Intermediate Financial Accounting I Cash and Receivables.
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Transcript of Intermediate Financial Accounting I Cash and Receivables.
Intermediate Financial Accounting I
Cash and Receivables
Cash and Receivables 2
Objectives of this Chapter
I. Discuss the asset valuation methods.II. Identify items to be included in the
cash account and discuss how cash and related items are reported.
III. Explain accounting issues related to valuation of accounts receivables -- trade discount, sales discount, sales returns and allowance, and uncollectible accounts.
Cash and Receivables 3
Objectives of this Chapter (contd.)
IV.Discuss the means to use accounts receivable as a financial instrument -- pledge, assign and factor.
V. Discuss the valuation of notes receivable and the disposition of notes receivable.
Cash and Receivables 4
I. Assets Valuation Methods
A. Acquisition Cost (Historical Cost):Used in the initial recording for all assets except for:1. Investment in debt securities-held-to-
maturity.2. Long-term monetary assets (i.e., Long-
term N/R).
B. Current Entry Value (Replacement Cost): Applied in the inventory valuation (LCM).
Cash and Receivables 5
Assets Valuation Methods (contd.)
C. Current Exit Value (net selling price or market value): Applied in the valuation of trading securities and securities-available-for-sale.
D. Net Present Value:
Applied in the valuation of investment in debt securities-held-to-maturity and long-term monetary assets.
Note: SFAS 159 allows the fair value option for financial assets and liablitlieis.
Cash and Receivables 6
Cash and Receivables
Liquidity: The amount of time expected to 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 company’s ability to meet its obligation.
Cash and Receivables 7
II. Cash
What are included in the cash account?
A.Cash on hand:
B.Cash in bank:
Cash and Receivables 8
Cash (contd.)
What are excluded from the cash account (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 in another account in the same bank (offsetting is required in this case).
Cash and Receivables 9
Cash (contd.) What are excluded from the cash account
(source: FRR No. 1): Postdated checks- Receivables. IOUs - 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.
Cash and Receivables 10
Restricted Cash
Compensating balances are examples of restricted cash which may require separate reporting.
Other restricted cash: petty cash, cash for payroll, cash for dividends. If the amount is material, separate reporting is required.
Cash and Receivables 11
Cash
Compensating Balances (CB) CB: The portion of any deposit
maintained by a corporation to support an existing borrowing arrangements (ASR No. 148).
CB will increase the effective interest rate.
CB may also be payment for bank services rendered to the company.
Cash and Receivables 12
CashCompensating Balances (contd.) If the CB is significant and is to support
short-term borrowing, the CB should be stated separately among the “cash and cash equivalent item” in current assets..
If the CB is significant and is to support long-term borrowing, the CB should be classified as noncurrent assets in either “Investments” or “ Cash on Other Assets” using a caption such as “Deposit Maintained as Compensating Balance”.
Cash and Receivables 13
CashCompensating Balances (contd.)
The following two situations only require a footnote disclosure of the CB, not a separate reporting:
1) CB arrangement exists without agreements that restrict the use of cash amount shown on the balance sheet statement;
2) CB arrangement is to assure future credit availability.
Cash and Receivables 14
Other Cash Related Topics
Electronic Fund Transfer (EFT): Cash Equivalents: short-term, highly liquid
investments that are both Readily convertible to known amount of
cash, and So near their maturity that they present
insignificant risk of change in value.
Cash and Receivables 15
Cash Equivalents (CEs) In general, only investments with original
maturity of three months or less qualify under these definitions. Examples: Treasury bills, Commercial
paper, and Money Market Funds. Hard lesson learned: reporting the auction-
rate notes as CEs by Kohl’s and ADC Telecommunications resulting in sizeable write-downs of these CE during the credit crunch due to no market exist for these investments.
Cash and Receivables 16
Cash Equivalents (CEs) Although these auction-rate notes often
have long maturity dates (i.e., 30-year), they were traded on daily basis prior to the credit crunch in 2008.
This is how the holders of these notes argued to present them as CEs.
When the market for these notes froze (i.e., no buyers of these notes), the value of these assets dropped significantly to warrant a sizeable write down.
Cash and Receivables 17
Cash Equivalents (CEs) FASB is considering to separate
reporting of cash from CEs. In July 2010, FASB staff proposed to
report cash equivalents (i.e., money market fund) as short-term investments.
This project was reassessed as a low priority project and no action was taken recently.
Cash and Receivables 18
Cash
Using Bank Account
General checking accounts Imprest bank accounts Lockbox accounts
Cash and Receivables 19
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 by theft
of fraud 1. Immediate deposit of cash.2.Cash payment by checks except for small
amounts.3.Separation of duties.4.Bank account reconciliation.
Cash and Receivables 20
III.Receivables
Receivables: claims held against customers and others for money, goods or services.
Current Receivables: expected to be collected within one year or one operating cycle, whichever is longer.
Cash and Receivables 21
Receivables (contd.)
Trade Receivables: amount owed by customers for goods sold and services rendered as part of normal business operations (i.e., accounts receivable and notes receivable).
Nontrade Receivables: all others (i.e., interest receivable, advances to employees, deposits to cover potential damages, etc.)
Balance Sheet Presentation of Receivables (Illustration 7-3, KWW, 14th e)
Cash and Receivables 22
Cash and Receivables 23
Trade Receivables
Accounts Receivable (A/R): oral promises of the purchasers to pay for goods sold and services rendered. They are usually collected in 30-60 days. Thus, A/R is always reported as a current asset with the net realizable value (i.e., A/R minus the allowance for uncollectible accounts).
