This document provides an overview of accounting concepts related to cash, receivables, and notes receivable. It defines types of cash and cash equivalents, internal controls over cash, and differences between US GAAP and IFRS treatment of cash. It also discusses accounts receivable, allowances for uncollectible accounts, notes receivable, and factors to consider when determining whether a transfer of receivables is a sale or secured borrowing.
2. Page 338 Balances in checking accounts Currency and coins Cash equivalents are short-term, highly liquid investments that can be readily converted to cash. Money market funds Treasury bills Commercial paper Cash Items for deposit such as checks and money orders from customers
3. Internal Control (page 239) Encourages adherence to company policies and procedures Promotes operational efficiency Minimizes errors and theft Enhances the reliability and accuracy of accounting data
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6. Cash Discounts (pages 343-344) (note: gross & net methods) 2/10,n/30 Number of days discount is available Otherwise, net (or all) is due Credit period Discount percent
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8. Cash Discounts (see entries on p.343) Sales are recorded at the invoice amounts. Sales discounts taken are recorded as reduction of revenue if payment is received within the discount period. Gross Method Sales are recorded at the invoice amount less the discount. Sales discounts forfeited are recorded as interest revenue if payment is received after the discount period. Net Method
9. Sales Returns (pages 344-346) Merchandise may be returned by a customer to a supplier. A special price reduction, called an allowance, may be given as an incentive to keep the merchandise. sales revenue and accounts receivable should be reduced by the amount of returns in the period of sale
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17. Notes Receivable – Regular (pages 352-355) A written promise to pay a specific amount at a specific future date. Even for maturities less than 1 year, the rate is annualized.
18. NOTE RECEIVABLE JOURNAL ENTRIES: A) USE EXERCISE 7-12 (PAGE 378) AND, B) TEXT EXAMPLE: PAGE 352-3
31. Receivables Management This ratio measures how many times a company converts its receivables into cash each year. This ratio is an approximation of the number of days the average accounts receivable balance is outstanding. Net Sales Average Accounts Receivable Receivables Turnover Ratio = 365 Receivables Turnover Ratio Average Collection Period =
Chapter 7: Cash and Receivables We begin our study of assets by looking at cash and receivables—the two assets typically listed first in a balance sheet. For cash, the key issues are internal control and classification in the balance sheet. For receivables, the key issues are valuation and the related income statement effects of transactions involving accounts receivable and notes receivable.
Cash includes currency and coins, balances in checking accounts, and items acceptable for deposit such as checks and money orders received from customers. Cash equivalents include short-term, highly liquid investments that are: easily converted into a known amount of cash. close to maturity. not sensitive to interest rate changes. Examples are money market funds, treasury bills, and commercial paper.
The success of any business enterprise depends on an effective system of internal control. Internal control refers to a company’s plan to (a) encourage adherence to company policies and procedures, (b) promote operational efficiency, (c) minimize errors and theft, and (d) enhance the reliability and accuracy of accounting data. From a financial accounting perspective, the focus is on controls intended to improve the accuracy and reliability of accounting information and to safeguard the company’s assets. Recall from our discussion in Chapter 1 that Section 404 of the Sarbanes-Oxley Act of 2002 requires that companies document their internal controls and assess their adequacy . The Public Company Accounting Oversight Board’s Auditing Standard No. 5 further requires the auditor to express its own opinion on whether the company has maintained effective internal control over financial reporting.
In general, cash and cash equivalents are treated similarly under U.S. GAAP and IFRS. One difference relates to bank overdrafts, which occur when withdrawals exceed the available balance. U.S. GAAP requires that overdrafts be treated as liabilities. In contrast, IFRS allows bank overdrafts to be offset against other cash accounts when overdrafts are payable on demand and fluctuate between positive and negative amounts as part of the normal cash management program of the company.
