07 Cash and Receivables

8/3/2019 07 Cash and Receivables

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Intermediate

Financial Accounting I

Cash and Receivables


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Cash and Receivables 2

Objectives of this Chapter

I. Discuss the asset valuation methods.

II. Identify items to be included in thecash account and discuss how cashand related items are reported.

III.Explain accounting issues related tovaluation of accounts receivables --

trade discount, sales discount, salesreturns and allowance, anduncollectible accounts.


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Objectives of this Chapter (contd.)

IV.Discuss the means to use accountsreceivable as a financial instrument --pledge, assign and factor.

V. Discuss the valuation of notesreceivable and the disposition of notesreceivable.


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I. Assets Valuation Methods

A. Acquisition Cost (Historical Cost):

Used in the initial recording for all assetsexcept for:

1. Investment in debt securities-held-to-maturity.

2. Long-term monetary assets (i.e., Long-

term N/R).

B. Current Entry Value (ReplacementCost):Applied in the inventory valuation

(LCM).


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Assets Valuation Methods (contd.)

C. Current Exit Value (net selling price ormarket value):Applied in the valuationof trading securities and securities-

available-for-sale.D. Net Present Value:

Applied in the valuation of investment in

debt securities-held-to-maturity andlong-term monetary assets.

Note: SFAS 159 allows the fair value

option for financial assets and liablitlieis.


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Liquidity: The amount of time expectedto elapse until an asset is converted

into cash. Liquid assets: Assets are available for

conversion into cash quickly (i.e., cash,

receivables, trading securities, etc..). Liquidity is an indication of a companys

ability to meet its obligation.


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II. Cash

What are included in the cash account?

A.Cash on hand:

B.Cash in bank:


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Cash (contd.)

What are excluded from the cashaccount (source: FRR No. 1): Foreign currency with severe

restrictions - separate cash account. Certificates of deposits (CDs) -

Temporary Investments.

Bank overdrafts - current liabilities (i.e.,A/P) unless available cash is present inanother account in the same bank(offsetting is required in this case).


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Cash (contd.)

What are excluded from the cash account(source: FRR No. 1):Postdated checks- Receivables.

IOU

s - Receivables.Travel Advances - Prepaids.Employees Advances - Receivables.Postage stamps -Office supplies.

Special purpose funds - Investments.Compensating balances - Restricted cash.Short-term papera (i.e., commercial paper)

- S-T investments.a. Investments with maturity of 3 to 12 months.


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Restricted Cash

Compensating balances are examplesof restricted cash which may require

separate reporting.

Other restricted cash: petty cash, cashfor payroll, cash for dividends. If the

amount is material, separate reportingis required.


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Cash

Compensating Balances (CB)

CB: The portion of any depositmaintained by a corporation to

support an existing borrowingarrangements (ASR No. 148).

CB will increase the effective interest

rate. CB may also be payment for bank

services rendered to the company.


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Cash

Compensating Balances (contd.)

If the CB is significant and is to supportshort-term borrowing, the CB should bestated separately among the cash and

cash equivalent item in current assets..

If the CB is significant and is to supportlong-term borrowing, the CB should be

classified as noncurrent assets in eitherInvestments or Cash on OtherAssets using a caption such as DepositMaintained as Compensating Balance.


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Cash

Compensating Balances (contd.)

The following two situations only requirea footnote disclosure of the CB, not aseparate reporting:

1) CB arrangement exists without agreementsthat restrict the use of cash amount shownon the balance sheet statement;

2) CB arrangement is to assure future creditavailability.


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Other Cash Related Topics

Electronic Fund Transfer (EFT):

Cash Equivalents: short-term, highly liquidinvestments that are both 1) readily

convertible to known amount of cash, and 2)so near their maturity that they presentinsignificant risk of change in value.

In general, only investments with originalmaturity of three months or less qualifyunder these definitions.

Examples: Treasury bills, Commercial

paper, and Money Market Funds.


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Cash

Using Bank Account

General checking accounts

Imprest bank accounts

Lockbox accounts


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Cash Management and Control

Cash Management:1)to maintain sufficient balance of cash on

hand for day-to-day operation;2)to prevent large amount of idle cash on

hand.

Cash Control: to prevent losses of cash bytheft of fraud1

. Immediate deposit of cash.2.Cash payment by checks except for smallamounts.

3.Separation of duties.4.Bank account reconciliation.


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III.Receivables

Receivables: claims held againstcustomers and others for money, goodsor services.

Current Receivables: expected to becollected within one year or oneoperating cycle, whichever is longer.


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Receivables (contd.)

Trade Receivables: amount owed bycustomers for goods sold and servicesrendered as part of normal businessoperations (i.e., accounts receivablesand notes receivables).

Nontrade Receivables: all others (i.e.,interest receivable, advances toemployees, deposits to cover potentialdamages, etc.)


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Accounts Receivable: oral promises ofthe purchasers to pay for goods sold and

services rendered. They are usuallycollected in 30-60 days. Thus, A/R isalways reported as a current asset with

the net realizable value (i.e., A/R minusthe allowance for uncollectible accounts).


