Chapter 6: Cash and Accounts Receivable

1. Chapter 6:Cash and Accounts Receivable

2. Current asset: if intended to be converted into cash, or used up, within one year or within an operating cycle, whichever is longer. Industries like aerospace and manufacturers of farm equipment may have operating cycles longer than a year. Chapter 6: Cash and Accounts Receivable

3. The Operating Cycle, Figure 6-1 Cash Receive payment Manufacture or purchase inventory Accounts Receivable Inventory Sales to customers Note that the operating cycle is effectively complete when the cash is “collectible,” or at the A/R stage.

4. The distinction is useful because it provides easy-to-determine, low-cost measures of a company’s short term liquidity. Working capital = current assets - current liabilities Current ratio = current assets/current liabilities Current Asset Classification

5. Current assets are often compared to current liabilities as an indicator of a company’s solvency. Average current ratios also vary across industries. Caution regarding this ratio, as it can actually increase in years before bankruptcy. Current Ratio=Current assets/Current liabilities

6. The cash account is the first asset listed in the current asset section of the balance sheet. It consists of coin, checks, and bank drafts received by the company. The only reporting issues for cash is whether there are restrictions on its use. Some companies now report “cash and cash equivalents.” (More in Chapter 14) Cash

7. Proper cash management requires that enough cash be available to meet the needs of the company’s operations. Too much cash is undesirable as it loses purchasing power in periods of inflation, and can generate additional cash if it is invested properly. Control of cash Control of records Bank reconciliation Physical control Separation of duties Proper Management and Control of Cash

8. Accounts receivable arise from selling goods or services to customers on account. Recorded at face amount to be collected. However, we must also reflect the fact that a portion of A/R may not be collected. Reasons for lack of collection: 1. sales discounts (cash discounts) 2. sales returns 3. sales allowances 4. uncollectible A/R (bad debts) Accounts Receivable

9. Cash discounts are offered by a company to encourage its customers to pay early. The terms are usually expressed as “1/10, n/30”, which would mean a 1% discount if the customer pays within 10 days, or the net (full) amount is due within 30 days. “Cash Discount” or “Sales Discount” is presented as a contra to Sales Revenue on the income statement. Calculation of net sales on the I/S: Sales revenue - Sales discounts (SD) - sales returns (see slide 11) (SR) - sales allowances (see slide 11) (SA) = Net sales Formula: S - SD - SR - SA = S(net) 1. Cash Discounts

10. Original sale: $100, terms 2/10, n/30. At time of sale: A/R 100 Sales Revenue 100 If received within 10 days: Cash 98 Sales Discount 2 A/R 100 If received after 10 days: Cash 100 A/R 100 Journal Entries for Cash Discounts (gross method)

11. If sales returns are small in amount, adjust A/R and create a contra to Sales called Sales Returns when the merchandise is returned. Sales allowances are negotiated reductions in sales price after the sale. Sales Allowance xx Sales Returns xx A/R xx If sales returns are significant (e.g., bookstore), company must estimate the amount of sales returns expected, and adjust A/R (with a contra account similar to Allowance for Bad Debts) at the end of the period. Estimated Sales Returns xx Allowance for Returns xx 2. Sales Returns and Allowances

12. Created as a contra account to A/R to indicate the portion of A/R that will not be collected due to defaults on payments by customers. Reason for Allowance account: Assume $1,000 sale in 2004 and default on collection in 2005. Record sale in 2004: A/R 1,000 Sales Revenue 1,000 Record default in 2005: Bad Debt Expense 1,000 A/R 1,000 Note: this is called the direct method, and is not GAAP, for the reasons listed on the next page. 3.Allowance for Doubtful Accounts

13. Problem: the direct method, on the previous slide, does not achieve matching (revenues recognized in 2004, but a related expense was recognized in 2005). Problem: the direct method does not correctly value the asset, A/R. The assets are overvalued until 2005, when the receivable is written off. Problems with Direct Method

14. Solution: create a contra to A/R, and estimate the A/R that will not be collected. The AJE to record an estimate for uncollectibles in 2004 (for all uncollectibles): Bad Debt Expense 4,000 Allowance 4,000 The GJEduring 2005, when a specific A/R is deemed uncollectible (this is called the write-off of a specific A/R): Allowance 1,000 A/R 1,000 When are the income statement and balance sheet affected? Solution: the Allowance Method At the 2004 estimate.

