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Cash and Receivables

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Cash and Receivables

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  1. Cash and Receivables

  2. Objectives of this Chapter I. Discuss the asset valuation methods. II. Identify items to be included in the cash account and discuss how cash and related items are reported. III. Explain accounting issues related to valuation of accounts receivables -- trade discount, sales discount, sales returns and allowance, and uncollectible accounts. Cash and Receivables

  3. Objectives of this Chapter (contd.) IV. Discuss the means to use accounts receivable as a financial instrument -- pledge, assign and factor. V. Discuss the valuation of notes receivable and the disposition of notes receivable. Cash and Receivables

  4. I. Assets Valuation Methods A. Acquisition Cost (Historical Cost): Used in the initial recording for all assets except for: 1. Investment in debt securities-held-to-maturity. 2. Long-term monetary assets (i.e., Long-term N/R). B. Current Entry Value(Replacement Cost): Applied in the inventory valuation (LCM). Cash and Receivables

  5. Assets Valuation Methods (contd.) C. Current Exit Value (net selling price or market value): Applied in the valuation of trading securities and securities-available-for-sale. D.Net Present Value: Applied in the valuation of investment in debt securities-held-to-maturity and long-term monetary assets. Note: SFAS 159 allows the fair value option for financial assets and liablitlieis. Cash and Receivables

  6. Cash and Receivables • Liquidity: The amount of time expected to elapse until an asset is converted into cash. • Liquid assets: Assets are available for conversion into cash quickly (i.e., cash, receivables, trading securities, etc..). • Liquidity is an indication of a company’s ability to meet its obligation. Cash and Receivables

  7. II. Cash • What are included in the cash account? A. Cash on hand: B. Cash in bank: Cash and Receivables

  8. Cash (contd.) • What are excluded from the cash account (source: FRR No. 1): • Foreign currency with severe restrictions - separate cash account. • Certificates of deposits (CDs) - Temporary Investments. • Bank overdrafts - current liabilities (i.e., A/P) unless available cash is present in another account in the same bank (offsetting is required in this case). Cash and Receivables

  9. Cash (contd.) • What are excluded from the cash account (source: FRR No. 1): • Postdated checks- Receivables. • IOUs - Receivables. • Travel Advances - Prepaids. • Employees’ Advances - Receivables. • Postage stamps -Office supplies. • Special purpose funds - Investments. • Compensating balances - Restricted cash. • Short-term papera (i.e., commercial paper) - S-T investments. a. Investments with maturity of 3 to 12 months. Cash and Receivables

  10. Restricted Cash • Compensating balances are examples of restricted cash which may require separate reporting. • Other restricted cash: petty cash, cash for payroll, cash for dividends. If the amount is material, separate reporting is required. Cash and Receivables

  11. CashCompensating Balances (CB) • CB: The portion of any deposit maintained by a corporation to support an existing borrowing arrangements (ASR No. 148). • CB will increase the effective interest rate. • CB may also be payment for bank services rendered to the company. Cash and Receivables

  12. CashCompensating Balances (contd.) • If the CB is significant and is to support short-term borrowing, the CB should be stated separately among the “cash and cash equivalent item” in current assets.. • If the CB is significant and is to support long-term borrowing, the CB should be classified as noncurrent assets in either “Investments” or “ Cash on Other Assets” using a caption such as “Deposit Maintained as Compensating Balance”. Cash and Receivables

  13. CashCompensating Balances (contd.) • The following two situations only require a footnote disclosure of the CB, not a separate reporting: 1) CB arrangement exists without agreements that restrict the use of cash amount shown on the balance sheet statement; 2) CB arrangement is to assure future credit availability. Cash and Receivables

  14. Other Cash Related Topics • Electronic Fund Transfer (EFT): • Cash Equivalents: short-term, highly liquid investments that are both • Readily convertible to known amount of cash, and • So near their maturity that they present insignificant risk of change in value. Cash and Receivables

  15. Cash Equivalents (CEs) • In general, only investments with original maturity of three months or less qualify under these definitions. • Examples: Treasury bills, Commercial paper, and Money Market Funds. • Hard lesson learned: reporting the auction-rate notes as CEs by Kohl’s and ADC Telecommunications resulting in sizeable write-downs of these CE during the credit crunch due to no market exist for these investments. Cash and Receivables

  16. Cash Equivalents (CEs) • Although these auction-rate notes often have long maturity dates (i.e., 30-year), they were traded on daily basis prior to the credit crunch in 2008. • This is how the holders of these notes argued to present them as CEs. • When the market for these notes froze (i.e., no buyers of these notes), the value of these assets dropped significantly to warrant a sizeable write down. Cash and Receivables

