1 Chapter 6: Cash and Accounts Receivable

2 Current asset: if intended to be converted into cash, or used up, within one year or within an operating cycle, whichever is longer. Industries like aerospace and manufacturers of farm equipment may have operating cycles longer than a year.

3 The Operating Cycle, Figure 6-1 Cash Sales to customers Receive payment Manufacture or purchase inventory Inventory AccountsReceivable Note that the operating cycle is effectively complete when the cash is “collectible,” or at the A/R stage.

4 Current Asset Classification The distinction is useful because it provides easy- to-determine, low-cost measures of a company’s short term liquidity. Working capital = current assets - current liabilities Current ratio = current assets/current liabilities

5 Current Ratio= Current assets/Current liabilities Current assets are often compared to current liabilities as an indicator of a company’s solvency. Average current ratios also vary across industries. Caution regarding this ratio, as it can actually increase in years before bankruptcy.

6 Cash The cash account is the first asset listed in the current asset section of the balance sheet. It consists of coin, checks, and bank drafts received by the company. The only reporting issues for cash is whether there are restrictions on its use. Some companies now report “cash and cash equivalents.” (More in Chapter 14)

7 Proper Management and Control of Cash Proper cash management requires that enough cash be available to meet the needs of the company’s operations. Too much cash is undesirable as it loses purchasing power in periods of inflation, and can generate additional cash if it is invested properly. Control of cash – Control of records Bank reconciliation – Physical control Separation of duties

8 Accounts Receivable Accounts receivable arise from selling goods or services to customers on account. Recorded at face amount to be collected. However, we must also reflect the fact that a portion of A/R may not be collected. Reasons for lack of collection: 1. sales discounts (cash discounts) 2. sales returns 3. sales allowances 4. uncollectible A/R (bad debts)

9 1. Cash Discounts Cash discounts are offered by a company to encourage its customers to pay early. The terms are usually expressed as “1/10, n/30”, which would mean a 1% discount if the customer pays within 10 days, or the net (full) amount is due within 30 days. “Cash Discount” or “Sales Discount” is presented as a contra to Sales Revenue on the income statement. Calculation of net sales on the I/S: Sales revenue - Sales discounts (SD) - sales returns (see slide 11) (SR) - sales allowances (see slide 11) (SA) = Net sales Formula: S - SD - SR - SA = S(net)

10 Journal Entries for Cash Discounts (gross method) Original sale: $100, terms 2/10, n/30. At time of sale: A/R100 Sales Revenue 100 If received within 10 days: Cash 98 Sales Discount 2 A/R 100 If received after 10 days: Cash100 A/R 100

11 2. Sales Returns and Allowances If sales returns are small in amount, adjust A/R and create a contra to Sales called Sales Returns when the merchandise is returned. Sales allowances are negotiated reductions in sales price after the sale. Sales Allowancexx Sales Returnsxx A/Rxx If sales returns are significant (e.g., bookstore), company must estimate the amount of sales returns expected, and adjust A/R (with a contra account similar to Allowance for Bad Debts) at the end of the period. Estimated Sales Returns xx Allowance for Returnsxx

12 3.Allowance for Doubtful Accounts Created as a contra account to A/R to indicate the portion of A/R that will not be collected due to defaults on payments by customers. Reason for Allowance account: Assume $1,000 sale in 2004 and default on collection in Record sale in 2004: A/R1,000 Sales Revenue 1,000 Record default in 2005: Bad Debt Expense 1,000 A/R 1,000 Note: this is called the direct method, and is not GAAP, for the reasons listed on the next page.

13 Problems with Direct Method Problem: the direct method, on the previous slide, does not achieve matching (revenues recognized in 2004, but a related expense was recognized in 2005). Problem: the direct method does not correctly value the asset, A/R. The assets are overvalued until 2005, when the receivable is written off.

14 Solution: the Allowance Method Solution: create a contra to A/R, and estimate the A/R that will not be collected. The AJE to record an estimate for uncollectibles in 2004 (for all uncollectibles): Bad Debt Expense4,000 Allowance 4,000 The GJE during 2005, when a specific A/R is deemed uncollectible (this is called the write-off of a specific A/R): Allowance1,000 A/R 1,000 When are the income statement and balance sheet affected?

15 Estimation of Uncollectibles Note that we do not know in 2004 which A/Rs will not be collected in Therefore, we must estimate uncollectibles. There are two methods: 1. Percentage of sales 2. Percentage of accounts receivable Both methods are used to estimate uncollectibles for the AJE. The percentage of sales method is simpler, but the percentage of A/R method is more accurate.