15. Note that we do not know in 2004 which A/Rs will not be collected in 2005. Therefore, we must estimate uncollectibles. There are two methods: 1. Percentage of sales 2. Percentage of accounts receivable Both methods are used to estimate uncollectibles for the AJE. The percentage of sales method is simpler, but the percentage of A/R method is more accurate. Estimation of Uncollectibles

16. Usually based on credit sales, but may use total sales or net sales as basis. Calculation: Sales x % = Bad Debt Expense (focus on the debit side of the AJE) Called the Income Statement approach, because: revenues x % = expense. 1. Percentage of Sales Method

17. Based on ending A/R and ending Allowance account. Calculation: Ending A/R x % = Ending Allowance (focus on the credit side of the AJE) Called Balance Sheet approach, because: ending asset x % = ending contra asset. Requires the analysis of the Allowance account before preparing the AJE. An aging schedule of A/R is the most accurate way to estimate uncollectibles (see Figure 6-11). 2. Percentage of A/R Method (using Aging Schedule)

18. Based on the analysis of the Allowance account. Calculate the “desired ending balance” based on an aging of A/R. Now, given the Beginning, Ending and Write-off amounts, calculate the amount of the current estimate that must be added to the Allowance account to achieve the “desired ending balance.” T-Account Approach for Percentage of A/R Method

19. Allowance for Doubtful Accts. (T-account) Allowance for Doubtful Accts. 1. Beginning Balance 1. The allowance established in the prior period carries forward for current period write-offs.

20. Allowance for Doubtful Accts. (T-account) Allowance for Doubtful Accts. Beginning Balance 2. Write-off of specific accounts receivable 2. As specific accounts are determined uncollectible during the year, they are written-off to the allowance account as shown. These write-offs may cause the allowance account to have a debit balance before the AJE if the prior year’s expense was underestimated. Accounts Receivable 2. Write-off of specific accounts receivable

21. Allowance for Doubtful Accts.(T-account) Allowance for Doubtful Accts. Beginning Balance Write-off of accounts receivable 3. Ending Balance 3. The “desired ending balance” in the allowance account is estimated using the percentage calculation or the aging schedule. Accounts Receivable Write-off of accounts receivable

22. Allowance for Doubtful Accts. (T-account) Allowance for Doubtful Accts. Beginning Balance Write-off of accounts receivable 4. Recovery of write-offs 4. The recovery of an account receivable that has been written off must first be reversed back into A/R and the Allowance account. Then the collection is like the collection of any other A/R. Ending Balance Accounts Receivable 4. Recovery of write-offs Write-off of accounts receivable

23. Allowance for Doubtful Accts. (T-account) Allowance for Doubtful Accts. Bad Debts Expense Beginning Balance 5. Recognition of bad debt expense Write-off recovery Write-off of accounts receivable 5. Recognition of bad debt expense Ending Balance 5. The AJE to record the estimate of uncollectibles is calculated based on the amount necessary to achieve the “desired ending balance” in the allowance account. The focus is on the Allowance account. Accounts Receivable Write-off of accounts receivable Write off recovery

24. Given the following information: At December 31, 2004, Company Z prepared an aging schedule to determine that the uncollectible accounts receivable at that date were $18,000. The balance in the Allowance for Doubtful Accounts at 1/1/04 was a $3,000 credit. During 2004, the company wrote off $5,000 of specific accounts receivable that were deemed to be uncollectible. Required: prepare the AJE to record the estimated uncollectibles at 12/31/04. Class Problem

