© 2013 The McGraw-Hill Companies, Inc.

CASH AND CASH AND RECEIVABLESRECEIVABLES

Chapter 7

7 - 2

Cash and Cash Equivalents

Balances incurrent bank

accounts

Balances incurrent bank

accounts

Currency and coinsCurrency and coins

Cash equivalents are short-term, highly liquid investments that can be readily converted to cash.

Cash equivalents are short-term, highly liquid investments that can be readily converted to cash.

Money marketfunds

Money marketfunds Treasury billsTreasury bills Commercial

paperCommercial

paper

CashCash

Items for deposit such as checks and money orders

from customers

Items for deposit such as checks and money orders

from customers

7 - 3

Internal Control

Encourages adherence to company policiesand procedures

Encourages adherence to company policiesand procedures

Promotes operational efficiency

Promotes operational efficiency

Minimizes errorsand theft

Minimizes errorsand theft

Enhances the reliability and accuracy of accounting dataEnhances the reliability and accuracy of accounting data

7 - 4

Internal Control Procedures

Cash Receipts

• Separate responsibilities for receiving 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 Receipts

• Separate responsibilities for receiving 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

• All disbursements, except petty cash, made by check.

• Separate responsibilities for cash disbursement documents, check authorization, check signing, and record keeping.

• Checks should be signed only by authorized individuals.

Cash Disbursements

• All disbursements, except petty cash, made by check.

• Separate responsibilities for cash disbursement documents, check authorization, check signing, and record keeping.

• Checks should be signed only by authorized individuals.

7 - 5

Restricted Cash andCompensating Balances

Restricted CashManagement’s intent to use a certain amountof cash for a specific purpose – future plant expansion, future payment of debt.

Compensating BalanceMinimum balance that must bemaintained in a company’s bankaccount as support for fundsborrowed from the bank.

Restricted CashManagement’s intent to use a certain amountof cash for a specific purpose – future plant expansion, future payment of debt.

Compensating BalanceMinimum balance that must bemaintained in a company’s bankaccount as support for fundsborrowed from the bank.

7 - 6

U.S. GAAP vs. IFRS

• Bank overdrafts are treated as liabilities.

In general, cash and cash equivalents aretreated similarly under IFRS and U.S. GAAP. One difference

is highlighted below.

• Bank overdrafts may be offset against other cash accounts.

7 - 7

Accounts Receivable

Result from the credit sales of goods or

services to customers.

Are classified as current assets.

Are recorded net of trade discounts.

7 - 8

Cash discountsCash discounts

Cash Discounts

7 - 9

2/10,n/302/10,n/30Number of

days discount is available

Number of days

discount is available

Otherwise, net (or all)

is due

Otherwise, net (or all)

is due

CreditperiodCreditperiod

Discount percent

Discount percent

Cash Discounts

7 - 10

Cash Discounts

Sales are recorded at the invoice

amounts.

Sales are recorded at the invoice

amounts.

Sales discounts are recorded as reduction of revenue if payment is

received within the discount period.

Sales discounts are recorded as reduction of revenue if payment is

received within the discount period.

Gross Method

Sales are recorded at the invoice amount less the discount.

Sales are recorded at the invoice amount less the discount.

Sales discounts forfeited are recorded

as interest revenue if payment is received after

the discount period.

Sales discounts forfeited are recorded

as interest revenue if payment is received after

the discount period.

Net Method

7 - 11

Cash Discounts On October 5, Hawthorne sold merchandise for $20,000 with terms 2/10,

n/30. On October 14, the customer sent a check for $13,720 taking advantage of the discount to settle $14,000 of the amount. On November

4, the customer paid the remaining $6,000.

7 - 12

Merchandise may be

returned by a customer to a supplier.

A special price reduction, called

an allowance, may be given as an incentive to

keep the merchandise.

Sales Returns

To avoid misstating the financial statements, sales revenue and accounts receivable

should be reduced by the amount of returns in the period of sale if the amount of returns

is anticipated to be material.

7 - 13

Sales ReturnsDuring the first year of operations, Hawthorne sold $2,000,000 of merchandise that had cost them $1,200,000 (60%). Industry

experience indicates 10% return rate. During the year $130,000 was returned prior to customer payment. Record the

returns and the end of the year adjustment.

