Chapter 8--Learning Objectives
1. Understand the composition and
control of cash
What is cash ?
What is cash ?
 For accounting purposes, cash includes:
 Currency and coins (including petty cash)
 Demand deposits (checking accounts)
 Checks, drafts and money orders
 Readily usable foreign currency
 Savings accounts (technically investments)
What is NOT cash ?
 Postage stamps
 Post-dated checks
 Certificates of deposit
 IOUs and notes receivable
Cash equivalents
 Must be readily convertible to cash
 Must be close to maturity
 Cash equivalents frequently include:
 Treasury bills
 Commercial paper
 Certificates of deposit
 (within 90 days of maturity)
Internal control
 Procedures used to safeguard assets
 Probably cannot prevent theft altogether
 But can make the potential crook’s job more
difficult
 Separate duties
 Create paper trails
Cash Control
 Record and deposit receipts promptly
 Separation of duties
 No unauthorized or undocumented disbursements
 Job rotation
 Imprest funds
 Internal and external audits
 Bank reconciliations
Petty cash fund
 Known as imprest (advanced) fund
 Establish fund with set amount
 Debit “Petty Cash” when fund set up
 Subsequent entries debit various expenses
and credit “Cash”
 Shortages debited to “Cash Over and
Short,” treated as misc. expense
Bank reconciliation
 Prepared when statements received
 Start with “balance per bank” and “balance
per books”
 Bring both numbers to “corrected cash” or
“true cash”
 Adjust books for items on “books” side of
reconciliation
Typical items on
“bank” side of reconciliation
 Balance per bank
 Deposits in transit
 Outstanding checks
 Errors by bank
 Corrected cash balance
XXX
+ XXX
- XXX
+ or - XXX
XXX
Typical items on
“books” side of reconciliation
 Balance per books
XXX
 Interest earned on account
+ XXX
 Items collected by bank
+ XXX
 Bank service charges
- XXX
 NSF checks
- XXX
 Errors on books
+ or - XXX
 Corrected cash balance
XXX
Typical bank reconciliation
adjusting entry
Acct. Receivable--Ima Deadbeat
Service Charge Expense
Interest Income
Cash
XXX
XXX
XXX
XXX
 Note handling of NSF check from Ima Deadbeat,
one of our customers.
Chapter 8--Learning Objectives
2. Record and value accounts
receivable
Trade Receivables
 Result from sales of goods or services on account
 Balance Sheet Measurement:
Net Realizable Value
 Discounts
Trade Discounts
Cash Discounts
Net Realizable Value
 Amount expected to be realized (collected)
 Gross Accounts Receivable, net of
Expected returns & Allowances
Cash discounts expected to be taken
Expected uncollectible amounts
Trade Discounts
 Used to determine prices for different types
of customers
 e.g.,
builder’s discount
Cash Discounts
 Offered to encourage early payment
 Examples
 2, 10, net 30
 2, 10, eom
 Accounting approaches
 Gross Method
 Net Method
Terms and discounts
2 / 10 , n / 30
means that a
2 percent discount is available
if paid within 10 days
and that the balance is due in 30 days
Recording sales discounts
The gross method
Assume a $100 sale, terms 2/10, n/30
The sale is recorded:
Accounts Receivable
Sales
100
100
Recording sales discounts
The gross method
If paid within 10 days:
Cash
Sales Discounts
Accounts Receivable
98
2
100
“Sales Discounts” is a contra-account to
“Sales Revenue”
Recording sales discounts
The gross method
If paid after 10 days:
Cash
100
Accounts Receivable
100
Recording sales discounts
The net method
 Assume a $100 sale, terms 2/10, n/30
 The sale is recorded:
Accounts Receivable
Sales
98
98
Recording sales discounts
The net method
If paid within 10 days:
Cash
98
Accounts Receivable
98
Recording sales discounts
The gross method
If paid after 10 days:
Cash
100
Accounts Receivable
Sales Discounts Forfeited
“Sales Discounts Forfeited” is a
miscellaneous revenue account
98
2
BAD DEBTS
If you do business on credit,
the question is not “whether”
but “how much”
Some people cannot or will not pay their
bills
You know that they are out there
You just don’t know who they are
Accounts receivable entries
Making a credit sale
Accounts Receivable
Sales
XXX
XXX
Accounts receivable entries
Collecting from a credit customer
Cash

Accounts Receivable
XXX
XXX
Accounts receivable entries
Writing off an uncollectible account
Allowance for Bad Debts XXX

