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Chapter 7 Lecture Notes 1. Cash and Cash Equivalents a.

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 i. These forms of cash represent amounts readily available to pay off debt or to use in operations without any legal or contractual restriction b. Managers typically invest temporarily idle cash to earn interest on those funds rather than keep an unnecessarily large checking account i. These amounts are essentially equivalent to cash because they can quickly become available for use as cash 1. So short-term, highly liquid investments that can be readily converted to cash with little risk of loss are viewed as cash equivalents c. Cash equivalents include money market funds, treasury bills, and commercial paper i. To be classified as cash equivalents, these investments must have a maturity date no longer than three months from the date of purchase 1. Companies are permitted flexibility in designating cash equivalents and must establish individual policies regarding which short-term, highly liquid investments are classified as cash equivalents a. The policy should be disclosed in the notes to the financial statements d. Cash and cash equivalents usually are combined and reported as a single amount in the balance sheet i. However, cash that is not available for use in current operations because it is restricted for a special purposes usually is classified in one of the noncurrent asset categories e. Internal Control i. Internal control refers to a companys 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 ii. From a financial accounting perspective, the focus is on controls intended to improve the accuracy and reliability of accounting information and to safeguard the companys assets iii. A framework for designing an internal control system is provided by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission 1. COSO defines internal control as a process, undertaken by an entitys board of directors, management and other personnel, designed to provide reasonable assurance regarding the achievement of objectives in the following categories a. Effectiveness and efficiency of operations

b. Reliability of financial reporting c. Compliance with applicable laws and regulations iv. A critical aspect of an internal control system is the separation of duties 1. Individuals that have physical responsibility for assets should not also have access to accounting records v. Internal Control Procedures Cash Receipts 1. An approach to internal control over cash receipts might include the following steps a. Employee A opens the mail each day and prepares a multicopy listing of all checks including the amount and payors name b. Employee B takes the checks, along with one copy of the listing, to the person responsible for depositing the checks in the companys bank account c. A second copy of the check listing is sent to the accounting department where the receipts are entered into the records i. The amount received should equal the amount deposited as verified by comparison with the bank-generated deposit slip and the amount recorded in the accounting records vi. Internal Control Procedures Cash Disbursements 1. Important elements of a cash disbursement control system include a. All disbursements, other than very small disbursements from petty cash, should be made by check. This provides a permanent record of all disbursements. b. All expenditures should be authorized before a check is prepared c. Checks should be signed only by authorized individuals i. Responsibilities for check signing, check writing, check mailing, cash disbursement documentation, and recordkeeping ideally should be separated whenever possible f. Restricted Cash and Compensating Balances i. Cash that is restricted in some way and not available for current use usually is reported as a noncurrent asset such as investments and funds or other assets ii. Restrictions on cash can be informal, arising from managements intent to use a certain amount of cash for a specific purpose 1. For example, a company may set aside funds for future plant expansion a. This cash, if material, should be classified as investments and funds or other assets

iii. Sometimes restrictions are contractually imposed 1. Debt instruments, for instance, frequently require the borrower to set aside funds (often referred to as a sinking fund) for the future payment of a debt a. In these circumstances, the restricted cash ins classified as noncurrent investments and funds or other assets if the debt is classified as noncurrent iv. Disclosure notes should describe any material restrictions of cash v. Banks frequently require cash restrictions in connection with loans or loan commitments (lines of credit) 1. Typically, the borrower is asked to maintain a specified balance in a low interest or noninterest-bearing account at the bank (creditor) a. The required balance usually is some percentage of the committed amount (say 2% to 5%) i. These are known as compensating balances because they compensate the bank for granting the loan or extending the line of credit 1. A compensating balance results in the borrowers paying an effective interest rate higher than the stated rate on the debt because cash cant be invested regularly and is limited to a low-interest account 2. The classification and disclosure of a compensating balance depends on the nature of the restriction and the classification of the related debt a. If the restriction is legally binding, the cash is classified as either current or noncurrent (investments and funds or other assets) depending on the classification of the related debt b. If the compensating balance is informal with no contractual agreement that restricts the use of cash, the compensating balance can be reported as part of cash and cash equivalents, with note disclosure of the arrangement vi. Managements goal is to hold the minimum amount of cash necessary to conduct normal business operations, meet its obligations, and take advantage of opportunities 1. Too much cash reduces profits through lost returns, while too little cash increases risk vii. Liquidity is a measure of a companys cash position and overall ability to obtain cash in the normal course of business

