Walk Through Balance Sheet. Chapter 7. Learning Objectives. Learning Objectives 1, 2. Learning Objectives 1, 2. Cash and Receivables.

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1 Chapter 7 Walk Through Balance Sheet Cash and Receivables Chapters 1 6 Accounting cycle: JE, AJE, financial stmts Conceptual framework, GAAP, revenue Time value of money concepts Remaining chapters (ACTG 161, 162) Start at top of balance sheet (Cash) Finish at bottom (Stockholders equity) 1 Look at each balance sheet account Related income statement accounts 2 Learning Objectives Cash and Receivables 1. Identify items considered cash 2. Indicate how to report cash and related items 3. Define receivables, identify types of receivables 4. Recognition of accounts receivable 5. Valuation of accounts receivable 6. Recognition and valuation of notes receivable 7. Fair value option 8. Disposition of accounts and notes receivable 9. Reporting and analyzing receivables Cash " What is cash? " Reporting cash " Summary of cash-related items Accounts Receivable " Recognition of accounts receivable " Valuation of accounts receivable Notes Receivable " Recognition of notes receivable " Valuation of notes receivable Special Issues " Fair value option " Disposition of accounts and notes receivable " Presentation and analysis 3 4 Learning Objectives 1, 2 Identify items considered cash Indicate how to report cash Learning Objectives 1, 2 Identify items considered cash Indicate how to report cash Dr. Pepper, AMR, Blockbuster, SAP, Peet s, Whole Foods (restricted cash) A/R:Apple,Dominos, Office Depot (n), Tiffany (n) 5 6 1

2 Cash Cash Equivalents Accepted deposit at financial institutions Coins and currency Checks from customers and money orders Certified checks and cashier s checks Savings accounts Petty cash Amounts ready to deposit counted as cash, even though not deposited 7 Earn interest on unneeded cash Readily convertible to cash Highly liquid debt securities Maturities of 90 days or less at purchase Highest rating, AAA; little interest rate risk Similar to money market fund Interest = Principal Rate Time Interest = $10,000,000,000 3% 30/360 Interest = $25,000,000 8 Cash Equivalents Cash and Cash Equivalents Debt securities Treasury notes, other government debt Corporate debt (commercial paper, notes) Readily available to Pay off debt Use in operations Money market funds Managed by third party (Fidelity, Schwab) No legal or contractual restrictions No distinction between Cash Cash equivalents Restricted cash NOT cash or equivalent 9 10 Restricted Cash Restricted Cash Cash not available for current use reported as Restricted cash Investments Other assets Can be current or non-current asset Disclosure required 11 Restrictions on cash can be Informal Contractually imposed Informal (management intent) Management sets aside cash for purpose Plant expansion or payment of debt Can be used for other purposed if needed Contractually imposed (legally binding) Vendor or lender requirement in writing 12 2

3 Not Cash If not readily convertible to cash with no penalties or restrictions, not cash Must look at nature of asset Example: Certificate of deposit (CD) Penalty to convert to cash before due date Classify as Short-term investment Compensating Balance Restricts use of cash borrowed Minimum balance required in bank account to reduce risk to bank Can be current of noncurrent Disclosure required If contractual requirement not cash If informal may be cash Compensating Balance Amount borrowed $10,000,000 Compensating balance 2,000,000 Available for use $8,000,000 Interest rate 12% Interest per year 10,000,000 12% = 1,200,000 Effective interest rate 1,200,000 / 8,000,000 = 15% Bank Overdrafts Generally reported as a current liability May net against other cash accounts at same bank, but not at other banks When a company writes a check for more than the amount in its cash account. Compensating balance increases effective interest rate Learning Objectives 3, 4, 5 Define receivables, identify types of receivables Recognition of accounts receivable Valuation of accounts receivable Codification: 305 Cash and Cash Equivalents,10 Overall

4 Receivables Claims held against customers and others for money, goods, or services Accounts receivable Notes receivable We are seller Goods are delivered, service provided Promise of purchaser to pay Open account (no contract signed) Short-term extension of credit Usually 30 to 60 days No interest if paid on time Notes receivable We are lender Use note receivable when Larger amount Repayment longer term Contract signed by borrower stating Principal Interest (stated interest rate) Due date Non-trade Receivables Advances or loans to employees Advances or loans to subsidiaries Deposits for potential damages / losses Deposits as a guarantee of performance or payment Dividends and interest receivable Trade receivables: Receivables from sale of goods or services on account Deliver merchandise or service today, customer pays later Current asset: Converted to cash within normal operating cycle Record receivable at amount of sale Do not use present value Time less than one year Difference between PV and FV small APB Opinion 21 excludes accounts receivable from PV valuation Accounts receivable 5,000 Sales 5,

