Agenda Administrative • Go over Midterm • DQ Multiple Deliverables due Monday Feb 21st (will be posted today) In Class today and Wed - Cash and Receivables (Ch. 7, Appendix 7A, Ch. 18 pp 930-937)
Chapter 7 & 18 (pp930-937)Cash, Cash Equivalents, Basic Revenue Recognition & Receivables Cash & Cash Equivalents • Cash: Currency and coins held, checks & money orders received, bank account balances • Cash Equivalents are short-term, highly liquid investments that are: • Readily convertible into known amounts of cash • So near maturity that there is no risk of change in valuation from fluctuating interest rates (original maturities of no longer than 3 months) • Ex: T-bills, commercial paper, money market funds
Reporting Issues with Cash • Cash Equivalents • Grouped together with cash • reported as the most liquid current asset on the balance sheet • Restricted Cash • Disclosed separately • If relates terms of LT liability classify as LT • Bank Overdrafts • US GAAP: Disclosed as a current liability unless there are other positive-balance cash accounts at the same bank that it can be netted against • IFRS: Included in cash and cash equivalents if repayable on demand and form a part of an entity’s cash management
Controls and Cash Questions • Why are internal controls over cash so important? • What is the purpose of controls over cash? Three Key Controls 1) Management oversight and authorization • Especially useful in small organizations where the owner can monitor activities (and where there are limited resources to have separation of duties) • Separation of duties: • Physical control, authorization and record keeping • E.g., one employee prepare the deposit slip and make the entry, and another employee will actually make the deposit 3) The bank reconciliation
Controls and Cash: Bank Reconciliation Example: Hawthorne Co.’s May bank statement is as follows: Balance May 1, 2011 $33,240 Deposits 82,140 Checks processed (78,433) Service Chg ( 80) NSF checks ( 2,187) Balance May 31, 2011 $34,680 Hawthorne’s GL cash account has a balance of $35,396 at 5/31/11. A review of the co’s records and the bank statement reveals: • Cash receipts not yet deposited totaled $2965 • A deposit of $1020 made on 5/31 was not credited to the company’s account until June. • All checks written in April have been processed by the bank, but $5536 of checks from May have not.
Controls and Cash: Bank Reconciliation Bank Balance to Corrected Balance: Balance per bank statement $34,680 Add: Outstanding deposits 3,985 Less: Outstanding checks (5,536) Corrected cash balance $33,129 Balance per books $35,396 Less: Service charge ( 80) Less: NSF checks ( 2,187) Corrected cash balance $33,129 Why is this an effective control?
Basic Revenue Recognition Recall: Revenue is recognized at the earliest moment that both of the following conditions are met: • Earned: The critical event in the process of earning revenue has taken place. (seller) 2. Realized: The amount of revenue that will be collected is reasonably assured and measurable with a reasonable degree of reliability. (buyer)
Basic Revenue Recognition Example : On 1/1/07 a magazine publisher receives $300,000 for 1,000 3-year subscriptions. Magazine delivery begins in January. Can the revenue be recognized on 1/1/07? • Is the revenue earned? • Is the revenue realized? When can the revenue be recognized?
Expense Recognition (Matching) Hierarchy of matching • Direct – match expense to the revenue it helps generate • Systematic and rational – match expense to periods in which it helps to generate revenue (indirect cause and effect relation between expense and revenue in periods expected to be benefited) • Immediate – expense in period the cost is incurred (i.e. no discernable or measurable future benefit.)
Timing of Revenue Recognition • Revenue Recognition at point of sale (delivery) • Revenue Recognition before delivery • Revenue Recognition after delivery • Revenue Recognition for specific sales transactions – franchises & consignment
Revenue Recognition at Point of Sale Revenues from manufacturing and selling are commonly recognized at point of sale. Exceptions: • Sales with buyback agreements – No Sale • Trade loading and channel stuffing – No Sale • Sales when right of return exists (high rates that are not reliably estimable) –Specific criteria to be met
Revenue Recognition at Point of Sale When right of return exists all of the following 6 criteria must be met to qualify as sale: • Price fixed or determinable at sale date • Buyer has paid seller, or is obligated to pay seller, and obligation is not contingent on resale of product • Buyer’s obligation to seller would not be changed in event of theft or damage to product • Buyer has economic substance apart from the seller • Seller does not have significant obligations for future performance to directly bring about resale of product by buyer • Seller can reasonably estimate amount of future returns
Recognition of Accounts Receivable • Trade Discounts – reduction in list price for differential volume • Cash discounts – reduction in amount owed if paid within a specified period. Possible accounting methods : • Gross method records discounts when taken by customers (most commonly used) • Net method records discounts not taken by customers.