25. Solution to Class Problems (1) Post the beginning balance and write-off. (2) Post the desired ending balance. (3) Post the adjusting journal entry. Allowance for Doubtful Accounts 3,000 Beginning (1) (1) W/O 5,000 20,000 AJE (3) 18,000 End. Balance (2) AJE: Bad debt expense 20,000 Allowance for D.A. 20,000

26. (a) Sale on Dec. 12: A/R 40,000 Sales 40,000 AJE on Dec. 31? - none needed; discount already lost. Payment on Jan. 5 (all $40,000): Cash 40,000 A/R 40,000 Exercise 6-3

27. (b) Sale on Dec. 12: A/R 40,000 Sales 40,000 Payment on Dec. 20: ($40,000 x 98% = 39,200): Cash 39,200 Sales Disc. 800 A/R 40,000 Less cash received; less sales (net) recognized because of the sales discount. Exercise 6-3

28. Percentage of Sales method (a) 2005 Net sales = Sales - SD - SR - SA = 1,800,000 - 130,000 - 20,000 = 1,650,000 B.D. Expense = 3% of net sales = .03 (1,650,000) = $49,500 AJE at 12/31: Bad debt expense 49,500 Allow. for D.A. 49,500 Problem 6-4, Part (a) 2005

29. Problem 6-4, Part (b) 2005 Note that, for the percentage of sales method, the AJE is posted before calculating the ending balance. Allowance for Doubtful Accounts 65,000 Beginning (1) (1) W/O 70,000 49,500 AJE (2) 44,500 End. Balance (3)

30. (c) 2006 Net sales = Sales - SD - SR - SA = 1,500,000 - 100,000 - 50,000 = 1,350,000 B.D. Expense = 3% of net sales = .03 (1,350,000) = $40,500 AJE at 12/31: Bad debt expense 40,500 Allow. for D.A. 40,500 Problem 6-4, Part (c) 2006

31. Problem 6-4, Part (d) 2006 Note that, for the percentage of sales method, the AJE is posted before calculating the ending balance. Allowance for Doubtful Accounts 44,500 Beginning (1) (1) W/O 85,000 40,500 AJE (2) -0- End. Balance (3) Problem? Systematic underestimation!

32. Given in your text: 2003 2002 Beginning $5,500 $4,792 Increases 4,400 3,788 Decreases (4,492) (3,722) Recoveries 848 642 Ending $6,256 $5,500 Brief Exercise 6-2, Parts (a) and (b) (a) BDE = Increases = 4,400 in 2003 and 3,788 in 2002 (b) Write-offs = Decreases = 4,492 in 2003 and 3,722 in 2002 W/O Net of Recoveries = 3,644 in 2003 and 3,080 in 2002

33. Given in your text: 2003 2002 Beginning $5,500 $4,792 Increases 4,400 3,788 Decreases (4,492) (3,722) Recoveries 848 642 Ending $6,256 $5,500 Brief Exercise 6-2, Part (c) (c) Increase from 5,500 to 6,256 = 756 increase 756/5,500 = 13.7% increase Possibilities: Increase in sales, changing credit terms, changing market, or overestimating . . .)

34. Financial statement users should be aware of the fact that policies may vary from company to company in recognition of sales and in estimation of bad debt expense. Additionally, users should watch for consistency in the recognition of these amounts from period to period. Manipulation of Sales and Bad Debt Expense

35. U.S. companies may buy and sell inventory with foreign companies located in foreign countries. If the contract is denominated in a foreign currency, U. S. companies must recognize gains and losses from the change in the exchange rate between the foreign currency and the U.S. dollar. Foreign Currency Receivables and Payables

