Topic #1 Cash Reporting Controls Accounts & Notes Receivables Initial Measurement Subsequent Measurement Financing with Receivables User’s Perspective Current Issues

2 Cash consists of... coins currency checks money orders money on hand deposits in bank

3 REPORTING CASH Cash  Recorded in both the balance sheet and the statement of cash flows  The balance sheet shows the amount of cash available at a given point in time  The statement of cash flows shows the sources and uses of cash during a period of time. 11 5

4 REPORTING CASH Cash Equivalents Cash equivalents are  Readily convertible to known amounts of cash  So near maturity that their value is relatively insensitive to interest rate changes  Examples include treasury bills, commercial paper, and money market funds

5 Restricted Cash Is cash that is not available for general use. Is set aside for special purpose. If not to be used within next year, report as noncurrent asset.

7-6 Restricted Cash and Compensating Balances Restricted Cash 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 bank account as support for funds borrowed from the bank. Restricted Cash 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 bank account as support for funds borrowed from the bank.

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.

8 Internal control Safeguards an organization’s assets from Employee theft, robbery, unauthorized use Enhances the accuracy and reliability of accounting records Risk of errors and irregularities PRINCIPLES OF INTERNAL CONTROL 11 1

9 PRINCIPLES OF INTERNAL CONTROL

 Establishment of responsibility:  most effective when only one person is responsible for a given task  Segregation of duties:  the work of one employee should provide a reliable basis for evaluating the work of another employee

11 Documentation procedures: documents provide evidence that transactions and events have occurred PRINCIPLES OF INTERNAL CONTROL

Physical, Mechanical, and Electronic Controls

Independent Internal Verification

14 Limitations of Internal Controls Cost/Benefit - cost of establishing procedure should not exceed expected benefit Human element - fatigue, carelessness, indifference Collusion - two or more individuals who work together to get around controls Size of business

15 Review Segregation of duties means? a. Rotating employee duties and requiring vacations. b. Reviewing, comparing and reconciling information from two sources. c. The responsibility for related activities should be assigned to different individuals. d. Physical separation of employees from each other.

16 Cash is the most desirable asset... because it is readily convertible into any other asset.

INTERNAL CONTROL OVER CASH RECEIPTS 11 2

18 Review Which of the following is not an internal control over cash receipts? a. Store cash in safes and bank vaults. b. Supervisors count cash receipts daily c. Bond personnel who handle cash. d. Having the same person who receives the cash to be the one that records it.

INTERNAL CONTROL OVER CASH DISBURSEMENTS 11 3

20  Check processing is expensive new methods are being developed to transfer funds among parties without the use of paper  Electronic Funds Transfer (EFT) System a disbursement system that uses wire, telephone, telegraph, or computer to transfer cash from one location to another Cash Disbursements ELECTRONIC FUNDS TRANSFER SYSTEM

21 Review Which of the following is not an internal control over cash disbursements? a. Stamp invoices paid. b. Use prenumbered checks and account for the sequence. c. Independent internal verification of cash disbursements. d. Have multiple people available to sign checks so they can be mailed promptly.

22  The use of a bank  minimizes the amount of currency that must be kept on hand  contributes significantly to good internal control over cash.  A “double” record of cash is maintained, one by the company, one by the bank. These two accounts must be reconciled. USE OF A BANK

23 Bank Statement shows check & other debits deposits & other credits daily cash balance Bank Statement - a copy of the bank’s records sent to the customer for periodic review.

24 RECONCILING THE BANK ACCOUNT Reconciliation  is necessary as the balance per bank and balance per books are seldom in agreement due to time lags and errors A bank reconciliation  should be prepared by an employee who has no other responsibilities pertaining to cash 11 4

25  Steps in preparing a bank reconciliation:  Determine deposits in transit  Determine outstanding checks  Note any errors discovered  Trace bank memoranda to the records  Each reconciling item used in determining the “Adjusted cash balance per books” should be recorded by the depositor with an adjusting entry RECONCILING THE BANK ACCOUNT

BANK RECONCILIATION

27 Terms Deposits in transit - deposits recorded by the depositor that have not been recorded by the bank. Outstanding checks - checks issued and recorded by the company that have not been paid by the bank. NSF check - a check that is not paid by the bank because of insufficient funds in the customer’s bank account. Adjusted balance - same as true cash balance, correct cash balance

28 BANK RECONCILIATION See Appendix 7-A for an illustration of a bank reconcilation

29 ENTRIES FROM BANK RECONCILIATION Collection of Note Receivable This entry involves four accounts. Interest of $50 has not been accrued and the collection fee is charged to Miscellaneous Expense Reconciliation items to the bank statement balance do not require journal entries!

