2Objectives 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
3Objectives 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
4I. 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
5Assets 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
6Cash and ReceivablesLiquidity: 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
7II. Cash What are included in the cash account? A. Cash on hand: B. Cash in bank:Cash and Receivables
8Cash (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
9Cash (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
10Restricted CashCompensating 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
11Cash Compensating 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
12Cash Compensating 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
13Cash Compensating 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
14Other Cash Related Topics Electronic Fund Transfer (EFT):Cash Equivalents: short-term, highly liquid investments that are bothReadily convertible to known amount of cash, andSo near their maturity that they present insignificant risk of change in value.Cash and Receivables
15Cash Equivalents (CEs) 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.Hard lesson learned: reporting the auction-rate notes as CEs by Kohl’s and ADC Telecommunications resulting in sizeable write-downs of these CE during the credit crunch due to no market exist for these investments.Cash and Receivables
16Cash Equivalents (CEs) Although these auction-rate notes often have long maturity dates (i.e., 30-year), they were traded on daily basis prior to the credit crunch in 2008.This is how the holders of these notes argued to present them as CEs.When the market for these notes froze (i.e., no buyers of these notes), the value of these assets dropped significantly to warrant a sizeable write down.Cash and Receivables
17Cash Equivalents (CEs) 4/14/2017Cash Equivalents (CEs)FASB is considering to separate reporting of cash from CEs.In July 2010, FASB staff proposed to report cash equivalents (i.e., money market fund) as short-term investments.This project was reassessed as a low priority project and no action was taken recently.Cash and Receivables
18Cash Using Bank Account General checking accountsImprest bank accountsLockbox accountsCash and Receivables
19Cash Management and Control 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 fraud1. Immediate deposit of cash.2. Cash payment by checks except for small amounts.3. Separation of duties.4. Bank account reconciliation.Cash and Receivables
20III.ReceivablesReceivables: 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
21Receivables (contd.)Trade Receivables: amount owed by customers for goods sold and services rendered as part of normal business operations (i.e., accounts receivable and notes receivable).Nontrade Receivables: all others (i.e., interest receivable, advances to employees, deposits to cover potential damages, etc.)Cash and Receivables
22Balance Sheet Presentation of Receivables (Illustration 7-3, KWW, 14th e) Cash and Receivables
23Trade ReceivablesAccounts Receivable (A/R): oral promises of the purchasers to pay for goods sold and services rendered. They are usually collected in 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
24Trade Receivables (contd.) Notes Receivable (N/R): 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
25Trade 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
27Adjustments Related to Sales 1. Volume Dis. (Trade Discounts)2. Cash Discounts (Sales Discounts)3. Sales Returns and Allowances4. Uncollectible AccountsCash and Receivables
281. Volume DiscountWhen to Recognize the Adjustments: Not reflected on the J.E.Unit price = $10Volume Dis. => 5% if purchase 100 or more unitsSale => 200 unitsJ.E.:Cash 1,900Sales 1,900OR A/R 1,900Sales 1,900Cash and Receivables
292. Cash Discounts (Sales Discounts) When to Recognize the Adjustments: both Methods are acceptable.A. Recognized at time of sale (Net Price Method)B. Recognized at time of occurrence (Gross price Method)Cash and Receivables
302A. Recognized at Time of Sale (Net Price Method) Sales = $100, terms 2/10, n/3012/26/x1 A/R 98Sales 98a. 1/2/x2 Cash 98A/R 98Cash and Receivables
312A. Recognized at Time of Sale (Net Price Method) (contd.) If discounts were not taken:b. 1/31/x2 Cash 100A/R 98Cash Discounts Not Taken 2 Finance charge or Cash Dis. Forfeited(interest revenue)Note: If the discount period expired on 12/31, adjustment is required to bring the A/R to the gross amount.Cash and Receivables
322B. Recognized at time of occurrence (Gross price Method) Sales = $100, terms 2/10, n/3012/26/x1 A/R 100Sales 100a. 1/2/x2 Cash 98Sales Discounts 2AR 100If discounts were not taken:b. 1/31/x2 Cash 100A/R 100Cash and Receivables
