Chapter 7 Cash and Receivables 7 1 Managing

Chapter 7 Cash and Receivables 7– 1

Managing Cash at Nike ü Poised to become a $20 billion company by the end of the decade ü Cash provided by operations = $1. 8 billion in fiscal 2007 ü Effective use of supply-chain management system © Royalty Free Photo. Disc/ Getty Images As you study this chapter, consider the issues involved with collection of accounts receivable and protecting cash. Click to explore financial news on Nike. Copyright © Cengage Learning. All rights reserved. 7– 2

LO 1: Managing Cash and Receivables 1. Cash needs 2. Credit policies 3. Level of accounts receivable 4. Financing receivables 5. Ethical estimates of credit losses © Royalty Free Photo. Disc/ Getty Images Copyright © Cengage Learning. All rights reserved. 7– 3

Cash Considerations Ø Most liquid of all assets Ø Central to operating cycle Consists of: Ø Currency and coins on hand Ø Checks and money orders from customers Ø Deposits in checking and savings accounts Copyright © Cengage Learning. All rights reserved. © Royalty Free Photo. Disc/ Getty Images Cash may include a compensating balance—a minimum amount required by a bank for a creditgranting agreement. 7– 4

Seasonal Cash Needs Cycles of business activities require different levels of cash needs Plan for these cash activities: Cash inflows Borrowing Copyright © Cengage Learning. All rights reserved. Cash outflows Investing 7– 5

Cash Requirements Copyright © Cengage Learning. All rights reserved. 7– 6

Accounts Receivable (A/R) Ø Short-term financial assets Ø Result from extending credit to an individual or a business, also called trade credit Retailers like Sears, Lowe’s, and JCPenney offer credit terms to customers Wholesalers and manufacturers also provide credit terms to their customers for purchases Copyright © Cengage Learning. All rights reserved. © Royalty Free Photo. Disc/ Getty Images 7– 7

Credit Policies To increase the likelihood of selling to customers who will pay on time, companies develop control procedures and maintain a credit department The credit department: ü Examines the financial resources and debts of the credit applicant ü Asks for personal references ü Gets credit rating from credit bureaus ü Determines the extent to which the company can grant credit, if any Copyright © Cengage Learning. All rights reserved. 7– 8

Evaluating the Level of Accounts Receivable How many times, on average, does a company turn its receivables into cash during an accounting period? Receivable Turnover Copyright © Cengage Learning. All rights reserved. How long, on average, does it take a company to collect its accounts receivables? Days’ Sales Uncollected 7– 9

Receivable Turnover Reflects the relative size of a company’s accounts receivable and the success of its credit and collection policies Net Sales Receivable Turnover = Average Net Accounts Receivable (Amounts in Millions) Nike’s Receivable Turnover for 2007 = = Copyright © Cengage Learning. All rights reserved. $16, 325. 9 ($2, 494. 7 + $2, 382. 9) ÷ 2 6. 7 times 7– 10

Days’ Sales Uncollected To interpret a company’s ratios, take into consideration the industry in which it operates Days’ Sales Uncollected 365 days = Nike’s Days’ Sales Uncollected Copyright © Cengage Learning. All rights reserved. Receivable Turnover = 365 days 6. 7 = 54. 5 days 7– 11

Receivable Turnover for Selected Industries Copyright © Cengage Learning. All rights reserved. 7– 12

Financing Receivables Money tied up in receivables is something that many companies seek to avoid Companies may use one or more of these methods so that they can receive cash faster: Set up a separate finance company Ford Motor Credit Company GM General Motors Acceptance Corp. Sears Roebuck Acceptance Corp. Borrow money and pledge A/R In case of default on loan, A/R (collateral) can be taken and converted to cash to satisfy the loan Copyright © Cengage Learning. All rights reserved. Factor A/R Sale or transfer of A/R; the buyer may bear risk of collection (factoring without recourse) or the seller may bear risk of collection (factoring with recourse) 7– 13

How Factoring Works Copyright © Cengage Learning. All rights reserved. 7– 14

Factoring Details What fees are charged? Typically 2% of total A/R for sales with recourse; Higher fee for sales without recourse What does the seller of receivables with recourse report in financials? Reports a contingent liability (a potential debt that can develop if customers don’t pay receivables) Copyright © Cengage Learning. All rights reserved. 7– 15

