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Administrative –Go over Midterm –DQ Multiple Deliverables due Monday Feb 21 st (will be posted today) In Class today and Wed - Cash and Receivables (Ch.

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Presentation on theme: "Administrative –Go over Midterm –DQ Multiple Deliverables due Monday Feb 21 st (will be posted today) In Class today and Wed - Cash and Receivables (Ch."— Presentation transcript:

1 Administrative –Go over Midterm –DQ Multiple Deliverables due Monday Feb 21 st (will be posted today) In Class today and Wed - Cash and Receivables (Ch. 7, Appendix 7A, Ch. 18 pp ) Agenda

2 Chapter 7 & 18 (pp ) Cash, Cash Equivalents, Basic Revenue Recognition & Receivables Cash & Cash Equivalents Cash: Currency and coins held, checks & money orders received, bank account balances Cash Equivalents are short-term, highly liquid investments that are: 1.Readily convertible into known amounts of cash 2.So near maturity that there is no risk of change in valuation from fluctuating interest rates (original maturities of no longer than 3 months) –Ex: T-bills, commercial paper, money market funds

3 Cash Equivalents –Grouped together with cash –reported as the most liquid current asset on the balance sheet Restricted Cash –Disclosed separately –If relates terms of LT liability classify as LT Bank Overdrafts –US GAAP: Disclosed as a current liability unless there are other positive-balance cash accounts at the same bank that it can be netted against –IFRS: Included in cash and cash equivalents if repayable on demand and form a part of an entity’s cash management Reporting Issues with Cash

4 Questions Why are internal controls over cash so important? What is the purpose of controls over cash? Three Key Controls 1)Management oversight and authorization Especially useful in small organizations where the owner can monitor activities (and where there are limited resources to have separation of duties) 2)Separation of duties: Physical control, authorization and record keeping E.g., one employee prepare the deposit slip and make the entry, and another employee will actually make the deposit 3)The bank reconciliation Controls and Cash

5 Example: Hawthorne Co.’s May bank statement is as follows: Balance May 1, 2011$33,240 Deposits 82,140 Checks processed(78,433) Service Chg( 80) NSF checks( 2,187) Balance May 31, 2011$34,680 Hawthorne’s GL cash account has a balance of $35,396 at 5/31/11. A review of the co’s records and the bank statement reveals: Cash receipts not yet deposited totaled $2965 A deposit of $1020 made on 5/31 was not credited to the company’s account until June. All checks written in April have been processed by the bank, but $5536 of checks from May have not. Controls and Cash: Bank Reconciliation

6 Bank Balance to Corrected Balance: Balance per bank statement$34,680 Add: Outstanding deposits 3,985 Less: Outstanding checks (5,536) Corrected cash balance$33,129 Balance per books$35,396 Less: Service charge( 80) Less: NSF checks( 2,187) Corrected cash balance$33,129 Why is this an effective control? Controls and Cash: Bank Reconciliation

7 Recall: Revenue is recognized at the earliest moment that both of the following conditions are met: 1.Earned: The critical event in the process of earning revenue has taken place. (seller) 2. Realized: The amount of revenue that will be collected is reasonably assured and measurable with a reasonable degree of reliability. (buyer) Basic Revenue Recognition

8 Example : On 1/1/07 a magazine publisher receives $300,000 for 1,000 3-year subscriptions. Magazine delivery begins in January. Can the revenue be recognized on 1/1/07? Is the revenue earned? Is the revenue realized? When can the revenue be recognized? Basic Revenue Recognition

9 Hierarchy of matching Direct – match expense to the revenue it helps generate Systematic and rational – match expense to periods in which it helps to generate revenue (indirect cause and effect relation between expense and revenue in periods expected to be benefited) Immediate – expense in period the cost is incurred (i.e. no discernable or measurable future benefit.) Expense Recognition (Matching)

10 1.Revenue Recognition at point of sale (delivery) 2.Revenue Recognition before delivery 3.Revenue Recognition after delivery 4.Revenue Recognition for specific sales transactions – franchises & consignment Timing of Revenue Recognition

11 Revenues from manufacturing and selling are commonly recognized at point of sale. Exceptions: 1.Sales with buyback agreements – No Sale 2.Trade loading and channel stuffing – No Sale 3.Sales when right of return exists (high rates that are not reliably estimable) –Specific criteria to be met Revenue Recognition at Point of Sale

