Chapter 8
Cash and Receivables
What is Cash?
Most liquid asset
Standard medium of exchange
Basis for measuring and accounting for all items
Current asset
Examples: Coin, currency, available funds on
deposit, money orders, certified checks,
cashier’s checks, personal checks, bank drafts,
and savings accounts.
Control of Cash
•
1) To establish proper controls to
prevent any unauthorized transactions,
and
•
(2) To provide information necessary to
the proper management of cash on hand
and cash transactions.
Restricted Cash
•
Companies segregate restricted cash from “regular”
cash for reporting purposes.
•
Examples, restricted for:
•
(1) Plant expansion, (2) Retirement of long-term debt,
and (3) Compensating balances.
Bank Overdrafts
• When a company writes a check for
more than the amount in its cash
account.
Generally reported as a current liability.
Offset against cash account only when
available cash is present in another
account in the same bank on which the
overdraft occurred.
Cash Equivalents
• Short-term, highly liquid investments that
are both
(a)readily convertible to cash, and
(b)so near their maturity that they present
insignificant risk of changes in interest
rates
Examples: Treasury bills, Commercial paper,
and Money market funds.
Receivables
• Claims held against customers and
others for money, goods, or services.
• Accounts Receivable: promises of the
purchaser to pay for goods and services
sold.
• Notes Receivable: Written promises to
pay a sum of money on a specified
future date.
Non-trade Receivable
1. Advances to officers and employees.
2. Advances to subsidiaries.
3. Deposits to cover potential damages or
losses.
4. Deposits as a guarantee of performance
or payment.
5. Dividends and interest receivable.
Cash Discounts [Gross Method]
Inducements for prompt payment
Gross method vs. Net method
• Common payment terms are 2/10, n/30 [Gross
Method]:
Accounts Receivable 5,000
Sales
5,000
Cash (5,000 x 98%)
4,900
Sales Discounts
100
Accounts Receivable
5,000
Cash Discounts [Net Method]
Accounts Receivable
4,900
Sales
4,900
Cash
4,900
Accounts Receivable
4,900
If discount forfeited:
Cash
5,000
Accounts Receivable
4,900
Sales Discounts Forfeited
100
Non-recognition of Interest
•
A company should measure receivables
in terms of their present value.
•
In practice, companies ignore interest
revenue related to accounts receivable
because the amount of the discount is
not usually material.
Balance Sheet Presentation (including
doubtful accounts)
Assets
Current assets:
Cash
Accounts receivable, net of $25 allowance
for doubtful accounts
Inventory
Prepaids
Total current assets
Fixed assets:
Office equipment
Furniture & fixtures
Less: Accumulated depreciation
Total fixed assets
Total assets
$ 346
475
812
_ 40
1,673
5,679
6,600
(3,735)
8,544
$10,217
Valuing Receivables
• Reporting Receivables:
Classification
Valuation (net realizable value)
Sales on account raise the possibility of
accounts not being collected
Uncollectible Accounts
• Direct Write-Off
• Theoretically undesirable:
No matching
Receivable not stated at net realizable
value
Allowance Method
Losses are Estimated:
Percentage-of-sales
Percentage-of-receivables
Uncollectible Accounts Receivable
•
•
•
•
•
•
•
•
Income Statement Approach:
Percentage of Sales
Matching
Sales --- Bad Debt Expense
Balance Sheet Approach:
Percentage of Receivables
Net Realizable Value
Receivables - Allowance for Bad Debt
Uncollectible Accounts Receivable
Credit sales
Example Data
$500,000
Estimated % of credit sales not collected
1.25%
Accounts receivable balance
Estimated % of A/R not collected
$72,500
8%
Allowance for Doubtful Accounts:
Case I
$150 (credit balance)
Uncollectible Accounts Receivable:
Percentage of Sales Method
Charge sales
Estimated percentage
Estimated expense
$500,000
x
$
1.25%
6,250
======================================
=============
Journal Entry:
Bad Debts Expense
6,250
Allowance for Doubtful Accounts 6,250
Percentage of Sales Method
• The calculation is based on net sales.
• If gross sales is $12,000 and sales returns and
allowances is $600, net sales is $11,400
• Assume bad debts is 2% of sales, then the
adjusting entry is for $11,400 x 2% or $228:
• Bad Debts Expense
228
Allowance for Uncollectible Accounts 228
Uncollectible Accounts Receivable:
Percent of Receivables Method
What should the ending balance be for
the allowance account? –Credit balance:
$150
Actual Balance
Adjustments
Ending Balance
150
(6,250)
6,100
Uncollectible Accounts Receivable:
Percentage of Receivables Method
Accounts receivable
Estimated percentage
Desired balance
Balance
150
Desired Balance 5800
Adjustment
5650
$ 72,500
x
8%
$ 5,800
Bad Debts Expense 5,650
Allowance for Doubtful Accounts 5,650
Uncollectible Accounts Receivable
• Percent of Sales Approach:
Bad debt expense estimate is related to a nominal
account (Sales), balance in allowance account is
ignored.
Achieves a proper matching of cost and revenues.
Percent of Receivables Approach:
Results in a more accurate valuation of receivables
on the balance sheet.
Method may also be applied using an aging schedule.