1. A company is assumed to be liquid if it has sufficient cash or is capable of converting its other assets to cash in a relatively short period of time so that current needs can be met 2. Current Receivables a. Definitions and Types i. Receivables represent a companys claims to the future collections of cash, other assets, or services ii. Receivables resulting from the sale of goods or services on account are called accounts receivable and often are referred to as trade receivables iii. Nontrade receivables are those other than trade receivables and include tax refund claims, interest receivable, and loans by the company to other entities including stockholders and employees iv. When a receivable, trade or nontrade, is accompanied by a formal promissory note, it is referred to as a note receivable b. Accounts Receivable i. Most businesses provide credit to their customers, either because its not practical to require immediate cash payment or to encourage customers to purchase the companys product or service ii. Accounts receivable are informal credit arrangements supported by an invoice and normally are due in 30 to 60 days after the sale iii. Initial Valuation of Accounts Receivable 1. Receivables should be recorded at present value of future cash receipts using a realistic interest rate a. 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 2. Trade discounts a. Companies frequently offer trade discounts to customers, usually a percentage reduction from the list price b. Trade discounts can be a way to change prices without publishing a new catalog or to disguise real prices from competitors i. They are also used to give quantity discounts to large customers c. The trade discount is not recognized directly when recording the transaction but rather indirectly be recording the sale at the net of the discount price 3. Cash discounts (AKA sales discounts) a. Cash discounts represent reductions not in the selling price of a good or service but in the amount to be paid by a credit customer if paid within a specified period of time

b. The amount of the discount and the time period within which its available usually are conveyed by terms like 2/10, net 30 (meaning a 2% discount if paid within 10 days, otherwise full payment within 30 days) c. There are two ways to record cash discounts, the gross method and the net method i. The gross method views a discount not taken by the customer as part of sales of revenue 1. Relevant Journal Entries a. At time of credit sale (ignore COGS) i. Debit A/R for price of merchandise ii. Credit Sales Revenue b. At time of payment (within discount period) i. Debit Cash for difference or plug ii. Debit Sales Discounts for gross amount due multiplied by discount percentage iii. Credit Accounts Receivable for gross amount due ii. The net method considers sales revenue to be the net amount, after discount, and any discounts not taken by the customer as interest revenue 1. Relevant Journal Entries a. At time of credit sale (ignore COGS) i. Debit A/R for net amount of price of merchandise sale and discount ii. Credit Sales Revenue b. At time of payment (within discount period) i. Debit cash for cash received ii. Credit Accounts Receivable c. At time of payment (not within discount period) i. Debit cash for cash received ii. Credit Interest Revenue for amount of discount not taken advantage of iii. Credit Accounts Receivable for balance or plug iii. Total revenue is the same under either method iv. Conceptually, the net method usually reflects the reality of the situation by recording the sales revenue at the real price and the interest as a penalty for not paying promptly

