INTERMEDIATE ACCOUNTING Chapter 6 Cash and Receivables 2013

INTERMEDIATE ACCOUNTING Chapter 6 Cash and Receivables © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Objectives 1. 2. 3. 4. Identify items of cash and cash equivalents. Understand the importance of cash controls. Define and identify different types of receivables. Explain the accounting issues associated with recording accounts receivable. 5. Explain the estimation of uncollectible accounts receivable and its effect on the valuations of receivables. 6. Explain the accounting issues associated with secured borrowings and sales of accounts receivable. 7. Account for short-term notes receivable. 8. Understand how petty cash funds and bank © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

What is Cash? (Slide 1 of 2) • Cash, the most liquid of all assets, is the resource used to engage in day-to-day business transactions and take advantage of business opportunities when they arise. Cash includes the following: • coins and currency • unrestricted funds on deposit with a bank (including foreign currency deposits) • negotiable instruments (such as checks) • bank drafts • undeposited credit card sales receipts © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

What is Cash? Non-Cash Items (Slide 2 of 2) • Sinking funds are accounts into which a company deposits cash over an extended period (e. g. , to retire long-term bonds). Sinking funds are normally reported as long-term investments. • Certificates of deposit (CDs) are financial instruments issued by banks that allow a company to invest idle cash for contractual periods (shortterm or long-term investments). • Bank overdrafts are overdrawn checking accounts. They are reported as current liabilities. • Postdated checks from customers are checks dated in the future so they become payable on a date later than the issue date. Postdated checks are included as receivables. • Travel advances are funds or checks given to employees to cover outof-pocket expenses while traveling on company business and are classified as prepaid items. • Required deposits called compensating balances because they “compensate” the bank for granting the loan. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Classification of Cash and Noncash Items Item Classification Coins and currency Cash Demand deposits (checking and savings accounts) Negotiable instruments (bank drafts, money orders) Foreign currencies on deposit in foreign banks Sinking funds Cash Certificates of deposit Bank overdrafts Short-term (or long-term) investments Current liabilities Postdated checks Receivables Travel advances Prepaid expenses Compensating balances Current or noncurrent asset Cash Long-term investment © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Cash and Cash Equivalents • • According to Accounting Trends and Techniques (2010), approximately 97% of surveyed companies use the line item Cash and Cash Equivalents on their balance sheet. Cash equivalents are short-term, highly liquid investments that are readily convertible into known amounts of cash and so near their maturity (90 days or less) that there is little risk of changes in value because of changes in interest rates. • commercial paper, treasury bills, and money market funds are examples of cash equivalents © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Real Report: Cash and Cash Equivalents © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Real Report: Starbucks Corporation Question: 1. Why does Starbucks combine cash and cash equivalents into one amount on the balance sheet? Cash and cash equivalents are reported as one combined amount because the investment is readily convertible into cash (three months or less at the date of purchase), and the risk that the short-term investment’s value will change significantly due to a change in interest rates is minimal. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Why do Businesses need Cash Controls? • Because cash is a company’s most liquid asset (and most desired), it’s important to protect it from theft, loss, and waste. • Internal control systems are the policies and procedures a company uses to ensure its financial reports are reliable, its operations (including safeguarding its assets) are effective and efficient, and it complies with applicable laws and regulations. • Sarbanes-Oxley Act of 2002 requires all publicly traded companies to maintain (document and test) adequate internal control systems (including internal controls for cash). © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Cash Control Procedures • Control Over Receipts: Should be designed to safeguard all cash inflows from the time they arrive at the company until they are deposited in its bank account. • immediate counting of receipts by the person opening the mail or the salesperson using the cash register, and subsequent verification by an independent person • daily recording of all cash receipts in the accounting records • daily deposit of all receipts in the company’s bank account • Control Over Payments: Should ensure that only authorized payments are made for actual company expenditures • making all payments by check so there is a record for every company expenditure • authorizing and signing checks only after an expenditure is approved • periodically reconciling the cash balance in the bank statement with the company’s accounting records © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Electronic Payments • Electronic funds transfers (EFT) transfers cash between companies electronically without the need for a check • Accounts receivable conversion (ARC) allows for faster processing of checks. When paper checks arrive at a lockbox, they are converted into electronic payments, and the check itself is destroyed • Check Clearing for the 21 st Century Act (termed Check 21) is a law that allows merchants to scan checks and transmit the digital images to the bank instead of sending the actual check © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