Notes Receivable
A negotiable instrument
Maker signs in favor of a payee
Interest-bearing (has a stated rate of
interest) OR
Noninterest-bearing (interest included
in face amount)
Notes Receivable
Used When:
Customers need to extend the payment period
of an outstanding receivable
High-risk or new customers
Loans to employees and subsidiaries
Sales of property, plant, and equipment
Lending transactions (the majority of notes)
Notes Receivable
•
•
•
•
•
•
Short-term:
Record at Face Value,
less allowance
Long-term:
Record at Present Value
of cash expected to be collected
Note Issued at Face Value
•
Present value of interest $ 31,942
•
Present value of principal
•
Bond current market value $100,000
Date
Account Title
Jan. yr. 1 Notes receivable
68,058
Debit
100,000
Cash
Dec. yr. 1 Cash
Interest revenue
($100,000 x 8%)
Credit
100,000
8,000
8,000
Zero-interest-bearing Note
• Non-interest-bearing note:
Cash
Received
Date of issue
End of yr. 1
End of yr. 2
End of yr. 3
End of yr. 4
End of yr. 5
-
6%
Interest
Revenue
$
4,484
4,753
5,038
5,340
5,660
25,274
Discount
Amortized
$
4,484
4,753
5,038
5,340
5,660
25,274
Carrying
Amount
of Note
$ 74,726
79,210
83,962
89,000
94,340
100,000
Zero-interest-bearing Note
Present value of principal
$74,726
Date
Account Title
Jan. yr. 1 Notes receivable
Debit
Credit
100,000
Discount on notes receivable
25,274
Cash
74,726
Dec. yr. 1 Disount on notes receivable
Interest revenue
($74,726 x 6%)
4,484
4,484
Interest-bearing Note
• Example:
•
Present value of principle:
•
$100,000 (PVF 5, 10%) = $100,000 x
.62092 =
$ 62,092
•
Present value of interest:
• $8,000 (PVF 5, 10%) = $8,000 x 3.79079
=
•
Present value of note
30,326
$ 92,418
Interest-bearing Note
• Amortization schedule:
Cash
Received
Date of issue
End of yr. 1
End of yr. 2
End of yr. 3
End of yr. 4
End of yr. 5
8,000
8,000
8,000
8,000
8,000
40,000
10%
Interest
Revenue
$
9,242
9,366
9,503
9,653
9,818
47,582
Discount
Amortized
$
1,242
1,366
1,503
1,653
1,818
7,582
Carrying
Amount
of Note
$ 92,418
93,660
95,026
96,529
98,182
100,000
Interest-bearing Note
• Journal entries:
Date
Account Title
Jan. yr. 1 Notes receivable
Debit
100,000
Discount on notes receivable
7,582
Cash
Dec. yr. 1 Cash
Disount on notes receivable
Interest revenue
($92,418 x 10%)
Credit
92,418
8,000
1,242
9,242
Valuation of Notes Receivable
Short-Term reported at Net Realizable Value (same
as accounting for accounts receivable).
Long-Term
 Companies have option to use fair value.
 Receivables recorded at fair value.
 Unrealized gains or losses reported as part of net
income.
• Impaired when it is probable that creditor will be unable
to collect all amounts due (both principal and interest).
Receivable should be written off and a loss recorded.
Transferring Receivables
•
Owner may transfer accounts or notes
receivables to another company for cash.
•
Reasons:
Competition.
Sell receivables because money is tight.
Billing / collection are time-consuming and
costly.
Transfer accomplished by:
Secured borrowing
Factoring
• Factors are finance companies or banks that
buy receivables from businesses for a fee.
Selling Receivables
• Sale without recourse:
Purchaser assumes risk of collection
Transfer is outright sale of receivable
Seller records loss on sale
Seller uses Due from Factor (receivable) account to
cover discounts, returns, and allowances
• Sale with recourse:
Seller guarantees payment to purchaser
Financial components approach used to record
transfer
Secured Borrowing Versus Sales
• The FASB concluded that a sale occurs only if the seller
surrenders control of the receivables to the buyer. Three
conditions must be met:
Recording Receivables
1. Segregate the different types of receivables that a
2.
3.
4.
5.
6.
company possesses, if material.
Appropriately offset the valuation accounts against the
proper receivable accounts.
Determine that receivables classified in the current
assets section will be converted into cash within the year
or the operating cycle, whichever is longer.
Disclose any loss contingencies that exist on the
receivables.
Disclose any receivables designated or pledged as
collateral.
Disclose all significant concentrations of credit risk
arising from receivables.
Account Receivable Turnover
•
This ratio used to:
Assess the liquidity of the receivables.
Measure the number of times, on
average, a company collects receivables
during the period.
Evaluating Receivables
• Related to credit sales; therefore, the amounts,
changes in amount, and allowance for bad debts
important considerations
• Aggressive revenue recognition would be
associated with rising AR balances, often without
increasing bad debts allowance
• Evaluate sales, accounts receivable & allowance
for bad debts together (i.e., they are interrelated)
• Large and growing receivables suggest declining
credit terms
• Potential for factoring or “selling” to a special
purpose entity (SPE)
Bad Debts & Other Reserves
• Companies may have dozens or hundred of reserve
accounts; an income smoothing (“cookie jar reserve”)
issue
• Allowance for doubtful accounts is the only reserve
account likely to be disclosed (plus loan loss reserves
for financial institutions)
• The allowance should be a reasonable percent of sales
& expected to stay relatively constant
• Doubtful accounts for the Dow 30 (24 disclosers)
averaged 2% of receivables
• Large drops in this percentage are a potential signal of
Earnings Manipulation (e.g., GM & Ford in 2005)