balance between the theory and practice of internal control systems by relating some of the well-publicised weaknesses in a bank's control systems to its financial stability.

1. The following are among the major weaknesses in the internal control systems of Barings Bank:

   

a.       Lax control environment and lack of knowledge of business: Senior executives were uncertain of their responsibilities and did not understand the business of trading in derivatives.

b.       No formal management structure.

c.        Failure of top management: Peter Baring, chairman of Barings PLC, the holding company, Andrew Tuckey, deputy chairman, and Peter Norris failed to recognise Leeson’s profits were too good to be true. Significantly, the three stood to take bonuses for 1994 of £1 million or more. The “smoking gun” indicating unauthorised trading was the discovery of a receivable of £50 million for which there was insufficient documentation. The matter should have much more prompt and firm action by senior management in London and Singapore than it received. Others responsible would include Ron Baker, head of financial products group, George Maclean, head of banking, Geoffrey Broadhurst, group finance director, Geoffrey Barnett, chief operating officer, James Bax, regional manager for south-east Asia, Anthony Hawkes, treasurer, Ian Hopkins, head of group treasury and risk, Mary Walz, head of equity financial products, and Simon Jones, regional operations manager for south-east Asia.

d.       Non-segregation of duties: Leeson’s duties were not segregated and he was permitted to remain in charge of both the front and back offices and this was a serious failing.

e.        Lack of supervision:  Many of the activities of Leeson would seem to be unauthorised. James Bax, regional manager for south-east Asia, and Simon Jones, regional operations manager for south-east Asia, failed to deal satisfactorily with letters from Simex to Barings Futures pointing out irregularities in account 88888, Leeson’s hidden account. Further, Barings’ settlement and treasury departments in London did nothing to clarify whether the sums were for client trading or Barings’ own house trading.

f.        Inadequate controls over computer programs: The alacrity with which Leeson was able to get the systems analyst to introduce account 88888 and later exclude the transactions in the account from all files is a clear failure of controls over the security of computer programs. How was Leeson able to direct Wong and why did Wong comply? What was the reporting relationship between Leeson and Wong? It is difficult to believe that Wong did not accept the effect of his action. Mark Gaunt, director at UK information technology consultant said: “It is unbelievable that this happened and no one picked it up. It should have been picked up either from systems’ reports or a review of operations.” Since there was a dual responsibility to run the back office as well as the trading activity there was a weakness.

g.        Internal audit and inspection: The case does not mention about the role of internal audit in identifying weaknesses in control systems. Banks have routine as well as special audits to uncover such cases.

2. There seem to be two sides to this question. One, C&L’s sister firm in Singapore which audited Barings Futures Singapore expressed the view for 1994 that the controls were “satisfactory”. Clearly, this does not accord with the major control failures pointed out in answer to question 1 above. What did C&L London do about this comment? Did it conduct an independent examination of Singapore’s certificate or merely accepted it without such an examination? Two, C&L had not completed the 1994 consolidated audit when the bank went bust, and it is a moot point whether C&L would have identified and raised with the management these control failures. It is not clear whether they had raised these issues in 1993 or earlier years and what the management’s response was. There is need for more information on this point. Further, it is not known whether there was adequate communication between the bank’s external and internal auditors on the soundness of internal control systems. Further, there seems to be need for greater communication between external auditors and bank supervisors. This point was emphasised in the earlier BCCI collapse and has also become important in the present case.

Selected readings on the Barings Bank collapse:

 “Senior managers `failed to do jobs properly’ says Bank of England report: Control failure sank Barings” Financial Times July 19, 1995.

“Unanswered questions about $190 million hole in accounts” Financial Times July 19, 1995.

“Coopers and sister firm are criticised” Financial Times July 19, 1995.

“The bell that didn’t ring” The Banker August 1995, pp. 78-80.

“Out of control” The Banker August 1995, pp. 15-16.

“Another fine mess” The Banker April 1995, pp. 57-59.

“Why Barings was doomed” Euromoney March 1995, pp. 38-41.

“Internal Control and Financial Reporting: Guidance for Directors of Listed Companies Registered in the UK” Accountancy February 1995, pp. 134-135.

Frances Miley and Andrew  Read “The Emperor’s New Clothes” Australian Accountant May 1995, pp. 35-36.

II. Voltas Limited

About the case: The case looks at the effect of certain transactions on the accounting equation.

1. Both assets and equity will decrease by Rs 183.21 each. Liabilities will be unaffected.

2. Both assets and equity will decrease by Rs 183.21 each. Liabilities will be unaffected.

3. No effect on total assets appearing on the balance sheet, as both assets and provision (contra asset) will decrease.

4. The following possibilities exist:

a.       The  criminal proceedings are at an advanced stage and the management is hopeful of early recovery of the amount.

b.       The employees and stockists  have provided some security to the company in the form of cash deposits and these can be utilised in case of non-payment.

c.        Fidelity insurance has been arranged and the insurance company will pay the amount in accordance with the terms of the insurance.

d.       The management is not hopeful of recovery of the amount, but is merely trying to postpone recognition of the loss.