Cash and Receivables 24
Trade Receivables (contd.)
Notes Receivable (N/R): written promises to pay a certain sum of money on a specific future date. N/R can be long-term or short-term and can be interesting-bearing or noninterest bearing.
Cash and Receivables 25
Trade Receivables (contd.)
Short-term N/R is reported at net realizable value (face amount – allowances for uncollectibles accounts).
Long-term N/R is reported at present value or the fair value (i.e., the quoted market prices of identical assets in active markets).
Cash and Receivables 26
Valuation of A/R & N/R
Journal Entry of Transaction
Valuation of A/R or N/R
Adjustment(s)
1. Cash xx Sales xx
No Volume Dis. Sales R&A
2. A/R xx Sales xx
Net Realizable Value (NRV)
Cash Discount, Sales R&A, Volume Dis.,
Uncollectible Acc. 3. N/R xx Sales xx
Short-Term- NRV Long-Term-
Present Value or Fair value
Sales R&A
Uncollectible accounts (for short-term)
Cash and Receivables 27
Adjustments Related to Sales
1. Volume Dis. (Trade Discounts)
2. Cash Discounts (Sales Discounts)
3. Sales Returns and Allowances
4. Uncollectible Accounts
Cash and Receivables 28
1. Volume Discount
When to Recognize the Adjustments: Not reflected 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
Cash and Receivables 29
2. Cash Discounts (Sales Discounts)
When to Recognize the Adjustments: both Methods are acceptable.
A. Recognized at time of sale (Net Price Method)
B. Recognized at time of occurrence (Gross price Method)
Cash and Receivables 30
2A. Recognized at Time of Sale(Net Price Method)
Sales = $100, terms 2/10, n/3012/26/x1 A/R 98
Sales 98
a. 1/2/x2 Cash 98A/R 98
Cash and Receivables 31
2A. Recognized at Time of Sale(Net Price Method) (contd.)
If discounts were not taken:b. 1/31/x2 Cash 100
A/R 98Cash Discounts Not Taken 2
Finance charge or Cash Dis. Forfeited (interest revenue)
Note: If the discount period expired on 12/31, adjustment is required to bring the A/R to the gross amount.
Cash and Receivables 32
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 98Sales Discounts 2
AR 100If discounts were not taken:b. 1/31/x2 Cash 100
A/R 100
Cash and Receivables 33
3. Sales Returns & Allowances (FASB 48)
A. The amount of sales R&A is not significant.
B. The amount of sales R&A is significant and six conditions are not met.
C.The amount of sales R&A is significant and six conditions are met.
Cash and Receivables 34
3A. The amount of Sales R&A Is Not Significant
If the amount of sales R&A is not significant, sales R&A are recognized at time of occurrence:
Sales Returns & Allowances xxx
A/R (or cash)xxx
Cash and Receivables 35
3B. The Amount of Sales R&A Is Significant and Six Conditions Are Not Met
If the amount of sales R&A is significant, and the following six conditions are not met, postpone the revenue recognition until all six conditions are met or the return period expired.
Cash and Receivables 36
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 buyer’s 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;
Cash and Receivables 37
Six Conditions (SFAS No. 48)
5. Buyers and sellers are two separate economic entities;
6. The amount of returns can be estimated.
If the amount of returns is significant and these conditions are not met, revenue cannot be recognized.
Cash and Receivables 38
3C. The Amount of Sales R&A Is Significant and Six Conditions Are Met
Sales can be recognized in the period in which the sales are made.
Also, at the end of the same period, the amount of sales returns would be estimated and recognized.
10/5/x1 A/R 10,000Sales 10,000
12/31/x1 Sales R&A 1,000Allow. for sale R& A 1,000(estimate 10% returns)
1/10/x2 Allowance for sales R&A 900A/R 900
Cash and Receivables 39
4. Uncollectible Accounts The Allowance Method for Uncollectible Accounts:
Estimate the bad debt (B/D) expense at the end of the period and recognize the expense (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
2,000
When B/D actually occurred: (i.e.,$200 B/D)Allowance for doubtful Accounts 200
A/R200
Cash and Receivables 40
4. Uncollectible Accounts (contd.)
If $100 of the B/D recovered:A/R 100
Allow. for Doubtful Acct. 100Cash 100
A/R 100 The current practice is complied with the
matching principle. The direct write-off method (recognize the B/D
expense when it occurs) is not recommended.
Presentation of Allowance for Doubtful Accounts
Cash and Receivables 41
Cash and Receivables 42
Three Methods in the Estimation of B/D Expense
1. Percentage-of-sales (income statement approach).
2. Percentage-of-accounts receivable (balance sheet approach).
3. Aging of accounts receivable (B/S approach using individual account information).
Cash and Receivables 43
1. Percentage-of-Sales (I/S Approach)
Example:
Net credit sales = $20,000
Estimated B/D exp. = 2% of net credit sales
Adjusting Entry
12/31 B/D Expense 400
Allow. for Doubtful Accounts400
Cash and Receivables 44
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 = $300The new balance of the allow. for doubtful
accounts = $50,000 x 1% = $500Bad Debt Expense = $500 - 300 = 200
Adjusting EntryB/D expense 200
Allowance for Doubtful accounts200
Cash and Receivables 45
3. Aging of A/R Method
The balance of the allowance prior to adj.= $100
B/D Expense= $2,300 - $100 = $2,200Adj. Entry: B/D expense 2,200 Allowance for Doubtful Account. 2,200
Age Amount B/D% Allowance Amount
0-30 10,000 4 400
31-60 7,000 10 700
61-90 4,000 17 680
Over 90 2,000 26 520
Total 2,300
Cash and Receivables 46
Earnings Management
Discretionary accruals require a large degree of managers’ judgment
Managers can use the discretionary accruals to manage earnings.