5 Subsidiary Ledgers General ledger account shows total receivable from all customers Subsidiary ledgers show amount due from each customer Accounts receivable 5,000 General ledger Accounts receivable subsidiary ledgers 5,000 A/R: Smith Description Debit Credit Accounts receivable 5,000 Service revenue 5,000 Performed service on account for customer Smith General ledger Accounts receivable subsidiary ledgers Trade Discounts 5,000 1,000 3,000 9,000 5,000 1,000 3,000 A/R: Smith A/R: Chi A/R: Marx 27 Seller publishes price list Buyers given discount off list price Trade discount reduces selling price Record sale net of discount List price trade discount = sell price No entry made for discount amount If more than one trade discount, apply in chain; second discount applied to net amount after first disc. 28 Trade Discount Trade Discount Description Item Number Price Bookcase NCK749 $1,200 Chair JRK483 $1,000 Table TLW497 $800 Seller offers trade discount of 20% Description Item Number Price Bookcase NCK749 $1,200 Chair JRK483 $1,000 Table TLW497 $800 Seller offers trade discounts of 20%, 15%, 10% Account receivable 800 Sales 800 Sold one chair, 20% trade discount: $1,000 (1 0.20) = $ Account receivable 612 Sales 612 Sold one chair with trade discounts: $1, = $

6 Cash Discounts (Sales Disc.) Cash Discounts 2/10,n/30 Also called early payment discount Sales discount / Purchase discount Reduces amount buyer pays if payment made within a specified period of time Increase sales Discount Percent Number of Days Discount is Available Otherwise, Net (or All) is Due Credit Period 31 Encourage early payment Increase likelihood of collections Not the same as trade discount be careful 32 Cash Discounts: Gross Method Cash Discounts: Net Method Sales are recorded at invoice amounts Sales discounts recorded if payment received within discount period Discount not taken is sales revenue Sales recorded at invoice less discount Sales discounts forfeited if payment received after discount period Discount not taken is interest revenue Cash Discounts On May 10 sold $5,000 of merchandise, cash discount of 1/10, n/30. Net method preferred by GAAP Difference between the gross and net methods usually not material Most companies use gross method Gross Method May 10 Accounts receivable 5,000 Sales 5,000 Net Method May 10 Accounts receivable 4,950 Sales 4,

7 On May 19 received payment in full payment for the sale made on May 10 Financial Statements Gross Method May 19 Cash 4,950 Sales discounts 50 Accounts receivable 5,000 Income Statement (Gross method) Sales $5,000 Sales discounts 50 Net sales 4,950 Net Method May 19 Cash 4,950 Accounts receivable 4, Income Statement (Net method) Sales $4,950 Other income: Financing revenue 0 38 If payment in full received on May 31 (not within discount period) Financial Statements Gross Method May 31 Cash 5,000 Accounts receivable 5,000 Net Method May 31 Cash 5,000 Accounts receivable 4,950 Financing revenue Income Statement (Gross method) Sales $5,000 Sales discounts 0 Net sales 5,000 Income Statement (Net method) Sales $4,950 Other income: Financing revenue Returns and Allowances Accounts receivable decreased Return: Merchandise returned Allowance: Buyer keeps merchandise Sales returns and allowances?,??? Accounts receivable?,???

8 Adjusting Journal Entries AJE required if returns or cash discounts in future periods are material Estimate future returns and discounts Amount material Record in same period as related sale ACCOUNT ACTIVITY Sales Sales Sales returns Returns Sales discounts Discounts Net Sales Sales (after trade discounts) Sales returns and allowances Sales discounts (cash discounts) Net sales Will all receivable be collected? No! Balance sheet must show amount expected to be collected Net realizable value Bad debt expense is operating expense Match to revenue in period of sale Revenue Contra-revenue Direct Write-off Method Not permitted by GAAP Only use direct write-off when uncollectible accounts immaterial Write-off account when identified No allowance account Bad debt expense?,??? Accounts receivable?,??? ALLOWANCE METHOD If uncollectible accounts material Allowance method required by GAAP Do not wait for specific accounts to become uncollectible Estimate future uncollectible accounts Match expense with related sales revenue Balance sheet shows net collectible

9 Matching Principle Sales Revenue Accounts receivable Allowance for uncollectible accounts Matching Principle Record in same period Net accounts receivable Bad Debt Expense 49 Asset Contra-asset 50 ACCOUNT ACTIVITY Estimate Bad Debt Expense Accounts receivable Sales Returns Collections Write-offs Asset Estimate bad debt expense with AJE Bad debt expense?,??? Allowance for uncoll. acc.?,??? Allow Uncollectible Write-offs AJE Est. Contra asset Assets = Liabilities + Equity È È Estimating Expense Methods to Estimate Two methods to estimate Income Statement Approach Balance Sheet Approach Percent of Sales A/R Aging Emphasis on Matching Sales Bad Debts Exp. Emphasis on Realizable Value Accts. Rec. All. for Uncoll. Accts. 53 Percentage of Sales Accounts receivable aging 54 9

10 Percentage-of-Sales Estimate bad debt expense associated with credit sales in current period Income statement approach Match expense to revenue Income statement fairly stated Balance sheet (net A/R) not fairly stated Percent-of-sales Balances before year-end adjustments Contra asset account Allow Uncollectible 100,000 5, Percent-of-sales method ignores these two values 56 Percent-of-Sales Percent-of-Sales Sales $500,000 Uncollectible estimated 1.5% of sales Bad debt expense = $500, Bad debt expense = $7, ,000 Allow Uncollectible 5,000 7,500 12,500 Bad debt expense 7,500 Allowance for uncoll. acc. 7,500 Balance Sheet Accounts receivable 100,000 Less allowance 12, Net accounts receivable 87, Percent-of-Sales Matched expense to revenue Income statement fairly stated Ignored values on balance sheet Balance sheet may not be fairly valued Changes in estimate prospective Less accurate estimates from previous periods never corrected Aging Of Receivables Age invoices, predict % not collected Estimate receivables not collectible

