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Cash and Receivables

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  1. Cash and Receivables

  2. Objectives of this Chapter I. Discuss the asset valuation methods. II. Identify items to be included in the cash account and discuss how cash and related items are reported. III. Explain accounting issues related to valuation of accounts receivables -- trade discount, sales discount, sales returns and allowance, and uncollectible accounts. Cash and Receivables

  3. Objectives of this Chapter (contd.) IV. Discuss the means to use accounts receivable as a financial instrument -- pledge, assign and factor. V. Discuss the valuation of notes receivable and the disposition of notes receivable. Cash and Receivables

  4. I. Assets Valuation Methods A. Acquisition Cost (Historical Cost): Used in the initial recording for all assets except for: 1. Investment in debt securities-held-to-maturity. 2. Long-term monetary assets (i.e., Long-term N/R). B. Current Entry Value(Replacement Cost): Applied in the inventory valuation (LCM). Cash and Receivables

  5. Assets Valuation Methods (contd.) C. Current Exit Value (net selling price or market value): Applied in the valuation of trading securities and securities-available-for-sale. D.Net Present Value: Applied in the valuation of investment in debt securities-held-to-maturity and long-term monetary assets. Note: SFAS 159 allows the fair value option for financial assets and liablitlieis. Cash and Receivables

  6. Cash and Receivables • Liquidity: The amount of time expected to elapse until an asset is converted into cash. • Liquid assets: Assets are available for conversion into cash quickly (i.e., cash, receivables, trading securities, etc..). • Liquidity is an indication of a company’s ability to meet its obligation. Cash and Receivables

  7. II. Cash • What are included in the cash account? A. Cash on hand: B. Cash in bank: Cash and Receivables

  8. Cash (contd.) • What are excluded from the cash account (source: FRR No. 1): • Foreign currency with severe restrictions - separate cash account. • Certificates of deposits (CDs) - Temporary Investments. • Bank overdrafts - current liabilities (i.e., A/P) unless available cash is present in another account in the same bank (offsetting is required in this case). Cash and Receivables

  9. Cash (contd.) • What are excluded from the cash account (source: FRR No. 1): • Postdated checks- Receivables. • IOUs - Receivables. • Travel Advances - Prepaids. • Employees’ Advances - Receivables. • Postage stamps -Office supplies. • Special purpose funds - Investments. • Compensating balances - Restricted cash. • Short-term papera (i.e., commercial paper) - S-T investments. a. Investments with maturity of 3 to 12 months. Cash and Receivables

  10. Restricted Cash • Compensating balances are examples of restricted cash which may require separate reporting. • Other restricted cash: petty cash, cash for payroll, cash for dividends. If the amount is material, separate reporting is required. Cash and Receivables

  11. CashCompensating Balances (CB) • CB: The portion of any deposit maintained by a corporation to support an existing borrowing arrangements (ASR No. 148). • CB will increase the effective interest rate. • CB may also be payment for bank services rendered to the company. Cash and Receivables

  12. CashCompensating Balances (contd.) • If the CB is significant and is to support short-term borrowing, the CB should be stated separately among the “cash and cash equivalent item” in current assets.. • If the CB is significant and is to support long-term borrowing, the CB should be classified as noncurrent assets in either “Investments” or “ Cash on Other Assets” using a caption such as “Deposit Maintained as Compensating Balance”. Cash and Receivables

  13. CashCompensating Balances (contd.) • The following two situations only require a footnote disclosure of the CB, not a separate reporting: 1) CB arrangement exists without agreements that restrict the use of cash amount shown on the balance sheet statement; 2) CB arrangement is to assure future credit availability. Cash and Receivables

  14. Other Cash Related Topics • Electronic Fund Transfer (EFT): • Cash Equivalents: short-term, highly liquid investments that are both 1) readily convertible to known amount of cash, and 2) so near their maturity that they present insignificant risk of change in value. • In general, only investments with original maturity of three months or less qualify under these definitions. • Examples: Treasury bills, Commercial paper, and Money Market Funds. Cash and Receivables

  15. CashUsing Bank Account • General checking accounts • Imprest bank accounts • Lockbox accounts Cash and Receivables

  16. Cash Management and Control • Cash Management: 1) to maintain sufficient balance of cash on hand for day-to-day operation; 2) to prevent large amount of idle cash on hand. • Cash Control: to prevent losses of cash by theft of fraud 1. Immediate deposit of cash. 2. Cash payment by checks except for small amounts. 3. Separation of duties. 4. Bank account reconciliation. Cash and Receivables

  17. III.Receivables • Receivables: claims held against customers and others for money, goods or services. • Current Receivables: expected to be collected within one year or one operating cycle, whichever is longer. Cash and Receivables

