Chapter 7 CASH AND RECEIVABLES Sommers ACCT 3311

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Discussion Questions. Q 7
Chapter 7 CASH AND RECEIVABLES Sommers ACCT 3311

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1. Chapter 7 CASH AND RECEIVABLES Sommers ? ACCT 3311 Chapter 1: Environment and Theoretical Structure of Financial Accounting.Chapter 1: Environment and Theoretical Structure of Financial Accounting.

2. Discussion Questions Q 7?13 Explain any possible differences between accounting for an account receivable factored with recourse compared with one factored without recourse.

3. Discussion Questions Q7?15 What is meant by the discounting of a note receivable? Describe the four- step process used to account for discounted notes.

4. 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. On occasion, a company might make a loan with a noninterest-bearing note. Even though the note is called a noninterest-bearing note, the note actually does bear interest. The face amount of the note includes both the amount borrowed and the interest. Let?s look at an example to see how we might determine the amount of interest on a noninterest-bearing note. On occasion, a company might make a loan with a noninterest-bearing note. Even though the note is called a noninterest-bearing note, the note actually does bear interest. The face amount of the note includes both the amount borrowed and the interest. Let?s look at an example to see how we might determine the amount of interest on a noninterest-bearing note.

5. E7-21 Weldon Corporation?s fiscal year ends December 31. The following is a list of transactions involving receivables that occurred during 2011: 3/17 Accounts receivable of $1,700 were written off as uncollectible. The company uses the allowance method. 3/30 Loaned an officer of the company $20,000 and received a note requiring principal and interest at 7% to be paid on March 30, 2012. 5/30 Discounted the $20,000 note at a local bank. The bank?s discount rate is 8%. The note was discounted without recourse and the sale criteria are met. 6/30 Sold merchandise to the Blankenship Company for $12,000. Terms of the sale are 2/10, n/30. Weldon uses the gross method to account for cash discounts. 7/8 The Blankenship Company paid its account in full. 8/31 Sold stock in a nonpublic company with a book value of $5,000 and accepted a $6,000 non-interest-bearing note with a discount rate of 8%. The $6,000 payment is due on February 28, 2012. The stock has no ready market value. 12/31 Bad debt expense is estimated to be 2% of credit sales for the year. Credit sales for 2011 were $700,000. Prepare all journal entries.

6. E7-21 3/17 Accounts receivable of $1,700 were written off as uncollectible. The company uses the allowance method. 3/30 Loaned an officer of the company $20,000 and received a note requiring principal and interest at 7% to be paid on March 30, 2012.

7. E7-21 5/30 Discounted the $20,000 note at a local bank. The bank?s discount rate is 8%. The note was discounted without recourse and the sale criteria are met.

8. E7-21 5/30 Discounted the $20,000 note at a local bank. The bank?s discount rate is 8%. The note was discounted without recourse and the sale criteria are met.

9. E7-21 6/30 Sold merchandise to the Blankenship Company for $12,000. Terms of the sale are 2/10, n/30. Weldon uses the gross method to account for cash discounts. 7/8 The Blankenship Company paid its account in full.

10. E7-21 8/31 Sold stock in a nonpublic company with a book value of $5,000 and accepted a $6,000 non-interest-bearing note with a discount rate of 8%. The $6,000 payment is due on February 28, 2012. The stock has no ready market value. 12/31 Bad debt expense is estimated to be 2% of credit sales for the year. Credit sales for 2011 were $700,000.

