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Intermediate Financial Accounting I Cash and Receivables.

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2 Intermediate Financial Accounting I Cash and Receivables

3 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.

4 Cash and Receivables3 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.

5 Cash and Receivables4 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).

6 Cash and Receivables5 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.

7 Cash and Receivables6 n Liquidity: The amount of time expected to elapse until an asset is converted into cash. n Liquid assets: Assets are available for conversion into cash quickly (i.e., cash, receivables, trading securities, etc..). n Liquidity is an indication of a company’s ability to meet its obligation.

8 Cash and Receivables7 II. Cash n What are included in the cash account? A.Cash on hand: B.Cash in bank:

9 Cash and Receivables8 Cash (contd.) n What are excluded from the cash account (source: FRR No. 1): u Foreign currency with severe restrictions - separate cash account. u Certificates of deposits (CDs) - Temporary Investments. u 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).

10 Cash and Receivables9 Cash (contd.) n What are excluded from the cash account (source: FRR No. 1): u Postdated checks- Receivables. u IOUs - Receivables. u Travel Advances - Prepaids. u Employees’ Advances - Receivables. u Postage stamps -Office supplies. u Special purpose funds - Investments. u Compensating balances - Restricted cash. u Short-term paper a (i.e., commercial paper) - S-T investments. a. Investments with maturity of 3 to 12 months.

11 Cash and Receivables10 Restricted Cash n Compensating balances are examples of restricted cash which may require separate reporting. n Other restricted cash: petty cash, cash for payroll, cash for dividends. If the amount is material, separate reporting is required.

12 Cash and Receivables11 Cash Compensating Balances (CB) n CB: The portion of any deposit maintained by a corporation to support an existing borrowing arrangements (ASR No. 148). n CB will increase the effective interest rate. n CB may also be payment for bank services rendered to the company.

13 Cash and Receivables12 Cash Compensating Balances (contd.) n 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.. n 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”.

14 Cash and Receivables13 Cash Compensating Balances (contd.) n 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.

15 Cash and Receivables14 Other Cash Related Topics n Electronic Fund Transfer (EFT): n Cash Equivalents: short-term, highly liquid investments that are both  Readily convertible to known amount of cash, and  So near their maturity that they present insignificant risk of change in value.

16 Cash and Receivables15 Cash Equivalents (CEs) u In general, only investments with original maturity of three months or less qualify under these definitions. u Examples: Treasury bills, Commercial paper, and Money Market Funds. u 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.

17 Cash and Receivables16 Cash Equivalents (CEs) u 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 u This is how the holders of these notes argued to present them as CEs. u 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.

18 Cash and Receivables17 Cash Equivalents (CEs) u FASB is considering to separate reporting of cash from CEs. u In July 2010, FASB staff proposed to report cash equivalents (i.e., money market fund) as short-term investments. u This project was reassessed as a low priority project and no action was taken recently.

19 Cash and Receivables18 Cash Using Bank Account u General checking accounts u Imprest bank accounts u Lockbox accounts

20 Cash and Receivables19 Cash Management and Control n 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. n 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.

21 Cash and Receivables20 III.Receivables n Receivables: claims held against customers and others for money, goods or services. n Current Receivables: expected to be collected within one year or one operating cycle, whichever is longer.

22 Cash and Receivables21 Receivables (contd.) n 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). n Nontrade Receivables: all others (i.e., interest receivable, advances to employees, deposits to cover potential damages, etc.)

23 Balance Sheet Presentation of Receivables ( Illustration 7-3, KWW, 14 th e) Cash and Receivables22

24 Cash and Receivables23 Trade Receivables n Accounts 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).

25 Cash and Receivables24 Trade Receivables (contd.) n 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.

26 Cash and Receivables25 Trade Receivables (contd.) n Short-term N/R is reported at net realizable value (face amount – allowances for uncollectibles accounts). n 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).

