© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Chapter 7 Cash and Receivables

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-2 Cash Amounts on deposit with financial institutions Coins and currency Petty cash Cashier’s checks Certified checks Money orders

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-3 Cash Equivalents Items very near cash but not in negotiable form Money market funds Treasury bills Commercial paper

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-4 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-5 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-6 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-7 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-8 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-9 Cash Discounts Increase sales. Encourage early payment. Increase likelihood of collections. Cash discounts...

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide /10,n/30 Number of Days Discount is Available Otherwise, Net (or All) is Due Credit Period Discount Percent Cash Discounts

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-11 Cash Discounts Sales are recorded at the invoice amounts. Sales discounts are recorded if payment is received within the discount period. Gross Method

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-12 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-13 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. Eddy uses the periodic method to account for inventory. 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. Eddy uses the periodic method to account for inventory. Prepare the journal entry to record the sale if Eddy uses: (a) the gross method. (b) the net method.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-14 Cash Discounts

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-15 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-16 Cash Discounts

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-17 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-18 Cash Discounts

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-19 Sales Returns Merchandise returned by a customer to a supplier. Sales Allowance A reduction in the cost of defective merchandise. Sales Returns and Allowances

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-20 Sales Returns and Allowances On June 1, a customer of LarCo returns $750 of merchandise that was damaged. 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 that was damaged. LarCo uses the periodic method to account for inventory. Record the journal entry for the return of merchandise.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-21 Sales Returns and Allowances Sales Returns and Allowances is a contra account that reduces Sales Revenue in the current accounting period.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-22 Uncollectible Accounts Receivable Bad debts result from credit customers who will not pay the amount they owe, regardless of continuing collection efforts. PAST DUE

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-23 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-24 Uncollectible Accounts Receivable Most businesses record an estimate of the bad debt expense by an adjusting entry at the end of the accounting period.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-25 Uncollectible Accounts Receivable Normally classified as a selling expense and closed at year-end. Contra asset account to Accounts Receivable.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-26 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-27 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-28 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-29 Bad debts expense is computed as follows: Income Statement Approach

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-30 In 2003, MusicLand has credit sales of $400,000 and estimates that 0.6% of credit sales are uncollectible. What is Bad Debts Expense for 2003? Income Statement Approach

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-31 MusicLand computes estimated Bad Debts Expense of $2,400. Income Statement Approach

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-32 Balance Sheet Approach l Focuses on the collectibility of accounts receivable to make the estimate of uncollectible accounts. l Involves the direct computation of the desired balance in the allowance for uncollectible accounts.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-33  Compute the estimate of the Allowance for Uncollectible Accounts.  Bad Debts Expense is computed as: Balance Sheet Approach Composite Rate

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-34 On Dec. 31, 2003, 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 2003? On Dec. 31, 2003, 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 2003? Balance Sheet Approach Composite Rate

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-35 Desired balance in Allowance for Uncollectible Accounts Balance Sheet Approach Composite Rate

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-36 Now, let’s look at the accounts receivable aging approach!

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-37  Year-end Accounts Receivable is broken down into age classifications.  Each age grouping has a different likelihood of being uncollectible.  Compute estimated uncollectible amount. Balance Sheet Approach Aging of Receivables  Compare estimated uncollectible amount with the balance in the allowance account.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-38    Balance Sheet Approach Aging of Receivables At December 31, 2003, the receivables for EastCo, Inc. were categorized as follows:

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-39 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. Balance Sheet Approach Aging of Receivables Prepare the entry to record bad debts expense at Dec. 31, 

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-40 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. 

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-41 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-42 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?

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-43 Collection of Previously Written- Off Accounts When a customer makes a payment after an account has been written off, two journal entries are required.  

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-44 If uncollectible accounts are immaterial, bad debts are simply recorded as they occur (without the use of an allowance account). Direct Write-off Method

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-45 Let’s move to a new challenge. Notes Receivable

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-46 PROMISSORY NOTE Face Value Date after date I promise to pay to the order of National Bank Boston, MA Dollars plus interest at the annual rate of. $2,000Sept. 30, 2003 Sixty days 12% Two thousand and no/ Janet Lee Maker Payee Principal Interest Rate Date of Note Due Date Notes Receivable

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-47 Even for maturities less than 1 year, the rate is annualized. Interest Computation

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-48 Interest-Bearing Notes On November 1, 2002, Winn, Inc. loans $25,000 to Westward, Co. The note bears interest at 12% and is due on November 1, Prepare the journal entry on November 1, 2002, December 31, 2002, (year-end) and November 1, 2003.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-49 Interest-Bearing Notes

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-50 Interest-Bearing Notes $25,000 × 12% = $3,000 - $500 = $2,500

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-51 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-52 Noninterest-Bearing Notes On January 1, 2003, Winn, Inc. accepted a $25,000 noninterest-bearing note from Westward, 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, 2003, and December 31, On January 1, 2003, Winn, Inc. accepted a $25,000 noninterest-bearing note from Westward, 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, 2003, and December 31, 2003.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-53 Noninterest-Bearing Notes

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-54 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-55 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-56 Secured Borrowing – Pledging Receivables in general are pledged as collateral for loans. Pledged Receivable are disclosed in notes to the financial statements. Receivables in general are pledged as collateral for loans. Pledged Receivable are disclosed in notes to the financial statements.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-57 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-58 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-59 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-60 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-61 Discounting a Note On May 31, Apex discounts a customer’s $25,000 note receivable at the bank. The note was dated May 1 and matures in 90 days. The receivable bears interest at 12% and the bank charges a discount of 15% on the maturity value of the note. Prepare the journal entry to record the discounting of the note receivable as a secured borrowing. On May 31, Apex discounts a customer’s $25,000 note receivable at the bank. The note was dated May 1 and matures in 90 days. The receivable bears interest at 12% and the bank charges a discount of 15% on the maturity value of the note. Prepare the journal entry to record the discounting of the note receivable as a secured borrowing.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-62 Discounting a Note

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-63 Discounting a Note If the three conditions for sale treatment are met, the transaction would be accounted for as a sale, recognizing a gain or loss for the difference between the cash proceeds and the book value of the note.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 7-64 End of Chapter 7