Cash and Receivables Insert Book Cover Picture 7 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 7-2 Cash Coins and currency Petty cash Cashier’s checks Certified checks Money orders Amounts on deposit with financial institutions 7-3 Cash Equivalents Items very near cash but not in negotiable form Money market funds Treasury bills Commercial paper 7-4 Learning Objectives Define what is meant by internal control and describe some key elements of an internal control system for cash receipts and disbursements. 7-5 Internal Control of Cash Encourages adherence to company policies and procedures Enhances the reliability and accuracy of accounting data Promotes operational efficiency Minimizes errors and theft 7-6 Control of Cash Receipts Separate responsibility for handling cash, recording cash transactions, and reconciling cash balances. Agreed cash amounts deposited with cash amounts received. Close supervision of cash-handling and cashrecording activities. 7-7 Control of Cash Disbursements Separate responsibilities for cash disbursement documents, check writing, check signing, check mailing, and record keeping. All disbursements, except petty cash, made by check. 7-8 Learning Objectives Explain the possible restrictions on cash and their implications for classification in the balance sheet. Restricted Cash and Compensating Balances Restricted Cash Management’s intent to use a certain amount of cash for a specific purpose – future plant expansion, future payment of debt. Compensating Balance Minimum balance that must be maintained in a company’s account as support for funds borrowed from the bank. 7-9 7-10 Learning Objectives Distinguish between the gross and net methods of accounting for cash discounts 7-11 Accounts Receivable Amounts due from customers for credit sales. Credit sales require: Maintaining a separate account receivable for each customer. Accounting for bad debts that result from credit sales. 7-12 Cash Discounts Increase sales. Cash discounts . . . Encourage early payment. Increase likelihood of collections. 7-13 Cash Discounts 2/10,n/30 Discount Percent Number of Days Discount is Available Otherwise, Net (or All) is Due Credit Period 7-14 Cash Discounts Sales are recorded at the invoice amounts. Gross Method Sales discounts are recorded if payment is received within the discount period. 7-15 Cash Discounts Net Method Sales are recorded at the Sales discounts forfeited invoice amount less the are recorded if payment discount. is received after the discount period. 7-16 Cash Discounts On May 10, Eddy, Inc. sold $5,000 of merchandise to a customer subject to a cash discount of 1/10, n/30. Prepare the journal entry to record the sale if Eddy uses: (a) the gross method. (b) the net method. 7-17 Cash Discounts GENERAL JOURNAL Date Description Post. Ref. Page 56 Debit Credit GROSS METHOD May 10 Accounts Receivable 5,000 Sales Revenue 5,000 NET METHOD May 10 Accounts Receivable Sales Revenue 4,950 4,950 7-18 Cash Discounts Assume that on May 19, Eddy, Inc. received a check in full payment of the sale made on May 10. Prepare the journal entry to record the cash receipt if Eddy uses: (a) the gross method. (b) the net method. 7-19 Cash Discounts GENERAL JOURNAL Date Description Post. Ref. Page 56 Debit Credit GROSS METHOD May 19 Cash 4,950 Sales Discount 50 Accounts Receivable 5,000 NET METHOD May 19 Cash Accounts Receivable 4,950 4,950 7-20 Cash Discounts Instead of the payment on May 19, now assume that Eddy, Inc. received a check on May 31, in full payment of the sale made on May 10. Prepare the journal entry to record the cash receipt if Eddy uses: (a) the gross method. (b) the net method. 7-21 Cash Discounts GENERAL JOURNAL Date Description Post. Ref. Page 56 Debit Credit GROSS METHOD May 31 Cash 5,000 Accounts Receivable 5,000 NET METHOD May 31 Cash Interest Revenue Accounts Receivable 5,000 50 4,950 7-22 Learning Objectives Describe the accounting treatment for merchandise returns. 7-23 Sales Returns and Allowances Sales Returns Sales Allowances Merchandise returned by a customer to a supplier. A reduction in the cost of defective merchandise. 