11. E7-21 Adjusting Entries:

12. Financing With Receivables Companies may use their receivables to obtain immediate cash. Sale of Receivables remove receivable, record cash, difference is loss subsequent cash goes to buyer of receivable Secured Borrowing record cash, record borrowing subsequent cash used to repay borrowing Financial institutions have developed a wide variety of ways for companies to use their receivables to obtain immediate cash. Companies can find this attractive because it shortens their operating cycles by providing cash immediately rather than having to wait until credit customers pay the amounts due. Also, many companies avoid the difficulties of servicing (billing and collecting) receivables by having financial institutions take on that role. Of course, financial institutions require compensation for providing these services, usually interest and/or a finance charge. The various approaches used to finance with receivables differ with respect to which rights and risks are retained by the transferor (the company who was the original holder of the receivables) and which are passed on to the transferee (the new holder, the financial institution). Despite this diversity, any of these approaches can be described as either: A secured borrowing. Under this approach, the transferor (borrower) simply acts like it borrowed money from the transferee (lender), with the receivables remaining in the transferor?s balance sheet and serving as collateral for the loan. On the other side of the transaction, the transferee recognizes a note receivable. A sale of receivables. Under this approach, the transferor (seller) ?derecognizes? (removes) the receivables from its balance sheet, acting like it sold them to the transferee (buyer). On the other side of the transaction, the transferee recognizes the receivables that it obtained and measures them at their fair value. Financial institutions have developed a wide variety of ways for companies to use their receivables to obtain immediate cash. Companies can find this attractive because it shortens their operating cycles by providing cash immediately rather than having to wait until credit customers pay the amounts due. Also, many companies avoid the difficulties of servicing (billing and collecting) receivables by having financial institutions take on that role. Of course, financial institutions require compensation for providing these services, usually interest and/or a finance charge. The various approaches used to finance with receivables differ with respect to which rights and risks are retained by the transferor (the company who was the original holder of the receivables) and which are passed on to the transferee (the new holder, the financial institution). Despite this diversity, any of these approaches can be described as either: A secured borrowing. Under this approach, the transferor (borrower) simply acts like it borrowed money from the transferee (lender), with the receivables remaining in the transferor?s balance sheet and serving as collateral for the loan. On the other side of the transaction, the transferee recognizes a note receivable. A sale of receivables. Under this approach, the transferor (seller) ?derecognizes? (removes) the receivables from its balance sheet, acting like it sold them to the transferee (buyer). On the other side of the transaction, the transferee recognizes the receivables that it obtained and measures them at their fair value.

13. Factoring Arrangements In the diagram on your screen, the retailer buys merchandise on account from a supplier. The supplier (transferor) then transfers the receivables to a factor (transferee) in exchange for cash. A factor is a financial institution who buys receivables for cash, handles the billing and collection of the receivables and charges a fee for the service. The transferor usually relinquishes all rights to the receivables in exchange for cash from the factor. In the diagram on your screen, the retailer buys merchandise on account from a supplier. The supplier (transferor) then transfers the receivables to a factor (transferee) in exchange for cash. A factor is a financial institution who buys receivables for cash, handles the billing and collection of the receivables and charges a fee for the service. The transferor usually relinquishes all rights to the receivables in exchange for cash from the factor.

14. Sale of Receivables Treat as a sale if all of these conditions are met: receivables are isolated from transferor. transferee has right to pledge or exchange receivables. transferor does not have control over the receivables. Transferor cannot repurchase receivable before maturity. Transferor cannot require return of specific receivables. In many financing arrangements involving receivables it is unclear whether the transaction is a sale or a borrowing. The basic issue that determines the substance of the transaction is the degree to which control of the surrendered receivables has been transferred. Regardless of how the transaction is characterized, control is judged to have been transferred, and the transaction is treated as a sale of the receivables, if all of these three conditions are met: ? the receivables are isolated from transferor. ? the transferee has right to pledge or exchange the receivables. ? the Transferor does not have control over the receivables. The transferor does not have control over the transferred receivables if the: Receivables cannot be repurchased by the transferor before maturity. Transferor cannot require return of specific receivables. In many financing arrangements involving receivables it is unclear whether the transaction is a sale or a borrowing. The basic issue that determines the substance of the transaction is the degree to which control of the surrendered receivables has been transferred. Regardless of how the transaction is characterized, control is judged to have been transferred, and the transaction is treated as a sale of the receivables, if all of these three conditions are met: ? the receivables are isolated from transferor. ? the transferee has right to pledge or exchange the receivables. ? the Transferor does not have control over the receivables. The transferor does not have control over the transferred receivables if the: Receivables cannot be repurchased by the transferor before maturity. Transferor cannot require return of specific receivables.

15. 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. 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. Part I. Receivables may be sold with or without recourse. When a company sells receivables without recourse, the: transaction is essentially treated just like an ordinary sale of any other asset. factor (transferee) assumes all of the risk of uncollectibility. control of the receivable passes to the factor. receivables are removed from the books, cash is received, and a financing expense or loss is recognized. Part II. When a company sells receivables with recourse, the transferor (seller) retains risk of uncollectibility, transaction must meet the three conditions of determining surrender of control to be recognized as a sale. if the transaction fails to meet the three conditions necessary to be classified as a sale, it will be treated as a secured borrowing. Part I. Receivables may be sold with or without recourse. When a company sells receivables without recourse, the: transaction is essentially treated just like an ordinary sale of any other asset. factor (transferee) assumes all of the risk of uncollectibility. control of the receivable passes to the factor. receivables are removed from the books, cash is received, and a financing expense or loss is recognized. Part II. When a company sells receivables with recourse, the transferor (seller) retains risk of uncollectibility, transaction must meet the three conditions of determining surrender of control to be recognized as a sale. if the transaction fails to meet the three conditions necessary to be classified as a sale, it will be treated as a secured borrowing.

