Chapter 8--Learning Objectives 4 1.Understand the composition and control of cash

What is cash ?

4 For accounting purposes, cash includes: 4 Currency and coins (including petty cash) 4 Demand deposits (checking accounts) 4 Checks, drafts and money orders 4 Readily usable foreign currency 4 Savings accounts (technically investments)

What is NOT cash ? 4 Postage stamps 4 Post-dated checks 4 Certificates of deposit 4 IOUs and notes receivable

Cash equivalents 4 Must be readily convertible to cash 4 Must be close to maturity 4 Cash equivalents frequently include: 4 Treasury bills 4 Commercial paper 4 Certificates of deposit 4 (within 90 days of maturity)

Internal control 4 Procedures used to safeguard assets 4 Probably cannot prevent theft altogether 4 But can make the potential crook’s job more difficult 4 Separate duties 4 Create paper trails

Cash Control 4 Record and deposit receipts promptly 4 Separation of duties 4 No unauthorized or undocumented disbursements 4 Job rotation 4 Imprest funds 4 Internal and external audits 4 Bank reconciliations

Petty cash fund 4 Known as imprest (advanced) fund 4 Establish fund with set amount 4 Debit “Petty Cash” when fund set up 4 Subsequent entries debit various expenses and credit “Cash” 4 Shortages debited to “Cash Over and Short,” treated as misc. expense

Bank reconciliation 4 Prepared when statements received 4 Start with “balance per bank” and “balance per books” 4 Bring both numbers to “corrected cash” or “true cash” 4 Adjust books for items on “books” side of reconciliation

Typical items on “bank” side of reconciliation 4 Balance per bankXXX 4 Deposits in transit+ XXX 4 Outstanding checks- XXX 4 Errors by bank+ or - XXX 4 Corrected cash balanceXXX

Typical items on “books” side of reconciliation 4 Balance per booksXXX 4 Interest earned on account+ XXX 4 Items collected by bank+ XXX 4 Bank service charges- XXX 4 NSF checks- XXX 4 Errors on books+ or - XXX 4 Corrected cash balanceXXX

Typical bank reconciliation adjusting entry Acct. Receivable--Ima DeadbeatXXX Service Charge ExpenseXXX Interest IncomeXXX CashXXX 4 Note handling of NSF check from Ima Deadbeat, one of our customers.

Chapter 8--Learning Objectives 4 2.Record and value accounts receivable

Trade Receivables 4 Result from sales of goods or services on account 4 Balance Sheet Measurement: ‡Net Realizable Value 4 Discounts ‡Trade Discounts ‡Cash Discounts

Net Realizable Value 4 Amount expected to be realized (collected) 4 Gross Accounts Receivable, net of ‡Expected returns & Allowances ‡Cash discounts expected to be taken ‡Expected uncollectible amounts

Trade Discounts 4 Used to determine prices for different types of customers ‡ e.g., builder’s discount

Cash Discounts 4 Offered to encourage early payment 4 Examples ‡ 2, 10, net 30 ‡ 2, 10, eom 4 Accounting approaches ‡ Gross Method ‡ Net Method

Terms and discounts 2 / 10, n / 30 means that a 2 percent discount is available if paid within 10 days and that the balance is due in 30 days

Recording sales discounts The gross method Assume a $100 sale, terms 2/10, n/30 The sale is recorded: Accounts Receivable100 Sales100

Recording sales discounts The gross method 4 If paid within 10 days: Cash98 Sales Discounts2 Accounts Receivable100 4 “Sales Discounts” is a contra-account to “Sales Revenue”

Recording sales discounts The gross method 4 If paid after 10 days: Cash100 Accounts Receivable100

Recording sales discounts The net method 4 Assume a $100 sale, terms 2/10, n/30 4 The sale is recorded: Accounts Receivable98 Sales98

Recording sales discounts The net method 4 If paid within 10 days: Cash98 Accounts Receivable98

Recording sales discounts The gross method 4 If paid after 10 days: Cash100 Accounts Receivable98 Sales Discounts Forfeited2 4 “Sales Discounts Forfeited” is a miscellaneous revenue account

BAD DEBTS If you do business on credit, the question is not “whether” but “how much” Some people cannot or will not pay their bills You know that they are out there You just don’t know who they are