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Notes Receivable: written promises topay a certain sum of money on a

specific future date. N/R can be long-term or short-term and can beinteresting-bearing or noninterestbearing.


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Short-term N/R is reported at netrealizable value (face amount

allowances for uncollectibles accounts). Long-term N/R is reported at present

value or the fair value (i.e., the quotedmarket prices of identical assets inactive markets).


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Valuation of A/R & N/R

Valuation Adjustment(s)

1. Cash xxSales xx

No Volume Dis.Sales R&A

2. A/R xxSales xx

Net RealizableValue (NRV)

Cash Discount,Sales R&A,

Volume Dis.,Uncollectible Acc.

3. N/R xxSales xx Short-Term- NRVLong-Term-Present Value or

Fair value

Sales R&AUncollectibleaccounts (for

short-term)


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Adjustments Related to Sales

1. Volume Dis. (Trade Discounts)

2. Cash Discounts (Sales Discounts)

3. Sales Returns and Allowances

4. Uncollectible Accounts


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1. Volume Discount

When to Recognize the Adjustments: Notreflected on the J.E.

Unit price = $10Volume Dis. => 5% if purchase 100 or more units

Sale => 200 units

J.E.:Cash 1,900

Sales 1,900OR A/R 1,900

Sales 1,900


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2. Cash Discount

When to Recognize the Adjustments: AllMethods are acceptable.

A. Recognized at time of sale (Net PriceMethod)

B. Recognized at time of occurrence

(Gross price Method)C. Recognized at time of sale

(Allowance method)


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2A. Recognized at Time of Sale(Net Price Method)

Sales = $100, terms 2/10, n/30

12/26/x1 A/R 98

Sales 98

a. 1/2/x2 Cash 98

A/R 98


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2A. Recognized at Time of Sale(Net Price Method) (contd.)

If Dis. not taken:

b. 1/31/x2 Cash 100

A/R 98Cash Dis. not taken 2

q qFinance charge or Cash Dis. Forteited

(interest revenue)Note: If the discount period post on 12/31,adjustment is required to bring the A/R to the grossamount.


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2B. Recognized at time of occurrence(Gross price Method)

Sales = $100, terms 2/10, n/3012/26/x1 A/R 100

Sales 100

a. 1/2/x2 Cash 98Cash Dis. 2

AR 100

If Dis. not taken:b. 1/31/x2 Cash 100A/R 100


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2C. Recognized at Time of Sale(Allowance method)

Sales = $100, terms 2/10, n/3012/26/x1 A/R 100

Allowance for Cash Dis. 2S

ales 98a. 1/2/x2 Cash 98

Allowance 2AR 100

If Dis. not taken:b. 1/31/x2 Cash 100

A/R 100Allowance 2

Cash Dis. not taken 2


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3. Sales Returns & Allowances(FASB 48)

A. The amount of sales R&A is notsignificant.

B. The amount of sales R&A is significantand six conditions are not met.

C.The amount of sales R&A is significantand six conditions are met.


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3A. The amount of Sales R&AIs Not Significant

If the amount of sales R&A is notsignificant, sales R&A are recognized

at time of occurrence:

Sales Returns & Allowances xxx

A/R (or cash) xxx


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3B. The Amount of Sales R&A Is Significantand Six Conditions Are Not Met

If the amount of sales R&A issignificant, and the following six

conditions are not met, postpone therevenue recognition until all sixconditions are met or the return periodexpired.


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Six Conditions (SFAS No. 48)

1. Sales price is determinable or fixed;

2. Buyers have paid or have the obligation

to pay the sales price;3. The buyers obligation would not be

changed due to theft or damage of the

product after purchase;4. Sellers are not responsible for the

performance of the product;


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Six Conditions (SFAS No. 48)

5. Buyers and sellers are two separateeconomic entities;

6. The amount of returns can beestimated.

If the amount of returns is significantand these conditions are not met,revenue cannot be recognized.


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3C. The Amount of Sales R&A Is Significantand Six Conditions Are Met

Sales can be recognized in the period in whichthe sales are made.

Also, at the end of the same period, the

amount of sales returns would be estimatedand recognized.10/5/x1 A/R 10,000

Sales 10,000

12/3

1/x1

Sales R&A1

,000

Allow. for sale R& A 1,000(estimate 10% returns)

1/10/x2 Allowance for sales R&A 900A/R 900


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4. Uncollectible Accounts

Current practice: Estimate the B/D exp. atthe end of the period and recognize theexpense (SFAS No. 5).