16 1. Percentage of Sales Method Usually based on credit sales, but may use total sales or net sales as basis. Calculation: Sales x % = Bad Debt Expense (focus on the debit side of the AJE) Called the Income Statement approach, because: revenues x % = expense.

17 2. Percentage of A/R Method (using Aging Schedule) Based on ending A/R and ending Allowance account. Calculation: Ending A/R x % = Ending Allowance (focus on the credit side of the AJE) Called Balance Sheet approach, because: ending asset x % = ending contra asset. Requires the analysis of the Allowance account before preparing the AJE. An aging schedule of A/R is the most accurate way to estimate uncollectibles (see Figure 6-11).

18 T-Account Approach for Percentage of A/R Method Based on the analysis of the Allowance account. Calculate the “desired ending balance” based on an aging of A/R. Now, given the Beginning, Ending and Write-off amounts, calculate the amount of the current estimate that must be added to the Allowance account to achieve the “desired ending balance.”

19 Allowance for Doubtful Accts. (T-account) Allowance for Doubtful Accts. 1. Beginning Balance 1. The allowance established in the prior period carries forward for current period write-offs.

20 Allowance for Doubtful Accts. (T-account) Allowance for Doubtful Accts. Beginning Balance Accounts Receivable 2. Write-off of specific accounts receivable 2. Write-off of specific accounts receivable 2. As specific accounts are determined uncollectible during the year, they are written-off to the allowance account as shown. These write-offs may cause the allowance account to have a debit balance before the AJE if the prior year’s expense was underestimated.

21 Allowance for Doubtful Accts. (T-account) Allowance for Doubtful Accts. Beginning Balance Accounts Receivable Write-off of accounts receivable 3. Ending Balance Write-off of accounts receivable 3. The “desired ending balance” in the allowance account is estimated using the percentage calculation or the aging schedule.

22 Allowance for Doubtful Accts. (T-account) Allowance for Doubtful Accts. Beginning Balance 4. Recovery of write-offs 4. Recovery of write-offs Accounts Receivable Write-off of accounts receivable Ending Balance Write-off of accounts receivable 4. The recovery of an account receivable that has been written off must first be reversed back into A/R and the Allowance account. Then the collection is like the collection of any other A/R.

23 Allowance for Doubtful Accts. (T-account) Allowance for Doubtful Accts. Beginning Balance 5. Recognition of bad debt expense Bad Debts Expense 5. Recognition of bad debt expense Accounts Receivable Write-off of accounts receivable Ending Balance Write-off of accounts receivable 5. The AJE to record the estimate of uncollectibles is calculated based on the amount necessary to achieve the “desired ending balance” in the allowance account. The focus is on the Allowance account. Write-off recovery Write off recovery

24 Class Problem Given the following information: At December 31, 2004, Company Z prepared an aging schedule to determine that the uncollectible accounts receivable at that date were $18,000. The balance in the Allowance for Doubtful Accounts at 1/1/04 was a $3,000 credit. During 2004, the company wrote off $5,000 of specific accounts receivable that were deemed to be uncollectible. Required: prepare the AJE to record the estimated uncollectibles at 12/31/04.

25 Solution to Class Problems Allowance for Doubtful Accounts (1) Post the beginning balance and write-off. (2) Post the desired ending balance. (3) Post the adjusting journal entry.

26 Exercise 6-3 (a)Sale on Dec. 12: AJE on Dec. 31? Payment on Jan. 5 (all $40,000):

27 Exercise 6-3 (b)Sale on Dec. 12: Payment on Dec. 20: Less cash received; less sales (net) recognized because of the sales discount.

28 Problem 6-4, Part (a) 2005 Percentage of Sales method (a) 2005 Net sales = Sales - SD - SR - SA B.D. Expense = 3% of net sales AJE at 12/31:

29 Problem 6-4, Part (b) 2005 Allowance for Doubtful Accounts Note that, for the percentage of sales method, the AJE is posted before calculating the ending balance.

30 Problem 6-4, Part (c) 2006 (c) 2006 Net sales = Sales - SD - SR - SA B.D. Expense = 3% of net sales AJE at 12/31:

31 Problem 6-4, Part (d) 2006 Allowance for Doubtful Accounts Note that, for the percentage of sales method, the AJE is posted before calculating the ending balance.