Receivables represent a company’s claims to the future collection of cash, other assets, or services. Accounts receivable result from the credit sales of goods or services to customers. Most businesses provide credit to their customers, either because it’s not practical to require immediate cash payment or to encourage customers to purchase the company’s product or service. Accounts receivable are informal credit arrangements supported by an invoice and normally are due in 30 to 60 days after the sale. They almost always are classified as current assets because their normal collection period, even if longer than a year, is part of, and therefore less than, the operating cycle. We know from prior discussions that receivables should be recorded at the present value of future cash receipts using a realistic interest rate. However, because the difference between the future and present values of accounts receivable often is immaterial, GAAP specifically excludes accounts receivable from the general rule that receivables be recorded at present value. Therefore, accounts receivable initially are valued at the exchange price agreed on by the buyer and seller. Companies frequently offer trade discounts to customers, usually a percentage reduction from the list price. Trade discounts can be a way to change prices without publishing a new catalog or to disguise real prices from competitors. They also are used to give quantity discounts to large customers. A trade discount is recognized indirectly by recording the sale at the net of discount price, not at the list price.
Cash discount terms are typically written in terms such as shown on this slide. This particular discount term would be read as “two ten, net thirty.” The first number represents the discount percentage. The second number represents the discount period. The letter “n” stands for the word net. The last number represents the entire credit period. In this case, if the customer pays within 10 days, then a 2 percent discount may be taken. If not, then all of the amount is due within 30 days.
Some companies use the gross method to record sales. Under the gross method, sales are originally recorded at the full invoice amount. Sales discounts are recorded only if payment is received within the discount period. Sales discounts taken by customers are treated as contra revenue accounts and are deducted from sales revenue to obtain net sales revenue. Other companies use the net method, initially recording sales net of the discount. If a cash discount is not taken within the discount period offered, then the amount of the discount is recorded as interest revenue.
Customers frequently are given the right to return merchandise if they are not satisfied. When merchandise is returned for a refund or for credit to be applied to other purchases, the situation is called a sales return. When practical, a dissatisfied customer might be given a special price reduction as an incentive to keep the merchandise purchased, which is sometimes referred to as a sales allowance. Returns are common and often substantial in some industries such as food products, publishing, and retailing. In these cases, recognizing returns and allowances only as they occur could cause profit to be overstated in the period of the sale and understated in the return period. To avoid misstating the financial statements, sales revenue and accounts receivable should be reduced by the amount of returns in the period of sale if the amount of returns is anticipated to be material. We must account for all returns, including those that occur in the period of sale and those that are estimated to occur in future periods. The returns that occur in the period of sale are easy to account for, but the returns estimated for future periods are more difficult. We reduce sales revenue and accounts receivable for estimated returns by debiting a sales returns account (which is a contra account to sales revenue) and crediting an “allowance for sales returns” account (which is a contra account to accounts receivable). When returns actually occur in a following reporting period, the allowance for sales returns is debited and accounts receivable is credited. In this way, income is not reduced in the return period but in the period of the sales revenue. Note that this process requires that we be able to estimate returns. If we cannot, we may need to defer revenue recognition, as discussed in chapter 5.
Whenever a company extends credit on the sale of merchandise or provides a service on account, there is always the possibility that the customer may not be able to pay the amount due. Bad debts result from credit customers who are unable to pay the amount they owe, regardless of continuing collection efforts. In conformity with the matching principle, bad debt expense should be recorded in the same accounting period in which the sales related to the uncollectible account were recorded. We will accomplish this with the allowance method of accounting for bad debts. The allowance method attempts to match bad debts expense in the period with the related revenue. This method has two advantages: It adheres to the matching principle because the bad debts expense is recorded in the period of the sale, and It reports accounts receivable on the balance sheet at the estimated amount of cash to be collected. Note that, as with sale returns, this process requires that we be able to estimate bad debts. If we cannot, we may need to defer revenue recognition and use the installment or cost-recovery methods, as discussed in chapter 5.
On the balance sheet, the allowance for uncollectible accounts is subtracted from the accounts receivable balance. The reported value is called the net realizable, which is the amount of accounts receivable that we actually think we will collect. How does a company arrive at the estimate for the bad debt expense adjusting entry at the end of the year? There are two methods from which to choose: the income statement approach (percentage of credit sales method). the balance sheet approach (percentage of accounts receivable method). Under the balance sheet approach, there are actually two separate methods a company can use: percent of accounts receivable and aging of accounts receivable. Let’s look at the income statement approach first.
