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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) PowerPoint Presentation
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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) - PowerPoint PPT Presentation


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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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slide1

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 & 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
slide3

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
slide4

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
slide5

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
slide6

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.
cash discounts net gross methods
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:
slide8

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)
slide9

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
slide10

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

accounts receivable
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

two types of allowance methods
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)
allowance example
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

allowance examples cntd
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

slide16

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

allowance examples cntd17
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

slide18

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
a r bad debt expense allowance for doubtful accounts example
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?

a r bad debt expense allowance for doubtful accounts example20
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?

a r bad debt expense allowance for doubtful accounts example21
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?

a r bad debt expense allowance for doubtful accounts example22
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?

slide23

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
slide24

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

notes receivable non interest bearing
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.

non interest bearing notes
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)
non interest bearing notes28
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)

notes where stated rate is different from market rate
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?
slide30

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

example where stated rate and market rate differ
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)
stated rate and market rate differ
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

slide34

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).
slide35

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.
slide36

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)
transferred assets isolated from transferor
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.
transfer of receivables secured borrowing
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

transfer of receivables sale without recourse
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

transfer of receivables sale with recourse
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?