Chapter 7 Cash and Receivables

Amounts on deposit with financial institutions Cash Coins and currency Petty cash Cashier’s cheques Certified cheques Amounts on deposit with financial institutions Money orders 3 3 3

Items very near cash but not in negotiable form Cash Equivalents Items very near cash but not in negotiable form Money market funds Treasury bills Commercial paper 4 4 4

Internal Control of Cash Encourages adherence to company policies and procedures Promotes operational efficiency Enhances the reliability and accuracy of accounting data Minimizes errors and theft 6 6 6

Control of Cash Receipts Separate responsibility for handling cash, recording cash transactions, and reconciling cash balances. Agreed cash amounts deposited with cash amounts received. Close supervision of cash-handling and cash-recording activities. 7 7 7

Control of Cash Disbursements Separate responsibilities for cash disbursement documents, cheque writing, cheque signing, cheque mailing, and record keeping. All disbursements, except petty cash, made by cheque. 8 8 8

Bank Reconciliation Bank reconciliations are prepared periodically to explain the difference between cash reported on the bank statement and the cash balance on company’s books. * Why are the balances different?

Bank Reconciliation Balance per Bank + Deposits in Transit - Outstanding Cheques ± Bank Errors = Adjusted Balance Balance per Book + Deposits by Bank (credit memos) - Service Charge - NSF Cheques ± Book Errors 10 10 91 91

Bank Reconciliation All reconciling items on the book side require an adjusting entry to the cash account. Balance per Bank + Deposits in Transit - Outstanding Checks ± Bank Errors = Adjusted Balance Balance per Book + Deposits by Bank (credit memos) - Service Charge - NSF Cheques ± Book Errors 10 10 91 91

Bank Reconciliation Prepare a May 30 bank reconciliation statement and the resulting journal entries for Jeremy’s Sports Equipment. The July 31 bank statement indicated a cash balance of $26,821.56, while the cash ledger account on that date shows a balance of $27,852.80. Additional information necessary for the reconciliation is shown on the next page. 14 14 95 95

Outstanding cheques totaled $17,718.87. The May 31 deposit had not reached the bank at the statement date. The bank returned a customer’s NSF cheque for $450.25 received as payment of an account receivable. The bank statement showed $160.12 interest earned and $12 bank charges on the bank balance for the month of May. Cheque 467 for supplies cleared the bank for $360 but was erroneously recorded in our books as $306. The insurance premium of $250 is paid by a automatic debit to the bank account. 15 15 96 96

17 17 98 98

Bank Reconciliation 18 18 99 99

Petty Cash Imprest fund providing limited cash for routine disbursements. Intended for payment of: Minor transportation costs. Postage. Office supplies. Delivery charges. 19 19 19

Increase, decrease or close fund. Petty Cash Only entries to “Petty Cash” Establish the fund. Increase, decrease or close fund. 20 20 20

Petty Cash Jeremy’s Sports Equipment established a petty cash fund of $200. The following summary information was taken from petty cash vouchers for July: Postage $40.00 Office supplies 35.00 Delivery charges 55.00 Entertainment 30.00 Prepare the journal entry to record replenishing fund if the balance on July 31 was $37.00. 21 21 21

Petty Cash What amount of cash will be required to replenish the petty cash fund? a. $160.00 b. $163.00 c. $167.00 d. $170.00 22 22 22

Petty Cash What amount of cash will be required to replenish the petty cash fund? a. $160.00 b. $163.00 c. $167.00 d. $170.00 Desired Balance $200.00 Actual Balance 37.00 Amount Needed $163.00 23 23 23

Petty Cash 24 24 24

Restricted Cash and Compensating Balances Management’s intent to use a certain amount of cash for a specific purpose – future plant expansion, future payment of debt. Compensating Balance Minimum balance that must be maintained in a company’s account as support for funds borrowed from the bank. 5 5 5

customers for credit sales. Accounts Receivable Amounts due from customers for credit sales. Credit sales require: Maintaining a separate account receivable for each customer. Accounting for bad debts that result from credit sales.

Encourage early payment. Increase likelihood of collections. Cash Discounts Increase sales. Encourage early payment. Cash discounts . . . Increase likelihood of collections. 27 27 27

Number of Days Discount is Available Otherwise, Net (or All) is Due Cash Discounts 2/10,n/30 Discount Percent Number of Days Discount is Available Otherwise, Net (or All) is Due Credit Period 32 32 32

Sales are recorded at the invoice amounts. Cash Discounts Sales are recorded at the invoice amounts. Gross Method Sales discounts are recorded if payment is received within the discount period. 23 23

Sales are recorded at the invoice amount less the discount. Cash Discounts Net Method Sales are recorded at the invoice amount less the discount. Sales discounts forfeited are recorded if payment is received after the discount period. 23 23

Prepare the journal entry to record the sale if Jeremy’s uses: Cash Discounts On October 5, Jeremy’s Sports Equipment sold $20,000 of merchandise to a customer subject to a cash discount of 2/10, n/30. Eddy uses the periodic method to account for inventory. The customer paid $13,720 ($14,000 less discount) on October 14 and the remainder on November 4. Prepare the journal entry to record the sale if Jeremy’s uses: (a) the gross method. (b) the net method. 34 34 34

Cash Discounts 36 36 36

Cash Discounts 39 39 39

Cash Discounts 42 42 42

Sales Returns and Allowances Sales Allowance Merchandise returned by a customer to a supplier. A reduction in the cost of defective merchandise.