Using the income statement approach, bad debt percentage is based on records of actual uncollectible accounts from prior years’ credit sales. The focus is on determining the amount to record on the income statement as bad debt expense. The income statement approach emphasizes the matching principle by estimating the bad debt expense associated with the current period’s credit sales. When using the income statement approach, we determine the estimated bad debt expense at the end of the period by multiplying current period credit sales by an established bad debt percentage. The bad debt percentage is determined based on past history of the company and current economic trends. Also, the sales transactions included in this computation are typically only the credit sales. There are not any collection issues to consider for cash sales transactions.
When using the balance sheet approach, we focus on the collectibility of accounts receivable to make an estimate of uncollectible accounts. We compute the desired balance in allowance for uncollectible accounts using a percentage of accounts receivable. First, we compute the desired balance in allowance for uncollectible accounts by multiplying the year-end accounts receivable balance times an established bad debt percentage. The bad debt percentage is determined based on past history of the company and current economic trends. Second, because the allowance for uncollectible accounts is a permanent account, it will always have an existing balance. The estimated bad debt expense is the difference between the desired balance in allowance for uncollectible accounts and the existing balance in allowance for uncollectible accounts. After determining the estimated bad debt expense, we make the entry for the amount needed to arrive at the desired balance.
The actual write-off of a receivable occurs when it is determined that all or a portion of the amount due will not be collected. Using the allowance method, the write-off is recorded as a debit to allowance for uncollectible accounts and a credit to accounts receivable. Note that, because both accounts receivable and the allowance for uncollectible accounts are being reduced, the net carrying value of accounts receivable (which is the account receivable minus the allowance) is unchanged. That net carrying value changes when we recognized bad debt expense, not when we write off specific bad debts. Sometimes, after an account receivable has been written off, a customer will send in a payment. When this happens, two entries are necessary. The first entry is required to reverse the write-off and re-establish the account receivable. This entry includes a debit to accounts receivable and a credit to allowance for uncollectible accounts. The second entry records the receipt of cash with a debit to cash and a credit to accounts receivable.
A note is a written promise to pay a specific amount at a specific future date. The following information is included in a note: term of the note, the payee, the maker, the principal amount, and the interest rate. The payee on the note is the recipient of the cash at maturity. The maker on the note is the debtor who owes the money. Most notes receivable have an interest rate associated with them. For the borrower, this is the interest expense that is paid, and for the lender, this is the interest revenue that is received. Interest is calculated as principal times the interest rate times the time the note is outstanding. Time is expressed as a fraction of a year, the number of months out of twelve that the interest period covers.
Sometimes a receivable assumes the form of a so-called noninterest-bearing note. The name is a misnomer, though. Noninterest-bearing notes actually do bear interest, but the interest is deducted (or discounted) from the face amount to determine the cash proceeds made available to the borrower at the outset.
In general, IFRS and U.S. GAAP are very similar with respect to accounts receivable and notes receivable. One difference relates to the “fair value option.” U.S. GAAP allows a “fair value option” for accounting for receivables while IFRS restricts the circumstances in which a “fair value option” for accounting for receivables is allowed. Another difference relates to the treatment of receivables as “available for sale” investments. U.S. GAAP does not allow receivables to be accounted for as “available for sale” investments. For IFRS, in the years between 2010 and 2012, companies may account for receivables as “available for sale” investments under IAS 39 if the approach is elected initially. However, after January 1, 2013, this treatment is no longer allowed. Finally, U.S. GAAP requires more disaggregation of accounts and notes receivable in the balance sheet or notes.
Financial institutions have developed a wide variety of ways for companies to use their receivables to obtain immediate cash. Companies can find this attractive because it shortens their operating cycles by providing cash immediately rather than having to wait until credit customers pay the amounts due. Also, many companies avoid the difficulties of servicing (billing and collecting) receivables by having financial institutions take on that role. Of course, financial institutions require compensation for providing these services, usually interest and/or a finance charge. The various approaches used to finance with receivables differ with respect to which rights and risks are retained by the transferor (the company who was the original holder of the receivables) and which are passed on to the transferee (the new holder, the financial institution). Despite this diversity, any of these approaches can be described as either: A secured borrowing. Under this approach, the transferor (borrower) simply acts like it borrowed money from the transferee (lender), with the receivables remaining in the transferor’s balance sheet and serving as collateral for the loan. On the other side of the transaction, the transferee recognizes a note receivable. A sale of receivables. Under this approach, the transferor (seller) “derecognizes” (removes) the receivables from its balance sheet, acting like it sold them to the transferee (buyer). On the other side of the transaction, the transferee recognizes the receivables that it obtained and measures them at their fair value.
