INTERMEDIATE
ACCOUNTING
CCOUNTING
INTERMEDIATE A
Chapter 6
Cash and Receivables
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Cash and Cash Equivalents
• Cash, the most liquid of all assets, is the resource used to engage in day-to-day
business transactions and take advantage of business opportunities when they arise.
• coins and currency
• unrestricted funds on deposit with a bank (including foreign currency deposits)
• negotiable instruments (such as checks)
• bank drafts
• undeposited credit card sales receipts
•
Cash equivalents are short-term, highly liquid investments that are readily
convertible into known amounts of cash and so near their maturity (90 days or less)
that there is little risk of changes in value because of changes in interest rates.
•
commercial paper, treasury bills, and money market funds are examples of cash
equivalents
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Non-Cash Items
• Sinking funds are accounts into which a company deposits cash over an
extended period (e.g., to retire long-term bonds). Sinking funds are normally
reported as long-term investments.
• Certificates of deposit (CDs) are financial instruments issued by banks that
allow a company to invest idle cash for contractual periods (short-term or longterm investments).
• Bank overdrafts are overdrawn checking accounts. They are reported as current
liabilities.
• Postdated checks from customers are checks dated in the future so they become
payable on a date later than the issue date. Postdated checks are included as
receivables.
• Travel advances are funds or checks given to employees to cover out-of-pocket
expenses while traveling on company business and are classified as prepaid
items.
• Required deposits called compensating balances because they “compensate”
the bank for granting the loan.
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Classification of Cash and Noncash Items
Item
Classification
Coins and currency
Cash
Demand deposits (checking
and savings accounts)
Negotiable instruments (bank
drafts, money orders)
Foreign currencies on deposit
in foreign banks
Sinking funds
Cash
Certificates of deposit
Bank overdrafts
Short-term (or long-term)
investments
Current liabilities
Postdated checks
Receivables
Travel advances
Prepaid expenses
Compensating balances
Current or noncurrent asset
Cash
Cash
Long-term investment
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Cash Control Procedures
• Control Over Receipts: Should be designed to safeguard all cash
inflows from the time they arrive at the company until they are
deposited in its bank account.
• immediate counting of receipts by the person opening the mail or the
salesperson using the cash register, and subsequent verification by an
independent person
• daily recording of all cash receipts in the accounting records
• daily deposit of all receipts in the company’s bank account
• Control Over Payments: Should ensure that only authorized
payments are made for actual company expenditures
• making all payments by check so there is a record for every company
expenditure
• authorizing and signing checks only after an expenditure is approved
• periodically reconciling the cash balance in the bank statement with the
company’s accounting records
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Electronic Payments
• Electronic funds transfers (EFT) transfers cash between companies
electronically without the need for a check
• Accounts receivable conversion (ARC) allows for faster processing of
checks. When paper checks arrive at a lockbox, they are converted into
electronic payments, and the check itself is destroyed
• Check Clearing for the 21st Century Act (termed Check 21) is a law that
allows merchants to scan checks and transmit the digital images to the bank
instead of sending the actual check
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What are the Different Types of Receivables?
• Receivables are amounts owed to the company by customers
and other parties arising from the company’s operations
• Those receivables expected to be collected within one year or
the current operating cycle, whichever is longer, are classified
as current assets; the remainder are classified as noncurrent
• Trade receivables arise from the sale of the company’s
products or services to customers
• Notes receivable arise when customers sign debt obligations with
terms different from standard trade receivables
• Nontrade receivables arise from transactions that are not
directly related to the sale of the company’s goods and
services
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Overview of Receivables
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How are Accounts Receivable Recorded?
• The initial recognition of accounts receivable involves the proper
application of the revenue recognition criteria, as well as
consideration of any trade discounts or cash discounts, and sales
returns and allowances.
• Revenue is recognized when realization has occurred and the
revenue is earned.
• Revenue recognition criteria are usually satisfied when the product
or service is delivered. Therefore, credit sales trigger recognition of
both an asset (an account or note receivable) and revenue.