7-24 Sales Returns and Allowances On June 1, a customer of LarCo returns $750 of merchandise. The merchandise had been purchased on account and the customer had not yet paid. LarCo uses the periodic method to account for inventory. Record the journal entry for the return of merchandise. 7-25 Sales Returns and Allowances GENERAL JOURNAL Date Jun Description 1 Sales Returns and Allowances Post. Ref. Page 56 Debit Credit 750 Accounts Receivable Sales Returns and Allowances is a contra account that reduces Sales Revenue in the current accounting period. 750 7-26 Learning Objectives Describe the accounting treatment of anticipated uncollectible accounts receivable. 7-27 Uncollectible Accounts Receivable Bad debts result from credit customers who are unable to pay the amount they owe, regardless of continuing collection efforts. PAST DUE 7-28 Uncollectible Accounts Receivable In conformity with the matching principle, bad debt expense should be recorded in the same accounting period in which the sales related to the uncollectible account were recorded. 7-29 Uncollectible Accounts Receivable Most businesses record an estimate of the bad debt expense by an adjusting entry at the end of the accounting period. GENERAL JOURNAL Date Description Dec. 31 Bad Debt Expense Allowance for Uncollectible Accounts Page 78 Post. Ref. Debit Credit #### #### 7-30 Uncollectible Accounts Receivable Normally classified as a selling expense and closed at year-end. Contra asset account to Accounts Receivable. GENERAL JOURNAL Date Description Dec. 31 Bad Debt Expense Allowance for Uncollectible Accounts Page 78 Post. Ref. Debit Credit #### #### 7-31 Allowance for Uncollectible Accounts Accounts Receivable Less: Allowance for Uncollectible Accounts Net Realizable Value Net realizable value is the amount of the accounts receivable that the business expects to collect. 7-32 Learning Objectives Describe the two approaches to estimating bad debts. 7-33 Estimating Bad Debts Income Statement Approach Balance Sheet Approach Composite Rate Aging of Receivables PAST DUE 7-34 Income Statement Approach Focuses on past credit sales to make estimate of bad debt expense. Emphasizes the matching principle by estimating the bad debt expense associated with the current period’s credit sales. 7-35 Income Statement Approach Bad debts expense is computed as follows: Current Period Credit Sales × Bad Debt % = Estimated Bad Debts Expense 7-36 Income Statement Approach In 2006, MusicLand has credit sales of $400,000 and estimates that 0.6% of credit sales are uncollectible. What is Bad Debts Expense for 2006? 7-37 Income Statement Approach $ 400,000 MusicLand computes × 0.60% estimated Bad Debts = $ 2,400 Expense of $2,400. GENERAL JOURNAL Date Dec. Description 31 Bad Debts Expense Allowance for Uncollectible Accounts Post Ref. Page 95 Debit 2,400 Credit 2,400 7-38 Balance Sheet Approach Focuses on the collectibility of accounts receivable to make the estimate of uncollectible accounts. Involves the direct computation of the desired balance in the allowance for uncollectible accounts. 7-39 Balance Sheet Approach Composite Rate Compute the desired balance in the Allowance for Uncollectible Accounts. Year-end Accounts Receivable × Bad Debt % Bad Debts Expense is computed as: Balance Sheet Approach Composite Rate On Dec. 31, 2006, MusicLand has $50,000 in Accounts Receivable and a $200 credit balance in Allowance for Uncollectible Accounts. Past experience suggests that 5% of receivables are uncollectible. What is MusicLand’s Bad Debts Expense for 2006? 7-40 7-41 Balance Sheet Approach Composite Rate Desired balance in Allowance for Uncollectible Accounts $ × = $ 50,000 5.00% 2,500 GENERAL JOURNAL Date Dec. Description 31 Bad Debts Expense Allowance for Uncollectible Accounts Post Ref. Page 95 Debit 2,300 Credit 2,300 7-42 Now, let’s look at the accounts receivable aging approach! Balance Sheet Approach Aging of Receivables Year-end Accounts Receivable is broken down into age classifications. Each age grouping has a different likelihood of being uncollectible. Compute desired uncollectible amount. Compare desired uncollectible amount with the existing balance in the allowance account. 