Adjusting entry for B/D expense:Estimated B/D expense = $2,00012/31 B/D Expense 2,000

Allowance for

Doubtful accounts 2,000When B/D actually occurred: ($200 B/D)

Allowance for doubtful Accounts 200A/R 200


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Estimation of B/D Expense

1. Percentage of net credit sales (I/Sapproach).

2. Percentage of accounts receivable(B/S approach).

3. Aging of accounts receivable (B/Sapproach using individual accountinformation).


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1. Percentage of Net Credit Sales (I/SApproach)

Example:

Net credit sales = $20,000

Estimated B/D exp. = 2% of net credit sales

AdjustingEntry

12/31 B/D Expense 400

Allow. for Doubtful accounts 400


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2. Percentage of A/R(B/S Approach)

A/R Balance = $50,000Estimated B/D = 1% of A/RBalance of the allow for doubtful accounts prior

to the adjustment = $300

The new balance of the allow. for doubtfulaccounts = $50,000 x 1% = $500

Bad Debt Expense = $500 - 300 = 200

AdjustingEntryB/D expense 200

Allowance for Doubtful accounts 200


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Age Amount B/D (%) Allowance Amount0-30 $10,000 1 $100

31-60 $7,000 2 $14061-90 $4,000 3 $120over 90 $2,000 4 $80

Total $440

3. Aging-of-A/R

The balance of the allow. acct. = $100

B/D expense = $440 - 100 = 340

12/31 adjusting entry:B/D Exp. 340

Allowance for Doubtful Accounts 340


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Earnings Management

Managers can use the discretionaryaccruals to manipulate the income

number.

Examples of discriminatory accruals:

bad debt expense, warranty expense,sales returns (when expecting sig.returns), etc.


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Interest on Receivables

Most of the A/R does not bear interestif the customers pay the amount within

the term period. However, if paymentis not made within the term period, thecustomer may have to pay interest on

the unpaid balance.


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Example A

Credit sale of $1,000 was made on3/1/x1, terms 2/10 and n/30. Financial

charge is 1% per month on the unpaidbalance. The customer paid the firsthalf of the A/R on 5/1/x1 and the

second half on 6/1/x1.


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Example A (contd.)

Journal Entries:3/1/x1A/R 1,000

Sales 1,000

5/1/x1Cash 510A/R 500Interest Revenue 10 a

6/1/x1Cash 505

A/R 500Interest Revenue 5 b

a. 1% x 1000b. (1,000-500) x 1%


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Example B

Installment Sales (with Interest):

Sales Price = $1,200

CGS = $900

Sales were made on 5/1/x1, four equalpayments of $322.83 were made on 8/1/x1,11/1/x1, 2/1/x2 and 5/1/x2 with 3% of

quarterly interest rate.$1,200 = Xv 3.7171

X= $322.83


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Example B (contd.)

Accrual Method:Journal Entries5/1/x1 A/R 1,200

Sales Revenue1

,200

8/1/x1 Cash 322.83A/R 286.83Interest Revenue 36 1

11/1/x1Cash 322.83A/R 295.43Interest Revenue 27.40 2

1. 3% v 1,2002. (1,200 - 286.83) v 3%


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Example B (contd.)

2/1/x2 Cash 322.83A/R 304.30Interest Revenue 18.53 1

5/1/x2 Cash 322.83

A/R 313.43Interest Revenue 9.40 2

1. (1,200 - 286.83 - 295.43) v 3%2. (1,200 - 286.83 - 295.43 - 304.30) v 3%

A/R1,200 286.43 - 5/1/x1295.43 - 8/1/x1304.30 - 2/1/x2313.43 - 5/1/x2


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IV. Financing with Accounts Receivable toaccelerate the receipt of cash from receivables

Two ways: 1. Secured borrowing

Pledge (General Assignment) Assign (Specific Assignment)

2. Sale of receivables (Factoring) With recourse

Without recourse


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IV. Financing with Accounts Receivable(contd.)

Advantages:1) Immediate use of cash (i.e., pledge,

assign and factor);

2) Avoid the cost of billing and collection(i.e., factor).

Disadvantages:1) Service charge (i.e., assign and factor);2) Interest charge (i.e., pledge and assign)


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IV. Financing with Accounts Receivable- Reasons

Pledge and Assign: Cash shortage and other ways of

borrowing are not available or too

expensive. Factor: In some industries (i.e., durable goods such

as automobiles, equipments), product

financing is virtually mandatory to becompetitive. Companies in theseindustries often created wholly-ownedsubsidiaries specializing in receivables

financing (i.e., to buy receivables from the


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IV. Financing with Accounts Receivable Reasons (Contd.)

Factor (cont.): To avoid billing and collection costs. To avoid violation of existing lending

agreements. From a purchasers point of view,

buying receivables may be analternative of making profits when

reaching its legal lending limit.

Note: Credit card sale is a form of factorwithout recourse.


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Pledge of A/R(General assignment of A/R)

Pledge of A/R:

Use A/R as a security (collateral) to

borrow money from financialinstitutions.

No journal entries are required for the

pledge. Information related to thepledge is disclosed in the footnote.


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Pledge of A/R

Example

Borrow $100,000 by pledging allreceivables for the borrowing:

Journal Entry:Cash 100,000

Notes Payable 100,000

Notes: The companys trade accounts arepledged as collateral for the $100,000 notespayable


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Pledge of A/R

Example (contd.)