12 When right of return exists all of the following 6 criteria must be met to qualify as sale: 1.Price fixed or determinable at sale date 2.Buyer has paid seller, or is obligated to pay seller, and obligation is not contingent on resale of product 3.Buyer’s obligation to seller would not be changed in event of theft or damage to product 4.Buyer has economic substance apart from the seller 5.Seller does not have significant obligations for future performance to directly bring about resale of product by buyer 6.Seller can reasonably estimate amount of future returns Revenue Recognition at Point of Sale

13 Trade Discounts – reduction in list price for differential volume Cash discounts – reduction in amount owed if paid within a specified period. Possible accounting methods : –Gross method records discounts when taken by customers (most commonly used) –Net method records discounts not taken by customers. Recognition of Accounts Receivable

14 Cash Discounts - Net & Gross Methods Sale of $1,000 of inventory, 2/10, n/30 on 1/1/06, for two scenarios: a) Payment is made on 1/10/06 b) Payment is made on 1/15/06:

15 Short term receivables are reported at their net realizable value (NRV) What is NRV? –less estimated non-collectible accounts –less allowance for returns. Valuation of Accounts Receivable

16 Classification of Accounts Receivable US GAAP: –Must separately disclose material related party receivables (i.e., trade receivables separate from non- trade) IFRS: –Classified on balance sheet as a financial asset –May separately disclose material related party receivables Accounts Receivable: IFRS vs. US GAAP

17 Methods Direct Write-Off Allowance Not based on the matching Based on the matching principle Appropriate only if Must be followed if amounts are not material amounts are material Accounts are written off Estimated; bad debts are when determined non-collectible matched against revenue Estimating Uncollectible Receivables

18 Accounts Receivable Direct write-off (used only if low & infrequent bad debts) Bad debt expense (I/S)XXX AR (B/S - Asset)XXX Indirect (allowance method) In year of the sale: Bad debt expense (I/S)XXX Allowance for bad debts (B/S – Asset)XXX When found to be uncollectible: Allowance for bad debts (B/S – Asset)XXX AR (B/S – Asset)XXX If payment received after account written off: AR (B/S – Asset)XXX Allowance for bad debts (B/S – Asset)XXX Cash (B/S – Asset)XXX AR (B/S – Asset)XXX

19 AR Allowance Methods: Determining the Amount of the Adjustment Percent of Receivables Allowance method Balance-sheet oriented Uses one B/S account (AR) to estimate another B/S account (Allowance) Estimates the ENDING balance in the allowance account Bad debt expense is the “plug” Percent of Sales Allowance method Income-statement oriented Uses one I/S account (revenue) to estimate another I/S account (bad debt expense) Estimates the TOTAL bad debt expense The allowance is the “running total”

20 Allowance Example 1. “Percent of Receivables” method (B/S-oriented) Husky Co. has $60,000 in sales in AR at 12/31/05 is $24,000. Allowance for doubtful accounts at 12/31/05 is $200. What adjusting entry should be made at year end? The company estimates allowance based on 1% of AR 90 days: Amount $24,00010,0008,0004,0002,000 Uncollectible %1%2%5%20% Allow. Est. $860 =

21 Allowance Example (cntd.) 2.“Percent of Sales” method (I/S-oriented) Assume instead that Husky estimates bad debt expense based on 1.5% of sales. Sales$60,000 Uncollectible %1.5% Bad debt expense $900

22 3. % of Sales Method is based on credit sales during the year Example: Crawford Inc. Total sales, 2006: $20,000,000 Credit sales, 2006: $15,000,000 A/R Balance, Dec 31, 2006: $1,900,000 Allow. for bad debt balance (before adjustment) 12/31/06: $62,000 Prior history: 1% of credit sales are uncollectible What is the journal entry to record bad debt expense for 2006 Allowance Examples (cntd.)

23 4. Percent of Receivables Now assume Crawford estimates their Allowance using an A/R aging. Prior collections history is used to estimate the percentage of each category that is uncollectible. AgeBalance % bad 0-30 days1,200,000 x 0.75% = 9, days 500,000 x 8.00%= 40, days 200,000 x 20.00% = 40,000 89,000 What is the adjusting journal entry at year end? Allowance Examples (cntd.)