What are the Different Types of Receivables? • Receivables are amounts owed to the company by customers and other parties arising from the company’s operations • Those receivables expected to be collected within one year or the current operating cycle, whichever is longer, are classified as current assets; the remainder are classified as noncurrent • Trade receivables arise from the sale of the company’s products or services to customers • Notes receivable arise when customers sign debt obligations with terms different from standard trade receivables • Nontrade receivables arise from transactions that are not directly related to the sale of the company’s goods © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Overview of Receivables © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

How are Accounts Receivable Recorded? • The initial recognition of accounts receivable involves the proper application of the revenue recognition criteria, as well as consideration of any trade discounts or cash discounts, and sales returns and allowances. • Revenue is recognized when realization has occurred and the revenue is earned. • Revenue recognition criteria are usually satisfied when the product or service is delivered. Therefore, credit sales trigger recognition of both an asset (an account or note receivable) and revenue. • There are two issues related to the valuation of receivables: • initial recording of the receivables… present value versus maturity value (maturity value most common) • estimation of the probability of collection… normally reported at net © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. realizable value

Trade Discounts and Cash (Sales) Discounts • Companies frequently offer trade discounts (or quantity discounts) to purchasers as a means to provide incentives to important customers, grant price reductions for large purchases, or to hide real prices from competitors. • Trade discounts are usually given as a percentage reduction of the list price of a product. • Companies may also offer a cash discount (or sales discount) to induce prompt payment. This discount frequently is expressed using terms such as 2/10, n/30. • Cash discounts have two main positive effects: • stimulates faster collection of cash for use in current operations. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Gross and Net Price Methods (Slide 1 of 2) • If a selling company extends cash discounts to its customers, it may use either the gross or net price method to account for the discounts • When using the gross price method, record the total invoice price in both the Accounts Receivable and Sales accounts at the time of sale as if no cash discount were involved. • When the customer pays and takes the allowable cash discount, the company records the difference between the cash received and the original amount of Accounts Receivable as a debit to Sales Discounts Taken. • Sales Discounts is a contra-revenue account. • The gross price method is more popular because it requires less record keeping. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Gross and Net Price Methods (Slide 2 of 2) • When using the net price method, records the net invoice price (after deducting the allowable cash discount) in both the Accounts Receivable and Sales accounts at the time of sale. • When the customer pays and takes the allowable cash discount, no adjustment is needed because the amount of cash received is equal to the recorded amount of the receivable. However, if the customer does not take the cash discount, it pays an amount that is greater than the amount in the company’s Accounts Receivable account. The company credits this excess to an account entitled Sales Discounts Not Taken • This account is an interest income account that is reported in the Other Items section of the income statement • Theoretically, the use of the net price method is superior because it values the accounts receivable at the net realizable value and also separates the amount of sales © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. revenue from interest revenue.

Example: Alternative Methods of Accounting for Sales Discounts © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Sales Returns and Allowances • When the customer returns goods to the seller, the exchange is called a sales return. • In addition, when goods are sold that turn out to be defective, the customer may retain the goods and be allowed a reduction in the purchase price. This reduction is called a sales allowance. • If a company can make reliable estimates, it should record the estimated amount of future returns and allowances in the period of sale to correctly report net sales revenue and appropriately report the net realizable value of ending accounts receivable. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Example: Sales Returns and Allowances • Barclay Corporation sells $500, 000 of goods during 2013, and the company estimates that returns and allowances will be 2% of sales. To anticipate the returns and allowances, Barclay records the following adjusting entry at the end of the period of sale (assuming it uses the gross price method of recording sales): Sales Returns and Allowances ($500, 000 × 0. 02) 10, 000 Allowance for Sales Returns and Allowances 10, 000 • Consequently, when sales returns and allowances of $8, 000 actually occur for goods sold on credit, Barclay records this transaction as follows: Allowance for Sales Returns and Allowances Accounts Receivable 8, 000 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

How are Uncollectible Accounts Receivable Valued? (Slide 1 of 2) • Not all accounts receivable will be collected, some will become bad debts. This uncertainty about the collectibility of accounts receivables represents a loss contingency. • GAAP requires companies to estimate their losses from loss contingencies and deduct the amounts from income and assets when both of the following conditions are met: • Information available prior to the issuance of the financial statements indicates that it is probable that an asset has been impaired at the date of the financial statements. • The amount of the loss can be reasonably estimated. • Because both conditions normally are met in regard to uncollectible accounts, most companies estimate bad debts in their financial statements. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

