ch7 lecture notes

8/22/2019 Ch7 Lecture Notes

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CHAPTER 7

CASH and RECEIVABLES

(CICA HB section 1510, 1540, 3856, IAS 1, 7, 32, 39)

LEARNING OBJECTIVES

1. Define financial assets, and identify items considered cash and cash equivalents andhow they are reported.

2. Define receivables and identify the different types of receivables.

3. Account for and explain accounting issues related to the recognition and measurementof accounts receivable.

4. Account for and explain accounting issues related to the valuation of accountsreceivable.

5. Account for and explain the accounting issues related to the recognition andmeasurement of short-term notes and loans receivable.

6. Account for and explain the accounting issues related to the recognition andmeasurement of long-term notes and loans receivable

7. Account for and explain the basics related to the derecognition of receivables.

8. Explain how receivables and loans are reported and analyzed.

9. Identify differences in accounting between accounting standards for private enterprises

(private entity GAAP) and IFRS, and what changes are expected in the near future

10.Explain common techniques for controlling cash (Appendix 7A).

What is a financial asset?

A financial asset is defined by the CICA HandbookSection 3856 as any asset that is:a. cash;b. a contractual right to receive cash or another financial asset from another party;c. a contractual right to exchange financial instruments with another party under conditions that

are potentially favourable;d. or an equity instrument of another entity.

Cash

Cash is the most liquid asset, therefore needs tight control

includes: coin, currency, bank deposits including chequing and savings accounts, andnegotiable instruments such as money orders, cashiers cheques, personal cheques andbank drafts.

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The reporting of cash is relatively straightforward, except when dealing with:

a. bank overdraftsb. restricted cashc.cash equivalentsd. foreign currencies

Special treatment for the following items:

Bank overdrafts Occurs when a cheque is written for more than the amount in the cash account

should be reported as current liabilities (accounts payable).

Disclosed separately if amount is material

They are not offset against the cash account unless there is available cash in anotheraccount at the same bank.

Restricted casha. Cash restricted for some special purpose (such as the retirement of bonds) is reported

separately in either the current asset section or the non-current asset section of thebalance sheet, depending on the date of availability or disbursement.

b. Legally restricted deposits held as compensatingbalances against borrowing arrangementsshould be reported separately in either the current asset section or the non-current assetsection, depending on whether the borrowing arrangement is a short-term or long-term one. When an agreement exists where the bank requires the enterprise to maintain a

minimum cash balance on deposit. The nature of the borrowing arrangement determines whether the compensating balance

is classified as a current asset or a non-current asset.

Cash equivalentsare short-term, highly liquid investments that are both

a) readily convertible to known amounts of cash, andb) so near their maturity that they present a insignificant risk of change in interest rates (e.g.,

30-day treasury bill, short term commercial paper, money market funds).

From an international perspective, IAS 7 allows some equity investments, such as preferredshares close to their redemption date to be included as a cash equivalent.

Private entity GAAP excludes equity investments from the definition of cash equivalents.

Cash equivalents must be measured at their fair value.Investments classified as cash equivalents are very short term so therefore their cost (or

cost plus accrued interest) is generally the same as their fair value.

Cash in foreign currenciesThe foreign currency is translated into Cdn Dollars at the exchange rate on the balancesheet dateIf not restrictions on the transfer of funds to the Cdn company then included in currentassetsIf restrictions, then must be reported as restricted cash.

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Cash Controls Appendix 7A

Cash presents special management and control problems becausea) cash enters into a great many transactions;b) cash is the single asset readily convertible into any other type of asset; andc) neither too much nor too little should be available at any time.

Among the control procedures that are used for cash transactions is the use of bank accountssuch as a general checking account, imprest bank account, and lockbox account

PETTY CASH

Imprest bank accounts are used to make a specific amount of cash available for a limitedpurpose.

a petty cash custodian is given a small amount of currency from which to make smallpayments (minor office supplies, taxi, postage, etc.).

Each time a disbursement is made, the petty cashier obtains a signed receipt for thepayment. (for such things as office supplies, postage, entertainment, etc.)

