Cash and Receivables
Chapter
7
Cash and Receivables
Learning Objectives
After studying this chapter, you should be able to:
LO7-1 Define what is meant by internal control and describe some key elements of an internal control system for cash receipts and disbursements.
LO7-2 Explain the possible restrictions on cash and their implications for classification in the balance sheet.
LO7-3 Distinguish between the gross and net methods of accounting for cash discounts.
LO7-4 Describe the accounting treatment for merchandise returns.
LO7-5 Describe the accounting treatment of anticipated uncollectible accounts receivable.
LO7-6 Describe the two approaches to estimating bad debts.
LO7-7 Describe the accounting treatment of short-term notes receivable.
LO7-8 Differentiate between the use of receivables in financing arrangements accounted for as a secured borrowing and those accounted for as a sale.
LO7-9 Describe the variables that influence a company’s investment in receivables and calculate the key ratios used by analysts to monitor that investment.
LO7-10 Discuss the primary differences between U.S. GAAP and IFRS with respect to cash and receivables.
Chapter Highlights
Part A: Cash and Cash Equivalents
Cash includes currency and coins, balances in checking accounts, and items acceptable for deposit in these accounts, such as checks and money orders received from customers. Cash equivalents include such things as certain money market funds, treasury bills, and commercial paper. To be classified as cash equivalents, these investments must have a maturity date no longer than three months from the date of purchase. Cash and cash equivalents usually are combined and reported as a single amount in the current asset section of the balance sheet.
Cash that is restricted in some way and not available for current use usually is reported as investments and funds or other assets. For example, banks frequently ask borrowers to maintain a specified balance in a low-interest or noninterest-bearing account at the bank. These are known as compensating balances. The classification of these balances depends on the nature of the restriction and the classification of the related debt.
U.S. GAAP and IFRS are similar with respect to accounting for cash and cash equivalents. One difference relates to bank overdrafts, which occur when withdrawals from a bank account exceed the available balance. U.S. GAAP requires that overdrafts typically be treated as liabilities. IFRS allows bank overdrafts to be offset against other cash accounts.
Internal Control of Cash
A system of 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. Since cash is the most liquid asset and the asset most easily expropriated, a system of internal control of cash is a key issue.
The Sarbanes-Oxley Act of 2002 requires that companies not only document their internal controls and assess their adequacy, but that their auditors must provide an opinion on management’s assessment. The Public Company Accounting Oversight Board’s Auditing Standard No. 2 further requires the auditor to express its own opinion on whether the company has maintained effective internal control over financial reporting
A critical aspect of an internal control system is the separation of duties. Employees involved in recordkeeping should not also have physical access to assets. For example, in the cash area, the employee or employees who receive checks and make deposits should not be the same as the employee who enters the receipts in the accounting records. Periodic bank reconciliations and the use of a petty cash system are other important control procedures involving cash. These two topics are covered in the appendix to the chapter.
Part B: Current Receivables
Receivables represent a company's claim to the future collection of cash, other assets, or services. Accounts receivable result from the sale of goods or services on account. When a receivable, trade or nontrade, is accompanied by a formal promissory note, it’s referred to as a note receivable.
Initial Valuation of Accounts Receivable
The typical account receivable is initially valued at the exchange price agreed upon by the buyer and seller. Trade discounts are reductions in list prices of goods and services to arrive at the exchange price. Cash discounts, often called sales discounts, on the other hand, reduce the agreed upon exchange price if remittance is made within a specified short period of time. For example, terms of 2/10,n/30 mean that a 2% discount is available to the buyer if paid within 10 days, otherwise full payment is due within 30 days.
There are two ways to record cash discounts, the gross method and the net method.
Illustration
McQuire Company sold merchandise on credit. The invoice price was $5,000, subject to a 2% cash discount if paid within 10 days.
