Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Cash and Receivables 7 Insert Book Cover Picture

7-2 Cash Amounts on deposit with financial institutions Coins and currency Petty cash Cashier’s checks Certified checks Money orders

7-3 Cash Equivalents Items very near cash but not in negotiable form Money market funds Treasury bills Commercial paper

7-4 Learning Objectives Define what is meant by internal control and describe some key elements of an internal control system for cash receipts and disbursements.

7-5 Internal Control of Cash Encourages adherence to company policies and procedures Promotes operational efficiency Minimizes errors and theft Enhances the reliability and accuracy of accounting data

7-6 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. 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 Control of Cash Disbursements Separate responsibilities for  cash disbursement documents,  check writing,  check signing,  check mailing, and  record keeping. All disbursements, except petty cash, made by check. Separate responsibilities for  cash disbursement documents,  check writing,  check signing,  check mailing, and  record keeping. All disbursements, except petty cash, made by check.

7-8 Learning Objectives Explain the possible restrictions on cash and their implications for classification in the balance sheet.

7-9 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 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 account as support for funds borrowed from the bank.

7-10 Learning Objectives Distinguish between the gross and net methods of accounting for cash discounts

7-11 Credit sales require:  Maintaining a separate account receivable for each customer.  Accounting for bad debts that result from credit sales. Credit sales require:  Maintaining a separate account receivable for each customer.  Accounting for bad debts that result from credit sales. Amounts due from customers for credit sales. Amounts due from customers for credit sales. Accounts Receivable

7-12 Cash Discounts Increase sales. Encourage early payment. Increase likelihood of collections. Cash discounts...

7-13 2/10,n/30 Number of Days Discount is Available Otherwise, Net (or All) is Due Credit Period Discount Percent Cash Discounts

7-14 Cash Discounts Sales are recorded at the invoice amounts. Sales discounts are recorded if payment is received within the discount period. Gross Method

7-15 Cash Discounts Sales are recorded at the invoice amount less the discount. Sales discounts forfeited are recorded if payment is received after the discount period. Net Method

7-16 Cash Discounts On May 10, Eddy, Inc. sold $5,000 of merchandise to a customer subject to a cash discount of 1/10, n/30. Prepare the journal entry to record the sale if Eddy uses: (a) the gross method. (b) the net method. On May 10, Eddy, Inc. sold $5,000 of merchandise to a customer subject to a cash discount of 1/10, n/30. Prepare the journal entry to record the sale if Eddy uses: (a) the gross method. (b) the net method.

7-17 Cash Discounts

7-18 Cash Discounts Assume that on May 19, Eddy, Inc. received a check in full payment of the sale made on May 10. Prepare the journal entry to record the cash receipt if Eddy uses: (a) the gross method. (b) the net method. Assume that on May 19, Eddy, Inc. received a check in full payment of the sale made on May 10. Prepare the journal entry to record the cash receipt if Eddy uses: (a) the gross method. (b) the net method.

7-19 Cash Discounts

7-20 Cash Discounts Instead of the payment on May 19, now assume that Eddy, Inc. received a check on May 31, in full payment of the sale made on May 10. Prepare the journal entry to record the cash receipt if Eddy uses: (a) the gross method. (b) the net method. Instead of the payment on May 19, now assume that Eddy, Inc. received a check on May 31, in full payment of the sale made on May 10. Prepare the journal entry to record the cash receipt if Eddy uses: (a) the gross method. (b) the net method.

7-21 Cash Discounts

7-22 Learning Objectives Describe the accounting treatment for merchandise returns.

7-23 Sales Returns Merchandise returned by a customer to a supplier. Sales Allowances A reduction in the cost of defective merchandise. Sales Returns and Allowances

7-24 Sales Returns and Allowances On June 1, a customer of LarCo returns $750 of merchandise. The merchandise had been purchased on account and the customer had not yet paid. LarCo uses the periodic method to account for inventory. Record the journal entry for the return of merchandise. On June 1, a customer of LarCo returns $750 of merchandise. The merchandise had been purchased on account and the customer had not yet paid. LarCo uses the periodic method to account for inventory. Record the journal entry for the return of merchandise.

7-25 Sales Returns and Allowances Sales Returns and Allowances is a contra account that reduces Sales Revenue in the current accounting period.