1. The net price usually is the price expected by the seller because the discount usually reflects a hefty interest cost that prudent buyers are unwilling to bear a. For example, in order to save $2 (assuming a 2/10, net 30 situation) the buyer must pay $98 twenty days earlier than otherwise due, effectively investing $98 to earn $2, a rate of return of 2.04% ($2/$98) for a 20-day period i. To convert this 20-day rate to an annual rate, we multiply by 365/20 to get a 37.23% effective rate v. The difference between the two methods, in terms of the effect of the transactions on income, is the timing of the recognition of any discounts not taken 1. The gross method recognizes discounts not taken as revenue when the sale is made 2. The net method recognizes them as revenue after the discount period has passed and the cash is collected vi. From a practical standpoint, the effect on the financial statements of the difference between the two methods usually is immaterial and as a result most companies use the gross method because its easier and doesnt require any adjusting entries for discounts not taken iv. Subsequent Valuation of Accounts Receivable 1. Following the initial valuation of an account receivable, two situations could cause the cash ultimately collected to be less than the initial valuation of the receivable a. The customer could return the product, OR b. The customer could default and not pay the agreedupon sales price 2. Sales Returns a. When merchandise is returned for a refund or for credit to be applied to other purchases, the situation is called a sales return b. 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 i. 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 1. 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 a. The returns that occur in the period of sale are easy to account for, but the returns estimated for future periods are more difficult i. 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). Also, we debit inventory and credit cost of goods sold for the estimated cost of the inventory to be returned ii. When returns actually occur in a following reporting period, the allowance for sales returns is debited and accounts receivable is credited. b. If the estimate of returns turns out to be wrong, we dont revise prior years financial statements to reflect the new estimate, instead we incorporate the new estimate in any related accounting determinations from that point on i. Companies estimate returns by relying on past history, taking into account any changes that might affect future experience such as changes in customer base and overall economic conditions 3. Uncollectible Accounts Receivable a. Bad debt expense is an inherent cost of granting credit i. Its an operating expense incurred to make sales and as a result even when specific customer accounts havent been proven uncollectible by

the end of the reporting period, the expense should be matched with sales revenue in the income statement for that period b. As its not expected that all accounts receivable will be collected, the balance sheet should report only the expected net realizable value of the asset, that is, the amount of cash the company expects to actually collect from customers c. Companies account for bad debts by recording an adjusting entry that debits bad debt expense and reduces accounts receivable indirectly by crediting a contra account (allowance for uncollectible accounts) to accounts receivable for an estimate of the amount that eventually will prove uncollectible i. This approach to accounting for bad debts is known as the allowance method 1. There are two ways commonly used to arrive at the estimate of future bad debts the income statement approach and the balance sheet approach (except for the amounts, the accounting entries are identical) a. Using the income statement approach, we estimate bad debt expense as a percentage of each periods net credit sales i. This percentage usually is determined by reviewing the companys recent history of the relationship between credit sales and actual bad debts (for a relatively new company, this percentage may be obtained by referring to other sources such as industry averages) ii. Under the income statement approach, bad debts expense is debited for the % of the credit sales estimated to be uncollectible and the allowance account is credited iii. The income statement approach focuses on the current years credit sales and the effect on the balance sheet the allowance for uncollectible accounts and hence net accounts receivable

is an incidental result of estimating the expense b. Using the balance sheet approach to estimate future bad debts, we determine bad debts expense by estimating the net realizable value of accounts receivable to be reported in the balance sheet i. In other words, the allowance for uncollectible accounts is determined ii. Bad debt expense is an incidental result of adjusting the allowance account to the desired balance iii. The approach can be done by analyzing each customer account, by applying different percentages to the entire outstanding receivable balance, or by applying different percentages to accounts receivable balances depending on the length of time outstanding (the aging method) iv. The entry to record bad debts adjusts the balance in the allowance for uncollectible accounts to the required amount (that was calculated) with a debit to bad debt expense and a credit to the allowance account 2. When accounts are deemed uncollectible a. 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 b. Using the allowance method, the write-off is recorded as a debit to allowance for uncollectible accounts and a credit to A/R 3. When previously written-off accounts are collected a. Occasionally, a receivable that has been written off will be collected in part or in full

b. When this happens, the receivable and the allowance should be reinstated by reversing the entry made when the receivable was written off i. Debit Accounts Receivable ii. Credit Allowance c. The collection is then recorded the usual way i. Debit Cash ii. Credit Accounts Receivable d. This process ensures that the company will have a complete record of the payment history of the customer 4. Direct write-off of uncollectible accounts a. If uncollectible accounts are not anticipated or are immaterial, or if its not possible to reliably estimate uncollectible accounts, an allowance for uncollectible accounts is not appropriate i. In these few cases, adjusting entries are not recorded and any bad debts that do arise simple are written off as bad debt expense (this approach is known as the direct write off method) ii. Of course, if the sale that generated this receivable occurred in a previous reporting period, the matching principle is violated and operating expenses would have been understated and assets overstated in that period c. Notes Receivable i. Definition and Characteristics 1. Notes receivable are formal credit arrangements between a creditor (lender) and a debtor (borrower) 2. Notes arise from loans to other entities including affiliated companies and to stockholders and employees, from the extension of the credit period to trade customers, and occasionally from the sale of merchandise, other assets, or services