Accounts Receivable
XXX
Accounts receivable entries
Reinstating an account previously written
off
Accounts Receivable
XXX
Allowance for Bad Debts
Cash
XXX
Accounts Receivable
XXX
XXX
Accounts receivable entries
The provision for bad debts
(an adjusting entry)
Bad Debt Expense
XXX
Allowance for Bad Debts
XXX
Valuation of accounts receivable
or estimating bad debt expense
Two methods will be examined:
1. The percentage of sales method
(also known as the income
statement method)
2. The percentage of receivables
method (also known as the balance
sheet method)
Percentage of sales method
 An income statement approach
 The more you sell--the more you can expect
to lose
 Consistent with matching principle
 Select a percentage based on past
experience or industry averages
 Multiply the percentage by total credit sales
Percentage of sales method
 Assume $1,000,000 sales and 3% estimated
bad debts
Bad Debt Expense
30,000
Allow. for Bad Debts
30,000
Percentage of receivables
 Based on “aging” the individual accounts
receivable
 The later they are in paying--the less likely
they are to pay up
 Percentages likely to default are assigned to
each age category
 The result is the balance needed in the
“Allowance for Bad Debts” account
Assume that an aging schedule yields the
following information:
Status
Amount
Current
$ 70,000
30-60 days overdue 40,000
60-90 days overdue 30,000
90-180 days overdue 30,000
Over 180 days
10,000
Totals
$180,000
Percent Amount
likely to likely to
default default
0 $
-05
2,000
10
3,000
25
7,500
30
3,000
$15,500
The $15,500 is the total amount
needed in the “Allowance” account
 Assume that the “Allowance for Bad Debts”
account has a $3,000 credit balance prior to
adjustment
Allowance for Bad Debts
3,000
The $15,500 is the total amount
needed in the “Allowance” account
 To go from a $3,000 credit to a $15,500
credit will require a $12,500 credit
Allowance for Bad Debts
3,000
12,500
15,500
$12,500 is the amount needed to
adjust the “Allowance” account
 The necessary entry is:
Bad Debt Expense
12,500
Allow. for Bad Debts
12,500
Account write-offs do not reduce
total assets !
 Assume $10,000 of Accts. Receivable and a
$1,000 Allowance for Bad Debts
 Net collectible receivables are $9,000
Accounts receivable
Less: AFBD
Net receivables
$10,000
1,000
$ 9,000
 Now assume we write off a $100 account
 The entry to write off the account is

Allowance for Bad Debts 100
Account Receivable
100

Accts. Rec.
10,000
AFBD
1,000
 Now assume we write off a $100 account
 The entry to write off the account is

