1. © 2013 The McGraw-Hill Companies, Inc. CASH AND RECEIVABLES Chapter 7

2. 7 - 2 Cash and Cash Equivalents Balances in current bank 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

3. 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

4. 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.

5. 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.

6. 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 - 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.

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

9. 7 - 9 2/10,n/30 Number of days discount is available Otherwise, net (or all) is due Credit period Discount percent Cash Discounts

10. 7 - 10 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

11. 7 - 11 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.

12. 7 - 12 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.

13. 7 - 13 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

14. 7 - 14 Subsequent valuation of AR: The Incurred Loss Model Objective evidence of impairment as a result of one or more loss events Indication of Impairment Impairment loss is (1) computed based on the discounted present value of currently expected cash flows at the loan’s original effective rate, and (2) is expensed. Impairment Loss If a future event indicates a decrease in the impairment, a reversal of the impairment is allowed up to an amount such that the carrying amount of the accounts receivable does not exceeds what the account balance would have been had the impairment not been recognized initially. The reversal is recognized in the income statement Recovery (If Any)

15. 7 - 15 The Incurred Loss Model Objective Evidence of Impairment as a Result of One or More Loss Events Loss events occur after initial recognition of the receivables and have an adverse impact on the receivables’ future cash flows Accounts receivables are organized into two classes: individually significant and individually not significant Assessment of impairment evidence for individually significant accounts is carried out individually. If no impairment evidence, whether significant or not, these accounts are assessed again for impairment collectively in groups of accounts that similar credit risk characteristics. Assessment for individually not significant accounts is done either individually or collectively Writing off Bad Debts The bad debt amount can be written off against (credit) the carrying amount of the accounts receivable either directly or through the use of an allowance for bad debts account he bad debt amount is recognized in the income statement as an expense (debit)

16. 7 - 16 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.

17. 7 - 17 Interest-Bearing Notes On November 1, 2013, West, Inc. loans $25,000 to Winn Co. The note bears interest at 12% and is due on November 1, 2014. Prepare the journal entry on November 1, 2013, December 31, 2013, (year-end) and November 1, 2014 for West. November 1, 2013 Notes receivable 25,000 Cash 25,000 December 31, 2013 Interest receivable 500 Interest revenue 500 November 1, 2014 Cash 28,000 Note receivable 25,000 Interest receivable 500 Interest revenue 2,500

18. 7 - 18 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.

19. 7 - 19 Noninterest-Bearing Notes On Jan. 1, 2013, 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, 2013. Prepare the journal entries on Jan. 1, 2013, and Dec. 31, 2013. On Jan. 1, 2013, 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, 2013. Prepare the journal entries on Jan. 1, 2013, and Dec. 31, 2013. January 1, 2013 Notes receivable 25,000 Discount on notes receivable 3,000 Sales revenue 22,000 ($25,000 * 12% = $3,000) December 31, 2013 Cash 25,000 Discount on notes receivable 3,000 Interest revenue 3,000 Note receivable25,000

20. 7 - 20 Subsequent valuation of NR: Impairment Objective evidence of the occurrence of loss events that adversely affect the estimated future cash flows Indication of Impairment Impairment loss is computed based on the discounted present value of currently expected cash flows at the loan’s original effective rate Impairment Loss If additional information indicates that conditions have changed, bad debts expense and the allowance are adjusted accordingly Repeat

21. 7 - 21 Subsequent valuation of NR: When Receivable is Continued but with Modified Terms When a company holds a receivable from another company, there is some potential that the receivable will eventually be impaired. Impairment of a receivable occurs if the company believes it is probable that it will not receive all of the cash flows (principal and any interest payments) associated with the receivable.

22. 7 - 22 Subsequent valuation of NR: When Receivable is Settled Outright

23. 7 - 23 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 statement of financial position 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 2014, companies may account for receivables as “available for sale” investments if the approach is elected initially. After January 1, 2015, this treatment is no longer allowed.

24. 7 - 24 Financing With Receivables Companies may use their receivables to obtain immediate cash.

25. 7 - 25 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.

26. 7 - 26 Secured Borrowing

27. 7 - 27 Sale of Receivables Treat as a sale only if the conditions for derecognition, under IFRS No. 9 and IAS No. 39, can be met. Rights to cash flows from the receivables expire? Continue to recognize the receivables Continuing Investment Derecognize the receivables Transfer rights to receive cash flows from the receivables? Assume obligations to pay cash flows that meet three conditions? Transfer substantially all the risks and reward of the receivables? Retain substantially all the risks and rewards of the receivables? Retain control of the receivables? NO Yes

28. 7 - 28 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.