11 Aging Of Receivables Balance sheet approach Balance sheet fairly stated Income stmt may not be fairly stated (no matching) Aging Of Receivables Balances before year-end adjustments Balance Sheet Accounts receivable 547,000 Less allowance 37,650 Net accounts receivable 509,350 Allow Uncollectible 100,000 5,000 Aging method uses these two values Days from invoice date Invoice Total ,000 3,000 Invoice number ,000 15, ,000 12,000 Invoice amount ,000 13, ,000 30, ,000 27,000 Total 57,000 25,000 15,000 3, ,000 Est % 2% 5% 10% 60% Allow. 1,140 1,250 1,500 1,800 5, Days from invoice date Invoice Total ,000 3,000 Invoice number ,000 15, ,000 12,000 Invoice amount ,000 13, ,000 30, ,000 27,000 Total Balance Sheet 57,000 25,000 15,000 3, ,000 Accounts receivable 100,000 Est % 2% 5% 10% 60% Less allowance 5,690 Allow. 1,140 1,250 1,500 1,800 5,690 Net accounts receivable 94,

12 Aging Of Receivables Aging estimates $5,690 not collectible Aging Of Receivables Aging estimates $5,690 not collectible Allow Uncollectible Allow Uncollectible 100,000 5, , ,000 5, , Balance Sheet Accounts receivable 100,000 Less allowance 5,690 Net accounts receivable 94, Aging Of Receivables Adjusting journal entry $690 Aging Of Receivables What if Allowance balance was $500? Allow Uncollectible Allow Uncollectible 100,000 5, , , ??? 5,690 Bad debt expense 690 Allowance for uncoll. acc Aging Of Receivables Adjusting journal entry $5,190 Aging Of Receivables What if Allowance balance was $6,000? Allow Uncollectible Allow Uncollectible 100, ,190 5, ,000 6,000??? 5,690 Bad debt expense 5,190 Allowance for uncoll. acc. 5,

13 Aging Of Receivables Adjusting journal entry $310 Allow Uncollectible 100, ,000 5,690 Aging Of Receivables Balance sheet fairly valued Net A/R fairly estimated Income statement not fairly stated Expenses not matched to revenue Estimates from previous periods that were too high (too low) are reversed Allowance for uncoll. acc. 310 Bad debt expense Estimate Bad Debt Expense Writing Off Accounts Estimate doubtful accounts expense with an adjusting journal entry Write-off $1,000 Bad debt expense?,??? Allowance for uncoll. acc.?,??? Allowance for uncollectible acc. 1,000 Accounts receivable 1,000 Assets = Liabilities + Equity È È 75 Assets = Liabilities + Equity Ç È 76 Writing Off Accounts Estimates And Actual AJE Doubtful Acc. Exp. (Estimated) Before Write-off After Write-off Accounts receivable $100,000-1,000 $99,000 Write-off account receivable (Actual) Less allowance 5,000-1,000 4,000 Accounts receivable, net $95,000 $95,000 Allowance for Uncoll Acc Actual Estimated

14 Collect Account Written-Off Sale On Account Reverse write-off Accounts receivable 1,000 Allowance for uncollect. acc. 1,000 Record collection of receivable Accounts receivable Sales A L SE Ç Ç Cash 1,000 Accounts receivable 1, Collect Cash On Account AJE Estimate Doubtful Accounts Expense A L SE A L SE Accounts receivable Ç Accounts receivable Ç Sales Ç Sales Ç Cash Ç Cash Ç Accounts receivable È Accounts receivable È Doubtful accounts expense È Allowance for doubtful acc. È Write-off Account Account Activity Accounts receivable Sales Cash A L SE Ç Ç Ç Accounts receivable Sales Returns Collections Write-offs Asset Accounts receivable È Doubtful accounts expense Allowance for doubtful acc. Allowance for doubtful acc. È Ç È Allow Uncollectible Write-offs AJE Est. Contra asset Accounts receivable È

15 Learning Objectives 6 Recognition of notes receivable Valuation of notes receivable Notes Receivable Written contract From borrower to lender Negotiable (may be sold) Promise to pay From borrower (maker) to lender (payee) Principal (amount borrowed) Plus interest (stated or unstated) On date Notes Receivable vs. A/R Compared to accounts receivable Dollar amount higher Payment terms longer Higher risk of default Earn interest on outstanding balance Legal contract Easier to enforce in court Why Notes Receivable? Customers extend payment period High-risk or new customers Sales of property, plant, and equipment Lending transactions (majority of notes) Loans to employees, subsidiaries, vendors PROMISSORY NOTE $25,000 Nov. 1, 2011 Face Value Term Date One year Principal Notes Receivable after date I promise to pay to the order of Payee Westward, Inc. Twenty-five thousand and no/ Dollars plus interest at the annual rate of 12%. Maker Interest Rate Date of Note Janet Lee, Winn,Co. 89 Interest Computation Principal Interest rate Time = Interest Rate is rate per year Time is years or fractions of years If time one year, simple interest If time > one year, compound interest (TVM) Home / Broad Transactions / 835 Interest / 30 Imputation of Interest 90 15

