FA2 Module 6. Current financial assets and current liabilities

Module 6. Current financial assets and
current liabilities
Nature of financial instruments
Recognition of accounts receivable
Valuation (the doubtful accounts issue)
Disposition of accounts receivable
Notes receivable
Notes payable
1. Nature of financial instruments
A financial instrument is any contract that
gives rise to a financial asset of one party and
a financial liability or equity instrument of
another party.
A financial asset is an asset that is:
a) Cash
b) An equity instrument of another entity.
c) A contractual right to (i) receive cash or
another financial asset from another party;
or (ii) to exchange financial instruments
with another party under conditions that
are potentially favourable to the entity; or
d) A contract that will or may be settled in
the entity’s own equity instruments . . .
A financial liability is a liability that is a :
a) A contractual obligation (i) to deliver cash
or another financial asset to another party;
or to exchange financial instruments with
another party under conditions that are
potentially unfavourable to the entity; or
b) A contract that will or may be settled in the
entity’s own equity instruments . . .
Categories of financial assets
1. Amortized cost – financial asset is held to
collect contractual cash flows; and the
contractual cash flows are solely principal
and interest (e. g., loans, receivables)
2. FVTPL (fair value through profit or loss) –
other financial assets, plus assets that could
be amortized cost but are meant to be sold
in the short term or where there is a related
or hedged instrument that is FVTPL
Amortized cost
Item is initially recorded at fair value
(transaction value) + any transaction costs
Subsequently measured at amortized cost,
which is initial value, minus principal
repayment, plus or minus cumulative
amortization using effective interest method
of any difference between initial amount and
maturity amount, less any reduction for
impairment or uncollectibility.
Item is initially recorded at fair value
(transaction value).
Subsequently measured at fair value, with any
gains and losses from change in fair value
recognized in earnings.
2. Cash: Composition
Cash is currency, funds on deposit in a bank
and certain negotiable instruments.
• Currency on hand
• Petty cash funds
• Bank deposits (current or savings accounts)
• Cheques, bank drafts, money orders
Cash is FVTPL (measured at fair value with
any fluctuations reported as gains and losses
on the income statement).
2. Cash: Management and control
Control of cash is of vital importance in any
business because:
• Cash can be easily concealed and transported
• Everybody wants it (high inherent risk)
• Cash is not a productive asset - it is
important to maintain sufficient cash to meet
current obligations, but no more than
Reconciliation of bank balances
The balance in the bank account at any given
time will often not agree with the balance in
the company’s books. A bank reconciliation is
an important tool in the control of cash whose
object is to identify the items that make up the
difference between the balance on the bank
statement and the balance of cash according to
the depositor’s records (i. e., the items that are
recorded by the bank or the depositor, but not
Typical bank account discrepancies
Depositor Bank action
Outstanding cheques Yes
Deposits in transit
Depositor errors
Bank service charges No
Yes Exp, cash
Interest revenue
Yes Rev, cash
NSF cheques
Yes Cash, AR
Bank errors
Yes Tell bank
Recorded by:
Procedure: Doing a bank reconciliation
1. Compare company deposits to deposits
recorded by the bank to identify deposits in
2. Compare cheques written by company to
cheques cashed by the bank to identify
outstanding cheques.
3. Record all proper bank entries not recorded
in company books.
4. Correct any company errors. Note any
bank errors.
Format of a bank reconciliation
Bal. per bank stmt
+ cash on hand
+ deposits in transit
- outstanding cheques
+/- bank errors
Correct balance
Example: A7-32
Balance per books
+ revenue from bank
- bank service charges
+/- other bank dr./cr.
+/- depositor errors
Correct balance
3. Accounts receivable
Non-derivative financial assets in the form of
claims held against customers and others for
money (IAS 39).
Trade receivables
Amounts owed by customers for goods sold
and services rendered as part of normal
business operations.
3. Accounts receivable
Nontrade receivables
Receivables that arise from transaction other
than sale of products or services that are part
of normal business operations (e. g.,
dividends, tax refunds, loans to employees).
3. Accounts receivable
Accounts receivable
Oral promises of customer to pay for goods
sold or services rendered, usually supported
by an invoice or bill, and normally payable
within 30 - 60 days.
Notes receivable
Written promises to pay, potentially arising
from many different sorts of transactions; can
be short-term or long-term.
4. Recognition of accounts receivable
Discounts offered to customers
Vendors often offer terms like 2/10, n/30 (2%
discount if payment is received within 10 days,
otherwise the full amount is due within 30
Two methods are used in practice:
Gross method: Sales/receivables are recorded
at list price; discounts taken are deducted from
Net method: Sales/receivables recorded at
value net of discount; discounts missed are
treated as interest income
4. Recognition of accounts receivable
Discounts example
Vendor Ltd. sells merchandise (list price =
$100) on credit to a customer, 2/10, n/30.
Prepare journal entries to record the sale and
payment under both the gross and net methods,
(a) that the customer pays seven days after the
merchandise is delivered.
(b) that the customer pays 30 days after the
merchandise is delivered.
4. Recognition of accounts receivable
Nonrecognition of interest
Accounts receivable are carried at face value
(the amount the customer promises to pay),
rather than the present value of the promised
payment (amortized cost). This is because:
(1) the interest component is probably
immaterial; and
(2) it is not clear what interest rate should be
used in present value calculations.