24 5. Percent of Receivables – Write off ’ s and recovery. At the beginning of 2004, the balance in the Allowance account was $11,000 (CR). During the year, $8,000 of delinquent accounts were written off. Then, $2,000 of these delinquent accounts was ultimately determined to be collectible, and these accounts were collected. Additionally, the 2004 ending balance in A/R was $150,000. If XYZ estimates that 5% of A/R is uncollectible, what adjusting entry would be made to account for the bad debts? What would be the ending balance in the Allowance for Doubtful Accounts account?

25 Short-term accounts receivable are shown at their net realizable value as follows: Accounts Receivable (gross): $ XXX less: Allowance:($ XX) Net Realizable Value: $ XX Or present in line item as: “AR net of $xxx allowance for doubtful accounts” Balance Sheet Representation

26 The holder of accounts or notes receivable may transfer them for cash. The transfer may be either: 1.A secured borrowing (i.e., the “seller” is really borrowing from the transferee) –Holder retains ownership of receivables in a secured borrowing transaction. 2.A sale of receivables –Holder transfers ownership of receivables in a sale (transfers risks of collection). Disposition of Accounts and Notes Receivable

27 Transfers Secured BorrowingSale Without RecourseWith Recourse Accounting for Transfers of Receivables -Seller guarantees payment if debtor does not pay -Factored receivables are written off, but a recourse liability is recognized based on estimate of future payment firm will have to make -Seller has no future obligation -Write-off factored receivables (and recognize any gain / loss)

28 Overall - Receivables remain on the books of the company borrowing money (i.e. – no sale) (and continue to treat A/R as usual (collections, write-off, etc.) Also called “pledged” receivables Transferor: –Records liability –Records a finance charge. –Collects accounts receivable. –Records sales returns and sales discounts. –Absorbs bad debts expense. –Records interest expense on notes payable. –Pays on the note periodically from collections. Secured Borrowing – the Basics

29 Secured Borrowing Example To help overcome a cash shortage, H Software took out a loan with T Bank. H Software used $1000 of A/R as collateral for the loan. T Bank withheld $30 as a finance charge, and forwarded $970 to H Software on July 1. H Software collected the on the accounts on July 31 ($120 were written off), and repaid T Bank on August 2 nd with interest of $50. July 1: Dr. Cash970 Dr. Finance charge 30 Cr.Note Payable1,000 July 31: Dr. Cash880 Dr.Allowance for doubtful accounts120 Cr.A/R1,000 August 2: Dr. Interest Expense 50 Dr. Note Payable1,000 Cr.Cash1,050

30 Factor records the (transferred) accounts as assets in its books. Transferor: –Transfers ownership of receivables to factor. –Records any amount retained by transferee as “due from factor.” This is an amount held back to protect the transferee in case of non- payment by customer –Records loss on sale of receivables. –Records any component liability IF with recourse i.e., any estimated future liability that the transferor will need to pay if customers do not pay (and if the amount held back by the factor is insufficient) Sale of Receivables – the Basics

31 Transfer of Receivables: Sale Without Recourse To help overcome a cash shortage, H Software factored $1,000 of receivables to W Factor on July 1, W Factor withheld $100 pending collectability, and charged H Software $40. The remaining $860 was forwarded to H Software on July 1. W Factor collected on the A/R, without recourse. On August 2 nd, W Factor informed H Software that $75 of the accounts were uncollectible, and W Factor returned to H Software the appropriate payment. Dr. Cash Dr. Due from Factor Dr. Loss on sale of A/R Cr.A/R Dr. Cash Dr. Loss Cr.Due from Factor What if instead, W Factor informed H Software on Aug 2 that it was able to collect all of the AR? What would be the journal entry? Dr. Cash Cr.Due from Factor

32 Transfer of Receivables: Sale With Recourse To help overcome a cash shortage, H Software factored $1,000 of receivables to W Factor on July 1, W Factor withheld $100 pending collectability, and charged H Software $40. The remaining $860 was forwarded to H Software on July 1. W Factor collected on the A/R, but had recourse in case of bad debts. H Software estimated that $150 of the receivables would ultimately be uncollectible. On August 2 nd, W Factor informed H Software that $120 of the accounts were uncollectible, and H Software sent W Factor the appropriate recourse payment. Dr. Cash Dr. Due from Factor Dr. Loss on Sale of A/R (plug) Cr.A/R Cr.Recourse Liability Dr. Recourse Liability Cr.Cash Cr.Due from Factor Cr.Recovery of loss sale What if W Factor informed H Software that $220 of the accounts were uncollectible?