333. 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
343A. 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 xxxA/R (or cash) xxxCash and Receivables
353B. 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
36Six 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
37Six 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
383C. 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 10,000Sales 10,00012/31/x1 Sales R&A 1,000Allow. for sale R& A 1,000(estimate 10% returns)1/10/x2 Allowance for sales R&A 900A/R 900Cash and Receivables
394. Uncollectible Accounts The Allowance Method for Uncollectible Accounts: Estimate the bad debt (B/D) expense at the end of the period and recognize the expense (SFAS No. 5).Adjusting entry for B/D expense:Estimated B/D expense = $2,00012/31 B/D Expense 2,000Allowance forDoubtful Accounts 2,000When B/D actually occurred: (i.e.,$200 B/D)Allowance for doubtful Accounts 200A/R 200Cash and Receivables
404. Uncollectible Accounts (contd.) If $100 of the B/D recovered:A/R 100Allow. for Doubtful Acct. 100Cash 100The 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
41Presentation of Allowance for Doubtful Accounts Cash and Receivables
42Three Methods in the Estimation of B/D Expense 1. Percentage-of-sales (income statement approach).2. Percentage-of-accounts receivable (balance sheet approach).3. Aging of accounts receivable (B/S approach using individual account information).Cash and Receivables
431. Percentage-of-Sales (I/S Approach) Example:Net credit sales = $20,000Estimated B/D exp. = 2% of net credit salesAdjusting Entry12/31 B/D Expense 400Allow. for Doubtful Accounts 400Cash and Receivables
442. Percentage of A/R (B/S Approach) A/R Balance = $50,000Estimated B/D = 1% of A/RBalance of the allow for doubtful accounts prior to the adjustment = $300The new balance of the allow. for doubtful accounts = $50,000 x 1% = $500Bad Debt Expense = $ = 200Adjusting EntryB/D expense 200Allowance for Doubtful accounts 200Cash and Receivables
453. Aging of A/R MethodThe balance of the allowance prior to adj.= $100B/D Expense= $2,300 - $100 = $2,200Adj. Entry: B/D expense ,200Allowance for Doubtful Account. 2,200AgeAmountB/D%Allowance Amount0-3010,000440031-607,0001070061-904,00017680Over 902,00026520Total2,300Cash and Receivables
46Earnings ManagementDiscretionary accruals require a large degree of managers’ judgmentManagers can use the discretionary accruals to manage earnings.Examples of discriminatory accruals: bad debt expense, warranty expense, sales returns (when expecting sig. returns), etc.Cash and Receivables
47Earnings Management Using Accruals: The Case of Nortel Background: A Canadian communication company filed bankruptcy in It was hit very hard by the technology stock price decline in the early 2000s.Accounting Scandals: Nortel overstated its bad debt expense of 2002 in order to reduce its bad debt expense of 2003 (thus, increase its earnings) even though the outstanding accounts receivables were similar for both years.Cash and Receivables
48Earnings Management Using Accruals: The Case of Nortel (contd.) Cash and Receivables
49Earnings Management Using Accruals – Sun Trust Banks Similar to Nortel, some banks also overstated the loan loss reserve (an expense) for outstanding loans in a good earnings year and reduce the reserve in the following year to manage earnings.Cash and Receivables
50Earnings Management Using Accruals – Sun Trust Banks (contd.) The SEC brought action against Sun Trust in 1999, alleging Sun Trust manipulated its earnings by overstating loss reserve when it was not experiencing significant loan losses.The SEC required Sun Trust to reverse the $100 million of loan loss reserve.source: KWW,14th e, p377 and “The Mythical FDIC Fund by William M. Isaac*, AM BKR Final, 8/27/08).Cash and Receivables
51Presentation of Receivables (see Illustration 7-23 of KWW 14th e) General Rules :Segregate the different types of receivables.Appropriately offset the valuation accounts against the proper receivables.Disclose any loss contingencies.Disclose any receivables pledged as collateral.Disclose the nature of credit risk, especially the concentration of credit risk of receivables (i.e., receivable with common characteristics.).Cash and Receivables
53Interest 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
54Interest 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
55Example A (contd.) Journal Entries: 3/1/x1 A/R 1,000 Sales 1,000 5/1/x1 Cash 510A/R 500Interest Revenue 10 a6/1/x1 Cash 505Interest Revenue 5 ba. 1% x 1000b. (1, ) x 1%Cash and Receivables
56Interest on Receivables Example B Installment Sales (with Interest):Sales Price = $1,200CGS = $900Sales were made on 5/1/x1, four equal payments of $ 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 X = $322.83Cash and Receivables