  17. Cash Equivalents (CEs) • FASB is considering to separate reporting of cash from CEs. • In July 2010, FASB staff proposed to report cash equivalents (i.e., money market fund) as short-term investments. • This project was reassessed as a low priority project and no action was taken recently. Cash and Receivables

  18. CashUsing Bank Account • General checking accounts • Imprest bank accounts • Lockbox accounts Cash and Receivables

  19. Cash Management and Control • Cash Management: 1) to maintain sufficient balance of cash on hand for day-to-day operation; 2) to prevent large amount of idle cash on hand. • Cash Control: to prevent losses of cash by theft of fraud 1. Immediate deposit of cash. 2. Cash payment by checks except for small amounts. 3. Separation of duties. 4. Bank account reconciliation. Cash and Receivables

  20. III.Receivables • Receivables: claims held against customers and others for money, goods or services. • Current Receivables: expected to be collected within one year or one operating cycle, whichever is longer. Cash and Receivables

  21. Receivables (contd.) • Trade Receivables: amount owed by customers for goods sold and services rendered as part of normal business operations (i.e., accounts receivable and notes receivable). • Nontrade Receivables: all others (i.e., interest receivable, advances to employees, deposits to cover potential damages, etc.) Cash and Receivables

  22. Balance Sheet Presentation of Receivables (Illustration 7-3, KWW, 14th e) Cash and Receivables

  23. Trade Receivables • Accounts Receivable (A/R): oral promises of the purchasers to pay for goods sold and services rendered. They are usually collected in 30-60 days. Thus, A/R is always reported as a current asset with the net realizable value (i.e., A/R minus the allowance for uncollectible accounts). Cash and Receivables

  24. Trade Receivables (contd.) • Notes Receivable (N/R): written promises to pay a certain sum of money on a specific future date. N/R can be long-term or short-term and can be interesting-bearing or noninterest bearing. Cash and Receivables

  25. Trade Receivables (contd.) • Short-term N/R is reported at net realizable value (face amount – allowances for uncollectibles accounts). • Long-term N/R is reported at present value or the fair value (i.e., the quoted market prices of identical assets in active markets). Cash and Receivables

  26. Valuation of A/R & N/R Cash and Receivables

  27. Adjustments Related to Sales 1. Volume Dis. (Trade Discounts) 2. Cash Discounts (Sales Discounts) 3. Sales Returns and Allowances 4. Uncollectible Accounts Cash and Receivables

  28. 1. Volume Discount • When to Recognize the Adjustments: Not reflected on the J.E. Unit price = $10 Volume Dis. => 5% if purchase 100 or more units Sale => 200 units J.E.: Cash 1,900 Sales 1,900 • ORA/R 1,900 • Sales 1,900 Cash and Receivables

  29. 2. Cash Discounts (Sales Discounts) • When to Recognize the Adjustments: both Methods are acceptable. A. Recognized at time of sale (Net Price Method) B. Recognized at time of occurrence (Gross price Method) Cash and Receivables

  30. 2A. Recognized at Time of Sale(Net Price Method) • Sales = $100, terms 2/10, n/30 12/26/x1 A/R 98 Sales 98 a. 1/2/x2 Cash 98 A/R 98 Cash and Receivables

  31. 2A. Recognized at Time of Sale(Net Price Method) (contd.) If discounts were not taken: b. 1/31/x2 Cash 100 A/R 98 Cash Discounts Not Taken 2   Finance charge or Cash Dis. Forfeited (interest revenue) Note: If the discount period expired on 12/31, adjustment is required to bring the A/R to the gross amount. Cash and Receivables

  32. 2B. Recognized at time of occurrence(Gross price Method) • Sales = $100, terms 2/10, n/30 12/26/x1 A/R 100 Sales 100 a. 1/2/x2 Cash 98 Sales Discounts 2 AR 100 If discounts were not taken: b. 1/31/x2 Cash 100 A/R 100 Cash and Receivables

  33. 3. Sales Returns & Allowances (FASB 48) A. The amount of sales R&A is not significant. B. The amount of sales R&A is significant and six conditions are not met. C. The amount of sales R&A is significant and six conditions are met. Cash and Receivables

  34. 3A. The amount of Sales R&A Is Not Significant • If the amount of sales R&A is not significant, sales R&A are recognized at time of occurrence: Sales Returns & Allowances xxx A/R (or cash) xxx Cash and Receivables

  35. 3B. The Amount of Sales R&A Is Significant and Six Conditions Are Not Met • If the amount of sales R&A is significant, and the following six conditions are not met, postpone the revenue recognition until all six conditions are met or the return period expired. Cash and Receivables