Discounting The sale of promissory notes held as notes receivable Company X Holds $20, 000 note from Company Z; Note will pay $1, 200 in interest ü Company X should disclose the contingent liability (in the amount of note plus interest) in notes to its financial statements Copyright © Cengage Learning. All rights reserved. Bank Buys the note for $19, 200 ü If Company X pays, bank will receive $21, 200 and realize a $2, 000 profit ü If Company X defaults, Company X is liable for the note 7– 16

Estimating Uncollectibles ü There will always be ü Match these expenses customers who do not of selling on credit to pay their accounts, the revenues they help called uncollectible generate accounts, or bad debts Estimate the uncollectible expense in the fiscal year in which the sales are made © Royalty Free Photo. Disc/ Getty Images Copyright © Cengage Learning. All rights reserved. 7– 17

Estimating Uncollectibles and Ethics Because estimations are involved, earnings may be easily manipulated… If the amount of losses from uncollectible accounts earnings are overstated. are understated, If the amount of losses from uncollectible accounts earnings are understated. are overstated, Copyright © Cengage Learning. All rights reserved. 7– 18

Discussion: Ethics in the World. Com increased revenues and hid losses by continuing to bill customers for service for years after the customers had stopped paying. Q. What impact do you think World. Com’s actions had on Accounts Receivable and Sales? Copyright © Cengage Learning. All rights reserved. 7– 19

Stop & Review Q. What is a compensating balance? A. A minimum amount kept on account required by a bank in accordance with a credit granting agreement. Copyright © Cengage Learning. All rights reserved. 7– 20

Stop & Review Q. If you owned a snow cone business with kiosks operating on three boardwalks along the New Jersey shore, what seasonal cash needs might you anticipate? A. Cash inflows and outflows might be greatest in the summer months, while the fall and winter months will not yield much cash, nor will much be required for operations. Copyright © Cengage Learning. All rights reserved. 7– 21

Stop & Review Q. Does the buyer or seller bear the risk of collection if receivables are sold with recourse? A. The seller bears the risk of collection because the buyer may return to the seller for payment if customers do not pay on their accounts. Copyright © Cengage Learning. All rights reserved. 7– 22

Stop & Apply Q. Slippery Elm Homeopathic Drug Store has net sales of $85, 355. The year began with Accounts Receivable of $15, 385 and ended with $19, 358. What is the company’s receivable turnover? A. $85, 355 ($19, 358 + $15, 385) ÷ 2 = 4. 9 times Copyright © Cengage Learning. All rights reserved. 7– 23

Stop & Review Q. How might a company use uncollectible estimates to manipulate earnings? A. If the company underestimated uncollectibles, it would overstate earnings. If the company wanted to minimize earnings, it could overestimate uncollectibles for the period. Copyright © Cengage Learning. All rights reserved. 7– 24

LO 2: Cash Equivalents Investments like time deposits or certificates of deposit (CDs) that have a term of 90 days or less Nike’s Annual Report Cash and equivalents represent cash and short-term, highly liquid investments with maturities of three months or less at date of purchase. The carrying amounts reflected in the consolidated balance sheet for cash and equivalents approximate fair value. © Royalty Free Photo. Disc/ Getty Images Copyright © Cengage Learning. All rights reserved. 7– 25

Cash Control: Imprest Systems Petty Cash Fund ü Established at a fixed amount ü Reimbursed periodically, based on documented expenditures ü Total cash and receipts must equal the original amount ü One person should be made responsible for the accuracy and security of the fund Copyright © Cengage Learning. All rights reserved. © Royalty Free C Squared Studios/ Getty Images 7– 26

Cash Control: Electronic Funds Transfer (EFT) Method of conducting business transactions in which funds are transferred electronically from one bank to another bank Wal-Mart makes 75% of its payments to suppliers using EFT Copyright © Cengage Learning. All rights reserved. Electronic Banking ATM transactions Debit and credit card purchases Online bill-pay 7– 27

Cash Control: Bank Reconciliations The bank statement is reconciled to the company’s Cash account to account for any difference between the two balances What items might appear in the company’s records that do not appear on the bank statement? What items might appear on the bank statement that do not appear in the company’s records? üOutstanding checks üDeposits in transit üErrors üService charges üNSF (nonsufficient funds) checks üMiscellaneous debits or credits üInterest income üErrors Copyright © Cengage Learning. All rights reserved. 7– 28

Illustration: Bank Reconciliation 1. A $138. 00 deposit was mailed to the bank on

Bank Reconciliation (cont’d) 2. Five checks issued in August or earlier have not been

Bank Reconciliation (cont’d) 3. A deposit on August 6 was incorrectly recorded in the company’s books as $165. 00. The bank correctly recorded the deposit as $150. 00. Copyright © Cengage Learning. All rights reserved. 7– 31