• There are two issues related to the valuation of receivables:
• initial recording of the receivables… present value versus maturity value
(maturity value most common)
• estimation of the probability of collection… normally reported at net
realizable value
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Trade Discounts and Cash (Sales) Discounts
• Companies frequently offer trade discounts (or quantity
discounts) to purchasers as a means to provide incentives to
important customers, grant price reductions for large
purchases, or to hide real prices from competitors.
• Trade discounts are usually given as a percentage reduction of the
list price of a product.
• Companies may also offer a cash discount (or sales discount)
to induce prompt payment. This discount frequently is
expressed using terms such as 2/10, n/30.
• Cash discounts have two main positive effects:
• stimulates faster collection of cash for use in current operations.
• tends to reduce the losses resulting from uncollectible accounts.
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Gross and Net Price Methods
(Slide 1 of 2)
• If a selling company extends cash discounts to its customers, it
may use either the gross or net price method to account for the
discounts
• When using the gross price method, record the total invoice
price in both the Accounts Receivable and Sales accounts at the
time of sale as if no cash discount were involved.
• When the customer pays and takes the allowable cash discount, the
company records the difference between the cash received and the
original amount of Accounts Receivable as a debit to Sales Discounts
Taken.
• Sales Discounts is a contra-revenue account.
• The gross price method is more popular because it requires less record
keeping.
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Gross and Net Price Methods
(Slide 2 of 2)
• When using the net price method, records the net invoice price (after
deducting the allowable cash discount) in both the Accounts
Receivable and Sales accounts at the time of sale.
• When the customer pays and takes the allowable cash discount, no
adjustment is needed because the amount of cash received is equal to
the recorded amount of the receivable. However, if the customer does
not take the cash discount, it pays an amount that is greater than the
amount in the company’s Accounts Receivable account. The company
credits this excess to an account entitled Sales Discounts Not Taken
• This account is an interest income account that is reported in the Other Items
section of the income statement
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Sales Returns and Allowances
• When the customer returns goods to the seller, the exchange is
called a sales return.
• In addition, when goods are sold that turn out to be defective,
the customer may retain the goods and be allowed a reduction
in the purchase price. This reduction is called a sales
allowance.
• If a company can make reliable estimates, it should record the
estimated amount of future returns and allowances in the
period of sale to correctly report net sales revenue and
appropriately report the net realizable value of ending
accounts receivable.
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How are Uncollectible Accounts Receivable
Valued? (Slide 1 of 2)
• Not all accounts receivable will be collected, some will become bad
debts. This uncertainty about the collectibility of accounts receivables
represents a loss contingency.
• GAAP requires companies to estimate their losses from loss
contingencies and deduct the amounts from income and assets when
both of the following conditions are met:
• Information available prior to the issuance of the financial statements indicates
that it is probable that an asset has been impaired at the date of the financial
statements.
• The amount of the loss can be reasonably estimated.
• Because both conditions normally are met in regard to uncollectible
accounts, most companies estimate bad debts in their financial
statements.
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How are Uncollectible Accounts Receivable
Valued? (Slide 2 of 2)
• A company can record uncollectible accounts (bad debts) by
either of two procedures:
• Allowance Method: Companies record uncollectible accounts in the
year of sale, based upon an estimate of the amount of uncollectible
accounts.
• Direct Write-Off Method: Companies record uncollectible accounts
when they determine that a specific customer account is uncollectible.
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Allowance Method
(Slide 1 of 2)
• Under the allowance method, a company attempts to forecast the
expected future bad debts in accounts receivable (i.e., a forecast of
credit risk).
• An organization can use multiple methodologies, including historical
bad debts it has incurred, its credit risk strategy and policy,
industry-wide experiences, and historical trends and economic
conditions.
• It compares this information to its current sales or accounts receivable to
determine relationships to use to estimate its current uncollectible
accounts.
• These relationships provide the information the company needs to
prepare the adjusting entry to adjust the accounts receivable to the
appropriate net realizable value and recognize the estimated bad
debt expense for the period.