27 Cash and Receivables26 Valuation of A/R & N/R

28 Cash and Receivables27 Adjustments Related to Sales 1. Volume Dis. (Trade Discounts) 2. Cash Discounts (Sales Discounts) 3. Sales Returns and Allowances 4. Uncollectible Accounts

29 Cash and Receivables28 1. Volume Discount n 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 OR A/R 1,900 Sales 1,900

30 Cash and Receivables29 2. Cash Discounts (Sales Discounts) n 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)

31 Cash and Receivables30 2A. Recognized at Time of Sale (Net Price Method) n Sales = $100, terms 2/10, n/30 12/26/x1 A/R98 Sales98 a. 1/2/x2Cash98 A/R98

32 Cash and Receivables31 2A. Recognized at Time of Sale (Net Price Method) (contd.) If discounts were not taken: b. 1/31/x2Cash100 A/R98 Cash 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.

33 Cash and Receivables32 2B. Recognized at time of occurrence (Gross price Method) n Sales = $100, terms 2/10, n/30 12/26/x1 A/R100 Sales100 a. 1/2/x2Cash98 Sales Discounts2 AR100 If discounts were not taken: b. 1/31/x2Cash100 A/R100

34 Cash and Receivables33 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.

35 Cash and Receivables34 3A. The amount of Sales R&A Is Not Significant n If the amount of sales R&A is not significant, sales R&A are recognized at time of occurrence: Sales Returns & Allowancesxxx A/R (or cash)xxx

36 Cash and Receivables35 3B. The Amount of Sales R&A Is Significant and Six Conditions Are Not Met n 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.

37 Cash and Receivables36 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;

38 Cash and Receivables37 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.

39 Cash and Receivables38 3C. The Amount of Sales R&A Is Significant and Six Conditions Are Met n Sales can be recognized in the period in which the sales are made. n Also, at the end of the same period, the amount of sales returns would be estimated and recognized. 10/5/x1 A/R10,000 Sales10,000 12/31/x1 Sales R&A1,000 Allow. for sale R& A1,000 (estimate 10% returns) 1/10/x2 Allowance for sales R&A900 A/R900

40 Cash and Receivables39 4. Uncollectible Accounts n 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 = $2,000 12/31 B/D Expense2,000 Allowance for Doubtful Accounts2,000 When B/D actually occurred: (i.e.,$200 B/D) Allowance for doubtful Accounts200 A/R200

41 Cash and Receivables40 4. Uncollectible Accounts (contd.) If $100 of the B/D recovered: A/R100 Allow. for Doubtful Acct.100 Cash100 A/R100 u The current practice is complied with the matching principle. u The direct write-off method (recognize the B/D expense when it occurs) is not recommended.

42 Presentation of Allowance for Doubtful Accounts Cash and Receivables41

43 Cash and Receivables42 Three 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).

44 Cash and Receivables43 1. Percentage-of-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 Expense400 Allow. for Doubtful Accounts400

45 Cash and Receivables44 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 = $ = 200 Adjusting Entry B/D expense200 Allowance for Doubtful accounts200

46 Cash and Receivables45 3. Aging of A/R Method The balance of the allowance prior to adj.= $100 B/D Expense= $2,300 - $100 = $2,200 Adj. Entry: B/D expense 2,200 Allowance for Doubtful Account. 2,200 AgeAmountB/D%Allowance Amount , , , Over 90 2, Total2,300

47 Cash and Receivables46 Earnings Management n Discretionary accruals require a large degree of managers’ judgment n Managers can use the discretionary accruals to manage earnings. n Examples of discriminatory accruals: bad debt expense, warranty expense, sales returns (when expecting sig. returns), etc.

48 Earnings 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 Receivables47

49 Earnings Management Using Accruals: The Case of Nortel (contd.) Cash and Receivables48

50 Earnings 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 Receivables49

51 Earnings 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,14 th e, p377 and “The Mythical FDIC Fund by William M. Isaac*, AM BKR Final, 8/27/08). Cash and Receivables50

52 Presentation of Receivables (see Illustration 7-23 of KWW 14 th 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 Receivables51

53 Cash and Receivables52

54 Cash and Receivables53 Interest on Receivables n 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.

55 Cash and Receivables54 Interest on Receivables Example A n 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.

56 Cash and Receivables55 Example A (contd.) Journal Entries: 3/1/x1A/R 1,000 Sales1,000 5/1/x1Cash510 A/R500 Interest Revenue10 a 6/1/x1Cash505 A/R500 Interest Revenue5 b a. 1% x 1000 b. (1, ) x 1%