Actual ReturnsSales returns 130,000

Accounts receivable 130,000Inventory 78,000

Cost of goods sold (60%) 78,000Adjusting EntriesSales returns 70,000

Allowance for sales returns 70,000Inventory-estimated returns 42,000

Cost of goods sold (60%) 42,000

7 - 14

Subsequent valuation of AR: The Incurred Loss Model

7 - 15

The Incurred Loss Model

7 - 16

Notes Receivable

A written promise to pay a specificamount at a specific future date.

Even for maturities less than 1 year, the

rate is annualized.

Even for maturities less than 1 year, the

rate is annualized.

7 - 17

Interest-Bearing Notes On November 1, 2013, West, Inc. loans $25,000 to Winn Co. The

note bears interest at 12% and is due on November 1, 2014.

Prepare the journal entry on November 1, 2013, December 31, 2013, (year-end) and November 1, 2014 for West.

November 1, 2013Notes receivable 25,000

Cash 25,000December 31, 2013Interest receivable 500

Interest revenue 500November 1, 2014Cash 28,000

Note receivable 25,000Interest receivable 500Interest revenue 2,500

7 - 18

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.

7 - 19

Noninterest-Bearing NotesOn Jan. 1, 2013, West, Inc. accepted a $25,000 noninterest-bearing note from Winn, Co as payment for a sale. The note

is discounted at 12% and is due on Dec. 31, 2013.

Prepare the journal entries on Jan. 1, 2013, and Dec. 31, 2013.

On Jan. 1, 2013, West, Inc. accepted a $25,000 noninterest-bearing note from Winn, Co as payment for a sale. The note

is discounted at 12% and is due on Dec. 31, 2013.

Prepare the journal entries on Jan. 1, 2013, and Dec. 31, 2013.

January 1, 2013Notes receivable 25,000

Discount on notes receivable 3,000Sales revenue 22,000

($25,000 * 12% = $3,000)December 31, 2013Cash 25,000Discount on notes receivable 3,000

Interest revenue 3,000Note receivable 25,000

7 - 20

Subsequent valuation of NR: Impairment

7 - 21

Subsequent valuation of NR: When Receivable is Continued but with Modified Terms

When a company holds a receivable from another company, there is some potential

that the receivable will eventually be impaired.

Impairment of a receivable occurs if the company

believes it is probable that it will not receive all of the cash

flows (principal and any interest payments) associated

with the receivable.

7 - 22

Subsequent valuation of NR: When Receivable is Settled Outright

7 - 23

U.S. GAAP vs. IFRS

• U.S. GAAP allows a “fair value option” for accounting for receivables.

• U.S. GAAP does not allow receivables to be accounted for as “available for sale” investments.

• U.S. GAAP requires more disaggregation of accounts and notes receivable in the statement of financial position or notes.

In general, IFRS and U.S. GAAP are very similar with respect to accounts receivable and notes receivable. Differences are

highlighted below.

• IFRS restricts the circumstances in which a “fair value option” for accounting for receivables is allowed.

• In the years between 2010 and 2014, companies may account for receivables as “available for sale” investments if the approach is elected initially. After January 1, 2015, this treatment is no longer allowed.

7 - 24

Financing With Receivables

Companies may use their receivables to obtain

immediate cash.

7 - 25

Factoring Arrangements

FACTOR (Transferee)

SUPPLIER(Transferor)

RETAILER

1. Merchandise

2. Accounts Receivable

3. Accounts Receivable

4. Cash5.

Cas

h

A factor is a financial institution that buys receivablesfor cash, handles the billing and collection of thereceivables and charges a fee for the service.

A factor is a financial institution that buys receivablesfor cash, handles the billing and collection of thereceivables and charges a fee for the service.

7 - 26

Secured Borrowing

7 - 27

Sale of Receivables

Treat as a sale only if the conditions for derecognition, under IFRS No. 9 and IAS No. 39, can be met.

Treat as a sale only if the conditions for derecognition, under IFRS No. 9 and IAS No. 39, can be met.

Rights to cash flows from the receivables expire?

Continue to recognize the receivables Continuing Investment

Derecognize the receivables

Transfer rights to receive cash flows from the receivables?

Assume obligations to pay cash flows that meet three

conditions?

Transfer substantially all the risks and reward of the receivables?

Retain substantially all the risks and rewards of the receivables?

Retain control of the receivables?

