Pivotal Issues When Managing. Chapter 7. Cash and Receivables. Skyline College Lecture Notes. Cash Considerations. Cash Requirements.

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1 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 7 2 Consists of: Currency and coins on hand Checks and money orders from customers Deposits in checking and savings accounts Cash Considerations Most liquid of all assets Central to operating cycle Cash may include a compensating balance a minimum amount required by a bank for a creditgranting agreement. Seasonal Cycles and Cash Requirements for a Manufacturer of Athletic Sportswear Cash Requirements Credit Policies Evaluating the Level of Accounts Receivable 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 How many times, on average, does a company turn its receivables into cash during an accounting period? Receivable Turnover How long, on average, does it take a company to collect its accounts receivables? Days Sales Uncollected

2 Receivable Turnover Reflects the relative size of a company s accounts receivable and the success of its credit and collection policies Days Sales Uncollected To interpret a company s ratios, take into consideration the industry in which it operates Receivable Turnover = Net Sales Average Net Accounts Receivable Days Sales Uncollected = 365 days Receivable Turnover (Amounts in Millions) Nike s Receivable Turnover for 2004 = $12,253.1 ($2, $2,083.9) 2 Nike s Days Sales Uncollected = 365 days 5.8 = 5.8 times = 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 finance company Borrow money and pledge A/R Factor A/R 7 9 Ford Ford Motor Credit Company GM General Motors Acceptance Corp. Sears Sears Roebuck Acceptance Corp. In case of default on loan, A/R (collateral) can be taken and converted to cash to satisfy the loan Sale or transfer of A/R; the buyer may bear risk of collection (factoring without recourse) or the seller may bear risk of collection (factoring with recourse) 7 10 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 receivables with recourse report in financials? Reports a contingent liability (a potential debt that can develop if customers don t pay receivables)

3 Securitization A company may sell a group of receivables in a batch at a discount to another company or to investors Discounting The sale of promissory notes held as notes receivable 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 Company A Holds $10,000 note payable to Company B; Note will pay $600 in interest Company A should disclose the contingent liability (in the amount of note plus interest) in notes to its financial statements Bank Buys the note for $9,600 If Company B pays, bank will receive $10,600 and realize a $1,000 profit If Company B defaults, Company A is liable for the note Estimating Uncollectibles Estimating Uncollectibles and Ethics There will always be customers who do not pay their accounts, called uncollectible accounts,, or bad debts Match these expenses of selling on credit to the revenues they help generate Estimate the uncollectible expense in the fiscal year in which the sales are made Because estimations are involved, earnings may be easily manipulated If the amount of losses from uncollectible accounts are understated, ttd If the amount of losses from uncollectible accounts are overstated, earnings are overstated. earnings are understated Discussion: Ethics in the World Cash Equivalents 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? 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, 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

4 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 75% of its payments to suppliers using EFT Electronic Banking ATM transactions Debit and credit card purchases Online bill-pay Direct Charge-Off Method Recognize a loss at the time it is determined that an account is uncollectible Tax law requires use of this method when computing 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 Alternate Account Names 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 Allowance for Uncollectible Accounts Allowance for Doubtful Accounts Allowance for Bad Debts Uncollectible Accounts Expense Bad Debts Expense Estimating Uncollectible Accounts Percentage of Net Sales Method Estimated loss should be: Realistic Based on objective information Based on past experience Based don current economic conditions i Two commonly used methods for estimating loss 1. Percentage of net sales method 2. Accounts receivable aging method How much of this year s net sales will not be collected? The answer determines the amount of uncollectible 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

5 Percentage of Net Sales Method Accounts Receivable Aging 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. Uncollecti bleaccountsexpense=.02x ($645,000 $40,000 $5,000) = $12,000 Dec. 31 Uncollectible Accounts Expense 12,000 12,000 To record the uncollectible accounts expense at 2 percent of $600,000 net sales After the above entry is posted, Allowance for Uncollectible Accounts will have a credit balance of $15,600 Dec. 31 3,600 Dec. 31 adj. 12,000 Dec 31 bal. 15,600 How much of the ending balance of accounts receivable will not be collected? The ending balance of Allowance for Uncollectible Accounts is determined directly through an analysis 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 GM1 Analysis of Accounts Receivable by Age Accounts Receivable Aging Method (Case 1) Dec. 31, 20x6: Management has estimated that $2,459 of Accounts Receivable are uncollectible. has a credit balance of $800. Dec Dec. 31 adj. 1,659 Dec. 31 bal. 2,459 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 Notice that the estimated percentage uncollectible increases as accounts become further past due The target balance for the account is $2,459 A credit adjustment of $1,659 will bring the account to its target balance Dec. 31 Uncollectible Accounts Expense 1,659 1,659 To bring the allowance for uncollectible accounts to the level of estimated losses 7 28 Accounts Receivable Aging Method (Case 2) Dec. 31, 20x6: Management has estimated that $2,459 of Accounts Receivable are uncollectible. has a debit balance of $800. Comparison of Two Methods Dec Dec. 31 adj. 3,259 Dec. 31 bal. 2,459 The target balance for the account is $2,459 A credit adjustment of $3,259 will bring the account to its target balance Dec. 31 Uncollectible Accounts Expense 3,259 3,259 To bring the allowance for uncollectible accounts to the level of estimated losses

6 Slide 27 GM1 Insert Exhibit 1, chapter 7, Financial Accounting,8e, Needles,titled "Analysis of Accounts REceivable by Age" Without the exhibit, it is difficult for me to tell where the two boxes should be placed on the slide. Please palce boxes where appropriate Order of appearance: 1. Exhibit 2. Box - Bullets, no background or outline 3. Box - Ornage and outlined Gail Mestas, 10/23/2002

7 Estimates Differ from Write-Offs? Accounts receivable written off during a period will rarely equal the estimated uncollectible amount Shows a debit balance when the total of accounts written off is greater than the estimated uncollectible amount Shows a credit balance when the total of accounts written off is less than the estimated uncollectible amount Writing Off an Uncollectible Account When it becomes clear an account will not be collected, the amount should be written off to: Accounts Receivable The uncollectible amount was already accounted for as an expense when the allowance was established Writing Off an Uncollectible Making and Paying Notes Jan. 15, 20x7: R. Deering, who owes the company $250, is declared bankrupt by federal court. Jan Accounts Receivable 250 To write off receivable from R. Deering as uncollectible because of his bankruptcy Dec. 31 2,459 Jan Bal. 2,209 The write-off does not affect the estimated net realizable value of accounts receivable Accounts Receivable Dec ,400 Jan Bal. 44,150 Net realizable value of A/R Before write-off $44,400 $2,459 = $41,941 After write-off $44,150 $2,209 = $41, A promissory note is an unconditional promise to pay a definite sum of money on demand at a future date Maker Person or company that signs the note and promises to pay the amount All promissory notes that the maker holds that are due in less than one year are categorized as notes payable in the current liability section of the balance sheet Payee Entity to whom payment is to be made All promissory notes that the payee holds that are due in less than one year are categorized as notes receivable in the current assets section of the balance sheet 7 34 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 Interest Rate Maturity Value Cost of borrowing money or the return for lending money, usually stated on an annual basis Total proceeds of a note at maturity date (face value plus interest)

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