33 On January 1, 2006, Dawson Associates is considering outsourcing the collection of its accounts receivable. The following factoring options are available to Dawson. Speedy Finance, Inc. Under the terms of the agreement, Speedy Finance would pay Dawson 98% of the gross amount of the transferred receivables and Dawson would be responsible to pay Speedy Finance for any uncollectible accounts. Dawson estimates its recourse liability would be $60,000. Speedy Finance will collect the receivables and will have the right to pledge or sell the receivables to another party. Strapped Solutions, Inc. Under the terms of the agreement, Strapped Solutions would pay Dawson 96.5% of the gross amount of Dawson’s receivables without recourse. Strapped Solutions will collect the receivables and will have the right to pledge or sell the receivables to another party. The following information is available from Dawson’s Balance Sheet at Dec. 31, 2005: Accounts Receivable$5,000,000 Allowance for doubtful accounts 80,000 Transfer of Receivables: Dawson Example

34 Prepare the journal entry that Dawson would record on January 1, 2006 if it decides to enter into the agreement with Speedy Finance. Transfer of Receivables: Dawson Example

35 Prepare the journal entry that Dawson would record on January 1, 2006 if it decides to enter into the agreement with Strapped Solutions. Transfer of Receivables: Dawson Example

36 Which alternative should Dawson select if it wants to maximize reported income in 2006? Transfer of Receivables: Dawson Example

37 Notes Receivable Short term N/RLong term N/R Record at face value less allowance Record at present value of cash expected to be collected Recognition of Notes Receivable

38 Why does a company issue a notes receivable? NR provides a stream of cash to the issuer –Principle –interest What gets recorded? –Revenue: Present value cash inflow = fair value transaction –Note Receivable: Amount of the note –Maybe a discount or premium: contra account to the note –Interest revenue: Market rate of interest on the net receivable –Cash received (interest and principle) Long-Term Notes Receivable: The Basics

39 What are the true economics of a transaction involving a note? Consider this example. Several years ago my husband and I purchased a Ford Explorer. The sticker price was $30,000. My husband negotiated it down to $27,000. When we went to pay, we were given two options: 1)Receive a $2000 rebate off the negotiated price, OR 2)Finance for 5 years at 0% interest. Questions: 1) What is the true value of the transaction (i.e, revenue)? 2)Is the loan really at 0% interest? Long-Term Notes Receivable: The Basics

40 To ensure this happens, need to consider interest rates. Interest rates: Stated vs. market –Stated rate = effective (market rate)  note issued at face value –Stated rate < market rate  note issued at a discount. –Stated rate > market rate  note issued at a premium. –The discount or premium is amortized to interest revenue by the effective interest method. Record interest revenue each period using the effective interest method. –Yields steady market rate of interest on net investment in note receivable (i.e., note receivable + premium/discount) Long-Term Notes Receivable: The Basics

41 On December 31, 2007, Nemo, Inc. finished consultation services and accepted in exchange a promissory note with a face value of $600,000, a due date of December 31, 2010, and a stated rate of 6%, with interest receivable at the end of each year. The note is considered to have a market rate of interest of 6%. How much should the Note Receivable be recorded for? What is the fair value of the transaction? –PV of cash interest payments –PV of principle payment Notes Receivable: Stated Rate = Market Rate

42 Table 6-2 (PV of single sum) Periods (n) 3%6%9% Table 6-4 (PV of an ordinary annuity) Periods (n) 3%6%9% Notes Receivable: Stated Rate = Market Rate