16 November 1, 2011: Loan $25,000, 12%, one year Journal entries November 1, December 31, 2011 November 1, 2011: Loan $25,000, 12%, one year Journal entry on due date, November 1, 2012 Entry to record receivable Nov 1 Note receivable 25,000 Cash 25,000 Adjusting journal entry to accrue interest: $25,000 12% 2/12 Dec 31 Interest receivable 500 Interest revenue 500 Entry to record collection of receivable Nov 1 Cash 28,000 Note receivable 25,000 Interest receivable 500 Interest revenue 2,500 $25,000 12% 10/12 = $2, Non-Interest-Bearing Notes Actually do bear interest Interest is deducted (discounted) from the face value of the note Use market rate of interest Face value = Principal + interest Cash received = Face value interest Non-Interest-Bearing Notes Discount is future interest revenue Discount is contra account to notes receivable December 31, 2011, accepted $25,000, one-year non-interest-bearing, note discounted at 12% Entry to record acceptance of note receivable Discount = $25, = $3,000 Dec 31 Note receivable 25, Discount on note receivable 3,000 Cash 22,000 Note Receivable 25,000 Balance Sheet December 31, 2011 Note receivable $25,000 Discount on note receivable 3,000 Net note receivable $22,000 Discount is revenue to be recognized in future periods Discount on N/R 3,

17 December 31, 2011, accepted $25,000, one-year non-interest-bearing, note discounted at 12% Entry to record acceptance of note receivable Discount = $25, = $3,000 Dec 31 Note receivable 25, Discount on note receivable 3,000 Cash 22,000 Entry to record collection of note receivable Dec 31 Cash 25, Discount on note receivable 3,000 Interest revenue 3,000 Note receivable 97 25,000 Notes Received in Exchange for Property, Goods, Services In arm s length bargained transaction stated rate is presumed fair unless No interest rate is stated Stated interest rate is unreasonable Face amount of the note is materially different from the current cash sales price 98 Notes Received in Exchange for Property, Goods, Services Stated rate not fair, use better known of FMV of goods, services FMV of note Interest rate (estimate market rate) Given all numbers except one Work backwards to plug for unknown Notes Receivable for Land: 1 Sold land, received five year, non-interest bearing N/R Face value note $35,000 Fair value land $20,000 Interest rate Unknown Cost of land $14,000 PV of note = Cash value of asset today = Fair value of land = $20,000 Calculation of Discount on Note Receivable Future value (face value of note) $35,000 Present value (fair value of land) 20, Discount (future interest revenue) 15, Sold land, received five year, non-interest bearing N/R Face value note $35,000 Fair value land $20,000 Interest rate Unknown Cost of land $14,000 Calculation of Discount on Note Receivable Future value (face value of note) $35,000 Present value (fair value of land) 20,000 Discount (future interest revenue) 15,000 Description Debit Credit Note receivable 35,000 Discount on note receivable Plug 15,000 Land 14,000 Gain on sale of land 6, Notes Receivable for Land: 2 Sold land, received five year, non-interest bearing N/R Face value note Unknown Fair value land $30,000 Interest rate 8% Cost of land $10,000 Present value FV$1 factor = Future value $30, (8%, 5) = $44,080 Calculation of Discount on Note Receivable Future value (face value of note) $44,080 Present value (fair value of land) 30,000 Discount (future interest revenue) $14,

18 Sold land, received five year, non-interest bearing N/R Face value note Unknown Fair value land $30,000 Interest rate 8% Cost of land $10,000 Calculation of Discount on Note Receivable Future value (face value of note) $44,080 Present value (fair value of land) 30,000 Discount (future interest revenue) $14,080 Description Debit Credit Note receivable 44,080 Discount on note receivable Plug 14,080 Gain on sale of land 20,000 Land 10, Notes Receivable for Land: 3 Sold land, received five year, non-interest bearing N/R Face value note $40,000 Fair value land Unknown Interest rate 10% Cost of land $14,000 Future value PV$1 factor = Present value $40, (10%, 5) = $24,837 Calculation of Discount on Note Receivable Future value (face value of note) $40,000 Present value (fair value of land) 24,837 Discount (future interest revenue) $15, Notes Receivable for Land: 3 Notes Receivable Fair value of land = $24,837 Sold land, received five year, non-interest bearing N/R Face value note $40,000 Fair value land Unknown Interest rate 10% Cost of land $14,000 Description Debit Credit Note receivable 40,000 Discount on N/R Plug 15,163 Gain on sale of land 10,837 Land 14, Short-Term Record at face value, less allowance Long-Term Record at present value of cash expected to be collected 106 Non-Interest-Bearing Note Non-Interest-Bearing Note Face value $10,000 Term Three years Stated rate 0% Interest paid At maturity Market rate 9% Compounding Annually PV of $1 Discount at market rate of interest, 9% $10,000 Future value $0 $0 $0 Annuity n = Future value PV$1 Present value $10, = $7,

