1. 7-1 ©2006 Prentice Hall, Inc.

2. 7-2 ©2006 Prentice Hall, Inc. CASH, ACCOUNTS RECEIVABLE, AND BAD DEBTS EXPENSE  Learning objectives Learning objectives  Accounts receivable & bad debts expense Accounts receivable & bad debts expense  Notes receivable Notes receivable  Controlling cash Controlling cash  Reporting cash Reporting cash  Ratio analysis Ratio analysis  Business, risk, control, and ethics Business, risk, control, and ethics

3. 7-3 ©2006 Prentice Hall, Inc. Learning Objectives (1 of 2)  Calculate bad debts expense and explain how a firm evaluates and reports accounts receivable  Account for and report notes receivable  Explain how a firm controls cash and prepares a bank reconciliation

4. 7-4 ©2006 Prentice Hall, Inc. Learning Objectives (2 of 2)  Describe how cash is reported on the financial statements  Analyze a firm’s accounts receivable with ratio analysis  Identify the risks and controls associated with cash and receivables

5. 7-5 ©2006 Prentice Hall, Inc. Accounts Receivable and Bad Debts Expense  Extending credit Extending credit  Recording uncollectible accounts Recording uncollectible accounts  Methods of estimating bad debts expense Methods of estimating bad debts expense  Writing off a specific account Writing off a specific account  The direct write-off method The direct write-off method  How is the estimate for uncollectibles used to achieve smoothing?

6. 7-6 ©2006 Prentice Hall, Inc. Extending Credit (1 of 3)  Credit sales result in an increase in accounts receivable  If a firm usually does not expect to collect 100% of its receivables, why should it extend credit to customers?  Allowance method  Amount of uncollectible accounts is estimated at end of each period

7. 7-7 ©2006 Prentice Hall, Inc. Extending Credit (2 of 3)  Net realizable value (NRV) of Accounts Receivable  Accounts Receivable less amount it estimates it cannot collect  Bad Debts Expense  Records amount a firm estimates it cannot collect in an accounting period

8. 7-8 ©2006 Prentice Hall, Inc. Extending Credit (3 of 3)  Why do companies use allowance method instead of recognizing bad debts expense when a customer’s account is determined to be uncollectible?  Which principle (see ch 2) is the basis for this practice?

9. 7-9 ©2006 Prentice Hall, Inc. Recording Uncollectible Accounts  End of period adjustment  Increase (debit) Bad Debts Expense  Decrease Accounts Receivable (AR)  Increase (credit) contra-asset Allowance for Uncollectible Accounts  Why don’t we just reduce AR directly? Similar reasoning is used to justify using the contra- asset Accumulated Depreciation instead of directly decreasing the Fixed Assets account

10. 7-10 ©2006 Prentice Hall, Inc. Methods of Estimating Bad Debts Expense (1 of 5)  Allowance methods  Percentage of sales method  Focuses on the income statement  Directly computes bad debts expense as a percentage of credit sales for the period  Big Arch Shoes estimates that its bad debts for the current year will be 3% of its $400,000 of sales

11. 7-11 ©2006 Prentice Hall, Inc. Methods of Estimating Bad Debts Expense (2 of 5)  Record the journal entry using the % of sales method DateTransactionDebitCredit Assets = Liab. + Cont. Cap. + R/E

12. 7-12 ©2006 Prentice Hall, Inc. Methods of Estimating Bad Debts Expense (3 of 5)  Accounts receivable method  Also called AR % method or aging method  Focuses on the balance sheet  Two-step process 1. Estimate amount of AR that will be uncollectible  Often done by using aging schedule Aging schedule categorized by how long receivables have been outstanding and multiplies total for each category by expected collection percentage

