Cash and Receivables Chapter 7 Power Point Authors

Cash and Receivables Chapter 7 Power. Point Authors: Susan Coomer Galbreath, Ph. D. , CPA Charles W. Caldwell, D. B. A. , CMA Jon A. Booker, Ph. D. , CPA, CIA Cynthia J. Rooney, Ph. D. , CPA Copyright © 2013 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

7 -2 Cash and Cash Equivalents Cash Currency and coins Balances in checking accounts Items for deposit such as checks and money orders from customers Cash equivalents are short-term, highly liquid investments that can be readily converted to cash. Money market funds Treasury bills Commercial paper

7 -3 Internal Control Encourages adherence to company policies and procedures Promotes operational efficiency Minimizes errors and theft Enhances the reliability and accuracy of accounting data

7 -4 Internal Control Procedures Cash Receipts Separate responsibilities for receiving cash, recording cash transactions, and reconciling cash balances. Match the amount of cash received with the amount of cash deposited. Close supervision of cash-handling and cash-recording activities. Cash Disbursements All disbursements, except petty cash, made by check. Separate responsibilities for cash disbursement documents, check authorization, check signing, and record keeping. Checks should be signed only by authorized individuals.

Restricted Cash and Compensating Balances Restricted Cash Management’s intent to use a certain amount of cash for a specific purpose – future plant expansion, future payment of debt. Compensating Balance Minimum balance that must be maintained in a company’s bank account as support for funds borrowed from the bank. 7 -5

7 -6 U. S. GAAP vs. IFRS In general, cash and cash equivalents are treated similarly under IFRS and U. S. GAAP. One difference is highlighted below. Bank overdrafts are treated as liabilities. Bank overdrafts may be offset against other cash accounts.

7 -7 Accounts Receivable Result from the credit sales of goods or services to customers. Are classified as current assets. Are recorded net of trade discounts.

7 -8 Cash Discounts Cash discounts

7 -9 Cash Discounts 2/10, n/30 Discount percent Number of days discount is available Otherwise, net (or all) is due Credit period

7 -10 Cash Discounts Gross Method Net Method Sales are recorded at the invoice amounts. Sales are recorded at the invoice amount less the discount. Sales discounts are recorded as reduction of revenue if payment is received within the discount period. Sales discounts forfeited are recorded as interest revenue if payment is received after the discount period.

7 -11 Cash Discounts On October 5, Hawthorne sold merchandise for $20, 000 with terms 2/10, n/30. On October 14, the customer sent a check for $13, 720 taking advantage of the discount to settle $14, 000 of the amount. On November 4, the customer paid the remaining $6, 000. October 5, 2013 October 14, 2013 November 4, 2013

7 -12 Sales Returns Merchandise may be returned by a customer to a supplier. A special price reduction, called an allowance, may be given as an incentive to keep the merchandise. To avoid misstating the financial statements, sales revenue and accounts receivable should be reduced by the amount of returns in the period of sale if the amount of returns is anticipated to be material.

7 -13 Sales Returns During the first year of operations, Hawthorne sold $2, 000 of merchandise that had cost them $1, 200, 000 (60%). Industry experience indicates a 10% return rate. During the year $130, 000 was returned prior to customer payment. Record the returns and the end of the year adjustment. Actual Returns Sales returns Accounts receivable Inventory Cost of goods sold (60%) Adjusting Entries Sales returns Allowance for sales returns Inventory estimated returns Cost of goods sold (60%) 130, 000 78, 000 70, 000 42, 000

7 -14 Uncollectible Accounts Receivable Bad debts result from credit customers who are unable to pay the amount they owe, regardless of continuing collection efforts. In conformity with the matching principle, bad debt expense should be recorded in the same accounting period in which the sales related to the uncollectible account were recorded. PAST DUE

7 -15 Uncollectible Accounts Receivable Most businesses record an estimate of the bad debt expense by an adjusting entry at the end of the accounting period. Normally classified as a selling expense and closed at year-end. Contra asset account to accounts receivable. Bad debt expense Allowance for uncollectible accounts xxx

7 -16 Allowance for Uncollectible Accounts Receivable Less: Allowance for Uncollectible Accounts Net Realizable Value Net realizable value is the amount of the accounts receivable that the business expects to collect. Income Statement Approach Balance Sheet Approach Composite Rate Aging of Receivables

7 -17 Income Statement Approach Focuses on past credit sales to make estimate of bad debt expense. Emphasizes the matching principle by estimating the bad debt expense associated with the current period’s credit sales. Bad debt expense is computed as follows:

7 -18 Income Statement Approach In 2014, Music. Land has credit sales of $400, 000 and estimates that 0. 6% of credit sales are uncollectible. What is Bad Debt Expense for 2014? Music. Land computes estimated Bad Debt Expense of $2, 400. Bad debt expense Allowance for uncollectible accounts 2, 400

7 -19 Balance Sheet Approach Focuses on the collectability of accounts receivable to make the estimate of uncollectible accounts. Involves the direct computation of the desired balance in the allowance for uncollectible accounts. ŒCompute the desired balance in the allowance for uncollectible accounts. Bad debt expense is computed as:

