Chapter 7: Cash and Receivables Fundamentals of Intermediate Accouting Weygandt, Kieso, and Warfield Chapter 7: Cash and Receivables Prepared by Bonnie Harrison, College of Southern Maryland LaPlata, Maryland

Chapter 7 Cash and Receivables 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. 1 2 3 4 5

Chapter 7 Cash and Receivables After studying this chapter, you should be able to: Explain accounting issues related to recognition of notes receivable. Explain accounting issues related to valuation of notes receivable. Explain accounting issues related to disposition of accounts and notes receivable. Explain how receivables are reported and analyzed. 6 7 8 9

Part 1: Cash and Cash Equivalents

Cash and Cash Equivalents: Issues Definition of “cash” : various items that comprise cash. Management and control of cash : the importance of internal control of cash Reporting of cash in the balance sheet

Items Comprising “Cash” Cash must be readily available and be free of restrictions Cash consists of coins, currency and available funds Deposits (CDs) and short term paper are classified as temporary investments Post dated checks, travel advances and stamps on hand are not classified as cash

Management and Control of Cash Since cash is the most liquid asset, internal control of cash is imperative. Controls must prevent unauthorized use of cash Management must have necessary information for proper use of cash

Reporting of Cash The reporting of cash depends upon whether it is: restricted cash a bank overdraft or a cash equivalent 1 2 3

Restricted Cash Compensating balances: are amounts maintained by a corporation with a bank in support of existing borrowing arrangements. are identified as current assets separate from cash, if they relate to short- term loans. are identified as non-current assets separate from cash, if they relate to long-term loans.

Bank Overdrafts Overdrafts represent checks written in excess of cash account. Overdrafts may be offset against available cash in another account in the same bank. Otherwise, such offsetting is not allowed. An overdraft should be reported as a current liability.

Cash Equivalents Short term highly liquid investment (original maturities of three months or less) Readily convertible to known amounts of cash AND So near maturity they present insignificant risk of changes in interest rates.

Part 2: Accounts Receivable

Accounts Receivable: Issues Types of accounts receivable : current and non-current : trade and non-trade Recognition of accounts receivable in the financial statements - cash discounts / interest Valuation of accounts receivable : estimated bad debts and net realizable value Disposition of receivable - transfers / sale

Accounts Receivable: Recognition Trade or quantity discounts are not recorded in books of account. Cash (sales) discounts are inducements to customers for prompt payment of amounts billed. Cash discounts are recorded in books as reductions of sales revenue.

Accounts Receivable: Recording Cash Discounts There are two methods: Gross and Net Gross method records A/R at the gross amount of sale and records discounts when taken. Net method records A/R at the net amount of the sale and captures sales discounts when not taken.

Accounts Receivable: Recording Cash Discounts GROSS method NET method Record revenue at gross amount of sales When customer takes the discount, record cash discounts Cash discounts reduce gross sales revenue Record revenue at gross amount of sales less cash discount When customer forfeits discount, record discounts not taken. Report discounts not taken as other revenue

Valuation of Accounts Receivable Short term receivables are reported at their net realizable value (NRV) The NRV is the net amount expected to be collected The NRV is gross accounts receivable less estimated uncollectible accounts.

Estimating Uncollectible Receivables Methods Direct Write-Off Allowance Not based on the matching Based on the matching principle principle 1 Accounts are written off Estimated bad debts are when determined uncollectible matched against revenue 2 Appropriate only if Must be followed if amounts are not material amounts are material 3

Estimating Uncollectible Accounts: the Allowance Method The estimate of uncollectible accounts may be based on: Percentage of sales OR Percentage of outstanding receivables These approaches are referred to as Income statement and Balance sheet approaches

The Allowance Method (Sales method-first year) Indcom Company reports the following balances for the year 2003 (first year): Net Sales: $50,000 Accounts Rec (Dec 31, 2003): $4,600 The company estimates bad debts at 2% of net sales. Determine estimated uncollectible accounts expense for 2003.

The Allowance Method (Sales Method - First Year) Est. uncollectible accounts (bad debts) expense: $50,000 * 2% = $1,000 1 2 To record bad debts expense: Estimated bad debts expense $1,000 Allowance for Uncollectible accounts $1,000 2003: $1,000 closed Bad debts expense $1,000 Allowance

The Allowance Method (Sales Approach-Second year) Indcom Company reports the following balances for the year 2004 (second year): Net Sales: $70,000 Accounts Rec (Dec 31,2004): $5,700 The company estimates bad debts at 2% of net sales. Determine estimated uncollectible accounts expense for 2004.

