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Chapter 8--Learning Objectives 1. Understand the composition and control of cash What is cash ? What is cash ? For accounting purposes, cash includes: Currency and coins (including petty cash) Demand deposits (checking accounts) Checks, drafts and money orders

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Chapter 8 learning objectives l.jpg
Chapter 8--Learning Objectives

  • 1. Understand the composition and control of cash



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What is cash ?

  • For accounting purposes, cash includes:

  • Currency and coins (including petty cash)

  • Demand deposits (checking accounts)

  • Checks, drafts and money orders

  • Readily usable foreign currency

  • Savings accounts (technically investments)


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What is NOT cash ?

  • Postage stamps

  • Post-dated checks

  • Certificates of deposit

  • IOUs and notes receivable


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Cash equivalents

  • Must be readily convertible to cash

  • Must be close to maturity

  • Cash equivalents frequently include:

  • Treasury bills

  • Commercial paper

  • Certificates of deposit

  • (within 90 days of maturity)


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Internal control

  • Procedures used to safeguard assets

  • Probably cannot prevent theft altogether

  • But can make the potential crook’s job more difficult

  • Separate duties

  • Create paper trails


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Cash Control

  • Record and deposit receipts promptly

  • Separation of duties

  • No unauthorized or undocumented disbursements

  • Job rotation

  • Imprest funds

  • Internal and external audits

  • Bank reconciliations


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Petty cash fund

  • Known as imprest (advanced) fund

  • Establish fund with set amount

  • Debit “Petty Cash” when fund set up

  • Subsequent entries debit various expenses and credit “Cash”

  • Shortages debited to “Cash Over and Short,” treated as misc. expense


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Bank reconciliation

  • Prepared when statements received

  • Start with “balance per bank” and “balance per books”

  • Bring both numbers to “corrected cash” or “true cash”

  • Adjust books for items on “books” side of reconciliation


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Typical items on“bank” side of reconciliation

  • Balance per bank XXX

  • Deposits in transit + XXX

  • Outstanding checks - XXX

  • Errors by bank + or - XXX

  • Corrected cash balance XXX


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Typical items on“books” side of reconciliation

  • Balance per books XXX

  • Interest earned on account + XXX

  • Items collected by bank + XXX

  • Bank service charges - XXX

  • NSF checks - XXX

  • Errors on books + or - XXX

  • Corrected cash balance XXX


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Typical bank reconciliationadjusting entry

Acct. Receivable--Ima Deadbeat XXX

Service Charge Expense XXX

Interest Income XXX

Cash XXX

  • Note handling of NSF check from Ima Deadbeat, one of our customers.


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Chapter 8--Learning Objectives

  • 2. Record and value accounts receivable


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Trade Receivables

  • Result from sales of goods or services on account

  • Balance Sheet Measurement:

    • Net Realizable Value

  • Discounts

    • Trade Discounts

    • Cash Discounts


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Net Realizable Value

  • Amount expected to be realized (collected)

  • Gross Accounts Receivable, net of

    • Expected returns & Allowances

    • Cash discounts expected to be taken

    • Expected uncollectible amounts


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Trade Discounts

  • Used to determine prices for different types of customers

    • e.g., builder’s discount


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Cash Discounts

  • Offered to encourage early payment

  • Examples

    • 2, 10, net 30

    • 2, 10, eom

  • Accounting approaches

    • Gross Method

    • Net Method


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Terms and discounts

2 / 10 , n / 30

means that a

2 percent discount is available

if paid within 10 days

and that the balance is due in 30 days


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Recording sales discountsThe gross method

Assume a $100 sale, terms 2/10, n/30

The sale is recorded:

Accounts Receivable 100

Sales 100


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Recording sales discountsThe gross method

  • If paid within 10 days:

    Cash 98

    Sales Discounts 2

    Accounts Receivable 100

  • “Sales Discounts” is a contra-account to “Sales Revenue”


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Recording sales discountsThe gross method

  • If paid after 10 days:

    Cash 100

    Accounts Receivable 100


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Recording sales discountsThe net method

  • Assume a $100 sale, terms 2/10, n/30

  • The sale is recorded:

    Accounts Receivable 98

    Sales 98


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Recording sales discountsThe net method

  • If paid within 10 days:

    Cash 98

    Accounts Receivable 98


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Recording sales discountsThe gross method

  • If paid after 10 days:

    Cash 100

    Accounts Receivable 98

    Sales Discounts Forfeited 2

  • “Sales Discounts Forfeited” is a miscellaneous revenue account


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BAD DEBTS

If you do business on credit,

the question is not “whether”

but “how much”