How are Uncollectible Accounts Receivable Valued? (Slide 2 of 2) • A company can record uncollectible accounts (bad debts) by either of two procedures: • Allowance Method: Companies record uncollectible accounts in the year of sale, based upon an estimate of the amount of uncollectible accounts. • Direct Write-Off Method: Companies record uncollectible accounts when they determine that a specific customer account is uncollectible. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Allowance Method (Slide 1 of 2) • Under the allowance method, a company attempts to forecast the expected future bad debts in accounts receivable (i. e. , a forecast of credit risk). • An organization can use multiple methodologies, including historical bad debts it has incurred, its credit risk strategy and policy, industry-wide experiences, and historical trends and economic conditions. • It compares this information to its current sales or accounts receivable to determine relationships to use to estimate its current uncollectible accounts. • These relationships provide the information the company needs to prepare the adjusting entry to adjust the accounts receivable to the appropriate net realizable value and recognize the estimated bad debt expense for the period. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Allowance Method (Slide 2 of 2) • When the company records the estimate of bad debts, the journal entry is a debit to Bad Debt Expense and a credit to Allowance for Doubtful Accounts (alternatively, Allowance for Bad Debts or Allowance for Uncollectible Accounts). • Bad debt expense is normally reported on the income statement as an operating expense. • Allowance for Doubtful Accounts is a valuation (contra) account that is offset against Accounts Receivable in the current assets section of the company’s balance sheet. • Offsetting Allowance for Doubtful Accounts against Accounts Receivable informs financial statement users of the net realizable value (the amount of cash expected to be collected) of the company’s receivables. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Estimating Bad Debt © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Percentage of Credit Sales • Estimating bad debts based on the relationship to credit sales matches current bad debt expenses against current credit sales. • This income statement oriented method results in recording bad debt expense in the period during which credit sales occur • Example Lema Company’s net credit sales during the year were $525, 000. Bad debts have historically amounted to 2% of net credit sales, and current conditions indicate that a 2% bad debt loss is likely for the current year. Lema makes the following year-end adjusting entry: Bad Debt Expense ($525, 000 × 0. 02) 10, 500 Allowance for Doubtful Accounts 10, 500 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Percentage of Outstanding Accounts Receivable (Slide 1 of 2) • Bad debts may be estimated based on the relationship between the actual amounts not collected and accounts receivable (balance sheet oriented) • The goal is to determine the ending balance in Allowance for Doubtful Accounts, and therefore the appropriate net realizable value of Accounts Receivable • Example Weir Company has determined that historically there has been a 4% relationship between actual bad debts and the year-end accounts receivable balance. Weir’s accounts at the end of the year (prior to adjustment) are as follows: • Accounts Receivable 475, 000 • Allowance for Doubtful Accounts 4, 500 (credit balance) © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Percentage of Outstanding Accounts Receivable (Slide 2 of 2) • Allowance for Doubtful Accounts 4, 500 (current balance) 14, 500 (required adjustment 19, 000 – 4, 500) 19, 000 (required ending balance (4% of $475, 000) • Based on the preceding information, Weir records the following year-end adjusting entry: Bad Debt Expense 14, 500 Allowance for Doubtful Accounts 14, 500 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Aging of Accounts Receivable (Slide 1 of 2) • Individual accounts receivable are classified based on the length of time they have been outstanding. • An estimate of the allowance for bad debts is computed by applying appropriate bad debts percentages to each age category. • Example © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Aging of Accounts Receivable (Slide 2 of 2) • The ending balance of Allowance for Doubtful Accounts should be $16, 330 on December 31, 2013. If Rhorke has a current $1, 350 credit balance in its allowance account, the amount of recorded expense necessary to bring the allowance account up to its required balance is $14, 980 ($16, 330 − $1, 350). © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Conceptual Evaluation • To properly report the net realizable value of accounts receivable on the balance sheet and properly measure net income for the period, a company should estimate and record bad debt expense in the period of sale rather than record bad debt expense when accounts are written off. • The income statement approach, in which a percentage of credit sales is used, matches bad debt expenses with sales in the current period. • The balance sheet approach, which uses a percentage of outstanding accounts receivable or an aging analysis for estimating bad debts. • Currently, both approaches are used in practice, and both are allowed under GAAP © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Writing Off Uncollectible Accounts • When a company determines that an individual account is uncollectible, it writes off that account, removing it from Accounts Receivable (credit) and a debit to Allowance for Doubtful Accounts. • This write-off has no effect on the net realizable value of the accounts receivable because the allowance account and the accounts receivable balance are reduced by the same amount. For example, a company writing off a $1 k account records this journal entry: Allowance for Doubtful Accounts Receivable 1, 000 • The allowance for uncollectible accounts is an estimate and always involves future uncertainties. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Collection of an Account Previously Written Off • Most accountants favor reestablishing the customer’s account receivable and then recording the payment. • Example If Uphoff Company receives a $300 payment from a customer whose account it had previously written off, the company makes the following journal entries: 1. Accounts Receivable 300 Allowance for Doubtful Accounts 300 2. Cash 300 Accounts Receivable 300 • The first entry “reverses” the initial write-off and the second entry records the cash collection in the usual manner © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Direct Write-Off Method • The direct write-off method, records bad debt expense when it is determined that a specific customer account is uncollectible. At that time, it writes off the account by debiting Bad Debt Expense and crediting Accounts Receivable. • While this method is simple to apply, it has the disadvantage of matching the bad debt expenses associated with previous sale against revenues of the current period. It also overstates accounts receivable associated with previous sales. • Furthermore, it allows earnings management because the company selects the period of write-off (and expense). For these reasons, the direct write-off method © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Why It Matters • Sales and cash flows are essential elements to any company’s success, and accounting for accounts receivable involves both of these elements. • Interested parties carefully monitor accounts receivable to gain insight into a company’s future profitability and cash flow. • The receivables turnover ratio and the average collection period are two measures often used as indicators of the efficiency with which a company collects its receivables and converts them to cash. Receivables turnover = Net credit sales / avg Net receivables Average collection period = 365 / Receivables turnover ratio © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Financing Accounts Receivable • Turning accounts receivable into cash is a popular funding opportunity for businesses. • The two basic forms of financing agreements that companies use to obtain cash from accounts receivable are: • secured borrowing (pledging or assigning) • sale of receivables (factoring, securitizations) • The accounting issue for transfers of receivables and other financial assets revolves around who possesses (owns) the benefits and risks associated with the transferred assets. • In a transfer with recourse, the transferor retains the risk of ownership and bears any loss from a nonpayment of receivables. • In a transfer without recourse, the transferee has assumed all the risks of ownership and bears any loss from a nonpayment of receivables. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Accounting for Transfers of Accounts Receivable © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Secured Borrowing • In a secured borrowing, a company may assign or pledge its accounts receivable as collateral for a loan. If the company is unable to make payments on the loan, the creditor can require the amounts collected from the accounts receivable be used to repay the amount owed. • Under a basic assignment agreement, the borrowing company (assignor) usually retains ownership of the assigned accounts, incurs any bad debts, collects the amounts due from customers, and uses these funds to repay the loan. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Example: Assignment (Slide 1 of 2) • On December 1, 2013, Trussel Company assigns $60, 000 of its accounts receivable to a finance company. The finance company advances 80% of the accounts receivable assigned minus a service charge of $500. It also charges an annual interest rate of 12% on any outstanding loan balance. Trussel records this assignment as follows: 1. Cash [($60, 000 × 0. 80) − $500] 47, 500 Assignment Service Charge Expense Notes Payable ($60, 000 × 0. 80) 48, 000 2. Accounts Receivable Assigned 60, 000 Accounts Receivable 60, 000 500 • The first journal entry records the receipt of cash. The Assignment Service Charge Expense account is a cost of borrowed funds, and most companies usually record it as an expense at the time of the advance. The second journal entry reclassifies the receivables as © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Example: Assignment (Slide 2 of 2) • On December 31, 2013, Trussel collects $10, 000 on assigned accounts. It pays this amount along with the 12% interest for 1 month to the finance company. Trussel records these transactions as follows: 1. Cash 10, 000 Accounts Receivable Assigned 2. Notes Payable 10, 000 Interest Expense ($48, 000 × 0. 12 × 1/12) 480 Cash 10, 480 • The interest expense on any future payments is based upon the balance remaining (beginning balance) in the Note Payable account. During the period in which the note is outstanding, Trussel credits any bad debt losses and sales returns and allowances related to the assigned accounts receivable against the Accounts Receivable Assigned account. After Trussel fully repays the note, it reclassifies © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. any remaining balance in Accounts Receivable Assigned as