29. 7 - 29 Sale of Receivables In December 2013, the Santa Teresa Glass Company factored accounts receivable that had a book value of $600,000 to Factor Bank. The transfer was made without recourse. Under this arrangement, Santa Teresa transfers the $600,000 of receivables to Factor, and Factor immediately remits to Santa Teresa cash equal to 90% of the factored amount (90% × $600,000 = $540,000). Factor retains the remaining 10% to cover its factoring fee (equal to 4% of the total factored amount; 4% × $600,000 = $24,000) and to provide a cushion against potential sales returns and allowances. Assume the same facts as above, except that Santa Teresa sold the receivables to Factor with recourse and estimates the fair value of the recourse obligation to be $5,000.

30. 7 - 30 Sale of Receivables Securitization: Transfer receivables to a SPE Special Purpose Entity (SPE) (usually a trust or subsidiary) Qualifying Special Purpose Entity (QSPE) Changing rules…eliminate QSPE…require consolidation! Participating Interests: Transfer portion of a receivable Example: transfer right to interest, but retain right to principal Changing rules…require a partial transfer be treated as a secured borrowing, unless specific conditions are met!

31. 7 - 31 Interest receivable 5,000 Interest revenue 5,000 Transfers of Notes Receivable On December 31, Stridewell accepted a nine-month 10 percent note for $200,000 from a customer. Three months later on March 31, Stridewell discounted the note at its local bank. The bank’s discount rate is 12 percent. $200,000 × 10% × 3/12 Before preparing the journal entry to record the discounting, Stridewell must record the accrued interest on the note from December 31 until March 31.

32. 7 - 32 Transfers of Notes Receivable Cash 202,100 Loss on sale of note receivable 2,900 Notes receivable 200,000 Interest receivable 5,000 $205,000 - $202,100

33. 7 - 33 U.S. GAAP vs. IFRS U.S. GAAP focuses on whether control of assets has shifted from the transferor to the transferee. The U.S. GAAP and the IFRS approaches often lead to similar accounting treatment for transfers of receivables. IFRS requires a more complex decision process. The company has to have transferred the rights to receive the cash flows from the receivable, and then considers whether the company has transferred “substantially all of the risks and rewards of ownership,” as well as whether the company has transferred control.

34. 7 - 34 This ratio measures how many times a company converts its receivables into cash each year. Net Sales Average Accounts Receivable Receivables Turnover Ratio = This ratio is an approximation of the number of days the average accounts receivable balance is outstanding. 365 Receivables Turnover Ratio Average Collection Period = Receivables Management

35. 7 - 35 Symantec Corp. vs. CA, Inc. comparison Receivables Management (All dollar amounts in millions)

36. 7 - 36 Appendix 7-A: Cash Controls Bank Balance + Deposits in Transit - Outstanding Checks ± Bank Errors = Corrected Balance Book Balance + Bank Collections - Service Charges - NSF Checks ± Book Errors = Corrected Balance Provides information for reconciling journal entries. A bank reconciliation explains the difference between cash reported on bank statement and cash balance on a company’s books.

37. 7 - 37 Petty cash is used for minor expenditures. Has one custodian. Replenished periodically. Petty cash fund Appendix 7-A: Cash Controls

38. 7 - 38 Appendix 7-B: Methods for Estimating Future Bad Debts 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.

39. 7 - 39 Appendix 7-B: Methods for Estimating Future Bad Debts 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.

40. 7 - 40 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

41. 7 - 41 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:

42. 7 - 42 In 2013, MusicLand has credit sales of $400,000 and estimates that 0.6% of credit sales are uncollectible. What is Bad Debt Expense for 2013? Income Statement Approach MusicLand computes estimated Bad Debt Expense of $2,400. Bad debt expense2,400 Allowance for uncollectible accounts 2,400

43. 7 - 43 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:

44. 7 - 44 On Dec. 31, 2013, 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 2013? On Dec. 31, 2013, 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 2013? Balance Sheet Approach Composite Rate

45. 7 - 45 Desired balance in Allowance for Uncollectible Accounts Balance Sheet Approach Composite Rate Bad debt expense2,300 Allowance for uncollectible accounts 2,300

46. 7 - 46  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.  Year-end Accounts Receivable is broken down into age classifications.

47. 7 - 47    At December 31, 2013, the receivables for EastCo, Inc. were categorized as follows: Balance Sheet Approach Aging of Receivables

48. 7 - 48 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

49. 7 - 49 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

50. 7 - 50 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

51. 7 - 51 Appendix 7-C: Deciding Whether to Account for a Transfer as a Sale or a Secured Borrowing Under U.S.GAAP Does the transfer meet the requirements for derecognition?

52. End of Chapter 7