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Intermediate Accounting, 9ed

Intermediate Accounting, 9ed. Kieso and Weygandt. Prepared by Catherine Katagiri, CPA The College of Saint Rose Albany, New York. John Wiley & Sons, Inc. 1. 1. 1. 1. 1. Chapter 7: Cash and Receivables. After studying this chapter you should be able to:

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Intermediate Accounting, 9ed

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  1. Intermediate Accounting, 9ed Kieso and Weygandt Prepared by Catherine Katagiri, CPA The College of Saint Rose Albany, New York John Wiley & Sons, Inc. 1 1 1 1 1

  2. Chapter 7: Cash and Receivables After studying this chapter you should be able to: • Identify items considered cash. • Indicate how cash and related items are reported. • Define receivables and identify the different types of receivables. • Explain accounting issues related to recognition of accounts receivable. • Explain accounting issues related to valuation of accounts receivable. • Explain accounting issues related to recognition of notes receivable. • Explain accounting issues related to valuation of notes receivable. • Explain accounting issues related to the disposition of accounts and notes receivable. • Explain how receivables are reported and analyzed.

  3. Cash • Cash--Current asset unless restricted. • Demand deposits • Petty cash • Money orders • Certificates of deposit • Savings • IOUs, postdated checks (these are receivables) • Restrictions: • Compensating balances--Arrangements must be properly disclosed. 3 3 3

  4. Cash • Bank overdrafts--Current liabilities. Generally not offset against current assets unless in same bank as another cash account. Proper disclosure required. • Cash and cash equivalents • Cash equivalents are short-term, highly liquid investments that are both • readily convertible to cash. • so near to maturity that they represent insignificant risk of interest rate changes. • Generally only investments with original maturities of three months or less fall under this classification. 4 4 4

  5. Cash Controls • Management--Control of cash. • Cash--Highly liquid, easily removed, etc. • Need to avoid deficiency or excess of cash. • Control • Limit access. • Separate assets from the records for the asset. • Separation of duties. • Electronic funds transfers, use of ATMs, debit cards (your account to the bank is an A/P--Decrease your balance by a debit to reflect payment of bills, etc.) • Minimize the float period (lockboxes, credit cards, etc.) 5 5 5

  6. Cash Controls • Imprest Petty Cash Account--See appendix on cash controls. • Set up correctly to minimize any potential loss as well as time spent on what should be an immaterial account. • Violates internal control (no separation). • Use of the over and short account. • Review entries for • Setting up of fund. • Reimbursement of fund. • Increase in the size of the fund. 6 6 6

  7. Cash Controls • Physical protection of cash. • Minimize cash on hand. • Deposit receipts intact, daily. • Timely bank reconciliations done. • Prenumbered checks used and accounted for. • Use of a voucher system for cash disbursements. • Bank Reconciliation (see reconciling items page 361) • Please see the following example of the bank reconciliation form. From the bank reconciliation the required AJEs to update balance of cash are drawn up. 7 7 7

  8. Bank Reconciliation Books (GL amount) Bank statement (end of period) Plus:ReceiptsPlus: Notes collected Deposits in transit Interest earned Errors Errors Less:DisbursementsLess: NSF checks Outstanding Checks Service charges Errors Bank fees Errors **End Balance of cash **End Balance of Cash **The above figures should agree = “True” Cash 8 8 8 5

  9. Receivables • Current receivables--Collected within the operating cycle or one year, whichever is longer. • Trade receivables--From sale of stock-in-trade. • Accounts receivable • Notes receivable • Non-trade receivables--Sundries-separately reported. • Advances to employees, officers or subsidiaries. • Deposits paid by you. • Interest, dividends, taxes, etc. 9 9 9

  10. Accounts Receivable Accounts receivable concerns: • Recognition • Valuation • Disposition • Recognition of A/R--Timing and Measurement • Recorded at exchange or settlement price. • Trade discounts • To adjust sales price. • Taken “off-the-top” and net price used in accounting records. 10 10 10

  11. Accounts Receivable • Sales discounts • Common terms are 2/10, net 30. • Gross method--Overstates sales and A/R; purchases and A/P (most common). • Net method (theoretically best)--Must adjust beyond due date. Discounts lost represents additional revenue or, on purchases, interest expense. • Please see Illustration 7-5 for entries. 11 11 11

  12. Bad Debt Expense • Valuation--Follow conservatism--Disregard Present Value! • Carry at the Net Realizable Value (NRV) • Historical value of A/R less a reasonable estimate of uncollectible accounts. • Estimated value of A/R to be ultimately collected by the firm. • Match expenses to revenues. Concept of bad debts. • Direct write-off method (not allowed unless immaterial difference between it and the allowance method). • Allowance Method--Use of the contra account the Allowance for Doubtful (or Uncollectible) Accounts (ADA). 12 12 12

  13. Bad Debt Expense • Allowance method leads to: • Less manipulation of income. • Follows conservatism and matching. • Smoothes assets and income. • Methods: • % of sales method (I/S approach, page 340) • % of A/R method (B/S approach , page 341) • Please see the following example of the creation and use of the ADA. 13 13 13

  14. Bad Debt Expense • % of sales method--Income statement approach: • Through analysis and judgment a firm decides the percent of current credit sales that will prove uncollectible. It then records the following entry: • Bad debt expense XX • Allowance for doubtful accounts XX Notice you did not reference the existing balance in the ADA. A firm will need to periodically review the ADA to prevent excessive debit or credit (usual) balances. 14 14 14