19 Non-Interest-Bearing Note Year Beg bal Interest 9% End bal 0 7, , , , , , ,000 Total 2,278 Non-Interest-Bearing Note Year Beg bal Interest 9% End bal 0 7, , , , , , ,000 Total 2,278 Entry to record creation of note receivable Dec 31 Note receivable 10, Discount on note receivable 2, Cash 7, Note Receivable 10,000 Balance Sheet December 31, 2011 Note receivable $10,000 Discount on note receivable 2,278 Net note receivable $7,722 Discount is revenue to be recognized in future periods Discount on N/R 2, Non-Interest-Bearing Note Year Beg bal Interest 9% End bal 0 7, , , , , , ,000 Total 2,278 Entry to record annual interest revenue earned during first year Dec 31 Discount on note receivable 695 Interest revenue Non-Interest-Bearing Note Non-Interest-Bearing Note Year Beg bal Interest 9% End bal 0 7, , , , , , ,000 Total 2,278 Year Beg bal Interest 9% End bal 0 7, , , , , , ,000 Total 2,278 Entry to record annual interest revenue earned during second year Dec 31 Discount on note receivable 758 Interest revenue Entry to record annual interest revenue earned during third year Dec 31 Discount on note receivable 826 Interest revenue

20 Non-Interest-Bearing Note Year Beg bal Interest 9% End bal 0 7, , , , , , ,000 Total 2,278 Entry to record collection of note receivable on due date Dec 31 Cash 10,000 Note receivable 10, ,000 2,278 Cash 7,722 Interest revenue ,278 Note Year Receivable Beg bal Interest Discount 9% on End N/R bal 0 7,722 10,000 10, , , , , , , Total 2, Year Cash Beg bal Interest Interest 9% revenue End bal 0 7,722 10,000 7, , , , , , ,000 2,278 2,278 Total 2,278 Cash 10,000 7,722 2,278 Interest revenue ,278 Note Receivable 10,000 10,000 0 Discount on N/R 695 2, Note Receivable 10,000 10,000 0 Discount on N/R 695 2, Two interest rates Note Issued at Par (Face Value) Interest rate Stated rate = Market rate Stated rate < Market rate Stated rate > Market rate Note issued at Face value (par) Discount (less than par) Premium (more than par) Face value $10,000 Term Three years Stated rate 10% Interest paid Annually Market rate 10% Compounding Annually Interest paid (annuity) = Face value stated rate time $1,000 = $10,000 10% 1 Discount at market rate of interest, 10% $10,000 Future value $1,000 1,000 1,000 Annuity n =

21 Note Issued at Face Value Note Issued at Face Value PV of annuity $1 PV of $1 Annuity PV$1 Ord Ann Present value $1, = $2, Future value PV$1 Present value $10, = $7, Note Issued at Face Value Note Issued at Face Value Calculation of present value of note receivable Present value of face value of note (FV) $ 7,513 Present value of interest payments (annuity) 2,487 Present value of note receivable $ 10,000 Creation of note receivable at par (face value), interest rate 10% Jan 1 Note receivable 10,000 Cash 10,000 Annual interest revenue earned and cash collected, interest rate 10% Dec 31 Cash (10,000 10% 1) 1,000 Interest revenue 123 1,000 Beginning Balance Interest Revenue Cash Received Ending Balance 0 10, ,000 1,000 1,000 10, ,000 1,000 1,000 10, ,000 1,000 1,000 10,000 3,000 3,000 Interest revenue = Beginning balance market rate time Cash received (annuity) = Face value stated rate time 124 Two interest rates Note Issued at Discount Interest rate Stated rate = Market rate Stated rate < Market rate Stated rate > Market rate Note issued at Face value (par) Discount (less than par) Premium (more than par) Face value $10,000 Term Three years Stated rate 10% Interest paid Annually Market rate 12% Compounding Annually Interest paid (annuity) = Face value stated rate time $1,000 = $10,000 10% 1 Discount at market rate of interest, 12% $10,000 Future value $1,000 1,000 1,000 Annuity n =

22 Note Issued at Discount Note Issued at Discount PV of annuity $1 PV of $1 Annuity PV$1 Ord Ann Present value $1, = $2, Future value PV$1 Present value $10, = $7, Note Issued at Discount Note Issued at Discount Calculation of discount on note receivable Face value of note $ 10,000 Present value of note ($7,118 + $2,402) 9,520 Discount $ 480 Calculation of discount on note receivable Face value of note $ 10,000 Present value of note ($7,118 + $2,402) 9,520 Discount $ 480 Creation of note receivable; stated rate 10%, market rate 12% Jan 1 Note receivable 10,000 Discount on note receivable 480 Cash 9, Balance sheet Note receivable $ 10,000 Less discount on note receivable 480 Net note receivable $ 9, Beginning Balance Interest Revenue Cash Received Discount Amortized Discount Remaining Ending Balance , ,520 1,142 1, , ,662 1,159 1, , ,821 1,179 1, ,000 3,480 3, Interest revenue = Beginning balance market rate time Cash received (annuity) = Face value stated rate time Discount amortized = Interest revenue cash received Discount remaining = Previous discount discount amortized Ending balance = Face value discount remaining OR Ending balance = Previous balance + discount amortized 131 Beginning Balance Note Issued at Discount Interest Revenue Cash Received Discount Amortized Discount Remaining First period: Annuity, interest revenue; stated rate 10%, market rate 12% Dec 31 Cash 1,000 Discount on note receivable 142 Ending Balance , ,520 1,142 1, , ,662 1,159 1, , ,821 1,179 1, ,000 3,480 3, Interest revenue 1,