Examples of discriminatory accruals: bad debt expense, warranty expense, sales returns (when expecting sig. returns), etc.
Earnings Management Using Accruals: The Case of Nortel
Background: A Canadian communication company filed bankruptcy in 2009. It was hit very hard by the technology stock price decline in the early 2000s.
Accounting Scandals: Nortel overstated its bad debt expense of 2002 in order to reduce its bad debt expense of 2003 (thus, increase its earnings) even though the outstanding accounts receivables were similar for both years.
Cash and Receivables 47
Earnings Management Using Accruals: The Case of Nortel (contd.)
Cash and Receivables 48
Earnings Management Using Accruals – Sun Trust Banks Similar to Nortel, some banks also
overstated the loan loss reserve (an expense) for outstanding loans in a good earnings year and reduce the reserve in the following year to manage earnings.
Cash and Receivables 49
Earnings Management Using Accruals – Sun Trust Banks (contd.) The SEC brought action against Sun
Trust in 1999, alleging Sun Trust manipulated its earnings by overstating loss reserve when it was not experiencing significant loan losses.
The SEC required Sun Trust to reverse the $100 million of loan loss reserve.
source: KWW,14th e, p377 and “The Mythical FDIC Fund by William M. Isaac*, AM BKR Final, 8/27/08).
Cash and Receivables 50
Presentation of Receivables (see Illustration 7-23 of KWW 14th e)
General Rules : Segregate the different types of receivables. Appropriately offset the valuation accounts
against the proper receivables. Disclose any loss contingencies. Disclose any receivables pledged as collateral. Disclose the nature of credit risk, especially the
concentration of credit risk of receivables (i.e., receivable with common characteristics.).
Cash and Receivables 51
Cash and Receivables 52
Cash and Receivables 53
Interest on Receivables
Most of the A/R does not bear interest if the customers pay the amount within the term period. However, if payment is not made within the term period, the customer may have to pay interest on the unpaid balance.
Cash and Receivables 54
Interest on Receivables
Example A
Credit sale of $1,000 was made on 3/1/x1, terms 2/10 and n/30. Financial charge is 1% per month on the unpaid balance. The customer paid the first half of the A/R on 5/1/x1 and the second half on 6/1/x1.
Cash and Receivables 55
Example A (contd.)
Journal Entries:3/1/x1 A/R 1,000
Sales 1,0005/1/x1 Cash 510
A/R 500Interest Revenue 10 a
6/1/x1 Cash 505A/R 500Interest Revenue 5 b
a. 1% x 1000 b. (1,000-500) x 1%
Cash and Receivables 56
Interest on Receivables
Example B Installment Sales (with Interest):
Sales Price = $1,200
CGS = $900
Sales were made on 5/1/x1, four equal payments 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 = X 3.7171
X = $322.83
Cash and Receivables 57
Example B (contd.) Accrual Method:
Journal Entries5/1/x1 A/R 1,200
Sales Revenue 1,2008/1/x1 Cash 322.83
A/R 286.83Interest Revenue 36 1
11/1/x1Cash 322.83A/R 295.43Interest Revenue 27.40 2
1. 3% 1,2002. (1,200 - 286.83) 3%
Cash and Receivables 58
Example B (contd.)
2/1/x2 Cash 322.83A/R 304.30Interest Revenue 18.53 1
5/1/x2 Cash 322.83A/R 313.43Interest Revenue 9.40 2
1. (1,200 - 286.83 - 295.43) 3%2. (1,200 - 286.83 - 295.43 - 304.30) 3%
A/R1,200 286.43 - 5/1/x1
295.43 - 8/1/x1304.30 - 2/1/x2313.43 - 5/1/x2
Cash and Receivables 59
IV. Financing with Accounts Receivable –to accelerate 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
Cash and Receivables 60
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)
Cash and Receivables 61
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),
product financing is mandatory to be competitive. Companies in these industries often created wholly-owned subsidiaries specializing in receivables financing.
Cash and Receivables 62
IV. Financing with Accounts Receivable – Reasons (Contd.)
Factor (cont.): To avoid billing and collection costs. To avoid violation of existing lending
agreements. From a purchaser’s point of view,
buying receivables may be an alternative of making profits when reaching its legal lending limit.
Note: Credit card sale is a form of factor without recourse.
Cash and Receivables 63
Pledge of A/R(General assignment of A/R)
Pledge of A/R:
Use A/R as a security (collateral) to borrow money from financial institutions.
No journal entries are required for the pledge. Information related to the pledge is disclosed in the footnote.
Cash and Receivables 64
Pledge of A/R
Example Borrow $100,000 by pledging all receivables
for the borrowing:
Journal Entry:
Cash 100,000Notes Payable
100,000
Notes: The company’s trade accounts are pledged as collateral for the $100,000 notes payable
Cash and Receivables 65
Pledge of A/R
Example (contd.) When the note is due and paid, the following
entry will be recorded:
Notes Payable 100,000Interest Expense 3,000
Cash 103,000
Assume a 12% interest and a 3-month duration.
