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Administrative Quiz #2 due today Quiz #3 due Wednesday 2/18 Midterm 2 Monday 2/23 Cash and Receivables (ch. 7)

Agenda. Administrative Quiz #2 due today Quiz #3 due Wednesday 2/18 Midterm 2 Monday 2/23 Cash and Receivables (ch. 7). Cash & Cash Equivalents. Cash: Currency and coins held, checks & money orders received, bank account balances

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Administrative Quiz #2 due today Quiz #3 due Wednesday 2/18 Midterm 2 Monday 2/23 Cash and Receivables (ch. 7)

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  1. Agenda • Administrative • Quiz #2 due today • Quiz #3 due Wednesday 2/18 • Midterm 2 Monday 2/23 • Cash and Receivables (ch. 7)

  2. Cash & Cash Equivalents • Cash: Currency and coins held, checks & money orders received, bank account balances • Cash Equivalents are short-term, highly liquid investments that are: • Readily convertible into known amounts of cash • So near maturity that there is no risk of change in valuation from fluctuating interest rates (original maturities of no longer than 3 months) • E.G., T-bills, commercial paper, money market funds

  3. Reporting of Cash Cash Equivalents – cash is grouped together with cash equivalents and reported as the most liquid current asset on the balance sheet • Restricted Cash (i.e., cash restricted or “earmarked” for a specific purpose, such as a loan contract that requires the firm to maintain a certain cash balance) is disclosed as a long-term asset if it relates to long-term items (such as payment of L/T debt) • Bank Overdraft – disclosed as a current liability unless there are other positive-balance cash accounts at the same bank that it can be netted against • IFRS vs. US GAAP • US GAAP: Does NOT offset bank overdrafts against the cash account (unless cash available in another account in the same bank) • IFRS: Includes bank overdrafts in cash and cash equivalents if repayable on demand and form a part of an entity’s cash management

  4. Controls and Cash • Since cash is the most liquid asset, internal control of cash is imperative. • Controls must prevent unauthorized use of cash. • Management must have necessary information for proper use of cash. • Three Key Controls: • Management oversight and authorization • Especially useful in small organizations where the owner can monitor activities (and where there are limited resources to have separation of duties) • Separation of duties: i.e., separate the responsibilities of physical control over cash and record keeping for cash • E.g., have one employee prepare the deposit slip and make the entry, and another employee will actually make the deposit • The bank reconciliation

  5. Receivables Accounts receivable – oral promises to pay for goods and services sold. Receivable topics: • Trade and Cash Discounts • A/R valuation • Notes receivable – written promises to pay amount at a specified future date. Arise from a variety of transactions (i.e. not just trade) and may be short-term or long-term • A/R transfers

  6. Recognition of Accounts Receivable • Trade Discounts – reduction in list price for differential volume • Cash discounts – reduction in amount paid if paid within a specified period. Two accounting methods for recording cash discounts: • Gross method records discounts when taken by customers (most commonly used) • Net method records discounts not taken by customers.

  7. Cash Discounts - Net & Gross Methods Sale of $1,000 of inventory, 2/10, n/30 on 1/1/06, for two scenarios: • Payment is made on 1/10/06 b) Payment is made on 1/15/06:

  8. Valuation of Accounts Receivable • Short term receivables are reported at their net realizable value (NRV) • The NRV is the net amount expected to be collected • The NRV is gross accounts receivable less: • Allowance for estimated returns (customer returns merchandise for a refund or a credit) • Allowance for estimated uncollectible accounts (customer does not pay account in full)

  9. Accounts Receivable: IFRS vs. US GAAP Classification of Accounts Receivable • Under US GAAP: • Must separately disclose material related party receivables • Under IFRS: • May separately disclose material related party receivables • AR classified on balance sheet as a financial asset

  10. Methods Allowance Direct Write-Off Not based on the matching Based on the matching principle principle Appropriate only if Must be followed if amounts are not material amounts are material Accounts are written off Estimated; bad debts are when determined non-collectible matched against revenue Estimating Uncollectible Receivables

  11. Accounts Receivable Bad Debt Expense Methods • Direct write-off (used only if low & infrequent bad debts) Bad debt expense (I/S) XXX AR (B/S - Asset) XXX 2. Indirect (allowance method) In year of the sale: Bad debt expense (I/S) XXX Allowance for bad debts (B/S – Asset) XXX When found to be uncollectible: Allowance for bad debts (B/S – Asset) XXX AR (B/S – Asset) XXX If payment received after account written off: AR (B/S – Asset) XXX Allowance for bad debts (B/S – Asset) XXX Cash (B/S – Asset) XXX AR (B/S – Asset) XXX