7-26 Learning Objectives Describe the accounting treatment of anticipated uncollectible accounts receivable.

7-27 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

7-28 Uncollectible 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 uncollectible account were recorded.

7-29 Uncollectible Accounts Receivable Most businesses record an estimate of the bad debt expense by an adjusting entry at the end of the accounting period.

7-30 Uncollectible Accounts Receivable Normally classified as a selling expense and closed at year-end. Contra asset account to Accounts Receivable.

7-31 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

7-32 Learning Objectives Describe the two approaches to estimating bad debts.

7-33  Income Statement Approach  Balance Sheet Approach Composite Rate Aging of Receivables  Income Statement Approach  Balance Sheet Approach Composite Rate Aging of Receivables PAST DUE Estimating Bad Debts

7-34 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.

7-35 Bad debts expense is computed as follows: Income Statement Approach

7-36 In 2006, MusicLand has credit sales of $400,000 and estimates that 0.6% of credit sales are uncollectible. What is Bad Debts Expense for 2006? Income Statement Approach

7-37 MusicLand computes estimated Bad Debts Expense of $2,400. Income Statement Approach

7-38 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.

7-39  Compute the desired balance in the Allowance for Uncollectible Accounts.  Bad Debts Expense is computed as: Balance Sheet Approach Composite Rate

7-40 On Dec. 31, 2006, 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 2006? On Dec. 31, 2006, 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 2006? Balance Sheet Approach Composite Rate

7-41 Desired balance in Allowance for Uncollectible Accounts Balance Sheet Approach Composite Rate

7-42 Now, let’s look at the accounts receivable aging approach!

7-43  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.

7-44    At December 31, 2006, the receivables for EastCo, Inc. were categorized as follows: Balance Sheet Approach Aging of Receivables

7-45 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

7-46 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. 

7-47 Balance Sheet Approach Emphasis on Realizable Value Accts. Rec. 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

7-48 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?

7-49 Collection of Previously Written-Off Accounts When a customer makes a payment after an account has been written off, two journal entries are required.  

7-50 If uncollectible accounts are immaterial, bad debts are simply recorded as they occur (without the use of an allowance account). Direct Write-off Method

7-51 Learning Objectives Describe the accounting treatment of short- term notes receivable.

7-52 PROMISSORY NOTE Face Value Date I after date I promise to pay to the order of Westward, Inc. Dollars plus interest at the annual rate of. $25,000Nov. 1, 2006 One year 12% Twenty-five thousand and no/ Janet Lee, Winn,Co. Maker Payee Principal Interest Rate Date of Note Term Notes Receivable

7-53 Even for maturities less than 1 year, the rate is annualized. Interest Computation

7-54 Interest-Bearing Notes On November 1, 2006, Westward, 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, 2006, December 31, 2006, (year-end) and November 1, 2007 for Westward.

7-55 Interest-Bearing Notes

7-56 Interest-Bearing Notes $25,000 × 12% = $3,000 - $500 = $2,500

7-57 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.

7-58 Noninterest-Bearing Notes On January 1, 2006, Westward, 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 December 31, Prepare the journal entries on January 1, 2006, and December 31, 2006 for Westward. On January 1, 2006, Westward, 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 December 31, Prepare the journal entries on January 1, 2006, and December 31, 2006 for Westward.

7-59 Noninterest-Bearing Notes

7-60 Learning Objectives Differentiate between the use of receivables in financing arrangements accounted for as a secured borrowing and those accounted for as a sale.

7-61 Financing With Receivables Secured borrowing or Sale of receivables Secured borrowing or Sale of receivables Method depends on the surrender of control over the receivables transferred.

7-62 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.  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.

7-63 Secured Borrowing – Pledging  Receivables in general are pledged as collateral for loans.  Pledged receivables are disclosed in notes to the financial statements.  Receivables in general are pledged as collateral for loans.  Pledged receivables are disclosed in notes to the financial statements.

7-64 Sale of Accounts Receivable 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.

7-65 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. Sale of Accounts Receivable

7-66 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. 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.