Accounts receivable entries 4 Making a credit sale Accounts ReceivableXXX SalesXXX

Accounts receivable entries 4 Collecting from a credit customer 4 CashXXX 4 Accounts ReceivableXXX

Accounts receivable entries 4 Writing off an uncollectible account 4 Allowance for Bad DebtsXXX 4 Accounts ReceivableXXX

Accounts receivable entries 4 Reinstating an account previously written off Accounts ReceivableXXX Allowance for Bad DebtsXXX CashXXX Accounts ReceivableXXX

Accounts receivable entries 4 The provision for bad debts 4 (an adjusting entry) Bad Debt ExpenseXXX Allowance for Bad DebtsXXX

Valuation of accounts receivable or estimating bad debt expense Two methods will be examined: 1.The percentage of sales method (also known as the income statement method) 2.The percentage of receivables method (also known as the balance sheet method)

Percentage of sales method 4 An income statement approach 4 The more you sell--the more you can expect to lose 4 Consistent with matching principle 4 Select a percentage based on past experience or industry averages 4 Multiply the percentage by total credit sales

Percentage of sales method 4 Assume $1,000,000 sales and 3% estimated bad debts Bad Debt Expense30,000 Allow. for Bad Debts30,000

Percentage of receivables 4 Based on “aging” the individual accounts receivable 4 The later they are in paying--the less likely they are to pay up 4 Percentages likely to default are assigned to each age category 4 The result is the balance needed in the “Allowance for Bad Debts” account

Assume that an aging schedule yields the following information: PercentAmountlikely to StatusAmountdefaultdefault Current $ 70,0000$ days overdue40,00052, days overdue30,000103, days overdue30,000257,500 Over 180 days10,000303,000 Totals$180,000$15,500

The $15,500 is the total amount needed in the “Allowance” account 4 Assume that the “Allowance for Bad Debts” account has a $3,000 credit balance prior to adjustment Allowance for Bad Debts 3,000

The $15,500 is the total amount needed in the “Allowance” account 4 To go from a $3,000 credit to a $15,500 credit will require a $12,500 credit Allowance for Bad Debts 3,000 15,500 12,500

$12,500 is the amount needed to adjust the “Allowance” account 4 The necessary entry is: Bad Debt Expense12,500 Allow. for Bad Debts12,500

Account write-offs do not reduce total assets ! 4 Assume $10,000 of Accts. Receivable and a $1,000 Allowance for Bad Debts 4 Net collectible receivables are $9,000 Accounts receivable$10,000 Less: AFBD 1,000 Net receivables$ 9,000

Accts. Rec.AFBD 10,000 1,000 4 Now assume we write off a $100 account 4 The entry to write off the account is 4 Allowance for Bad Debts100 4 Account Receivable100

4 Now assume we write off a $100 account 4 The entry to write off the account is 4 Allowance for Bad Debts100 4 Account Receivable100 4 Posting the entry has this result: Accts. Rec.AFBD 10,0001, ,900900

Note that net collectible receivables are: Accounts receivable$ 9,900 Less: AFBD 900 Net receivables$ 9,000 BEFORE = $9,000 AFTER = $9,000 Accts. Rec.AFBD 10,0001, ,900900

DIRECT WRITE-OFF METHOD

DIRECT WRITE-OFF METHOD

Chapter 8--Learning Objectives 4 3.Demonstrate how accounts receivable are used as the basis for financing

Receivables can be used as an immediate source of cash 4 Assigning accounts receivable means using them as collateral for a loan 4 Factoring accounts receivable means selling them 4 Factoring can be with recourse or without recourse 4 Recourse refers to ultimate responsibility for payment

Factoring with recourse When accounts are factored with recourse, uncollectible accounts are absorbed by the transferor Transaction is treated as a sale if all of the following conditions are met: 1.Risks, rewards & benefits are transferred 2.Future cash flows are estimable at time of transfer 3.Transferee cannot require transferor to repurchase receivables except under recourse provisions

Factoring with recourse as a borrowing 4 If all conditions for treatment as a sale are not meant, factoring with recourse is treated as a borrowing

Chapter 8--Learning Objectives 4 4.Record and value notes receivable

Notes receivable 4 Formal, written promises to pay 4 Negotiable 4 Provide legal evidence of debt 4 Usually interest bearing, but may be noninterest bearing 4 Should be valued at present value of future cash inflows

