1 practical issues in cash and receivable: disposition and recognitions instructor adnan shoaib part...

Practical Issues in Cash and Receivable: Disposition and

Recognitions

InstructorAdnan Shoaib

PART II: Corporate Accounting Concepts and Issues

Lecture 09

1. Explain accounting issues related to recognition and valuation of notes

receivable.

2. Explain the fair value option.

3. Explain accounting issues related to disposition of accounts and notes

receivable.

4. Describe how to report and analyze receivables.

Learning ObjectivesLearning ObjectivesLearning ObjectivesLearning Objectives

What is cash?

Reporting cash

Summary of cash-related items

CashSpecial Issues

Recognition of notes receivable

Valuation of notes receivable

Cash and ReceivablesCash and ReceivablesCash and ReceivablesCash and Receivables

Accounts Receivable

Notes Receivable

Recognition of accounts receivable

Valuation of accounts receivable

Fair value option

Disposition of accounts and notes receivable

Presentation and analysis

Supported by a formal promissory note.

Recognition of Notes ReceivableRecognition of Notes ReceivableRecognition of Notes ReceivableRecognition of Notes Receivable

LO 1 Explain accounting issues related to recognition of notes receivable.

Notes Receivable

A negotiable instrument.

Maker signs in favor of a Payee.

Interest-bearing (has a stated rate of interest) OR

Zero-interest-bearing (interest included in face amount).

Generally originate from:

Customers who need to extend payment period of

an outstanding receivable.

High-risk or new customers.

Loans to employees and subsidiaries.

Sales of property, plant, and equipment.

Lending transactions (the majority of notes).

6 LO 1 Explain accounting issues related to recognition of notes receivable.

Short-Term Long-Term

Record at Face Value,

less allowance

Record at Present Value

of cash expected to be collected

Interest Rates

Stated rate = Market rate

Stated rate > Market rate

Stated rate < Market rate

Note Issued at

Face Value

Premium

Discount

Illustration: Bigelow Corp. lends Scandinavian Imports $10,000 in exchange for a $10,000, three-year note bearing interest at 10 percent annually. The market rate of interest for a note of similar risk is also 10 percent. How does Bigelow record the receipt of the note?

Note Issued at Face ValueNote Issued at Face ValueNote Issued at Face ValueNote Issued at Face Value

0 1 2 3

1,000 1,000 Interest$1,000

$10,000 Principal

i = 10%

$1,000 x 2.48685 = $2,487

Interest Received Factor Present Value

PV of Interest

$10,000 x .75132 = $7,513

Principal Factor Present Value

PV of Principal

Summary Present value of interest $ 2,487

Present value of principal 7,513

Note current market value $10,000

Date Account Title Debit Credit

J an. yr. 1

Dec. yr. 1

Notes receivable 10,000

Cash 10,000

Cash 1,000

Interest revenue1,000

Illustration: Jeremiah Company receives a three-year, $10,000 zero-interest-bearing note. The market rate of interest for a note of similar risk is 9 percent. How does Jeremiah record the receipt of the note?

Zero-Interest-Bearing NoteZero-Interest-Bearing NoteZero-Interest-Bearing NoteZero-Interest-Bearing Note

0 1 2 3

$0 $0 Interest$0

$10,000 Principal

i = 9%

$10,000 x .77218 = $7,721.80

PV of Principal

Illustration 7-12

Journal Entries for Zero-Interest-Bearing note

Present value of Principal $7,721.80

Jan. yr. 1 Notes receivable 10,000.00

Discount on notes receivable 2,278.20

Cash 7,721.80

Dec. yr. 1 Discount on notes receivable 694.96

Interest revenue 694.96

($7,721.80 x 9%)

Illustration: Morgan Corp. makes a loan to Marie Co. and receives in exchange a three-year, $10,000 note bearing interest at 10 percent annually. The market rate of interest for a note of similar risk is 12 percent. How does Morgan record the receipt of the note?

