Lecture Intermediate accounting (IFRS/e) - Chapter 7: Cash and receivables

In this chapter, we begin our study of assets by looking at cash and receivables-the two assets typically listed first in a balance sheet. Internal control and classification in the balance sheet are key issues we address in consideration of cash. For receivables, the key issues are valuation and the related income statement effects of transactions involving accounts receivable and notes receivable.

CASH AND

RECEIVABLES

Chapter 7

Cash and Cash Equivalents

Balances incurrent bank accounts

Balances incurrent bank accounts

Internal Control

Encourages adherence to

company policies and procedures

Encourages adherence to

company policies and procedures

Enhances the reliability and

accuracy of accounting data

Enhances the reliability and

accuracy of accounting data

Internal Control Procedures

• Separate responsibilities for receiving cash, recording

cash transactions, and reconciling cash balances.

• Match the amount of cash received with the amount of

cash deposited.

• Close supervision of cash-handling and cash-recording

activities.

Cash Disbursements

• All disbursements, except petty cash, made by check.

• Separate responsibilities for cash disbursement

documents, check authorization, check signing, and record keeping.

• Checks should be signed only by authorized

individuals.

Cash Disbursements

• All disbursements, except petty cash, made by check.

• Separate responsibilities for cash disbursement

documents, check authorization, check signing, and

record keeping.

• Checks should be signed only by authorized

individuals.

Restricted Cash and Compensating Balances

Restricted Cash

Management’s intent to use a certain amount

of cash for a specific purpose – future plant expansion, future payment of debt.

Compensating Balance

Minimum balance that must be maintained in a company’s bank account as support for funds

borrowed from the bank.

Restricted Cash

Management’s intent to use a certain amount

of cash for a specific purpose – future plant expansion, future payment of debt.

Compensating Balance

Minimum balance that must be maintained in a company’s bank account as support for funds

borrowed from the bank.

U.S GAAP vs IFRS

liabilities.

In general, cash and cash equivalents aretreated similarly under IFRS and U.S GAAP One difference

is highlighted below

against other cash accounts

Are recorded net of trade discounts

Cash discounts

Cash Discounts

Number of days discount is available

Number of days discount is available

Otherwise, net (or all)

is due

Otherwise, net (or all)

is due

Credit period

Credit period

Discount percent

Discount percent

Cash Discounts

Cash Discounts

Sales are recorded

at the invoice amounts.

Sales are recorded

at the invoice

amounts.

Sales discounts are recorded as reduction

of revenue if payment is

received within the discount period.

Sales discounts 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 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.

Sales discounts forfeited

are recorded

as interest revenue if payment is received after

the discount period.

Net Method

Cash Discounts

On October 5, Hawthorne sold merchandise for $20,000 with terms 2/10, n/30 On October 14, the customer sent a check for $13,720 taking advantage of the discount to settle $14,000 of the amount

On November 4, the customer paid the remaining $6,000

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 Returns

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

Sales Returns

During the first year of operations, Hawthorne sold $2,000,000

of merchandise that had cost them $1,200,000 (60%) Industry

experience indicates 10% return rate During the year

$130,000 was returned prior to customer payment Record the

returns and the end of the year adjustment

Subsequent valuation of AR: The Incurred Loss Model

The Incurred Loss Model

Notes Receivable

A written promise to pay a specific amount at a specific future date.

Even for maturities less than 1 year, the

rate is annualized.

Even for maturities less than 1 year, the

rate is annualized.

Interest-Bearing Notes

On November 1, 2013, West, Inc loans $25,000 to Winn Co The

note bears interest at 12% and is due on November 1, 2014.

Prepare the journal entry on November 1, 2013, December 31,

2013, (year-end) and November 1, 2014 for West.

Noninterest-Bearing Notes

 Actually do bear interest.

 Interest is deducted (discounted) from the face value of the note.

 Cash proceeds equal face value of note less discount.