Short term note example assumptions 4 $1,000 note received in exchange for an account receivable 4 Received on March 1 4 Matures in six months 4 Interest rate 10 percent

Short term note journal entries On March 1 Note Receivable1,000 Accounts Receivable1,000 On September 1 Cash1,050 Note Receivable1,000 Interest Revenue50

Noninterest bearing notes 4 Amount of note is greater than cash or fair value 4 Difference is recorded in a contra-account to Notes Receivable called “Discount on Note Receivable” 4 Interest is recorded with debits to “Discount on Note Receivable” and credits to “Interest Revenue”

Noninterest bearing note entries At time of issue Note ReceivableXXX Discount on Note Rec.XXX Cash (etc.)XXX Interest accrual Discount on Note Rec.XXX Interest RevenueXXX

Notes receivable with interest rates lower than current market rate 4 Effective interest rate is assigned to note 4 Determine whether fair market value (FMV) of assets surrendered is known or unknown 4 If FMV is known, use as present value of note 4 If FMV not known, use current rate for borrower or rate on other similar loans

Note with low interest rate assumptions--FMV known 4 Three-year, noninterest bearing note dated Face value $10,000 4 Exchanged for land which originally cost $5,000 with a fair market value of $7,120 4 Discount rate for note is 12 percent ($7,120 is the present value of $10,000 to be received in 3 years at 12 percent) 4 Discount must be amortized over life of note

Note with low interest rate entries-- FMV known On Note Receivable10,000 Discount on Note Rec.2,880 Land5,000 Gain on Sale of Land2,120 On (rounded to nearest dollar) Discount on Note Rec.854 Interest Revenue854

Note with low interest rate entries-- FMV known On Discount on Note Rec.957 Interest Revenue957 On (maturity) Discount on Note Rec.1,069 Interest Revenue1,069 Cash10,000 Note Receivable10,000

Note with low interest rate assumptions--FMV unknown 4 Three-year note dated Face value $5,000 4 Stated interest rate 12 percent paid annually 4 Exchanged for land which cost $2,000 with unknown fair market value 4 Incremental interest rate for borrower is 15 percent 4 Present value of note at 15 percent is $4,658 (based on PV of principal and interest)

Note with low interest rate entries-- FMV unknown On Note Receivable5,000 Land2,000 Discount on Note Rec.342 Gain on Sale of Land2,658 “Discount” based on difference between PV of note and $5,000 face amount “Gain” based on difference between PV of note and cost of Land

Formulas for discounting notes receivable Interest (I) = P x R x T P = Principal R = Interest Rate T = Time Maturity Value (MV) = P + I Discount = MV x DR x DP DR = Discount Rate DP = Discount Period Proceeds = MV - Discount

Discounting note receivable assumptions 4 $1,000, six month note dated Face interest rate 10 percent 4 Discounted on Discount rate 12 percent 4 Time to maturity (discount period) is two months 4 Discounted without recourse

Discount calculations 4 Interest = $1,000 x.10 x 6/12 = $50 4 Maturity Value = $1,000 + $50 = $1,050 4 Discount = $1,050 x.12 x 2/12 = $21 4 Proceeds = $1,050 - $21 = $1,029 4 Note value at discount date 4 Interest = $1,000 x.10 x 4/12 = $33 4 Value = $1,000 + $33 = $1,033

Entry to record discounting of note July 1, 1995 Cash1,029 Loss on Sale of Note Rec.4 Note Receivable1,000 Interest Revenue33 Interest Revenue is interest earned to date Loss on Sale is difference between Proceeds and value of note at date of sale

Same note discounted with recourse 4 The bad news here is that if the original maker of the note defaults when the note is due... 4 The bank or finance company will hold the party discounting the note responsible for payment

Chapter 8--Learning Objectives 4 5.Calculate and interpret key liquidity and asset management ratios

Current ratio Current assets Current liabilities

Quick ratio Current assets - Inventory - Prepaid items Current liabilities A more stringent indicator of liquidity than the current ratio

Accounts receivable turnover Credit Sales Average net accounts receivable 4 Average accounts receivable is frequently approximated by adding beginning and ending net receivables and dividing by two

Average collection period for accounts receivable d a y s Accounts receivable turnover 4 Calculation of accounts receivable turnover illustrated on previous slide