59IV. Financing with Accounts Receivable –to accelerate the receipt of cash from receivables Two ways:1. Secured borrowingPledge (General Assignment)Assign (Specific Assignment)2. Sale of receivables (Factoring)With recourseWithout recourseCash and Receivables
60IV. 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
61IV. Financing with Accounts Receivable - Reasons Pledge and Assign:Cash shortage and other ways of borrowing are not available or too expensive.Factor:In some industries (i.e., durable goods), product financing is mandatory to be competitive. Companies in these industries often created wholly-owned subsidiaries specializing in receivables financing.Cash and Receivables
62IV. Financing with Accounts Receivable – Reasons (Contd.) Factor (cont.):To avoid billing and collection costs.To avoid violation of existing lending agreements.From a purchaser’s point of view, buying receivables may be an alternative of making profits when reaching its legal lending limit.Note: Credit card sale is a form of factor without recourse.Cash and Receivables
63Pledge of A/R (General assignment of A/R) Use A/R as a security (collateral) to borrow money from financial institutions.No journal entries are required for the pledge. Information related to the pledge is disclosed in the footnote.Cash and Receivables
64Borrow $100,000 by pledging all receivables for the borrowing: Pledge of A/R ExampleBorrow $100,000 by pledging all receivables for the borrowing:Journal Entry:Cash 100,000Notes Payable 100,000Notes: The company’s trade accounts are pledged as collateral for the $100,000 notes payableCash and Receivables
65Pledge of A/R Example (contd.) When the note is due and paid, the following entry will be recorded:Notes Payable 100,000Interest Expense 3,000Cash 103,000Assume a 12% interest and a 3-month duration.Cash and Receivables
66Pledge of A/R Example (contd.) If the note is not paid on the maturity date, the lending institution can seize and collect the pledged A/R.The borrower (the company) continues to have the control of the A/R. Cash used to pay off the note can be from any sources including proceeds received from the pledged A/R.Cash and Receivables
67Assignment of Accounts Receivable (specific) Use A/R as a means to borrow money from banks or financial institutions.Specific A/R are assigned as collateral for the borrowing.Companies (the borrowers) continue to have the control of the A/R assigned and continue to collect assigned A/R from the customers.Cash and Receivables
68Assignment of Accounts Receivable (contd.) The amount collected from the assigned A/R must be remitted to the lending institution periodically.The proceeds collected from the assigned A/R cannot be used for any other purposes until all loans are paid off.The lender usually charges: 1) a service charge (i.e., 5% of the loan amount), 2) interest on the loan.Cash and Receivables
69Example of (Specific) Assignment (Illustration 7-16 of KWW , 14th e with little modification for April collections.)On March 1, 2010, Howat Mills Inc. (HM), assigns $700,000 of its accounts receivable to Citizens Bank as collateral for a $500,000 borrowing. HM continues to collect the A/R; the account debtors are not notified of the assignment (a non-notification assignment). Citizens Bank charges a finance charge of 1% of the A/R assigned. The annual interest on the note is 12%. Settlement by HM to the bank is made monthly for all cash collection on the assigned receivable.Cash and Receivables
70Example of Assignment (contd.) Cash and Receivables
71Example of Assignment (contd.) Cash and Receivables
72Example of Assignment (contd.) Cash and Receivables
73An Alternative: Accounts Receivable Are Not Transferred to A/R Assigned Cash and Receivables
74Accounts Receivable are Not Transferred to A/R Assigned (cont) Cash and Receivables
75Accounts Receivable are Not Transferred to A/R Assigned (cont.) Cash and Receivables
76Example of Assignment (contd.) The balance sheet statement of HM on 4/1 after the remittance of $434,000 cash collected from A/R Assigned in March, the balance of the A/R assigned account is $246,000 ($700,000 - $454,000) and the balance of the Notes Payable account is $66,000 ($500,000-$434,000). These two accounts will be presented on the balance sheet statement as :Current Assets:Accounts Receivable Assigned $246,000Notes Payable (66,000)Equity in A/R Assigned $180,000Cash and Receivables
77Sale (Factor) of Accounts Receivable A common type of sale of A/R is a sale to a factor.Factors are finance companies or banks that buy receivables from businesses for a fee and then collect the receivables directly from the customers.Cash and Receivables