  12. Two types of allowance methods Two types of allowance methods: • Percent of Receivables Allowance method • Balance-sheet oriented • Uses one B/S account (AR) to estimate another B/S account (Allowance) • This method always estimates the ENDING balance in the allowance account • Percent of Sales Allowance method • Income-statement oriented • Uses one I/S account (revenue) to estimate another I/S account (bad debt expense) • This method estimates the bad debt expense (***NOT the ending balance in the allowance account as in the Percent of Receivables method)

  13. Comparison of Methods for Estimating Uncollectibles

  14. Allowance Example Allowance Example • Husky Company has $60,000 in sales in 2005. • AR at 12/31/05 is $24,000. • Allowance for doubtful accounts at 12/31/05 is $200. 1. “Percent of Receivables” method (B/S-oriented) The company estimates allowance based on 1% of AR < 31 days, 2% 31-60 days, 5% 61-90 days and 20% > 90 days: Amount0-3031-6061-9091+ $24,000 10,000 8,000 4,000 2,000 Uncollectible % 1% 2% 5% 20% Allow. Est. $860 = 100 160 200 400 The estimated allowance calculated, $860, is the ENDING balance in allowance for bad debts account. Therefore an adjusting entry of $660 ($860 - $200) is required: Bad Debt Expense (I/S) $660 Allowance for bad debts (B/S) $660

  15. Allowance Examples (cntd.) 2. “Percent of Sales” method (I/S-oriented) The company estimates bad debt expense based on 1.5% of sales. Sales $60,000 Uncollectible % 1.5% Bad debt expense $900 Remember when using the Percent of Sales method, this estimate is NOT the ending balance in allowance for bad debts. Therefore, the following adjusting entry is required: Bad Debt Expense (I/S) $900 Allowance for bad debts (B/S) $900

  16. Allowance Examples (cntd.) 3. % of Sales Method is based on credit sales during the year Example: Crawford Inc. Total sales, 2006: $20,000,000 Credit sales, 2006: $15,000,000 A/R Balance, Dec 31, 2006: $1,900,000 Allow. for bad debt balance (before adjustment) 12/31/06: $62,000 Prior history: 1% of credit sales are uncollectible J/E to record bad debts expense for 2006: Dr. Bad Debts Expense ($15m x 1%) 150,000 Cr. Allow. For bad debts 150,000

  17. Allowance Examples (cntd.) 4. Percent of Receivables (using Crawford Example data from above) We need to know the age of A/R Balances and the prior history of collections – assume: AgeBalance % bad 0-30 days 1,200,000 x 0.75% = 9,000 31-60 days 500,000 x 8.00% = 40,000 61+ days 200,000 x 20.00% = 40,000 89,000 Total: 89,000 Less Allow for BD open balance: (62,000) Adjustment Needed: 27,000 Dr. Bad Debts Expense 27,000 Cr. Allow. For Bad debts 27,000

  18. Balance Sheet Representation Short-term accounts receivable are shown at their net realizable value as follows: • Accounts Receivable (gross): $ XXX less: Allowance: ($ XX) Net Realizable Value: $ XX

  19. A/R – Bad Debt Expense – Allowance for Doubtful Accounts Example (1) Before making any 2004 adjusting entries, Company XYZ has a balance in the Allowance for Doubtful Accounts of $4,000 (CR). Assume that XYZ uses the Percentage of A/Rmethod to estimate bad debts. If, after using an aging schedule, it is estimated that 2% of the $500,000 in A/R will be uncollectible, what adjusting entry would be required? What would be the ending balance in the Allowance for Doubtful Accounts account?

  20. A/R – Bad Debt Expense – Allowance for Doubtful Accounts Example (2) Before making any 2004 adjusting entries, Company XYZ has a balance in the Allowance for Doubtful Accounts of $4,000 (CR). Assume that XYZ uses the Percentage of Sales method to estimate bad debts. If XYZ estimates that 5% of total credit sales for 2004 will ultimately prove uncollectible, what adjusting entry would be required if credit sales for 2004 totaled $100,000? What would be the ending balance in the Allowance for Doubtful Accounts account?

  21. A/R – Bad Debt Expense – Allowance for Doubtful Accounts Example (3) At the beginning of 2004, the balance in the Allowance account was $11,000 (CR). During the year, $8,000 of delinquent accounts were written off. Then, $2,000 of these delinquent accounts was ultimately determined to be collectible, and these accounts were collected. Additionally, the 2004 ending balance in A/R was $150,000. If XYZ uses the Percentage of A/R method to estimate bad debts, and 5% of A/R is estimated to be uncollectible, what adjusting entry would be made to account for the bad debts? What would be the ending balance in the Allowance for Doubtful Accounts account?