57 Cash and Receivables56 Interest on Receivables Example B n Installment Sales (with Interest): Sales Price = $1,200 CGS = $900 Sales 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 = $322.83

58 Cash and Receivables57 Example B (contd.) n Accrual Method: Journal Entries 5/1/x1A/R1,200 Sales Revenue1,200 8/1/x1Cash A/R Interest Revenue /1/x1Cash A/R Interest Revenue %  1, (1, )  3%

59 Cash and Receivables58 Example B (contd.) 2/1/x2Cash A/R Interest Revenue /1/x2Cash A/R Interest Revenue (1, )  3% 2. (1, )  3% A/R 1, /1/x /1/x /1/x /1/x2

60 Cash and Receivables59 IV. Financing with Accounts Receivable –to accelerate the receipt of cash from receivables n Two ways: n 1. Secured borrowing  Pledge (General Assignment)  Assign (Specific Assignment)  2. Sale of receivables (Factoring)  With recourse  Without recourse

61 Cash and Receivables60 IV. Financing with Accounts Receivable (contd.) n Advantages: 1) Immediate use of cash (i.e., pledge, assign and factor); 2) Avoid the cost of billing and collection (i.e., factor). n Disadvantages: 1) Service charge (i.e., assign and factor); 2) Interest charge (i.e., pledge and assign)

62 Cash and Receivables61 IV. Financing with Accounts Receivable - Reasons n Pledge and Assign: u Cash shortage and other ways of borrowing are not available or too expensive. n Factor: u 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.

63 Cash and Receivables62 IV. Financing with Accounts Receivable – Reasons (Contd.) n Factor (cont.): u To avoid billing and collection costs. u To avoid violation of existing lending agreements. u From a purchaser’s point of view, buying receivables may be an alternative of making profits when reaching its legal lending limit. n Note: Credit card sale is a form of factor without recourse.

64 Cash and Receivables63 Pledge of A/R (General assignment of A/R) n Pledge 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.

65 Cash and Receivables64 Pledge of A/R Example n Borrow $100,000 by pledging all receivables for the borrowing: Journal Entry: Cash100,000 Notes Payable100,000 Notes: The company’s trade accounts are pledged as collateral for the $100,000 notes payable

66 Cash and Receivables65 Pledge of A/R Example (contd.) n When the note is due and paid, the following entry will be recorded: Notes Payable100,000 Interest Expense3,000 Cash103,000 u Assume a 12% interest and a 3-month duration.

67 Cash and Receivables66 Pledge of A/R Example (contd.) n If the note is not paid on the maturity date, the lending institution can seize and collect the pledged A/R. n 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.

68 Cash and Receivables67 Assignment of Accounts Receivable (specific) n Use A/R as a means to borrow money from banks or financial institutions. n Specific A/R are assigned as collateral for the borrowing. n Companies (the borrowers) continue to have the control of the A/R assigned and continue to collect assigned A/R from the customers.

69 Cash and Receivables68 Assignment of Accounts Receivable (contd.) n The amount collected from the assigned A/R must be remitted to the lending institution periodically. n The proceeds collected from the assigned A/R cannot be used for any other purposes until all loans are paid off. n The lender usually charges: 1) a service charge (i.e., 5% of the loan amount), 2) interest on the loan.

70 Cash and Receivables69 Example of (Specific) Assignment (Illustration 7-16 of KWW, 14 th e with little modification for April collections.) n 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.

71 Cash and Receivables70 Example of Assignment (contd.)

72 Cash and Receivables71 Example of Assignment (contd.)

73 Cash and Receivables72 Example of Assignment (contd.)

74 Cash and Receivables73 An Alternative: Accounts Receivable Are Not Transferred to A/R Assigned

75 Cash and Receivables74 Accounts Receivable are Not Transferred to A/R Assigned (cont)

76 Cash and Receivables75 Accounts Receivable are Not Transferred to A/R Assigned (cont.)

77 Cash and Receivables76 Example of Assignment (contd.) n 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$246,000 Notes Payable (66,000) Equity in A/R Assigned $180,000

78 Cash and Receivables77 Sale (Factor) of Accounts Receivable n A common type of sale of A/R is a sale to a factor. n Factors are finance companies or banks that buy receivables from businesses for a fee and then collect the receivables directly from the customers.