13. 7-13 ©2006 Prentice Hall, Inc. Methods of Estimating Bad Debts Expense (4 of 5)  Accounts receivable method (continued) 2. Compute bad debts expense  Amount uncollectible less (credit) balance in Allowance for Uncollectible Accounts  Big Arch Shoes estimates that its bad debts for the current year will be 5% of its $180,000 of Accounts Receivable  Assume that the current balance in Allow for Uncollectible Accounts is $2,500

14. 7-14 ©2006 Prentice Hall, Inc. Methods of Estimating Bad Debts Expense (5 of 5)  Record the journal entry using the accounts receivable method DateTransactionDebitCredit Assets = Liab. + Cont. Cap. + R/E

15. 7-15 ©2006 Prentice Hall, Inc. Writing off a Specific Account (1 of 3)  When a specific customer’s account is determined to be uncollectible  Remove the AR from the books  Reduce Accounts Receivable (credit)  And the customer’s balance in AR subsidiary ledger  Reduce Allowance for Uncollectible Accounts (debit)  After the write-off, the firm no longer needs to “allow” for the account to become uncollectible

16. 7-16 ©2006 Prentice Hall, Inc. Writing off a Specific Account (2 of 3)  The following period, Desert Boat Gear informs Big Arch Shoes that it cannot pay its $1,200 receivable DateTransactionDebitCredit Assets = Liab. + Cont. Cap. + R/E

17. 7-17 ©2006 Prentice Hall, Inc. Writing off a Specific Account (3 of 3)  How does writing off a specific account affect  The income statement?  Net realizable value of Accounts Receivable?  What happens if the estimate of uncollectible accounts for a period is substantially incorrect?

18. 7-18 ©2006 Prentice Hall, Inc. Direct Write off Method  Bad debts expense recognized only when an account receivable is determined to be uncollectible  Increase (debit) Bad Debts Expense  Decrease (credit) Accounts Receivable  Why does this violate GAAP?  When is it acceptable under GAAP to use the direct write-off method?

19. 7-19 ©2006 Prentice Hall, Inc. Notes Receivable (1 of 3)  Promissory note  Written promise to pay a specific amount of money at a particular time  Maker: person making the promise to pay  Payee: entity receiving the payment  Generally has a longer collection period than regular accounts receivable  Interest = Principal x Rate x Time

20. 7-20 ©2006 Prentice Hall, Inc. Notes Receivable (2 of 3)  On 6/1/08 Big Arch Shoes allowed Foot Closet to convert an overdue account to a promissory note, $9,000 at 7%, for 60 days DateTransactionDebitCredit Assets = Liab. + Cont. Cap. + R/E

21. 7-21 ©2006 Prentice Hall, Inc. Notes Receivable (3 of 3)  Record repayment of the note and interest ($9,000 x 7% x [90/365 days]) DateTransactionDebitCredit Assets = Liab. + Cont. Cap. + R/E

22. 7-22 ©2006 Prentice Hall, Inc. Controlling Cash (1 of 5)  Assignment of responsibilities for cash  Person with physical access to cash should not do record keeping for cash  Reduces opportunities for errors and fraud  Why can’t segregation of duties completely eliminate fraud related to cash?

23. 7-23 ©2006 Prentice Hall, Inc. Controlling Cash (2 of 5)  Bank reconciliations  Compares cash balance per bank statement to firm’s cash account balance  Differences due to  Items recorded in one place, but not the other  Errors in the bank statement and/or cash balance  Differences are resolved to arrive at true cash balance

24. 7-24 ©2006 Prentice Hall, Inc. Controlling Cash (3 of 5)  Steps in bank reconciliation 1. Balance per bank  Adjust for items not yet recorded by bank  Will the adjustment add to or subtract from the bank balance when recorded?  + Deposits in transit (DIT) - Outstanding checks +/-Bank errors  Ending balance should be true cash balance

25. 7-25 ©2006 Prentice Hall, Inc. Controlling Cash (4 of 5)  Steps in bank reconciliation (cont’d) 2. Balance per general ledger  Adjust for items not yet recorded by firm  Will the adjustment add to or subtract from the bank balance when recorded?  + Collections made by the bank for firm - Service charges -Customer checks that bounced (NSF checks) +/-Bank errors  Ending balance should be true cash balance

26. 7-26 ©2006 Prentice Hall, Inc. Controlling Cash (5 of 5)  Steps in bank reconciliation (cont’d) 3. Need adjusting entries for reconciling items on G/L balance side  Items not yet recorded by the firm  Bank reconciliation example Bank reconciliation example  Why does a bank credit your account when you deposit money when you know that cash increases with debits?

