Cash and Receivables Skyline College Lecture Notes

Chapter 7
Cash and
Receivables
Skyline College
Lecture Notes
Pivotal Issues When Managing
Cash and Receivables
1. Cash needs
2. Credit policies
3. Level of accounts receivable
4. Financing receivables
5. Ethical estimates on credit sale
losses
Copyright © Houghton Mifflin 7–2

Cash Considerations
 Most liquid of all assets
 Central to operating cycle
Consists of:
 Currency and coins on
hand
 Checks and money Cash may include a
compensating balance—a
orders from customers minimum amount required
 Deposits in checking by a bank for a credit-
granting agreement.
and savings accounts

Cash Requirements
Seasonal
Cycles and
Cash
Requirements
for a
Manufacturer
of Athletic
Sportswear

Credit Policies
To increase the likelihood of selling to customers who will

pay on time, companies develop control procedures and
maintain a credit department
The credit department:

 Examines the financial resources and debts of the
credit applicant
 Asks for personal references
 Gets credit rating from credit bureaus
 Determines the extent to which the company can
grant credit, if any

Evaluating the Level of
Accounts Receivable
How many times, on How long, on
average, does a company average, does it take a
turn its receivables into company to collect its
cash during an accounting accounts receivables?
period?
Receivable Turnover Days’ Sales

Uncollected

Receivable Turnover
Reflects the relative size of a company’s accounts
receivable and the success of its credit and
collection policies
Net Sales
Receivable Turnover =
Average Net Accounts Receivable
(Amounts in Millions)
Nike’s Receivable $12,253.1

Turnover for 2004 =
($2,120.2 + $2,083.9) ÷ 2
= 5.8 times

Days’ Sales Uncollected
To interpret a company’s ratios, take into

consideration the industry in which it operates
Days’ 365 days

Sales Uncollected =
Receivable Turnover
Nike’s Days’ 365 days

Sales Uncollected =
5.8
= 62.9 days

Receivable Turnover for
Selected Industries

Financing Receivables
Money tied up in receivables is something that many

companies seek to avoid
Companies may use one or more of these methods

so that they can receive cash faster:
Set up a separate Borrow money Factor

finance company and pledge A/R A/R
Ford Ford Motor Credit In case of default on Sale or transfer of A/R;
Company loan, A/R (collateral) the buyer may bear risk
GM General Motors can be taken and of collection (factoring
Acceptance Corp. converted to cash to without recourse) or the
Sears Sears Roebuck satisfy the loan seller may bear risk of
Acceptance Corp. collection (factoring
with recourse)

How Factoring Works

Factoring Details
What fees are charged? Typically 2% of total A/R for

sales with recourse; Higher fee
for sales without recourse
What does the seller of Reports a contingent liability (a

receivables with potential debt that can develop if
recourse report in customers don’t pay receivables)
financials?

Securitization
A company may sell a group of receivables in a batch

at a discount to another company or to investors
When receivables are paid, buyer gets full

amount, thus their profit depends on the amount
of discount they negotiated
Circuit City
Sells its receivables without recourse, so it
has no further liability even if customers
do not pay

Discounting
The sale of promissory notes held

as notes receivable
Company A Bank
Holds $10,000 note Buys the note for
payable to Company B; $9,600
Note will pay $600 in
interest  If Company B pays,
bank will receive
 Company A should
$10,600 and realize a
disclose the contingent
$1,000 profit
liability (in the amount
 If Company B defaults,
of note plus interest) in
Company A is liable
notes to its financial
for the note
statements

Estimating Uncollectibles
 There will always be  Match these expenses

customers who do not of selling on credit to
pay their accounts, the revenues they help
called uncollectible generate
accounts, or bad debts
Estimate the
uncollectible expense in
the fiscal year in which
the sales are made

Estimating Uncollectibles and Ethics
Because estimations are involved, earnings may

be easily manipulated…
If the amount of losses
from uncollectible accounts earnings are overstated.
are understated,
If the amount of losses

from uncollectible accounts earnings are
are overstated, understated.

Discussion: Ethics in the World
WorldCom increased revenues and hid losses by

continuing to bill customers for service for years
after the customers had stopped paying.
Q. What impact do you think WorldCom’s

actions had on Accounts Receivable and
Sales?