Noninterest-Bearing Notes

On Jan 1, 2013, West, Inc accepted a $25,000 bearing note from Winn, Co as payment for a sale The note

noninterest-is dnoninterest-iscounted at 12% and noninterest-is due on Dec 31, 2013

Prepare the journal entries on Jan 1, 2013, and Dec 31, 2013

On Jan 1, 2013, West, Inc accepted a $25,000 bearing note from Winn, Co as payment for a sale The note

noninterest-is dnoninterest-iscounted at 12% and noninterest-is due on Dec 31, 2013

Prepare the journal entries on Jan 1, 2013, and Dec 31, 2013

Subsequent valuation of NR:

Impairment

Subsequent valuation of NR: When Receivable

is Continued but with Modified Terms

When a company holds a receivable from another company, there is some potential

that the receivable will eventually be

impaired

Impairment of a receivable occurs if the company believes it is probable that it

will not receive all of the cash

flows (principal and any interest payments) associated

with the receivable.

Subsequent valuation of NR: When

Receivable is Settled Outright

U.S GAAP vs IFRS

• U.S GAAP allows a “fair value

option” for accounting for

receivables.

• U.S GAAP does not allow

receivables to be accounted for

as “available for sale”

investments.

• U.S GAAP requires more

disaggregation of accounts and

notes receivable in the statement

of financial position or notes

In general, IFRS and U.S GAAP are very similar with respect

to accounts receivable and notes receivable Differences are

highlighted below

• IFRS restricts the circumstances

in which a “fair value option” for accounting for receivables is allowed.

• In the years between 2010 and

2014, companies may account for receivables as “available for sale” investments if the approach is

elected initially After January 1,

2015, this treatment is no longer allowed.

Financing With Receivables

Companies may use their receivables to obtain immediate cash

Factoring Arrangements

FACTOR (Transferee)

ts R ec eiv

A factor is a financial institution that buys receivablesfor cash, handles the billing and collection of thereceivables and charges a fee for the service

Secured Borrowing

Derecognize the receivables

Transfer rights to receive cash

flows from the receivables?

Assume obligations to pay cash flows that meet three

Yes

Yes

Sale of Receivables

Without recourse

• An ordinary sale of receivables to the factor

• Factor assumes all risk of uncollectibility

• Control of 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

Without recourse

• An ordinary sale of receivables to the factor

• Factor assumes all risk of uncollectibility

• Control of 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

With recourse

• 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

With recourse

• 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

Sale of Receivables

In December 2013, the Santa Teresa Glass Company factored accounts receivable that had a book value of $600,000 to Factor Bank The transfer was made without recourse Under this arrangement, Santa Teresa transfers the $600,000 of receivables to Factor, and Factor immediately remits to Santa Teresa cash equal to 90% of the factored amount (90%

× $600,000 = $540,000) Factor retains the remaining 10% to cover its factoring fee (equal

to 4% of the total factored amount; 4% × $600,000 = $24,000) and to provide a cushion against potential sales returns and allowances

Assume the same facts as above, except that Santa Teresa sold the receivables to Factor

with recourse and estimates the fair value of the recourse obligation to be $5,000.

Sale of Receivables

Securitization: Transfer receivables to a SPE

Special Purpose Entity (SPE)

(usually a trust or subsidiary)

Qualifying Special Purpose Entity (QSPE)

Changing rules…eliminate QSPE…require

consolidation!

Participating Interests: Transfer portion of a

receivable

Example: transfer right to interest, but retain right to principal

Changing rules…require a partial transfer be treated

as a secured borrowing, unless specific conditions

are met!

Interest receivable 5,000

Transfers of Notes Receivable

On December 31, Stridewell accepted a nine-month 10

percent note for $200,000 from a customer Three months later on March 31, Stridewell discounted the note

at its local bank The bank’s discount rate is 12 percent

Transfers of Notes Receivable

U.S GAAP vs IFRS

• U.S GAAP focuses on whether

control of assets has shifted

from the transferor to the

transferee

The U.S GAAP and the IFRS approaches often lead to similar accounting treatment for transfers

of receivables

• IFRS requires a more complex

decision process The company has to have transferred the

rights to receive the cash flows from the receivable, and then considers whether the company has transferred “substantially all

of the risks and rewards of ownership,” as well as whether the company has transferred control.

This ratio measures how many times a company converts its receivables into cash each year.