Bank Reconciliation (cont’d) 4. A credit memorandum was enclosed with the bank statement showing a note had been collected in the amount of $140. 00 along with interest of $10. 00. A debit memorandum was enclosed for the $2. 50 collection fee. Copyright © Cengage Learning. All rights reserved. 7– 32

Bank Reconciliation (cont’d) 5. An NSF check was returned with the statement for $64. 07. The NSF check from Austin Chase was not reflected in the company’s books. Copyright © Cengage Learning. All rights reserved. 7– 33

Bank Reconciliation (cont’d) 6. A debit memorandum for the monthly $6. 25 service charge

Bank Reconciliation (cont’d) 7. Interest earned by the company on its average balance was

Bank Reconciliation (cont’d) After all items have been listed on the reconciliation, total the columns. The adjusted bank balance should equal the adjusted book balance. Copyright © Cengage Learning. All rights reserved. 7– 36

Stop & Review Q. What are cash equivalents? A. Investments like time deposits or

Stop & Review Q. Why are electronic funds transfers considered to be a form of cash control? A. Because no money actually changes hands, there is less likelihood of theft or error. Copyright © Cengage Learning. All rights reserved. 7– 38

Stop & Review Q. What types of items will be added to the balance

Stop & Review Q. What types of items will be deducted from the balance per books when performing a bank reconciliation? A. Charges and fees like service charges, check charges, and NSF checks Copyright © Cengage Learning. All rights reserved. 7– 40

LO 3: Direct Charge-Off Method for uncollectibles ü Recognize a loss ü Tax law requires at the time it is use of this determined that method when an account is computing uncollectible taxable income Date Uncollectible Accounts Expense Accounts Receivable XXX Most companies do not use this method for financial reporting purposes because it does not conform to GAAP. Copyright © Cengage Learning. All rights reserved. 7– 41

The Allowance Method Losses from bad debts are matched against the sales they help generate üAt the time of sale, management cannot identify which customers will not pay üTo observe the matching rule, losses from uncollectible accounts must be estimated üThe estimate becomes an expense in the fiscal year in which the sales are made Copyright © Cengage Learning. All rights reserved. 7– 42

Alternate Account Names Allowance for Uncollectible Accounts Expense ü Allowance for Doubtful Accounts ü Allowance for Bad Debts ü Reserve for Bad Debts (not used in modern practice) ü Bad Debts Expense © Royalty Free C Squared Studios/ Getty Images Copyright © Cengage Learning. All rights reserved. 7– 43

Estimating Uncollectible Accounts • Estimated loss should be: üRealistic üBased on objective information üBased on past experience üBased on current economic conditions Two commonly used methods for estimating loss 1. Percentage of net sales method 2. Accounts receivable aging method Copyright © Cengage Learning. All rights reserved. 7– 44

Percentage of Net Sales Method How much of this year’s net sales will not be collected? The answer determines the amount of uncollectible accounts expense for the year The amount is actually based on the company’s historic losses © Royalty Free C Squared Studios/ Getty Images Copyright © Cengage Learning. All rights reserved. 7– 45

Percentage of Net Sales Method Dec. 31, 2012: Account balances: Sales, $322, 500; Sales Returns and Allowances, $20, 000; Sales Discounts, $2, 500; Allowance for Uncollectible Accounts, $1, 800. Management estimates that uncollectible accounts will average about 2 percent of net sales. After the above entry is posted, Allowance for Uncollectible Accounts will have a credit balance of $7, 800 Copyright © Cengage Learning. All rights reserved. Allowance for Uncollectible Accounts Dec. 31 adj. 1, 800 6, 000 Dec. 31 bal. 7, 800 Dec. 31 7– 46

Accounts Receivable Aging Method How much of the ending balance of accounts receivable will not be collected? The ending balance of Allowance for Uncollectible Accounts is determined directly through an analysis of accounts receivable The difference between the amount determined to be uncollectible and the actual balance of Allowance for Uncollectible Accounts is the expense for the period. Copyright © Cengage Learning. All rights reserved. 7– 47

Analysis of Accounts Receivable by Age ü The total past due for each category is multiplied by the estimated percentage uncollectible ü The sum of the totals for each category is the estimated balance of Allowance for Uncollectible Accounts Notice that the estimated percentage uncollectible increases as accounts become further past due. 7– 48

