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Chapter 7 Cash: What is it?

Coins, currency, funds on deposit (checking and savings), money orders, cashiers checks, personal checks, bank drafts, petty cash Cash Equivalents: Very short term investments, highly liquid, maturities of 3 months or less Reporting Cash: 3 Issues 1. Restricted Cash If restricted to support short-term borrowing (this could be a compensating balance), then that amount must be reported separately among the cash and cash equivalents item in current assets If compensating balance supports long-term borrowing, then its separately classified as non-current asset in either investments or other assets Other types of restrictions if restricted for a long time (outside of current period), then its classified as non-current Subject to materiality constraint 2. Bank Overdrafts when a check is written for more than the amount in cash account -reported as a current liability usually added to accounts payable -usually not offset against cash unless there is another account in the same bank 3. Cash Equivalents highly liquid (1) readily convertible to cash (2) so close to maturity that they have insignificant risk of change in interest rates i.e. 3 month maturity or less T Bills, commercial paper, money market Receivables claims against customers for money, goods or services Trade Receivables A/R oral promises N/R written, often with interest Non-Trade loans to officers, deposits, advances to subsidiary dividends receivable and interest receivable generally classified and reported as separate items on Balance Sheet Because theyre short term, we do not record at their present value (i.e., discount the receivable to its present value) or recognize interest on them

Recognition Issues A) Trade Discounts or Quantity Discounts These are deductions from Gross Billing amount Ex. HP sells a server for $12,000 Offers Trade Discount of 10% -1,200 $10,800 HP would record receivable of $10,800, not $12,000 B) Cash Discounts used to encourage prompt payment. Most common method of recording is Gross method, but a company may also use Net method. 9/1/2009 Sales $1,000 2/10, n/30 9/10/2009 Paid 10/1/2009 Paid Outside Discount Period Gross A/R 1,000 Sales 1,000 Cash 980 Sales Disc. 20 A/R 1,000 Cash 1,000 A/R 1,000 A/R Cash Cash Net 980 Sales 980 A/R 1,000 A/R Sales Disc. Not Taken 980 20

980 980

Valuation of A/R -reported at NRV -Uncollectible A/R: 2 methods (1) Direct Write-Off simple, doesnt match, not allowable under GAAP (2) Allowance Method (1) % Sales (Income Stmt) approach -focuses on Bad Debt Expense Ex. Estimates 2% of credit sales is uncollectible Credit Sales = 100,000 100,000 (.02) = 2,000 Bad Debt Exp 2,000 Allowance for Bad Debt 2,000

(2) % Receivables (Balance Sheet) approach -uses either % of receivables or aging -focuses on the balance in the allowance account Writing off account: Determine Jones cant pay $500 account Allowance for Bad Debt 500 A/R


If Jones subsequently pays, 1) Reestablish Receivable A/R 500 Allowance for Bad Debt 2) Show it paid Cash 500 A/R 500


If a company generally has material sales returns, it may be necessary to have allowance accounts for SR&A Assume that ABC Corp generally has sales returns of 8% of sales during a period Sales = $100,000 On Income Stmt Sales Less: SR&A Net Sales $100,000 (8,000) 92,000 Sales Returns & Allowances Allowances for SR&A On Balance Sheet A/R Less: Allow. for SR&A Net Receivables 8,000 8,000

100,000 (8,000) 92,000

Recognition of N/R May be interest bearing or non-interest bearing Short-term notes are recorded at face value Long-term notes are recorded at present value of cash to be collected Notes issued at Face these typically have interest rates which are equivalent to market rates These are recorded at Face Value Notes Receivable Cash XX XX

Notes not issued at Face these can either have no stated interest rate called Zero-Interest Bearing - or the interest rate is different from market rates Notes with No Interest or Interest Different than Market No Interest Interest is computed Assume the company has a $1,000 A/R that the customer wants to turn into a note and take 3 years to pay. So, the company agrees to accept $1,200 in payment for the receivable 3 years from now

PV | | 1,000

FV | 1,200

1000 = 1200 (PVss, n=3, i=?) (1000/1200) = .833 or approximately 6.2% They would record this note N/R 1200 (recorded at FV) A/R 1000 Disc. on N/R 200 (represents the interest to be earned) (reported on BS as a contra-asset to N/R) Thus: N/R 1200 Less: Disc (200) Net N/R 1000 The discount is amortized using the Effective Interest Method YR 1: Disc. on N/R 62 Int. Rev. 62 Cash Received At Issue YR 1 YR 2 YR 3 0 0 0 Interest Rev =CV*Effective Int. Rate 62 66 70 Disc. Amortized =Int. Rev. Cash Received 62 66 70 Carrying Value 1000 1,062 1,128 1,198 = 1,200

