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Intermediate Accounting, Intermediate Accounting, 9ed9ed

Kieso and WeygandtKieso and Weygandt

Prepared byPrepared by

Catherine Katagiri, CPACatherine Katagiri, CPA

The College of Saint RoseThe College of Saint Rose

Albany, New YorkAlbany, New York

John Wiley & Sons, IncJohn Wiley & Sons, Inc..

Chapter 7: Cash and Chapter 7: Cash and ReceivablesReceivables

After studying this chapter you should be able to:After studying this chapter you should be able to:• Identify items considered cash.

• Indicate how cash and related items are reported.

• Define receivables and identify the different types of receivables.

• Explain accounting issues related to recognition of accounts receivable.

• Explain accounting issues related to valuation of accounts receivable.

• Explain accounting issues related to recognition of notes receivable.

• Explain accounting issues related to valuation of notes receivable.

• Explain accounting issues related to the disposition of accounts and notes receivable.

• Explain how receivables are reported and analyzed.

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CashCash

• Cash--Current asset unless restricted.

– Demand deposits

– Petty cash

– Money orders

– Certificates of deposit

– Savings

– IOUs, postdated checks (these are receivables)

– Restrictions:

• Compensating balances--Arrangements must be

properly disclosed.

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CashCash

– Bank overdrafts--Current liabilities. Generally not

offset against current assets unless in same bank as

another cash account. Proper disclosure required.

• Cash and cash equivalents

– Cash equivalents are short-term, highly liquid

investments that are both

• readily convertible to cash.

• so near to maturity that they represent

insignificant risk of interest rate changes.

– Generally only investments with original maturities of

three months or less fall under this classification.

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Cash ControlsCash Controls

• Management--Control of cash.

– Cash--Highly liquid, easily removed, etc.

– Need to avoid deficiency or excess of cash.

– Control

• Limit access.

• Separate assets from the records for the asset.

• Separation of duties.

– Electronic funds transfers, use of ATMs, debit cards

(your account to the bank is an A/P--Decrease your

balance by a debit to reflect payment of bills, etc.)

– Minimize the float period (lockboxes, credit cards, etc.)

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• Imprest Petty Cash Account--See appendix on cash

controls.

– Set up correctly to minimize any potential loss as well

as time spent on what should be an immaterial

account.

– Violates internal control (no separation).

– Use of the over and short account.

– Review entries for

• Setting up of fund.

• Reimbursement of fund.

• Increase in the size of the fund.

Cash ControlsCash Controls

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• Physical protection of cash.

– Minimize cash on hand.

– Deposit receipts intact, daily.

– Timely bank reconciliations done.

– Prenumbered checks used and accounted for.

– Use of a voucher system for cash disbursements.

Cash ControlsCash Controls

• Bank Reconciliation (see reconciling items page 361)

– Please see the following example of the bank

reconciliation form. From the bank reconciliation the

required AJEs to update balance of cash are drawn

up.

8885

Books (GL amount) Bank statement (end of period)Books (GL amount) Bank statement (end of period)

Plus: Receipts Plus:

Notes collected Deposits in transit

Interest earned Errors

Errors

Less: Disbursements Less:

NSF checks Outstanding Checks

Service charges Errors

Bank fees

Errors

**End Balance of cash **End Balance of Cash

**The above figures should agree = “True” Cash

Bank ReconciliationBank Reconciliation

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• Current receivables--Collected within the operating cycle

or one year, whichever is longer.

– Trade receivables--From sale of stock-in-trade.

• Accounts receivable

• Notes receivable

– Non-trade receivables--Sundries-separately reported.

• Advances to employees, officers or subsidiaries.

• Deposits paid by you.

• Interest, dividends, taxes, etc.

ReceivablesReceivables

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Accounts ReceivableAccounts Receivable

Accounts receivable concerns:

• Recognition

• Valuation

• Disposition

• Recognition of A/R--Timing and Measurement

– Recorded at exchange or settlement price.

• Trade discounts

–To adjust sales price.