78Sale (Factor) of Accounts Receivable In the case of factor, A/R would be transferred to the purchaser.The buyer would collect the accounts, not the seller.The seller relinquishes all rights pertaining to the future collection of A/R.Cash and Receivables
79Sale (Factor) of A/R (contd.) Sale of A/R (commission is 0.75% to 1.5%) is a common practice in some industries such as textile, apparel, footwear, furniture, etc.For some industries, sales financing is necessary in order to be competitive.Credit card transaction is also a type of factoring arrangement (commission is 4 to 5%).Cash and Receivables
80Sale (Factor) of A/R (contd.) Credit Card Sale (Contd.)The buyer (the card issuer) of the receivable charges the seller (the merchant) a commission for the receivables purchased.The buyer collects directly from customers (card holder).Cash and Receivables
81Accounting for Factor Factor without recourse Factor with recourse Recourse is a right of a buyer of receivables to receive payments from the seller when debtors fail to pay.Cash and Receivables
82Factor without Recourse (A Sale of Receivables) In the case of factor without recourse, the buyer assumes the risk of uncollectibility and absorbs any credit losses (i.e., bad debts).Thus, factor without recourse is a sale of receivables both in form and in substance.Cash and Receivables
83Example of Factor without Recourse (Source: Illustrations Kieso, etc. textbook with some modifications.)Crest Textiles factors $500,000 of A/R with ABC Bank on a without recourse basis. The receivables are transferred to ABC bank on 5/1. ABC bank charges 3% of financial charge for factor without recourse and retain an amount equals to 5% of the A/R to cover sales returns and discounts. Credit losses (bad debts) are absorbed by ABC bank due to factor without recourse. The ABC bank expects $4,100 of uncollectible accounts from the receivables purchased.Cash and Receivables
84Example of Factor without Recourse (contd.) ABC BankA/R 500,000Due toCrest Texti. 25,000Interest Rev. 15,000Cash ,000Recognition of Bad Debt Exp.:Bad Debt Exp. 4,100Allow. ForDoub. Acct ,100Crest Textiles5/1Cash 460,000Due fromFactor 25,000Loss on Saleof Rec. 15,000A/R ,000Cash and Receivables
85Example of Factor without Recourse (contd.) Crest Textiles.Sales R&A 9,500Sales Dis. 2,600Due fromFactor ,100ABC BankCash 483,800Due toCrest Texti. 12,100A/R ,900Allow. forDoub. Acct. 4,100A/R ,100Transactions in May and June: collects of $483,800 by ABC bank; sales R&A of $9,500; sales discounts taken of $2,600 and $4,100 bad debts written off by ABC bank.Cash and Receivables
86Example of Factor without Recourse (contd.) Crest TextilesCash 12,900Due fromFactor 12,900ABC BankDue toCrest Texi 12,900Cash ,900Final settlement between Crest Text and ABC Bank:Note: The factor’s (ABC Bank) income from this factor is $15, ,100 (Interest revenue – bad debt expense).Cash and Receivables
87Factor with Recourse (source: Kieso, etc. textbook) When receivables are sold with recourse, the seller “guarantees payment to the buyer in the event the debtor fails to pay” (or the payment of the debtor is less than expected by the purchaser).Thus, the seller retains the risk of uncollectibility.Cash and Receivables
88Factor with RecourseSFAS No. 140 requires that a sale of receivables with recourse be recognized as a sale only if all three conditions are met, otherwise, the sale with recourse should be treated as a secured borrowing.Cash and Receivables
89Factor with Recourse Three Conditions 1. The transferred assets have been isolated from the transferor (beyond the reach of the seller and its creditors);2. Each buyer (transferee) has the right to pledge or exchange the assets it received and no constrains attached;3. The seller does not maintain effective control over the transferred assets through repurchase agreement.Cash and Receivables
90Factor with Recourse (Contd.) A recourse is an example of “continuing involvement” in a transfer of receivablesIn the case of factor with recourse and meeting all three criteria, the transaction will be recorded as a sale with the recognition of assets obtained and liabilities expected.The buyer (transferee) usually charges a higher fee in the case of factor without recourse than in the case of factor with recourse.Cash and Receivables
91Example of Factor with Recourse (Source: illustrations 7-18, 7-19 and 7-20 of Kieso, etc. textbook) Crest Textiles factors $500,000 of A/R with ABC Bank on a with recourse basis. The receivables are transferred to ABC Bank on 5/1. ABC Bank charges 3% of financial charge for factor with recourse and retains an amount equals to 5% of the A/R to cover sales returns and discounts. Credit losses (bad debts) are absorbed by Crest Textiles, Inc. due to factor with recourse. The Crest Textiles, Inc. expects $6,000 of uncollectible accounts from the receivables factored.Cash and Receivables