79 Cash and Receivables78 Sale (Factor) of Accounts Receivable n In the case of factor, A/R would be transferred to the purchaser. n The buyer would collect the accounts, not the seller. n The seller relinquishes all rights pertaining to the future collection of A/R.

80 Cash and Receivables79 Sale (Factor) of A/R (contd.) n 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. n For some industries, sales financing is necessary in order to be competitive. n Credit card transaction is also a type of factoring arrangement (commission is 4 to 5%).

81 Cash and Receivables80 Sale (Factor) of A/R (contd.) n Credit Card Sale (Contd.) n The buyer (the card issuer) of the receivable charges the seller (the merchant) a commission for the receivables purchased. n The buyer collects directly from customers (card holder).

82 Cash and Receivables81 Accounting for Factor n Factor without recourse n Factor with recourse Recourse is a right of a buyer of receivables to receive payments from the seller when debtors fail to pay.

83 Cash and Receivables82 Factor without Recourse (A Sale of Receivables) n In the case of factor without recourse, the buyer assumes the risk of uncollectibility and absorbs any credit losses (i.e., bad debts). n Thus, factor without recourse is a sale of receivables both in form and in substance.

84 Cash and Receivables83 Example of Factor without Recourse (Source: Illustrations 7-18 Kieso, etc. textbook with some modifications.) n 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.

85 Cash and Receivables84 Example of Factor without Recourse (contd.) Crest Textiles 5/1 Cash460,000 Due from Factor25,000 Loss on Sale of Rec.15,000 A/R 500,000 ABC Bank A/R500,000 Due to Crest Texti.25,000 Interest Rev.15,000 Cash 460,000 Recognition of Bad Debt Exp.: Bad Debt Exp. 4,100 Allow. For Doub. Acct. 4,100

86 Cash and Receivables85 Example of Factor without Recourse (contd.) Crest Textiles. Sales R&A9,500 Sales Dis.2,600 Due from Factor 12,100 ABC Bank Cash483,800 Due to Crest Texti.12,100 A/R 495,900 Allow. for Doub. Acct.4,100 A/R 4,100 Transactions 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.

87 Cash and Receivables86 Example of Factor without Recourse (contd.) Crest Textiles Cash12,900 Due from Factor12,900 ABC Bank Due to Crest Texi12,900 Cash 12,900 Final 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).

88 Cash and Receivables87 Factor with Recourse (source: Kieso, etc. textbook) n 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). n Thus, the seller retains the risk of uncollectibility.

89 Cash and Receivables88 Factor with Recourse n SFAS 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.

90 Cash and Receivables89 Factor 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.

91 Cash and Receivables90 Factor with Recourse (Contd.)  A recourse is an example of “continuing involvement” in a transfer of receivables  In 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.

92 Cash and Receivables91 Example of Factor with Recourse ( Source: illustrations 7-18, 7-19 and 7-20 of Kieso, etc. textbook) n 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.

93 Cash and Receivables Factor with Recourse : Example (Contd.) – All Three Conditions Are Met and Treated As a Sale Crest Textile Cash 460,000 Due from Factor 25,000 Loss on Sale of Receivable 21,000* A/R 500,000 Recourse Liability 6,000 *$21,000= $500,000x3% or Net Proceeds = $460,000+25, =479,000. $21,000 = $500,000 – 479,000 ABC Bank A/R 500,000 Due to 25,000 Crest Interest Rev. 15,000 Cash 460,000

94 Cash and Receivables93 Example of Factor with Recourse (contd.) Crest Textiles. Sales R&A9,500 Sales Dis.2,600 Due from Factor 12,100 Recourse Liability 6,000 Due from Factor 6,000 ABC Bank Cash481,900* Due to Crest12,100 A/R 494,000 Due to Crest 6,000 A/R 6,000 *500,000-12,100-6,000 Transactions 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, ).