–Taken “off-the-top” and net

price used in accounting records.

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Accounts ReceivableAccounts Receivable

– Sales discounts

• Common terms are 2/10, net 30.

• Gross method--Overstates sales and A/R;

purchases and A/P (most common).

• Net method (theoretically best)--Must adjust

beyond due date. Discounts lost represents

additional revenue or, on purchases, interest

expense.

• Please see Illustration 7-5 for entries.

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• Valuation--Follow conservatism--Disregard Present Value!

– Carry at the Net Realizable Value (NRV)

• Historical value of A/R less a reasonable estimate of

uncollectible accounts.

• Estimated value of A/R to be ultimately collected by the firm.

– Match expenses to revenues. Concept of bad debts.

• Direct write-off method (not allowed unless immaterial

difference between it and the allowance method).

• Allowance Method--Use of the contra account the Allowance for

Doubtful (or Uncollectible) Accounts (ADA).

Bad Debt ExpenseBad Debt Expense

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– Allowance method leads to:

• Less manipulation of income.

• Follows conservatism and matching.

• Smoothes assets and income.

• Methods:

–% of sales method (I/S approach, page 340)

–% of A/R method (B/S approach , page 341)

• Please see the following example of the creation and

use of the ADA.

Bad Debt ExpenseBad Debt Expense

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Bad Debt ExpenseBad Debt Expense

• % of sales method--Income statement approach:

– Through analysis and judgment a firm decides the

percent of current credit sales that will prove

uncollectible. It then records the following entry:

Bad debt expense XX

Allowance for doubtful accounts XX

Notice you did not reference the existing balance in the

ADA. A firm will need to periodically review the ADA to

prevent excessive debit or credit (usual) balances.

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Bad Debt ExpenseBad Debt Expense

• % of receivables method--Balance sheet approach.

– Receivables classified by age (“aging”-see Illustration 7-7)

– Based on analysis, judgment and the age of the receivables,

percentages are applied to the various age groups of the

receivables.

• Generally percentages increase as receivables age.

• This yields the desired balance in the contra-A/R account the

allowance for doubtful accounts (ADA). Entry made:

Bad debt expense XX

Allowance for doubtful accounts XX

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Bad Debt ExpenseBad Debt Expense

– If a credit balance already exists, only the amount

needed to bring the balance to the proper credit

balance is entered.

– If a debit balance already exists, you have written off

more than you previously provided. You must

increase the ADA by the sum of the debit balance and

the needed credit balance from your calculations.

– This method follows the ADA closely. Matching is

not adhered to as closely as the percent of sales

method.

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Bad Debt ExpenseBad Debt Expense

• Collection of previously written-off accounts.

– Reinstate A/R to the amount collected, increase ADA.

– Reduce A/R for that amount and record cash.

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– Special Allowance Accounts:

• Allowance for Sales Returns

–To avoid distortion of A/R

–To anticipate large returns

Accounts ReceivableAccounts Receivable

Sales R & A XX

Allowance for Sales Returns (contra A/R) XX

– Allowance for Collection Expenses--to provide for

material expenses in the collection of the A/R.

Collection Expense XX

Allowance for Collection Expense (contra A/R) XX

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Notes ReceivableNotes Receivable

• Written promise to pay you, i.e., you are the payee.

– Stated amount (principle), face value.

– Stated (face) rate of interest (SR)

– Prevailing (market) rate of interest (MR)

– Maturity date; maturity value

Interest-bearing notes (Long-term):

If the stated rate (what the seller (maker) is willing to give up) equals what the buyer (you-the payee) demand, then the note will sell at face value.

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Notes ReceivableNotes Receivable

• For example: $8,000 Note Receivable (N/R); 4 years,

interest and principle paid at the end of the period,

stated rate of interest = market rate of interest = 8%

Annual cash interest = $8,000 x .08 x 360/360 days = $640

What is the “price” of this note?

Note will sell for the present value of the future cash flows

which equal the sum of (PV + PV-AO).(PV + PV-AO).

Single sum payment is the principle, 4 years hence.