30 ENTRIES FROM BANK RECONCILIATION Book Error An examination of the cash disbursements journal shows that check No. 443 was a payment on account to Andrea Company, a supplier. The check, with a correct amount of $1,226.00, was recorded at $1,

31 ENTRIES FROM BANK RECONCILIATION NSF Check An NSF check becomes an accounts receivable to the depositor

32 ENTRIES FROM BANK RECONCILIATION Bank Service Charges Check printing charges (DM) and other bank service charges (SC) are debited to Miscellaneous Expense because they are usually nominal in amount. 30

33 Review In a bank reconciliation, adjustments to the book balance could include adding or subtracting company errors in its cash accounting. a. True because the bank will notify the company of errors in the companies accounting records. b. False because errors on the company’s books mean the bank statement is inaccurate. c. True errors in the company’s books will not be duplicated in the bank’s accounting records. d. False company errors do not effect the reconciliation of the two balances

Initial Valuation of Receivables Definition Cash (Quick Pay) discounts Gross Method Net Method Non-Interest & Below Market Rate Interest Bearing Notes 34

7-35 Accounts Receivable Result from the credit sales of goods or services to customers. Are classified as current assets. Are recorded net of trade discounts.

7-36 increase sales encourage early payment increase likelihood of collections Cash discounts Cash Discounts

7-37 2/10,n/30 Number of days discount is available Otherwise, net (or all) is due Credit period Discount percent Cash Discounts

7-38 Cash Discounts Sales are recorded at the invoice amounts. 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 discounts forfeited are recorded as interest revenue if payment is received after the discount period. Net Method

7-39 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. October 5, 2013 October 14, 2013 November 4, 2013

7-40 REVIEW  On November 10 of the current year, Flores Mills sold carpet to a customer for $1,000 with credit terms 2/10, n/30. If the customer pays in full on November 18 th, what percentage off will be discounted?  A. 10%  B. 2%  C. 30%  D. 0%

7-41 Notes Receivable A written promise to pay a specific amount at a specific future date. Even for maturities less than 1 year, the rate is annualized.

7-42 Interest-Bearing Notes On November 1, 2014, West, Inc., loans $25,000 to Winn Co. The note bears interest at 12% and is due on November 1, Prepare the journal entry on November 1, 2014, December 31, 2014, (year-end) and November 1, 2015, for West. November 1, 2014 Notes receivable 25,000 Cash 25,000 December 31, 2014 Interest receivable 500 Interest revenue 500 November 1, 2015 Cash 28,000 Note receivable 25,000 Interest receivable 500 Interest revenue 2,500

7-43 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.

7-44 Noninterest-Bearing Notes On Jan. 1, 2014, 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, Prepare the journal entries on Jan. 1, 2014, and Dec. 31, On Jan. 1, 2014, 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, Prepare the journal entries on Jan. 1, 2014, and Dec. 31, January 1, 2014 Notes receivable 25,000 Discount on notes receivable 3,000 Sales revenue 22,000 ($25,000 * 12% = $3,000) December 31, 2014 Cash 25,000 Discount on notes receivable 3,000 Interest revenue 3,000 Note receivable25,000

7-45 Review Long-term noninterest bearing notes receivable issued for sale of merchandise will be: A. Discounted at an imputed interest rate. B. Recorded at the contract amount. C. Recorded at an amount equal to the future cash flows. D. Accounted for on the installment basis.

7-46  Subsequent Valuation of Accounts Receivable  Sales Returns  Bad Debt  Financing with receivables

7-47 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.

7-48 Sales Returns During the first year of operations, Hawthorne sold $2,000,000 of merchandise that had cost them $1,200,000 (60%). Industry experience indicates a10% return rate. During the year $130,000 was returned prior to customer payment. Record the returns and the end of the year adjustment. Actual Returns Sales returns130,000 Accounts receivable 130,000 Inventory 78,000 Cost of goods sold (60%) 78,000 Adjusting Entries Sales returns 70,000 Allowance for sales returns 70,000 Inventory  estimated returns 42,000 Cost of goods sold (60%) 42,000

7-49 Review  Recognizing sales returns when they occur could result in an overstatement of income in the period of the related sale.  A. True  B. False

7-50 Uncollectible Accounts Receivable 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.