36. Foreign currency exchange rates fluctuate daily. Daily quotes can be found in the newspaper or Wall Street Journal. The class examples use direct quotes which express one unit of a foreign currency in terms of the U.S. dollar. The rates move directly in relation to the related foreign currency receivable or payable. Ex: Direct: one British pound (£) = $0.70 (Indirect: one U. S. dollar = 1.4286 £) To convert indirect to direct: 1/indirect = direct or 1/direct = indirect Dealing with Exchange Rates

37. See Motorola example in text (pp. 248 - 249). This example is denominated in euros (1.5 million euros). DateDirect quote Dec. 1: $1.10 per euro Dec. 31: $1.00 per euro Receivables Denominated in a Foreign Currency

38. See journal entries for Motorola. At the date of sale, we record a N/R in U.S. dollar equivalent based on one euro = $1.10 Calculation: 1.5 million euros x $1.10 = 1.65 million dollars. Journal entry (in millions) at 12/1 to record sale: A/R (foreign currency) 1.65 Sales revenue 1.65 Note that a receivable in a foreign currency must be converted to dollars before it can be recorded in a U.S. company’s books. Also, the receivable must be revalued as the foreign currency fluctuates. Receivables Denominated in a Foreign Currency

39. Why a loss for Motorola at Dec. 31? The foreign currency went down with respect to the dollar ($1.10 down to $1.00 = decrease of $0.10). If we received the euros today, we would sell it for less dollars, so decrease (credit) the foreign currency accounts receivable for $0.15 million (1.5 million x $0.10). Journal entry (in millions): Exchange rate loss 0.15 A/R (foreign currency) 0.15 Receivables Denominated in a Foreign Currency - continued

40. The same concepts hold when a U. S. company buys goods from a foreign country, and the contract is denominated in the foreign currency, except that adecrease in the direct exchange rate means a decrease in the liability (as expressed in dollars) and an exchange gain(the liability will be payable with fewer dollars). Increases in the direct exchange rate of the dollar with respect to the foreign currency will yield reverse effects for gains and losses. Payables Denominated in a Foreign Currency

41. A company may “pass off” the risk of an unfavorable exchange rate change by entering into the marketplace and taking a equal and opposite position. For example, if the company will be receiving 1.5 million euros, it could contract to sell 1.5 million euros on the same date. This offsets any losses or gains from the exchange rate to the date of sale. Hedging of Foreign Currency Receivables and Payables

42. (a)First, convert the currencies to direct exchange rates (dollars per unit of foreign currency). For example, convert .5 British pound per dollar (indirect) to dollars per British pound (direct) = $1 per 0.50 £= 1/.5 = $2.00 per £: At sale/ purchaseAt 12/31 British pound $2.00 $1.66667 Euros $1.25 $1.11111 Class Problem P6-11 (1 and 3)

43. Part 1: (b) Journal entry at sale: 320,000 £ x $2.00 = $640,000 A/R (foreign currency) 640,000 Sales revenue 640,000 (c) Journal entry at 12/31: Rate change from $2.00 to 1.66667 A/R down $0.33333 x 320,000 £ =$106,667 Exchange loss 106,667 A/R(foreign currency) 106,667 Now journal entries for P6-11, parts 1 and 3 (use direct rates).

44. Part 3: (b) Journal entry at purchase: 500 euros x $1.25 = $625 Purchases 625 N/P(foreign currency) 625 (c) Journal entry at 12/31: Rate change from $1.25 to $1.11111 N/P down $0.13889 x 500 euros = $69 N/P(foreign currency) 69 Exchange gain 69 Now journal entries for P6-11, parts 1 and 3 (use direct rates).

45. Exchange gains and losses occur because of the differential movement of the two currencies, and are dependent on whether the company holds a receivable or payable. If the company has a receivable denominated in a foreign currency, the dollar value of the receivable will decrease as the dollar moves down with respect to the foreign currency, and will result in a loss (see Part 1). If the company has a payable denominated in a foreign currency, the dollar value of the payable will decrease as the dollar moves down with respect to the foreign currency, and will result in a gain (see Part 3). P6-11, Part (d)