Allowance for Bad Debts 100

Account Receivable
100
 Posting the entry has this result:
Accts. Rec.
10,000
9,900
100
AFBD
100
1,000
900
Note that net collectible receivables are:
Accounts receivable
$ 9,900
Less: AFBD
900
Net receivables
$ 9,000
BEFORE = $9,000
AFTER = $9,000
Accts. Rec.
10,000
9,900
100
AFBD
100
1,000
900
DIRECT
WRITE-OFF
METHOD
DIRECT
WRITE-OFF
METHOD
Chapter 8--Learning Objectives
3. Demonstrate how accounts
receivable are used as the basis for
financing
Receivables can be used as an immediate
source of cash
 Assigning accounts receivable means using
them as collateral for a loan
 Factoring accounts receivable means selling
them
 Factoring can be with recourse or without
recourse
 Recourse refers to ultimate responsibility
for payment
Factoring with recourse
When accounts are factored with recourse,
uncollectible accounts are absorbed by the
transferor
Transaction is treated as a sale if all of the following
conditions are met:
1. Risks, rewards & benefits are transferred
2. Future cash flows are estimable at time of transfer
3. Transferee cannot require transferor to repurchase
receivables except under recourse provisions
Factoring with recourse
as a borrowing
 If all conditions for treatment as a sale are not
meant, factoring with recourse is treated as a
borrowing
Chapter 8--Learning Objectives
4. Record and value notes receivable
Notes receivable
 Formal, written promises to pay
 Negotiable
 Provide legal evidence of debt
 Usually interest bearing, but may be
noninterest bearing
 Should be valued at present value of future
cash inflows
Short term note example assumptions
 $1,000 note received in exchange for an
account receivable
 Received on March 1
 Matures in six months
 Interest rate 10 percent
Short term note journal entries
On March 1
Note Receivable
1,000
Accounts Receivable
On September 1
Cash
1,050
Note Receivable
Interest Revenue
1,000
1,000
50
Noninterest bearing notes
 Amount of note is greater than cash or fair
value
 Difference is recorded in a contra-account
to Notes Receivable called “Discount on
Note Receivable”
 Interest is recorded with debits to
“Discount on Note Receivable” and credits
to “Interest Revenue”
Noninterest bearing note entries
At time of issue
Note Receivable
XXX
Discount on Note Rec.
Cash (etc.)
Interest accrual
Discount on Note Rec.
XXX
Interest Revenue
XXX
XXX
XXX
Notes receivable with interest rates
lower than current market rate
 Effective interest rate is assigned to note
 Determine whether fair market value (FMV) of
assets surrendered is known or unknown
 If FMV is known, use as present value of note
 If FMV not known, use current rate for borrower
or rate on other similar loans
Note with low interest rate
assumptions--FMV known
 Three-year, noninterest bearing note dated 12-31-
95
 Face value $10,000
 Exchanged for land which originally cost $5,000
with a fair market value of $7,120
 Discount rate for note is 12 percent ($7,120 is the
present value of $10,000 to be received in 3 years
at 12 percent)
 Discount must be amortized over life of note
Note with low interest rate entries-FMV known
On 12-31-95
Note Receivable
10,000
Discount on Note Rec.
Land
Gain on Sale of Land
On 12-31-96 (rounded to nearest dollar)
Discount on Note Rec.
854
Interest Revenue
2,880
5,000
2,120
854
Note with low interest rate entries-FMV known
On 12-31-97
Discount on Note Rec.
Interest Revenue
On 12-31-98 (maturity)
Discount on Note Rec.
Interest Revenue
Cash
Note Receivable
957
957
1,069
1,069
10,000
10,000
Note with low interest rate
assumptions--FMV unknown
 Three-year note dated 12-31-95
 Face value $5,000
 Stated interest rate 12 percent paid annually
 Exchanged for land which cost $2,000 with
unknown fair market value
 Incremental interest rate for borrower is 15
percent
 Present value of note at 15 percent is $4,658
(based on PV of principal and interest)
Note with low interest rate entries-FMV unknown
On 12-31-95
Note Receivable
Land
Discount on Note Rec.
Gain on Sale of Land
5,000
2,000
342
2,658
“Discount” based on difference between PV of note
and $5,000 face amount
“Gain” based on difference between PV of note and
cost of Land
Formulas for discounting notes
receivable
Interest (I) = P x R x T
P = Principal
R = Interest Rate
T = Time
Maturity Value (MV) = P + I
Discount = MV x DR x DP
DR = Discount Rate
DP = Discount Period
Proceeds = MV - Discount
Discounting note receivable assumptions
 $1,000, six month note dated 3-1-95
 Face interest rate 10 percent
 Discounted on 7-1-95
 Discount rate 12 percent
 Time to maturity (discount period) is two
months
 Discounted without recourse
Discount calculations
 Interest = $1,000 x .10 x 6/12 = $50
 Maturity Value = $1,000 + $50 = $1,050
 Discount = $1,050 x .12 x 2/12 = $21
 Proceeds = $1,050 - $21 = $1,029
 Note value at discount date
 Interest = $1,000 x .10 x 4/12 = $33
 Value = $1,000 + $33 = $1,033
Entry to record discounting of note
July 1, 1995
Cash
Loss on Sale of Note Rec.
Note Receivable
Interest Revenue
1,029
4
1,000
33
Interest Revenue is interest earned to date
Loss on Sale is difference between Proceeds and
value of note at date of sale
Same note discounted
with recourse
The bad news here is that if the original
maker of the note defaults when the note is
due...
The bank or finance company will hold the
party discounting the note responsible for
payment
Chapter 8--Learning Objectives
5. Calculate and interpret key liquidity
and asset management ratios
Current ratio
Current assets
Current liabilities
Quick ratio
Current assets - Inventory - Prepaid items
Current liabilities
A more stringent indicator of liquidity
than the current ratio
Accounts receivable turnover
Credit Sales
Average net accounts receivable
Average accounts receivable is frequently
approximated by adding beginning and ending net
receivables and dividing by two
Average collection period
for accounts receivable
365 days
Accounts receivable turnover
 Calculation of accounts receivable turnover
illustrated on previous slide