Chapter 7 Cash and Receivables Copyright © Cengage Learning. All rights reserved.

Management Issues Related to Cash and Receivables Objective 1 Identify and explain the management and ethical issues related to cash and receivables. Copyright © Cengage Learning. All rights reserved.

Key Issues In Dealing With Short-Term Financial Assets Management must address five key issues: Managing cash needs Setting credit policies Evaluating the level of accounts receivable Financing receivables Making ethical estimates of credit losses Copyright © Cengage Learning. All rights reserved.

Cash Management Cash Currency and coins on hand Checks and money orders from customers Deposits in checking and savings accounts May include a compensating balance -- a minimum amount that a bank requires a company to keep in its bank account as part of a credit-granting arrangement Seasonal cycles of businesses require them to carefully plan cash inflows, cash outflows, borrowing, and investing. Copyright © Cengage Learning. All rights reserved.

Accounts Receivables and Credit Policies Companies sell on credit to be competitive and increase sales. To increase the likelihood of selling to customers who will pay on time, companies develop control procedures and maintain a credit department. Copyright © Cengage Learning. All rights reserved.

Evaluating the Level of Accounts Receivables Two common measures of the effect of a company’s credit policies are Receivable turnover Reflects the relative size of a company's accounts receivable and the success of its seasonal conditions and interest rates Days’ sales uncollected (Average Collection Period or Daily Sales Outstanding) Shows, on average, how long it takes to collect accounts receivable Copyright © Cengage Learning. All rights reserved.

Average Net Accounts Receivable Receivable Turnover Reflects the relative size of a company’s accounts receivable and the success of its credit and collection policies Net Sales Average Net Accounts Receivable Receivable Turnover = Nike’s Receivable Turnover = $16,325.9 ($2,494.7 + $2,382.9) ÷ 2 = 6.7 times Copyright © Cengage Learning. All rights reserved.

Receivable Turnover for Selected Industries Copyright © Cengage Learning. All rights reserved.

Days’ Sales Uncollected To interpret a company’s ratios, take into consideration the industry in which it operates. Days’ Sales Uncollected = (ACP) 365 days Receivable Turnover Nike’s Days’ Sales Uncollected = 365 6.7 = 54.5 days Copyright © Cengage Learning. All rights reserved.

Days’ Sales Uncollected Suppose the company can reduce collection period to 45 days w/o changing sales. What effect will this have on A/R and Cash? RTO = 365/45 = 8.111… Avg A/R = S/RTO =16,325.9/8.1111 = $2012.78 Old A/R = $2438.80 Assuming everything but cash stays the same Change in Cash = 2438.80 – 2012.78 = $462 So a decrease in A/R is a source of cash. Copyright © Cengage Learning. All rights reserved.

Financing Receivables Companies with significant amounts tied up in accounts receivable may not be willing or able to wait until cash is collected Solutions Set up financing companies Borrowing funds using receivables as collateral Factoring Securitization Copyright © Cengage Learning. All rights reserved.

Financing Companies Examples: Companies set up by corporations to help their customers pay for the purchase of their products Examples: Ford Motor Credit Company (FMCC) General Motors Acceptance Corp. (GMAC) Sears Roebuck Acceptance Corp. (SRAC) Copyright © Cengage Learning. All rights reserved.

Borrowing Some companies borrow funds using their accounts receivable as collateral. If the company does not pay back its loan, the creditor takes possession of the accounts receivable and converts them to cash to satisfy the loan. Copyright © Cengage Learning. All rights reserved.

The sale or transfer of accounts receivable with or without recourse. Factoring The sale or transfer of accounts receivable with or without recourse. With recourse The seller of the receivables is liable to the purchaser if a receivable is not collected. Without recourse The factor that buys the accounts receivable bears any losses from uncollectible accounts. A credit card sale is an example of factoring without recourse because the credit card issuer accepts the risk of nonpayment Copyright © Cengage Learning. All rights reserved.

Factoring (cont’d) The factor charges a fee for its service. Usually about 1 percent for sales with recourse. Higher fees for sales without recourse because of increased risk. Selling receivables with recourse creates a contingent liability. A potential liability that can develop into a real liability if a particular subsequent event occurs, which should be disclosed Copyright © Cengage Learning. All rights reserved.