92Factor with Recourse : Example (Contd Factor with Recourse : Example (Contd.) – All Three Conditions Are Met and Treated As a SaleCrest TextileCash ,000Due from Factor 25,000Loss on Saleof Receivable ,000*A/R ,000Recourse Liability 6,000*$21,000= $500,000x3% orNet Proceeds = $460,000+25, =479,000.$21,000 = $500,000 – 479,000ABC BankA/R 500,000Due to 25,000CrestInterestRev ,000Cash ,000Cash and Receivables
93Example of Factor with Recourse (contd.) Crest Textiles.Sales R&A 9,500Sales Dis. 2,600Due fromFactor ,100Recourse Liability 6,000Due from Factor 6,000ABC BankCash 481,900*Due toCrest 12,100A/R ,000Due to Crest 6,000A/R ,000*500,000-12,100-6,000Transactions in May and June: bad debts occurred, $6,000; sales R&A occurred,$9,500; sales discounts taken, $2,600. The A/R collected, $481,900 (i.e., $500,000-12, ).Cash and Receivables
94Example of Factor with Recourse (contd.) ABC BankDue to Crest 6,900Cash ,900Crest Textile(Treated as a Sale)Cash 6,900aDue from Factor 6,900Settlement between Crest and ABCa. $6,900 is $6,000 less than $12,900 in the case of factor without recourse. This is due to the bad debt amount $6,000 is absorbed by Crest Textile in the case of factor with recourse.Cash and Receivables
95What if only $5,000 bad debts occurred in stead of the expected $6,000 in factor with recourse example on p78?Crest Textiles.Sales R&A 9,500Sales Dis. 2,600Due fromFactor ,100Recourse Liability 6,000Due from Factor 5,000Loss on Sale of Rec. 1,000ABC BankCash 482,900*Due toCrest 12,100A/R ,000Due to Crest 5,000A/R ,000Transactions in May and June: bad debts occurred, $5,000; sales R&A occurred,$9,500; sales discounts taken, $2,600. A/R collected, $482,900 (*500,000-12,100-5,000).Cash and Receivables
96What if only $5,000 bad debts occurred (contd.) : ABC BankDue to Crest 7,900Cash ,900Crest Textile(Treated as a Sale)Cash 7,900aDue from Factor 7,900Settlement between Crest and ABCa. $7,900 is $5,000 less than in the case of factor without recourse. This is due to the bad debt amount $5,000 is absorbed by the seller (Crest Textile) in the case of factor with recourse.Cash and Receivables
97The Profits of the Buyer (Transferee)under Factor With Recourse Unlike factor without recourse, the profits for the buyer in the factor with recourse always equal the interest revenue (i.e., $15,000 in the above examples) due to bad debts being covered by the seller . Using previous examples:When bad debts=$6,000, the profits of ABC = $489,100-$460,000-$6,900 =$15,000.When bad debts =$5,000, the profits of ABC=$482, ,000-7,900=$15,000.Cash and Receivables
98V. Notes ReceivableNote receivable: A written promissory note; can be interest bearing or non- interest bearing.Short-term N/R: Recorded at the amount expected to be collected (i.e., NRV).Interest bearing: Accrued interest recognized at the end of a period.Non-interest bearingCash and Receivables
99Notes Receivable (contd.) 4/14/2017Notes Receivable (contd.)Long-term N/R:1. Recorded at net present value2. End of period valuation –NPV or the fair value (SFAS 159)Note: Reporting a long-term note receivable at the fair value is an option. Once chose, the fair value method will be used for all subsequent periods.Cash and Receivables
100Notes Receivable Case I: Non-Interesting Bearing Example Receiving a 3 month non-interest bearing note on 11/1/x1 with a face amount of $10,000.11/1/x1 N/R 10,000Sales 10,00012/31/x1 No adjusting entry for accrued interest because the note is a non-interest bearing note.1/31 Cash 10,000N/R 10,000If the note is dishonored on 1/31 =>A/R 10,000Cash and Receivables
101Notes Receivable Case II: Interesting Bearing Example Short-term note with interest bearing; annual interest rate = 12%.Receiving a 3-month interest bearing note on 11/1/x1. Face amount is $10,000 and the annual interest rate is 12%Cash and Receivables
103Discount of Notes (to a bank or to any finance institution) Example: A 3-month note with a face amount of $10,000 (received on 11/1/x1) is discounted on 12/1/x1.Interest rate of the note = 12% (annual)Int. rate charged by the bank = 18% (annual)Cash and Receivables
104Discount of Notes (contd.) 1. Maturity value of the note= $10, ,000 12% 3/12= $10,3002. Interest charged by the bank (discount)= $10,300 x 18% x 2/12 = $30911/1/x11/31/x212/1/x1Bank is lending $10,300 on 12/1/x1Bank is receiving $10,300 on 1/31/x2Cash and Receivables
105Discount of Notes (contd.) Proceeds received by the firm from discounting the note (the bank will deduct the interest charge from the proceeds):$10, = $9,991Cash and Receivables