NO

NO

NO

NO

NO

NO

Yes

YesYes

Yes

Yes

7 - 28

Sale of ReceivablesWithout 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, fair value of

cash and other assets received is recorded, and a financing expense or loss is recognized.

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, fair value of

cash and other assets received is recorded, and a financing expense or loss is recognized.

With recourse• Transferor (seller) retains risk of uncollectibility.• If the transaction fails to meet the three conditions

necessary to be classified as a sale, it will be treated as a secured borrowing.

With recourse• Transferor (seller) retains risk of uncollectibility.• If the transaction fails to meet the three conditions

necessary to be classified as a sale, it will be treated as a secured borrowing.

7 - 29

Sale of ReceivablesIn December 2013, the Santa Teresa Glass Company factored accounts receivable that had a book value of $600,000 to Factor Bank. The transfer was made without recourse. Under this arrangement, Santa Teresa transfers the $600,000 of receivables to Factor, and Factor immediately remits to Santa Teresa cash equal to 90% of the factored amount (90% × $600,000 = $540,000). Factor retains the remaining 10% to cover its factoring fee (equal to 4% of the total factored amount; 4% × $600,000 = $24,000) and to provide a cushion against potential sales returns and allowances.

Assume the same facts as above, except that Santa Teresa sold the receivables to Factor with recourse and estimates the fair value of the recourse obligation to be $5,000.

7 - 30

Sale of Receivables

Securitization: Transfer receivables to a SPESpecial Purpose Entity (SPE)

(usually a trust or subsidiary)

Qualifying Special Purpose Entity (QSPE)

Changing rules…eliminate QSPE…require consolidation!

Participating Interests: Transfer portion of a receivable

Example: transfer right to interest, but retain right to principal

Changing rules…require a partial transfer be treated as a secured borrowing, unless specific conditions

are met!

7 - 31

Interest receivable 5,000Interest revenue 5,000

Transfers of Notes ReceivableOn December 31, Stridewell accepted a nine-month 10

percent note for $200,000 from a customer. Three months later on March 31, Stridewell discounted the note at its local bank. The bank’s discount rate is 12 percent.

$200,000 × 10% × 3/12

Before preparing the journal entry to record the discounting, Stridewell must record the accrued interest on the note

from December 31 until March 31.

7 - 32

Transfers of Notes Receivable

Cash 202,100Loss on sale of note receivable 2,900

Notes receivable 200,000Interest receivable 5,000

$205,000 - $202,100

7 - 33

U.S. GAAP vs. IFRS

• U.S. GAAP focuses on whether control of assets has shifted from the transferor to the transferee.

The U.S. GAAP and the IFRS approaches often lead to similar accounting treatment for transfers

of receivables.

• IFRS requires a more complex decision process. The company has to have transferred the rights to receive the cash flows from the receivable, and then considers whether the company has transferred “substantially all of the risks and rewards of ownership,” as well as whether the company has transferred control.

7 - 34

This ratio measures how many times a company converts its

receivables into cash each year.

Net Sales Average Accounts Receivable

ReceivablesTurnover

Ratio=

This ratio is an approximation of the number of days the average accounts

receivable balance is outstanding.

365 Receivables Turnover Ratio

Average Collection

Period=

Receivables Management

7 - 35

Symantec Corp. vs. CA, Inc. comparisonSymantec Corp. vs. CA, Inc. comparison

2011 2010 2011 2010Accounts receivable (net) 1,013$ 856$ 849$ 931$ Net sales 6,190 4,429

Symantec Corp. CA, Inc.2011 2010 2011 2010

Accounts receivable (net) 1,013$ 856$ 849$ 931$ Net sales 6,190 4,429

Symantec Corp. CA, Inc.

Receivables Management

(All dollar amounts in millions)

Symantec Corp CA, Inc Industry AverageReceivables Turnover 6.61 4.98 5.96 Average collection period 55.14 days 73.29 days 61.3 days

Symantec Corp CA, Inc Industry AverageReceivables Turnover 6.61 4.98 5.96 Average collection period 55.14 days 73.29 days 61.3 days

7 - 36

Appendix 7-A: Cash Controls

Bank Balance

+ Deposits in Transit

- Outstanding Checks

± Bank Errors

= Corrected Balance

Book Balance

+ Bank Collections

- Service Charges - NSF Checks

± Book Errors

= Corrected Balance

A bank reconciliation explains the difference between cash reported on bank statement and cash balance on a company’s books.