7-51 Uncollectible Accounts Receivable Most businesses record an estimate of the bad debt expense by an adjusting entry at the end of the accounting period. Bad debt expensexxx Allowance for uncollectible accounts xxx Contra asset account to accounts receivable. Normally classified as a selling expense and closed at year-end.

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 Approach Balance Sheet Approach Composite Rate Aging of Receivables Hybrid Combine both approaches Income Statement Approach Balance Sheet Approach Composite Rate Aging of Receivables Hybrid Combine both approaches PAST DUE Estimating Bad Debts

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 debts expense is computed as follows: Income Statement Approach

In 2012, MusicLand has credit sales of $400,000 and estimates that 0.6% of credit sales are uncollectible. What is Bad Debts Expense for 2012? Income Statement Approach

MusicLand computes estimated Bad Debts Expense of $2,400. Income Statement Approach

Balance Sheet Approach Focuses on the collectibility 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 collectibility 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 Debts Expense is computed as: Balance Sheet Approach Composite Rate

On Dec. 31, 2012, 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 Debts Expense for 2012? On Dec. 31, 2012, 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 Debts Expense for 2012? Balance Sheet Approach Composite Rate

Desired balance in Allowance for Uncollectible Accounts Balance Sheet Approach Composite Rate

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

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

   At December 31, 2012, the receivables for EastCo, Inc. were categorized as follows: 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. Prepare the entry to record bad debts expense at Dec. 31,  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. 

Balance Sheet Approach Emphasis on Realizable Value Accts. Rec. Balance or Aging All. for Uncoll. Accts. Income Statement Focus Balance Sheet Focus Income Statement Approach Emphasis on Matching Sales Bad Debts Exp. Methods to Estimate Bad Debts Hybrid Approach – 1.For interim reporting, income statement approach maybe used. 2.At year end balance sheet approach can be applied and both allowance and bad debt expense be adjusted

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 xxx Accounts receivable xxx This is a method not generally permitted by GAAP

7-69 Summary of Measurement and Reporting Issues for Accounts Receivable Recognition Depends on the earnings process; for most credit sales, revenue and the related receivables are recognized at the point of delivery. Initial valuation Initially recorded at the exchange price agreed upon by the buyer and seller. Subsequent valuation Initial valuation reduced to net realizable value by: 1. Allowance for sales returns 2. Allowance for uncollectible accounts:  The income statement approach  The balance sheet approach Classification Almost always classified as a current asset.

7-70 Review  The income statement approach to estimating bad debts requires an adjusting entry at the end of the period which includes a credit to accounts receivables?  True  False

7-71 Notes Receivable A written promise to pay a specific amount at a specific future date. Even for maturities less than 1 year, the rate is annualized.

7-72 Interest-Bearing Notes On November 1, 2014, West, Inc., loans $25,000 to Winn Co. The note bears interest at 12% and is due on November 1, Prepare the journal entry on November 1, 2014, December 31, 2014, (year-end) and November 1, 2015, for West. November 1, 2014 Notes receivable 25,000 Cash 25,000 December 31, 2014 Interest receivable 500 Interest revenue 500 November 1, 2015 Cash 28,000 Note receivable 25,000 Interest receivable 500 Interest revenue 2,500

7-73 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.

7-74 Noninterest-Bearing Notes On Jan. 1, 2014, 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, Prepare the journal entries on Jan. 1, 2014, and Dec. 31, On Jan. 1, 2014, 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, Prepare the journal entries on Jan. 1, 2014, and Dec. 31, January 1, 2014 Notes receivable 25,000 Discount on notes receivable 3,000 Sales revenue 22,000 ($25,000 * 12% = $3,000) December 31, 2014 Cash 25,000 Discount on notes receivable 3,000 Interest revenue 3,000 Note receivable25,000

7-75 Review Long-term notes receivable issued for sale of merchandise at an unrealistically low interest rate will be: A. Discounted at an imputed interest rate. B. Recorded at the contract amount. C. Recorded at an amount equal to the future cash flows. D. Accounted for on the installment basis.

7-76 Review Long-term notes receivable issued for sale of merchandise at an unrealistically low interest rate will be: A. Discounted at an imputed interest rate. B. Recorded at the contract amount. C. Recorded at an amount equal to the future cash flows. D. Accounted for on the installment basis.