Cash and Receivables 66
Pledge of A/R
Example (contd.) If the note is not paid on the maturity date,
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 from any sources including proceeds received from the pledged A/R.
Cash and Receivables 67
Assignment of Accounts Receivable(specific)
Use A/R as a means to borrow money from banks or financial institutions.
Specific A/R are assigned as collateral for the borrowing.
Companies (the borrowers) continue to have the control of the A/R assigned and continue to collect assigned A/R from the customers.
Cash and Receivables 68
Assignment of Accounts Receivable(contd.) The amount collected from the assigned
A/R must be remitted to the lending institution periodically.
The proceeds collected from the assigned A/R cannot be used for any other purposes until all loans are paid off.
The lender usually charges: 1) a service charge (i.e., 5% of the loan amount), 2) interest on the loan.
Cash and Receivables 69
Example of (Specific) Assignment
(Illustration 7-16 of KWW , 14th e with little modification for April collections.)
On March 1, 2010, Howat Mills Inc. (HM), assigns $700,000 of its accounts receivable to Citizens Bank as collateral for a $500,000 borrowing. HM continues to collect the A/R; the account debtors are not notified of the assignment (a non-notification assignment). Citizens Bank charges a finance charge of 1% of the A/R assigned. The annual interest on the note is 12%. Settlement by HM to the bank is made monthly for all cash collection on the assigned receivable.
Cash and Receivables 70
Example of Assignment (contd.)
Howat Mills Inc Citizens Bank Issuance of note and assignment of A/R on 3/1: Cash 493,000 Interest Exp. 7,000 Notes Payable 500,000 A/R Assigned 700,000 A/R 700,000
N/R 500,000 Cash 493,000 Interest Revenue 7,000
Collection in March of $440,000 of assigned A/R less cash discounts of $6,000. Sales returns of $14,000 were received. Cash 434,000 Cash Discounts 6,000 Sales Returns 14,000 A/R Assigned 454,000
No Entry
Cash and Receivables 71
Example of Assignment (contd.)
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. 5,000Notes Payable 434,000
Cash 439,000
Cash 439,000Interest Rev. 5,000N/R 434,000
Collection in April of $144,000 of assigned A/R and $2,000write-off as uncollectible:Cash 144,000Allow. for Doub. Acct. 2,000
A/R Assigned 146,000
No Entry
Cash and Receivables 72
Example of Assignment (contd.)
Howat Mills Inc Citizens BankRemitted the balance due of 66,000 ($500,000-434,000) plusinterest on May 1 ($66,000 x 0.12 x 1/12)Notes Payable 66,000Interest Exp. 660
Cash 66,660
Cash 66,660N/R 66,000Interest Rev. 660
To transfer the remaining A/R assigned to A/R when the loanis paid off:A/R 100,000
A/R Assigned 100,000 No Entry
Cash and Receivables 73
An Alternative: Accounts Receivable Are Not Transferred to A/R Assigned
Howat Mills Inc Citizens Bank Issuance of note and assignment of A/R on 3/1: Cash 493,000 Interest Exp. 7,000 Notes Payable 500,000
N/R 500,000 Cash 493,000 Interest Revenue 7,000
Collection in March of $440,000 of assigned A/R less cash discounts of $6,000. Sales returns of $14,000 were received. Cash 434,000 Cash Discounts 6,000 Sales Returns 14,000 A/R 454,000
No Entry
Cash and Receivables 74
Accounts Receivable are Not Transferred to A/R Assigned (cont)
Howat Mills Inc Citizens Bank Remitted March collections plus accrued interest ($500,000 x 0.12 x 1/12 = 5,000) to the bank on 4/1: Interest Exp. 5,000 Notes Payable 434,000 Cash 439,000
Cash 439,000 Interest Rev. 5,000 N/R 434,000
Collection in April of $144,000 of assigned A/R and $2,000 write-off as uncollectible: Cash 144,000 Allow. for Doub. Acct. 2,000 A/R 146,000
No Entry
Cash and Receivables 75
Accounts Receivable are Not Transferred to A/R Assigned (cont.)
Howat Mills Inc Citizens Bank Remitted the balance due of 66,000 ($500,000-434,000) plus interest on May 1 ($66,000 x 0.12 x 1/12) Notes Payable 66,000 Interest Exp. 660 Cash 66,660
Cash 66,660 N/R 66,000 Interest Rev. 660
To transfer the remaining A/R assigned to A/R when the loan is paid off: No Entry
No Entry
Cash and Receivables 76
Example of Assignment (contd.) The balance sheet statement of HM on 4/1 after the
remittance of $434,000 cash collected from A/R Assigned in March, the balance of the A/R assigned account is $246,000 ($700,000 - $454,000) and the balance of the Notes Payable account is $66,000 ($500,000-$434,000). These two accounts will be presented on the balance sheet statement as :
Current Assets:Accounts Receivable Assigned $246,000 Notes Payable (66,000)Equity in A/R Assigned $180,000
Cash and Receivables 77
Sale (Factor) of Accounts Receivable
A common type of sale of A/R is a sale to a factor.
Factors are finance companies or banks that buy receivables from businesses for a fee and then collect the receivables directly from the customers.
Cash and Receivables 78
Sale (Factor) of Accounts Receivable
In the case of factor, A/R would be transferred 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.
Cash and Receivables 79
Sale (Factor) of A/R (contd.)
Sale of A/R (commission is 0.75% to 1.5%) is a common practice in some industries such as textile, apparel, footwear, furniture, etc.
