1. Intermediate Accounting
Chapter 6
Cash and Receivables
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2. Cash and Cash Equivalents
Cash, the most liquid of all assets, is the resource used to engage in day-to-day business transactions and take advantage of business opportunities when they arise.
coins and currency
unrestricted funds on deposit with a bank (including foreign currency deposits)
negotiable instruments (such as checks)
bank drafts
undeposited credit card sales receipts
Cash equivalents are short-term, highly liquid investments that are readily convertible into known amounts of cash and so near their maturity (90 days or less) that there is little risk of changes in value because of changes in interest rates.
commercial paper, treasury bills, and money market funds are examples of cash equivalents
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3. Non-Cash Items
Sinking funds are accounts into which a company deposits cash over an extended period (e.g., to retire long-term bonds). Sinking funds are normally reported as long-term investments.
Certificates of deposit (CDs) are financial instruments issued by banks that allow a company to invest idle cash for contractual periods (short-term or long- term investments).
Bank overdrafts are overdrawn checking accounts. They are reported as current liabilities.
Postdated checks from customers are checks dated in the future so they become payable on a date later than the issue date. Postdated checks are included as receivables.
Travel advances are funds or checks given to employees to cover out-of-pocket expenses while traveling on company business and are classified as prepaid items.
Required deposits called compensating balances because they “compensate” the bank for granting the loan.
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4. Classification of Cash and Noncash Items
Coins and currency
Cash
Demand deposits (checking and savings accounts)
Negotiable instruments (bank drafts, money orders)
Foreign currencies on deposit in foreign banks
Sinking funds
Long-term investment
Certificates of deposit
Short-term (or long-term) investments
Bank overdrafts
Current liabilities
Postdated checks
Receivables
Travel advances
Prepaid expenses
Compensating balances
Current or noncurrent asset
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5. Cash Control Procedures
Control Over Receipts: Should be designed to safeguard all cash inflows from the time they arrive at the company until they are deposited in its bank account.
immediate counting of receipts by the person opening the mail or the salesperson using the cash register, and subsequent verification by an independent person
daily recording of all cash receipts in the accounting records
daily deposit of all receipts in the company’s bank account
Control Over Payments: Should ensure that only authorized payments are made for actual company expenditures
making all payments by check so there is a record for every company expenditure
authorizing and signing checks only after an expenditure is approved
periodically reconciling the cash balance in the bank statement with the company’s accounting records
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6. Electronic Payments
Electronic funds transfers (EFT) transfers cash between companies electronically without the need for a check
Accounts receivable conversion (ARC) allows for faster processing of checks. When paper checks arrive at a lockbox, they are converted into electronic payments, and the check itself is destroyed
Check Clearing for the 21st Century Act (termed Check 21) is a law that allows merchants to scan checks and transmit the digital images to the bank instead of sending the actual check
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7. What are the Different Types of Receivables?
Receivables are amounts owed to the company by customers and other parties arising from the company’s operations
Those receivables expected to be collected within one year or the current operating cycle, whichever is longer, are classified as current assets; the remainder are classified as noncurrent
Trade receivables arise from the sale of the company’s products or services to customers
Notes receivable arise when customers sign debt obligations with terms different from standard trade receivables
Nontrade receivables arise from transactions that are not directly related to the sale of the company’s goods and services
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8. Overview of Receivables
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9. How are Accounts Receivable Recorded?
The initial recognition of accounts receivable involves the proper application of the revenue recognition criteria, as well as consideration of any trade discounts or cash discounts, and sales returns and allowances.
Revenue is recognized when realization has occurred and the revenue is earned.
Revenue recognition criteria are usually satisfied when the product or service is delivered. Therefore, credit sales trigger recognition of both an asset (an account or note receivable) and revenue.
There are two issues related to the valuation of receivables:
initial recording of the receivables… present value versus maturity value (maturity value most common)
estimation of the probability of collection… normally reported at net realizable value
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10. Trade Discounts and Cash (Sales) Discounts
Companies frequently offer trade discounts (or quantity discounts) to purchasers as a means to provide incentives to important customers, grant price reductions for large purchases, or to hide real prices from competitors.
Trade discounts are usually given as a percentage reduction of the list price of a product.
Companies may also offer a cash discount (or sales discount) to induce prompt payment. This discount frequently is expressed using terms such as 2/10, n/30.
Cash discounts have two main positive effects:
stimulates faster collection of cash for use in current operations.
tends to reduce the losses resulting from uncollectible accounts.
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11. Gross and Net Price Methods (Slide 1 of 2)
If a selling company extends cash discounts to its customers, it may use either the gross or net price method to account for the discounts
When using the gross price method, record the total invoice price in both the Accounts Receivable and Sales accounts at the time of sale as if no cash discount were involved.
When the customer pays and takes the allowable cash discount, the company records the difference between the cash received and the original amount of Accounts Receivable as a debit to Sales Discounts Taken.
Sales Discounts is a contra-revenue account.
The gross price method is more popular because it requires less record keeping.
