Chapter 7
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Cash
Currency and coins
Balances in checking accounts
Items for deposit such as checks and money orders from customers
Cash equivalents are short-term, highly liquid investments that can be readily converted to cash.
Money market funds
Treasury bills
Commercial paper
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Encourages adherence to company policies and procedures
Promotes operational efficiency
Minimizes errors and theft
Enhances the reliability and accuracy of accounting data
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Cash Receipts



Separate responsibilities for receiving cash, recording cash transactions, and reconciling cash balances.
Match the amount of cash received with the amount of cash deposited.
Close supervision of cash-handling and cash-recording activities.
Cash Disbursements

All disbursements, except petty cash, made by check.


Separate responsibilities for cash disbursement documents, check authorization, check signing, and record keeping.
Checks should be signed only by authorized individuals.
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Management’s intent to use a certain amount of cash for a specific purpose – future plant expansion, future payment of debt.
Minimum balance that must be maintained in a company’s bank account as support for funds borrowed from the bank.
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In general, cash and cash equivalents are treated similarly under IFRS and U.S. GAAP. One difference is highlighted below.
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
Bank overdrafts are treated as liabilities.

Bank overdrafts may be offset against other cash accounts.

Result from the credit sales of goods or services to customers.
Are classified as current assets.
Are recorded net of trade discounts.
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Cash discounts increase sales encourage early payment increase likelihood of collections
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2/10,n/30
Discount percent
Number of days discount is available
Otherwise, net (or all) is due
Credit period
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Gross
Method
Net
Method
Sales are recorded at the invoice amounts .
Sales discounts are recorded as reduction of revenue if payment is received within the discount period.
Sales are recorded at the invoice amount less the discount .
Sales discounts forfeited are recorded as interest revenue if payment is received after the discount period.
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On October 5, Hawthorne sold merchandise for $20,000 with terms 2/10, n/30. On October 14, the customer sent a check for $13,720 taking advantage of the discount to settle $14,000 of the amount. On November
4, the customer paid the remaining $6,000.
October 5, 2013 October 5, 2013
October 14, 2013 October 14, 2013
November 4, 2013
November 4, 2013

Merchandise may be returned by a customer to a supplier.
A special price reduction, called an allowance, may be given as an incentive to keep the merchandise.
To avoid misstating the financial statements, sales revenue and accounts receivable should be reduced by the amount of returns in the period of sale if the amount of returns is anticipated to be material.
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During the first year of operations, Hawthorne sold $2,000,000 of merchandise that had cost them $1,200,000 (60%). Industry experience indicates a10% return rate. During the year $130,000 was returned prior to customer payment. Record the returns and the end of the year adjustment.
Actual Returns
Sales returns
Accounts receivable
Inventory
Cost of goods sold (60%)
Adjusting Entries
Sales returns
Allowance for sales returns
Inventory
 estimated returns
Cost of goods sold (60%)
130,000
78,000
70,000
42,000
130,000
78,000
70,000
42,000

Bad debts result from credit customers who are unable to pay the amount they owe, regardless of continuing collection efforts.
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.
PAST DUE
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Most businesses record an estimate of the bad debt expense by an adjusting entry at the end of the accounting period.
Normally classified as a selling expense and closed at year-end.
Contra asset account to accounts receivable.
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Bad debt expense
Allowance for uncollectible accounts xxx xxx

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.


Income Statement Approach
Balance Sheet Approach

Composite Rate

Aging of Receivables
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
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.
Bad debt expense is computed as follows:
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In 2014, MusicLand has credit sales of $400,000 and estimates that 0.6% of credit sales are uncollectible.
What is Bad Debt Expense for 2014?
MusicLand computes estimated Bad Debt
Expense of $2,400.
×
=
$ 400,000
0.60%
$ 2,400
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Bad debt expense
Allowance for uncollectible accounts
2,400
2,400



Focuses on the collectability of accounts receivable to make the estimate of uncollectible accounts.
Involves the direct computation of the desired balance in the allowance for uncollectible accounts.
 Compute the desired balance in the allowance for uncollectible accounts.
 Bad debt expense is computed as:
-
Desired Balance in Allowance for
Uncollectible Accounts
Existing Year-End Balance in Allowance for
Uncollectible Accounts
= Estimated Bad Debt Expense
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Composite Rate
On Dec. 31, 2014, 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 debt expense for 2014?
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Composite Rate
Determine the desired balance in allowance for uncollectible accounts
×
=
$ 50,000
5.00%
$ 2,500
Allowance for
Uncollectible
Accounts
200
2,300
2,500
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Bad debt expense
Allowance for uncollectible accounts
2,300
2,300

Aging of Receivables

Year-end accounts receivable is broken down into age classifications.

Each age grouping has a different likelihood of being uncollectible.

Compute required uncollectible amount.