27. 7-27 ©2006 Prentice Hall, Inc. Bank Reconciliation Example (1 of 5) a. Oct 31 balance on the bank statement = $8,750. b. Oct 31 balance in our cash account = $6,900. c. Checks not cleared: #345 for $700 & #356 for $680. d. Bank stmt. showed a $30 service charge for October. e. A $400 dep. made on Oct 31 at 8pm not on bank stmt f. Bank returned a customer’s NSF check for $100 that was part of our October 28 deposit. g. With the bank statement was a credit memo telling us that the bank was successful in collecting a $900 note and $100 interest for us (total collected $1,000).

28. 7-28 ©2006 Prentice Hall, Inc. Bank Reconciliation Example (2 of 5) Balance per bank Plus: Less: True cash balance Balance per G/L Plus: Less: True cash balance

29. 7-29 ©2006 Prentice Hall, Inc. Bank Reconciliation Example Adjusting Journal Entries (3 of 5) DateTransactionDebitCredit Assets = Liab. + Cont. Cap. + R/E  Bank stmt showed $30 service charge for October

30. 7-30 ©2006 Prentice Hall, Inc. Bank Reconciliation Example Adjusting Journal Entries (4 of 5) DateTransactionDebitCredit Assets = Liab. + Cont. Cap. + R/E  Bank returned customer’s NSF check for $100 that was part of Oct 28 deposit

31. 7-31 ©2006 Prentice Hall, Inc. Bank Reconciliation Example Adjusting Journal Entries (5 of 5) DateTransactionDebitCredit Assets = Liab. + Cont. Cap. + R/E  Credit memo received that the bank collected $900 note and $100 interest

32. 7-32 ©2006 Prentice Hall, Inc. Reporting Cash  Cash equivalents  Highly liquid investments with a maturity of three months or less  Can be easily converted into a known amount of cash  The statement of cash flows  Can a company have net income and a negative cash flow? How?

33. 7-33 ©2006 Prentice Hall, Inc. Ratio Analysis (1 of 2)  Accounts receivable turnover  Measures a firm’s ability to collect the cash from its credit customers Net credit sales _ Average net Accts Receivable  Average net AR = (Beg AR + End AR) / 2  Average days to collect Accts Rec.  365 (days in year) / AR turnover

34. 7-34 ©2006 Prentice Hall, Inc. Ratio Analysis (2 of 2)  Financial statements generally do not separate cash sales from credit sales  How does this affect the AR turnover ratio and average days to collect AR?  How should avg days to collect AR compare to a company’s credit policy (e.g., 2/10, n/30)?

35. 7-35 ©2006 Prentice Hall, Inc. Business Risk, Control, and Ethics (1 of 2)  Clear assignment of responsibility  Specific procedures for documentation related to the assets  Independent internal verification of the data

36. 7-36 ©2006 Prentice Hall, Inc. Business Risk, Control, and Ethics (2 of 2)  Fraud involving cash (Acct in the News)  Describe signs of the following frauds  Skimming  Removal of cash prior to its entry into the accounting system  Larceny  Removal of cash from firm after it has been entered into the accounting system  Fraudulent disbursements

37. Comments or questions about PowerPoint Slides? Contact Dr. Richard Newmark at University of Northern Colorado’s Kenneth W. Monfort College of Business richard.newmark@PhDuh.com 7-37 ©2006 Prentice Hall, Inc.