When the note is due and paid, thefollowing entry will be recorded:

Notes Payable 100,000Interest Expense 3,000

Cash 103,000

Assume a 12% interest and a 3-monthduration.


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Pledge of A/R

Example (contd.)

If the note is not paid on the maturitydate, the lending institution can seize

and collect the pledged A/R. The borrower (the company) continues

to have the control of the A/R. Cash

used to pay off the note can be fromany sources including proceedsreceived from the pledged A/R.

A i t f A t R i bl


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Assignment of Accounts Receivable(specific)

Use A/R as a mean to borrow moneyfrom banks or financial institutions.

Specific A/R are assigned as collateralfor the borrowing.

Companies (the borrowers) continue to

have the control of the A/R assignedand continue to collect assigned A/Rfrom the customers.

A i f A R i bl


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Assignment of Accounts Receivable(contd.) The amount collected from the assignedA/R must be remitted to the lendinginstitution periodically.

The proceeds collected from the assignedA/R cannot be used for any otherpurposes until all loans are paid off.

The lender usually charges:1) a servicecharge (i.e., 5% of the loan amount), 2)interest on the loan.


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Example of (Specific) Assignment

(Illustration 7-15 of KWW textbook with littlemodification for April collections.)

On March 1, 2010, Howat Mills Inc. (HM),assigns $700,000 of its accounts receivable toCitizens Bank as collateral for a $500,000borrowing. HM continues to collect the A/R; theaccount debtors are not notified of theassignment (a non-notification assignment).

Citizens Bank charges a finance charge of1

%of the A/R assigned. The annual interest on thenote is 12%. Settlement by HM to the bank ismade monthly for all cash collection on theassigned receivable.


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Example of Assignment (contd.)

Howat Mills Inc Citizens Bank

Issuance ofnote and assignment ofA/R on 3/1:

Cash 493,000Finance Charge 7,000

Notes Payable 500,000A/R Assigned 700,000

A/R 700,000

N/R 500,000Cash 493,000Finance Revenue 7,000

Collection in March of$440,000 ofassigned A/R less cash

discounts of

$6,000.S

ales returns of

$14,000 were received.Cash 434,000Cash Discounts 6,000Sales Returns 14,000

A/R Assigned 454,000

No Entry


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Howat Mills Inc Citizens BankRemitted March collections plus accrued interest ($500,000 x0.12 x 1/12 = 5,000) to the bank on 4/1:

Interest Exp. 5,000

Notes Payable 434,000Cash 439,000

Cash 439,000

Interest Rev. 5,000N/R 434,000

Collection in April of$144,000 ofassigned A/R and $2,000write-offas uncollectible:

Cash 144,000Allow. forDoub. Acct. 2,000

A/R Assigned 146,000

No Entry


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The balance sheet statement of HM on 4/1after the remittance of $434,000 cash collectedfrom A/R Assigned in March, the balance ofthe A/R assigned account is $246,000

($700,000 - $454,000) and the balance of theNotes Payable account is $66,000 ($500,000-$434,000). These two accounts will bepresented on the balance sheet statement as :

Current Assets:Accounts Receivable Assigned $246,000Notes Payable (66,000)Equity in A/R Assigned $180,000


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Sale (Factor) of Accounts Receivable

A common type of sale of A/R is a saleto a factor.

Factors are finance companies or banksthat buy receivables from businesses fora fee and then collect the receivablesdirectly from the customers.


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Sale (Factor) of Accounts Receivable

In the case of factor, A/R would betransferred to the purchaser.

The buyer would collect the accounts,not the seller.

The seller relinquishes all rights

pertaining to the future collection of A/R.


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Sale (Factor) of A/R (contd.)

Sale of A/R is a common practice insome industries such as textile,apparel, footwear, furniture, etc.

For some industries, sales financingis necessary in order to becompetitive.

Credit card transaction is also a typeof factoring arrangement.


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Sale (Factor) of A/R (contd.)

Credit Card Sale (Contd.)

The buyer (the card issuer) of the

receivable charges the seller (themerchant) a commission for thereceivables purchased.

The buyer collects directly fromcustomers (card holder).


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Accounting for Factor

Factor without recourse

Factor with recourse

Recourse is a right of a buyer ofreceivables to receive payments fromthe seller when debtors fail to pay.


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Factor without Recourse

In the case of factor without recourse,the buyer assumes the risk of

uncollectibility and absorbs any creditlosses (i.e., bad debts).

Thus, factor without recourse is a sale

of receivables both in form and insubstance.


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Example of Factor without Recourse

(Source: Illustrations 7-15 and 7-17 of Kieso, etc. textbook withsome modifications.)

Crest Textiles factors $500,000 of A/R withABC Bank on a without recourse basis. The

receivables are transferred to ABC bank on5/1. ABC bank charges 3% of financialcharge for factor without recourse and retainan amount equals to 5% of the A/R to cover

sales returns and discounts. Credit losses(bad debts) are absorbed by ABC bank due tofactor without recourse. The ABC bankexpects $4,100 of uncollectible accounts fromthe receivables purchased.