16. Deciding Whether to Account for a Transfer as a Sale or a Secured Borrowing To summarize, transfers of a receivable may be accounted for as either a sale of a secured borrowing. Transferors usually prefer to use the sales approach rather than the secured borrowing approach because the sales approach which removes the receivable will make the transferor seem less leveraged, more liquid, and perhaps more profitable than the secured borrowing approach. First, companies must distinguish whether the arrangement to finance with receivables is a transfer of specific receivables of simply a pledging of receivables in general as collateral for a loan. If it is a transfer of receivables, the critical element is the extent to which the company surrenders control over the assets transferred. GAAP requires three conditions to determine if control has been surrendered: Transferred assets have been isolated from the transferor?beyond the reach of the transferor and its creditors. Each transferee has the right to pledge or exchange the assets it received. The transferor does not maintain effective control over the transferred assets. If these three conditions are met, the transfer may be recorded as a sale which means that the receivables are removed from the books, proceeds are recorded, and any gain or loss is recognized. If any of the three conditions are not met, the transaction is treated as a secured borrowing. To summarize, transfers of a receivable may be accounted for as either a sale of a secured borrowing. Transferors usually prefer to use the sales approach rather than the secured borrowing approach because the sales approach which removes the receivable will make the transferor seem less leveraged, more liquid, and perhaps more profitable than the secured borrowing approach. First, companies must distinguish whether the arrangement to finance with receivables is a transfer of specific receivables of simply a pledging of receivables in general as collateral for a loan. If it is a transfer of receivables, the critical element is the extent to which the company surrenders control over the assets transferred. GAAP requires three conditions to determine if control has been surrendered: Transferred assets have been isolated from the transferor?beyond the reach of the transferor and its creditors. Each transferee has the right to pledge or exchange the assets it received. The transferor does not maintain effective control over the transferred assets. If these three conditions are met, the transfer may be recorded as a sale which means that the receivables are removed from the books, proceeds are recorded, and any gain or loss is recognized. If any of the three conditions are not met, the transaction is treated as a secured borrowing.

17. Sale of Receivables Part I In December 2011, 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. Part II When a company sells accounts receivable with recourse, the seller retains all of the risk of bad debts. In effect, the seller guarantees that the buyer will be paid even if some receivables prove to be uncollectible. If the receivables were sold with recourse, Santa Teresa Glass still could account for the transfer as a sale so long as the conditions for sale treatment are met. The only difference would be the additional requirement that Santa Teresa record the estimated fair value of its recourse obligation as a liability. The recourse obligation is the estimated amount that Santa Teresa will have to pay Factor Bank as a reimbursement for uncollectible receivables. In this example, Santa Teresa estimates the fair value of the recourse obligation to be $5,000. Notice that the estimated recourse liability increases the loss on sale. If the factor collects all of the receivables, Santa Teresa eliminates the recourse liability and increases income (reduces the loss).Part I In December 2011, 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. Part II When a company sells accounts receivable with recourse, the seller retains all of the risk of bad debts. In effect, the seller guarantees that the buyer will be paid even if some receivables prove to be uncollectible. If the receivables were sold with recourse, Santa Teresa Glass still could account for the transfer as a sale so long as the conditions for sale treatment are met. The only difference would be the additional requirement that Santa Teresa record the estimated fair value of its recourse obligation as a liability. The recourse obligation is the estimated amount that Santa Teresa will have to pay Factor Bank as a reimbursement for uncollectible receivables. In this example, Santa Teresa estimates the fair value of the recourse obligation to be $5,000. Notice that the estimated recourse liability increases the loss on sale. If the factor collects all of the receivables, Santa Teresa eliminates the recourse liability and increases income (reduces the loss).

18. E7-13 On June 30, 2011, the Esquire Company sold some merchandise to a customer for $30,000 and agreed to accept as payment a noninterest- bearing note with an 8% discount rate requiring the payment of $30,000 on March 31, 2012. The 8% rate is appropriate in this situation. Prepare all journal entries (omit any entry that might be required for the cost of the goods sold).


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