Chapter 7 CASH AND RECEIVABLES © 2009 The McGraw-Hill Companies, Inc. Slide 2 Cash and Cash Equivalents 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 McGraw-Hill /Irwin Treasury bills Commercial paper Slide 3 Internal Control Encourages adherence to company policies and procedures Enhances the reliability and accuracy of accounting data Promotes operational efficiency Minimizes errors and theft McGraw-Hill /Irwin Slide 4 Internal Control Procedures Cash Receipts Separate responsibilities for handling 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 • • Separate responsibilities for cash disbursement documents, check writing, check signing, check mailing, and record keeping. All disbursements, except petty cash, made by check. McGraw-Hill /Irwin Slide 5 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 bank account as support for funds borrowed from the bank. McGraw-Hill /Irwin Slide 6 Accounts Receivable Amounts due from customers for credit sales. Credit sales require: • maintaining a separate account receivable account for • each customer. accounting for bad debts and sales returns that result from credit sales. Credit sales and the resulting accounts receivable are recorded net of trade discounts, not at list price. McGraw-Hill /Irwin Slide 7 Cash Discounts increase sales Cash discounts encourage early payment increase likelihood of collections McGraw-Hill /Irwin Slide 8 Cash Discounts 2/10,n/30 Discount percent McGraw-Hill /Irwin Number of days discount is available Otherwise, net (or all) is due Credit period Slide 9 Cash Discounts Gross Method Net Method Sales are recorded at the invoice amounts. Sales are recorded at the invoice amount less the discount. Sales discounts are recorded if payment is received within the discount period. Sales discounts forfeited are recorded if payment is received after the discount period. McGraw-Hill /Irwin Slide 10 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: GENERAL JOURNAL (a) the gross method; (b) the net method. Page 56 Date Description Post. Ref. Debit Credit GROSS METHOD May 10 Accounts Receivable 5,000 Sales Revenue 5,000 NET METHOD May 10 Accounts Receivable Sales Revenue McGraw-Hill /Irwin 4,950 4,950 Slide 11 Cash Discounts Assume that on May 19, Eddy, Inc. received a check in full payment of the sale made on May 10. GENERAL 56 Prepare the journal entryJOURNAL to record the cash receiptPage if Eddy uses (a) the gross method;Post. (b) the net method. Date Description Ref. Debit Credit GROSS METHOD May 19 Cash 4,950 Sales Discount 50 Accounts Receivable 5,000 NET METHOD May 19 Cash Accounts Receivable McGraw-Hill /Irwin 4,950 4,950 Slide 12 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 GENERAL JOURNAL Page 56 sale made on May 10. Post. Ref. record Date Prepare Description Creditif the journal entry to theDebit cash receipt GROSS METHOD Eddy uses: (a) the gross method; (b) the net method. May 31 Cash 5,000 Accounts Receivable 5,000 NET METHOD May 31 Cash Interest Revenue Accounts Receivable McGraw-Hill /Irwin 5,000 50 4,950 Slide 13 Sales Returns and Allowances Sales Returns Sales Allowances Merchandise returned by a customer to a supplier. A reduction in the cost of defective merchandise. McGraw-Hill /Irwin Slide 14 Sales Returns 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 the return merchandise. Sales Returns is a entry contraforaccount thatofreduces Sales Revenue in the current accounting period. GENERAL JOURNAL Date Jun Description 1 Sales Returns Accounts Receivable McGraw-Hill /Irwin Post. Ref. Page 56 Debit Credit 750 750 Slide 15 Uncollectible Accounts Receivable 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 McGraw-Hill /Irwin Slide 16 Uncollectible Accounts Receivable 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. GENERAL JOURNAL Date Description Dec. 31 Bad Debt Expense Allowance for Uncollectible Accounts McGraw-Hill /Irwin Page 78 Post. Ref. Debit Credit #### #### Slide 17 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. Income