Sales Returns and Allowances Jeremy’s sold merchandise on account for $2,000,000. The merchandise cost $1,200,000. Industry experience indicates that 10% of all sales are returned. Customers returned merchandise sold for $130,000. The perpetual method to account for inventory. Record the journal entry for the return of merchandise. 45 45 45

Sales Returns and Allowances 36 36 36

Sales Returns and Allowances We must now make an adjusting entry to account for the difference between the total estimated returns and the actual returns. In effect, we are creating a liability for future returns expected on current year sales. This is in accordance with the matching principle. 45 45 45

Sales Returns and Allowances 42 42 42

Doubtful Accounts Receivable Bad debts result from credit customers who will not pay the amount they owe, regardless of continuing collection efforts. PAST DUE 42 42

Doubtful Accounts Receivable In conformity with the matching principle, bad debt expense should be recorded in the same accounting period in which the sales related to the doubtful account were recorded. 43 43

Doubtful Accounts Receivable Most businesses record an estimate of the bad debt expense by an adjusting entry at the end of the accounting period. 44 44

Doubtful Accounts Receivable Normally classified as a selling expense and closed at year-end. Contra asset account to Accounts Receivable. 44 44

Allowance for Uncollectible Accounts Accounts Receivable Less: Allowance for Doubtful Accounts Net Realizable Value Net realizable value is the amount of the accounts receivable that the business expects to collect. 49 49

Estimating Bad Debts Income Statement Approach Balance Sheet Approach Composite Rate Aging of Receivables PAST DUE 50 50 50

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. 51 51 51

Income Statement Approach Bad debts expense is computed as follows:

Income Statement Approach In 2005, Jeremy’s Sports Equipment had credit sales of $1,200,000 and estimates that 2% of credit sales are uncollectible. What is Bad Debts Expense for 2005?

Income Statement Approach Jeremy’s computes estimated Bad Debts Expense of $24,000.

Balance Sheet Approach Focuses on the collectibility of accounts receivable to make the estimate of doubtful accounts. Involves the direct computation of the desired balance in the allowance for doubtful accounts. 55 55 55

Now, let’s look at the accounts receivable aging approach!

Balance Sheet Approach Aging of Receivables Year-end Accounts Receivable is broken down into age classifications. Each age grouping has a different likelihood of being uncollectible. Compute estimated uncollectible amount. Compare estimated uncollectible amount with the balance in the allowance account.

Balance Sheet Approach Aging of Receivables At December 31, 2005, the receivables for Jeremy’s were categorized as follows:

Balance Sheet Approach Aging of Receivables Jeremy’s unadjusted balance in the allowance account is $4,000. Per the previous computation, the desired balance is $25,500. Prepare the entry to record bad debts expense at Dec. 31, 2005.

Balance Sheet Approach Aging of Receivables Jeremy’s unadjusted balance in the allowance account is $4,000. Per the previous computation, the desired balance is $22,500.

Methods to Estimate Bad Debts Income Statement Approach Balance Sheet Approach Emphasis on Matching Emphasis on Realizable Value Sales Bad Debts Exp. Accts. Rec. All. for Doubt. Accts. Income Statement Focus Balance Sheet Focus

Uncollectible Accounts As accounts become uncollectible, the following entry is made: So what happens if someone pays after a write-off of the accounts receivable? 65 65 65

Collection of Previously Written-Off Accounts When a customer makes a payment after an account has been written off, two journal entries are required. 66 66 66

Direct Write-off Method If uncollectible accounts are immaterial, bad debts are simply recorded as they occur (without the use of an allowance account).

Let’s move to a new challenge. Notes Receivable Let’s move to a new challenge.

Two thousand and no/100------------------------------------ Notes Receivable Date of Note PROMISSORY NOTE Face Value Date after date I promise to pay to the order of National Bank Vancouver,BC Dollars plus interest at the annual rate of . $2,000 Sept. 30, 2005 Sixty days 12% Two thousand and no/100------------------------------------ Janet Lee Due Date Payee Principal Maker Interest Rate

Even for maturities less than 1 year, the rate is annualized. Interest Computation Even for maturities less than 1 year, the rate is annualized.