32 Brief Exercise 6-2, Parts (a) and (b) Given in your text: Beginning$5,500$4,792 Increases 4,400 3,788 Decreases (4,492) (3,722) Recoveries Ending$6,256$5,500 (a) Bad debt expense? (b) Write-offs?

33 Brief Exercise 6-2, Part (c) Given in your text: Beginning$5,500$4,792 Increases 4,400 3,788 Decreases(4,492) (3,722) Recoveries Ending$6,256$5,500 (c) Change?

34 Manipulation of Sales and Bad Debt Expense Financial statement users should be aware of the fact that policies may vary from company to company in recognition of sales and in estimation of bad debt expense. Additionally, users should watch for consistency in the recognition of these amounts from period to period.

35 Foreign Currency Receivables and Payables U.S. companies may buy and sell inventory with foreign companies located in foreign countries. If the contract is denominated in a foreign currency, U. S. companies must recognize gains and losses from the change in the exchange rate between the foreign currency and the U.S. dollar.

36 Dealing with Exchange Rates Foreign currency exchange rates fluctuate daily. Daily quotes can be found in the newspaper or Wall Street Journal. The class examples use direct quotes which express one unit of a foreign currency in terms of the U.S. dollar. The rates move directly in relation to the related foreign currency receivable or payable. Ex: Direct: one British pound (£) = $0.70 (Indirect: one U. S. dollar = £) To convert indirect to direct: 1/indirect = direct or 1/direct = indirect

37 Receivables Denominated in a Foreign Currency See Motorola example in text (pp ). This example is denominated in euros (1.5 million euros). Date Direct quote Dec. 1: $1.10 per euro Dec. 31: $1.00 per euro

38 Receivables Denominated in a Foreign Currency See journal entries for Motorola. At the date of sale, we record a N/R in U.S. dollar equivalent based on one euro = $1.10 Calculation: 1.5 million euros x $1.10 = 1.65 million dollars. Journal entry (in millions) at 12/1 to record sale: A/R (foreign currency)1.65 Sales revenue 1.65 Note that a receivable in a foreign currency must be converted to dollars before it can be recorded in a U.S. company’s books. Also, the receivable must be revalued as the foreign currency fluctuates.

39 Receivables Denominated in a Foreign Currency - continued Why a loss for Motorola at Dec. 31? The foreign currency went down with respect to the dollar ($1.10 down to $1.00 = decrease of $0.10). If we received the euros today, we would sell it for less dollars, so decrease (credit) the foreign currency accounts receivable for $0.15 million (1.5 million x $0.10). Journal entry (in millions): Exchange rate loss0.15 A/R (foreign currency)0.15

40 Payables Denominated in a Foreign Currency The same concepts hold when a U. S. company buys goods from a foreign country, and the contract is denominated in the foreign currency, except that a decrease in the direct exchange rate means a decrease in the liability (as expressed in dollars) and an exchange gain (the liability will be payable with fewer dollars). Increases in the direct exchange rate of the dollar with respect to the foreign currency will yield reverse effects for gains and losses.

41 Hedging of Foreign Currency Receivables and Payables A company may “pass off” the risk of an unfavorable exchange rate change by entering into the marketplace and taking a equal and opposite position. For example, if the company will be receiving 1.5 million euros, it could contract to sell 1.5 million euros on the same date. This offsets any losses or gains from the exchange rate to the date of sale.

42 Class Problem P6-11 (1 and 3) (a)First, convert the currencies to direct exchange rates (dollars per unit of foreign currency). For example, convert.5 British pound per dollar (indirect) to dollars per British pound (direct) = $1 per 0.50 £ = 1/.5 = $2.00 per £: At sale/ purchaseAt 12/31 British pound $2.00$ Euros $1.25$

43 Now journal entries for P6-11, parts 1 and 3 (use direct rates). Part 1: (b) Journal entry at sale: (c) Journal entry at 12/31:

44 Now journal entries for P6-11, parts 1 and 3 (use direct rates). Part 3: (b) Journal entry at purchase: (c) Journal entry at 12/31:

45 P6-11, Part (d) Exchange gains and losses occur because of the differential movement of the two currencies, and are dependent on whether the company holds a receivable or payable. If the company has a receivable denominated in a foreign currency, the dollar value of the receivable will decrease as the dollar moves down with respect to the foreign currency, and will result in a loss (see Part 1). If the company has a payable denominated in a foreign currency, the dollar value of the payable will decrease as the dollar moves down with respect to the foreign currency, and will result in a gain (see Part 3).