95 Cash and Receivables94 Example of Factor with Recourse (contd.) Crest Textile (Treated as a Sale) Cash6,900 a Due from Factor 6,900 ABC Bank Due to Crest 6,900 Cash 6,900 Settlement between Crest and ABC a. $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.

96 Cash and Receivables95 What 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&A9,500 Sales Dis.2,600 Due from Factor 12,100 Recourse Liability 6,000 Due from Factor 5,000 Loss on Sale of Rec. 1,000 ABC Bank Cash482,900* Due to Crest12,100 A/R 495,000 Due to Crest 5,000 A/R 5,000 Transactions 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).

97 Cash and Receivables96 What if only $5,000 bad debts occurred (contd.) : Crest Textile (Treated as a Sale) Cash7,900 a Due from Factor 7,900 ABC Bank Due to Crest 7,900 Cash 7,900 Settlement between Crest and ABC a. $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.

98 Cash and Receivables97 The Profits of the Buyer (Transferee)under Factor With Recourse n 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: n When bad debts=$6,000, the profits of ABC = $489,100-$460,000-$6,900 =$15,000. n When bad debts =$5,000, the profits of ABC=$482, ,000-7,900=$15,000.

99 Cash and Receivables98 V. Notes Receivable n Note receivable: A written promissory note; can be interest bearing or non- interest bearing. n Short-term N/R: Recorded at the amount expected to be collected (i.e., NRV). n Interest bearing: Accrued interest recognized at the end of a period. n Non-interest bearing

100 Cash and Receivables99 Notes Receivable (contd.) n Long-term N/R: 1. Recorded at net present value 2. 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.

101 Cash and Receivables100 Notes Receivable Case I: Non-Interesting Bearing Example n Receiving a 3 month non-interest bearing note on 11/1/x1 with a face amount of $10, /1/x1 N/R10,000 Sales10,000 12/31/x1 No adjusting entry for accrued interest because the note is a non-interest bearing note. 1/31 Cash10,000 N/R10,000 If the note is dishonored on 1/31 => A/R10,000 N/R10,000

102 Cash and Receivables101 Notes Receivable Case II: Interesting Bearing Example n Short-term note with interest bearing; annual interest rate = 12%. n Receiving a 3-month interest bearing note on 11/1/x1. Face amount is $10,000 and the annual interest rate is 12%

103 Cash and Receivables102 Case II (contd.) 11/1/x1 N/R10,000 Sales10,000 12/31/x1 Interest Receivable200 Interest Revenue200 1/1/x2 Reversing Entry: Interest Revenue200 Interest Receivable200 1/31/x2 Cash10,300 N/R10,000 Interest Revenue 300

104 Cash and Receivables103 Discount of Notes (to a bank or to any finance institution) n 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)

105 Cash and Receivables104 11/1/x1 1/31/x2 12/1/x1 Bank is lending $10,300 on 12/1/x1 Bank is receiving $10,300 on 1/31/x2 Discount of Notes (contd.) 1. Maturity value of the note = $10, ,000  12%  3/12 = $10, Interest charged by the bank (discount) = $10,300 x 18% x 2/12 = $309

106 Cash and Receivables105 Discount of Notes (contd.) n Proceeds received by the firm from discounting the note (the bank will deduct the interest charge from the proceeds): $10, = $9,991

107 Cash and Receivables106 Discount of Notes (contd.) J.E. on 12/1: Cash9,991 Loss on Dis. of Note 109 N/R Discounted10,000 Interest Revenue a 100 a.Interest earned by the firm from holding the note for one month (11/1 ~ 12/1) = $10,000  12%  1/12 =100 Footnote (FASB): Contingent liability of discounted note of $10,000

108 Cash and Receivables107 Discount of Notes (contd.) n On 1/31/x2, the note is paid, the following entry will be recorded: N/R discounted10,000 N/R10,000 If on 1/31/x2, the note is dishonored, the following entry will be recorded: (Assuming the bank charge $10 fee) N/R Discounted10,000 Loss on Dishonored Note10,310 N/R10,000 Cash10,310

109 Cash and Receivables108 Long-Term Notes Receivable Initial Recording: Net present value End of Period: Net present value or the fair value.