23 Beginning Balance Interest Revenue Cash Received Discount Amortized Discount Remaining Last period: Annuity, interest revenue; stated rate 10%, market rate 12% Dec 31 Cash 1,000 Discount on note receivable 179 Ending Balance , ,520 1,142 1, , ,662 1,159 1, , ,821 1,179 1, ,000 3,480 3, Interest revenue 1,179 Collection of note receivable on due date Dec 31 Cash 10,000 Note receivable 10, ,000 1,000 1,000 10,000 3,480 Cash 9,520 Interest revenue 1,142 1,159 1,179 3,480 Beginning Interest Cash Discount Discount Ending Note Receivable Discount on N/R Balance Revenue Received Amortized Remaining Balance 0 10,000 10, , ,520 9,662 1,142 1,159 1,000 1, ,662 9, ,821 1,179 1, , ,480 3, Beginning Cash Interest Cash Discount Interest Discount revenue Ending Balance Revenue Received Amortized Remaining Balance 0 1,000 9, ,142 9,520 1, ,520 1,142 1, ,159 9,662 1, ,662 1,179 10,000 1,159 1, , ,821 3,480 1,179 1, ,000 3,480 3,480 3, ,000 1,000 1,000 10,000 3,480 Cash 9,520 Interest revenue 1,142 1,159 1,179 3,480 Note Receivable 10,000 10,000 0 Discount on N/R Note Receivable 10,000 10,000 0 Discount on N/R Two interest rates Note Issued at Premium Interest rate Stated rate = Market rate Stated rate < Market rate Stated rate > Market rate Note issued at Face value (par) Discount (less than par) Premium (more than par) Face value $10,000 Term Three years Stated rate 15% Interest paid Annually Market rate 12% Compounding Annually Interest paid (annuity) = Face value stated rate time $1,500 = $10,000 15% 1 Discount at market rate of interest, 12% $10,000 Future value $1,500 1,500 1,500 Annuity n =

24 Note Issued at Premium Note Issued at Premium PV of annuity $1 PV of $1 Annuity PV$1 Ord Ann Present value $1, = $3, Future value PV$1 Present value $10, = $7, Note Issued at Premium Note Issued at Premium Calculation of discount on note receivable Face value of note $ 10,000 Present value of note ($7,118 + $3,603) 10,721 Premium $ 721 Calculation of discount on note receivable Face value of note $ 10,000 Present value of note ($7,118 + $3,603) 10,721 Premium $ 721 Creation of note receivable; stated rate 15%, market rate 12% Jan 1 Note receivable 10,000 Premium on note receivable 721 Cash 10, Balance sheet Note receivable $ 10,000 Add premium on note receivable 721 Net note receivable $ 10, Beginning Balance Interest Revenue Cash Received Premium Amortized Premium Remaining Ending Balance , ,721 1,287 1, , ,508 1,261 1, , ,269 1,232 1, ,000 3,780 4, Interest revenue = Beginning balance market rate time Cash received (annuity) = Face value stated rate time Premium amortized = Cash received interest revenue Premium remaining = Previous premium premium amortized Ending balance = Face value + premium remaining OR Ending balance = Previous balance premium amortized 143 Beginning Balance Note Issued at Premium Interest Revenue Cash Received Premium Amortized Premium Remaining Ending Balance , ,721 1,287 1, , ,508 1,261 1, , ,269 1,232 1, ,000 3,780 4, First period: Annuity, interest revenue; stated rate 15%, market rate 12% Dec 31 Cash 1,500 Premium on note receivable 213 Interest revenue 1,

25 Valuation of Notes Receivable Short-Term Record at net realizable value (like A/R) NRV = Face value less allowance Long-Term Record at present value of cash flows Disclose cost and fair value in notes Fair value option Learning Objectives 7 Fair value option Fair Value Option Optional, not required Make valuation decision (fair value or cost) when note receivable acquired Irrevocable: Cannot change valuation method during lifetime of note Fair Value Option If fair value option chosen: Change in fair value AJE each period Unrealized holding gains (losses) are Other rev and exp on income stmt Notes Receivable at Fair Value Notes receivable Carrying amount (book value): $800,000 Fair value on balance sheet date $700,000 Company selected fair value option Adjusting journal entry required Learning Objectives 7 Disposition of accounts and notes receivable Description Debit Credit Unrealized holding loss 100,000 Note receivable 100,

26 Seller Financing Practice of seller financing to increase sales volume has grown over time GE Finance Caterpillar Finance Automobile financing Seller often does not hold receivable Immediately sells to convert to cash Financing With Receivables Have receivable, need cash How do we convert receivable to cash? Two types of financing with receivables Secured borrowing (A/R used as collateral) Factoring (Sale of receivables) Method depends on the surrender of control over the receivables transferred Terminology Secured borrowing (A/R as collateral) Pledging Assigning Factoring (Sale of receivables) Sale with recourse Sale without recourse Securitization Secured Borrowing: Pledging Receivables in general pledged as collateral for loans Pledged receivables disclosed in notes to financial statements No journal entries No change in financial statements Receivables transferred to custodian Secured Borrowing: Pledging Borrowed $50,000 Issued note payable Pledged A/R as collateral Description Debit Credit Cash 50,000 Note payable 50,000 Secured Borrowing: Assigning Use of specific receivables as collateral If fail to repay debt, proceeds from specific accounts receivable collections used to repay debt On balance sheet reclassify specific accounts receivable as Assigned