3. Notes receivable are classified as either current or noncurrent depending on the expected collection date(s) ii. Interest-Bearing Notes 1. The typical note receivable requires payment of a specified face amount, also called principal, at a specified maturity date or dates a. In addition, interest is paid at a stated percentage of the face amount and is calculated as i. Face Amount (P) x Annual Rate x Fraction of the Annual Period (T) 2. Journal Entries a. Note Issuance for Sale of Goods (ignore COGS) i. Debit Note Receivable for amount of note ii. Credit Sales Revenue b. Accrual of interest at Fiscal Year-End (if note is held crossing over a new fiscal period) i. Debit Interest Receivable for interest accrued using interest formula above and measuring fraction as time since issuance to accrual date (for example 3/12 for 3 months) ii. Credit Interest Revenue c. Collection of Note Receivable (assuming interest previously accrued) i. Debit Cash for maturity value (face amount plus total amount of interest earned since note issuance) ii. Credit Interest Receivable for amount previously accrued iii. Credit Note Receivable for face amount iv. Credit Interest Revenue for interest earned from accrual date (fiscal year-end to maturity date) iii. Noninterest-Bearing Notes 1. Sometimes a receivable assumes the form of a so-called noninterest-bearing note 2. 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 offset 3. Journal Entries a. Note Issuance for Sale of Goods (ignore COGS) i. Debit Note Receivable for amount of note ii. Credit Discount on Note Receivable (a contra account to Note Receivable) for the future interest revenue that will be recognized as it is earned over the period the note is outstanding (face value x discount rate x fraction of time note will be outstanding) iii. Credit Sales Revenue for the difference

b. Accrual of interest at Fiscal Year-End (if note is held crossing over a new fiscal period) i. Debit Discount on Note Receivable for interest accrued using interest formula above and measuring fraction as time since issuance to accrual date (for example 3/12 for 3 months) ii. Credit Interest Revenue c. Collection of Note Receivable (assuming interest previously accrued) i. Debit Cash for face amount of note ii. Credit Note Receivable for face amount iii. Debit Discount on Note Receivable for interest earned from fiscal year-end to maturity date iv. Credit Interest Revenue for same amount as debit to Discount on Note Receivable 4. More Information on Discount on Note Receivable a. The discount on note receivable is a contra account to the note receivable account and therefore the note receivable would be reported in the balance sheet net (less) any remaining discount b. The discount represents future interest revenue that will be recognized as it is earned over time c. Interest is calculated as the discount rate times the face amount which causes the effective interest rate to be higher than the stated rate i. If you divide the interest by the sales revenue you will get the effective rate (which may need to be adjusted to achieve an annual effective rate for comparison to the stated rate which is expressed annually divide the formula result by 2 to translate a 6-month rate to annual) iv. Notes Received Solely for Cash 1. If a note with an unrealistic interest rate even a noninterest-bearing note is received solely in exchange for cash, the cash paid to the issuer is considered to be its present value 2. Journal Entry to Record when Cash is Received in Exchange a. Debit Note Receivable for face amount b. Credit Cash v. Subsequent Valuation of Notes Receivable 1. If a company anticipates bad debts on short-term notes receivable, it uses an allowance account to reduce the receivable to net realizable value a. The process of recording bad debt expense is the same as with accounts receivable 2. GAAP requires that companies disclose the fair value of their notes receivable in the disclosure notes (they dont have to disclose the fair value of accounts receivable when the