To record the sale and cash collection using the Gross Method:
To record the sale:
Accounts receivable 5,000
Sales revenue 5,000
To record cash collection if made within discount period:
Cash 4,900
Sales discounts (2% x $5,000) 100
Accounts receivable 5,000
To record cash collection if made after discount period:
Cash 5,000
Accounts receivable 5,000
To record the sale and cash collection using the Net Method:
To record the sale:
Accounts receivable 4,900
Sales revenue 4,900
To record cash collection if made within discount period:
Cash 4,900
Accounts receivable 4,900
To record cash collection if made after discount period:
Cash 5,000
Accounts receivable 4,900
Interest revenue (2% x $5,000) 100
Subsequent Valuation of Accounts Receivable — Sales Returns
If sales revenue is recognized at delivery of a product, recognizing sales returns when they occur could result in an overstatement of income in the period of sale. If returns are material, they should be estimated and recorded in the same period as the related sale. This is accomplished by recording adjusting journal entries at the end of an accounting period. For example, if at the end of 2013 a company anticipated that returns in early 2014 from year 2013 sales would be $20,000 (merchandise cost $12,000), the following adjusting entries are recorded:
Sales returns 20,000
Allowance for sales returns 20,000
Inventory - estimated returns 12,000
Cost of goods sold 12,000
Sales returns are a reduction in sales revenue and the allowance for sales returns is a contra account to accounts receivable. When returns occur in the next period, the allowance account is reduced (debited) and accounts receivable also is reduced (credited).
Subsequent Valuation of Accounts Receivable — Uncollectible Accounts Receivable
If material amounts of bad debts are anticipated, the allowance method should be used. The allowance method attempts to estimate future bad debts and match them with the related sales revenue. An adjusting entry records a debit to bad debt expense and a credit to allowance for uncollectible accounts, a contra account to accounts receivable. Actually, bad debt write-offs reduce both accounts receivable and the allowance account.
There are two ways commonly used to arrive at the estimate of future bad debts, the income statement approach and the balance sheet approach. Using the income statement approach, we estimate bad debt expense as a percentage of each period's credit sales. Using the balance sheet approach, we determine bad debt expense by estimating the net realizable value of accounts receivable to be reported in the balance sheet. In other words, the allowance for uncollectible accounts is determined and bad debt expense is an indirect outcome of adjusting the allowance account to the desired balance. An aging of accounts receivable often is used to determine net realizable value.
Illustration
The Zeltech Company uses the allowance method to account for bad debts. At the beginning of 2013, the allowance account had a credit balance of $23,000. Credit sales for 2013 totaled $1,200,000 and the year-end accounts receivable balance was $245,000. During the year, $21,000 in receivables was determined to be uncollectible.
The Income Statement Approach
Assuming that Zeltech anticipates that 3% of all credit sales will ultimately become uncollectible, the following adjusting entries record the write-off of accounts receivable and bad debt expense:
Allowance for uncollectible accounts 21,000
Accounts receivable 21,000
Bad debt expense (3% x $1,200,000) 36,000
Allowance for uncollectible accounts 36,000
Notice that in recording bad debt expense net realizable value was not a determining factor.
The Balance Sheet Approach
Assume that at the end of 2013, an aging of accounts receivable indicated a net realizable value of $205,000. This means that the allowance account at the end of 2013 must have a credit balance of $40,000 to reduce gross accounts receivable of $245,000 to net realizable value of $205,000. After the year 2013 write-offs, the allowance account has a credit balance of only $2,000 ($23,000 beginning balance less write-offs of $21,000). Therefore, bad debt expense for 2013 is $38,000 ($40,000 - 2,000).
Allowance for uncollectible accounts 21,000
Accounts receivable 21,000
Bad debt expense 38,000
Allowance for uncollectible accounts ($40,000 - 2,000) 38,000
Notice that the allowance account is determined directly, and bad debt expense is an indirect outcome of adjusting the allowance account to the desired balance
Accounts receivable is reported in the balance sheet net of the allowance for uncollectible accounts. Using the balance sheet approach from above, Zeltech would report the following in the current asset section of the year 2013 balance sheet:
Accounts receivable $245,000
Less: Allowance for uncollectible accounts (40,000)
Net accounts receivable $205,000
When a receivable that has been written off is subsequently collected, the receivable and allowance should be reinstated. The collection is then recorded the usual way as a debit to cash and a credit to accounts receivable.