Net Sales Average Accounts Receivable

Receivables Turnover Ratio

=

This ratio is an approximation of the number of days the average accounts receivable balance is outstanding.

365 Receivables Turnover Ratio

Average Collection Period

=

Receivables Management

Symantec Corp vs CA, Inc comparison

(All dollar amounts in millions)

Symantec Corp CA, Inc Industry Average Receivables Turnover 6.61 4.98 5.96

Appendix 7-A: Cash Controls

Bank Balance + Deposits in Transit

- Outstanding Checks

± Bank Errors

= Corrected Balance

Book Balance + Bank Collections

- Service Charges

- NSF Checks

± Book Errors

= Corrected Balance

A bank reconciliation explains the difference between cash reported on

bank statement and cash balance on a company’s books.

Petty cash is used for minor expenditures.

Has one custodian.

Replenished periodically.

Petty cash

fund

Appendix 7-A: Cash Controls

Appendix 7-B: Methods for Estimating

Future Bad Debts

Bad debts result from credit customers who are

unable to pay the amount they owe, regardless of continuing collection efforts.

Bad debts result from credit customers who are

unable to pay the amount they owe, regardless of continuing collection efforts.

PAST DUE

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.

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.

Appendix 7-B: Methods for Estimating

Future Bad Debts

Most businesses record an estimate of the

bad debt expense by an adjusting entry

at the end of the accounting period.

Most businesses record an estimate of the

bad debt expense by an adjusting entry

at the end of the accounting period.

Allowance for uncollectible accounts xxx

Contra asset account to Accounts Receivable.

Normally classified as

a selling expense and

closed at year-end.

Allowance for Uncollectible Accounts

Net realizable value is the amount of the accounts

receivable that the business expects to collect.

◦Composite Rate

◦Aging of Receivables

Income Statement Approach

Balance Sheet Approach

◦Aging of Receivables

Income Statement Approach

• Focuses on past credit sales to make

estimate of bad debt expense.

• Emphasizes the matching principle by

estimating the bad debt expense associated with the current period’s credit sales.

• Focuses on past credit sales to make

estimate of bad debt expense.

• Emphasizes the matching principle by

estimating the bad debt expense associated with the current period’s credit sales.

Bad debt expense is computed as follows:

In 2013, MusicLand has credit sales of $400,000 and estimates that 0.6% of credit sales are uncollectible.

What is Bad Debt Expense for 2013?

Income Statement Approach

MusicLand computes

estimated Bad Debt

Expense of $2,400.

Allowance for uncollectible accounts 2,400

Balance Sheet Approach

• Focuses on the collectability of accounts receivable

to make the estimate of uncollectible accounts.

• Involves the direct computation of the desired

balance in the allowance for uncollectible accounts

• Focuses on the collectability of accounts receivable

to make the estimate of uncollectible accounts.

• Involves the direct computation of the desired

balance in the allowance for uncollectible accounts

Compute the desired balance in the Allowance for Uncollectible Accounts.

On Dec 31, 2013, MusicLand

has $50,000 in Accounts Receivable and a $200 credit

balance in Allowance for Uncollectible Accounts

Past experience suggests that

balance in Allowance for

Desired balance in Allowance

for Uncollectible Accounts

Balance Sheet Approach

Composite Rate

Allowance for uncollectible accounts 2,300

Each age grouping has a different likelihood

of being uncollectible.

Each age grouping has a different likelihood

of being uncollectible.

 Compute desired uncollectible amount.

 Compute desired uncollectible amount.

Balance Sheet Approach

Aging of Receivables

Compare desired uncollectible amount with

the existing balance in the

allowance account.

Compare desired uncollectible amount with

the existing balance in the

allowance account.

 Year-end Accounts Receivable is broken

down into age classifications.

 Year-end Accounts Receivable is broken

down into age classifications.

Balance Sheet Approach

Aging of Receivables

• EastCo’s unadjusted balance

in the allowance account is

$500.

• Per the previous computation,

the desired balance is $1,350.

in the allowance account is

$500.

the desired balance is $1,350.

Uncollectible Accounts

As accounts become uncollectible, this entry is made:

When a customer makes a payment after an account has

been written off, two journal entries are required.

Allowance for uncollectible accounts 500