PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA Cash and Receivables 7 Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

7 - 2 Cash and Cash Equivalents Balances in checking accounts Currency and coins Cash equivalents are short-term, highly liquid investments that can be readily converted to cash. Money market funds Treasury bills Commercial paper Cash Items for deposit such as checks and money orders from customers

7 - 3 Internal Control Encourages adherence to company policies and procedures Promotes operational efficiency Minimizes errors and theft Enhances the reliability and accuracy of accounting data

7 - 4 Internal Control Procedures Cash Receipts Separate responsibilities for receiving cash, recording cash transactions, and reconciling cash balances. Match the amount of cash received with the amount of cash deposited. Close supervision of cash-handling and cash-recording activities. Cash Receipts Separate responsibilities for receiving cash, recording cash transactions, and reconciling cash balances. Match the amount of cash received with the amount of cash deposited. Close supervision of cash-handling and cash-recording activities. Cash Disbursements All disbursements, except petty cash, made by check. Separate responsibilities for cash disbursement documents, check authorization, check signing, and record keeping. Checks should be signed only by authorized individuals. Cash Disbursements All disbursements, except petty cash, made by check. Separate responsibilities for cash disbursement documents, check authorization, check signing, and record keeping. Checks should be signed only by authorized individuals.

7 - 5 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 - 6 U.S. GAAP vs. IFRS Bank overdrafts are treated as liabilities. In general, cash and cash equivalents are treated similarly under IFRS and U.S. GAAP. One difference is highlighted below. Bank overdrafts may be offset against other cash accounts.

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.

7 - 8 increase sales encourage early payment increase likelihood of collections Cash discounts Cash Discounts

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

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

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.

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.

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 10% 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

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.

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 Income Statement Approach Balance Sheet Approach ◦ Composite Rate ◦ Aging of Receivables

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 debt expense is computed as follows:

In 2012, MusicLand has credit sales of $400,000 and estimates that 0.6% of credit sales are uncollectible. What is Bad Debt Expense for 2012? Income Statement Approach MusicLand computes estimated Bad Debt Expense of $2,400. Bad debt expense2,400 Allowance for uncollectible accounts 2,400

Balance Sheet Approach Focuses on the collectability 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 collectability 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 Debt Expense is computed as:

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 Debt 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 Debt Expense for 2012? Balance Sheet Approach Composite Rate

Desired balance in Allowance for Uncollectible Accounts Balance Sheet Approach Composite Rate Bad debt expense2,300 Allowance for uncollectible accounts 2,300

 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

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. Bad debt expense 850 Allowance for uncollectible accounts 850

Uncollectible Accounts As accounts become uncollectible, this entry is made: When a customer makes a payment after an account has been written off, two journal entries are required. Allowance for uncollectible accounts 500 Accounts receivable 500 Allowance for uncollectible accounts 500 Cash500 Accounts receivable 500

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

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.

Interest-Bearing Notes On November 1, 2012, 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, 2012, December 31, 2012, (year-end) and November 1, 2013 for West. November 1, 2012 Notes receivable 25,000 Cash 25,000 December 31, 2012 Interest receivable 500 Interest revenue 500 November 1, 2013 Cash 28,000 Note receivable 25,000 Interest receivable 500 Interest revenue 2,500

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.

Noninterest-Bearing Notes On Jan. 1, 2012, 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, 2012, and Dec. 31, On Jan. 1, 2012, 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, 2012, and Dec. 31, January 1, 2012 Notes receivable 25,000 Discount on notes receivable 3,000 Sales revenue 22,000 ($25,000 * 12% = $3,000) December 31, 2012 Cash 25,000 Discount on notes receivable 3,000 Interest revenue 3,000 Note receivable25,000

U.S. GAAP vs. IFRS U.S. GAAP allows a “fair value option” for accounting for receivables. U.S. GAAP does not allow receivables to be accounted for as “available for sale” investments. U.S. GAAP requires more disaggregation of accounts and notes receivable in the balance sheet or notes. In general, IFRS and U.S. GAAP are very similar with respect to accounts receivable and notes receivable. Differences are highlighted below. IFRS restricts the circumstances in which a “fair value option” for accounting for receivables is allowed. In the years between 2010 and 2012, companies may account for receivables as “available for sale” investments if the approach is elected initially. After January 1, 2013, this treatment is no longer allowed.

Financing With Receivables Companies may use their receivables to obtain immediate cash.

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.

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.

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.