27 Assignment of December 1, 2011, borrow $500,000 Interest rate 12%, payable monthly Assigned $620,000 of A/R as collateral Collateral > note reduces risk to lender Description Debit Credit Accounts receivable assigned 620,000 Accounts receivable 620, Assignment of December 1, 2011, borrow $500,000 Interest rate 12%, payable monthly Assigned $620,000 of A/R as collateral Collateral > note reduces risk to lender Finance fee: 1.5% of A/R assigned Description Debit Credit Cash Plug 490,700 Finance charge expense (1.5% $620,000) 9,300 Liability financing arrangement [Note pay] 500, Assignment of Balance Sheet December 1, 2011 Accounts receivable assigned $620,000 Less: Liability financing arrangement 500,000 Equity in accounts receivable assigned $120,000 Current asset shown net of current liability (rarely done) Assignment of During December, 2011 Collect $400,000 in accounts receivable Remit $400,000 to lender plus interest Description Debit Credit Cash 400,000 Accounts receivable 400, Interest expense ($500,000 12% 1/12) 5,000 Liability financing arrangement [Note pay] 400,000 Cash 405, Assignment of Balance Sheet December 31, 2011 Accounts receivable assigned $220,000 Less: Liability financing arrangement 100,000 Equity in accounts receivable assigned $120,000 Accounts receivable assigned = $620, ,000 Liability financing arrangement = $500, ,000 Terminology Secured borrowing (A/R as collateral) Pledging Assigning Factoring (Sale of receivables) Sale with recourse Sale without recourse Securitization

28 Three Conditions of Sale All conditions must be met for sale 1. Receivables isolated from seller 2. Buyer has right to pledge or exchange receivables 3. Seller does not have control Cannot repurchase before maturity Cannot require return of receivables Factoring A factor is a financial institution that Buys receivables for cash Handles billing, collection of receivables Charges a fee for the service Google search: sell accounts receivable to factor Parking arrangement allows seller to repurchase Not considered a sale of receivables With or Without Recourse Without recourse Buyer assumes all risk of uncollectibility Most sales without recourse With recourse Seller retains risk of uncollectibility Seller guarantees buyers will be paid Record the estimated fair value of the recourse obligation as a liability Sale of Receivables Control of receivable passes to factor A/R removed from sellers books Cash paid from buyer to seller Financing expense (or loss) recognized Sale of A/R Without Recourse Sold $600,000 of A/R without recourse Buyer immediately remits 90% in cash Buyer charges 4% of A/R sold as fee Buyer retains 6%, paid after collections Possible excessive returns and discounts Description Debit Credit Cash (90% $600,000) 540,000 Loss on sale of receivables (4% $600,000) 24,000 Receivable from factor (6% $600,000) 36, Accounts receivable 600,

29 Sale of A/R With Recourse Securitization Sold $600,000 of A/R with recourse Buyer immediately remits 90% in cash Buyer charges 4% of A/R sold as fee Buyer retains 6%, paid after collections Estimated recourse liability, $5,000 Description Debit Credit Cash (90% $600,000) 540,000 Loss on sale of receivables (4% $600,000)+5,000 29,000 Receivable from factor (6% $600,000) 36,000 Recourse liability 5,000 Accounts receivable 600, Factor creates special purpose entity (SPE), usually trust or subsidiary SPE buys pool of trade receivables or loans from Factor SPE sells notes (bonds, comm. paper) backed (collateralized) by receivables 170 Discounting Note Receivable A note receivable can be used to obtain immediate cash from a financial institution either by pledging note as collateral for a loan or selling note Selling note is called discounting Discounting Note Receivable Discounting Note Receivable The financial institution accepts note and gives seller cash equal to maturity value of note reduced by a discount Discount is computed by applying a discount rate to maturity value Discount represents financing fee financial institution charges for transaction 173 December 31 Loaned vendor $200,000 Accepted a nine-month note Stated interest rate on note, 10% Interest rate on note equals market rate Description Debit Credit Note receivable 200,000 Cash 200,

30 Discounting Note Receivable Three months later on March 31 Need cash to make payroll Discounted note at bank (factor) Factor discount rate, 12% Step 1: Accrue Interest Accrue interest during period held Face value of note, $200,000 Time, three months (Dec 31 Mar 31) Interest rate on note, 10% $200,000 10% 3/12 = $5,000 Description Debit Credit Interest receivable 5, Interest revenue 5, Step 2: Calc Maturity Value Calculate maturity value of note Face value of note, $200,000 Time, nine months Interest rate on note, 10% $200,000 10% 9/12 = $15,000 Face value $200,000 Interest to maturity 15,000 Maturity value $215, Step 3: Calc Cash Proceeds Discount maturity value of note Discount rate on note, 12% Time period of discount, six months $215,000 12% 6/12 = $12,900 Maturity value $215,000 Less discount 12,900 Cash proceeds $202, Step 4: Record Journal Entry Classifying Receivables Description Debit Credit Cash (Step 3) 202,100 Loss on sale of note receivable Plug 2,900 Note receivable (Given) 200,000 Interest receivable (Step 1) 5,000 Sale of receivable can result in gain or loss Segregate different types of receivables Use valuation accounts as needed (Allowance for uncollectibles, returns) Determine if current or non-current Disclose loss contingencies Disclose A/R pledged as collateral Disclose concentrations of credit risk