  22. A/R – Bad Debt Expense – Allowance for Doubtful Accounts Example (4) At the beginning of 2004, the balance in the Allowance account was $11,000 (CR). During the year, $8,000 of delinquent accounts was written off. Then, $2,000 of these delinquent accounts was ultimately determined to be collectible, and these accounts were collected. Additionally, assume that total credit sales for the year were $200,000. If XYZ uses the Percentage of Salesmethod to estimate bad debts, and 5% of credit sales are estimated to be uncollectible, what adjusting entry would be made to account for the bad debts? What would be the ending balance in the Allowance for Doubtful Accounts account?

  23. Recognition of Notes Receivable NR are written promises that will receive certain sum(s) of money at specified future date(s) • Record NR at the PV of future cash flows using the effective interest rate • Notes receivable are issued at face value when the stated rate of interest is the same as the effective (market) rate. • If the stated rate is less than the effective rate then a discount results. • If the stated rate is greater than the effective rate then a premium results. • The discount or premium is amortized to interest revenue by the effective interest method. • Record interest revenue each period using the effective interest method

  24. Issues NOT at face value Interest bearing Non-interest bearing Recognition of Notes Receivable 1. Determine issue price on notes receivable at the effective rate of interest. 2. The discount/premium is amortized to interest revenue by the effective interest method 1. Determine issue price on notes receivable at implicit rate of interest 2. The discount/premium is amortized to interest revenue by the effective interest method

  25. Notes Receivable – Non-Interest Bearing Club Soda Inc. purchases a machine from Fruit Juice Ltd. with a list price of $10,000 on January 1, 2006, and Club Soda accepts, in return, a note for $10,000, non-interest bearing, due on December 31, 2007. The fair value of the machine on January 1 is $7,972. Prepare journal entries to record the Fruit Juice’s sale, any adjusting entries, and the entry to record the payment on December 31, 2007.

  26. Non-interest Bearing Notes For non-interest bearing notes: 1. Determine issue price on notes receivable at implicit rate of interest 2. The discount is amortized to interest revenue by the effective interest method What is the implicit interest rate in the Fruit Juice example? It is the rate that equates $7,972 at t=0 to $10,000 at t=2, i.e., • 7,972F = 10,000; or F=10,000/7,972 = 1.2544 • In table 6.1, Future Value of 1 (p. 303), the rate is 12% (F=1.2544, n = 2)

  27. Non-interest Bearing Notes

  28. Non-interest Bearing Notes January 1, 2006: Dr. Note Receivable 10,000 Cr. Discount on NR 2,028 Cr. Sales Revenue 7,972 December 31, 2006: Dr. Discount ((7,972) x .12) 957 Cr. Interest Revenue 957 December 31, 2007: Dr. Discount (8,929) x .12) 1,071 Cr. Interest Revenue 1,071 Dr. Cash 10,000 Cr. Note Receivable 10,000 (use a T-account to verify that the discount account has a zero balance)

  29. Notes Where Stated Rate is Different from Market Rate • The non-interest bearing example is a special case of the situation where the stated interest rate is different from the market rate • What if an interest rate is given, but the market rate is different?

  30. Long-Term Notes Receivable • If market rate = stated rate Notes Receivable Face Value Cash, Sales, etc. Face Value • If market rate > stated rate (issued at a discount) Notes Receivable Face Value Discount on N/R Face Value – PV Cash, Sales, etc. PV • If market rate < stated rate (issued at a premium) Notes Receivable Face Value Premium on N/R PV - Face Value Cash, Sales, etc. PV

  31. Example where Stated Rate and Market Rate Differ Assume the data in the non-interest bearing note example, but now the note pays interest at 10% (stated rate) and the appropriate market rate for Fruit Juice Ltd. is 6%. Here the market rate < the stated rate, so there will be a premium. Determine PV of this note: • 1st: calculate the PV of the Annuity: (10,000 x 10%) = 1,000 for 2 years at 6%: 1,000 x 1.833 = 1,833 [PV of an Annuity, Table 6-4, p. 308 (n=2; i = market 6%)] • 2nd: calculate the PV of the principal payment in 2 years: 10,000 x .8900 = 8,900 [PV of 1, Table 6-2, p. 304 (n = 2; i = market 6%)] • So PV of note on January 1, 2006 is 10,733 (1833 + 8900) (i.e., a premium)