106Discount of Notes (contd.) J.E. on 12/1:Cash 9,991Loss on Dis. of NoteN/R Discounted 10,000Interest Revenuea 100a.Interest earned by the firm from holding the note for one month (11/1 ~ 12/1) = $10,000 12% 1/12 =100Footnote (FASB): Contingent liability of discounted note of $10,000Cash and Receivables
107Discount of Notes (contd.) On 1/31/x2, the note is paid, the following entry will be recorded:N/R discounted 10,000N/R 10,000If on 1/31/x2, the note is dishonored, the following entry will be recorded:(Assuming the bank charge $10 fee)N/R Discounted 10,000Loss on Dishonored Note 10,310Cash 10,310Cash and Receivables
108Long-Term Notes Receivable Initial Recording: Net present valueEnd of Period: Net present value orthe fair value.Cash and Receivables
109Long-Term N/R Example A Receiving a 2-year note on sales of goods on 1/1/x1. The face amount of this note is $100,000 and the annual interest of the note is 10%. The interests are paid annually and the market interest rate is 12%. Present value of the note:$100,000 ,000 =96,620Cash and Receivables
110Long-Term N/R Example A (contd.) Notes Receivable 100,000Sales Revenue 96,620Discounts on N/R 3,380Effective Interest of 20x1= PV of note on 1/1/x1 12%= ($100, ,380) 12%= 11,594.4Cash and Receivables
111Long-Term N/R Example A (contd.) 12/31/x1 (recording receiving of $10,000 interest)Cash 10,000Discount on N/R 1,594.4Interest Revenue 11,594.4P.V. of the note on 1/1/x2= 100,000 - (3, ) = 98,214.4Effective Interest of 20x2 = PV on 1/1/x2 12%= 98, 12% = 11,785.7Cash and Receivables
112Long-Term N/R Example A (contd.) 12/31/x2 (recording int. received on 12/31/x2):Cash 10,000Discount on N/R 1,785.7Int. Revenue 11,785.712/31/x1 (recording face amount of N/R received on maturity date):Cash 100,000N/R 100,000Discount on N/R has been amortized to zero after two years of amortization using the effective interest method.Cash and Receivables
113Example B: Notes Received for Property, Goods and Services Example: Lenex sold a lot to Impex as an office site. Lenex accepted a 3-year note with a maturity value of $ 93,169 and with no stated interest rate. The land originally cost Lenex $30,000 and had an appraised fair value of $70,000 on the selling date.Cash and Receivables
114Notes Received for Property, Goods and Services (contd.) 4/14/2017Notes Received for Property, Goods and Services (contd.)J.E.: N/R 93,169Dis. on N/R 23,169Land 30,000Gain 40,000When the market interest rate is unknown, the imputed interest rate is calculated as:$70,000 = $93,169 x ?? = 70,000/93,169 =is the present value factor of 10%, 3 periods and therefore, the imputed interest rate is 10%..Cash and Receivables
115Notes Received for Property, Goods and Services (contd.) 4/14/2017Notes Received for Property, Goods and Services (contd.)The discount on N/R will be amortized in the next three years as follows:.Year 1Year 2Year 3Discount on N/R7,0007,7008,469Interest Revenue8.469Cash and Receivables
116Notes Received for Property, Goods and Services (contd.) 4/14/2017Notes Received for Property, Goods and Services (contd.)If the effective rate of the note is known, the present value of the note will be calculated using the effective interest .The gain will be the difference between the P.V. of the note and the cost of the land.The discount amount will be the difference between the maturity value (i.e., $93,169) and the P.V. of the note..Cash and Receivables
117Long-Term N/R Example B (skip p114-121) On 12/31/x1 La Tourette Inc. rendered services to Husky Corp. at an agreed price of $73,844.10, accepting $18,000 down and agreeing to accept the balance in four equal installments of $18,000 receivable each 12/31. An assumed interest rate of 11% is imputed. Record the journal entries for La Tourette for the sale and for the receipts and interest on the following dates:1. 12/31/20x /31/20x23. 12/31/20x /31/20x45. 12/31/20x5Cash and Receivables
118Long-Term N/R Example B (contd.) PV of $18,000 four payments= 18,000 = 55,844.10Thus, the revenue from the services= 18, , = 73,844.1012/31/x1Cash 18,000Notes Receivable 72,000Discount on N/R 16,155.9aRevenue from Services 73,844.10a. (18,000 4) - 55, = 16,155.9Cash and Receivables
119Long-Term N/R Example B (contd.) 12/31/x2 (recording install. Payment of $18,000 and the amortization of discount on N/R):Cash 18,000N/R 18,000Discount on N/R 6,142.85Interest Revenue 6,142.85aa. Interest Revenue of 20x2= pv of note on 1/1/x2 (or 12/31/x1) 11%= 55,844.1 11% = 6,142.85Cash and Receivables
120Long-Term N/R Example B (contd.) Cash 18,000N/R 18,000Discount on N/R 4,838.56Interest Revenue 4,838.56aa. Interest Revenue of 20x3= pv of note on 1/1/x3 11%= (55, , ,142.85) 11%= 43, 11% = 4,838.56Cash and Receivables
121Long-Term N/R Example B (contd.) 12/31/x4 (recording install. Payment of 18,000 and the amortization of discount on N/R):Cash 18,000N/R 18,000Discount on N/R 3,390.81Interest Revenue 3,390.81aa. Interest Revenue of 20x4= pv of note on 1/1/x4 11%= (43, , ,836.56) 11%= 30, 11% = 3,390.81Cash and Receivables