Interest-Bearing Notes On May 1, 2005, Stridewell sold merchandise worth $700,000 and accepted a six month 12% note in payment. Prepare the journal entry on May 1, 2005 and on the maturity date (November 1, 2005). 69 69 69

Interest-Bearing Notes 70 70 70

Noninterest-Bearing Notes On August 1, 2005, Stridewell sold merchandise worth $700,000 and accepted a six month 12% note in payment. Prepare the required adjusting journal entry assuming the year end is December 31, 2005 and the entry at maturity. 73 73 73

Noninterest-Bearing Notes 74 74 74

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. 72 72 72

Noninterest-Bearing Notes On May 1, 2005, Stridewell sold merchandise worth $700,000 and accepted a six month non-interest bearing note in payment. The note has a 12% discount rate. Prepare the journal entry on May 1, 2005 and on the maturity date. 73 73 73

Noninterest-Bearing Notes 74 74 74

Noninterest-Bearing Notes On August 1, 2005, Stridewell sold merchandise worth $700,000 and accepted a six month non-interest bearing note in payment. The note has a 12% discount rate. Prepare the required adjusting journal entry assuming the year end is December 31, 2005 and the entry at maturity. 73 73 73

Noninterest-Bearing Notes 74 74 74

Valuation of Notes Receivable If a company anticipates bad debts an allowance account is used like accounts receivable. Process of recording bad debts is similar to account receivable. The objective is to state notes at their net realizable value.

Financing With Receivables Secured borrowing or Sale of receivables Method depends on the surrender of control over the receivables transferred. 76 76 76

Secured Borrowing – Assigning The use of specific receivables for collateral, and the promise that any failure to repay debt will result in proceeds from specific accounts receivable collections being used to repay the debt. Reclassify Accounts Receivable as Accounts Receivable Assigned. 77 77 77

Secured Borrowing – Assigning On December 1, 2005 Santa Teresa borrowed $500,000 from Finance Affiliates and signed a promissory note. Interest at 12% is payable monthly. Santa Teresa assigned $620,000 of its receivables as collateral for the loan. Finance Affiliates charges finance fee of 1.5% of the accounts receivable assigned. 77 77 77

Secured Borrowing – Assigning Prepare the journal entry to record the borrowing in Santa Teresa’s books: 65 65 65

Secured Borrowing – Assigning Santa Teresa will continue to collect receivables, record any discounts, sales returns and bad debt write-offs, but will remit cash to Finance Affiliates, usually on a monthly basis. The following entry is made when $400,000 of the assigned receivables are collected in December. 45 45 45

Secured Borrowing – Assigning 42 42 42

Financial Statement Disclosures Assets *($620,000 - $400,000) ** ($500,000 - $400,000)

Secured Borrowing – Pledging Receivables in general are pledged as collateral for loans. Pledged Receivables are disclosed in notes to the financial statements. 77 77 77

Sale of Accounts Receivable SUPPLIER (Transferor) 3. Accounts Receivable 5. Cash RETAILER 4. Cash 1. Merchandise FACTOR (Transferee) A factor is a financial institution that buys receivables for cash, handles the billing and collection of the receivables and charges a fee for the service. 80 80 80

Sale of Accounts Receivable Treat as a sale if all of these conditions are met: Receivables are isolated from transferor. Transferee has right to pledge or exchange receivables. Transferor does not have control over the receivables. Transferor cannot repurchase receivable before maturity. Transferor cannot require return of specific receivables.

Sale of Accounts Receivable 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, cash is received and a financing expense or loss is recognized. 81 81 81

Sale of Accounts Receivable In December 2005 Santa Teresa factored $600,000 of accounts receivable to Finance Affiliates. The transfer was made without recourse. Finance remits 90% of factored receivables to Santa Teresa and retains the remaining 10%. Finance remits to Santa Teresa the retained amount less a 4% fee (of total amount factored). 81 81 81

Sale of Accounts Receivable 70 70 70

Sale of Accounts Receivable With recourse Transferor (seller) retains risk of uncollectibility. Must meet the three conditions of determining surrender of control to be recognized as a sale. If the transaction fails to meet the three conditions necessary to be classified as a sale, it will be treated as a secured borrowing. 82 82 82

Sale of Accounts Receivable Assume same facts as previous example. Additional requirement is to record estimated fair value of the recourse obligation as a liability. Accounting is similar otherwise. Recourse obligation is the estimated amount that Santa Teresa will have to pay Finance Affiliates as reimbursement for uncollected receivables. 84 84 84

Sale of Accounts Receivable 70 70 70

Discounting a Note On December 31, 2005 Stridewell sold land in exchange for a nine month 10% note. The note required payment of $200,000 plus interest on September 30, 2006. On March 31, 2006 Stridewell discounted the note at the Bank of the East. The Bank’s discount rate is 12%. 84 84 84

Discounting a Note 85 85 85

Discounting a Note 70 70 70

Discounting a Note If the three conditions for sale treatment are met, the transaction would be accounted for as a sale, recognizing a gain or loss for the difference between the cash proceeds and the book value of the note. 85 85 85

Financing with Receivables

End of Chapter 7 86 86 86