(No journal entry required for use of petty cash)

When cash in the fund runs low, the petty cashier submits the signed receipts to thegeneral cashier and a cheque is prepared to replenish the petty cash fund.

Review the accounting procedures for a petty cash system:a. The petty cash account is debited or credited only when the fund is first established or is

changed in size.

Petty Cash Fund 300 Cash 300

To record cheque no. ### and to set up the petty cash account.

b. Reimbursements of petty cash on hand are recorded by debiting the expenses, assets, orliabilities involved and crediting the cash account.

When the cash fund is lowThe cash is counted $127The receipts are totalled 171The two are added $298This total is compared to

the original amount 300The difference represents $(2)

the cash shortage or overage.

*A cheque is written for the amount necessary to get the fund amount back to the original total.(300 127 = 173)

Journal Entry:Office SuppliesExpense 42 Postage Expense 53Entertainment Expense 76Cash Over and Short 2

Petty Cash 173

To record the petty cash receipts and cash shortage.

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Bank Reconciliation

A basic cash control is the preparation of the monthly bank reconciliation.

Proves that the cash balance per bank and the cash balance per book are in agreement.

Two forms of bank reconciliations may be prepared:a. Reconciliation from the bank statement balance to the book balance or vice versa.b. Reconciliation of bank and book balances to the corrected cash balance.

This form consists of two separate sections:Balance per bank statement section.

Balance per books section.

Balance per bank statementsection:

The balance per bank statement is the amount shown on the most recent bank statement as ofthe banks closing date for the month. Add deposits recorded in the companys books but not yet credited by the bank (e.g.,deposits in transit). Deduct charges recorded in the companys books but not yet recorded by the bank (e.g.,outstanding cheques).

Balance per books section:The balance per books is the amount shown in the companys cash or cash in chequingaccount general ledger account as of the desired reconciliation date (i.e., as of the balancesheet date, the month-end date, or whatever date for which it is desired to calculate the correctcash balance). Add deposits credited by the bank but not yet recorded by the company (e.g., collection ofnotes, interest earned on interest-bearing chequing accounts, etc.). Deduct charges recorded by the bank but not yet recorded by the company (e.g., service

charges, NSF cheques, etc.).Both sections end with the correct cash balance, which is the amount that should be reported onthe balance sheet.

BANK RECONCILIATIONBalance per bank statement $XXXAdd: Deposits recorded by business but not by bank XXX(Example: Deposits in transit, bank errors)

Deduct: Charges recorded by business but not by bank (XXX)(Example: Outstanding cheques)Corrected balance $

Balance per books $XXXAdd: Deposits recorded by bank but not by business XXX(Example: Note collection)

Deduct: Charges recorded by bank but not by business (XXX)(Examples: Service charges, NSF cheques)Corrected balance $

Every reconciling item that appears in the balance per books section requires an adjustingentry to bring the books to the correct cash balance.

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Receivables

Defined as claims held against customers and others for money, goods, or services.

Loans and receivables result from the delivery of cash or other assets by a lender to a borrowerin return for a promise to repay on a specified date or dates, or on demand, usually with interest

They can be classified as either current or non-current.1. Accounts receivable (trade) are oral promises of the purchaser to pay for goods andservices sold.2. Notes receivable are written promises to pay a certain sum of money on a specified future

date.3. Open accounts receivable are short-term extensions of credit that are based on

purchasers oral promise to pay for goods and services and are usually collected within 30 -

60 days.

Trade receivables (accounts receivable and notes receivable) are usually the mostsignificant receivables an enterprise possesses.

Accounts ReceivableRecognition Issues

These involve the concepts oftiming and measurement. Measurement is complicated by:1. Trade discounts. Trade discounts represent reductions from the list or catalogue prices of

merchandise. They are often used to avoid frequent changes in catalogues or to quotedifferent prices for different quantities purchased. These reductions from the list price are notrecognized in the accounting records; customers are billed net of trade discounts.