7-77 Financing with Receivables Companies may use their receivables to obtain immediate cash.

7-78 Factoring Arrangements FACTOR (Transferee) SUPPLIER (Transferor) RETAILER 1. Merchandise 2. Accounts Receivable 3. Accounts Receivable 4. Cash 5. Cash 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.

7-79 Secured Borrowing On December 1, 2013, the Santa Teresa Glass Company borrowed $500,000 from Finance Bank and signed a promissory note. Interest at 12% is payable monthly. The company assigned $620,000 of its receivables as collateral for the loan. Finance Bank charges a finance fee equal to 1.5% of the accounts receivable assigned. Cash (difference) 490,700 Finance charge expense (1.5% * $620,000) 9,300 Liability – financing arrangement 500,000 Santa Teresa Glass will continue to collect the receivables, and will record any discounts, sales returns, and bad debt write-offs, but will remit the cash to Finance Bank, usually on a monthly basis. When $400,000 of the receivables assigned are collected in December, Santa Teresa Glass records the following entries. Cash 400,000 Accounts receivable 400,000 Interest expense ($500,000 * 12% * 1/12) 5,000 Liability – financing arrangement 400,000 Cash405,000

7-80 Sale of Receivables 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. 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. FASC

7-81 Sale of Receivables 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. 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.

7-82 Sale of Receivables In 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% (estimated to have a fair value of $50,000) 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 Glass sold the receivables to Factor with recourse and estimates the fair value of the recourse obligation to be $5,000.

7-83 Sale of Receivables – Past Abuses Securitization: Transfer receivables to a SPE Special Purpose Entity (SPE) Qualifying Special Purpose Entity (QSPE) New rules eliminate QSPE and require consolidation! Participating Interests: Transfer portion of a receivable Example: transfer right to interest, but retain right to principal New rules require a partial transfer be treated as a secured borrowing, unless specific conditions are met!

7-84 Review Long-term notes receivable issued for sale of merchandise at an unrealistically low interest rate will be: A. Discounted at an imputed interest rate. B. Recorded at the contract amount. C. Recorded at an amount equal to the future cash flows. D. Accounted for on the installment basis.

7-85 Interest receivable 5,000 Interest revenue 5,000 Transfers of Notes Receivable On 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.

7-86 Transfers of Notes Receivable Cash 202,100 Loss on sale of note receivable 2,900 Notes receivable 200,000 Interest receivable 5,000 $205,000  $202,100

7-87 Deciding Whether to Account for a Transfer as a Sale or a Secured Borrowing

7-88 Review In deciding whether financing with receivables is a secured borrowing or a sale under U.S. GAAP, the critical element is the extent to which: A. The transferee has received substantially all the risks and rewards of ownership. B. The age of the receivables transferred differs from the average age of the receivables. C. The transferor of the receivable surrenders control over the assets transferred. D. The transferee relies on funds from the transferor to maintain operations.

7-89 User’s Perspective  Investors and creditors use financial statements to make future oriented decisions based on past historical performance.  Two important ratios related to accounts receivable include:  AR Turnover  Average Days to Collect  Both of these use NET accounts receivable which is based on accountant’s judgment not an actual measurement.

7-90 This ratio measures how many times a company converts its receivables into cash each year. Net Sales Average Accounts Receivable Receivables Turnover 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

7-91 Symantec Corp. vs. CA, Inc., comparison Receivables Management (All dollar amounts in millions)

7-92 Current Issues Recent events related to the collapse of the real estate financing bubble have reshaped GAAP. Much has been made of the ‘mark to market rule’

7-93 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. Current Issues: Accounting for Impairment of a Receivable and a Troubled Debt Restructuring

7-94 Accounting for Impairment of a Receivable and a Troubled Debt Restructuring Bad debt expense 8,867,670 Accrued interest receivable 3,000,000 Allowance for uncollectible accounts 5,867,670 ($30,000,000 - $24,132,330)

7-95 Accounting for Impairment of a Receivable and a Troubled Debt Restructuring A troubled debt restructuring occurs when a creditor makes concessions in response to a debtor’s financial difficulties. (in millions) Land (fair value) 20 Bad debt expense 13 Accrued interest receivable 3 Notes receivable 30 Sometimes a receivable in a troubled debt restructuring is actually settled at the time of the restructuring by the debtor making a payment of cash, some other noncash assets, or even shares of the debtor’s stock.