Statement Approach Balance Sheet Approach ◦ Composite Rate ◦ Aging of Receivables McGraw-Hill /Irwin Slide 18 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. Bad debt expense is computed as follows: Current Period Sales × Bad Debt % = Estimated Bad Debt Expense McGraw-Hill /Irwin Slide 19 Income Statement Approach In 2009, MusicLand has credit sales of $400,000 and estimates that 0.6% of credit sales are uncollectible. What is Bad Debt Expense for 2009? MusicLand computes estimated Bad Debt Expense of $2,400. $ 400,000 × 0.60% = $ 2,400 GENERAL JOURNAL Date Dec. Description 31 Bad debt expense Allowance for uncollectible accounts McGraw-Hill /Irwin Post Ref. Page 95 Debit 2,400 Credit 2,400 Slide 20 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. 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 - McGraw-Hill /Irwin Slide 21 Balance Sheet Approach Composite Rate On Dec. 31, 2009, 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 2009? McGraw-Hill /Irwin Slide 22 Balance Sheet Approach Composite Rate Desired balance in Allowance for Uncollectible Accounts $ × = $ 50,000 5.00% 2,500 Allowance for Uncollectible Accounts 200 2,300 2,500 GENERAL JOURNAL Date Dec. Description 31 Bad Debt Expense Allowance for Uncollectible Accounts McGraw-Hill /Irwin Post Ref. Page 95 Debit 2,300 Credit 2,300 Slide 23 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. McGraw-Hill /Irwin Slide 24 Balance Sheet Approach Aging of Receivables At December 31, 2009, 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, 2009 Accounts Estimated Receivable Percent Balance Uncollectible $ $ McGraw-Hill /Irwin 45,000 15,000 5,000 2,000 67,000 Estimated Allowance 1% $ 3% 5% 10% $ 450 450 250 200 1,350 Slide 25 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. 850 1,350 GENERAL JOURNAL Date Dec. Description 31 Bad Debt Expense Allowance for Uncollectible Accounts McGraw-Hill /Irwin Post Ref. Page 95 Debit 850 Credit 850 Slide 26 Uncollectible Accounts As accounts become uncollectible, this entry is made: GENERAL JOURNAL Date Description Page 69 Post. Ref. Allowance for Uncollectible Accounts Debit Credit #### Accounts Receivable #### When a customer makes a payment after an account has been writtenJOURNAL off, two journal entries are GENERAL Page 69 required. Post. Date Description Accounts Receivable Ref. Debit #### Allowance for Uncollectible Accounts Cash Accounts Receivable McGraw-Hill /Irwin Credit #### #### #### Slide 27 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 McGraw-Hill /Irwin Description Bad Debt Expense Accounts Receivable Post Ref. Page 18 Debit ##### Credit ##### Slide 28 Uncollectible Accounts Receivable Example Penn Company accrues a monthly charge to bad debt expense equal to 2 percent of credit sales. At year end, the allowance for uncollectible accounts is adjusted by aging accounts receivable. Penn’s relevant financial information for the year is: Accounts receivable, beginning balance Credit sales for the year Cash collections on account for the year Allowance for uncollectible accounts, beginning balance Actual write-offs during the year $ 305,000 1,300,000 1,250,000 (25,500) 25,000 An aging of accounts receivable at the end of the year indicates a required balance of $30,000. Determine (1) the balance in accounts receivable at year end, and (2) amount of the year-end adjustment to the allowance for uncollectible accounts. McGraw-Hill /Irwin Slide 29 Uncollectible Accounts Receivable Example Accounts Receivable 305,000 1,300,000 1,250,000 25,000 330,000 Allow a nce for Uncolle ctible Accounts 25,500 25,000 26,000 3,500 30,000 McGraw-Hill /Irwin Write-offs for the year Ending balance Monthly charge = 2% of $1,300,000 Amount needed to bring desired balance to $30,000 Slide 30 Notes Receivable A written promise to pay a specific amount at a specific future date. Face amount of the note × Annual interest rate Even for maturities less than 1 year, the rate is annualized. McGraw-Hill /Irwin × Fraction of the annual = period Interest Slide 31 Interest-Bearing Notes On November 1, 2008, West, Inc. loans $25,000 to Winn, Co. The note bears interest at 12% and is due on November 1, 2009. Prepare the journal entry on November 1, 2008, December 31, 2008, GENERAL (year-end) JOURNAL and November 1, 2009 for West. Page 56 Date Description Post. Ref. Debit Credit 2008 Nov 1 Notes Receivable 25,000 Cash Dec 31 Interest Receivable Interest Revenue $25,000 × 12% × (2 ÷ 12) = $500 McGraw-Hill /Irwin 25,000 500 500 Slide 32 Interest-Bearing Notes GENERAL JOURNAL Date Description Page 56 Post. Ref. Debit Credit 2009 Nov 1 Cash 28,000 Note Receivable Interest Receivable Interest Revenue $25,000 × 12% = $3,000 - $500 = $2,500 McGraw-Hill /Irwin 25,000 500 2,500 Slide 33 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. McGraw-Hill /Irwin Slide 34 Noninterest-Bearing Notes On January 1, 2009, West, Inc. accepted a $25,000 noninterest-bearing note from Winn, Co as payment for a JOURNAL at 12% and is duePage sale. The GENERAL note is discounted on 56 Post. December 31, 2009. Date Description Ref. Debit Credit 2009Prepare the journal entries on January 1, 2009, and Jan 1 Notes Receivable December 31, 2009 for West. 25,000 Discount on Notes Receivable 3,000 Sales Revenue 22,000 $25,000 × 12% = $3,000 Dec 31 Cash Discount on Notes Receivable McGraw-Hill /Irwin 25,000 3,000 Interest Revenue 3,000 Notes Receivable 25,000 Slide 35 Financing With Receivables Secured borrowing or sale of receivables 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. Pledging • Receivables in general are pledged as collateral for loans. • Pledged receivables are disclosed in notes to the financial statements. McGraw-Hill /Irwin Slide 36 Sale of Receivables 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. McGraw-Hill /Irwin Slide 37 Sale of Receivables 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. McGraw-Hill /Irwin Slide 38 Sale of Receivables 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. 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. McGraw-Hill /Irwin Slide 39 Discounting a Note On December 31, Apex accepted a nine-month 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 is 12 percent. Before preparing the journal to the record the discounting, Prepare the journal entry toentry record discounting of the Apex must record thereceivable accrued interest on the note from note as a sale. December 31 until March 31. GENERAL JOURNAL Date Description Page 69 Post. Ref. Mar. 31 Interest Receivable Interest Revenue $200,000 × 10% × 3/12 McGraw-Hill /Irwin Debit Credit 5,000 5,000 Slide 40 Discounting a Note 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 $ $ 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 McGraw-Hill /Irwin 200,000 15,000 215,000 (12,900) 202,100 Slide 41 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. McGraw-Hill /Irwin Slide 42 Receivables Management Electronic Arts vs. Activision comparison (All dollar amounts in millions) Accounts receivable (net) Net sales Electronic Arts Activision 2007 2006 2007 2006 $ 256 $ 199 $ 149 $ 29 3,091 1,513 Can you compute the receivables turnover ratio and the average collection period for these two companies? Receivables Turnover Average collection period McGraw-Hill /Irwin Electronic Arts 13.6 27 days Activision 17.0 21 days Industry Average 6.3 58 days Slide 43 Appendix 7 ─ Cash Controls 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 All reconciling items on the + Deposits in Transit book side - Outstanding requireChecks an adjusting entry ± Bank Errors to the cash account. = Corrected Balance McGraw-Hill /Irwin Book Balance + Bank Collections - Service Charges - NSF Checks ± Book Errors = Corrected Balance Slide 44 Appendix 7 ─ Cash Controls Petty cash is used for minor expenditures. Petty cash fund Has one custodian. McGraw-Hill /Irwin Replenished periodically. End of Chapter 7 McGraw-Hill /Irwin © 2008 The McGraw-Hill Companies, Inc.