31 Learning Objectives 9 Reporting and analyzing receivables Turnover How many times do we collect average receivables during year A/R turnover = Net sales Average A/R Turnover How many times do we collect average receivables during year Days To Collect A/R How many days to collect $1 of A/R A/R turnover = Net sales Beg A/R + End A/R ( 2 ) Days to collect A/R = 365 A/R turnover Cash Controls Management faces two problems in accounting for cash transactions Establish proper controls to prevent unauthorized transactions by officers or employees Properly manage cash on hand and cash transactions Cash Controls Physical Protection of Cash Balances Minimize the cash on hand Keep funds in a safe Transmit each day s receipts to the bank Reconcile general ledger and bank balance

32 Petty Cash Small amount of cash on hand ($100) Reimburse for small purchases Voucher, receipt required for payment Under control of petty cash custodian Replenished when below minimum Petty Cash Petty cash fund created (check written on bank account) Jan 1 Petty cash 100 Cash 100 Petty cash fund replenished (check written on bank account) Jan 31 Office supplies expense 25 Postage expense 50 Employee food expense Cash Cash Short and Over Income statement account Debit decreases, credit increases N/I Difference between actual cash and amount per independent records Bank Reconciliation Explains difference between cash reported on bank statement and cash balance on company s books (G/L) Provides information for adjusting journal entries Reconciliation of cash drawer, cash collected should equal cash sales May 10 Cash (actual increase in cash drawer) 820 Cash short and over 5 Sales (cash sales per register tape) Bank Reconciliation Book, bank balances differ because of timing differences Cash moves through books at a different time than through bank Bank Reconciliation Important internal control procedure Two records of transactions: book, bank Identifies all cash inflow and outflows

33 Bank Reconciliation Bank Reconciliation Bank Balance Book Balance Book Balance + Deposits in Transit - Outstanding Checks ± Bank Errors + Bank Collections - Service Charges - NSF Checks ± Book Errors All reconciling items on the book side require an adjusting entry to the cash account + Bank Collections - Service Charges - NSF Checks ± Book Errors = True Cash Balance = True Cash Balance 193 = True Cash Balance 194 Bank Reconciliation May 31 bank statement, $34,680 Cash G/L account, $35,276 Bank Reconciling Items May 31 bank statement, $34,680 Total unrecorded deposits, $3,985 Unrecorded cash deposits, $2,965 $1,020 check mailed to the bank for deposit had not reached bank Outstanding checks totaled $5, Bank Reconciling Items Book Reconciling Items Bank Balance Reconciliation Bank balance, May 31 $34,680 Add: Deposits in transit 3,985 Deduct: Outstanding checks (5,536) True cash balance $33,129 Cash G/L account, $35,276 On bank statement $80 service charge on bank statement Bank returned NSF checks, $2,187 Bank collected a note receivable for $1,120 that included $120 of interest Error found: Check written for $1,790 was erroneously recorded at $

34 Book Reconciling Items Book Balance Reconciliation Book balance, May 31 $35,276 Add: Note collected by bank 1,000 Add: Interest collect by bank 120 Deduct: Bank service charges (80) Deduct: NSF checks (2,187) Deduct: Correction of book error (1,000) True cash balance $33, Bank to Corrected Balance Reconciliation Bank balance, May 31 $34,680 Add: Deposits in transit 3,985 Deduct: Outstanding checks 5,536 True cash balance $33,129 Book to Corrected Balance Reconciliation Book balance, May 31 $35,276 Add: Note collected by bank 1,000 Add: Interest collect by bank 120 Deduct: Bank service charges (80) Deduct: NSF checks (2,187) Deduct: Correction of book error (1,000) True cash balance $33, Book to Corrected Balance Reconciliation Book balance, May 31 $35,276 Add: Note collected by bank 1,000 Add: Interest collect by bank 120 Deduct: Bank service charges AJE (80) Deduct: NSF checks (2,187) Deduct: Correction of book error (1,000) True cash balance $33,129 Description Debit Credit Cash 1,120 Note receivable 1,000 Interest revenue 120 Impairments of Receivables Companies evaluate receivables to determine collectability Allowance method is appropriate when: Probable asset has been impaired Amount of loss reasonably estimated Bank service charge 80 Accounts receivable 2,187 Accounts payable 1,000 Cash 3, Impairments of Receivables $100,000 note, 10% annual interest payment, 3 year life Impairment loss difference between Investment in loan (principal + accrued int) Expected future cash flows discounted at loan s historical effective interest rate 203 Adjusting journal entry to record loss on impairment of note receivable AJE Bad debt expense 12, Allowance for doubtful accounts 12,437 34

35 End of Chapter

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