Accounts Receivable Aging Method (Case 1) Dec. 31, 2010: Management has estimated that $4, 918 of Accounts Receivable are uncollectible. Allowance for Uncollectible Accounts has a credit balance of $1, 600. Allowance for Uncollectible Accounts Dec. 31 adj. 1, 600 3, 318 Dec. 31 bal. 4, 918 Dec. 31 The target balance for the account is $4, 918 Copyright © Cengage Learning. All rights reserved. A credit adjustment of $3, 318 will bring the account to its target balance 7– 49

Accounts Receivable Aging Method (Case 2) Dec. 31, 20 x 6: Management has estimated that $4, 918 of Accounts Receivable are uncollectible. Allowance for Uncollectible Accounts has a debit balance of $1, 600. Allowance for Uncollectible Accounts Dec. 31 1, 600 The target balance for the account is $4, 918 Copyright © Cengage Learning. All rights reserved. Dec. 31 adj. 6, 518 Dec. 31 bal. 4, 918 A credit adjustment of $6, 518 will bring the account to its target balance 7– 50

Comparison of Two Methods Copyright © Cengage Learning. All rights reserved. 7– 51

Estimates Differ from Write-Offs? Accounts receivable written off during a period will rarely equal the estimated uncollectible amount Allowance for Uncollectible Accounts Shows a debit balance when the total of accounts written off is greater than the estimated uncollectible amount Copyright © Cengage Learning. All rights reserved. Shows a credit balance when the total of accounts written off is less than the estimated uncollectible amount 7– 52

Writing Off an Uncollectible Account ü When it becomes clear an account will not be collected, the amount should be written off to Allowance for Uncollectible Accounts ü The uncollectible amount was already accounted for as an expense when the allowance was established Copyright © Cengage Learning. All rights reserved. 7– 53

Writing Off an Uncollectible Account Jan. 15, 2011: TV GO, who owes Gomez Company $500, is declared bankrupt by federal court. Accounts Receivable Allowance for Uncollectible Accounts Dec. 31 Jan. 15 4, 918 Dec. 31 88, 800 500 Jan. 15 Bal. The write-off does not affect the estimated net realizable value of accounts receivable 4, 418 Bal. 500 88, 300 Net realizable value of A/R Before write-off $88, 800 – $4, 918 = $83, 882 After write-off $88, 300 – $4, 418 = $83, 882 7– 54

Stop & Review Q. Why do most companies use the allowance method instead of the direct write-off method to account for uncollectible accounts? A. The direct write-off method does not conform to the matching rule and therefore does not adhere to GAAP. The allowance method matches losses from bad debts against the sales they helped produce. Copyright © Cengage Learning. All rights reserved. 7– 55

Stop & Review Q. Where does the Allowance for Uncollectible Accounts account appear in the financial statements? A. On the balance sheet as a contra account to Accounts Receivable. Copyright © Cengage Learning. All rights reserved. 7– 56

Stop & Apply Q. Write Brothers Office Supplies had the following account balances at year end: Sales $620, 000; Sales Returns and Allowances $35, 000; Sales Discounts, $2, 000; Allowance for Uncollectible Accounts, $2, 400. Uncollectible accounts is estimated at 3 percent of net sales. What amount will be debited to Uncollectible Accounts Expense if the company uses the percentage of net sales method? A. . 03 x ($620, 000 - $35, 000 - $2, 000) = $17, 490 Copyright © Cengage Learning. All rights reserved. 7– 57

Stop & Apply Q. Management estimates that $2, 707 of Accounts Receivable are uncollectible. Allowance for Uncollectible Accounts has a credit balance of $1, 200. If the company uses the aging method, what journal entry should be prepared? A. $2, 707 – $1, 200 = $1, 507 Copyright © Cengage Learning. All rights reserved. 7– 58

LO 4: Making and Paying Notes A promissory note is an unconditional promise to pay a definite sum of money on demand at a future date Maker Person or company that signs the note and promises to pay the amount All promissory notes that the maker holds that are due in less than one year are categorized as notes payable in the current liability section of the balance sheet Copyright © Cengage Learning. All rights reserved. Payee Entity to whom payment is to be made All promissory notes that the payee holds that are due in less than one year are categorized as notes receivable in the current assets section of the balance sheet 7– 59

A Promissory Note Copyright © Cengage Learning. All rights reserved. 7– 60

Key Components of Promissory Notes Maturity Date on which the note must be paid Duration Length of time in days between the note’s issue date and its maturity date Interest and Interest Rate Cost of borrowing money or the return for lending money, usually stated on an annual basis Maturity Value Total proceeds of a note at maturity date (face value plus interest) Copyright © Cengage Learning. All rights reserved. 7– 61