122Long-Term N/R Example B (contd.) Cash 18,000N/R 18,000Discount on N/R 1,783.68Interest Revenue 1,783.68aa. Interest Revenue of 20x5= pv of note on 1/1/x5 11%= (30, , ,390.81) 11%= 16, 11% = 1,783.68Cash and Receivables
123Notes Received for Cash and Other Rights Avon Co. accepts a 3-year, $100,000, zero-interest-bearing note from Andrew Co. plus the right to purchase 50 machines at a bargain price in exchange for $100,000 in cash. Assume that the current rate is 10% (for a similar note without the right):Cash and Receivables
124N/R Received for Cash and Other Rights (contd.) J.E. for Greene:N/R 100,000Prepaid Purchase 24,868Cash 100,000Discount on N/R 24,868The $24,868 will be amortized as interest revenue in next 3 years. The prepaid purchase will be amortized (proportionally to 50 machines) to increase the purchase price of machines.Cash and Receivables
125Fair Value Option (SFAS 159 or ASC825-10-25) Companies may choose the fair value option when the financial instrument is originally recognized or when an event triggers a new basis of accounting (i.e., acquisition).Once chosen, the company has to use the fair value option in subsequent periods.If the company does not elect the fair value option for the financial instrument at the initial recognition, it may not use this option for the instrument in subsequent periods.Cash and Receivables
126Fair Value Option – An Example Assume that Loftus Company has notes receivable with a fair value of $70,000 and a carrying amount of $58,000 (e.g. with $60,000 face amount and $2,000 discount on N/R) on 12/31/ The company chose the fair value option for these receivables on the first valuation of these recently acquired receivables.Adjusting Entry:Fair Value Adjustment-N/R 12,000Unrealized holding gain or loss* 12,000* Reported in the income statementCash and Receivables
127Fair Value Option – An Example For all subsequent periods, the change in fair value of the note will be reported as an unrealized holding gain or loss.For example, assuming the fair value of the note at December 31, 2012 is $65,000, Loftus will record the following adjusting entry on 12/31/2012:Unrealized holding gain or loss 5,000Fair Value Adj. – N/R ,000Cash and Receivables
128Impairment Measurement and Reporting on Investment in Loan Receivables 4/14/2017Impairment Measurement and Reporting on Investment in Loan ReceivablesA loan receivable impaired when it is probable that it will not collect all amounts due (both principle and interest).Measurement:Compare the recorded investment (i..e, the NRV or the carrying amount) with the present value of the expected future cash flows using the historical expected interest rate.
129Impairment Measurement and Reporting (contd.) 4/14/2017Impairment Measurement and Reporting (contd.)Example (illustration 7B-3 onP355 of KWW textbook):Carrying amount of investment $100,000The PV of expected future cash flows on the investment at 10% historical effective interest rate is $87,566.The loss on impairment = 100,000 – 87,566 = 12,434.
130Impairment Measurement and Reporting (contd.) 4/14/2017Impairment Measurement and Reporting (contd.)Recording of impairment losses:Bad Debt Expense ,434Allowance for Doubtful Accounts 12,434Write-off of impaired receivables:Allowance for Doubtful Accounts 12,434Notes Receivables ,434
131SecuritizationA sale of securities (i.e., bonds or commercial paper) backed (collateralized ) by a pool of assets.These assets can be mortgage receivables (i.e., mortgage-backed securities), consumer loans (i.e., assets-backed securities), and corporate bonds (i.e., collateralized debt obligations).Cash and Receivables
132Securitization (contd.) Securitizations are popular for two reasons:1. Investors have a strong appetite in acquiring collateralized securities.2. Companies and lenders with large amounts of receivables have incentives to engage in securitization.
133Securitization Performed by The Company When a company uses its assets (i.e., auto loan receivables) as collaterals to issue bonds (i.e., assets-backed securities), the receivables will remain on its balance sheet.The company’s liability will be increased from the increase of bonds payable.As a result, this transaction will have an adverse effect on its return on assets and debt/equity ratios.
134The Special Purpose Entity A special purpose entity (SPE) is usually created by a third party (referred to as a sponsor) which is independent of the company with receivables (referred to as the transferor).The SPE serves the purpose of buying receivables from the transferor and issuing securities collateralized on the receivables transferred from the transferor.