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Example of Factor without Recourse(contd.)

Crest Textiles

5/1

Cash 460

,000

Due fromFactor 25,000

Loss on Sale

of Rec.1

5,000

A/R 500,000

ABC Bank

A/R 500,000Due to

CrestT

exti. 25,000Financing Rev. 15,000Cash 460,000

Recognition ofBad DebtExp.:

Bad Debt Exp. 4,100Allow. ForDoub. Acct. 4,100



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Crest Textiles

.

Sales R&A 9,500

Sales Dis. 2,600

Due fromFactor 12,100

ABC Bank

Cash 483,800Due toCrest Texti.12,100

A/R 495,900Allow. forDoub. Acct. 4,100

A/R 100

Transactions in May and June: collects of $483,800 by ABCbank; sales R&A of $9,500; sales discounts taken of $2,600

and $4,100 bad debts written off by ABC bank.



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Crest Textiles

Cash 12,900Due fromFactor 12,900

ABC Bank

Due toCrest Texi 12,900

Cash 12,900

Final settlement between Crest Text and ABC Bank:

Note: The factors (ABC Bank) income from this factoris $15,000 - 4,100 (financing revenue -uncollectible receivables).

F t ith R


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Factor with Recourse (source: Kieso, etc.textbook)

When receivables are sold withrecourse, the seller guaranteespayment to the buyer in the event the

debtor fails to pay (or the payment ofthe debtor is less than expected by thepurchaser).

Thus, the seller retains the risk ofuncollectibility.


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Factor with Recourse

SFAS No. 140 requires that a sale ofreceivables with recourse be recognizedas a sale if all three conditions are met,

otherwise, the sale with recourse shouldbe treated as a secured borrowing.

F t ith R


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Factor with Recourse

Three Conditions

1. The transferred assets have been isolatedfrom the seller (transferor);

2. Each buyer has the right to pledge orexchange the assets it received and noconstrains attached;

3. The seller does not maintain effectivecontrol over the transferred assets throughrepurchase.


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Factor with Recourse (Contd.)

The buyer usually charges a higher feein the case of factor without recourse

than in the case of factor with recourse.

Example of Factor with Recourse


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Example of Factor with Recourse(Source: illustrations 7-18, 7-19 and 7-20 of Kieso, etc.textbook) Crest Textiles factors $500,000 of A/R with

ABC Bank on a with recourse basis. Thereceivables are transferred to ABC Bank on5/1. ABC Bank charges 3% of financial

charge for factorwith recourse and retainsan amount equals to 5% of the A/R to coversales returns and discounts. Credit losses(bad debts) are absorbed by Crest Textiles,

Inc. due to factorwith recourse. The CrestTextiles, Inc. expects $6,000of uncollectibleaccounts from the receivables factored.



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Example of Factor with Recourse(contd.) Treated as a Sale When All

Conditions are met.Crest TextileCash 460,000

Due from Factor 25,000Loss on Sale

of Receivable 21,000* A/R 500,000

Recourse Liability 6,000*$21,000= $500,000x3% +6000

orNet Proceeds = $460,000+25,000-6000=479,000.

$21,000 = $500,000 479,000

ABC Bank

A/R 500,000Due to 25,000CrestFinancingRev. 15,000Cash 460,000



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Crest Textiles

.

Sales R&A 9,500

Sales Dis. 2,600

Due fromFactor 12,100Recourse Liability 6,000

Due from Factor 6,000

ABC Bank

Cash 481,900*Due toCrest 12,100

A/R 494,000Due to Crest 6,000

A/R 000*500,000-12,100-6,000

Transactions in May and June: bad debts occurred, $6,000;sales R&A occurred,$9,500; sales discounts taken, $2,600. TheA/R collected, $481,900 (i.e., $500,000-12,100-6000).



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Example of Factor with Recourse(contd.)

Crest Textile(Treated as a Sale)

Cash 6,900a


ABC Bank

Due to Crest 6,900

Cash 6,900

S

ettlement between Crest and ABC

a. $6,000 less than in the case of factor withoutrecourse. This is due to the bad debt amount$6,000 is absorbed by the seller (CrestTextile) inthe case of factor with recourse.

What if only $5,000 bad debts occurred in stead


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What if only $5,000 bad debts occurred in steadof the expected $6,000 in factor with recourseexample on p78?

Crest Textiles

.

Sales R&A 9,500

Sales Dis. 2,600

Due fromFactor 12,100Recourse Liability 6,000


Loss onS

ale of Rec. 1,000

ABC Bank

Cash 482,900*Due toCrest 12,100

A/R 495,000Due to Crest 5,000

A/R 000

Transactions in May and June: bad debts occurred,$5,000;sales R&A occurred,$9,500; sales discounts taken, $2,600.

A/R collected, $482,900 (*500,000-12,100-5,000).