  15. Bad Debt Expense • % of receivables method--Balance sheet approach. • Receivables classified by age (“aging”-see Illustration 7-7) • Based on analysis, judgment and the age of the receivables, percentages are applied to the various age groups of the receivables. • Generally percentages increase as receivables age. • This yields the desired balance in the contra-A/R account the allowance for doubtful accounts (ADA). Entry made: • Bad debt expense XX • Allowance for doubtful accounts XX 15 15 15

  16. Bad Debt Expense • If a credit balance already exists, only the amount needed to bring the balance to the proper credit balance is entered. • If a debit balance already exists, you have written off more than you previously provided. You must increase the ADA by the sum of the debit balance and the needed credit balance from your calculations. • This method follows the ADA closely. Matching is not adhered to as closely as the percent of sales method. 16 16 16

  17. Bad Debt Expense • Collection of previously written-off accounts. • Reinstate A/R to the amount collected, increase ADA. • Reduce A/R for that amount and record cash. 17

  18. Accounts Receivable • Special Allowance Accounts: • Allowance for Sales Returns • To avoid distortion of A/R • To anticipate large returns • Sales R & A XX • Allowance for Sales Returns (contra A/R) XX • Allowance for Collection Expenses--to provide for material expenses in the collection of the A/R. • Collection Expense XX • Allowance for Collection Expense (contra A/R) XX 18

  19. Notes Receivable • Written promise to pay you, i.e., you are the payee. • Stated amount (principle), face value. • Stated (face) rate of interest (SR) • Prevailing (market) rate of interest (MR) • Maturity date; maturity value Interest-bearing notes (Long-term): If the stated rate (what the seller (maker) is willing to give up) equals what the buyer (you-the payee) demand, then the note will sell at face value. 19

  20. Notes Receivable • For example: $8,000 Note Receivable (N/R); 4 years, interest and principle paid at the end of the period, stated rate of interest = market rate of interest = 8% Annual cash interest = $8,000 x .08 x 360/360 days = $640 What is the “price” of this note? Note will sell for the present value of the future cash flows which equal the sum of (PV + PV-AO). Single sum payment is the principle, 4 years hence. Ordinary annuity is the cash interest, 4 payments which constitute a 4 year annuity. Discount factor = Market return = 8%; n = 4 periods 20

  21. Notes Receivable PV = $8,000 (.73503) = $5,880 PV-AO = $640 (3.31213) = 2,120 $8,000 • Journal Entry: • Note receivable 8,000 • Cash 8,000 There is a “meeting of the minds!” 21

  22. Notes Receivable What if SR not equal to the MR? SR = 8% MR = 12% This is to say you (the payee-the market) demand a return of 12%-you could get that with alternative investments. The maker (the seller) is willing to pay only 8%. What will happen to the price of the note? To calculate what the note will sell for: PV + PV-AO n = 4; i = 12% (i.e., the MR) PV = $8,000 (.63552) = $5,084 PV-AO = $640 (3.03735) = 1944 $7,028 22

  23. Notes Receivable Journal entry: Note receivable 8000 Cash 7028 Discount on N/R 972 Balance Sheet Presentation: Note Receivable, par (face) $8000 - Discount N/R (+ Premium) 972 Note Receivable,net (carrying or book value) $7,028 23

  24. Notes Receivable • The CV of the note will approach its par or face value as the maturity date approaches. • In this case the discount will be amortized to increase cash revenue to the actual total interest revenue (i.e., to reflect the higher market rate you are actually receiving). • As it is amortized the discount falls and the carrying value of the note rises. So, too, should the reported interest revenue. • The effective interest method reports a constant rate of interest (not constant amount) on the changing asset (or liability from the maker’s point of view). 24

  25. Notes Receivable To record the receipt of interest: Use of the effective interest method (yields constant rate of interest based on carrying value of the asset). Carrying value = (8,000 - 972) x .12 = 844 To record Cash 640 Discount 204 Interest revenue 844 Now remaining discount = 972 - 204 = 768 25

  26. Notes Receivable Next period: CV (8,000 - 768) (.12) = 868 (revenue rises) You could also record the note at the PV to start: N/R 7028 Cash 7028 And then record interest revenue: Cash 640 N/R 204 Interest revenue 844 26 25 25

  27. Notes Receivable Received for cash:Non-interest bearing note (or unreasonable rates) • N/R 8,000 • Cash 6,500 • Discount N/R 1,500 Interest rate must be imputed. Discount is amortized to revenue. 27

  28. Disposition of A/R and Notes Receivable Receivables • Assigned or pledged • As collateral in a secured borrowing • General assignment (footnote disclosure) • Cash XX • A/R XX • Specific assignment--particular A/R assigned • Accounts are transferred to a special account. • Collections received by borrower are remitted (plus a fee) to the lender. • For entries please Illustration 7-14 on page 351 28 28 28

  29. Disposition of A/R and Notes Receivable • Sales of A/R to a factor--Please see page 352. • Note: With recourse or without recourse • If the following conditions are met, account for as a sale and record any gain or loss: • Control effectively given up. • Repurchase not required of transferor. • Future obligation is minimal. • Please see Illustration 7-16, sales without recourse. • Please see Illustration 7-19, sales with recourse. • If the above three conditions are not met it is a borrowing and gives rise to interest expense (discount on A/R) See entries in Illustration 7-20. 29 29 29

  30. Analysis of Receivables • To help analyze the liquidity of a company’s accounts receivable, a common financial ratio is calculated: • Accounts receivable turnover ratio • Measures the number of times, on average, the A/R balance is collected within one period. Net credit sales Average accounts receivable balance • Note both numerator and denominator cover a period of time. • Yields a trend figure, not extremely precise. • Can be converted to days by dividing into 365 days. 30 30 30

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