For some industries, sales financing is necessary in order to be competitive.
Credit card transaction is also a type of factoring arrangement (commission is 4 to 5%).
Cash and Receivables 80
Sale (Factor) of A/R (contd.)
Credit Card Sale (Contd.)
The buyer (the card issuer) of the receivable charges the seller (the merchant) a commission for the receivables purchased.
The buyer collects directly from customers (card holder).
Cash and Receivables 81
Accounting for Factor
Factor without recourse Factor with recourse
Recourse is a right of a buyer of receivables to receive payments from the seller when debtors fail to pay.
Cash and Receivables 82
Factor without Recourse (A Sale of Receivables) In the case of factor without recourse,
the buyer assumes the risk of uncollectibility and absorbs any credit losses (i.e., bad debts).
Thus, factor without recourse is a sale of receivables both in form and in substance.
Cash and Receivables 83
Example of Factor without Recourse(Source: Illustrations 7-18 Kieso, etc. textbook with some
modifications.) Crest Textiles factors $500,000 of A/R with ABC
Bank on a without recourse basis. The receivables are transferred to ABC bank on 5/1. ABC bank charges 3% of financial charge for factor without recourse and retain an amount equals to 5% of the A/R to cover sales returns and discounts. Credit losses (bad debts) are absorbed by ABC bank due to factor without recourse. The ABC bank expects $4,100 of uncollectible accounts from the receivables purchased.
Cash and Receivables 84
Example of Factor without Recourse(contd.)
Crest Textiles
5/1Cash 460,000Due from Factor 25,000Loss on Sale of Rec. 15,000
A/R 500,000
ABC Bank
A/R 500,000Due to Crest Texti. 25,000Interest Rev. 15,000Cash 460,000
Recognition of Bad Debt Exp.:Bad Debt Exp. 4,100
Allow. For Doub. Acct. 4,100
Cash and Receivables 85
Example of Factor without Recourse(contd.)
Crest Textiles
.Sales R&A 9,500Sales Dis. 2,600
Due from Factor
12,100
ABC Bank
Cash 483,800Due to Crest Texti. 12,100
A/R 495,900Allow. for Doub. Acct. 4,100
A/R 4,100
Transactions in May and June: collects of $483,800 by ABC bank; sales R&A of $9,500; sales discounts taken of $2,600 and $4,100 bad debts written off by ABC bank.
Cash and Receivables 86
Example of Factor without Recourse(contd.)
Crest Textiles
Cash 12,900Due from Factor12,900
ABC Bank
Due to Crest Texi 12,900
Cash 12,900
Final settlement between Crest Text and ABC Bank:
Note: The factor’s (ABC Bank) income from this factor is $15,000 - 4,100 (Interest revenue – bad debt expense).
Cash and Receivables 87
Factor with Recourse (source: Kieso, etc. textbook)
When receivables are sold with recourse, the seller “guarantees payment to the buyer in the event the debtor fails to pay” (or the payment of the debtor is less than expected by the purchaser).
Thus, the seller retains the risk of uncollectibility.
Cash and Receivables 88
Factor with Recourse
SFAS No. 140 requires that a sale of receivables with recourse be recognized as a sale only if all three conditions are met, otherwise, the sale with recourse should be treated as a secured borrowing.
Cash and Receivables 89
Factor with Recourse
Three Conditions1. The transferred assets have been isolated
from the transferor (beyond the reach of the seller and its creditors);
2. Each buyer (transferee) has the right to pledge or exchange the assets it received and no constrains attached;
3. The seller does not maintain effective control over the transferred assets through repurchase agreement.
Cash and Receivables 90
Factor with Recourse (Contd.)
A recourse is an example of “continuing involvement” in a transfer of receivables
In the case of factor with recourse and meeting all three criteria, the transaction will be recorded as a sale with the recognition of assets obtained and liabilities expected.
The buyer (transferee) usually charges a higher fee in the case of factor without recourse than in the case of factor with recourse.
Cash and Receivables 91
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. The receivables are transferred to ABC Bank on 5/1. ABC Bank charges 3% of financial charge for factor with recourse and retains an amount equals to 5% of the A/R to cover sales returns and discounts. Credit losses (bad debts) are absorbed by Crest Textiles, Inc. due to factor with recourse. The Crest Textiles, Inc. expects $6,000 of uncollectible accounts from the receivables factored.
Cash and Receivables
Factor with Recourse : Example (Contd.)– All Three Conditions Are Met and Treated As a Sale
Crest TextileCash 460,000Due 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 25,000
Crest Interest Rev. 15,000
Cash 460,000
Cash and Receivables 93
Example of Factor with Recourse(contd.)
Crest Textiles
.Sales R&A 9,500Sales Dis. 2,600
Due from Factor 12,100
Recourse Liability 6,000 Due from Factor 6,000
ABC Bank
Cash 481,900*Due to Crest 12,100
A/R 494,000Due to Crest 6,000
A/R 6,000*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. The A/R collected, $481,900 (i.e., $500,000-12,100-6000).
Cash and Receivables 94
Example of Factor with Recourse(contd.)
Crest Textile(Treated as a Sale)
Cash 6,900a
Due from Factor 6,900
ABC Bank
Due to Crest 6,900 Cash 6,900
Settlement between Crest and ABC
a. $6,900 is $6,000 less than $12,900 in the case of factor without recourse. This is due to the bad debt amount $6,000 is absorbed by Crest Textile in the case of factor with recourse.