Cash Discounts - Net & Gross Methods Sale of $1,000 of inventory, 2/10, n/30 on 1/1/06, for two scenarios: • Payment is made on 1/10/06 b) Payment is made on 1/15/06:
Valuation of Accounts Receivable • Short term receivables are reported at their net realizable value (NRV) • What is NRV? • less estimated non-collectible accounts • less allowance for returns.
Accounts Receivable: IFRS vs. US GAAP Classification of Accounts Receivable • US GAAP: • Must separately disclose material related party receivables (i.e., trade receivables separate from non-trade) • IFRS: • Classified on balance sheet as a financial asset • May separately disclose material related party receivables
Methods Allowance Direct Write-Off Not based on the matching Based on the matching principle principle Appropriate only if Must be followed if amounts are not material amounts are material Accounts are written off Estimated; bad debts are when determined non-collectible matched against revenue Estimating Uncollectible Receivables
Accounts Receivable Direct write-off (used only if low & infrequent bad debts) Bad debt expense (I/S) XXX AR (B/S - Asset) XXX Indirect (allowance method) In year of the sale: Bad debt expense (I/S) XXX Allowance for bad debts (B/S – Asset) XXX When found to be uncollectible: Allowance for bad debts (B/S – Asset) XXX AR (B/S – Asset) XXX If payment received after account written off: AR (B/S – Asset) XXX Allowance for bad debts (B/S – Asset) XXX Cash (B/S – Asset) XXX AR (B/S – Asset) XXX
AR Allowance Methods: Determining the Amount of the Adjustment Percent of Receivables Allowance method • Balance-sheet oriented • Uses one B/S account (AR) to estimate another B/S account (Allowance) • Estimates the ENDING balance in the allowance account • Bad debt expense is the “plug” Percent of Sales Allowance method • Income-statement oriented • Uses one I/S account (revenue) to estimate another I/S account (bad debt expense) • Estimates the TOTAL bad debt expense • The allowance is the “running total”
Allowance Example 1. “Percent of Receivables” method (B/S-oriented) Husky Co. has $60,000 in sales in 2005. AR at 12/31/05 is $24,000. Allowance for doubtful accounts at 12/31/05 is $200. What adjusting entry should be made at year end? The company estimates allowance based on 1% of AR < 31 days, 2% 31-60 days, 5% 61-90 days and 20% > 90 days: Amount0-3031-6061-9091+ $24,000 10,000 8,000 4,000 2,000 Uncollectible % 1% 2% 5% 20% Allow. Est. $860 = 100 160 200 400
Allowance Example (cntd.) 2. “Percent of Sales” method (I/S-oriented) Assume instead that Husky estimates bad debt expense based on 1.5% of sales. Sales $60,000 Uncollectible % 1.5% Bad debt expense $900
Allowance Examples (cntd.) 3. % of Sales Method is based on credit sales during the year Example: Crawford Inc. Total sales, 2006: $20,000,000 Credit sales, 2006: $15,000,000 A/R Balance, Dec 31, 2006: $1,900,000 Allow. for bad debt balance (before adjustment) 12/31/06: $62,000 Prior history: 1% of credit sales are uncollectible What is the journal entry to record bad debt expense for 2006
Allowance Examples (cntd.) 4. Percent of Receivables Now assume Crawford estimates their Allowance using an A/R aging. Prior collections history is used to estimate the percentage of each category that is uncollectible. AgeBalance % bad 0-30 days 1,200,000 x 0.75% = 9,000 31-60 days 500,000 x 8.00% = 40,000 61+ days 200,000 x 20.00% = 40,000 89,000 What is the adjusting journal entry at year end?
Allowance Examples (cntd.) 5. Percent of Receivables – Write off’s and recovery. At the beginning of 2004, the balance in the Allowance account was $11,000 (CR). During the year, $8,000 of delinquent accounts were written off. Then, $2,000 of these delinquent accounts was ultimately determined to be collectible, and these accounts were collected. Additionally, the 2004 ending balance in A/R was $150,000. If XYZ estimates that 5% of A/R is uncollectible, what adjusting entry would be made to account for the bad debts? What would be the ending balance in the Allowance for Doubtful Accounts account?