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Allowance Method
(Slide 2 of 2)
• When the company records the estimate of bad debts, the journal
entry is a debit to Bad Debt Expense and a credit to Allowance for
Doubtful Accounts (alternatively, Allowance for Bad Debts or
Allowance for Uncollectible Accounts).
• Bad debt expense is normally reported on the income statement as an
operating expense.
• Allowance for Doubtful Accounts is a valuation (contra) account that is offset
against Accounts Receivable in the current assets section of the company’s
balance sheet.
• Offsetting Allowance for Doubtful Accounts against Accounts
Receivable informs financial statement users of the net realizable
value (the amount of cash expected to be collected) of the
company’s receivables.
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Estimating Bad Debt
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Percentage of Credit Sales and
Percentage of Outstanding Accounts Receivable
• Percentage of Credit Sales
• Estimating bad debts based on the relationship to credit sales matches
current bad debt expenses against current credit sales.
• This income statement oriented method results in recording bad debt
expense in the period during which credit sales occur
• Percentage of Outstanding Accounts Receivable
• Bad debts may be estimated based on the relationship between the
actual amounts not collected and accounts receivable (balance sheet
oriented)
• The goal is to determine the ending balance in Allowance for
Doubtful Accounts, and therefore the appropriate net realizable
value of Accounts Receivable
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Aging of Accounts Receivable and
Writing Off Uncollectible Accounts
• Aging of Accounts Receivable
• Individual accounts receivable are classified based on the length of time they
have been outstanding.
• An estimate of the allowance for bad debts is computed by applying
appropriate bad debts percentages to each age category.
• Writing off uncollectible accounts
• When a company determines that an individual account is uncollectible, it writes
off that account, removing it from Accounts Receivable (credit) and a debit to
Allowance for Doubtful Accounts.
• This write-off has no effect on the net realizable value of the accounts
receivable because the allowance account and the accounts receivable
balance are reduced by the same amount.
• The allowance for uncollectible accounts is an estimate and always involves
future uncertainties.
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Collection of an Account Previously Written Off
• Most accountants favor reestablishing the customer’s account
receivable and then recording the payment.
• The first entry “reverses” the initial write-off and the second
entry records the cash collection in the usual manner
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Direct Write-Off Method
• The direct write-off method, records bad debt expense when it
is determined that a specific customer account is uncollectible.
At that time, it writes off the account by debiting Bad Debt
Expense and crediting Accounts Receivable.
• While this method is simple to apply, it has the disadvantage
of matching the bad debt expenses associated with previous
sale against revenues of the current period. It also overstates
accounts receivable associated with previous sales.
• Furthermore, it allows earnings management because the
company selects the period of write-off (and expense). For
these reasons, the direct write-off method is generally not
allowed under GAAP.
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Financing Accounts Receivable
• Turning accounts receivable into cash is a popular funding
opportunity for businesses.
• The two basic forms of financing agreements that companies use to
obtain cash from accounts receivable are:
• secured borrowing (pledging or assigning)
• sale of receivables (factoring, securitizations)
• The accounting issue for transfers of receivables and other financial
assets revolves around who possesses (owns) the benefits and risks
associated with the transferred assets.
• In a transfer with recourse, the transferor retains the risk of ownership
and bears any loss from a nonpayment of receivables.
• In a transfer without recourse, the transferee has assumed all the risks
of ownership and bears any loss from a nonpayment of receivables.
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Accounting for Transfers of Accounts Receivable
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Secured Borrowing
• In a secured borrowing, a company may assign or pledge its accounts
receivable as collateral for a loan. If the company is unable to make
payments on the loan, the creditor can require the amounts collected from
the accounts receivable be used to repay the amount owed.
• Under a basic assignment agreement, the borrowing company (assignor) usually
retains ownership of the assigned accounts, incurs any bad debts, collects the
amounts due from customers, and uses these funds to repay the loan.