Cash Equivalents
Investments like time deposits or certificates of
deposit (CDs) that have a term of 90 days or less
Nike’s Annual Report, 2005

Cash and equivalents represent cash and short-term, highly liquid
investments with original maturities of three months or less at the time
of purchase. The carrying amounts reflected in the consolidated
balance sheet for cash and equivalents approximate fair value due to
their short maturities.

Cash Control:
Electronic Funds Transfer (EFT)
Method of conducting business transactions
in which funds are transferred electronically
from one bank to another bank
Wal-Mart makes Electronic Banking

75% of its
payments to
suppliers using ATM transactions
EFT Debit and credit card purchases
Online bill-pay

Direct Charge-Off Method
 Recognize a loss  Tax law requires

at the time it is use of this
determined that method when
an account is computing
uncollectible taxable income
Date Uncollectible Accounts Expense XXX
Accounts Receivable XXX
Most companies do not use this method for financial reporting

purposes because it does not conform to GAAP.

The Allowance Method
Losses from bad debts are matched against the

sales they help generate
At the time of sale, management cannot

identify which customers will not pay
To observe the matching rule, losses from
uncollectible accounts must be estimated
The estimate becomes an expense in the fiscal
year in which the sales are made
Alternate Account Names
Allowance for Uncollectible

Uncollectible Accounts Accounts Expense
 Allowance for Doubtful  Bad Debts Expense
Accounts
 Allowance for Bad
Debts

Estimating Uncollectible Accounts
• Estimated loss should be:

Realistic
Based on objective information
Based on past experience
Based on current economic conditions
Two commonly used

methods for
1. Percentage of net sales method
estimating loss 2. Accounts receivable aging method

Percentage of Net Sales Method
How much of this year’s The answer determines the

net sales will not be amount of uncollectible
collected? accounts expense for the year
The percentage amount is ususally based on the

company’s historic losses
It ignores the difference between last year’s estimated
losses and the actual losses incurred during the year

Percentage of Net Sales Method
Dec. 31, 20x9: Account balances: Sales, $645,000; Sales Returns and
Allowances, $40,000; Sales Discounts, $5,000; Allowance for
Uncollectible Accounts, $3,600. Management estimates that
uncollectible accounts will average about 2 percent of net sales.
Uncollectible accounts expense  .02 x ($645,000 – $40,000 – $5,000)  $12,000

Dec. 31 Uncollectible Accounts Expense 12,000
Allowance for Uncollectible Accounts 12,000
To record the uncollectible accounts
expense at 2 percent of $600,000 net sales
After the above entry is Allowance for Uncollectible Accounts

posted, Allowance for
Uncollectible Accounts will Dec. 31 3,600
have a credit balance of Dec. 31 adj. 12,000
$15,600 Dec 31 bal. 15,600

Accounts Receivable Aging Method
How much of the ending The ending balance of

balance of accounts Allowance for Uncollectible
Accounts is determined
receivable will not be directly through an analysis
collected? of accounts receivable
The difference between the amount determined to be

uncollectible and the actual balance of Allowance for
Uncollectible Accounts is the expense for the period.

Analysis of Accounts Receivable
by Age
 The total past due for each category is multiplied by the

estimated percentage uncollectible
 The sum of the totals for each category is the estimated balance
of Allowance for Uncollectible Accounts
Notice that the estimated percentage uncollectible increases as

accounts become further past due.
7–27
(Case 1)
Dec. 31, 20x6: Management has estimated that $2,459 of Accounts
Receivable are uncollectible. Allowance for Uncollectible Accounts
has a credit balance of $800.
Allowance for Uncollectible Accounts

Dec. 31 800
Dec. 31 adj. 1,659
Dec. 31 bal. 2,459
The target balance for A credit adjustment of $1,659 will bring the
the account is $2,459 account to its target balance

To bring the allowance for uncollectible
accounts to the level of estimated losses

(Case 2)
Dec. 31, 20x6: Management has estimated that $2,459 of Accounts
Receivable are uncollectible. Allowance for Uncollectible Accounts
has a debit balance of $800.