7 - 37

Petty cash is used for

minor expenditures.

Has one custodian.

Replenished periodically.

Petty cash fund

Appendix 7-A: Cash Controls

7 - 38

Appendix 7-B: Methods for Estimating Future Bad Debts

Bad debts result from credit customers who are unable to pay the amount they owe,

regardless of continuing collection efforts.

Bad debts result from credit customers who are unable to pay the amount they owe,

regardless of continuing collection efforts.

PAST DUE

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.

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.

7 - 39

Appendix 7-B: Methods for Estimating Future Bad Debts

Most businesses record an estimate of the bad debt expense by an adjusting entry

at the end of the accounting period.

Most businesses record an estimate of the bad debt expense by an adjusting entry

at the end of the accounting period.

Bad debt expense xxxAllowance for uncollectible accounts xxx

Contra asset account toAccounts Receivable.

Normally classified asa selling expense and

closed at year-end.

7 - 40

Allowance for Uncollectible Accounts

Net realizable value is the amount of the accounts receivable that the business expects to collect.

Accounts Receivable

Less: Allowance for Uncollectible Accounts

Net Realizable Value

Accounts Receivable

Less: Allowance for Uncollectible Accounts

Net Realizable Value

Income Statement ApproachBalance Sheet Approach

◦ Composite Rate◦ Aging of Receivables

Income Statement ApproachBalance Sheet Approach

◦ Composite Rate◦ Aging of Receivables

7 - 41

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.

• 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: Bad debt expense is computed as follows:

7 - 42

In 2013, MusicLand has credit sales of $400,000 and estimates that 0.6% of credit sales are uncollectible.

What is Bad Debt Expense for 2013?

Income Statement Approach

MusicLand computes estimated Bad Debt Expense of $2,400.

Bad debt expense 2,400Allowance for uncollectible accounts 2,400

7 - 43

Balance Sheet Approach• Focuses on the collectability of accounts receivable

to make the estimate of uncollectible accounts.

• Involves the direct computation of the desired balance in the allowance for uncollectible accounts.

• Focuses on the collectability 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:

7 - 44

On Dec. 31, 2013, 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 2013?

On Dec. 31, 2013, 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 2013?

Balance Sheet ApproachComposite Rate

7 - 45

Desired balance in Allowancefor Uncollectible Accounts

Balance Sheet ApproachComposite Rate

Bad debt expense 2,300Allowance for uncollectible accounts 2,300

7 - 46

Each age grouping has a different likelihood of being uncollectible.

Each age grouping has a different likelihood of being uncollectible.

Compute desired uncollectible amount. Compute desired uncollectible amount.

Balance Sheet Approach Aging of Receivables

Compare desired uncollectible amount with the existing balance in the

allowance account.

Compare desired uncollectible amount with the existing balance in the

allowance account.

Year-end Accounts Receivable is broken down into age classifications.

Year-end Accounts Receivable is broken down into age classifications.

7 - 47

At December 31, 2013, the receivables for EastCo, Inc. were categorized as follows:

Balance Sheet Approach Aging of Receivables

7 - 48

Balance Sheet Approach Aging of Receivables

• EastCo’s unadjusted balance in the allowance account is

$500.

• Per the previous computation, the desired balance is $1,350.

• EastCo’s unadjusted balance in the allowance account is

$500.

• Per the previous computation, the desired balance is $1,350.

Bad debt expense 850Allowance for uncollectible accounts 850

7 - 49

Uncollectible Accounts

As accounts become uncollectible, this entry is made:

When a customer makes a payment after an account has been written off, two journal entries are required.

Allowance for uncollectible accounts 500Accounts receivable 500

Accounts receivable 500Allowance for uncollectible accounts 500

Cash 500 Accounts receivable 500

7 - 50

If uncollectible accounts are immaterial, bad debts are simply recorded as they occur

(without the use of an allowance account).

If uncollectible accounts are immaterial, bad debts are simply recorded as they occur

(without the use of an allowance account).

Direct Write-off Method

Bad debts expense xxxAccounts receivable xxx

7 - 51

Appendix 7-C: Deciding Whether to Account for a Transfer as a Sale or a Secured Borrowing Under U.S.GAAP

Does the transfer meet the requirements for derecognition?

End of Chapter 7