5. Valuation of accounts receivable
Accounts receivable should be valued at net
realizable value, the amount of cash the entity
expects to collect.
Accounting for uncollectible accounts
1. Direct write-off method
Uncollectible accounts are written off, and
bad debt expense recognized, when it
becomes clear that a particular account is
uncollectible. Leads to mismatching of
expense and rev, and overstates value of AR.
Accounting for uncollectible accounts
2. Allowance method
Amount of uncollectible accounts (bad debt
expense) is estimated and recorded in the year
in which credit sales occur.
Dr. Bad debt expense
Cr. Allowance for doubtful accounts
When a particular account is uncollectible,
Dr. Allowance for doubtful accounts
Cr. Accounts receivable
Estimating bad debt expense
1. Balance sheet approach/Aging method
Year-end accounts receivable are analyzed
and an estimate made of the amount of
uncollectible accounts (e. g., percentage of
total accounts receivable , aging analysis,
account-by-account analysis).
Bad debt expense =
required balance in AFDA (per AR analysis)
– unadjusted balance in AFDA
Example: A7-7
Estimating bad debt expense
2. Income stmt approach/Credit sales method
An estimate is made of the amount of this
year’s sales that will ultimately be
uncollectible, based on company’s
experience, economic conditions, etc.
Bad debt expense =
This year’s (credit) sales
Estimated bad debt percentage
Example: A7-7
6. Disposition of accounts receivable
To accelerate the conversion of accounts
receivable into cash and/or to avoid collection
problems, a company can transfer its
receivables to another company in exchange
for cash. The broad categories of transfer
transactions include:
1. Secured borrowing
2. Sale of receivables
1. Secured Borrowing
Accounts receivable are designated as
collateral for a loan. If the loan is unpaid, the
lender has the right to collect the receivables
directly from the entity’s customers.
General assignment means all receivables are
collateral. No specific entry is made to record
the transaction (aside from the Cash/Note
Payable entry). Information regarding the
assignment of accounts receivable is disclosed
in a footnote to the financial statements.
2. Sale of receivables
Receivables are sold to an outside agency(ies)
(e. g., factoring, securitization) that collects
directly from the company’s customers (the
Sale or transfer without recourse
The purchaser of the receivables assumes the
risk of collectibility.
Sale or transfer with recourse
The seller of the receivables guarantees
payment if the debtor fails to pay.
Sale without recourse
The purchaser assumes all risks of
collectibility and absorbs any credit losses.
Cash is received from purchaser of AR
Dr. Cash
Cr. Accounts receivable
Dr. Financing expense
Purchaser collects AR without problem
NO ENTRY in the books of entity which sold
the accounts receivable.
Sale with recourse
We will not deal with that in FA2
Sale or secured borrowing?
Derecognition (recording a sale) occurs if and
only if one of the following conditions are met:
 Rights to cash flow from receivables has
 Transferor has no continuing involvement in
 Transferee (purchaser) is free to retransfer
receivables for its own benefit
If none of the three are met, the transaction
should be treated as a loan.
Example: A7-12 (part 1)
7. Notes receivable
Notes receivable are similar to accounts
receivable in that they represent amounts
owed by external entities. Unlike accounts
receivable, notes are contracts, typically
signed by both parties, that generally specify
payment dates and interest rates. They can be
trade or non-trade receivables, current or noncurrent, etc.
Unlike accounts receivable, the interest rate is
often specified and is frequently material.
Notes receivable vocabulary
Face value (or principal): This is the amount
written on the face of the note and represents
the total amount that will be paid by the
debtor (plus any explicit interest).
Interest rate: This is the rate that is written on
the face of the note and is used in the
calculation of interest payments.
Amortized cost: after acquisition, notes are
generally measured at amortized cost = initial
value – principal repayments +/- amortization
of discount/premium – any impairment
Types of notes receivable
1. Notes bearing normal interest rate
These notes are initially recorded at face value
which is equal to present value of implied
future cash flows.
2. Notes bearing abnormal (usually, low or
zero) interest rates
These notes are valued at their fair market
values, which is the present value of the
implied cash flows discounted at a normal
interest rate. With notes like this, face value
is not equal to fair value.
Recording notes receivable
1. Notes bearing normal interest rates
Dr. Note receivable Face value (Face)
Cr. Revenue (or whatever)
If the note is bearing a “normal” interest rate (i.
e., the rate at which we would discount the
future cash flows in computing the present
value), the present value of the implied cash
flows is equal to the face value of the note.
Recording notes receivable
2. Notes bearing abnormal (low or zero) interest
Net method
Dr. Note receivable PV of cash flows
Cr. Revenue (or whatever)
Gross method
Dr. Note receivable Face value (Face)
Cr. Discount on note receivable (Face-PV)
Cr. Revenue (or whatever)
8. Notes payable
Like accounts payable, notes payable are
amounts owed to external parties. Unlike
accounts payable, notes payable are contracts,
typically signed by both parties, that generally
specify payment dates and interest rates.
The interest rate on a note payable is often
specified and is frequently material.
Accounting for notes payable is just like
accounting for notes receivable, but from the
borrowers’ point of view.
Example: A7-20
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