135The Special Purpose Entity (contd.) The SPE can be in the form of a trust, partnership or corporation and is legally distinct from the transferor.
136Procedures of Securitization Performed by A SPE 1. The transferor will first transfer its receivables to the SPE.2. The SPE issues securities (i.e., commercial paper due in days) collateralized on receivables transferred.3. The cash received by the SPE from issuing securities goes back to the transferor to pay off the receivables transferred.
137Procedures of Securitization Performed by A SPE (contd.) The SPE is served as a “pass through”.The sponsor of the SPE charges the transferor fees for creating and operating the SPE.The transferor can continue to service the loan for a fee.
138Off Balance Sheet Financing SFAS 140 (2000): If the SPE is a qualifying SPE* ,the transferor does not have to consolidate the balance sheet of the SPE.As a result, both the receivables and the liabilities from issuing securities will appear only on the balance sheet of the SPE, not the transferor or the sponsor.*The SPE has at least 3% (10% under FIN 46 (R)) of the fair value of its total assets invested by a third party.
139Off Balance Sheet (B/S) Financing (contd.) 4/14/2017Off Balance Sheet (B/S) Financing (contd.)With a qualifying SPE, the transferor obtain an off-balance sheet financing.Problems Associated with off B/S financing:If the receivables defaulted, the transferor may be forced to take back receivables or the banks eat losses.A mismatch of long-term assets with short-term borrowing on the capital structure of the SPE..
140Subprime Mortgage Crisis in 2007 4/14/2017Subprime Mortgage Crisis in 2007Many of the subprime mortgage receivables defaulted in 2007 due to the reckless lending in the early to mid-2000s.When investors realized that the underlying assets for the SPEs’ securities were subprime mortgage receivables, SPEs had a hard time to issue new commerce paper to refinance the existing commercial paper.
141Subprime Mortgage Crisis in 2007 (contd.) 4/14/2017Subprime Mortgage Crisis in 2007 (contd.)As a result, many sponsors (i.e., banks) of the SPEs had to pay off the commercial paper issued by the SPEs when it matures due to the agreements with the transferors.These banks would, therefore, take these subprime mortgage receivables into their balance sheets.
142Subprime Mortgage Crisis in 2007 (contd.) 4/14/2017Subprime Mortgage Crisis in 2007 (contd.)The banks would subsequently recognize losses (i.e., impairment loss on the subprime mortgage receivables) on these receivables.
143SFAS 166 and SFAS 167The concept of qualifying SPE is eliminated by SFAS No.166 issued in June 2009, and became effective as of the beginning of the first annual reporting period beginning after Nov (i.e., January 2010).SFAS 167 redefine variable interest entity and the assessment method in determining the primary beneficiary.
144Consolidation of SPEs (source: KWW textbook , appendix 17B and FIN 46 ( R)). Based on FIN 46 (R) (2003), a SPE is a variable interest entity (VIE ) when1) wirth insufficient equity (i.e., thinly capitalized), or2) with equity holders cannot make decisions, or3) with equity holders have in-proportionate controlling interest (i.e., holding 60% of voting rights but receiving 20% of benefits).
145Consolidation (contd.) (source: KWW textbook , appendix 17B and FIN 46 ( R)). Once an entity is identified as a VIE, a risk-and-reward model, not the voting-interest-model, is used in determining the consolidation party.The voting-interest-model: the party with more than 50% of voting rights of an entity should consolidate the entity (ARB 51).
146Consolidation (contd.) (source: KWW textbook , appendix 17B and FIN 46 ( R)). The risk-and-reward model of FIN 46 (R ): the party who assumes majority of the risks and receive majority of benefits associated with the entity is the primary beneficiary party and should consolidate the entity.
147Avoiding Consolidation under FIN 46 ( R ) A SPE with at least 10% of the fair value of the total assets invested by a third independent party is considered not thinly capitalized and is a qualifying SPE, not a VIE, under FIN46 (R).A qualifying SPE is not subject to consolidation by the sponsor or transferor under FIN 46 ( R).
148IFRS Insights (Source: KWW 14th e, p428-429) The accounting on reporting related to cash and cash equivalent is essentially the same under both IFRS and GAAP except for the reporting of bank overdrafts, reported as cash under IFRS.The allowance for doubtful accounts sometimes refers as provisions for doubtful accounts.The fair value option is similar under GAAP and IFRS but not identical.Cash and Receivables
149IFRS Insights (contd.)IFRS and GAAP differ in the criteria used to account for transfers of receivables.IFRS focused on risks and rewards and loss of control while GAAP uses loss of control as the primary criterion.Also, IFRS allows partial transfer, GAAP does not.Cash and Receivables