110 Cash and Receivables109 Long-Term N/R Example A n 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  =96,620

111 Cash and Receivables110 Long-Term N/R Example A (contd.) 1/1/x1 Notes Receivable100,000 Sales Revenue96,620 Discounts on N/R3,380 F Effective Interest of 20x1 = PV of note on 1/1/x1  12% = ($100, ,380)  12% = 11,594.4

112 Cash and Receivables111 Long-Term N/R Example A (contd.) 12/31/x1 (recording receiving of $10,000 interest) Cash10,000 Discount on N/R 1,594.4 Interest Revenue11,594.4 P.V. of the note on 1/1/x2 = 100,000 - (3, ) = 98,214.4 F Effective Interest of 20x2 = PV on 1/1/x2  12% = 98,214.4  12% = 11,785.7

113 Cash and Receivables112 Long-Term N/R Example A (contd.) 12/31/x2 (recording int. received on 12/31/x2): Cash10,000 Discount on N/R1,785.7 Int. Revenue11, /31/x1 (recording face amount of N/R received on maturity date): Cash100,000 N/R100,000 F Discount on N/R has been amortized to zero after two years of amortization using the effective interest method.

114 Cash and Receivables113 Example B: Notes Received for Property, Goods and Services n 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.

115 Cash and Receivables114 Notes Received for Property, Goods and Services (contd.) J.E.: N/R 93,169 Dis. on N/R23,169 Land30,000 Gain40,000  When 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%..

116 Cash and Receivables115 Notes 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 3 Discount on N/R 7,0007,7008,469 Interest Revenue 7,000 7,

117 Cash and Receivables116 Notes 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..

118 Cash and Receivables117 Long-Term N/R Example B (skip p ) n 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. 12/31/20x12. 12/31/20x /31/20x34. 12/31/20x /31/20x5

119 Cash and Receivables118 Long-Term N/R Example B (contd.) n PV of $18,000 four payments = 18,000  = 55, Thus, the revenue from the services = 18, , = 73, /31/x1 Cash18,000 Notes Receivable72,000 Discount on N/R16,155.9 a Revenue from Services73, a. (18,000  4) - 55, = 16,155.9

120 Cash and Receivables119 Long-Term N/R Example B (contd.) 12/31/x2 (recording install. Payment of $18,000 and the amortization of discount on N/R): Cash18,000 N/R18,000 Discount on N/R6, Interest Revenue 6, a a. Interest Revenue of 20x2 = pv of note on 1/1/x2 (or 12/31/x1)  11% = 55,844.1  11% = 6,142.85

121 Cash and Receivables120 Long-Term N/R Example B (contd.) 12/31/x3 Cash18,000 N/R18,000 Discount on N/R4, Interest Revenue4, a a.Interest Revenue of 20x3 = pv of note on 1/1/x3  11% = (55, , ,142.85)  11% = 43,  11% = 4,838.56

122 Cash and Receivables121 Long-Term N/R Example B (contd.) 12/31/x4 (recording install. Payment of 18,000 and the amortization of discount on N/R): Cash18,000 N/R18,000 Discount on N/R3, Interest Revenue3, a a.Interest Revenue of 20x4 = pv of note on 1/1/x4  11% = (43, , ,836.56)  11% = 30,  11% = 3,390.81

123 Cash and Receivables122 Long-Term N/R Example B (contd.) 12/31/x5 Cash18,000 N/R18,000 Discount on N/R1, Interest Revenue1, a a.Interest Revenue of 20x5 = pv of note on 1/1/x5  11% = (30, , ,390.81)  11% = 16,  11% = 1,783.68

124 Cash and Receivables123 Notes Received for Cash and Other Rights n 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):

125 Cash and Receivables124 N/R Received for Cash and Other Rights (contd.) n J.E. for Greene: N/R100,000 Prepaid Purchase24,868 Cash100,000 Discount on N/R24,868 F The $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.