7-67 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. 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. Sale of Accounts Receivable

7-68 Discounting a Note On December 31, Apex accepted a nine- month 10 percent note for $200,000 from a customer. Three months later on March 31, Apex discounted the note at its local bank. The bank’s discount rate 12 percent. Prepare the journal entry to record the discounting of the note receivable as a sale. On December 31, Apex accepted a nine- month 10 percent note for $200,000 from a customer. Three months later on March 31, Apex discounted the note at its local bank. The bank’s discount rate 12 percent. Prepare the journal entry to record the discounting of the note receivable as a sale.

7-69 Discounting a Note Before the preparing the journal entry to record the discounting, Apex must record the accrued interest on the note from December 31 until March 31. $200,000 × 10% × 3/12

7-70 Discounting a Note $205,000 - $202,100

7-71 Discounting a Note If the three conditions for sale treatment are not met, the transaction would be recorded as a secured borrowing.

7-72 Learning Objectives Describe the variables that influence a company’s investment in receivables and calculate the key ratios used by analysts to monitor that investment.

7-73 Receivables Management Product or service sold Credit and collection policies Level of sales Factors influencing a company’s investment in receivables

7-74 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

7-75 Dell vs. Apple comparison Compute the receivables turnover ratio and the average collection period for both companies. Receivables Management (All dollar amounts in millions)

7-76 Receivables Management Net Sales Average Accounts Receivable Receivables Turnover Ratio = Dell $41,444 ($3,635 + $2,586)/2 = Apple $8,279 ($774 + $766)/2 = 10.75

7-77 Receivables Management Dell = 27.4 days Apple = 34 days 365 Receivables Turnover Ratio Average Collection Period =

7-78 Appendix 7 Cash Controls

7-79 Bank Reconciliation Provides information for reconciling journal entries. Explains the difference between cash reported on bank statement and cash balance on company’s books.

7-80 Bank Reconciliation Bank Balance + Deposits in Transit - Outstanding Checks ± Bank Errors = Corrected Balance Book Balance + Bank Collections - Service Charges - NSF Checks ± Book Errors = Corrected Balance

7-81 Bank Reconciliation Balance per Bank + Deposits in Transit - Outstanding Checks ± Bank Errors = Adjusted Balance All reconciling items on the book side require an adjusting entry to the cash account. Book Balance + Bank Collections - Service Charges - NSF Checks ± Book Errors = Corrected Balance

7-82 Let’s prepare a May 31 bank reconciliation for the Hawthorne Company.  The May 31 bank statement indicated a balance of $34,680.  The cash general ledger account on that date shows a balance of $35,276. Additional information necessary for the reconciliation is shown on the next screen. Let’s prepare a May 31 bank reconciliation for the Hawthorne Company.  The May 31 bank statement indicated a balance of $34,680.  The cash general ledger account on that date shows a balance of $35,276. Additional information necessary for the reconciliation is shown on the next screen. Bank Reconciliation

7-83  Cash receipts not yet deposited on May 31 totaled $2,965.  A $1,020 check mailed to the bank for deposit had not reached the bank at the statement date.  Outstanding checks totaled $5,536.  A check written to pay for raw materials purchased on account cleared the bank for $1,790 but was erroneously recorded at $790.  The bank statement showed $80 in service charges in May.  The bank returned NSF checks in the amount of $2,187 received as payment on accounts receivable.  The bank collected a note receivable for $1,120 that included $120 of interest. Bank Reconciliation

7-84 Bank Reconciliation

7-85 Bank Reconciliation

7-86 Prepare the entries to adjust the cash account to the corrected balance. Bank Reconciliation

7-87 Used for minor expenditures. Petty Cash Has one custodian. Replenished periodically. Petty cash fund

7-88 Petty Cash Hawthorne Co. established a petty cash fund on May 1 by writing a check for $200 to the petty cash custodian. Prepare the May1st journal entry to record the establishment of the fund. Hawthorne Co. established a petty cash fund on May 1 by writing a check for $200 to the petty cash custodian. Prepare the May1st journal entry to record the establishment of the fund.

7-89 Petty Cash During May, the petty cash custodian paid bills using cash from the fund totaling $160 as follows: Postage$40 Office supplies 35 Delivery charges 55 Entertainment 30 Prepare the May 31 journal entry to record replenishing the fund.

7-90 End of Chapter 7