Interest-Bearing NoteInterest-Bearing NoteInterest-Bearing NoteInterest-Bearing Note

0 1 2 3

1,000 1,000 Interest$1,000

$10,000 Principal

i = 12%

$1,000 x 2.40183 = $2,402

Interest Received Factor Present Value

PV of Interest

$10,000 x .71178 = $7,118

PV of Principal

Illustration: How does Morgan record the receipt of the note?

Illustration 7-14

Notes Receivable 10,000

Discount on Notes Receivable

Illustration 7-15

Journal Entries for Interest-Bearing Note

Beg. yr. 1 Notes receivable 10,000

Discount on notes receivable 480

Cash 9,520

End. yr. 1

($9,520 x 12%)

Cash 1,000

Discount on notes receivable 142

Interest revenue1,142

U.S. GAAP vs. IFRSU.S. GAAP vs. IFRSU.S. GAAP vs. IFRSU.S. GAAP vs. IFRS

U.S. GAAP allows a “fair value U.S. GAAP allows a “fair value option” for accounting for option” for accounting for receivables.receivables.

U.S. GAAP does not allow U.S. GAAP does not allow receivables to be accounted receivables to be accounted for as “available for sale” for as “available for sale” investments.investments.

U.S. GAAP requires more U.S. GAAP requires more disaggregation of accounts disaggregation of accounts and notes receivable in the and notes receivable in the balance sheet or notes. balance sheet 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 IFRS restricts the circumstances in which a “fair circumstances in which a “fair value option” for accounting value option” for accounting for receivables is allowed.for receivables is allowed.

In the years between 2010 and In the years between 2010 and 2012, companies may account 2012, companies may account for receivables as “available for receivables as “available for sale” investments if the for sale” investments if the approach is elected initially. approach is elected initially. After January 1, 2013, this After January 1, 2013, this treatment is no longer treatment is no longer allowed.allowed.

Notes Received for Property, Goods, or Services

In a bargained transaction entered into at arm’s length, the

stated interest rate is presumed to be fair unless:

1. No interest rate is stated, or

2. Stated interest rate is unreasonable, or

3. Face amount of the note is materially different from the

current cash sales price.

Illustration: Oasis Development Co. sold a corner lot to Rusty Pelican as a restaurant site. Oasis accepted in exchange a five-year note having a maturity value of $35,247 and no stated interest rate. The land originally cost Oasis $14,000. At the date of sale the land had a fair market value of $20,000. Oasis uses the fair market value of the land, $20,000, as the present value of the note. Oasis therefore records the sale as:

Notes Receivable 35,247Discount on Notes Receivable

15,247Land

14,000Gain on Sale of Land

($35,247 - $20,000) = $15,247

Valuation of Notes ReceivableValuation of Notes ReceivableValuation of Notes ReceivableValuation of Notes Receivable

LO 2 Explain the fair value option.

Short-Term reported at Net Realizable Value (same as

accounting for accounts receivable).

Long-Term - FASB requires companies disclose not only

their cost but also their fair value in the notes to the

financial statements.

► Fair Value Option. Companies have the option to use

fair value as the basis of measurement in the financial

statements.

Valuation of Notes ReceivableValuation of Notes ReceivableValuation of Notes ReceivableValuation of Notes Receivable

LO 2 Explain the fair value option.

Illustration (recording fair value option): Assume that

Escobar Company has notes receivable that have a fair value of

$810,000 and a carrying amount of $620,000. Escobar decides

on December 31, 2012, to use the fair value option for these

receivables. This is the first valuation of these recently acquired

receivables. At December 31, 2012, Escobar makes an

adjusting entry to record the increase in value of Notes

Receivable and to record the unrealized holding gain, as follows.

Notes Receivable 190,000

Unrealized Holding Gain or Loss—Income 190,000

Disposition of Accounts and Notes ReceivableDisposition of Accounts and Notes ReceivableDisposition of Accounts and Notes ReceivableDisposition of Accounts and Notes Receivable

Owner may transfer accounts or notes receivables to another company for cash.

Reasons:

Competition.

Sell receivables because money is tight.

Billing / collection are time-consuming and costly.