Cash and Receivables 95
What if only $5,000 bad debts occurred in stead of the expected $6,000 in factor with recourse example on p78?
Crest Textiles
.Sales R&A 9,500Sales Dis. 2,600
Due from Factor 12,100
Recourse Liability 6,000 Due from Factor 5,000 Loss on Sale of Rec. 1,000
ABC Bank
Cash 482,900*Due to Crest 12,100
A/R 495,000Due to Crest 5,000
A/R 5,000
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).
Cash and Receivables 96
What if only $5,000 bad debts occurred (contd.) :
Crest Textile(Treated as a Sale)
Cash 7,900a
Due from Factor 7,900
ABC Bank
Due to Crest 7,900 Cash 7,900
Settlement between Crest and ABC
a. $7,900 is $5,000 less than in the case of factor without recourse. This is due to the bad debt amount $5,000 is absorbed by the seller (Crest Textile) in the case of factor with recourse.
Cash and Receivables 97
The Profits of the Buyer (Transferee)under Factor With Recourse
Unlike factor without recourse, the profits for the buyer in the factor with recourse always equal the interest revenue (i.e., $15,000 in the above examples) due to bad debts being covered by the seller . Using previous examples:
When bad debts=$6,000, the profits of ABC = $489,100-$460,000-$6,900 =$15,000.
When bad debts =$5,000, the profits of ABC=$482,900-460,000-7,900=$15,000.
Cash and Receivables 98
V. Notes Receivable
Note receivable: A written promissory note; can be interest bearing or non-interest bearing.
Short-term N/R: Recorded at the amount expected to be collected (i.e., NRV).
Interest bearing: Accrued interest recognized at the end of a period.
Non-interest bearing
Cash and Receivables 99
Notes Receivable (contd.)
Long-term N/R:
1. Recorded at net present value
2. End of period valuation –NPV or the fair value (SFAS 159)
Note: Reporting a long-term note receivable at the fair value is an option. Once chose, the fair value method will be used for all subsequent periods.
Cash and Receivables 100
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 interest because the note is a non-interest bearing note.1/31 Cash 10,000
N/R 10,000
If the note is dishonored on 1/31 => A/R 10,000
N/R 10,000
Cash and Receivables 101
Notes Receivable
Case II: Interesting Bearing Example
Short-term note with interest bearing; annual interest rate = 12%.
Receiving a 3-month interest bearing note on 11/1/x1. Face amount is $10,000 and the annual interest rate is 12%
Cash and Receivables 102
Case II (contd.)
11/1/x1 N/R 10,000Sales 10,000
12/31/x1 Interest Receivable 200Interest Revenue 200
1/1/x2 Reversing Entry: Interest Revenue 200
Interest Receivable 2001/31/x2 Cash10,300
N/R 10,000Interest Revenue 300
Cash and Receivables 103
Discount of Notes (to a bank or to any finance institution)
Example: A 3-month note with a face amount of $10,000 (received on 11/1/x1) is discounted on 12/1/x1.
Interest rate of the note = 12% (annual)
Int. rate charged by the bank = 18% (annual)
Cash and Receivables 104
11/1/x1
1/31/x212/1/x1
Bank is lending $10,300 on
12/1/x1
Bank is receiving $10,300 on
1/31/x2
Discount of Notes (contd.)
1. Maturity value of the note= $10,000 + 10,000 12% 3/12 = $10,300
2. Interest charged by the bank (discount)= $10,300 x 18% x 2/12 = $309
Cash and Receivables 105
Discount of Notes (contd.)
Proceeds received by the firm from discounting the note (the bank will deduct the interest charge from the proceeds):
$10,300 - 309 = $9,991
Cash and Receivables 106
Discount of Notes (contd.)
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) = $10,000 12% 1/12 =100
Footnote (FASB): Contingent liability of discounted note of $10,000
Cash and Receivables 107
Discount of Notes (contd.) On 1/31/x2, the note is paid, the following entry
will be recorded:N/R discounted 10,000
N/R 10,000
If on 1/31/x2, the note is dishonored, the following 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
Cash and Receivables 108
Long-Term Notes Receivable
Initial Recording: Net present value
End of Period: Net present value or
the fair value.
Cash and Receivables 109
Long-Term N/R
Example A Receiving a 2-year note on sales of
goods on 1/1/x1. The face amount of this note is $100,000 and the annual interest of the note is 10%. The interests are paid annually and the market interest rate is 12%. Present value of the note:
$100,000 0.79719 + 10,000 1.69005=96,620
Cash and Receivables 110
Long-Term N/R
Example A (contd.)1/1/x1Notes Receivable 100,000
Sales Revenue 96,620Discounts on N/R 3,380
Effective Interest of 20x1 = PV of note on 1/1/x1 12% = ($100,000 - 3,380) 12% = 11,594.4
Cash and Receivables 111
Long-Term N/R
Example A (contd.)12/31/x1 (recording receiving of $10,000
interest)Cash 10,000 Discount on N/R 1,594.4
Interest 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/x2 12% = 98,214.4 12% = 11,785.7
Cash and Receivables 112
Long-Term N/R
Example A (contd.)12/31/x2 (recording int. received on 12/31/x2):Cash 10,000 Discount on N/R 1,785.7
Int. Revenue 11,785.7
12/31/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 the effective interest method.
Cash and Receivables 113
Example B: Notes Received for Property, Goods and Services Example: Lenex sold a lot to Impex as
an office site. Lenex accepted a 3-year note with a maturity value of $ 93,169 and with no stated interest rate. The land originally cost Lenex $30,000 and had an appraised fair value of $70,000 on the selling date.