Compare required uncollectible amount with the existing balance in the allowance account.
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Aging of Receivables
At December 31, 2014, the receivables for
EastCo, Inc., were categorized as follows:
Days Past Due
Current
1

30
31

60
Over 60

EastCo, Inc.
Schedule of Accounts Receivable by Age
December 31, 2014
Accounts
Receivable
Balance
$ 45,000
15,000
Estimated
Percent
Uncollectible
1%
3%
5,000
2,000

5%
10%
$ 67,000
Estimated
Allowance
$ 450
450
250

200
$ 1,350
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Aging of Receivables

EastCo’s unadjusted balance in the allowance account is $500.

Per the previous computation, the required balance is $1,350.
Allowance for
Uncollectible
Accounts
500
850
1,350
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Bad debt expense
Allowance for uncollectible accounts
850
850

As accounts are deemed to be uncollectible, a journal entry is made to record the actual write-off.
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Allowance for uncollectible accounts
Accounts receivable
500
500
If a customer makes a payment after an account has been written off, two journal entries are required.
Accounts receivable
Allowance for uncollectible accounts
500
500
Cash
Accounts receivable
500
500

If uncollectible accounts are immaterial, bad debts are simply recorded as they occur (without the use of an allowance account).
Bad debts expense
Accounts receivable xxx xxx
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Summary of Measurement and Reporting
Issues for Accounts Receivable
Recognition
Depends on the earnings process; for most credit sales, revenue and the related receivables are recognized at the point of delivery.
Initial valuation
Initially recorded at the exchange price agreed upon by the buyer and seller.
Subsequent valuation
Initial valuation reduced to net realizable value by:
1. Allowance for sales returns
2. Allowance for uncollectible accounts:
 The income statement approach
 The balance sheet approach
Classification
Almost always classified as a current asset.
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A written promise to pay a specific amount at a specific future date.
Face amount of the note
×
Annual interest rate
×
Fraction of the annual = Interest period
Even for maturities less than 1 year, the rate is annualized.
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On November 1, 2014, West, Inc., loans $25,000 to Winn Co. The note bears interest at 12% and is due on November 1, 2015.
Prepare the journal entry on November 1, 2014, December 31,
2014, (year-end) and November 1, 2015, for West.
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November 1, 2014
Notes receivable
Cash
December 31, 2014
Interest receivable
Interest revenue
November 1, 2015
Cash
Note receivable
Interest receivable
Interest revenue
25,000
500
28,000
25,000
500
25,000
500
2,500

 Actually do bear interest.
 Interest is deducted
(discounted) from the face value of the note.
 Cash proceeds equal face value of note less discount.
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On Jan. 1, 2014, West, Inc., accepted a $25,000 noninterestbearing note from Winn Co. as payment for a sale. The note is discounted at 12% and is due on Dec. 31, 2014.
Prepare the journal entries on Jan. 1, 2014, and Dec. 31, 2014.
January 1, 2014
Notes receivable
Discount on notes receivable
Sales revenue
($25,000 * 12% = $3,000)
December 31, 2014
Cash
Discount on notes receivable
Interest revenue
Note receivable
25,000
25,000
3,000
3,000
22,000
3,000
25,000
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In general, IFRS and U.S. GAAP are very similar with respect to accounts receivable and notes receivable. Differences are highlighted below.
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


U.S. GAAP allows a “fair value option” for accounting for receivables.
U.S. GAAP does not allow receivables to be accounted for as
“available for sale” investments.
U.S. GAAP requires more disaggregation of accounts and notes receivable in the balance sheet or notes.


IFRS restricts the circumstances in which a “fair value option” for accounting for receivables is allowed.
Until 2015, companies may account for receivables as “available for sale” investments if the approach is elected initially. After January 1,
2015, this treatment is no longer allowed.

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2. Accounts Receivable
SUPPLIER
(Transferor)
1. Merchandise
RETAILER
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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.

On December 1, 2013, the Santa Teresa Glass Company borrowed $500,000 from Finance
Bank and signed a promissory note. Interest at 12% is payable monthly. The company assigned
$620,000 of its receivables as collateral for the loan. Finance Bank charges a finance fee equal to 1.5% of the accounts receivable assigned.
Cash (difference)
Finance charge expense (1.5% * $620,000)
Liability – financing arrangement
490,700
9,300
500,000
Santa Teresa Glass will continue to collect the receivables, and will record any discounts, sales returns, and bad debt write-offs, but will remit the cash to Finance Bank, usually on a monthly basis. When $400,000 of the receivables assigned are collected in December, Santa Teresa
Glass records the following entries.
Cash 400,000
Accounts receivable 400,000
Interest expense ($500,000 * 12% * 1/12)
Liability
– financing arrangement
Cash
5,000
400,000
405,000
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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.
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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, fair value of cash and other assets received is recorded, and a financing expense or loss is recognized.
With recourse
 Transferor (seller) retains risk of uncollectibility.
 If the transaction fails to meet the three conditions necessary to be classified as a sale, it will be treated as a secured borrowing.
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In December 2013, the Santa Teresa Glass Company factored accounts receivable that had a book value of $600,000 to Factor Bank. The transfer was made without recourse .
Under this arrangement, Santa Teresa transfers the $600,000 of receivables to Factor, and Factor immediately remits to Santa Teresa cash equal to 90% of the factored amount (90% × $600,000 = $540,000). Factor retains the remaining 10% (estimated to have a fair value of $50,000) to cover its factoring fee (equal to 4% of the total factored amount; 4% × $600,000 = $24,000) and to provide a cushion against potential sales returns and allowances.
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Assume the same facts as above, except that Santa Teresa Glass sold the receivables to Factor with recourse and estimates the fair value of the recourse obligation to be
$5,000.