Balance Sheet Approach Composite Rate On Dec. 31, 2014, Music. Land has $50, 000 in accounts receivable and a $200 credit balance in allowance for uncollectible accounts. Past experience suggests that 5% of receivables are uncollectible. What is Music. Land’s bad debt expense for 2014? 7 -20

7 -21 Balance Sheet Approach Composite Rate Determine the desired balance in allowance for uncollectible accounts Bad debt expense Allowance for uncollectible accounts 2, 300

Balance Sheet Approach Aging of Receivables ΠYear-end accounts receivable is broken down into age classifications. Each age grouping has a different likelihood of being uncollectible. Compute required uncollectible amount. Compare required uncollectible amount with the existing balance in the allowance account. 7 -22

7 -23 Balance Sheet Approach Aging of Receivables At December 31, 2014, the receivables for East. Co, Inc. , were categorized as follows: Œ

7 -24 Balance Sheet Approach Aging of Receivables East. Co’s unadjusted balance in the allowance account is $500. Per the previous computation, the required balance is $1, 350. Bad debt expense Allowance for uncollectible accounts 850

7 -25 Uncollectible Accounts As accounts are deemed to be uncollectible, a journal entry is made to record the actual write-off. Allowance for uncollectible accounts Accounts receivable 500 If a customer makes a payment after an account has been written off, two journal entries are required. Accounts receivable Allowance for uncollectible accounts 500 Cash 500 Accounts receivable

7 -26 Direct Write-off Method If uncollectible accounts are immaterial, bad debts are simply recorded as they occur (without the use of an allowance account). Bad debts expense Accounts receivable xxx

Summary of Measurement and Reporting Issues for Accounts Receivable Recognition Depends on the earnings process; for most credit sales, revenue and the related receivables are recognized at the point of delivery. Initial valuation Initially recorded at the exchange price agreed upon by the buyer and seller. Subsequent valuation Initial valuation reduced to net realizable value by:  1. Allowance for sales returns  2. Allowance for uncollectible accounts:     The income statement approach     The balance sheet approach Classification Almost always classified as a current asset. 7 -27

7 -28 Notes Receivable A written promise to pay a specific amount at a specific future date. Even for maturities less than 1 year, the rate is annualized.

7 -29 Interest-Bearing Notes On November 1, 2014, West, Inc. , loans $25, 000 to Winn Co. The note bears interest at 12% and is due on November 1, 2015. Prepare the journal entry on November 1, 2014, December 31, 2014, (year-end) and November 1, 2015, for West. November 1, 2014 Notes receivable Cash December 31, 2014 Interest receivable Interest revenue November 1, 2015 Cash Note receivable Interest revenue 25, 000 500 28, 000 25, 000 500 2, 500

7 -30 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.

7 -31 Noninterest-Bearing Notes On Jan. 1, 2014, West, Inc. , accepted a $25, 000 noninterest-bearing note from Winn Co. as payment for a sale. The note is discounted at 12% and is due on Dec. 31, 2014. Prepare the journal entries on Jan. 1, 2014, and Dec. 31, January 1, 2014. Notes receivable 25, 000 Discount on notes receivable Sales revenue ($25, 000 * 12% = $3, 000) December 31, 2014 Cash Discount on notes receivable Interest revenue Note receivable 25, 000 3, 000 22, 000 3, 000 25, 000

7 -32 U. S. GAAP vs. IFRS In general, IFRS and U. S. GAAP are very similar with respect to accounts receivable and notes receivable. Differences are highlighted below. U. S. GAAP allows a “fair value option” for accounting for receivables. U. S. GAAP does not allow receivables to be accounted for as “available for sale” investments. U. S. GAAP requires more disaggregation of accounts and notes receivable in the balance sheet or notes. IFRS restricts the circumstances in which a “fair value option” for accounting for receivables is allowed. Until 2015, companies may account for receivables as “available for sale” investments if the approach is elected initially. After January 1, 2015, this treatment is no longer allowed.

7 -33 Financing with Receivables Companies may use their receivables to obtain immediate cash. Secured Borrowing Sale of Receivable s

7 -34 Factoring Arrangements 2. Accounts Receivable SUPPLIER (Transferor) RETAILER 1. Merchandise C 5. ec e bl va ei h as C R s nt as h ou cc A 3. 4. FACTOR (Transferee) A factor is a financial institution that buys receivables for cash, handles the billing and collection of the receivables, and charges a fee for the service.

7 -35 Secured Borrowing On December 1, 2013, the Santa Teresa Glass Company borrowed $500, 000 from Finance Bank and signed a promissory note. Interest at 12% is payable monthly. The company assigned $620, 000 of its receivables as collateral for the loan. Finance Bank charges a finance fee equal to 1. 5% of the accounts receivable assigned. Cash (difference) Finance charge expense (1. 5% * $620, 000) Liability – financing arrangement 490, 700 9, 300 500, 000 Santa Teresa Glass will continue to collect the receivables, and will record any discounts, sales returns, and bad debt write-offs, but will remit the cash to Finance Bank, usually on a monthly basis. When $400, 000 of the receivables assigned are collected in December, Santa Teresa Glass records the following entries. Cash 400, 000 Accounts receivable 400, 000 Interest expense ($500, 000 * 12% * 1/12) Liability – financing arrangement Cash 5, 000 400, 000 405, 000

7 -36 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.