Maturity Date Ways in which maturity date may be stated: Due “November 14, 2010” Due “three months after November 14, 2010” Due “ 90 days after November 14, 2010” Exclude the date of the note when computing the maturity date: A note dated May 20 and due in 90 days would be due on August 18, determined as follows: Days remaining in May (31 – 20) Days in June Days in July Days in August Total days Copyright © Cengage Learning. All rights reserved. 11 30 31 18 90 7– 62

Duration of a Note Why is duration of a note important? Interest is calculated on this basis If maturity date is stated as a specific number of days from date of note… If maturity date is stated as a specific date… Copyright © Cengage Learning. All rights reserved. duration is easy to calculate. Duration is the same as number of days must be calculated. 7– 63

Interest and Interest Rate Amount of interest is based on: ü Principal ü Rate of interest ü Loan’s length of time © Royalty Free Photo. Disc/ Getty Images What is the interest on a 90 -day, 8 percent, $1, 000 note? Principal x Rate of Interest x Time = Interest $1, 000 x. 08 x 90/365 = $19. 73 Copyright © Cengage Learning. All rights reserved. 7– 64

Maturity Value Total proceeds of loan 90 -day 8 percent proceeds $1, 000 loan = Principal + Interest = $1, 000 + ($1, 000 × 8/100 × 90/365) = $1, 000. 00 + $19. 73 = $1, 019. 73 The maturity value of a non-interest-bearing note is the principal amount. In this case, the principal includes an implied interest cost Copyright © Cengage Learning. All rights reserved. 7– 65

Accrued Interest ü A promissory note received in one accounting period may not be due until a later period ü Accrue the interest applicable to the note at the end of the accounting period $1, 000 note, 90 -day, 8 percent note was received on Aug. 31. The fiscal year ends on Sept. 30. © Royalty-Free/Corbis 30 days interest, or $6. 58 ($1, 000 × 8/100 × 30/365 = $6. 58), is earned in the fiscal year that ends on Sept. 30 Copyright © Cengage Learning. All rights reserved. 7– 66

Dishonored Notes ü When the maker of a note does not pay at maturity, the note is said to be a dishonored note. © Royalty Free Photo. Disc/ Getty Images Copyright © Cengage Learning. All rights reserved. ü The holder, or payee, of the note should make an entry to transfer the amount due to an accounts receivable from the debtor. 7– 67

Stop & Apply Q. On January 1, 20 x 6, Blake Company receives a 90 day, 9 percent, $5, 000 note. The company prepares financial statements monthly. What is the maturity date of the note? A. April 1 Days remaining in January (31 – 1) Days in February Days in March Days in April Total days Copyright © Cengage Learning. All rights reserved. 30 28 31 1 90 7– 68

Stop & Apply Q. If Cheep Company extends a 90 -day, $1, 000 note, at 9 percent, what total proceeds will the company receive? A. $1, 000 + ($1, 000 x. 09 x 90/365 = $1, 000. 00 + $22. 19 = $1, 022. 19 Copyright © Cengage Learning. All rights reserved. 7– 69

Chapter Review Problem JPG Company sells merchandise on account to its customers. During the year ended December 31, the company had net sales of $800, 000. At the end of the year, it had Accounts Receivable of $220, 000 and a debit balance in Allowance for Uncollectible Accounts of $3, 100. In the past, approximately 2. 0 percent of net sales have been uncollectible. Also, an aging analysis of accounts receivable reveals that $12, 000 in accounts receivable appears to be uncollectible. Required: Compute Uncollectible Accounts Expense, and determine the ending balance of Allowance for Uncollectible Accounts and the amount of Accounts Receivable, Net, under (a) the percentage of net sales method and (b) the accounts receivable aging method. Copyright © Cengage Learning. All rights reserved. 7– 70

Chapter Review Problem (Solution) (a) Percentage of net sales method: Uncollectible Accounts Expense = 2. 0 percent × $800, 000 = $16, 000 Allowance for Uncollectible Accounts = $16, 000 – $3, 100 = $12, 900 Accounts Receivable, Net = $220, 000 – $12, 900 = $207, 100 (b) Accounts receivable aging method: Uncollectible Accounts Expense = $3, 100 + $12, 000 = $15, 100 Allowance for Uncollectible Accounts = $12, 000 Accounts Receivable, Net = $220, 000 – $12, 000 = $208, 000 Copyright © Cengage Learning. All rights reserved. 7– 71