  18. Receivables (contd.) • Trade Receivables: amount owed by customers for goods sold and services rendered as part of normal business operations (i.e., accounts receivables and notes receivables). • Nontrade Receivables: all others (i.e., interest receivable, advances to employees, deposits to cover potential damages, etc.) Cash and Receivables

  19. Receivables (contd.) • Accounts Receivable: oral promises of the purchasers to pay for goods sold and services rendered. They are usually collected in 30-60 days. Thus, A/R is always reported as a current asset with the net realizable value (i.e., A/R minus the allowance for uncollectible accounts). Cash and Receivables

  20. Receivables (contd.) • Notes Receivable: written promises to pay a certain sum of money on a specific future date. N/R can be long-term or short-term and can be interesting-bearing or noninterest bearing. Cash and Receivables

  21. Receivables (contd.) • Short-term N/R is reported at net realizable value (face amount – allowances for uncollectibles accounts). • Long-term N/R is reported at present value or the fair value (i.e., the quoted market prices of identical assets in active markets). Cash and Receivables

  22. Valuation of A/R & N/R Cash and Receivables

  23. Adjustments Related to Sales 1. Volume Dis. (Trade Discounts) 2. Cash Discounts (Sales Discounts) 3. Sales Returns and Allowances 4. Uncollectible Accounts Cash and Receivables

  24. 1. Volume Discount • When to Recognize the Adjustments: Not reflected on the J.E. Unit price = $10 Volume Dis. => 5% if purchase 100 or more units Sale => 200 units J.E.: Cash 1,900 Sales 1,900 • ORA/R 1,900 • Sales 1,900 Cash and Receivables

  25. 2. Cash Discount • When to Recognize the Adjustments: All Methods are acceptable. A. Recognized at time of sale (Net Price Method) B. Recognized at time of occurrence (Gross price Method) C. Recognized at time of sale (Allowance method) Cash and Receivables

  26. 2A. Recognized at Time of Sale(Net Price Method) • Sales = $100, terms 2/10, n/30 12/26/x1 A/R 98 Sales 98 a. 1/2/x2 Cash 98 A/R 98 Cash and Receivables

  27. 2A. Recognized at Time of Sale(Net Price Method) (contd.) If Dis. not taken: b. 1/31/x2 Cash 100 A/R 98 Cash Dis. not taken 2   Finance charge or Cash Dis. Forteited (interest revenue) Note: If the discount period post on 12/31, adjustment is required to bring the A/R to the gross amount. Cash and Receivables

  28. 2B. Recognized at time of occurrence(Gross price Method) • Sales = $100, terms 2/10, n/30 12/26/x1 A/R 100 Sales 100 a. 1/2/x2 Cash 98 Cash Dis. 2 AR 100 If Dis. not taken: b. 1/31/x2 Cash 100 A/R 100 Cash and Receivables

  29. 2C. Recognized at Time of Sale(Allowance method) • Sales = $100, terms 2/10, n/30 12/26/x1 A/R 100 Allowance for Cash Dis. 2 Sales 98 a. 1/2/x2 Cash 98 Allowance 2 AR 100 If Dis. not taken: b. 1/31/x2 Cash 100 A/R 100 Allowance 2 Cash Dis. not taken 2 Cash and Receivables

  30. 3. Sales Returns & Allowances (FASB 48) A. The amount of sales R&A is not significant. B. The amount of sales R&A is significant and six conditions are not met. C. The amount of sales R&A is significant and six conditions are met. Cash and Receivables

  31. 3A. The amount of Sales R&A Is Not Significant • If the amount of sales R&A is not significant, sales R&A are recognized at time of occurrence: Sales Returns & Allowances xxx A/R (or cash) xxx Cash and Receivables

  32. 3B. The Amount of Sales R&A Is Significant and Six Conditions Are Not Met • If the amount of sales R&A is significant, and the following six conditions are not met, postpone the revenue recognition until all six conditions are met or the return period expired. Cash and Receivables

  33. Six Conditions (SFAS No. 48) 1. Sales price is determinable or fixed; 2. Buyers have paid or have the obligation to pay the sales price; 3. The buyer’s obligation would not be changed due to theft or damage of the product after purchase; 4. Sellers are not responsible for the performance of the product; Cash and Receivables

  34. Six Conditions (SFAS No. 48) 5. Buyers and sellers are two separate economic entities; 6. The amount of returns can be estimated. • If the amount of returns is significant and these conditions are not met, revenue cannot be recognized. Cash and Receivables

  35. 3C. The Amount of Sales R&A Is Significant and Six Conditions Are Met • Sales can be recognized in the period in which the sales are made. • Also, at the end of the same period, the amount of sales returns would be estimated and recognized. 10/5/x1 A/R 10,000 Sales 10,000 12/31/x1 Sales R&A 1,000 Allow. for sale R& A 1,000 (estimate 10% returns) 1/10/x2 Allowance for sales R&A 900 A/R 900 Cash and Receivables