If uncollectible accounts are not anticipated or are immaterial, or if it's not possible to reliably estimate uncollectible accounts, the allowance method need not be used. Any bad debts that do arise simply are written off as bad debt expense. This approach is known as the direct write-off method.
Notes Receivable
Notes receivable are formal credit arrangements between a creditor (lender) and a debtor (borrower). Notes receivable are classified as either current or noncurrent depending on the expected payment date(s).
Interest-Bearing Notes
The typical note receivable requires the payment of a specified face amount, also called principal, and interest at a stated percentage of the face amount. These are referred to as interest-bearing notes. Interest on notes is calculated as:
Face amount x Annual rate x Time to maturity
Illustration
Masterson Carpet Company's fiscal year end is December 31. On March 31, 2013, the company sold carpeting to Jacobsen Home Builders. Masterson agreed to accept a $300,000, 12-month, 10% note in payment for the carpeting. Interest is payable at maturity. The following entries record the note and related sales revenue, the accrual of interest on December 31, 2013, and the payment of the note:
March 31, 2013
Note receivable 300,000
Sales revenue 300,000
December 31, 2013
Interest receivable 22,500
Interest revenue ($300,000 x 10% x 9/12) 22,500
March 31, 2014
Cash [$300,000 + ($300,000 x 10%)] 330,000
Interest revenue ($300,000 x 10% x 3/12) 7,500
Interest receivable 22,500
Note receivable 300,000
Noninterest-Bearing Notes
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 from the face amount to determine the cash proceeds available to the borrower at the outset. For example, the Masterson Carpet Company note in the illustration on the previous page could be packaged as a $300,000 noninterest-bearing note with a 10% discount rate. In that case, the $30,000 of interest would be discounted at the outset and the selling price of the carpet would have been $270,000.
March 31, 2013
Note receivable 300,000
Discount on note receivable ($300,000 x 10%) 30,000
Sales revenue 270,000
December 31, 2013
Discount on note receivable 22,500
Interest revenue ($300,000 x 10% x 9/12) 22,500
March 31, 2014
Discount on note receivable 7,500
Interest revenue ($300,000 x 10% x 3/12) 7,500
Cash 300,000
Note receivable 300,000
U.S. GAAP and IFRS treat accounts and notes receivable similarly. One difference is that U.S. GAAP requires separate disclosure of accounts receivable from customers, from related parties, and from others. IFRS does not have that requirement.
Financing With Receivables
Financial institutions have developed a wide variety of methods for companies to use their receivables to obtain immediate cash. Despite this diversity, any of these methods can be described as either:
1. A secured borrowing.
2. A sale of receivables.
Secured Borrowing
These arrangements basically involve the use of receivables as collateral for a loan. The receivables stay on the balance sheet of the company, and they record a liability for the cash that they borrow. You may already be familiar with the concept of assigning or pledging receivables as collateral if you or someone you know has a mortgage on a home. The bank or other financial institution holding the mortgage will require that, if the homeowner defaults on the mortgage payments, the home be sold and the proceeds used to pay off the mortgage debt. Similarly, in the case of an assignment of receivables, nonpayment of a debt will require the proceeds from collecting the assigned receivables to go directly toward repayment of the debt.
Usually, the amount borrowed is less than the amount of receivables assigned. The difference provides some protection for the lender to allow for possible uncollectible accounts. Also, the assignee (transferee) usually charges the assignor an up-front finance charge in addition to stated interest on the collateralized loan. The receivables might be collected either by the assignor or the assignee, depending on the details of the arrangement.
Illustration
On November 1, 2013, the Weintrob Wholesale Fur Company borrowed $300,000 from a local finance company and signed a promissory note. Interest at 10% is payable monthly. Weintrob assigned $350,000 of its receivables as collateral for the loan. The finance company charges a finance fee equal to 2% of the receivables assigned.
Weintrob records the borrowing as follows:
Cash (difference) 293,000
Finance charge expense* (2% x $350,000) 7,000
Liability – financing arrangement 300,000
Weintrob will continue to collect the receivables, record any discounts, sales returns, and bad debt write-offs, but will remit the cash to the finance company, usually on a monthly basis. If $250,000 of the receivables assigned are collected in November, Weintrob records the following entries: