Cash and Receivables 7

Management Issues Related to Cash and Receivables OBJECTIVE 1: Identify and explain the management and ethical issues related to cash and receivables.

Key Ratios Receivable turnover Days’ sales uncollected

Figure 1: Seasonal Cycles and Cash Requirements for an Athletic Sportswear Company

Figure 2: Accounts Receivable as a Percentage of Total Assets for Selected Industries

Figure 3: Receivable Turnover for Selected Industries

Figure 4: Days’ Sales Uncollected for Selected Industries

Figure 5: How Factoring Works

Management Issues Related to Cash and Receivables There are five main management issues related to cash and receivables. –Managing cash needs –Setting credit policies –Evaluating the level of accounts receivable –Financing receivables –Making ethical estimates of credit losses

Management Issues Related to Cash and Receivables Cash –The most liquid of all assets and is central to the operating cycle –Other short-term financial assets are accounts receivable, notes receivable, and short-term investments, all of which can be converted readily to cash. –Cash may include a compensating balance in a bank account, which is not able to be spent and must be disclosed on financial statements.

Management Issues Related to Cash and Receivables Accounts receivable, or trade credit, are amounts owed by customers for sales or services and are current assets. –Installment accounts receivable allow customers to make a series of payments over an extended period.

Management Issues Related to Cash and Receivables The following measures of the effectiveness of credit policies should be compared with industry averages. –Receivable turnover (net credit sales divided by average net accounts receivable) –Days’ sales uncollected (365 days divided by the receivable turnover)

Management Issues Related to Cash and Receivables Some companies finance receivables to maintain financial flexibility. –Establish a finance company –Pledge accounts receivable

Management Issues Related to Cash and Receivables Some companies finance receivables to maintain financial flexibility. (cont.) –Through securitization, group receivables in batches and sell them at a discount to companies and investors –Discount (sell) notes receivable

Management Issues Related to Cash and Receivables Some companies finance receivables to maintain financial flexibility. (cont.) –Factor (sell) accounts receivable Without recourse (e.g., Visa, MasterCard, American Express) means that the factor bears the risk of loss. With recourse means that the seller bears the risk of loss. –A contingent liability is a potential liability that may develop into a real liability depending upon a future occurrence.

Management Issues Related to Cash and Receivables Deliberately overstating or understating earnings as a result of misrepresenting the level of uncollectible accounts is a serious ethical violation.

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Cash Equivalents and Cash Control OBJECTIVE 2: Define cash equivalents, and explain methods of controlling cash, including bank reconciliations.

Exhibit 1: Bank Reconciliation

Cash Equivalents and Cash Control Cash equivalents (e.g., CDs, U.S. Treasury notes) are any security with a term of 90 days or less in which idle cash is invested.

Cash Equivalents and Cash Control Cash control methods –Cash on hand should be kept in a fund, such as a petty cash fund, operated on an imprest system. –Funds may be transferred from one account to another without writing checks using electronic funds transfer.

Cash Equivalents and Cash Control Explain why a bank reconciliation is necessary –Transactions possibly in company’s records only: Outstanding checks Deposits in transit

Cash Equivalents and Cash Control Explain why a bank reconciliation is necessary (cont.) –Transactions possibly in bank’s records only: SC NSF checks Miscellaneous charges and credits Interest income –Recording transactions after reconciliation

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Uncollectible Accounts OBJECTIVE 3: Apply the allowance method of accounting for uncollectible accounts.

Exhibit 2: Analysis of Accounts Receivable by Age

Figure 6: Two Methods of Estimating Uncollectible Accounts

Uncollectible Accounts There are two methods of accounting for uncollectible accounts. –Journalize the write-off of an account under the direct charge-off method.

Uncollectible Accounts There are two methods of accounting for uncollectible accounts.(cont.) –Journalize the year-end adjustment for uncollectible accounts under the allowance method. Estimate uncollectible accounts using the percentage of net sales method. Any previous balance in Allowance for Uncollectible Accounts is irrelevant in making the adjusting entry.

Uncollectible Accounts

Estimate uncollectible accounts using the accounts receivable aging method. Any previous balance in Allowance for Uncollectible Accounts is relevant in making the adjusting entry.

Uncollectible Accounts There are two methods of accounting for uncollectible accounts.(cont.) –Journalize the write-off of a specific account under the allowance method. The net realizable value of Accounts Receivable is unchanged. –Journalize the recovery of accounts receivable written off under the allowance method.

Uncollectible Accounts

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Notes Receivable OBJECTIVE 4: Define promissory note, and make common calculations for promissory notes receivable.

Figure 7: A Promissory Note

Notes Receivable A promissory note is an unconditional promise to pay a sum of money on demand or on a certain date. –The maker of the note records Notes Payable. –The payee of the note records Notes Receivable.

Notes Receivable The maturity value of an interest-bearing note is the face value of the note (principal) plus interest. For a non-interest-bearing note, maturity value is equal to the face amount (which, however, includes implied interest). The maturity date and duration of note must be either stated on the promissory note or determinable from the information on the note.

Notes Receivable Interest = principal × rate of interest × time (length of note). –For example, interest on $800 at 5 percent for 90 days is $10, which is computed by solving $800 × (5 ÷ 100) × (90 ÷ 360). A 360-day year is commonly used to simplify the computation. If the length of the note were expressed in months, then the number of months divided by 12 would constitute the time.

Notes Receivable The maturity value equals principal plus interest. The interest on a note accrues by a small amount each date of the note’s duration. When the maker of a note does not pay the note at maturity, it is said to be a dishonored note.

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