  36. Six Conditions (SFAS No. 48) 1. Sales price is determinable or fixed; 2. Buyers have paid or have the obligation to pay the sales price; 3. The buyer’s obligation would not be changed due to theft or damage of the product after purchase; 4. Sellers are not responsible for the performance of the product; Cash and Receivables

  37. Six Conditions (SFAS No. 48) 5. Buyers and sellers are two separate economic entities; 6. The amount of returns can be estimated. • If the amount of returns is significant and these conditions are not met, revenue cannot be recognized. Cash and Receivables

  38. 3C. The Amount of Sales R&A Is Significant and Six Conditions Are Met • Sales can be recognized in the period in which the sales are made. • Also, at the end of the same period, the amount of sales returns would be estimated and recognized. 10/5/x1 A/R 10,000 Sales 10,000 12/31/x1 Sales R&A 1,000 Allow. for sale R& A 1,000 (estimate 10% returns) 1/10/x2 Allowance for sales R&A 900 A/R 900 Cash and Receivables

  39. 4. Uncollectible Accounts • The Allowance Method for Uncollectible Accounts: Estimate the bad debt (B/D) expense at the end of the period and recognize the expense (SFAS No. 5). Adjusting entry for B/D expense: Estimated B/D expense = $2,000 12/31 B/D Expense 2,000 Allowance for Doubtful Accounts 2,000 When B/D actually occurred: (i.e.,$200 B/D) Allowance for doubtful Accounts 200 A/R 200 Cash and Receivables

  40. 4. Uncollectible Accounts (contd.) If $100 of the B/D recovered: A/R 100 Allow. for Doubtful Acct. 100 Cash 100 A/R 100 • The current practice is complied with the matching principle. • The direct write-off method (recognize the B/D expense when it occurs) is not recommended. Cash and Receivables

  41. Presentation of Allowance for Doubtful Accounts Cash and Receivables

  42. Three Methods in the Estimation of B/D Expense 1. Percentage-of-sales (income statement approach). 2. Percentage-of-accounts receivable (balance sheet approach). 3. Aging of accounts receivable (B/S approach using individual account information). Cash and Receivables

  43. 1. Percentage-of-Sales (I/S Approach) Example: Net credit sales = $20,000 Estimated B/D exp. = 2% of net credit sales Adjusting Entry 12/31 B/D Expense 400 Allow. for Doubtful Accounts 400 Cash and Receivables

  44. 2. Percentage of A/R (B/S Approach) A/R Balance = $50,000 Estimated B/D = 1% of A/R Balance of the allow for doubtful accounts prior to the adjustment = $300 The new balance of the allow. for doubtful accounts = $50,000 x 1% = $500 Bad Debt Expense = $500 - 300 = 200 Adjusting Entry B/D expense 200 Allowance for Doubtful accounts 200 Cash and Receivables

  45. 3. Aging of A/R Method The balance of the allowance prior to adj.= $100 B/D Expense= $2,300 - $100 = $2,200 Adj. Entry: B/D expense 2,200 Allowance for Doubtful Account. 2,200 Cash and Receivables

  46. Earnings Management • Discretionary accruals require a large degree of managers’ judgment • Managers can use the discretionary accruals to manage earnings. • Examples of discriminatory accruals: bad debt expense, warranty expense, sales returns (when expecting sig. returns), etc. Cash and Receivables

  47. Earnings Management Using Accruals: The Case of Nortel • Background: A Canadian communication company filed bankruptcy in 2009. It was hit very hard by the technology stock price decline in the early 2000s. • Accounting Scandals: Nortel overstated its bad debt expense of 2002 in order to reduce its bad debt expense of 2003 (thus, increase its earnings) even though the outstanding accounts receivables were similar for both years. Cash and Receivables

  48. Earnings Management Using Accruals: The Case of Nortel (contd.) Cash and Receivables

  49. Earnings Management Using Accruals – Sun Trust Banks • Similar to Nortel, some banks also overstated the loan loss reserve (an expense) for outstanding loans in a good earnings year and reduce the reserve in the following year to manage earnings. Cash and Receivables

  50. Earnings Management Using Accruals – Sun Trust Banks (contd.) • The SEC brought action against Sun Trust in 1999, alleging Sun Trust manipulated its earnings by overstating loss reserve when it was not experiencing significant loan losses. • The SEC required Sun Trust to reverse the $100 million of loan loss reserve. source: KWW,14th e, p377 and “The Mythical FDIC Fund by William M. Isaac*, AM BKR Final, 8/27/08). Cash and Receivables