Transfer accomplished by:

1. Secured borrowing

2. Sale of receivables

LO 3 Explain accounting issues related to disposition of accounts and notes receivable.

Factoring ArrangementsFactoring ArrangementsFactoring ArrangementsFactoring Arrangements

FACTOR (Transferee)

SUPPLIER(Transferor)

RETAILER

1. Merchandise

2. Accounts Receivable

3. Accounts Receivable

4. Cash5.

A factor is a financial institution that buys receivablesfor cash, handles the billing and collection of the

receivables and charges a fee for the service.

A factor is a financial institution that buys receivablesfor cash, handles the billing and collection of the

receivables and charges a fee for the service.

Disposition of Accounts and Notes ReceivableDisposition of Accounts and Notes ReceivableDisposition of Accounts and Notes ReceivableDisposition of Accounts and Notes Receivable

Secured Borrowing

Illustration: March 1, 2012, Howat Mills, Inc. provides

(assigns) $700,000 of its accounts receivable to Citizens Bank

as collateral for a $500,000 note. Howat Mills continues to

collect the accounts receivable; the account debtors are not

notified of the arrangement. Citizens Bank assesses a finance

charge of 1 percent of the accounts receivable and interest on

the note of 12 percent. Howat Mills makes monthly payments to

the bank for all cash it collects on the receivables.

29 LO 8

Secured Borrowing - IllustrationSecured Borrowing - IllustrationSecured Borrowing - IllustrationSecured Borrowing - Illustration

Illustration 7-16

E7-13: On April 1, 2012, Prince Company assigns $500,000 of its

accounts receivable to the Third National Bank as collateral for a $300,000

loan due July 1, 2012. The assignment agreement calls for Prince Company

to continue to collect the receivables. Third National Bank assesses a

finance charge of 2% of the accounts receivable, and interest on the loan is

10% (a realistic rate of interest for a note of this type).

Secured Borrowing - ExerciseSecured Borrowing - ExerciseSecured Borrowing - ExerciseSecured Borrowing - Exercise

Instructions:

a) Prepare the April 1, 2012, journal entry for Prince Company.

b) Prepare the journal entry for Prince’s collection of $350,000 of the accounts receivable during the period from April 1, 2012, through June 30, 2012.

c) On July 1, 2012, Prince paid Third National all that was due from the loan it secured on April 1, 2012.

Exercise 7-13 continued

(a) Cash 290,000

Finance Charge 10,000

Notes Payable 300,000

($500,000 x 2% = $10,000)

(b) Cash 350,000

Accounts Receivable 350,000

(c) Notes Payable 300,000

Interest Expense 7,500

Cash 307,500

(10% x $300,000 x 3/12 = $7,500)

Secured Borrowing - ExerciseSecured Borrowing - ExerciseSecured Borrowing - ExerciseSecured Borrowing - Exercise

Factors are finance companies or banks that buy receivables from businesses for a fee.

Sales of ReceivablesSales of ReceivablesSales of ReceivablesSales of Receivables

Illustration 7-17

Sale Without Recourse

Purchaser assumes risk of collection

Transfer is outright sale of receivable

Seller records loss on sale

Seller use Due from Factor (receivable) account to cover discounts, returns, and allowances

Sale With Recourse Seller guarantees payment to purchaser

Financial components approach used to record transfer

Illustration: Crest Textiles, Inc. factors $500,000 of accounts

receivable with Commercial Factors, Inc., on a without recourse

basis. Commercial Factors assesses a finance charge of 3 percent of

the amount of accounts receivable and retains an amount equal to 5

percent of the accounts receivable (for probable adjustments). Crest

Textiles and Commercial Factors make the following journal entries

for the receivables transferred without recourse.

Illustration 7-18

Illustration: Assume Crest Textiles sold the receivables on a with

recourse basis. Crest Textiles determines that this recourse

obligation has a fair value of $6,000. To determine the loss on the

sale of the receivables, Crest Textiles computes

the net proceeds from the sale as follows.