  32. Market Rate < Stated Rate: Amortize Premium Using Effective Interest Method

  33. Stated Rate and Market Rate Differ January 1, 2006 Dr. Note Receivable 10,000 Dr. Premium on NR 733 Cr. Sales Revenue 10,733 December 31, 2006 Dr. Cash 1,000 Cr. Interest Revenue (10,733 x 6%) 644 Cr. Premium (plug) 356 December 31, 2007 Dr. Cash 1,000 Cr. Interest Revenue (10,377 x 6%) 623 Cr. Premium (plug) 377 Dr. Cash 10,000 Cr. Note Receivable 10,000

  34. Disposition of Accounts and Notes Receivable • The holder of accounts or notes receivable may transfer them for cash. • The transfer may be either: • A secured borrowing (i.e., the “seller” is really borrowing from the transferee) • The original holder retains ownership of receivables in a secured borrowing transaction. • A sale of receivables • Holder transfers ownership of receivables in a sale (transfers risks of collection).

  35. Secured Borrowing – the Basics • Overall - Receivables remain on the books of the company borrowing money (i.e. – no sale) (and continue to treat A/R as usual (collections, write-off, etc.) • Transferor: • Records liability • Records a finance charge. • Collects accounts receivable. • Records sales returns and sales discounts. • Absorbs bad debts expense. • Records interest expense on notes payable. • Pays on the note periodically from collections.

  36. Sale of Receivables – the Basics • Factor records the (transferred) accounts as assets in its books. • Transferor: • Transfers ownership of receivables to factor. • Records any amount retained by transferee as “due from factor.” • This is an amount held back to protect the transferee in case of non-payment by customer • Records loss on sale of receivables. • Records any component liability (when appropriate – i.e. if the sale is on a “with recourse” basis) • i.e., any estimated future liability that the transferor will need to pay if customers do not pay (and if the amount held back by the factor is insufficient)

  37. Transferred Assets Isolated from Transferor Isolated = put beyond the reach of transferor • So the transferor no longer has any rights over the A/R • This includes creditors of the transferor, if it goes bankrupt • This is not different from any other type of sale • If you “buy” a car from a dealership but must return the car if the dealership wants, and must turn the car over to the dealership’s creditors if it goes bankrupt, then you really don’t own it.

  38. Transfer of Receivables: Secured Borrowing To help overcome a cash shortage, H Software took out a loan with T Bank. H Software used $1000 of A/R as collateral for the loan. T Bank withheld $30 as a finance charge, and forwarded $970 to H Software on July 1. H Software collected the on the accounts on July 31 ($120 were written off), and repaid T Bank on August 2nd with interest of $50. July 1: Dr. Cash 970 Dr. Finance charge 30 Cr. Note Payable 1,000 July 31: Dr. Cash 880 Dr. Allowance for doubtful accounts 120 Cr. A/R 1,000 August 2: Dr. Interest Expense 50 Dr. Note Payable 1,000 Cr. Cash 1,050

  39. Transfer of Receivables: Sale Without Recourse To help overcome a cash shortage, H Software factored $1,000 of receivables to W Factor on July 1, 2006. W Factor withheld $100 pending collectability, and charged H Software $40. The remaining $860 was forwarded to H Software on July 1. W Factor collected on the A/R, without recourse. On August 2nd, W Factor informed H Software that $75 of the accounts were uncollectible, and W Factor returned to H Software the appropriate payment. Dr. Cash (1000 – 100 - 40) 860 Dr. Due from Factor 100 Dr. Loss on sale of A/R 40 Cr. A/R 1,000 Dr. Cash 25 Dr. Loss on sale of AR 75 Cr. Due from Factor 100 What if instead, W Factor informed H Software on Aug 2 that it was able to collect all of the AR? What would be the journal entry? Dr. Cash 100 Cr. Due from Factor 100

  40. Transfer of Receivables: Sale With Recourse To help overcome a cash shortage, H Software factored $1,000 of receivables to W Factor on July 1, 2006. W Factor withheld $100 pending collectability, and charged H Software $40. The remaining $860 was forwarded to H Software on July 1. W Factor collected on the A/R, but had recourse in case of bad debts. H Software estimated that $150 of the receivables would ultimately be uncollectible. On August 2nd, W Factor informed H Software that $120 of the accounts were uncollectible, and H Software sent W Factor the appropriate recourse payment. Dr. Cash (1000 – 100 – 40) 860 Dr. Due from Factor 100 Dr. Loss on Sale of A/R (plug) 190 Cr. A/R 1,000 Cr. Recourse Liability 150 Dr. Recourse Liability 150 Cr. Cash 20 Cr. Due from Factor 100 Cr. Recovery of loss sale 30 What ifW Factor informed H Software that $220 of the accounts were uncollectible?

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