  36. 4. Uncollectible Accounts • Current practice: Estimate the B/D exp. at the end of the period and recognize the expense (SFAS No. 5). Adjusting entry for B/D expense: Estimated B/D expense = $2,000 12/31 B/D Expense 2,000 Allowance for Doubtful accounts 2,000 When B/D actually occurred: ($200 B/D) Allowance for doubtful Accounts 200 A/R 200 Cash and Receivables

  37. 4. Uncollectible Accounts (contd.) If $100 of the B/D recovered: A/R 100 Allow. for Doubtful Acct. 100 Cash 100 A/R 100 • The current practice is complied with the matching principle. • The direct write-off method (recognize the B/D expense when it occurs) is not recommended. Cash and Receivables

  38. Estimation of B/D Expense 1. Percentage of net credit sales (I/S approach). 2. Percentage of accounts receivable (B/S approach). 3. Aging of accounts receivable (B/S approach using individual account information). Cash and Receivables

  39. 1. Percentage of Net Credit Sales (I/S Approach) Example: Net credit sales = $20,000 Estimated B/D exp. = 2% of net credit sales Adjusting Entry 12/31 B/D Expense 400 Allow. for Doubtful accounts 400 Cash and Receivables

  40. 2. Percentage of A/R (B/S Approach) A/R Balance = $50,000 Estimated B/D = 1% of A/R Balance of the allow for doubtful accounts prior to the adjustment = $300 The new balance of the allow. for doubtful accounts = $50,000 x 1% = $500 Bad Debt Expense = $500 - 300 = 200 Adjusting Entry B/D expense 200 Allowance for Doubtful accounts 200 Cash and Receivables

  41. 3. Aging-of-A/R The balance of the allow. acct. = $100 B/D expense = $440 - 100 = 340 12/31 adjusting entry: B/D Exp. 340 Allowance for Doubtful Accounts 340 Cash and Receivables

  42. Earnings Management • Managers can use the discretionary accruals to manipulate the income number. • Examples of discriminatory accruals: bad debt expense, warranty expense, sales returns (when expecting sig. returns), etc. Cash and Receivables

  43. Interest on Receivables • Most of the A/R does not bear interest if the customers pay the amount within the term period. However, if payment is not made within the term period, the customer may have to pay interest on the unpaid balance. Cash and Receivables

  44. Interest on Receivables Example A • Credit sale of $1,000 was made on 3/1/x1, terms 2/10 and n/30. Financial charge is 1% per month on the unpaid balance. The customer paid the first half of the A/R on 5/1/x1 and the second half on 6/1/x1. Cash and Receivables

  45. Example A (contd.) Journal Entries: 3/1/x1 A/R 1,000 Sales 1,000 5/1/x1 Cash 510 A/R 500 Interest Revenue 10a 6/1/x1 Cash 505 A/R 500 Interest Revenue 5 b a. 1% x 1000 b. (1,000-500) x 1% Cash and Receivables

  46. Interest on Receivables Example B • Installment Sales (with Interest): Sales Price = $1,200 CGS = $900 Sales were made on 5/1/x1, four equal payments of $322.83 were made on 8/1/x1, 11/1/x1, 2/1/x2 and 5/1/x2 with 3% of quarterly interest rate. $1,200 = X 3.7171 X = $322.83 Cash and Receivables

  47. Example B (contd.) • Accrual Method: Journal Entries 5/1/x1 A/R 1,200 Sales Revenue 1,200 8/1/x1 Cash 322.83 A/R 286.83 Interest Revenue 361 11/1/x1 Cash 322.83 A/R 295.43 Interest Revenue 27.40 2 1. 3%  1,200 2. (1,200 - 286.83)  3% Cash and Receivables

  48. Example B (contd.) 2/1/x2 Cash 322.83 A/R 304.30 Interest Revenue 18.53 1 5/1/x2 Cash 322.83 A/R 313.43 Interest Revenue 9.402 1. (1,200 - 286.83 - 295.43)  3% 2. (1,200 - 286.83 - 295.43 - 304.30)  3% A/R 1,200 286.43 - 5/1/x1 295.43 - 8/1/x1 304.30 - 2/1/x2 313.43 - 5/1/x2 Cash and Receivables

  49. IV. Financing with Accounts Receivable –to accelerate the receipt of cash from receivables • Two ways: • 1. Secured borrowing • Pledge (General Assignment) • Assign (Specific Assignment) • 2. Sale of receivables (Factoring) • With recourse • Without recourse Cash and Receivables

  50. IV. Financing with Accounts Receivable(contd.) • Advantages: 1) Immediate use of cash (i.e., pledge, assign and factor); 2) Avoid the cost of billing and collection (i.e., factor). • Disadvantages: 1) Service charge (i.e., assign and factor); 2) Interest charge (i.e., pledge and assign) Cash and Receivables