Interest Bearing Notes Different from Market Assume Smith Co. loans $5,000 to Jones Co. The note has an 8% interest rate. Market rates are currently 10%. N=4. To determine how much to loan, Smith takes PV of interest and return of principal. N=5 i=10 5000(.08) = 400 PV of principal = 5000 (PVss, i=10, n=5) =5000 (.62092) = PV of interest= 400 (PVordann, n=5, i=10) 400 (3.79079) = 3104.60

1516.32 $4620.92

So, Smith records N/R 5,000 Cash 4,620.92 (only loans this much to make up for underlying interest) Disc. on N/R 379.08 Then amortize Disc. using Effective Interest Method PMT # 0 1 2 3 4 5 Cash Received 400 400 400 400 400 Int Rev Mkt i*CV 462.09 468.30 475.13 482.64 490.91 400 62.09 462.09 Discount Amortized Int Rev $ Recd 62.09 68.30 75.13 82.64 90.91 Carrying Value 4620.92 4683.01 4751.31 4826.44 4909.08 5000

At first interest receipt YR 1 Cash Disc. on N/R Int. Rev

Valuation of N/R Short-term N/R should be valued at their NRV, just like trade A/R Note: Companies can elect to report Long-term N/R at their fair value each period o The FASB has given this option for most financial instruments, including receivables LT N/R would first be recorded at fair value (either cash equivalent or fair value of the asset given up) o Unrealized holding gains or losses would be reported each period as part of income If a company elects to use fair value for a fin instrument, then it must continue to use it until it no longer owns the instrument If a N/R becomes impaired, then the co. recognizes a loss in the period it recognizes the impairment

Transferring A/R or N/R Can be accomplished in 2 ways: 1) Secured borrowing -Rec. used as collateral for borrowings Assume ABC borrows 10,000 from XYZ on Sept. 1. ABC pledges 13,000 of Receivables to cover. XYZ charges 1% of receivables plus 10% interest on the loan ABC XYZ 9/1 Cash Financing Exp N/P 9870 130 10,000 9/1 N/R 10,000 Cash Financing Rev 9870 130

ABC collected $7000 of receivables less $200 in discounts and 500 in returns 10/1 Cash 6300 No entry Sales Disc 200 SR&A 500 A/R 7000 Remits to XYZ plus interest 10/3 Interest Exp 83.33 (10000*.1*1/12) N/P 6300 Cash 6383.33 Collects Balance 11/1 Cash 6000 A/R 6000 Remits to XYZ 11/3 N/P 3700 Int. Exp 30.83 (3700*.1*1/12) Cash 3730.83 10/3 Cash 6383.33 N/R 6300 Int. Rev. 83.33

No entry 11/3 Cash 3730.83 Int. Rev 30.83 N/R 3700

Factoring Receivables Factoring receivables = selling the receivables 1) Factored without recourse purchaser assumes risk of collectability and absorbs losses -This is an outright sale in both form and substance Basic form of entry: Loss on Sale of A/R Cash Due from Factor A/R xx (amount of factoring charge, non-collection estimates, discounts, etc.) xx (amount received less than A/R value) xx (amount withheld by factor to cover extra discounts, returns, etc.) xx

Assume Bugs Bunny Co. factors $100,000 in receivables to Yogi Bear Bank. Yogi charges 2% of amount factored (A/R) and retains 5% of A/R Bugs Yogi Cash 93,000 A/R 100,000 Loss on Sale Cash 93,000 of A/R 2,000 Financing Rev 2,000 Due from Factor 5,000 Due to Bugs 5,000 A/R 100,000 2) Factored with recourse -seller guarantees payment and purchases if the A/R proves uncollectible -in this case, the seller has to recognize a liability estimating its obligation under the recourse agreement Suppose same facts except that Bugs determines its obligation under the recourse agreement is $4500. Bugs A/R 100,000 Less: Charge (2,000) Less: Due from Factor (5,000) Resource Obligation (4,500) 88,500 Net proceeds = cash received + due from factor recourse obligation = 93000 + 5000 4500 Cash Received Add: Due from factor Less: Resource Obligation Net proceeds Loss = Carrying Value Less: (Net Proceeds) Loss on sale 93,000 5,000 (4,500) 93,500 100,000 (93,500) (6,500)

Note: A much easier way to determine the loss on the sale is to calculate it as the $2000 finance charge + recourse obligation of $4500 (2000 + 4500 = 6500) Bugs Cash Due from Factor Loss on Sale A/R Recourse liability 93,000 5,000 6,500 100,000 4,500

Yogi A/R Cash Fin. Rev. Due to Bugs

100,000 93,000 2,000 5,000

To be a sale, rather than a secured borrowing, 3 conditions must be met: 1) Transferred asset is isolated from the transferor 2) Buyer has the right to dispose of (transfer or exchange) the assets 3) Transferor doesnt maintain control through a repurchase agreement If it doesnt meet the 3 criteria, then its a secured borrowing