Balance Sheet Representation Short-term accounts receivable are shown at their net realizable value as follows: Accounts Receivable (gross): $ XXX less: Allowance: ($ XX) Net Realizable Value: $ XX Or present in line item as: “AR net of $xxx allowance for doubtful accounts”
Disposition of Accounts and Notes Receivable • The holder of accounts or notes receivable may transfer them for cash. • The transfer may be either: • A secured borrowing (i.e., the “seller” is really borrowing from the transferee) • Holder retains ownership of receivables in a secured borrowing transaction. • A sale of receivables • Holder transfers ownership of receivables in a sale (transfers risks of collection).
Secured Borrowing Sale With Recourse Without Recourse Accounting for Transfers of Receivables Transfers • Seller guarantees payment if debtor does not pay • Factored receivables are written off, but a recourse liability is recognized based on estimate of future payment firm will have to make • Seller has no future obligation • Write-off factored receivables (and recognize any gain / loss)
Secured Borrowing – the Basics • Overall - Receivables remain on the books of the company borrowing money (i.e. – no sale) (and continue to treat A/R as usual (collections, write-off, etc.) • Also called “pledged” receivables • Transferor: • Records liability • Records a finance charge. • Collects accounts receivable. • Records sales returns and sales discounts. • Absorbs bad debts expense. • Records interest expense on notes payable. • Pays on the note periodically from collections.
Secured Borrowing Example To help overcome a cash shortage, H Software took out a loan with T Bank. H Software used $1000 of A/R as collateral for the loan. T Bank withheld $30 as a finance charge, and forwarded $970 to H Software on July 1. H Software collected the on the accounts on July 31 ($120 were written off), and repaid T Bank on August 2nd with interest of $50. July 1: Dr. Cash 970 Dr. Finance charge 30 Cr. Note Payable 1,000 July 31: Dr. Cash 880 Dr. Allowance for doubtful accounts 120 Cr. A/R 1,000 August 2: Dr. Interest Expense 50 Dr. Note Payable 1,000 Cr. Cash 1,050
Sale of Receivables – the Basics • Factor records the (transferred) accounts as assets in its books. • Transferor: • Transfers ownership of receivables to factor. • Records any amount retained by transferee as “due from factor.” • This is an amount held back to protect the transferee in case of non-payment by customer • Records loss on sale of receivables. • Records any component liability IF with recourse • i.e., any estimated future liability that the transferor will need to pay if customers do not pay (and if the amount held back by the factor is insufficient)
Transfer of Receivables: Sale Without Recourse To help overcome a cash shortage, H Software factored $1,000 of receivables to W Factor on July 1, 2006. W Factor withheld $100 pending collectability, and charged H Software $40. The remaining $860 was forwarded to H Software on July 1. W Factor collected on the A/R, without recourse. On August 2nd, W Factor informed H Software that $75 of the accounts were uncollectible, and W Factor returned to H Software the appropriate payment. Dr. Cash Dr. Due from Factor Dr. Loss on sale of A/R Cr. A/R Dr. Cash Dr. Loss Cr. Due from Factor What if instead, W Factor informed H Software on Aug 2 that it was able to collect all of the AR? What would be the journal entry? Dr. Cash Cr. Due from Factor
Transfer of Receivables: Sale With Recourse To help overcome a cash shortage, H Software factored $1,000 of receivables to W Factor on July 1, 2006. W Factor withheld $100 pending collectability, and charged H Software $40. The remaining $860 was forwarded to H Software on July 1. W Factor collected on the A/R, but had recourse in case of bad debts. H Software estimated that $150 of the receivables would ultimately be uncollectible. On August 2nd, W Factor informed H Software that $120 of the accounts were uncollectible, and H Software sent W Factor the appropriate recourse payment. Dr. Cash Dr. Due from Factor Dr. Loss on Sale of A/R (plug) Cr. A/R Cr. Recourse Liability Dr. Recourse Liability Cr. Cash Cr. Due from Factor Cr. Recovery of loss sale What ifW Factor informed H Software that $220 of the accounts were uncollectible?