7 -37 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.

7 -38 Sale of Receivables In December 2013, 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% (estimated to have a fair value of $50, 000) 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. Assume the same facts as above, except that Santa Teresa Glass sold the receivables to Factor with recourse and estimates the fair value of the recourse obligation to be $5, 000.

7 -39 Sale of Receivables Securitization: Transfer receivables to a SPE Special Purpose Entity (SPE) Qualifying Special Purpose Entity (QSPE) New rules eliminate QSPE and require consolidation! Participating Interests: Transfer portion of a receivable Example: transfer right to interest, but retain right to principal New rules require a partial transfer be treated as a secured borrowing, unless specific conditions are met!

7 -40 Transfers of Notes Receivable On December 31, Stridewell accepted a nine-month 10 percent note for $200, 000 from a customer. Three months later on March 31, Stridewell discounted the note at its local bank. The bank’s discount rate is 12 percent. Before preparing the journal entry to record the discounting, Stridewell must record the accrued interest on the note from December 31 until March 31. Interest receivable Interest revenue $200, 000 × 10% × 3/12 5, 000

7 -41 Transfers of Notes Receivable Cash Loss on sale of note receivable Notes receivable Interest receivable 202, 100 2, 900 200, 000 5, 000 $205, 000 $202, 100

Deciding Whether to Account for a Transfer as a Sale or a Secured Borrowing 7 -42

7 -43 U. S. GAAP vs. IFRS The U. S. GAAP and the IFRS approaches often lead to similar accounting treatment for transfers of receivables. U. S. GAAP focuses on whether control of assets has shifted from the transferor to the transferee. IFRS requires a more complex decision process. The company has to have transferred the rights to receive the cash flows from the receivable, and then considers whether the company has transferred “substantially all of the risks and rewards of ownership, ” as well as whether the company has transferred control.

7 -44 Receivables Management Receivables Turnover = Ratio Net Sales Average Accounts Receivable This ratio measures how many times a company converts its receivables into cash each year. Average 365 Collection = Receivables Turnover Ratio Period This ratio is an approximation of the number of days the average accounts receivable balance is outstanding.

7 -45 Receivables Management Symantec Corp. vs. CA, Inc. , comparison (All dollar amounts in millions)

7 -46 Appendix 7 -A: Cash Controls A bank reconciliation explains the difference between cash reported on bank statement and cash balance on a company’s books. Bank Balance Book Balance + Deposits in Transit + Bank Collections - Outstanding Checks - Service Charges - NSF Checks ± Bank Errors = Corrected Balance ± Book Errors = Corrected Balance

7 -47 Appendix 7 -A: Cash Controls Petty cash is used for minor expenditures. Petty cash fund Has one custodian. Replenished periodically.

Appendix 7 -B: Accounting for Impairment of a Receivable and a Troubled Debt Restructuring When a company holds a receivable from another company, there is some potential that the receivable will eventually be impaired. Impairment of a receivable occurs if the company believes it is probable that it will not receive all of the cash flows (principal and any interest payments) associated with the receivable. 7 -48

Appendix 7 -B: Accounting for Impairment of a Receivable and a Troubled Debt Restructuring Bad debt expense Accrued interest receivable Allowance for uncollectible accounts ($30, 000 - $24, 132, 330) 8, 867, 670 3, 000 5, 867, 670 7 -49

Appendix 7 -B: Accounting for Impairment of a Receivable and a Troubled Debt Restructuring 7 -50 A troubled debt restructuring occurs when a creditor makes concessions in response to a debtor’s financial difficulties. Sometimes a receivable in a troubled debt restructuring is actually settled at the time of the restructuring by the debtor making a payment of cash, some other noncash assets, or even shares of the debtor’s stock. (in millions) Land (fair value) Bad debt expense Accrued interest receivable Notes receivable 20 13 3 30

7 -51 U. S. GAAP vs. IFRS The U. S. GAAP and the IFRS approaches to impairments of receivables are similar, but the process and criteria are somewhat different. Under U. S. GAAP the level of analysis is individual receivables. U. S. GAAP provides an illustrative list of information to consider when evaluating receivables for impairment, and requires measurement of potential impairment if impairment (a) is viewed as probable and (b) can be estimated reliably. Both U. S. GAAP and IFRS treat reversal of impairments the same. Under IFRS the level of analysis starts with consideration of impairment for individually significant receivables. IFRS provides an illustrative list of “loss events” and requires measurement of an impairment if there is objective evidence that a loss event has occurred that has an impact on the future cash flows collected and that can be estimated reliably. Both U. S. GAAP and IFRS treat reversal of impairments the same.

7 -52 End of Chapter 7