carrying value of the receivables approximates their fair value) 3. Also, GAAP recently changed to allow companies to choose to carry receivables at fair value in their balance sheets, with changes in fair value recognized as gains or losses in the income statements 4. When it becomes probable that a creditor will be unable to collect all amounts due according the contractual terms of the note, the receivable is considered impaired a. When a creditors investment in a note receivable becomes impaired for any reason, the receivable is remeasured as the discounted present value of currently expected cash flows at the loans original effective rate 3. Financing with Receivables a. Background i. Financial Institutions have developed a wide variety of ways for companies to use their receivables to obtain immediate cash 1. 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 2. Also, many companies avoid the difficulties of servicing (billing and collecting) receivables by having financial institutions take on that role a. Of course, financial institutions require compensation for providing these services, usually interest and/or a finance charge b. Secured Borrowing i. Assigning or pledging receivables as collateral (the bank gets the house if the borrower defaults on the loan) is done in conjunction with obtaining a mortgage on a home 1. Similarly, in the case of assignment of receivables, nonpayment of a debt will require the proceeds from collecting the assigned receivables to go directly toward repayment of the debt a. In these arrangements, the lender typically lends an amount of money that is less than the amount of the receivables assigned by the borrower i. The difference provides some protection for the lender to allow for possible uncollectible accounts ii. Also, the lender (sometimes called an assignee) usually charges the borrower (sometimes called an assignor) an up-front finance charge in addition to stated interest on the loan ii. Journal Entries for a Secured Borrowing 1. Journal Entry when Receivables are Assigned

a. Debit Cash for plug or difference b. Debit Finance Charge Expense for finance fee percentage multiplied by amount of receivables assigned c. Credit Liability Finance Arrangement for amount borrowed 2. Journal Entry when Receivables Collected by Borrower a. Debit Cash for amount of receivables collected b. Credit Accounts Receivable 3. Journal Entry when Payment(s) Made on Loan a. Debit Interest Expense for amount of interest incurred from borrowing date to repayment date ( P x R x T) b. Debit Liability Financing Arrangement for principal amount of loan repaid c. Credit Cash for principal and interest paid iii. Presentation of Accounts Receivable and Liability Financing Arrangement in Financial Statements 1. In the current Assets section, the balance of the accounts receivable assigned (original amount assigned less amount of loan principal repaid) is reduced by the balance of the Liability Financing Arrangement (principal borrowed less principal repaid) to arrive at Equity in Accounts Receivable Assigned a. Netting a liability against a related asset, also called offsetting, usually is not allowed by GAAP i. However, in this case, we deduct the note payable from the accounts receivable assigned because, by contractual agreement, the note will be paid with cash collected from the receivables iv. A variation of assigning specific receivables (called pledging) occurs when trade receivables in general rather than specific receivables are pledged as collateral 1. The responsibility for collection of the receivables remains solely with the company 2. No special accounting treatment is needed and the arrangement is simply described in a disclosure note c. Sale of Receivables i. Background 1. The sale of accounts receivable became an increasingly popular method of financing over the past couple of decades 2. A factor is a financial institution that buys receivables for cash, handles the billing and collection of the receivables, and charges a fee for this service a. The seller relinquishes all rights to the future cash receipts in exchange for cash from the buyer (the factor)

3. Another popular arrangement used to sell receivables has been securitization a. In a typical accounts receivable securitization, the company creates a special purpose entity (SPE) usually a trust or a subsidiary i. The SPE buys a pool of trade receivables, credit card receivables, or loans from the company, and then sells related securities, typically debt such as bonds or commercial paper, that are backed (collateralized) by the receivables ii. Securitizing receivables using an SPE can provided significant economic advantages, allowing companies to reach a large pool of investors and to obtain more favorable financing terms ii. Sale without Recourse 1. If a factoring arrangement is made without recourse, the buyer cant ask the seller for more money if customers dont pay the receivables 2. Journal Entry recorded at time of Factoring a. Debit Cash for cash received from bank (usually a percentage of the total accounts receivable) b. Debit Loss on Sale of Receivables for plug or difference needed to balance journal entry c. Credit Accounts Receivable for amount of receivables factored iii. Sale with Recourse 1. When a company sells accounts receivable with recourse, the seller retains all of the risk of bad debts a. The only difference between with Recourse and without Recourse is the additional requirement that the company record the estimated fair value of its recourse obligation as a liability i. The recourse obligation is the estimated amount that the company will have to pay the bank as a reimbursement for uncollectible receivables