Cash and Receivables 114
Notes Received for Property, Goods and Services (contd.)J.E.: N/R 93,169
Dis. on N/R 23,169Land 30,000Gain 40,000
When the market interest rate is unknown, the imputed interest rate is calculated as:
$70,000 = $93,169 x ? ? = 70,000/93,169 = 0.7513 0.7513 is the present value factor of 10%, 3 periods and
therefore, the imputed interest rate is 10%.
.
Cash and Receivables 115
Notes Received for Property, Goods and Services (contd.) The discount on N/R will be amortized in the
next three years as follows:
.
Year 1 Year 2 Year 3
Discount on N/R 7,000 7,700 8,469
Interest Revenue 7,000 7,700 8.469
Cash and Receivables 116
Notes Received for Property, Goods and Services (contd.) If the effective rate of the note is known, the present
value of the note will be calculated using the effective interest .
The gain will be the difference between the P.V. of the note and the cost of the land.
The discount amount will be the difference between the maturity value (i.e., $93,169) and the P.V. of the note.
.
Cash and Receivables 117
Long-Term N/R
Example B (skip p114-121) 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 accept the balance in four equal installments of $18,000 receivable each 12/31. An assumed interest rate of 11% is imputed. Record the journal entries for La Tourette for the sale and for the receipts and interest on the following dates:1. 12/31/20x1 2. 12/31/20x23. 12/31/20x3 4. 12/31/20x45. 12/31/20x5
Cash and Receivables 118
Long-Term N/R
Example B (contd.) PV of $18,000 annuity @11%, four payments
= 18,000 3.10245 = 55,844.10Thus, the revenue from the services = 18,000 + 55,844.10 = 73,844.10
12/31/x1Cash 18,000Notes Receivable 72,000
Discount on N/R 16,155.9aRevenue from Services 73,844.10
a. (18,000 4) - 55,844.10 = 16,155.9
Cash and Receivables 119
Long-Term N/R
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) 11% = 55,844.1 11% = 6,142.85
Cash and Receivables 120
Long-Term N/R
Example B (contd.)12/31/x3Cash 18,000
N/R 18,000 Discount on N/R 4,838.56
Interest Revenue 4,838.56a
a. Interest Revenue of 20x3 = pv of note on 1/1/x3 11% = (55,844.1 - 18,000 + 6,142.85) 11% = 43,986.95 11% = 4,838.56
Cash and Receivables 121
Long-Term N/R
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 18,000 Discount on N/R 3,390.81
Interest Revenue 3,390.81a
a. Interest Revenue of 20x4= pv of note on 1/1/x4 11% = (43,986.95 - 18,000 + 4,836.56) 11% = 30,825.51 11% = 3,390.81
Cash and Receivables 122
Long-Term N/R
Example B (contd.)12/31/x5Cash 18,000
N/R 18,000 Discount on N/R 1,783.68
Interest Revenue 1,783.68a
a. Interest Revenue of 20x5 = pv of note on 1/1/x5 11% = (30,825.51 - 18,000 + 3,390.81) 11% = 16,216.31 11% = 1,783.68
Cash and Receivables 123
Notes Received for Cash and Other Rights Avon Co. accepts a 3-year, $100,000,
zero-interest-bearing note from Andrew Co. plus the right to purchase 50 machines at a bargain price in exchange for $100,000 in cash. Assume that the current rate is 10% (for a similar note without the right):
Cash and Receivables 124
N/R Received for Cash and 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 purchase will be amortized (proportionally to 50 machines) to increase the purchase price of machines.
Cash and Receivables 125
Fair Value Option (SFAS 159 or ASC825-10-25) Companies may choose the fair value option
when the financial instrument is originally recognized or when an event triggers a new basis of accounting (i.e., acquisition).
Once chosen, the company has to use the fair value option in subsequent periods.
If the company does not elect the fair value option for the financial instrument at the initial recognition, it may not use this option for the instrument in subsequent periods.
Cash and Receivables 126
Fair Value Option – An Example Assume that Loftus Company has notes
receivable with a fair value of $70,000 and a carrying amount of $58,000 (e.g. with $60,000 face amount and $2,000 discount on N/R) on 12/31/2011. The company chose the fair value option for these receivables on the first valuation of these recently acquired receivables.
Adjusting Entry:Fair Value Adjustment-N/R 12,000 Unrealized holding gain or loss* 12,000 * Reported in the income statement
Cash and Receivables 127
Fair Value Option – An Example
For all subsequent periods, the change in fair value of the note will be reported as an unrealized holding gain or loss.
For example, assuming the fair value of the note at December 31, 2012 is $65,000, Loftus will record the following adjusting entry on 12/31/2012:
Unrealized holding gain or loss 5,000 Fair Value Adj. – N/R 5,000
128
Impairment Measurement and Reporting on Investment in Loan Receivables A loan receivable impaired when it is
probable that it will not collect all amounts due (both principle and interest).
Measurement: Compare the recorded investment (i..e,
the NRV or the carrying amount) with the present value of the expected future cash flows using the historical expected interest rate.
129
Impairment Measurement and Reporting (contd.) Example (illustration 7B-3 onP355 of
KWW 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.
130
Impairment Measurement and Reporting (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
Cash and Receivables 131
Securitization A sale of securities (i.e., bonds or
commercial paper) backed (collateralized ) by a pool of assets.