Sale of Accounts Receivable (Slide 1 of 2) • Factoring is when a company sells its individual accounts receivable to a financial institution (called a factor). At the time of sale, the factor charges the selling company a commission based who bears the risk of noncollection. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Sale of Accounts Receivable (Slide 2 of 2) • In a Securitization, accounts receivable are transferred to another entity, usually a trust or subsidiary and then sold as financial securities (usually debt instruments) collateralized by the accounts receivable. Investors receive cash as the accounts receivable are paid. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Recording the Sale of Accounts Receivable • In a Sale without Recourse, the buyer (or factor) assumes all the risks of ownership. If any receivables are not collected, the factor cannot demand payment from the seller. Because the risks of ownership have been transferred from the seller to the factor and the factor has control of the asset (the accounts receivable), the transaction is accounted for as a sale of accounts receivable. • Example Farber Corporation sells $80, 000 of accounts receivable to a factor without recourse, receives 90% of the value of the factored accounts, and is charged a 15% commission based on the gross amount of factored accounts receivable. Farber records the following journal © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. entry (assuming that it normally factors its accounts

Example: Sale without Recourse Cash [($80, 000 × 0. 90) − ($80, 000 × 0. 15)] 60, 000 Receivable from Factor ($80, 000 × 0. 10) 8, 000 Factoring Expense ($80, 000 × 0. 15) 12, 000 Accounts Receivable 80, 000 • If $500 of sales returns and allowances subsequently occur on factored accounts, Farber would make the following entry: Sales Returns and Allowances 500 Receivable from Factor 500 • At the conclusion of the factoring agreement, Farber would collect any balance remaining in the Receivable from Factor account and record the following entry (assuming there were no sales returns or allowances): Cash 7, 500 • Receivable from Factor ($8, 000 − $500) 7, 500 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Sale With Recourse • When receivables are sold with recourse, the seller retains the risks of ownership and uncollectible accounts. If any receivables are not collected, the factor can demand payment from the seller. • The transfer is accounted for as a sale. • A financial components approach must be used, assigning fair values to components such as the recourse obligation (the estimated amount the seller will have to pay the factor) and any servicing rights. This results in both the factor and the seller recognizing the financial and servicing assets it controls. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Example: Sale with Recourse • Farber Corporation sells $80, 000 of accounts receivable with recourse, receives 90% of the value of the transferred accounts receivable, and is charged an 8% commission (lower than the 15% commission without recourse, because the factor is taking less risk) based on the gross amount of the transferred accounts receivable. In addition, the recourse obligation has an estimated fair value of $2, 000. Farber records the following journal entry (assuming that it does not normally sell its accounts receivable): Cash [($80, 000 × 0. 90) − $6, 400] 65, 600 Receivable from Factor ($80, 000 × 0. 10) 8, 000 Loss on Sale of Receivables [($80, 000 × 0. 08) + $2, 000] 8, 400 Recourse Liability 2, 000 Accounts Receivable 80, 000 • The estimated recourse liability increases the loss on the sale of the receivables. All receivables collected will reduce the Receivable from Factor account. When all collected, eliminate the recourse liability and receivable from factor (recording a loss or gain). © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Credit Card Sales • A retailer accepting credit cards charges its customers the selling price for goods and services, but is assessed a service charge on credit card sales by the bank or credit card company. This charge is usually a percentage of each sale. The retailer usually records the fee as an operating expense. • Example Kerns Shoes sold $1, 500 of merchandise on credit which was billed to a national credit card company. If the collection fee charged by the credit card company is 5%, Kerns makes the following journal entry when it deposits the credit card sales receipts (assuming it is using the gross price method of recording sales): Cash 1, 425 Credit Card Expense ($1, 500 × 0. 05) 75 Sales Revenue 1, 500 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Disclosure of Financing Agreements of Accounts Receivable • A company should disclose the existence of the transfer of accounts receivable parenthetically or in the notes to its financial statements. In general, management should provide disclosures that allow financial statement users to understand: • the transferor’s continuing involvement, if any, with the transferred assets • the nature of any restrictions on transferred assets that are reported on the balance sheet • how servicing assets and liabilities are reported • how the transfer of financial assets affect a company’s balance sheet, income statement, and statement of cash flows © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Real Report: Disclosure of the Transfer of Accounts Receivable (slide 1 of 2) © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Real Report: Disclosure of the Transfer of Accounts Receivable (slide 1 of 2) Questions: 1. Does Office Depot transfer its credit card receivables with or without recourse? How do you know? • Office Depot sells its credit card receivables with recourse. This is evident because the company has disclosed a recourse liability of $16 million and $23 million at December 26, 2009, and December 27, 2008. This liability, which represents the company’s estimate of the risk of loss associated with its credit card receivables, would only be recorded if the buyer has recourse against the company 2. Why does Office Depot report the expense associated with this transfer of receivables as an operating expense? • Office Depot records the expense associated with the transfer as an operating expense because it is a normal part of their operations, © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