7-43 7-44 Balance Sheet Approach Aging of Receivables At December 31, 2006, the receivables for EastCo, Inc. were categorized as follows: EastCo, Inc. Schedule of Accounts Receivable by Age Days Past Due Current 1 - 30 31 - 60 Over 60 December 31, 2006 Accounts Estimated Estimated Receivable Bad Debts Uncollectible Balance Percent Amount $ $ 45,000 15,000 5,000 2,000 67,000 1% $ 3% 5% 10% $ 450 450 250 200 1,350 7-45 Balance Sheet Approach Aging of Receivables EastCo’s unadjusted balance in the allowance account is $500. Allowance for Uncollectible Accounts 500 Per the previous computation, the desired balance is $1,350. 1,350 GENERAL JOURNAL Date Description Post Ref. Page 95 Debit Prepare the entry to record bad debts expense at Dec. 31, 2006. Credit 7-46 Balance Sheet Approach Aging of Receivables EastCo’s unadjusted balance in the allowance account is $500. Allowance for Uncollectible Accounts 500 850 1,350 Per the previous computation, the desired balance is $1,350. GENERAL JOURNAL Date Dec. Description 31 Bad Debts Expense Allowance for Uncollectible Accounts Post Ref. Page 95 Debit 850 Credit 850 7-47 Methods to Estimate Bad Debts Income Statement Approach Balance Sheet Approach Emphasis on Matching Emphasis on Realizable Value Sales Bad Debts Exp. Income Statement Focus Accts. Rec. All. for Uncoll. Accts. Balance Sheet Focus 7-48 Uncollectible Accounts As accounts become uncollectible, the following entry is made: GENERAL JOURNAL Date Description Allowance for Uncollectible Accounts Accounts Receivable Page 69 Post. Ref. Debit Credit #### #### So what happens if someone pays after a write-off of the accounts receivable? 7-49 Collection of Previously Written-Off Accounts When a customer makes a payment after an account has been written off, two journal entries are required. GENERAL JOURNAL Date Description Accounts Receivable Cash Page 69 Post. Ref. Debit #### Allowance for Uncollectible Accounts Accounts Receivable Credit #### #### #### 7-50 Direct Write-off Method If uncollectible accounts are immaterial, bad debts are simply recorded as they occur (without the use of an allowance account). GENERAL JOURNAL Date Description Bad Debts Expense Accounts Receivable Post Ref. Page 18 Debit ##### Credit ##### 7-51 Learning Objectives Describe the accounting treatment of shortterm notes receivable. 7-52 Notes Receivable PROMISSORY NOTE $25,000 Face Value Term One year after date I Date of Note Nov. 1, 2006 Date promise to pay to the order of Payee Principal Westward, Inc. Twenty-five thousand and no/100------------------------ Dollars Maker plus interest at the annual rate of 12% . Interest Rate Janet Lee , Winn,Co. 7-53 Interest Computation Face amount of the note × Annual interest rate Even for maturities less than 1 year, the rate is annualized. × Fraction of the annual = period Interest 7-54 Interest-Bearing Notes On November 1, 2006, Westward, Inc. loans $25,000 to Winn, Co. The note bears interest at 12% and is due on November 1, 2007. Prepare the journal entry on November 1, 2006, December 31, 2006, (year-end) and November 1, 2007 for Westward. 7-55 Interest-Bearing Notes GENERAL JOURNAL Date Description Page 56 Post. Ref. Debit Credit 2006 Nov 1 Notes Receivable 25,000 Cash Dec 31 Interest Receivable Interest Revenue $25,000 × 12% × (2 ÷ 12) = $500 25,000 500 500 7-56 Interest-Bearing Notes GENERAL JOURNAL Date Description Page 56 Post. Ref. Debit Credit 2007 Nov 1 Cash 28,000 Note Receivable Interest Receivable Interest Revenue $25,000 × 12% = $3,000 - $500 = $2,500 25,000 500 2,500 7-57 Noninterest-Bearing Notes Actually do bear interest. Interest is deducted (discounted) from the face value of the note. Cash proceeds equal face value of note less discount. 7-58 Noninterest-Bearing Notes On January 1, 2006, Westward, Inc. accepted a $25,000 noninterest-bearing note from Winn, Co as payment for a sale. The note is discounted at 12% and is due on December 31, 2006. Prepare the journal entries on January 1, 2006, and December 31, 2006 for Westward. 