Securitization: Transfer receivables to a SPE
Special Purpose Entity (SPE)
Qualifying Special Purpose Entity (QSPE)
New rules eliminate QSPE and require consolidation!
Participating Interests: Transfer portion of a receivable
Example: transfer right to interest, but retain right to principal
New rules require a partial transfer be treated as a secured borrowing, unless specific conditions are met!
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On December 31, Stridewell accepted a nine-month 10 percent note for $200,000 from a customer. Three months later on
March 31, Stridewell discounted the note at its local bank. The bank’s discount rate is 12 percent.
Before preparing the journal entry to record the discounting, Stridewell must record the accrued interest on the note from December 31 until March 31.
Interest receivable
Interest revenue
5,000
5,000
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$200,000 × 10% × 3/12

Face amount of note receivable
Interest to maturity ($200,000 × 10% × 9/12)
Maturity value of note receivable
Discount fee ($215,000 × 12% × 6/12)
Cash proceeds
$ 200,000
15,000
215,000
(12,900)
$ 202,100
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Cash
Loss on sale of note receivable
Notes receivable
Interest receivable
202,100
$205,000

$202,100
2,900
200,000
5,000

Deciding Whether to Account for a Transfer as a Sale or a Secured Borrowing
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The U.S. GAAP and the IFRS approaches often lead to similar accounting treatment for transfers of receivables.
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
U.S. GAAP focuses on whether control of assets has shifted from the transferor to the transferee.

IFRS requires a more complex decision process. The company has to have transferred the rights to receive the cash flows from the receivable, and then considers whether the company has transferred “substantially all of the risks and rewards of ownership,” as well as whether the company has transferred control.

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.
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(All dollar amounts in millions)
Accounts receivable (net)
Net sales
Symantec Corp.
2011 2010
$ 1,013
6,190
$ 856
2011
CA, Inc.
2010
$ 849
4,429
$ 931
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Receivables turnover
Average collection period
Symantec Corp CA, Inc
6.62
4.98
55.14 days 73.29 days
Industry Average
5.96
61.3 days

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A bank reconciliation explains the difference between cash reported on bank statement and cash balance on a company’s books.
Provides information for reconciling journal entries.
Bank Balance
+ Deposits in Transit
- Outstanding Checks
± Bank Errors
= Corrected Balance
Book Balance
+ Bank Collections
- Service Charges
- NSF Checks
± Book Errors
= Corrected Balance

Petty cash is used for minor expenditures.
Petty cash fund
Has one custodian.
Replenished periodically.
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Appendix 7-B: Accounting for Impairment of a
Receivable and a Troubled Debt Restructuring
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When a company holds a receivable from another company, there is some potential that the receivable will eventually be impaired.
Impairment of a receivable occurs if the company believes it is probable that it will not receive all of the cash flows
(principal and any interest payments) associated with the receivable.

Appendix 7-B: Accounting for Impairment of a
Receivable and a Troubled Debt Restructuring
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Bad debt expense
Accrued interest receivable
Allowance for uncollectible accounts
($30,000,000 - $24,132,330)
8,867,670
3,000,000
5,867,670

Appendix 7-B: Accounting for Impairment of a
Receivable and a Troubled Debt Restructuring
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A troubled debt restructuring occurs when a creditor makes concessions in response to a debtor’s financial difficulties.
Sometimes a receivable in a troubled debt restructuring is actually settled at the time of the restructuring by the debtor making a payment of cash, some other noncash assets, or even shares of the debtor’s stock.
Land (fair value)
Bad debt expense
Accrued interest receivable
Notes receivable
20
13
(in millions)
3
30

The U.S. GAAP and the IFRS approaches to impairments of receivables are similar, but the process and criteria are somewhat different.
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


Under U.S. GAAP the level of analysis is individual receivables.
U.S. GAAP provides an illustrative list of information to consider when evaluating receivables for impairment, and requires measurement of potential impairment if impairment (a) is viewed as probable and
(b) can be estimated reliably.
Both U.S. GAAP and IFRS treat reversal of impairments the same.



Under IFRS the level of analysis starts with consideration of impairment for individually significant receivables.
IFRS provides an illustrative list of “loss events” and requires measurement of an impairment if there is objective evidence that a loss event has occurred that has an impact on the future cash flows collected and that can be estimated reliably.
Both U.S. GAAP and IFRS treat reversal of impairments the same.

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