Securitization The sale of batches of a company’s accounts receivables at a discount to companies and investors. The buyer receives the full amount when the receivables are paid. The revenue is the amount of the discount. Copyright © Cengage Learning. All rights reserved.

Ethics and Estimates in Accounting for Receivables Since estimations are involved, earnings may be easily manipulated… If amount of losses from uncollectible accounts are understated, earnings are overstated. If the amount of losses from uncollectible accounts are overstated, earnings are understated. Copyright © Cengage Learning. All rights reserved.

Cash Equivalents and Cash Control Objective 2 Define cash equivalents, and explain methods of controlling cash, including bank reconciliations. Copyright © Cengage Learning. All rights reserved.

Cash Equivalents Short-term, highly liquid investments that will revert to cash in 90 days or less from the time of purchase. Include: Money market accounts Commercial paper U.S. Treasury bills These funds revert to cash so quickly they are regarded as cash on the balance sheet. Copyright © Cengage Learning. All rights reserved.

Fair Value of Cash and Cash Equivalents Cash and cash equivalents are financial instruments that are valued at fair value. Companies often invest these funds in money market funds to earn interest with cash when they don’t need cash for current operations. Copyright © Cengage Learning. All rights reserved.

Notes Receivable Objective 4 Define promissory note, and make common calculations for promissory notes receivable. Copyright © Cengage Learning. All rights reserved.

Promissory Notes Unconditional promises to pay a definite sum of money on demand or at a future date. The signer of the note is called the maker. The entity to whom payment is to be made is called the payee. The payee regards all promissory notes it holds that are due in less than one year as notes receivable in the current assets section of the balance sheet. The maker regards them as notes payable in the current liability section of the balance sheet. Copyright © Cengage Learning. All rights reserved.

Computations for Promissory Notes Several terms are important in accounting for promissory notes 1. Maturity date The date on which the note must be paid 2. Duration of note The length of time in days between a promissory note’s issue date and its maturity date 3. Interest and interest rate The cost of borrowing money or the return for lending money. Usually stated on an annual basis 4. Maturity value The total proceeds of a note at the maturity date Copyright © Cengage Learning. All rights reserved.

Maturity Date Ways in which maturity date may be stated: Due “November 14, 2010” Due “three months after November 14, 2010” Due “60 days after November 14, 2010” Exclude the date of the note when computing the maturity date: A note dated May 20 and due in 90 days would be due on August 18, determined as follows: Days remaining in May (31 – 20) 11 Days in June 30 Days in July 31 Days in August 18 Total days 90 Copyright © Cengage Learning. All rights reserved.

Interest is calculated on this basis Duration of a Note Why is duration of a note important? Interest is calculated on this basis If maturity date is stated as a specific number of days from date of note… duration is easy to calculate. Duration is the same as number of days. If maturity date is stated as a specific date… number of days must be calculated. Copyright © Cengage Learning. All rights reserved.

Interest and Interest Rate Amount of interest is based on: Principal Rate of interest Loan’s length of time What is the interest on a three-month, 8 percent, $1,000 note? Principal x Rate of interest x Time = Interest $1,000 x .08 x 3/12 = $20 Copyright © Cengage Learning. All rights reserved.

Maturity Value Total proceeds of loan 90-day 8 percent $1,000 loan = Principal + Interest = $1,000 + ($1,000 × 8/100 × 90/365) = $1,000 + $19.73 = $1,019.73 The maturity value of a non-interest-bearing note is the principal amount. In this case, the principal includes an implied interest cost Copyright © Cengage Learning. All rights reserved.

Accrued Interest A promissory note received in one accounting period may not be due until a later period Accrue the interest applicable to the note at the end of the accounting period $1,000 note, 90-day, 8 percent note was received on Aug. 31. The fiscal year ends on Sept. 30. 30 days interest, or $6.58 ($1,000 × 8/100 × 30/365 = $6.58), is earned in the fiscal year that ends on Sept. 30 Copyright © Cengage Learning. All rights reserved.