Illustration 7-20Loss on Sale Computation

Illustration 7-19Net ProceedsComputation

Illustration: Prepare the journal entries for both Crest Textiles and

Commercial Factors for the receivables sold with recourse.

Cash 460,000 Due from Factor 25,000 Loss on Sale of Receivables 21,000

Accounts (Notes) Receivable 500,000

Recourse Liability 6,000Accounts Receivable 500,000

Due to Crest Textiles 25,000

Financing Revenue 15,000

Cash 460,000

Commercial Factors, Inc.

Crest Textiles, Inc.

Interest receivable 5,000Interest revenue 5,000

Transfers of Notes ReceivableTransfers of Notes ReceivableTransfers of Notes ReceivableTransfers of Notes Receivable

On December 31, Stridewell accepted a nine-month 10 On December 31, Stridewell accepted a nine-month 10 percent note for $200,000 from a customer. Three months percent note for $200,000 from a customer. Three months

later on March 31, Stridewell discounted the note at its later on March 31, Stridewell discounted the note at its local bank. The bank’s discount rate is 12 percent. local bank. The bank’s discount rate is 12 percent.

$200,000 × 10% × 3/12

Before preparing the journal entry to record the discounting, Stridewell must record the accrued interest on the note

from December 31 until March 31.

Transfers of Notes ReceivableTransfers of Notes ReceivableTransfers of Notes ReceivableTransfers of Notes Receivable

Cash 202,100Loss on sale of note receivable 2,900Notes receivable 200,000Interest receivable 5,000

$205,000 - $202,100

Deciding Whether to Account for a Transfer as Deciding Whether to Account for a Transfer as a Sale or a Secured Borrowinga Sale or a Secured Borrowing

U.S. GAAP vs. IFRSU.S. GAAP vs. IFRSU.S. GAAP vs. IFRSU.S. GAAP vs. IFRS

U.S. GAAP focuses on U.S. GAAP focuses on whether control of assets whether control of assets has shifted from the has shifted from the transferor to the transferee. 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 IFRS requires a more complex decision process. The decision process. The company has to have company has to have transferred the rights to receive transferred the rights to receive the cash flows from the the cash flows from the receivable, and then considers receivable, and then considers whether the company has whether the company has transferred “substantially all of transferred “substantially all of the risks and rewards of the risks and rewards of ownership,” as well as whether ownership,” as well as whether the company has transferred the company has transferred control.control.

The FASB

concluded that a

sale occurs only if

the seller surrenders

control of the

receivables to the

buyer.

Three conditions

must be met.

Secured Borrowing versus SaleSecured Borrowing versus SaleSecured Borrowing versus SaleSecured Borrowing versus Sale

Illustration 7-22

1. Segregate the different types of receivables that a company

possesses, if material.

2. Appropriately offset the valuation accounts against the proper

receivable accounts.

3. Determine that receivables classified in the current assets

section will be converted into cash within the year or the

operating cycle, whichever is longer.

4. Disclose any loss contingencies that exist on the receivables.

5. Disclose any receivables designated or pledged as collateral.

6. Disclose the nature of credit risk inherent in the receivables.

Presentation and AnalysisPresentation and AnalysisPresentation and AnalysisPresentation and Analysis

LO 4 Describe how to report and analyze receivables.

Presentation of Receivables

Analysis of Receivables

Presentation and AnalysisPresentation and AnalysisPresentation and AnalysisPresentation and Analysis

This Ratio used to:

Assess the liquidity of the receivables.

Measure the number of times, on average, a company

collects receivables during the period.

Illustration 7-24

LO 4 Describe how to report and analyze receivables.

44 LO 5 Explain common techniques employed to control cash.

Management faces two problems in accounting for cash transactions:

1. Establish proper controls to prevent any unauthorized transactions by officers or employees.

2. Provide information necessary to properly manage cash on hand and cash transactions.

CASH CONTROLS

To obtain desired control objectives, a company can vary the number and location of banks and the types of accounts.

General checking account

Collection float.

Lockbox accounts

Imprest bank accounts

Using Bank Accounts

CASH CONTROLS

To pay small amounts for miscellaneous expenses.