2. Journal Entry recorded at time of Factoring a. Debit Cash for cash received from bank (usually a percentage of the total accounts receivable) b. Debit Loss on Sale of Receivables for plug or difference needed to balance journal entry c. Credit Recourse Liability for the estimated fair value of the recourse obligation d. Credit Accounts Receivable for amount of receivables factored

i. Note that the estimated recourse liability will increase the loss on the sale when compared to factoring without recourse 1. If the factor collects all of the receivables, the company eliminates the recourse liability and increase income (reduces the loss) d. Transfers of Notes Receivable i. Background 1. We handle transfers of notes receivable in the same manner as transfers of accounts receivable 2. A note receivable can be used to obtain immediate cash from a financial institution either by pledging the note as collateral for a loan or by selling the note a. The transfer of a note to a financial institution is referred to as discounting i. The financial institution accepts the note and gives the seller cash equal to the maturity value of the note reduced by a discount 1. The discount is computed by applying a discount rate to the maturity value and represents the financing fee the financial institution charges for the transaction ii. Journal Entries for Discounting Note Receivable 1. Accrue Interest Earned from Issuance Date of Note to Discount Date (1st step) a. Debit Interest Receivable for amount of interest earned from note issuance date to date note is being discounted (P X R X T) b. Debit Interest Revenue 2. Record Discounting of Note a. Debit Cash for Maturity Value (Principal plus ALL of the interest to be earned on note up to maturity) multiplied by the discount rate, adjusted for the fraction of the year the bank will hold the note discount date to maturity date (for example, 3 months would be 3/12) b. Debit Loss on Sale of Note Receivable for plug or difference to make entry balance c. Credit Note Receivable for face amount d. Credit Interest Receivable for interest previously accrued e. Deciding Whether to Account for a Transfer as a Sale or a Secured Borrowing i. Transferors usually prefer to use the sale approach rather than the secured borrowing approach to account for the transfer of a receivable because the sale approach makes the transferor seem

less leveraged, more liquid, and perhaps more profitable than does the secured borrowing approach 1. A company is allowed to account for the transfer of a receivable as a sale if the company (transferor) surrenders control over the assets transferred a. The transferor (defined to include the company, its consolidated affiliates, and people acting on behalf of the company) is determined to have surrendered control over the receivables if and only if all of the following conditions are met i. The transferred assets have been isolated from the transferor beyond the reach of the transferor and its creditors ii. Each transferee has the right to pledge or exchange the assets it received iii. The transferor does not maintain effective control over the transferred assets 1. Effective control would exist, for example, if the transfer is structured such that the assets are likely to end up returned to the transferor b. If all of the conditions are met, the transferor accounts for the transfer as a sale, but if any of the above conditions are not met, the transferor treats the transaction as a secured borrowing f. Disclosures i. Transferors must provide qualitative and quantitative information about the transfer at a level that allows financial statement users to fully understand 1. The transfer 2. Any continuing involvement with the transferred assets 3. Any ongoing risk to the transferor ii. The company also has to provide information about the quality of the transferred assets such as the company needs to disclose the amount of receivables that are past due and any credit losses occurring during the period iii. Other information the company must disclose includes how fair values were estimated when recording the transaction, any cash flows occurring between the transferor and the transferee, and how any continuing involvement in the transferred assets will be accounted for on an ongoing basis 4. Receivables Management a. A companys investment in receivables is influenced by several variables, including the level of sales, the nature of the product or services sold, and credit and collection policies i. These variables are, of course, related 1. Managements choice of credit and collection policies often involves trade-offs

a. For example, offering cash discounts may increase

sales volume, accelerate customer payment, and reduce bad debts