43 Fair value of transaction: Interest: Principle: Journal entries Notes Receivable: Stated Rate = Market Rate

44 On December 31, 2007, Nemo, Inc. finished consultation services and accepted in exchange a promissory note with a face value of $600,000, a due date of December 31, 2010, and a stated rate of 3%, with interest receivable at the end of each year. The note is considered to have a market rate of interest of 6%. Is this a discount or a premium? How much should the Note Receivable be recorded for? Notes Receivable: Stated Rate < Market Rate

45 Fair value of transaction: Interest: Principle: Journal entry at 12/31/07 Notes Receivable: Stated Rate < Market Rate

46 N/R: Stated Rate < Market Rate Effective Interest Amortization Date Cash Interest Effective Int Rev Discount Amortized Carrying Amt N/R

47 Journal Entries Notes Receivable: Stated Rate < Market Rate

48 On December 31, 2007, Nemo, Inc. finished consultation services and accepted in exchange a promissory note with a face value of $600,000, a due date of December 31, 2010, and a stated rate of 9%, with interest receivable at the end of each year. The note is considered to have a market rate of interest of 6%. Is this a discount or a premium? How much should the Note Receivable be recorded for? Notes Receivable: Stated Rate > Market Rate

49 Fair value of transaction: Interest: Principle: Journal entry at 12/31/07 Notes Receivable: Stated Rate > Market Rate

50 N/R: Stated Rate > Market Rate Effective Interest Amortization Date Cash Interest Effective Int Rev Premium Amortized Carrying Amt N/R

51 Journal Entries Notes Receivable: Stated Rate > Market Rate

52 This is a special case of a discount. Steps: 1. Determine issue price on notes receivable at implicit rate of interest 2. The discount is amortized to interest revenue by the effective interest method Non-interest Bearing Notes

53 On 1/1/06 Mickey Co. purchases a machine from Mouse. Co. with a list price of $10,000. Mickey signs a non-interest bearing note promising to pay Mouse Co. $10,000 on December 31, The fair value of the machine on 1/1/06 is $7,972. Implicitly, how much interest revenue will Mouse receive over the 2 year period of the note? What is the implicit interest rate on this note receivable? –It is the rate that equates $7972 at t=0 to $10,000 at t=2 –7,972F = 10,000; or F=10,000/7,972 = –In table 6.1, Future Value of 1 (p. 303), the rate is 12% (F=1.2544, n = 2)- Notes Receivable – Non-Interest Bearing

54

55 January 1, 2006: December 31, 2006: December 31, 2007: Notes Receivable – Non-Interest Bearing

56 General Host’s annual accounting period ends on December 31. On July 1, 2004, General sold land having fair market value of $700,000 in exchange for a four-year non-interest bearing promissory note in the face amount of $1,101,460. The land is carried on General’s books at a cost of $620,000. Required: Prepare the journal entry to record the sale of land in exchange for the note. Another Non-Interest Bearing Example

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58 The “Crisis of Credit” When does impairment occur? How is the impairment measured? –Book value less PV future cash flows Impairment of Long-Term Receivables

59 Example: Brillard Properties owes First Prudent Bank $30million under a 10% note with two years remaining until maturity. Due to financial difficulties of the developer, the previous year’s interest of $3million was not paid. First Prudent agrees to 1.Forgive the interest payment from last year 2.Reduce the remaining two interest payments to $2 million each 3.Reduce the principal to $25 million How much impairment loss should be recorded? Assume 10% is market rate of interest. Impairment of Long-Term Receivables

60 Book value of asset: Accrued interest(10% x $30million)$ 3,000,000 Principal 30,000,000 Carrying amount of the receivable$33,000,000 New Value: PV of future interest ($2million x )$3,471,080 PV of principal($25million x.82645)20,661,250 PV of receivable(24,132,330) Loss$8,867,670 Journal Entry Loss on troubled debt restructuring8,867,670 Accrued interest receivable3,000,000 Note receivable ($30,000,000-24,132,330)5,867,670 Impairment of Long-Term Receivables

61 Rules: Segregate different types of receivables if material Offset valuation accounts against gross balance Ensure all receivables are really current Disclose any loss contingencies on the receivables Disclose amounts pledged as collateral Disclose significant concentrations of credit risk Presentation & Disclosure of Receivables

62 What is purpose of analysis? Ratios used AR Turnover = Net Sales/Average net Trade AR Days AR or Average Collection Period = 365 days/AR turnover Analysis of Receivables


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