What if only $5 000 bad debts occurred


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What if only $5,000 bad debts occurred(contd.) :

Crest Textile(Treated as a Sale)

Cash 7,900a


ABC Bank

Due to Crest 7,900

Cash 7,900

Settlement between Crest and ABC

a. $5,000 less than in the case of factor withoutrecourse. This is due to the bad debt amount$5,000 is absorbed by the seller (CrestTextile) inthe case of factor with recourse.

The Profits of the Buyer under


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The Profits of the Buyer underFactorWith Recourse Unlike factor without recourse, the profits for

the buyerin the factor with recourse alwaysequal the financing revenue (i.e., $15,000 in

the above examples) due to bad debts beingcovered by the seller. Using previousexamples:

When bad debts=$6,000, the profits of ABC

= $489,100-$460,000-$6,900 =$15,000. When bad debts =$5,000, the profits ofABC=$482,900-460,000-7,900=$15,000.


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V. Notes Receivable

Note receivable: A written promissorynote; can be interest bearing or non-interest bearing.

Short-term N/R: Recorded at theamount expected to be collected (i.e.,NRV).

Interest bearing: Accrued interestrecognized at the end of a period.

Non-interest bearing


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Notes Receivable (contd.)

Long-term N/R:

1. Recorded at net present value

2. End of period valuation NPV or thefair value (SFAS 159)

Note: Reporting a long-term note receivableat the fair value is an option. Once chose,the fair value method will be used for all

subsequent periods.

Notes Receivable


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Notes Receivable

Case I: Non-Interesting Bearing Example Receiving a 3 month non-interest bearing note

on 11/1/x1 with a face amount of $10,000.11/1/x1 N/R 10,000

Sales 10,000

12/31/x1 No adjusting entry for accrued interestbecause the note is a non-interest bearing note.1/31 Cash 10,000

N/R 10,000If the note is dishonored on 1/31 =>A/R 10,000

N/R 10,000

Notes Receivable


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Notes Receivable

Case II: Interesting Bearing Example

Short-term note with interest bearing;annual interest rate = 12%.

Receiving a 3-month interest bearingnote on 11/1/x1. Face amount is$10,000 and the annual interest rate is

12%

C II ( td )


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Case II (contd.)

11/1/x1 N/R 10,000Sales 10,000

12/31/x1 Interest Receivable 200

Interest Revenue 2001/1/x2 Reversing Entry:

Interest Revenue 200Interest Receivable 200

1/31/x2 Cash 10,300N/R 10,000Interest Revenue 300

Discount of Notes


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Discount of Notes(to a bank or to any finance institution)

Example: A 3-month note with a faceamount of $10,000 (received on 11/1/x1)

is discounted on12/1/x1.

Interest rate of the note = 12% (annual)

Int. rate charged by the bank = 18% (annual)

Di t f N t ( td )


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11/1/x1

1/31/x212/1/x1

Bank is lending$10,300 on12/1/x1

Bank is receiving$10,300 on1/31/x2

Discount of Notes (contd.)

1. Maturity value of the note= $10,000 + 10,000v 12% v 3/12= $10,300

2. Interest charged by the bank (discount)= $10,300 x 18% x 2/12 = $309

Di t f N t ( td )


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Proceeds received by the firm fromdiscounting the note (the bank willdeduct the interest charge from the

proceeds):

$10,300 - 309 = $9,991

Di t f N t ( td )


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J.E. on 12/1:Cash 9,991Loss on Dis. of Note 109

N/R Discounted 10,000Interest Revenuea 100

a.Interest earned by the firm from holding the note

for one month (11/1 ~ 12/1) = $10,000v 12% v1/12 =100

Footnote (FASB): Contingent liability ofdiscounted note of $10,000

Di t f N t ( td )


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On 1/31/x2, the note is paid, the followingentry will be recorded:N/R discounted 10,000

N/R10

,000

If on 1/31/x2, the note is dishonored, thefollowing entry will be recorded:(Assuming the bank charge $10 fee)

N/R Discounted 10,000Loss on Dishonored Note 10,310

N/R 10,000Cash 10,310

L T N t R i bl


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Long-Term Notes Receivable

Initial Recording: Net present value

End of Period: Net present value or

the fair value.

Long-Term N/R


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Long Term N/R

Example A

Receiving a 2-year note on sales ofgoods on 1/1/x1. The face amount of thisnote is $100,000 and the annual interestof the note is 10%. The interests arepaid annually and the market interest rateis 12%. Present value of the note:

$100,000v 0.79719 + 10,000v 1.69005=96,620

Long-Term N/R


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Long Term N/R

Example A (contd.)1/1/x1Notes Receivable 100,000

Sales Revenue 96,620

Discounts on N/R 3,380

Effective Interest of 20x1= PV of note on 1/1/x1 v 12%

= ($100,000 - 3,380) v 12%= 11,594.4

Long-Term N/R


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Long Term N/R

Example A (contd.)12/31/x1 (recording receiving of $10,000

interest)Cash 10,000

Discount on N/R 1,594.4Interest Revenue 11,594.4

P.V. of the note on 1/1/x2= 100,000 - (3,380 - 1594.4) = 98,214.4

Effective Interest of 20x2 = PV on 1/1/x2v 12%= 98,214.4 v 12% = 11,785.7

Long-Term N/R


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Long Term N/R

Example A (contd.)12/31/x2 (recording int. received on 12/31/x2):Cash 10,000Discount on N/R 1,785.7

Int. Revenue11

,785.712/31/x1 (recording face amount of N/R

received on maturity date):Cash 100,000

N/R 100,000 Discount on N/R has been amortized to zero

after two years of amortization using theeffective interest method.