These assets can be mortgage receivables (i.e., mortgage-backed securities), consumer loans (i.e., assets-backed securities), and corporate bonds (i.e., collateralized debt obligations).
132
Securitization (contd.)
Securitizations are popular for two reasons:
1. Investors have a strong appetite in acquiring collateralized securities.
2. Companies and lenders with large amounts of receivables have incentives to engage in securitization.
133
Securitization Performed by The Company When a company uses its assets (i.e.,
auto loan receivables) as collaterals to issue bonds (i.e., assets-backed securities), the receivables will remain on its balance sheet.
The company’s liability will be increased from the increase of bonds payable.
As a result, this transaction will have an adverse effect on its return on assets and debt/equity ratios.
134
The Special Purpose Entity A special purpose entity (SPE) is
usually created by a third party (referred to as a sponsor) which is independent of the company with receivables (referred to as the transferor).
The SPE serves the purpose of buying receivables from the transferor and issuing securities collateralized on the receivables transferred from the transferor.
135
The Special Purpose Entity (contd.) The SPE can be in the form of a trust,
partnership or corporation and is legally distinct from the transferor.
136
Procedures of Securitization Performed by A SPE1. The transferor will first transfer its
receivables to the SPE.
2. The SPE issues securities (i.e., commercial paper due in 30-60 days) collateralized on receivables transferred.
3. The cash received by the SPE from issuing securities goes back to the transferor to pay off the receivables transferred.
137
Procedures of Securitization Performed by A SPE (contd.) The SPE is served as a “pass
through”. The sponsor of the SPE charges the
transferor fees for creating and operating the SPE.
The transferor can continue to service the loan for a fee.
138
Off Balance Sheet Financing SFAS 140 (2000): If the SPE is a
qualifying SPE* ,the transferor does not have to consolidate the balance sheet of the SPE.
As a result, both the receivables and the liabilities from issuing securities will appear only on the balance sheet of the SPE, not the transferor or the sponsor.
*The SPE has at least 3% (10% under FIN 46 (R)) of the fair value of its total assets invested by a third party.
139
Off Balance Sheet (B/S) Financing (contd.) With a qualifying SPE, the transferor obtain
an off-balance sheet financing. Problems Associated with off B/S financing:
If the receivables defaulted, the transferor may be forced to take back receivables or the banks eat losses.
A mismatch of long-term assets with short-term borrowing on the capital structure of the SPE.
.
140
Subprime Mortgage Crisis in 2007 Many of the subprime mortgage
receivables defaulted in 2007 due to the reckless lending in the early to mid-2000s.
When investors realized that the underlying assets for the SPEs’ securities were subprime mortgage receivables, SPEs had a hard time to issue new commerce paper to refinance the existing commercial paper.
141
Subprime Mortgage Crisis in 2007 (contd.) As a result, many sponsors (i.e.,
banks) of the SPEs had to pay off the commercial paper issued by the SPEs when it matures due to the agreements with the transferors.
These banks would, therefore, take these subprime mortgage receivables into their balance sheets.
142
Subprime Mortgage Crisis in 2007 (contd.) The banks would subsequently
recognize losses (i.e., impairment loss on the subprime mortgage receivables) on these receivables.
143
SFAS 166 and SFAS 167 The concept of qualifying SPE is
eliminated by SFAS No.166 issued in June 2009, and became effective as of the beginning of the first annual reporting period beginning after Nov. 2009 (i.e., January 2010).
SFAS 167 redefine variable interest entity and the assessment method in determining the primary beneficiary.
144
Consolidation of SPEs (source: KWW textbook , appendix 17B and FIN 46 ( R)).
Based on FIN 46 (R) (2003), a SPE is a variable interest entity (VIE ) when 1) wirth insufficient equity (i.e., thinly
capitalized), or
2) with equity holders cannot make decisions, or
3) with equity holders have in-proportionate controlling interest (i.e., holding 60% of voting rights but receiving 20% of benefits).
145
Consolidation (contd.) (source: KWW textbook , appendix 17B and FIN 46 ( R)).
Once an entity is identified as a VIE, a risk-and-reward model, not the voting-interest-model, is used in determining the consolidation party.
The voting-interest-model: the party with more than 50% of voting rights of an entity should consolidate the entity (ARB 51).
146
Consolidation (contd.) (source: KWW textbook , appendix 17B and FIN 46 ( R)).
The risk-and-reward model of FIN 46 (R ): the party who assumes majority of the risks and receive majority of benefits associated with the entity is the primary beneficiary party and should consolidate the entity.
147
Avoiding Consolidation under FIN 46 ( R )
A SPE with at least 10% of the fair value of the total assets invested by a third independent party is considered not thinly capitalized and is a qualifying SPE, not a VIE, under FIN46 (R).
A qualifying SPE is not subject to consolidation by the sponsor or transferor under FIN 46 ( R).
IFRS Insights (Source: KWW 14th e, p428-429)
The accounting on reporting related to cash and cash equivalent is essentially the same under both IFRS and GAAP except for the reporting of bank overdrafts, reported as cash under IFRS.
The allowance for doubtful accounts sometimes refers as provisions for doubtful accounts.
The fair value option is similar under GAAP and IFRS but not identical.
Cash and Receivables 148
IFRS Insights (contd.)
IFRS and GAAP differ in the criteria used to account for transfers of receivables.
IFRS focused on risks and rewards and loss of control while GAAP uses loss of control as the primary criterion.
Also, IFRS allows partial transfer, GAAP does not.
Cash and Receivables 149