Some people cannot or will not pay their bills

You know that they are out there

You just don’t know who they are


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Accounts receivable entries

  • Making a credit sale

    Accounts Receivable XXX

    Sales XXX


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Accounts receivable entries

  • Collecting from a credit customer

  • Cash XXX

  • Accounts Receivable XXX


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Accounts receivable entries

  • Writing off an uncollectible account

  • Allowance for Bad Debts XXX

  • Accounts Receivable XXX


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Accounts receivable entries

  • Reinstating an account previously written off

    Accounts Receivable XXX

    Allowance for Bad Debts XXX

    Cash XXX

    Accounts Receivable XXX


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Accounts receivable entries

  • The provision for bad debts

  • (an adjusting entry)

    Bad Debt Expense XXX

    Allowance for Bad Debts XXX


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Valuation of accounts receivableor estimating bad debt expense

Two methods will be examined:

1. The percentage of sales method

(also known as the income

statement method)

2. The percentage of receivables

method (also known as the balance

sheet method)


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Percentage of sales method

  • An income statement approach

  • The more you sell--the more you can expect to lose

  • Consistent with matching principle

  • Select a percentage based on past experience or industry averages

  • Multiply the percentage by total credit sales


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Percentage of sales method

  • Assume $1,000,000 sales and 3% estimated bad debts

    Bad Debt Expense 30,000

    Allow. for Bad Debts 30,000


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Percentage of receivables

  • Based on “aging” the individual accounts receivable

  • The later they are in paying--the less likely they are to pay up

  • Percentages likely to default are assigned to each age category

  • The result is the balance needed in the “Allowance for Bad Debts” account


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Assume that an aging schedule yields the following information:

Percent Amount

likely to likely to

Status Amount default default

Current $ 70,000 0 $ -0-

30-60 days overdue 40,000 5 2,000

60-90 days overdue 30,000 10 3,000

90-180 days overdue 30,000 25 7,500

Over 180 days 10,000 30 3,000

Totals $180,000 $15,500


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Allowance for Bad Debts information:

The $15,500 is the total amount needed in the “Allowance” account

  • Assume that the “Allowance for Bad Debts” account has a $3,000 credit balance prior to adjustment

3,000


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The $15,500 is the total amount needed in the “Allowance” account

  • To go from a $3,000 credit to a $15,500 credit will require a $12,500 credit

Allowance for Bad Debts

3,000

12,500

15,500


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$12,500 is the amount needed to adjust the “Allowance” account

  • The necessary entry is:

    Bad Debt Expense 12,500

    Allow. for Bad Debts 12,500


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Account write-offs do not reduce total assets ! account

  • Assume $10,000 of Accts. Receivable and a $1,000 Allowance for Bad Debts

  • Net collectible receivables are $9,000

    Accounts receivable $10,000

    Less: AFBD 1,000

    Net receivables $ 9,000


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Accts. Rec.

AFBD

1,000

10,000


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Accts. Rec.

AFBD

10,000

100

100

1,000

9,900

900


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Note that net collectible receivables are: account

Accounts receivable $ 9,900

Less: AFBD 900

Net receivables $ 9,000

BEFORE = $9,000

AFTER = $9,000

Accts. Rec.

AFBD

10,000

100

100

1,000

9,900

900


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DIRECT account

WRITE-OFF

METHOD


Slide44 l.jpg

DIRECT account

WRITE-OFF

METHOD


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Chapter 8--Learning Objectives account

  • 3. Demonstrate how accounts receivable are used as the basis for financing


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Receivables can be used as an immediate source of cash account

  • Assigning accounts receivable means using them as collateral for a loan

  • Factoring accounts receivable means selling them

  • Factoring can be with recourse or without recourse

  • Recourse refers to ultimate responsibility for payment


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Factoring with recourse account

When accounts are factored with recourse, uncollectible accounts are absorbed by the transferor

Transaction is treated as a sale if all of the following conditions are met:

1. Risks, rewards & benefits are transferred

2. Future cash flows are estimable at time of transfer

3. Transferee cannot require transferor to repurchase receivables except under recourse provisions


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Factoring with recourse accountas a borrowing

  • If all conditions for treatment as a sale are not meant, factoring with recourse is treated as a borrowing


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Chapter 8--Learning Objectives account

  • 4. Record and value notes receivable


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Notes receivable account

  • Formal, written promises to pay

  • Negotiable

  • Provide legal evidence of debt

  • Usually interest bearing, but may be noninterest bearing

  • Should be valued at present value of future cash inflows


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Short term note example assumptions account

  • $1,000 note received in exchange for an account receivable

  • Received on March 1

  • Matures in six months

  • Interest rate 10 percent


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Short term note journal entries account