2. Cash discounts (sales discounts). These are inducements for prompt payment.a. Gross method (more practical than the net method). Sales and receivables are

recorded at the gross amount. Sales discounts taken by customers are debited to thesales discounts account, which is reported in the income statement as a reduction ofsales.

b. Net method. Sales and receivables are recorded at the net amount. Sales discounts nottaken by customers are credited to the sales discounts forfeited account, which isreported in the other revenue section of the income statement.

3. Interest element. Theoretically, receivables should be measured at their present value butaccountants have chosen to ignore the implicit interest element in receivables that are due

within one year.

Accounts ReceivableValuation Issues

Receivables are valued at net realizable value (the net amount expected to be received incash).

a. Direct write-off method NOT APPROPRIATE except when uncollectible amount isimmaterial.

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When a specific account is determined to be uncollectible (which may not occur in theperiod of sale), bad debt expense is debited and accounts receivable is credited.

This method is theoretically undesirable, because it:i. makes no attempt to match revenues and expenses.ii. does not result in receivables being stated at net realizable value in the balance

sheet.

b. Allowance methodAt the end of each accounting period an estimate is made of expectedlosses from uncollectible accounts. This estimate is debited to bad debt expense and credited to the allowance for doubtful

accounts. This method is justified, because a company has experienced a loss the moment

customers receive goods or services that they will never pay for. This is true even if the specific identity of such customers will not be known for some

time.The following amounts are entered in the T-accounts below:

(1)Beginning balance of Accounts Receivable.(2)Beginning balance of Allowance for Doubtful Accounts.(3)Credit sales.

Accounts Receivable . . . . . . . . . . . . . . XXXSales . . . . . . . . . . . . . . . . . . . XXX

(4) Collections on account.Cash . . . . . . . . . . . . . . . . . . . . . . XXX

Accounts Receivable . . . . . . . . . . . . . XXX

(5) Write-offs of uncollectible accounts.Allowance for Doubtful Accounts . . . . . . . . . XXX

Accounts Receivable . . . . . . . . . . . . . XXX

(6) Year-end adjusting entry for bad debts.Bad Debt Expense . . . . . . . . . . . . . . . . XXX

Allowance for Doubtful Accounts . . . . . . . XXX

(7) Ending balance of Accounts Receivable.(8) Ending balance of Allowance for Doubtful Accounts.

ALLOWANCE FOR DOUBTFUL ACCOUNTS RECEIVABLE ACCOUNTS

(1) Beginning (2) Beginningbalance XXX Balance

XXX(3) Credit sales XXX (4) Collections on

Account XXX (5) Write-offs ofuncollectible

accounts XXX(5) Write-offs (6) Year-endof uncol- adjusting entrylectible for bad debts XX

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accounts XXX(7) Ending (8) Endingbalance XXX balance

XXX

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METHODS FOR ESTIMATING THE YEAR-END ADJUSTINGENTRY FOR BAD DEBTS

(A) Percentage of Sales (Income Statement Approach)

Year-end adjusting entry for bad debts = Percentage Credit sales

(6) = Percentage (3)

(B) Percentage of Outstanding Receivables (Balance Sheet Approach) PREFERREDMETHOD

FirstStep: Required ending balance in Ending balance in

Allowance for Doubtful Accounts = Percentage Accounts Receivable

(8) = Percentage (7)

SecondStep:

Year-end adjusting Required ending balance Current balance in Write offs ofentry for bad debts = in Allowance for Doubtful - Allowance for Doubtful + uncollectible

Accounts Accounts Accounts

(6) = (8) - (2) + (5)

Comparison of Methods for Estimating UncollectiblesPREFERRED METHOD:

Percentage-of-Sales Percentage-of-ReceivablesMatching Net Realizable Value

Sales Bad Debts ReceivablesAllowance for

Expense Bad Debts

Income Statement Approach Balance SheetApproach

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EXAMPLE - ESTIMATING BAD DEBT EXPENSEData

Charge sales $ 500,000Estimated % of charge sales not collectible 1.25 %

Accounts receivable balance $ 72,500

Estimated % of accounts receivable not collectible 8%Case I:Allowance for Doubtful Accounts $ 150 (Credit balance)Case II: Allowance for Doubtful Accounts $ 150 (Debit balance)

Percentage-of-Sales Approach Percentage of Receivables Approach

Step 1:Determine sales figure Step 1: Determine balance in theused. Accounts Receivable account.Charge sales = $500,000 Accounts Receivable balance= $72,500.