126 Cash and Receivables125 Fair Value Option (SFAS 159 or ASC )  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.

127 Cash and Receivables126 Fair 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 12/31/2011. 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 12,000 Unrealized holding gain or loss* 12,000 * Reported in the income statement

128 Cash and Receivables127 Fair 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 5,000 Fair Value Adj. – N/R 5,000

129 128 Impairment Measurement and Reporting on Investment in Loan Receivables n A loan receivable impaired when it is probable that it will not collect all amounts due (both principle and interest). n Measurement: n 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.

130 129 Impairment Measurement and Reporting (contd.) n Example (illustration 7B-3 onP355 of KWW textbook): n Carrying amount of investment $100,000 n The PV of expected future cash flows on the investment at 10% historical effective interest rate is $87,566. n The loss on impairment = 100,000 – 87,566 = 12,434.

131 130 Impairment Measurement and Reporting (contd.) n Recording of impairment losses: Bad Debt Expense 12,434 Allowance for Doubtful Accounts 12,434 n Write-off of impaired receivables: Allowance for Doubtful Accounts 12,434 Notes Receivables 12,434

132 Cash and Receivables131 Securitization n A sale of securities (i.e., bonds or commercial paper) backed (collateralized ) by a pool of assets. n 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).

133 132 Securitization (contd.) n Securitizations are popular for two reasons: n 1. Investors have a strong appetite in acquiring collateralized securities. n 2. Companies and lenders with large amounts of receivables have incentives to engage in securitization.

134 133 Securitization Performed by The Company n 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. n The company’s liability will be increased from the increase of bonds payable. n As a result, this transaction will have an adverse effect on its return on assets and debt/equity ratios.

135 134 The Special Purpose Entity n 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). n The SPE serves the purpose of buying receivables from the transferor and issuing securities collateralized on the receivables transferred from the transferor.

136 135 The Special Purpose Entity (contd.) n The SPE can be in the form of a trust, partnership or corporation and is legally distinct from the transferor.

137 136 Procedures 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.

138 137 Procedures of Securitization Performed by A SPE (contd.) n The SPE is served as a “pass through”. n The sponsor of the SPE charges the transferor fees for creating and operating the SPE. n The transferor can continue to service the loan for a fee.

139 138 Off Balance Sheet Financing n SFAS 140 (2000) : If the SPE is a qualifying SPE*,the transferor does not have to consolidate the balance sheet of the SPE. n 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.

140 139 Off Balance Sheet (B/S) Financing (contd.) n With a qualifying SPE, the transferor obtain an off-balance sheet financing. n 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. n.n.

141 140 Subprime Mortgage Crisis in 2007 n Many of the subprime mortgage receivables defaulted in 2007 due to the reckless lending in the early to mid- 2000s. n 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.

142 141 Subprime Mortgage Crisis in 2007 (contd.) n 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. n These banks would, therefore, take these subprime mortgage receivables into their balance sheets.

143 142 Subprime Mortgage Crisis in 2007 (contd.) n The banks would subsequently recognize losses (i.e., impairment loss on the subprime mortgage receivables) on these receivables.

144 143 SFAS 166 and SFAS 167 n The 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). n SFAS 167 redefine variable interest entity and the assessment method in determining the primary beneficiary.

145 144 Consolidation of SPEs (source: KWW textbook, appendix 17B and FIN 46 ( R)). n Based on FIN 46 (R) (2003), a SPE is a variable interest entity (VIE ) when n 1) wirth insufficient equity (i.e., thinly capitalized), or n 2) with equity holders cannot make decisions, or n 3) with equity holders have in- proportionate controlling interest (i.e., holding 60% of voting rights but receiving 20% of benefits).

146 145 Consolidation (contd.) (source: KWW textbook, appendix 17B and FIN 46 ( R)). n 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. n The voting-interest-model: the party with more than 50% of voting rights of an entity should consolidate the entity (ARB 51).

147 146 Consolidation (contd.) (source: KWW textbook, appendix 17B and FIN 46 ( R)). n 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.

148 147 Avoiding Consolidation under FIN 46 ( R ) n 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). n A qualifying SPE is not subject to consolidation by the sponsor or transferor under FIN 46 ( R).

149 IFRS Insights (Source: KWW 14 th e, p )  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 Receivables148

150 IFRS 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 Receivables149

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