Long-Term N/R


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Long Term N/R

Example B (Similar to P7-9) On 12/31/x1 La Tourette Inc. rendered services to

Husky Corp. at an agreed price of $73,844.10,accepting $18,000 down and agreeing to acceptthe balance in four equal installments of $18,000

receivable each12/3

1. An assumed interest rate of11% is imputed. Record the journal entries for La

Tourette for the sale and for the receipts andinterest on the following dates:1. 12/31/20x1 2. 12/31/20x2

3. 12/31/20x3 4. 12/31/20x45. 12/31/20x5

Long-Term N/R


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Long Term N/R

Example B (contd.) PV of $18,000 annuity @11%, four payments

= 18,000v 3.10245 = 55,844.10

Thus, the revenue from the services

= 18,000 + 55,844.10 = 73,844.1012/31/x1

Cash 18,000Notes Receivable 72,000

Discount on N/R 16,155.9aRevenue from Services 73,844.10

a. (18,000v 4) - 55,844.10 = 16,155.9

Long-Term N/R


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g

Example B (contd.)12/31/x2 (recording install. Payment of $18,000

and the amortization of discount on N/R):

Cash 18,000

N/R 18,000

Discount on N/R 6,142.85

Interest Revenue 6,142.85a

a. Interest Revenue of 20x2= pv of note on 1/1/x2 (or 12/31/x1) v 11%= 55,844.1 v 11% = 6,142.85

Long-Term N/R


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g

Example B (contd.)12/31/x3

Cash 18,000N/R 18,000

Discount on N/R 4,838.56Interest Revenue 4,838.56a

a. Interest Revenue of 20x3= pv of note on 1/1/x3 v 11%= (55,844.1 - 18,000 + 6,142.85) v 11%= 43,986.95v 11% = 4,838.56

Long-Term N/R


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g

Example B (contd.)12/31/x4 (recording install. Payment of 18,000

and the amortization of discount on N/R):

Cash 18,000

N/R 18,000Discount on N/R 3,390.81


a. Interest Revenue of 20x4= pv of note on 1/1/x4 v 11%= (43,986.95 - 18,000 + 4,836.56) v 11%= 30,825.51 v 11% = 3,390.81

Long-Term N/R


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g

Example B (contd.)

12/31/x5

Cash 18,000

N/R 18,000

Discount on N/R 1,783.68


a. Interest Revenue of 20x5= pv of note on 1/1/x5v 11%= (30,825.51 - 18,000 + 3,390.81) v 11%= 16,216.31 v 11% = 1,783.68

Notes Received for Cash and


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Other Rights

Avon Co. accepts a 3-year, $100,000,zero-interest-bearing note from AndrewCo. plus the right to purchase 50

machines at a bargain price inexchange for $100,000 in cash.Assume that the current rate is 10%

(for a similar note without the right):

N/R Received for Cash and


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Other Rights (contd.) J.E. for Greene:

N/R 100,000Prepaid Purchase 24,868

Cash 100,000Discount on N/R 24,868

The $24,868 will be amortized as interest

revenue in next 3 years. The prepaid purchasewill be amortized (proportionally to 50machines) to increase the purchase price ofmachines.

Notes Received for Property, Goods


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p y,and Services

Example: Lenex sold a lot to Impex asan office site. Lenex accepted a 3-year

note with a maturity value of $ 93,1

69and with no stated interest rate. Theland originally cost Lenex $30,000 andhad an appraised fair value of $70,000on the selling date.

Notes Received for Property, Goods


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p y,and Services (contd.)J.E.: N/R 93,169

Dis. on N/R 23,169Land 30,000Gaina,b 40,000

a. Use the fair value of the land as the present valueof the note when the discount rate of the note isunknown. The discount rate cae be derived as10%.

b.T

he discount of N/R will be amortized in next threeyears. If the effective rate of the note is known, thepresent value of the note can be calculated. Thegain amount will be the difference between the P.V.of the note and the cost of the land. The discountamount will be the difference between the maturity

value and the P.V. of the note.

Fair Value Option


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Fair Value Option

Companies can choose the fair valueoption when the financial instrument isoriginally recognized or when an event

triggers a new basis of accounting (i.e.,acquisition).

Once chosen, the company has to usethe fair value option in subsequent

periods.

Fair Value Option An Example


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Assume that Loftus Company has notesreceivable with a fair value of $70,000 and acarrying amount of $58,000 on 12/31/2010.The company chose the fair value option for

these receivables on the initial valuation ofthese recently acquired receivables.