How do Companies Account for Notes Receivable? • A note receivable is an unconditional written agreement that gives the holder the right to collect a certain sum of money on a specific date. Notes receivable generally have two attributes that accounts receivable do not have: • They are negotiable instruments, which means that they are legally transferable among parties and may be used to satisfy debts by the holders of these instruments. • They usually involve interest, requiring the separation of the receivable into its principal and interest components. • A company may receive two types of short-term notes receivable: (1) interest-bearing notes and (2) noninterest-bearing notes. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Short-Term Interest-Bearing Notes Receivable (Slide 1 of 2) • When an interest-bearing note is issued, the amount borrowed (the principal) is listed as the face value, and the interest charged is stated as a specific rate applied to this face value. • Example On October 1, 2013, Trent Company made a $5, 000 credit sale to Jaynik Company and required the company to sign a $5, 000, 60 -day, 12% note. Trent makes the following entry to record the receipt of the interest-bearing note: Oct. 1 Notes Receivable 5, 000 Sales Revenue 5, 000 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Short-Term Interest-Bearing Notes Receivable (Slide 2 of 2) • The collection of the principal and interest (assuming, for simplicity, a 360 -day business year) would be recorded as follows: Dec. 1 Cash 5, 100 Notes Receivable 5, 000 Interest Revenue 100 • If the note had extended past the end of the year, Trent would have made a year-end adjusting entry to record the interest receivable and recognize the interest revenue. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Sales or Assignments of Notes Receivable • When a company sells or assigns a customer’s note receivable at the bank, it transfers the note in exchange for cash. • This financing arrangement is subject to the conditions as accounts receivable sales. If all the conditions are met, the company records the transfer as a sale. • The discount is determined by multiplying a discount rate, which is the interest rate charged by the financial institution, times the maturity value of the note for the discount period (Maturity Value × Rate × Time). • Any gain or loss from the discounting is computed by comparing the current book value of the note receivable (including accrued interest revenue) plus any recourse liability to the proceeds received © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Example: Selling a Note Receivable • On August 31, 2013, Kasper Corporation sells (with recourse) a customer’s note at its bank at a 14% discount rate. Kasper received the note from the customer on August 1. The note is for 90 days, has a face value of $5, 000, and carries an interest rate of 12% ($5, 150 MV). The estimated value of the recourse liability is $500. The customer pays the note on the October 30, 2013, maturity date. The calculations on August 31 for the discounted note are as follows (assuming a 360 -day business year for simplicity): Cash ($5, 150 × 0. 14 × 60/360=120. 17) 5, 029. 83 Loss from Sale of Receivable 520. 17 Notes Receivable Interest Revenue $50 ($5, 000 × 0. 12 × 30/360) Recourse Liability 5, 000. 00 50. 00 500. 00 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Example: Selling a Note Receivable (Customer Default) • If the bank notified Kasper that the note had not been paid when due, sold the note back to Kasper (at maturity value 0 f $5, 150) and also charged Kasper a $10 fee. Kasper would record the following journal entry: Recourse Liability 500. 00 Notes Receivable Dishonored 4, 660. 00 Cash [$5, 000 + ($5, 000 × 0. 12 × 90/360) + $10] 5, 160. 00 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Notes Receivable Reported at Fair Value • GAAP allows a company to elect to report many types of its financial assets (and financial liabilities) at their fair value. • Financial asset(s) valued at fair value must be reported separately from those reported at cost or amortized cost on the balance sheet. • Any unrealized gains or losses resulting from changes in the fair value must be recorded on the income statement • Example Wilson Company has notes receivable with a book value of $120, 000 and a fair value of $150, 000. If Wilson elects to use the fair value option for this note receivable, it would make the following adjusting entry to recognize the unrealized holding gain of $30, 000 ($150, 000 − $120, 000) Note Receivable Unrealized Holding Gain 30, 000 • Once Wilson elects to use the fair value option, it must continue to value the note receivable at fair value in all subsequent periods in which it holds the note receivable. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