In many financing arrangements involving receivables it is unclear whether the transaction is a sale or a borrowing. The basic issue that determines the substance of the transaction is the degree to which control of the surrendered receivables has been transferred. Regardless of how the transaction is characterized, control is judged to have been transferred, and the transaction is treated as a sale of the receivables, if all of these three conditions are met: the receivables are isolated from transferor. the transferee has right to pledge or exchange the receivables. the transferor does not have control over the receivables. The transferor does not have control over the transferred receivables if the: Receivables cannot be repurchased by the transferor before maturity. Transferor cannot require return of specific receivables.
Receivables may be sold with or without recourse. When a company sells receivables without recourse, the: transaction is essentially treated just like an ordinary sale of any other asset. factor (transferee) assumes all of the risk of uncollectibility. control of the receivable passes to the factor. receivables are removed from the books, fair value of cash and other assets received is recorded, and a financing expense or loss is recognized. When a company sells receivables with recourse, the transferor (seller) retains risk of uncollectibility, if the transaction fails to meet the three conditions necessary to be classified as a sale, it will be treated as a secured borrowing.
To summarize, transfers of a receivable may be accounted for as either a sale of a secured borrowing. Transferors usually prefer to use the sales approach rather than the secured borrowing approach because the sales approach which removes the receivable will make the transferor seem less leveraged, more liquid, and perhaps more profitable than the secured borrowing approach. First, companies must distinguish whether the arrangement to finance with receivables is a transfer of specific receivables of simply a pledging of receivables in general as collateral for a loan. If it is a transfer of receivables, the critical element is the extent to which the company surrenders control over the assets transferred. GAAP requires three conditions to determine if control has been surrendered: Transferred assets have been isolated from the transferor—beyond the reach of the transferor and its creditors. Each transferee has the right to pledge or exchange the assets it received. The transferor does not maintain effective control over the transferred assets. If these three conditions are met, the transfer may be recorded as a sale which means that the receivables are removed from the books, proceeds are recorded, and any gain or loss is recognized. If any of the three conditions are not met, the transaction is treated as a secured borrowing.
In many financing arrangements involving receivables it is unclear whether the transaction is a sale or a borrowing. The basic issue that determines the substance of the transaction is the degree to which control of the surrendered receivables has been transferred. Regardless of how the transaction is characterized, control is judged to have been transferred, and the transaction is treated as a sale of the receivables, if all of these three conditions are met: the receivables are isolated from transferor. the transferee has right to pledge or exchange the receivables. the transferor does not have control over the receivables. The transferor does not have control over the transferred receivables if the: Receivables cannot be repurchased by the transferor before maturity. Transferor cannot require return of specific receivables.
The U.S. GAAP and the IFRS approaches often lead to similar accounting treatment for transfers of receivables. Both seek to determine whether an arrangement should be treated as a secured borrowing or a sale, and, having concluded which approach is appropriate, both account for the approaches in a similar fashion. However, where they differ is in the conceptual basis for the choice of accounting treatment and in the decision process required to determine which approach to use.
Now we’ll discuss two ratios that are commonly used by managers, financial analysts and investors to evaluate receivables management. The receivables turnover ratio provides useful information for evaluating how efficient management has been in granting credit to produce revenue. This ratio measures how many times a company converts its receivables into cash each year. A higher receivables turnover ratio is usually consider better than a lower receivables turnover ratio. It is calculated by dividing net sales by average accounts receivable. Average accounts receivable is determined by adding together the beginning and ending accounts receivable balances and dividing this total by two. The average collection period is computed by dividing the number of days in a year by the receivables turnover ratio. This ratio is an approximation of the number of days the average accounts receivable balance is outstanding. A lower average collection period is usually considered to be better than a higher average collection period.