Step 2:Calculate estimated Step 2: Calculate required balance forexpense. the Allowance for Doubtful.0125$500,000 = $6,250 Accounts.

.08 $72,500 = $5,800

Step 3:Not necessary. Step 3: Calculate estimated bad debtexpense.

Case IDesired balance $5,800 Cr.

Actual balance 150 Cr.Amount of new expense $5,650

Case II

Desired balance $5,800 Cr.Actual balance 150 Dr.Amount of new expense $5,950

Step 4:Make entry. Step 4: Make entry

Case IBad Debt Expense 6,250 Bad Debt Expense 5,650

Allowance for Allowance forDoubtful Accounts 6,250 Doubtful Accounts 5,650

Case IIBad Debt Expense 5,950

Allowance forDoubtful Accounts 5,950

Special Allowance Accountsto properly match expenses to sales revenues, it is sometimes necessary to establishadditional allowance accounts as contra accounts to accounts receivable if sales returns

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are expected to be significant. The most common allowance is the allowance for salesreturns and allowances.

Short-term Notes ReceivableValuation Issues

The major differences between trade accounts receivable and trade notesreceivables are that:a) notes represent a formal promise to pay; andb) notes bear an interest element, because of the time value of money.

Notes always bear an interest element because of the time value of money, but theymay be classified as interest-bearing or non-interest-bearing.

Interest-bearing notes have a stated rate of interest, whereas non-interest-bearingnotes (zero-interest bearing) include the interest as part of their face amount instead ofstating it explicitly.

As are accounts receivable, short-term notes receivable are recorded and reportedat their net realizable value, that is, at their face value amount, and when material,less all necessary allowances.

o The calculations involved in valuing short-term notes receivable and for recordingbad debt expense and the related allowance are exactly the same as for tradeaccounts receivable. Either a percentage of sales revenue or an analysis ofreceivables can be used to make the estimate.

If financial statements are prepared while the note is outstanding, interest is accrued tothe balance sheet date for both interest and non-interest bearing notes.

Notes should be reported at net realizable value, although allowance for doubtful notescan be difficult to estimate for long-term notes.

Defaulted notes should be written off as a loss.

Long-term Notes and Loans receivable

Interest-bearing debt instruments: the company holding the security on the interestpayment date receives all the interest since the last interest payment date. Atransaction between interest payment dates means that the purchaser will pay anamount in excess of the face value of the debt to compensate. The purchaser thenreceives a full payment of interest at the next payment date.

Fornon-interest-bearing debt instruments, the difference between the securitys

purchase price and its face, or maturity value, represents the interest income.

With long-term loans receivable it is assumed that a note exists, but the difference is thelength oftime to maturity.

Transaction costs in acquiring loans or notes receivable can be:1) expensed when incurred or2) added to the fair value of the instrument (by recording them as an adjustment to

the discount or premium that will be amortized over the life of the loan)

Recognition and measurement standards require:

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A loan receivable is recognized when the entity becomes a party to thecontractual provisions of the financial instrument

When initially recognized, the loan receivable is measured at its fairvalue

After initial recognition, the loan receivable is measured at amortizedcost,

Bad debt losses on the loans receivable are recognized when they aredeemed to be impaired.

Under IFRS the effective interest method of amortization is used for the discountor premium, while under private entity GAAP the amortization method is notspecified. Some private entities prefer to use the straight-line method to amortizediscounts and premiums because of its simplicity.

When a note or loan is issued with the sale of property, goods, or services, the sellingprice will be equal to the present value of cash flows promised by the note,discounted at the market rate of interest.

If the market rate is not known, the fair value of the assets sold can be used todetermine the value of the note. Alternately, a market rate can be imputed by referencing such things as similar

transactions or the existing prime rate.

Accounts and Notes ReceivableDerecognition Issues

In order to accelerate the receipt of cash from receivables, they may be transferred to athird party for cash.