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Sale of Accounts Receivable
(Slide 1 of 2)
• Factoring is when a company sells its individual accounts
receivable to a financial institution (called a factor). At the
time of sale, the factor charges the selling company a
commission based who bears the risk of noncollection.
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Sale of Accounts Receivable
(Slide 2 of 2)
• In a Securitization, accounts receivable are transferred to
another entity, usually a trust or subsidiary and then sold as
financial securities (usually debt instruments) collateralized by
the accounts receivable. Investors receive cash as the accounts
receivable are paid.
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Disclosure of Financing Agreements
of Accounts Receivable
• A company should disclose the existence of the transfer of
accounts receivable parenthetically or in the notes to its
financial statements. In general, management should provide
disclosures that allow financial statement users to understand:
• the transferor’s continuing involvement, if any, with the transferred
assets
• the nature of any restrictions on transferred assets that are reported
on the balance sheet
• how servicing assets and liabilities are reported
• how the transfer of financial assets affect a company’s balance
sheet, income statement, and statement of cash flows
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How do Companies Account for Notes
Receivable?
• A note receivable is an unconditional written agreement that gives the
holder the right to collect a certain sum of money on a specific date. Notes
receivable generally have two attributes that accounts receivable do not
have:
• They are negotiable instruments, which means that they are legally
transferable among parties and may be used to satisfy debts by the
holders of these instruments.
• They usually involve interest, requiring the separation of the receivable
into its principal and interest components.
• A company may receive two types of short-term notes receivable: (1)
interest-bearing notes and (2) non-interest-bearing notes.
• When an interest-bearing note is issued, the amount borrowed (the
principal) is listed as the face value, and the interest charged is stated
as a specific rate applied to this face value.
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Sales or Assignments of Notes Receivable
• When a company sells or assigns a customer’s note receivable
at the bank, it transfers the note in exchange for cash.
• This financing arrangement is subject to the conditions as accounts
receivable sales. If all the conditions are met, the company records
the transfer as a sale.
• The discount is determined by multiplying a discount rate,
which is the interest rate charged by the financial institution,
times the maturity value of the note for the discount period
(Maturity Value × Rate × Time).
• Any gain or loss from the discounting is computed by comparing the
current book value of the note receivable (including accrued interest
revenue) plus any recourse liability to the proceeds received
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How Are Receivables Disclosed?
• In order to improve the reporting of a company’s risk, liquidity,
and financial flexibility, companies are required to disclose:
• any accounting policies related to their receivables that might be
helpful to external users
• major categories of receivables, either in the balance sheet or in the
notes to the financial statements
• any valuation accounts (e.g., allowance for doubtful accounts) as
well as the methodology used to estimate these amounts
• any receivables designated as collateral the fair value of all its
financial instruments, either on the balance sheet or in the notes
• all significant concentrations of credit risk due to its financial
instruments
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Internal Controls for Cash: Petty Cash
• A petty cash system involves a cash fund under the control of an
employee that enables a company to pay for small amounts that
might be impractical or impossible to pay by check.
• Step 1. An employee is appointed petty cash custodian, and the petty
cash fund is established. A journal entry is recorded to reduce cash and
increase petty cash.
• Step 2. Petty cash vouchers are printed, prenumbered, and given to the
custodian of the fund. The vouchers are used as evidence of
expenditures. The total of the cash in the fund plus the amounts of the
vouchers should be equal to the original amount of the fund.
• Step 3. When the amount of cash in the petty cash fund becomes low
and/or at the end of an accounting period, the vouchers are sorted into
expense categories and the remaining cash is counted. The expenses are
then recorded, and the fund is replenished.
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Bank Reconciliation
• A bank reconciliation is an analysis of the difference between
the ending cash balance in its accounting records and the
ending cash balance reported on its bank statement
• The bank statement and the company’s accounting records
usually will not be in complete agreement due to timing
differences and errors, including the following:
• outstanding check
• deposit in transit
• Charges Made Directly by the Bank (NSF or not-sufficientfunds)
• Deposits Made Directly by the Bank
• Errors
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