7-59 Noninterest-Bearing Notes GENERAL JOURNAL Date Description Page 56 Post. Ref. Debit Credit 2006 Jan 1 Notes Receivable 25,000 Discount on Notes Receivable 3,000 Sales Revenue 22,000 $25,000 × 12% = $3,000 Dec 31 Cash Discount on Notes Receivable 25,000 3,000 Interest Revenue 3,000 Notes Receivable 25,000 7-60 Learning Objectives Differentiate between the use of receivables in financing arrangements accounted for as a secured borrowing and those accounted for as a sale. 7-61 Financing With Receivables Secured borrowing or Sale of receivables Method depends on the surrender of control over the receivables transferred. 7-62 Secured Borrowing – Assigning The use of specific receivables for collateral, and the promise that any failure to repay debt will result in proceeds from specific accounts receivable collections being used to repay the debt. Reclassify Accounts Receivable as Accounts Receivable Assigned. 7-63 Secured Borrowing – Pledging Receivables in general are pledged as collateral for loans. Pledged receivables are disclosed in notes to the financial statements. 7-64 Sale of Accounts Receivable 2. Accounts Receivable SUPPLIER (Transferor) RETAILER 1. Merchandise FACTOR (Transferee) A factor is a financial institution that buys receivables for cash, handles the billing and collection of the receivables and charges a fee for the service. 7-65 Sale of Accounts Receivable Treat as a sale if all of these conditions are met: Receivables are isolated from transferor. Transferee has right to pledge or exchange receivables. Transferor does not have control over the receivables. Transferor cannot repurchase receivable before maturity. Transferor cannot require return of specific receivables. 7-66 Sale of Accounts Receivable Without recourse An ordinary sale of receivables to the factor. Factor assumes all risk of uncollectibility. Control of receivable passes to the factor. Receivables are removed from the books, cash is received and a financing expense or loss is recognized. 7-67 Sale of Accounts Receivable With recourse Transferor (seller) retains risk of uncollectibility, Must meet the three conditions of determining surrender of control to be recognized as a sale. If the transaction fails to meet the three conditions necessary to be classified as a sale, it will be treated as a secured borrowing. 7-68 Discounting a Note On December 31, Apex accepted a ninemonth 10 percent note for $200,000 from a customer. Three months later on March 31, Apex discounted the note at its local bank. The bank’s discount rate 12 percent. Prepare the journal entry to record the discounting of the note receivable as a sale. 7-69 Discounting a Note Before the preparing the journal entry to record the discounting, Apex must record the accrued interest on the note from December 31 until March 31. GENERAL JOURNAL Date Description Page 69 Post. Ref. Mar. 31 Interest Receivable Interest Revenue $200,000 × 10% × 3/12 Debit Credit 5,000 5,000 7-70 Discounting a Note GENERAL JOURNAL Date Page 69 Post. Ref. Description Mar. 31 Cash Debit Credit 202,100 Loss on Sale of Note Receivable 2,900 Notes Receivable 200,000 Interest Receivable 5,000 $205,000 - $202,100 7-71 Discounting a Note If the three conditions for sale treatment are not met, the transaction would be recorded as a secured borrowing. 7-72 Learning Objectives Describe the variables that influence a company’s investment in receivables and calculate the key ratios used by analysts to monitor that investment. 7-73 Receivables Management Factors influencing a company’s investment in receivables Credit and collection policies Product or service sold Level of sales 7-74 Receivables Management Receivables Turnover = Ratio Net Sales Average Accounts Receivable This ratio measures how many times a company converts its receivables into cash each year. Average Collection Period 365 = Receivables Turnover Ratio This ratio is an approximation of the number of days the average accounts receivable balance is outstanding. 