Ordinary annuity is the cash interest, 4 payments which

constitute a 4 year annuity.

Discount factor = Market return = 8%; n = 4 periods

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PV = $8,000 (.73503) = $5,880

PV-AO = $640 (3.31213) = 2,120

$8,000

Notes ReceivableNotes Receivable

Journal Entry:

Note receivable 8,000

Cash 8,000

There is a “meeting of the minds!”

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What if SR not equal to the MR?

SR = 8% MR = 12% This is to say you (the payee-the

market) demand a return of 12%-you could get that with

alternative investments. The maker (the seller) is willing

to pay only 8%. What will happen to the price of the

note?

To calculate what the note will sell for: PV + PV-AOPV + PV-AO

n = 4; i = 12% (i.e., the MR)

PV = $8,000 (.63552) = $5,084

PV-AO = $640 (3.03735) = 1944

$7,028

Notes ReceivableNotes Receivable

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Notes ReceivableNotes Receivable

Journal entry:

Note receivable 8000

Cash 7028

Discount on N/R 972

Balance Sheet Presentation:

Note Receivable, par (face) $8000

- Discount N/R (+ Premium) 972

Note Receivable,net (carrying or book value) $7,028

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• The CV of the note will approach its par or face value as The CV of the note will approach its par or face value as

the maturity date approaches. the maturity date approaches.

– In this case the discount will be amortized to increase

cash revenue to the actual total interest revenue (i.e.,

to reflect the higher market rate you are actually

receiving).

– As it is amortized the discount falls and the carrying

value of the note rises. So, too, should the reported

interest revenue.

– The effective interest method reports a constant rate

of interest (not constant amount) on the changing

asset (or liability from the maker’s point of view).

Notes ReceivableNotes Receivable

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To record the receipt of interest: Use of the effective

interest method (yields constant rate of interest based

on carrying value of the asset).

Carrying value = (8,000 - 972) x .12 = 844

Notes ReceivableNotes Receivable

To record

Cash 640

Discount 204

Interest revenue 844

Now remaining discount = 972 - 204 = 768

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Notes ReceivableNotes Receivable

Next period: CV (8,000 - 768) (.12) = 868 (revenue rises)

You could also record the note at the PV to start:

N/R 7028

Cash 7028

And then record interest revenue:

Cash 640

N/R 204

Interest revenue 844

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Received for cash:Non-interest bearing note (or

unreasonable rates)

Notes ReceivableNotes Receivable

N/R 8,000

Cash 6,500

Discount N/R 1,500

Interest rate must be

imputed.

Discount is amortized to

revenue.

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Receivables

– Assigned or pledged

• As collateral in a secured borrowing

• General assignment (footnote disclosure)

Disposition of A/R and Notes Disposition of A/R and Notes ReceivableReceivable

Cash XX

A/R

XX• Specific assignment--particular A/R assigned

–Accounts are transferred to a special account.

–Collections received by borrower are remitted

(plus a fee) to the lender.

–For entries please Illustration 7-14 on page 351

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– Sales of A/R to a factor--Please see page 352.

• Note: With recourse or without recourse

• If the following conditions are met, account for as a sale and

record any gain or loss:

–Control effectively given up.

–Repurchase not required of transferor.

–Future obligation is minimal.

• Please see Illustration 7-16, sales without recourse.

• Please see Illustration 7-19, sales with recourse.

• If the above three conditions are not met it is a borrowing and

gives rise to interest expense (discount on A/R) See entries in

Illustration 7-20.

Disposition of A/R and Notes Disposition of A/R and Notes ReceivableReceivable

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Analysis of ReceivablesAnalysis of Receivables

• To help analyze the liquidity of a company’s accounts

receivable, a common financial ratio is calculated:

– Accounts receivable turnover ratio

• Measures the number of times, on average, the A/R

balance is collected within one period.Net credit sales

Average accounts receivable balance

• Note both numerator and denominator cover a

period of time.

• Yields a trend figure, not extremely precise.

• Can be converted to days by dividing into 365 days.