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12. Gross and Net Price Methods (Slide 2 of 2)
When using the net price method, records the net invoice price (after deducting the allowable cash discount) in both the Accounts Receivable and Sales accounts at the time of sale.
When the customer pays and takes the allowable cash discount, no adjustment is needed because the amount of cash received is equal to the recorded amount of the receivable. However, if the customer does not take the cash discount, it pays an amount that is greater than the amount in the company’s Accounts Receivable account. The company credits this excess to an account entitled Sales Discounts Not Taken
This account is an interest income account that is reported in the Other Items section of the income statement
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13. Sales Returns and Allowances
When the customer returns goods to the seller, the exchange is called a sales return.
In addition, when goods are sold that turn out to be defective, the customer may retain the goods and be allowed a reduction in the purchase price. This reduction is called a sales allowance.
If a company can make reliable estimates, it should record the estimated amount of future returns and allowances in the period of sale to correctly report net sales revenue and appropriately report the net realizable value of ending accounts receivable.
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14. How are Uncollectible Accounts Receivable Valued? (Slide 1 of 2)
Not all accounts receivable will be collected, some will become bad debts. This uncertainty about the collectibility of accounts receivables represents a loss contingency.
GAAP requires companies to estimate their losses from loss contingencies and deduct the amounts from income and assets when both of the following conditions are met:
Information available prior to the issuance of the financial statements indicates that it is probable that an asset has been impaired at the date of the financial statements.
The amount of the loss can be reasonably estimated.
Because both conditions normally are met in regard to uncollectible accounts, most companies estimate bad debts in their financial statements.
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15. How are Uncollectible Accounts Receivable Valued? (Slide 2 of 2)
A company can record uncollectible accounts (bad debts) by either of two procedures:
Allowance Method: Companies record uncollectible accounts in the year of sale, based upon an estimate of the amount of uncollectible accounts.
Direct Write-Off Method: Companies record uncollectible accounts when they determine that a specific customer account is uncollectible.
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16. Allowance Method (Slide 1 of 2)
Under the allowance method, a company attempts to forecast the expected future bad debts in accounts receivable (i.e., a forecast of credit risk).
An organization can use multiple methodologies, including historical bad debts it has incurred, its credit risk strategy and policy, industry-wide experiences, and historical trends and economic conditions.
It compares this information to its current sales or accounts receivable to determine relationships to use to estimate its current uncollectible accounts.
These relationships provide the information the company needs to prepare the adjusting entry to adjust the accounts receivable to the appropriate net realizable value and recognize the estimated bad debt expense for the period.
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17. Allowance Method (Slide 2 of 2)
When the company records the estimate of bad debts, the journal entry is a debit to Bad Debt Expense and a credit to Allowance for Doubtful Accounts (alternatively, Allowance for Bad Debts or Allowance for Uncollectible Accounts).
Bad debt expense is normally reported on the income statement as an operating expense.
Allowance for Doubtful Accounts is a valuation (contra) account that is offset against Accounts Receivable in the current assets section of the company’s balance sheet.
Offsetting Allowance for Doubtful Accounts against Accounts Receivable informs financial statement users of the net realizable value (the amount of cash expected to be collected) of the company’s receivables.
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18. Estimating Bad Debt
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19. Percentage of Credit Sales and Percentage of Outstanding Accounts Receivable
Estimating bad debts based on the relationship to credit sales matches current bad debt expenses against current credit sales.
This income statement oriented method results in recording bad debt expense in the period during which credit sales occur
Percentage of Outstanding Accounts Receivable
Bad debts may be estimated based on the relationship between the actual amounts not collected and accounts receivable (balance sheet oriented)
The goal is to determine the ending balance in Allowance for Doubtful Accounts, and therefore the appropriate net realizable value of Accounts Receivable
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20. Aging of Accounts Receivable and Writing Off Uncollectible Accounts
Individual accounts receivable are classified based on the length of time they have been outstanding.
An estimate of the allowance for bad debts is computed by applying appropriate bad debts percentages to each age category.
Writing off uncollectible accounts
When a company determines that an individual account is uncollectible, it writes off that account, removing it from Accounts Receivable (credit) and a debit to Allowance for Doubtful Accounts.
This write-off has no effect on the net realizable value of the accounts receivable because the allowance account and the accounts receivable balance are reduced by the same amount.
The allowance for uncollectible accounts is an estimate and always involves future uncertainties.
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21. Collection of an Account Previously Written Off
Most accountants favor reestablishing the customer’s account receivable and then recording the payment.
The first entry “reverses” the initial write-off and the second entry records the cash collection in the usual manner
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22. Direct Write-Off Method
The direct write-off method, records bad debt expense when it is determined that a specific customer account is uncollectible. At that time, it writes off the account by debiting Bad Debt Expense and crediting Accounts Receivable.
While this method is simple to apply, it has the disadvantage of matching the bad debt expenses associated with previous sale against revenues of the current period. It also overstates accounts receivable associated with previous sales.
Furthermore, it allows earnings management because the company selects the period of write-off (and expense). For these reasons, the direct write-off method is generally not allowed under GAAP.