On March 1

Note Receivable 1,000

Accounts Receivable 1,000

On September 1

Cash 1,050

Note Receivable 1,000

Interest Revenue 50


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Noninterest bearing notes account

  • Amount of note is greater than cash or fair value

  • Difference is recorded in a contra-account to Notes Receivable called “Discount on Note Receivable”

  • Interest is recorded with debits to “Discount on Note Receivable” and credits to “Interest Revenue”


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Noninterest bearing note entries account

At time of issue

Note Receivable XXX

Discount on Note Rec. XXX

Cash (etc.) XXX

Interest accrual

Discount on Note Rec. XXX

Interest Revenue XXX


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Notes receivable with interest rates lower than current market rate

  • Effective interest rate is assigned to note

  • Determine whether fair market value (FMV) of assets surrendered is known or unknown

  • If FMV is known, use as present value of note

  • If FMV not known, use current rate for borrower or rate on other similar loans


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Note with low interest rate assumptions--FMV known market rate

  • Three-year, noninterest bearing note dated 12-31-95

  • Face value $10,000

  • Exchanged for land which originally cost $5,000 with a fair market value of $7,120

  • Discount rate for note is 12 percent ($7,120 is the present value of $10,000 to be received in 3 years at 12 percent)

  • Discount must be amortized over life of note


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Note with low interest rate entries--FMV known market rate

On 12-31-95

Note Receivable 10,000

Discount on Note Rec. 2,880

Land 5,000

Gain on Sale of Land 2,120

On 12-31-96 (rounded to nearest dollar)

Discount on Note Rec. 854

Interest Revenue 854


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Note with low interest rate entries--FMV known market rate

On 12-31-97

Discount on Note Rec. 957

Interest Revenue 957

On 12-31-98 (maturity)

Discount on Note Rec. 1,069

Interest Revenue 1,069

Cash 10,000

Note Receivable 10,000


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Note with low interest rate assumptions--FMV unknown market rate

  • Three-year note dated 12-31-95

  • Face value $5,000

  • Stated interest rate 12 percent paid annually

  • Exchanged for land which cost $2,000 with unknown fair market value

  • Incremental interest rate for borrower is 15 percent

  • Present value of note at 15 percent is $4,658 (based on PV of principal and interest)


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Note with low interest rate entries--FMV unknown market rate

On 12-31-95

Note Receivable 5,000

Land 2,000

Discount on Note Rec. 342

Gain on Sale of Land 2,658

“Discount” based on difference between PV of note and $5,000 face amount

“Gain” based on difference between PV of note and cost of Land


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Formulas for discounting notes receivable market rate

Interest (I) = P x R x T

P = Principal

R = Interest Rate

T = Time

Maturity Value (MV) = P + I

Discount = MV x DR x DP

DR = Discount Rate

DP = Discount Period

Proceeds = MV - Discount


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Discounting note receivable assumptions market rate

  • $1,000, six month note dated 3-1-95

  • Face interest rate 10 percent

  • Discounted on 7-1-95

  • Discount rate 12 percent

  • Time to maturity (discount period) is two months

  • Discounted without recourse


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Discount calculations market rate

  • Interest = $1,000 x .10 x 6/12 = $50

  • Maturity Value = $1,000 + $50 = $1,050

  • Discount = $1,050 x .12 x 2/12 = $21

  • Proceeds = $1,050 - $21 = $1,029

  • Note value at discount date

  • Interest = $1,000 x .10 x 4/12 = $33

  • Value = $1,000 + $33 = $1,033


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Entry to record discounting of note market rate

July 1, 1995

Cash 1,029

Loss on Sale of Note Rec. 4

Note Receivable 1,000

Interest Revenue 33

Interest Revenue is interest earned to date

Loss on Sale is difference between Proceeds and value of note at date of sale


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Same note discounted market ratewith recourse

  • The bad news here is that if the original maker of the note defaults when the note is due...

  • The bank or finance company will hold the party discounting the note responsible for payment


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Chapter 8--Learning Objectives market rate

  • 5. Calculate and interpret key liquidity and asset management ratios


Current ratio l.jpg
Current ratio market rate

Current assets

Current liabilities


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Quick ratio market rate

Current assets - Inventory - Prepaid items

Current liabilities

A more stringent indicator of liquidity

than the current ratio


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Accounts receivable turnover market rate

Credit Sales

Average net accounts receivable

  • Average accounts receivable is frequently approximated by adding beginning and ending net receivables and dividing by two


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Average collection period market ratefor accounts receivable

3 6 5 d a y s

Accounts receivable turnover

  • Calculation of accounts receivable turnover illustrated on previous slide


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