Chapter 7 Cash and Receivables Skyline College Lecture

Chapter 7 Cash and Receivables Skyline College Lecture Notes

Pivotal Issues When Managing Cash and Receivables 1. 2. 3. 4. 5. Cash needs Credit policies Level of accounts receivable Financing receivables Ethical estimates on credit sale losses Copyright © Houghton Mifflin Company. All rights reserved. 7– 2

Cash Considerations Ø Most liquid of all assets Ø Central to operating cycle Consists of: ü Currency and coins on hand ü Checks and money orders from customers ü Deposits in checking and savings accounts Copyright © Houghton Mifflin Company. All rights reserved. Cash may include a compensating balance—a minimum amount required by a bank for a creditgranting agreement. 7– 3

Cash Requirements Seasonal Cycles and Cash Requirements for a Manufacturer of Athletic Sportswear Copyright © Houghton Mifflin Company. All rights reserved. 7– 4

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 © Houghton Mifflin Company. All rights reserved. 7– 5

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 © Houghton Mifflin Company. All rights reserved. How long, on average, does it take a company to collect its accounts receivables? Days’ Sales Uncollected 7– 6

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 2004 = $12, 253. 1 ($2, 120. 2 + $2, 083. 9) ÷ 2 = Copyright © Houghton Mifflin Company. All rights reserved. 5. 8 times 7– 7

Days’ Sales Uncollected To interpret a company’s ratios, take into consideration the industry in which it operates Days’ Sales Uncollected Nike’s Days’ Sales Uncollected 365 days = Receivable Turnover = 365 days 5. 8 = 62. 9 days Copyright © Houghton Mifflin Company. All rights reserved. 7– 8

Receivable Turnover for Selected Industries Copyright © Houghton Mifflin Company. All rights reserved. 7– 9

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 © Houghton Mifflin Company. 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– 10

How Factoring Works Copyright © Houghton Mifflin Company. All rights reserved. 7– 11

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 © Houghton Mifflin Company. All rights reserved. 7– 12

Securitization A company may sell a group of receivables in a batch at a discount to another company or to investors When receivables are paid, buyer gets full amount, thus their profit depends on the amount of discount they negotiated Circuit City Sells its receivables without recourse, so it has no further liability even if customers do not pay Copyright © Houghton Mifflin Company. All rights reserved. 7– 13

Discounting The sale of promissory notes held as notes receivable Company A Holds $10, 000 note payable to Company B; Note will pay $600 in interest ü Company A should disclose the contingent liability (in the amount of note plus interest) in notes to its financial statements Copyright © Houghton Mifflin Company. All rights reserved. Bank Buys the note for $9, 600 ü If Company B pays, bank will receive $10, 600 and realize a $1, 000 profit ü If Company B defaults, Company A is liable for the note 7– 14

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 Copyright © Houghton Mifflin Company. All rights reserved. 7– 15

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 © Houghton Mifflin Company. All rights reserved. 7– 16

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 © Houghton Mifflin Company. All rights reserved. 7– 17

Cash Equivalents Investments like time deposits or certificates of deposit (CDs) that have a term of 90 days or less Nike’s Annual Report, 2005 Cash and equivalents represent cash and short-term, highly liquid investments with original maturities of three months or less at the time of purchase. The carrying amounts reflected in the consolidated balance sheet for cash and equivalents approximate fair value due to their short maturities. Copyright © Houghton Mifflin Company. All rights reserved. 7– 18

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 Electronic Banking ATM transactions Debit and credit card purchases Online bill-pay Copyright © Houghton Mifflin Company. All rights reserved. 7– 19

Direct Charge-Off Method ü Recognize a loss at the time it is determined that an account is uncollectible Date ü Tax law requires use of this method when computing taxable income 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 © Houghton Mifflin Company. All rights reserved. 7– 20

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 © Houghton Mifflin Company. All rights reserved. 7– 21

Alternate Account Names Allowance for Uncollectible Accounts Expense ü Allowance for Doubtful Accounts ü Allowance for Bad Debts ü Bad Debts Expense Copyright © Houghton Mifflin Company. All rights reserved. 7– 22

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 © Houghton Mifflin Company. All rights reserved. 7– 23

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 üThe percentage amount is ususally based on the company’s historic losses üIt ignores the difference between last year’s estimated losses and the actual losses incurred during the year Copyright © Houghton Mifflin Company. All rights reserved. 7– 24

Percentage of Net Sales Method Dec. 31, 20 x 9: Account balances: Sales, $645, 000; Sales Returns and Allowances, $40, 000; Sales Discounts, $5, 000; Allowance for Uncollectible Accounts, $3, 600. 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 $15, 600 Allowance for Uncollectible Accounts Copyright © Houghton Mifflin Company. All rights reserved. Dec. 31 adj. 3, 600 12, 000 Dec 31 bal. 15, 600 Dec. 31 7– 25

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 © Houghton Mifflin Company. All rights reserved. 7– 26

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– 27

Accounts Receivable Aging Method (Case 1) Dec. 31, 20 x 6: Management has estimated that $2, 459 of Accounts Receivable are uncollectible. Allowance for Uncollectible Accounts has a credit balance of $800. Allowance for Uncollectible Accounts Dec. 31 adj. 800 1, 659 Dec. 31 bal. 2, 459 Dec. 31 The target balance for the account is $2, 459 A credit adjustment of $1, 659 will bring the account to its target balance Copyright © Houghton Mifflin Company. All rights reserved. 7– 28

Accounts Receivable Aging Method (Case 2) Dec. 31, 20 x 6: Management has estimated that $2, 459 of Accounts Receivable are uncollectible. Allowance for Uncollectible Accounts has a debit balance of $800. Allowance for Uncollectible Accounts Dec. 31. The target balance for the account is $2, 459 800 Dec. 31 adj. 3, 259 Dec. 31 bal. 2, 459 A credit adjustment of $3, 259 will bring the account to its target balance Copyright © Houghton Mifflin Company. All rights reserved. 7– 29

Comparison of Two Methods Copyright © Houghton Mifflin Company. All rights reserved. 7– 30

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 © Houghton Mifflin Company. All rights reserved. Shows a credit balance when the total of accounts written off is less than the estimated uncollectible amount 7– 31

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 • Accounts Receivable ü The uncollectible amount was already accounted for as an expense when the allowance was established Copyright © Houghton Mifflin Company. All rights reserved. 7– 32

Writing Off an Uncollectible Jan. 15, 20 x 7: R. Deering, who owes the company $250, is declared bankrupt by federal court. Accounts Receivable Allowance for Uncollectible Accounts Dec. 31 Jan. 15 2, 459 Dec. 31 44, 400 250 Jan. 15 Bal. The write-off does not affect the estimated net realizable value of accounts receivable 2, 209 Bal. 250 44, 150 Net realizable value of A/R Before write-off $44, 400 – $2, 459 = $41, 941 After write-off $44, 150 – $2, 209 = $41, 941 7– 33

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 © Houghton Mifflin Company. 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– 34

A Promissory Note Copyright © Houghton Mifflin Company. All rights reserved. 7– 35

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 © Houghton Mifflin Company. All rights reserved. 7– 36