How Are Receivables Disclosed? • In order to improve the reporting of a company’s risk, liquidity, and financial flexibility, companies are required to disclose: • any accounting policies related to their receivables that might be helpful to external users • major categories of receivables, either in the balance sheet or in the notes to the financial statements • any valuation accounts (e. g. , allowance for doubtful accounts) as well as the methodology used to estimate these amounts • any receivables designated as collateral the fair value of all its financial instruments, either on the balance sheet or in the notes • all significant concentrations of credit risk due to its financial instruments © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Real Report: Disclosure of Accounts Receivable (Slide 1 of 2) © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Real Report: Disclosure of Accounts Receivable (Slide 1 of 2) Questions: 1. What amount of its accounts receivables does Starbucks believe is uncollectible? • Starbucks believes that $3. 3 million of its receivables at October 3, 2010, are uncollectible. 2. What method does Starbucks use to estimate its allowance for doubtful accounts? Is this method allowable by GAAP? • Starbucks uses the specific identification method to estimate its allowance for doubtful accounts. This method requires an accountby-account analysis to determine which past due accounts are uncollectible. While it is not common and used mainly by companies with a small number of receivables, it is a generally accepted accounting method to calculate the allowance for doubtful accounts. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Internal Controls for Cash: Petty Cash • A petty cash system involves a cash fund under the control of an employee that enables a company to pay for small amounts that might be impractical or impossible to pay by check. • Step 1. An employee is appointed petty cash custodian, and the petty cash fund is established. A journal entry is recorded to reduce cash and increase petty cash. • Step 2. Petty cash vouchers are printed, prenumbered, and given to the custodian of the fund. The vouchers are used as evidence of expenditures. The total of the cash in the fund plus the amounts of the vouchers should be equal to the original amount of the fund. • Step 3. When the amount of cash in the petty cash fund becomes low and/or at the end of an accounting period, the vouchers are sorted into expense categories and the remaining © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. cash is counted. The expenses are then recorded, and the fund

Example: Petty Cash • A count at the end of the month shows $67. 54 remaining in the petty cash fund for Plath Company, and the sorting of vouchers indicates the following costs were incurred during the month: • Office supplies $ 34. 16, Postage 178. 00, Transportation 132. 14, Miscellaneous 83. 76… Total expenses $428. 06 • Because these expenses total $428. 06, the fund is “short” by $4. 40. Plath records the following journal entry: Office Supplies Expense 34. 16 Postage Expense 178. 00 Transportation Expense 132. 14 Miscellaneous Expense 83. 76 Cash Short and Over Cash 4. 40 432. 46 • The $432. 46 is given to the fund custodian, and the actual amount of cash in the petty cash fund is now equal to the original fund balance of $500. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Bank Reconciliation • A bank reconciliation is an analysis of the difference between the ending cash balance in its accounting records and the ending cash balance reported on its bank statement • The bank statement and the company’s accounting records usually will not be in complete agreement due to timing differences and errors, including the following: • outstanding check • deposit in transit • Charges Made Directly by the Bank (NSF or notsufficient-funds) • Deposits Made Directly by the Bank © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. • Errors

Example: Bank Reconciliation (Slide 1 of 2) • The following example shows the preparation of a bank reconciliation and the required adjusting entries for the Craig Corporation for 6/30/13. The unadjusted cash balances are as follows: • Cash balance from bank statement, June 30 $12, 461. 15 • Cash balance from company records, June 30 12, 437. 94 • The bank statement disclosed the following information: • A customer note for $1, 200 plus $12 interest was collected on June 29. • A customer check for $138. 14 was returned because of insufficient funds (NSF check). • The monthly service charge was $15. • A review of the company records disclosed the following: • A deposit for $1, 142. 87 at the end of the day on June 30 did not appear on the bank statement. • Customer checks totaling $327. 40 were on hand at the end of June awaiting deposit. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Example: Bank Reconciliation (Slide 2 of 2) • The following company checks were outstanding at the end of June: • #862 $ 96. 19 • #864 147. 18 • #865 263. 25 • Check #843, written for $91. 20 in payment of an account payable and included with the canceled checks in the bank statement, was erroneously recorded as $19. 20 in the company’s records. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Example: Bank Reconciliation © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.