7-75 Receivables Management Dell vs. Apple comparison Dell Accounts receivable (net) Net sales Apple 2004 2003 2004 2003 $ 3,635 $ 2,586 $ 774 $ 766 41,444 8,279 (All dollar amounts in millions) Compute the receivables turnover ratio and the average collection period for both companies. 7-76 Receivables Management Dell Accounts receivable (net) Net sales Receivables Turnover = Ratio Apple 2004 2003 2004 2003 $ 3,635 $ 2,586 $ 774 $ 766 41,444 8,279 Net Sales Average Accounts Receivable Dell $41,444 = 13.32 ($3,635 + $2,586)/2 Apple $8,279 = 10.75 ($774 + $766)/2 7-77 Receivables Management Dell Accounts receivable (net) Net sales Average Collection Period Dell 365 = 27.4 days 13.32 = Apple 2004 2003 2004 2003 $ 3,635 $ 2,586 $ 774 $ 766 41,444 8,279 365 Receivables Turnover Ratio Apple 365 = 34 days 10.75 7-78 Cash Controls Appendix 7 7-79 Bank Reconciliation Explains the difference between cash reported on bank statement and cash balance on company’s books. Provides information for reconciling journal entries. 7-80 Bank Reconciliation Bank Balance Book Balance + Deposits in Transit + Bank Collections - Outstanding Checks - Service Charges - NSF Checks ± Bank Errors ± Book Errors = Corrected Balance = Corrected Balance 7-81 Bank Reconciliation All reconciling +items Deposits in Transit on the book side - Outstanding requireChecks an adjusting ± entry Bank Errors to the cash account. Balance per Bank = Adjusted Balance Book Balance + Bank Collections - Service Charges - NSF Checks ± Book Errors = Corrected Balance 7-82 Bank Reconciliation Let’s prepare a May 31 bank reconciliation for the Hawthorne Company. The May 31 bank statement indicated a balance of $34,680. The cash general ledger account on that date shows a balance of $35,276. Additional information necessary for the reconciliation is shown on the next screen. 7-83 Bank Reconciliation Cash receipts not yet deposited on May 31 totaled $2,965. A $1,020 check mailed to the bank for deposit had not reached the bank at the statement date. Outstanding checks totaled $5,536. A check written to pay for raw materials purchased on account cleared the bank for $1,790 but was erroneously recorded at $790. The bank statement showed $80 in service charges in May. The bank returned NSF checks in the amount of $2,187 received as payment on accounts receivable. The bank collected a note receivable for $1,120 that included $120 of interest. 7-84 Bank Reconciliation Bank balance, May 31 Add: Deposit in transit* Deduct: Outstanding checks Corrected cash balance *$2,965 + $1,020 = $3,985 $ $ 34,680 3,985 (5,536) 33,129 7-85 Bank Reconciliation Bank balance, May 31 Add: Deposit in transit* Deduct: Outstanding checks Corrected cash balance $ Book balance, May 31 Add: Note collected by bank Deduct: Services charges NSF checks Error Corrected cash balance $ *$2,965 + $1,020 = $3,985 $ $ 34,680 3,985 (5,536) 33,129 35,276 1,120 (80) (2,187) (1,000) 33,129 7-86 Bank Reconciliation Prepare the entries to adjust the cash account to the corrected balance. GENERAL JOURNAL Date Description May 31 Cash Interest Revenue Notes Receivable May 31 Miscellaneous Expense Accounts Receivable Accounts Payable Cash Post. Ref. Page 66 Debit 1,120 Credit 120 1,000 80 2,187 1,000 3,267 7-87 Petty Cash Used for minor expenditures. Petty cash fund Has one custodian. Replenished periodically. 7-88 Petty Cash Hawthorne Co. established a petty cash fund on May 1 by writing a check for $200 to the petty cash custodian. Prepare the May1st journal entry to record the establishment of the fund. GENERAL JOURNAL Date May Description 1 Petty Cash Cash Page 64 Post. Ref. Debit Credit 200 200 7-89 Petty Cash During May, the petty cash custodian paid bills using cash from the fund totaling $160 as follows: Postage $40 Office supplies 35 Delivery charges 55 Entertainment 30 Prepare the May 31 journal entry to record replenishing the fund. GENERAL JOURNAL Date Description May 31 Postage expense Page 65 Post. Ref. Debit Credit 40 Office supplies expense 35 Delivery expense 55 Entertainment expense 30 Cash 160 7-90 End of Chapter 7