The Imprest Petty Cash System

Steps:

1. Record $300 transfer of funds to petty cash:

Petty Cash 300

Cash 300

2. The petty cash custodian obtains signed receipts from each individual to whom he or she pays cash.

CASH CONTROLS

Steps:

LO 5 Explain common techniques employed to control cash.

Office Supplies Expense 42

Postage Expense 53

Entertainment Expense 76

Cash Over and Short 2

Cash 173

3. Custodian receives a company check to replenish the fund.

CASH CONTROLS

Steps:

Cash 50

Petty cash 50

4. If the company decides that the amount of cash in the petty cash fund is excessive by $50, it lowers the fund balance as follows.

CASH CONTROLS

Physical Protection of Cash Balances

Company should

Minimize the cash on hand.

Only have on hand petty cash and current day’s receipts.

Keep funds in a vault, safe, or locked cash drawer.

Transmit each day’s receipts to the bank as soon as practicable.

Periodically prove (reconcile) the balance shown in the general ledger.

CASH CONTROLS

Reconciliation of Bank Balances

Schedule explaining any differences between the bank’s and the company’s records of cash.

Reconciling Items:

1. Deposits in transit.

2. Outstanding checks.

3. Bank charges and credits.

4. Bank or Depositor errors.

Time Lags

CASH CONTROLS

Reconciliation of Bank Balances Illustration 7A-1Bank Reconciliation Form and Content

CASH CONTROLS

52 LO 10

CASH CONTROLS

Illustration 7A-2

CASH CONTROLS

Cash 542Nov. 30

Office expense 18

Accounts receivable 220

Accounts payable

180Interest revenue

Illustration: Journalize the adjusting entries at November 30 on the books of Nugget Mining Company.

CASH CONTROLS

The reconciling item in a bank reconciliation that will result

in an adjusting entry by the depositor is:

a. outstanding checks.

b. deposit in transit.

c. a bank error.

d. bank service charges.

Review Question

CASH CONTROLS

IMPAIRMENT OF RECEIVABLES

LO 6 Describe the accounting for a loan impairment.

Companies evaluate their receivables to determine their ultimate collectibility.

Allowance method is appropriate when:

probable that an asset has been impaired and

amount of the loss can be reasonably estimated.

Long-term receivables such as loans that are identified as impaired, companies perform an additional impairment evaluation.

57 LO 6 Describe the accounting for a loan impairment.

Impairment Measurement and Reporting

Impairment loss is calculated as the difference between

the investment in the loan (generally the principal plus

accrued interest) and

the expected future cash flows discounted at the loan’s

historical effective interest rate.

Illustration: At December 31, 2011, Ogden Bank recorded an

investment of $100,000 in a loan to Carl King. The loan has an

historical effective-interest rate of 10 percent, the principal is due in full

at maturity in three years, and interest is due annually. The loan officer

performs a review of the loan’s expected future cash flow and utilizes

the present value method for measuring the required impairment loss.

Illustration 7B-1

Illustration: Computation of Impairment LossIllustration 7B-2

Recording Impairment Losses

Bad Debt Expense 12,437

Allowance for Doubtful Accounts 12,437

RELEVANT FACTS

The accounting and reporting related to cash is essentially the same under both IFRS and GAAP. In addition, the definition used for cash equivalents is the same. One difference is that, in general, IFRS classifies bank overdrafts as cash.

Like GAAP, cash and receivables are generally reported in the current assets section of the balance sheet under IFRS. However, companies may report cash and receivables as the last items in current assets under IFRS.

RELEVANT FACTS

The fair value option is similar under GAAP and IFRS but not identical. The international standard related to the fair value option is subject to certain qualifying criteria not in the U.S. standard.

IFRS and GAAP differ in the criteria used to account for transfers of receivables. IFRS is a combination of an approach focused on risks and rewards and loss of control. GAAP uses loss of control as the primary criterion. In addition, IFRS generally permits partial transfers; GAAP does not.

End of Lecture 09End of Lecture 09End of Lecture 09End of Lecture 09

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