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23. Financing Accounts Receivable
Turning accounts receivable into cash is a popular funding opportunity for businesses.
The two basic forms of financing agreements that companies use to obtain cash from accounts receivable are:
secured borrowing (pledging or assigning)
sale of receivables (factoring, securitizations)
The accounting issue for transfers of receivables and other financial assets revolves around who possesses (owns) the benefits and risks associated with the transferred assets.
In a transfer with recourse, the transferor retains the risk of ownership and bears any loss from a nonpayment of receivables.
In a transfer without recourse, the transferee has assumed all the risks of ownership and bears any loss from a nonpayment of receivables.
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24. Accounting for Transfers of Accounts Receivable
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25. Secured Borrowing
In a secured borrowing, a company may assign or pledge its accounts receivable as collateral for a loan. If the company is unable to make payments on the loan, the creditor can require the amounts collected from the accounts receivable be used to repay the amount owed.
Under a basic assignment agreement, the borrowing company (assignor) usually retains ownership of the assigned accounts, incurs any bad debts, collects the amounts due from customers, and uses these funds to repay the loan.
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26. Sale of Accounts Receivable (Slide 1 of 2)
Factoring is when a company sells its individual accounts receivable to a financial institution (called a factor). At the time of sale, the factor charges the selling company a commission based who bears the risk of noncollection.
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27. Sale of Accounts Receivable (Slide 2 of 2)
In a Securitization, accounts receivable are transferred to another entity, usually a trust or subsidiary and then sold as financial securities (usually debt instruments) collateralized by the accounts receivable. Investors receive cash as the accounts receivable are paid.
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28. Disclosure of Financing Agreements of Accounts Receivable
A company should disclose the existence of the transfer of accounts receivable parenthetically or in the notes to its financial statements. In general, management should provide disclosures that allow financial statement users to understand:
the transferor’s continuing involvement, if any, with the transferred assets
the nature of any restrictions on transferred assets that are reported on the balance sheet
how servicing assets and liabilities are reported
how the transfer of financial assets affect a company’s balance sheet, income statement, and statement of cash flows
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29. How do Companies Account for Notes Receivable?
A note receivable is an unconditional written agreement that gives the holder the right to collect a certain sum of money on a specific date. Notes receivable generally have two attributes that accounts receivable do not have:
They are negotiable instruments, which means that they are legally transferable among parties and may be used to satisfy debts by the holders of these instruments.
They usually involve interest, requiring the separation of the receivable into its principal and interest components.
A company may receive two types of short-term notes receivable: (1) interest-bearing notes and (2) non-interest-bearing notes.
When an interest-bearing note is issued, the amount borrowed (the principal) is listed as the face value, and the interest charged is stated as a specific rate applied to this face value.
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30. Sales or Assignments of Notes Receivable
When a company sells or assigns a customer’s note receivable at the bank, it transfers the note in exchange for cash.
This financing arrangement is subject to the conditions as accounts receivable sales. If all the conditions are met, the company records the transfer as a sale.
The discount is determined by multiplying a discount rate, which is the interest rate charged by the financial institution, times the maturity value of the note for the discount period (Maturity Value × Rate × Time).
Any gain or loss from the discounting is computed by comparing the current book value of the note receivable (including accrued interest revenue) plus any recourse liability to the proceeds received
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31. How Are Receivables Disclosed?
In order to improve the reporting of a company’s risk, liquidity, and financial flexibility, companies are required to disclose:
any accounting policies related to their receivables that might be helpful to external users
major categories of receivables, either in the balance sheet or in the notes to the financial statements
any valuation accounts (e.g., allowance for doubtful accounts) as well as the methodology used to estimate these amounts
any receivables designated as collateral the fair value of all its financial instruments, either on the balance sheet or in the notes
all significant concentrations of credit risk due to its financial instruments
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32. Internal Controls for Cash: Petty Cash
A petty cash system involves a cash fund under the control of an employee that enables a company to pay for small amounts that might be impractical or impossible to pay by check.
Step 1. An employee is appointed petty cash custodian, and the petty cash fund is established. A journal entry is recorded to reduce cash and increase petty cash.
Step 2. Petty cash vouchers are printed, prenumbered, and given to the custodian of the fund. The vouchers are used as evidence of expenditures. The total of the cash in the fund plus the amounts of the vouchers should be equal to the original amount of the fund.
Step 3. When the amount of cash in the petty cash fund becomes low and/or at the end of an accounting period, the vouchers are sorted into expense categories and the remaining cash is counted. The expenses are then recorded, and the fund is replenished.
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33. Bank Reconciliation
A bank reconciliation is an analysis of the difference between the ending cash balance in its accounting records and the ending cash balance reported on its bank statement
The bank statement and the company’s accounting records usually will not be in complete agreement due to timing differences and errors, including the following:
outstanding check
deposit in transit
Charges Made Directly by the Bank (NSF or not-sufficient- funds)
Deposits Made Directly by the Bank
Errors
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