Dec. 31. 800
Dec. 31 adj. 3,259
Dec. 31 bal. 2,459
The target balance for A credit adjustment of $3,259 will bring the
the account is $2,459 account to its target balance

To bring the allowance for uncollectible
accounts to the level of estimated losses

Comparison of Two Methods

Estimates Differ from Write-Offs?
Accounts receivable written off during a period will

rarely equal the estimated uncollectible amount
Shows a debit balance Shows a credit balance

when the total of when the total of
accounts written off is accounts written off is
greater than the less than the estimated
estimated uncollectible uncollectible amount
amount

Writing Off an Uncollectible Account
 When it becomes clear an account will not

be collected, the amount should be written
off to:
• Allowance for Uncollectible Accounts
• Accounts Receivable
 The uncollectible amount was already

accounted for as an expense when the
allowance was established

Writing Off an Uncollectible
Jan. 15, 20x7: R. Deering, who owes the company $250, is

declared bankrupt by federal court.
Jan. 15 Allowance for Uncollectible Accounts 250
Accounts Receivable 250
To write off receivable from R. Deering as
uncollectible because of his bankruptcy
Allowance for Uncollectible Accounts Accounts Receivable

Dec. 31 2,459 Dec. 31 44,400
Jan. 15 250 Jan. 15 250
Bal. 2,209 Bal. 44,150
Net realizable value of A/R

The write-off does not affect Before write-off
the estimated net realizable $44,400 – $2,459 = $41,941
value of accounts receivable
After write-off
$44,150 – $2,209 = $41,941
7–33
Making and Paying Notes
A promissory note is an unconditional promise to pay

a definite sum of money on demand at a future date
Maker Payee
Person or company that Entity to whom
signs the note and payment is to be made
promises to pay the
amount
All promissory notes that the All promissory notes that the
maker holds that are due in less payee holds that are due in less
than one year are categorized as than one year are categorized as
notes payable in the current notes receivable in the current
liability section of the balance assets section of the balance sheet
sheet

A Promissory Note

Key Components of Promissory Notes
Maturity Date Date on which the note must be paid
Duration Length of time in days between the

note’s issue date and its maturity date
Interest and Cost of borrowing money or the return

Interest Rate for lending money, usually stated on an
annual basis
Maturity Value Total proceeds of a note at maturity

date (face value plus interest)

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Chapter 7

Copyright © Houghton Mifflin 7–2

Copyright © Houghton Mifflin 7–3

Copyright © Houghton Mifflin 7–4

To increase the likelihood of selling to customers who will

The credit department:

Copyright © Houghton Mifflin 7–5

Receivable Turnover Days’ Sales

Copyright © Houghton Mifflin 7–6

Nike’s Receivable $12,253.1

Copyright © Houghton Mifflin 7–7

To interpret a company’s ratios, take into

Days’ 365 days

Nike’s Days’ 365 days

Copyright © Houghton Mifflin 7–8

Copyright © Houghton Mifflin 7–9

Money tied up in receivables is something that many

Companies may use one or more of these methods

Set up a separate Borrow money Factor

Copyright © Houghton Mifflin 7–10

Copyright © Houghton Mifflin 7–11

What fees are charged? Typically 2% of total A/R for

What does the seller of Reports a contingent liability (a

Copyright © Houghton Mifflin 7–12

A company may sell a group of receivables in a batch

When receivables are paid, buyer gets full

Copyright © Houghton Mifflin 7–13

The sale of promissory notes held

Copyright © Houghton Mifflin 7–14

 There will always be  Match these expenses

Copyright © Houghton Mifflin 7–15

Because estimations are involved, earnings may

If the amount of losses

Copyright © Houghton Mifflin 7–16

WorldCom increased revenues and hid losses by

Q. What impact do you think WorldCom’s

Copyright © Houghton Mifflin 7–17

Nike’s Annual Report, 2005

Copyright © Houghton Mifflin 7–18

Wal-Mart makes Electronic Banking

Copyright © Houghton Mifflin 7–19

 Recognize a loss  Tax law requires

Most companies do not use this method for financial reporting

Copyright © Houghton Mifflin 7–20

Losses from bad debts are matched against the

At the time of sale, management cannot

Allowance for Uncollectible

Copyright © Houghton Mifflin 7–22

• Estimated loss should be:

Two commonly used

Copyright © Houghton Mifflin 7–23

How much of this year’s The answer determines the

The percentage amount is ususally based on the

Copyright © Houghton Mifflin 7–24

Uncollectible accounts expense  .02 x ($645,000 – $40,000 – $5,000)  $12,000

After the above entry is Allowance for Uncollectible Accounts

Copyright © Houghton Mifflin 7–25

How much of the ending The ending balance of

The difference between the amount determined to be

Copyright © Houghton Mifflin 7–26

 The total past due for each category is multiplied by the

Notice that the estimated percentage uncollectible increases as

Allowance for Uncollectible Accounts