1. Secured borrowing. The owner of the receivables borrows cash from a bank oranother company by designating the accounts receivable as collateral.

2. Sale(factoring). These transfers of receivables may be without recourse or withrecourse.

a. Transfer without recourse: The purchaser assumes the risk of collectibility and absorbs the credit

losses. This is an outright sale of receivables both in form and substance.

A loss on the sale is recognized for the excess of the face amount of thereceivables over the cash proceeds.

b. Transfer with recourseThe sellerguarantees payment to the purchaserfor those receivables that become uncollectible. Receivables that are factored

with recourse are generally accounted for as a sale, with the fair value of therecourse obligation net against the total cash proceeds received from thefactor.

A controversy exists as to whether these transfers should be recorded as a sale(with recognition of gain or loss) or as a collateralized borrowing (with recognition ofa liability).

These transfers should be recognized as a sale if the following conditions are met:

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The transferred assets have been isolated from the transferorput beyondthe reach of the transferor and its creditors, even in bankruptcy orreceivership.

Each transferee has the right to pledge or exchange the assets orbeneficial interests it received and no condition either constrains thetransferee from taking advantage of this right or provides more than atrivial benefit to the transferor.

The transferor does not maintain effective control over the transferredassets through either an agreement to repurchase or redeem them beforetheir maturity or through an ability to unilaterally cause the holder to returnspecific assets.

If the transfer with recourse does not meet these conditions, the transfer should beaccounted for as a secured borrowing and a liability is recorded.

Ratios to access the receivables liquidity & potential cash flow

Accounts Receivable Turnover = _______Net Sales_______

Average trade receivables (net)

Presentation of Receivables and Loans

The objective in presentation and disclosures related to receivables is to allow usersto evaluate the significance of these financial assets to the entitys financial positionand performance and to assess the nature and extent of the associated risks.Presentation of receivables on the balance sheet includes the followingconsiderations:

a. The segregation and separate reporting of ordinary trade accounts,

amounts owing to related parties, prepayments, and other significantamounts;b. Report the amounts and maturity dates of accounts with a maturity

extending beyond one year;c. Separate reporting of receivables that are current assets from those that

are noncurrent;d. Separate reporting of any impaired balance, the amount of any allowance

for credit losses including under IFRS, ad a reconciliation of the changesin the allowance account during the period

e. Disclosure on the income statement of the amounts of interest income,impairment losses, and any reversals associated with such losses.

Major disclosures are also required about the securitization or transfer ofreceivables, whether derecognized or not. Credit risk is the major concernassociated with loans and receivables so IFRS requires more extensiveinformation than what is required under private entity GAAP. In evaluating theliquidity of receivables, the receivable turnover ratio is used.

Refer to Illustration 7-19 in the text. While standards are similar, issues related toimpairment and derecognition are still under study by IFRS.

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ILLUSTRATION 7-1

INTEREST INCOME ON INTEREST-BEARING AND NON-INTEREST-BEARING NOTES RECEIVABLE

COMPANY A: Lends Company C $20,000 July 1, 2009 in exchange for a 2 yearnote that pays interest at a stated rate of 10% semi-annually on Jan. 1and July 1. The market rate of interest for a similar note is also 10%.Company B has a December 31 year end.

COMPANY B: purchases a six-month $20,000 note for $19,231 on March 15.The note matures on Sept 15 and was purchased to yield an 8% return.

COMPANY A COMPANY B

July 1, 2009 March 15 DR Note receivable 20,000 DR Note receivable 19,231CR Cash $20,000 CR Cash 19,231To record purchase To record purchase

December 31, 2009 Sept 15 DR Interest receivable 1,000 DR Cash 20,000CR Interest Revenue 1,000 CR Note receivable 19,231

Accrue semi-annual interest CR Interest revenue

769[$20,000 x 10% x ] To record proceeds on maturity

Jan 1, 2010DR Cash 1,000CR Interest receivable 1,000To record payment of accrued interest

To record payment of note at maturity:

June 1, 2011

DR Cash 21,000CR Notes receivable 20,000CR interest revenue 1,000

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ch7 lecture notes

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