The Allowance Method (Sales Method - Second Year) Est. uncollectible accounts (bad debts) expense: $70,000 * 2% = $1,400 1 2 To record bad debts expense: Estimated bad debts expense $1,400 Allowance for Uncollectible accounts $1,400 2004: $1,400 closed Bad debts expense 2003: 1,000 2004: 1,400 Allowance Note: No accounts were written off during the year

The Allowance Method (Acct Rec Approach-First Year) Indcom Company reports the following balances for the year 2003 (first year): Net sales: $50,000 Accounts Rec (Dec 31,2003): $4,600 The company estimates bad debts at 10% of accounts receivable. Determine estimated uncollectible accounts expense for 2003.

The Allowance Method (Acct Rec Approach - First Year) Est. uncollectible accounts (bad debts) expense: $4,600 * 10% = $460 1 2 To record bad debts expense: Estimated bad debts expense $460 Allowance for Uncollectible accounts $460 2003: $ 460 closed $ 460 Bad debts expense Allowance

The Allowance method (Acct Rec approach-second year) Indcom Company reports the following balances for the year 2004 (second year): Net Sales: $70,000 Accounts Rec (Dec 31, 2004): $5,700 The company estimates bad debts at 10% of accounts receivable. Determine estimated uncollectible accounts expense for 2004.

The Allowance Method (Acct Rec Approach - Second Year) Est. uncollectible accounts (bad debts) expense: $5,700 * 10% = $ 570 (required) less: existing allowance = ($ 460) Bad debts expense (2004) = $110 1 2 To record bad debts expense: Estimated bad debts expense $110 Allowance for Uncollectible accounts $110 **You must take into account the balance in “Allowance for Uncollectible Accounts”**

The Allowance Method (Acct Rec Approach - Second Year) 2004: $ 110 closed Bad debts expense $ 460 $ 110 $ 570 Allowance Required ending allowance Adjusting entry: Bad Debts expense $110 Allowance account $ 110

Balance Sheet Representation Short term accounts receivable are shown at their net realizable value as follows: Accounts Receivable (gross) : $ XXX less: Allowance : ($ XX) Net Realizable Value : $ XX

Part 3: Notes Receivable

Notes Receivable: Issues Recognition of Notes Receivable issues at face value and issues not at face value issues for cash / non-cash considerations Valuation issues Disposition of notes receivable

Recognition of Notes Receivable Short term N/R Long term N/R Record at face value less Allowance Record at present value of cash expected to be collected Issues at par Issues not at par

Recognition of Notes Receivable Notes receivable are issued at face value when the stated rate of interest is the same as the effective (market) rate. When the rates are unequal, a discount on the note results. The discount is amortized to interest revenue by the effective interest method.

Recognition of Notes Receivable Issues NOT at face value Non interest bearing Interest bearing 1. Determine discount on notes receivable at implicit rate of interest 2. The discount is amortized to interest revenue by the effective interest method 1. Determine discount on notes receivable at the effective rate of interest. 2. The discount is amortized to interest revenue by the effective interest method

Discount on notes receivable: Example Assume Debrief Company issues a notes receivable (FV= $10,000) on 1/1/2003. Stated Rate, 10%; Effective Rate, 12% The discount is $480. Assume that the discount to be amortized for 2003 is $ 142. Show necessary journal entries.

Discount on notes receivable: Example 1/1/2003: Notes Receivable $10,000 Discount (N/R) $ 480 Cash $ 9,520 December 31, 2003: Discount (N/R) $ 142 Cash $ 1,000 Interest Revenue $1,142

Disposition of Accounts Part 4: Disposition of Accounts and Notes Receivable

Disposition of Accounts and Notes Receivable The holder of accounts or notes receivable may transfer them for cash. The transfer may be: secured borrowing or a sale of receivables Holder retains ownership of receivables in a secured borrowing transaction. Holder transfers ownership of receivables in a sale (transfers risks of collection)

Transfer of Receivables: Borrowing vs. Sale Treatment Conditions 1. Are transferred assets isolated from transferor? and 2. Does transferee have right to pledge or sell assets? and 3. Has transferor divested itself of control through repurchase agreement? Yes Sale No Borrowing **All three conditions must be met for a sale to occur**

Accounting for Transfers of Receivables Secured Borrowing Sale Without Recourse With Recourse Continuing involvement by seller No continuing involvement by

Secured Borrowing (highlights) Transferor records a finance charge. Transferor collects accounts receivable. Transferor records sales returns and sales discounts. Transferor absorbs bad debts expense. Transferor records interest expense on notes payable. Transferor pays on the note periodically from collections.

Sales of Receivables(highlights) Transferor transfers ownership of receivables to factor. Factor records the (transferred) accounts as assets in its books. Transferor records any amount retained by transferee as “due from factor” Transferor records loss on sale of receivables Transferor records any recourse liability (when appropriate)

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