Adjusting Entry:

Fair Value Adjustment1

2,000

Unrealized holding gain or loss* 12,000

* Reported in the income statement



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For all subsequent periods, the fair valueof the note will be compared with thecarrying amount of the note.

The adjusting entry will be performed toadjust the carrying amount of the notesreceivable to the new fair value.

Impairment Measurement and Reporting


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113

p p gon Investment in Loan Receivables

A loan receivable impaired when it isprobable that it will not collect all amountsdue (both principle and interest).

Measurement: Compare the recorded investment (i..e,

the NRV or the carrying amount) with thepresent value of the expected future cashflows using the historical expectedinterest rate.



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114

p p g(contd.)

Example (illustration 7B-3 onP355 ofKWW textbook):

Carrying amount of investment

$100,000 The PV of expected future cash flows

on the investment at 10% historical

effective interest rate is $87,566. The loss on impairment = 100,000

87,566 = 12,434.



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115

g(contd.)

Recording of impairment losses:Bad Debt Expense 12,434

Allowance for Doubtful Accounts 12,434

Write-off of impaired receivables:

Allowance for Doubtful Accounts 12,434

Notes Receivables 12,434

Securitization


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Securitization

A sale of securities (i.e., bonds orcommercial paper) backed(collateralized ) by a pool of assets.

These assets can be mortgagereceivables (i.e., mortgage-backedsecurities), consumer loans (i.e.,

assets-backed securities), andcorporate bonds (i.e., collateralizeddebt obligations).

Securitization (contd.)


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117

( )

Securitizations are popular for tworeasons:

1. Investors have a strong appetite inacquiring collateralized securities.

2. Companies and lenders with large

amounts of receivables haveincentives to engage in securitization.

Securitization Performed by TheC


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118

Company When a company uses its assets (i.e.,

auto loan receivables) as collaterals toissue bonds (i.e., assets-backed

securities), the receivables will remainon its balance sheet.

The companys liability will be increasedfrom the increase of bonds payable.

As a result, this transaction will have anadverse effect on its return on assetsand debt/equity ratios.

The Special Purpose Entity


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119

The Special Purpose Entity

A special purpose entity (SPE) is usuallycreated by a third party which isindependent of the company withreceivables (referred to as the transferor).

The SPE serves the purpose of buyingreceivables from the transferorand issuingsecurities collateralized on the receivables

transferred from the transferor. The SPE can be in the form of a trust,

partnership or corporation and is legallydistinct from the transferor.

Procedures of Securitization


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120

Performed by A SPE

1. The transferorwill first transfer itsreceivables to the SPE.

2. The SPE issues securities (i.e.,commercial papers due in 30 days)using these receivables as collaterals.

3. The cash received by the SPE fromissuing securities will go back to thetransferorto pay off the receivablestransferred.

Procedures of SecuritizationP f d b A SPE ( td )


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121

Performed by A SPE (contd.) The SPE is served as a pass

through.

The independent third party (i.e., an

investment bank) charges thetransferorfees forcreating andoperating the SPE.

The transferorcan continue to servicethe loan for a fee.

Off Balance Sheet Financing


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122

Off Balance Sheet Financing

If the SPE is a qualifying SPE (i.e., withat least 10% of the fair value of itsbeneficial interests invested by a party

other than the transferor or its affiliates),the transferordoes not have toconsolidate the balance sheet of theSPE.

As a result, both the receivables andthe liabilities from issuing securities willappear only on the balance sheet of the

SPE, not the transferor.

Off Balance Sheet Financing( td )


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123

(contd.) The transferor, therefore, has an off-

balance sheet financing.

If the receivables went bad, the transferor

may be forced to take back receivables orthe banks eat losses.

Since the receivables on the SPEs arelong-term assets while the securitiesissued by the SPE are short termliabilities, there is a mismatch on thefinancing of SPEs assets.

Consolidation: An Update


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124

Consolidation: An Update

The concept of qualifying SPE has beeneliminated by SFAS No. 166 passed inMay 2009, and became effective as of

the beginning of the first annualreporting period beginning after Nov.2009.

The SPE has been replaced by thevariable-interest entity (VIE).

Consolidation (contd.) (source: KWW


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125

( )textbook , appendix 17B).

A VIE is an entity with 1) insufficientequity, or with 2) stockholders lackingcontrol, or with 3) stockholders not sharing

profits or losses (source: KWW textbook ,appendix 17B).

If an entity is a VIE, the risk-and-rewardmodel, instead of the voting-interest-model, is used in determining theconsolidation party.

Consolidation (contd.) (source: KWW


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( )textbook , appendix 17B).

Under the risk-and-reward model, theprimary beneficiary of a VIE needs toconsolidate the VIE.

Voting-interest-model:the party with morethan 50% of voting rights of an entity

should consolidate the entity.

The risk-and-reward model: the party who

assume majority of the risks and receivemajority of benefits associated with theentity is the primary beneficiary party and

07 Cash and Receivables

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