Transfer of Receivables: Dawson Example On January 1, 2006, Dawson Associates is considering outsourcing the collection of its accounts receivable. The following factoring options are available to Dawson. Speedy Finance, Inc. Under the terms of the agreement, Speedy Finance would pay Dawson 98% of the gross amount of the transferred receivables and Dawson would be responsible to pay Speedy Finance for any uncollectible accounts. Dawson estimates its recourse liability would be $60,000. Speedy Finance will collect the receivables and will have the right to pledge or sell the receivables to another party. Strapped Solutions, Inc. Under the terms of the agreement, Strapped Solutions would pay Dawson 96.5% of the gross amount of Dawson’s receivables without recourse. Strapped Solutions will collect the receivables and will have the right to pledge or sell the receivables to another party. The following information is available from Dawson’s Balance Sheet at Dec. 31, 2005: Accounts Receivable $5,000,000 Allowance for doubtful accounts 80,000
Transfer of Receivables: Dawson Example Prepare the journal entry that Dawson would record on January 1, 2006 if it decides to enter into the agreement with Speedy Finance.
Transfer of Receivables: Dawson Example Prepare the journal entry that Dawson would record on January 1, 2006 if it decides to enter into the agreement with Strapped Solutions.
Transfer of Receivables: Dawson Example Which alternative should Dawson select if it wants to maximize reported income in 2006?
Notes Receivable Short term N/R Long term N/R Record at face value less allowance Record at present value of cash expected to be collected Recognition of Notes Receivable
Long-Term Notes Receivable: The Basics • Why does a company issue a notes receivable? • NR provides a stream of cash to the issuer • Principle • interest • What gets recorded? • Revenue: Present value cash inflow = fair value transaction • Note Receivable: Amount of the note • Maybe a discount or premium: contra account to the note • Interest revenue: Market rate of interest on the net receivable • Cash received (interest and principle)
Long-Term Notes Receivable: The Basics What are the true economics of a transaction involving a note? Consider this example. Several years ago my husband and I purchased a Ford Explorer. The sticker price was $30,000. My husband negotiated it down to $27,000. When we went to pay, we were given two options: 1) Receive a $2000 rebate off the negotiated price, OR 2) Finance for 5 years at 0% interest. Questions: 1) What is the true value of the transaction (i.e, revenue)? 2) Is the loan really at 0% interest?
Long-Term Notes Receivable: The Basics • To ensure this happens, need to consider interest rates. • Interest rates: Stated vs. market • Stated rate = effective (market rate) note issued at face value • Stated rate < market rate note issued at a discount. • Stated rate > market rate note issued at a premium. • The discount or premium is amortized to interest revenue by the effective interest method. • Record interest revenue each period using the effective interest method. • Yields steady market rate of interest on net investment in note receivable (i.e., note receivable + premium/discount)
Notes Receivable:Stated Rate = Market Rate On December 31, 2007, Nemo, Inc. finished consultation services and accepted in exchange a promissory note with a face value of $600,000, a due date of December 31, 2010, and a stated rate of 6%, with interest receivable at the end of each year. The note is considered to have a market rate of interest of 6%. How much should the Note Receivable be recorded for? What is the fair value of the transaction? • PV of cash interest payments • PV of principle payment
Notes Receivable:Stated Rate = Market Rate Fair value of transaction: Interest: Principle: Journal entries
Notes Receivable:Stated Rate < Market Rate On December 31, 2007, Nemo, Inc. finished consultation services and accepted in exchange a promissory note with a face value of $600,000, a due date of December 31, 2010, and a stated rate of 3%, with interest receivable at the end of each year. The note is considered to have a market rate of interest of 6%. Is this a discount or a premium? How much should the Note Receivable be recorded for?
Notes Receivable:Stated Rate < Market Rate Fair value of transaction: Interest: Principle: Journal entry at 12/31/07
N/R: Stated Rate < Market RateEffective Interest Amortization
Notes Receivable:Stated Rate < Market Rate Journal Entries
Notes Receivable:Stated Rate > Market Rate On December 31, 2007, Nemo, Inc. finished consultation services and accepted in exchange a promissory note with a face value of $600,000, a due date of December 31, 2010, and a stated rate of 9%, with interest receivable at the end of each year. The note is considered to have a market rate of interest of 6%. Is this a discount or a premium? How much should the Note Receivable be recorded for?
Notes Receivable:Stated Rate > Market Rate Fair value of transaction: Interest: Principle: Journal entry at 12/31/07
N/R: Stated Rate > Market RateEffective Interest Amortization