Chapter 7: Cash & Receivables L7 (pg 399 436) UNDERSTANDING CASH AND ACCOUNTS RECEIVABLE How Do Companies Manage and Control Cash? Cash flow budgets help anticipate cash needs and minimize borrowing requirements Control of cash includes implementing internal control over physical custody of cash on hand and preparation of regular bank reconciliation What Types of Companies have Extensive Accounts Receivable? Manufacturing and wholesalers An increase in A/R might cause concern as it indicates an inability to collect receivables on a timely basis Retailers may have relatively low A/R because of customers use of major credit and debit cards for payments Accounts Receivable Categories i.e. trade receivables, loan receivables, non trade receivables, interest receivable, advances to employees, amounts due from officers Accounts Receivable Planning and Control Important to manage and control A/R A/R directly related to sales Cannot be too lenient with credit policy Companies typically assess creditworthiness then grant them credit limits Tight credit limits lose potential sales Loose & flexible credit policy higher risk customers, resulting in collectability difficulties Must monitor outstanding A/R by using aged A/R analysis If do not regularly assess A/R, customers may take advantage Should monitor A/R to minimize stress on working capital & bank related debt CASH RECOGNITION AND MEASUREMENT Financial asset is any asset that is: o Cash o Contractual right to receive cash or another financial asset from another party o Contractual right to exchange financial instruments with another party under conditions that are potentially favourable to the entity o Equity instrument of another entity What is Cash? Cash: most liquid financial asset, standard medium of exchange and the basis for measuring and accounting for all other items Consists of coins, currencies, available funds that are on deposit, negotiable instruments (money orders, certified cheques, cashier s cheques, personal cheques, bank drafts) Cash equivalents/short term investments: MMFs, certificates of deposits, short term paper that allow investors to earn interest IFRS also allows preferred shares that are acquired close to their maturity date Reporting Cash Restricted Cash Disclosed separately in long term assets Should not be classified as current asset if there are restrictions that prevent it from being used for current purposes, unless restricted cash offsets a current liability
Cash in long term section is usually set aside for investment or financing purposes Compensating balances: when banks require customers who borrow money from them to keep minimum cash balances Compensating balances give bank an effective interest rate on its loan higher than state rate, because can use restricted amount that must remain on deposit Cash in Foreign Currencies Short term highly liquid investments that are readily convertible to known amounts of cash and are subject to an insignificant risk of changes in value Investments w/ only 3 months or less when acquired qualify under definition I.e. T bills, commercial paper, mmfs Foreign currency translated in Canadian dollars on date of SFP Bank Overdrafts Occur when cheques are written for more than amount in bank account Reports in current liabilities Sometimes reported as A/P If overdraft t is material, should be disclosed separately on face of SFP or notes Should not be offset against cash account Cash Equivalents Short term highly liquid investments readily convertible to known amounts of cash which are subject to an insignificant risk of changes in values Usually hold it for upcoming cash requirements Usually apply to investments with maturities of 3 months or less when acquired to qualify for definition Sometimes bank overdrafts can be deducted when amount of cash and cash equivalents is being determined Summary of Cash Related Items RECEIVABLES RECOGNITION AND MEASUREMENT Definition and Types Receivable is financial asset when there is a contractual right to receive cash or other financial assets from a party Loans receivables: result from one party delivering cash or other assets/services to a borrower in exchange for a promise to repay the amount on a specified date or dates or on demand Trade receivables: amounts owed by customers to whom the company has sold goods or services as part of its normal business operations; result from operating transactions Open A/R: short term extensions of credit based on purchaser s verbal promise to pay for goods and services sold Notes receivables: written promises to pay a certain amount of money on a specified future date Loans receivable: when one party advances cash or other assets to a borrower and receives promise to pay later
Nontrade receivable: can be written promises to pay cash or deliver other assets; generally reported as separate items on SFP Recognition and Measurement of Accounts Receivable Recognize A/R when entity o Becomes party to contractual provisions of financial instrument When there is a legal claim to receive cash or other financial asset o Measure receivable initially at fair value Fair value may not equal exchange price Exchange price: amount due from customer to borrow, indicated on invoice Availability of discounts and length of time between sale and payment make short term receivables more complicated o After recognition, measure receivables at amortized costs Trade Discounts Used to avoid frequent changes in catalogues, quote different prices for different quantities purchased, to hide true invoice price for competitors Quoted in percentages Cash Discounts (Sales Discounts) Used to encourage fast payments In terms or 2/10 n/30 Receivable of sale should be recorded at net or fair value (PV of future cash flows) Most commonly used method to record short term receivables and related sales is to record gross amounts of receivable and sale; full amount assuming no discount will be taken If gross method is used, proper asset valuation requires that a reasonable estimate be made of discounts that are expected to be taken after the date of the statement of financial position and that the amount to be recorded if it is material o Allowance for sales and discounts : contra account to A/R on SFP Net method when receivables are at realizable value, no further adjustment needed o Sales discounts forfeited account: recognized as other revenue on income statement Net method theoretically preferred, rarely used requires more bookkeeping for additional adjusting entries after the discount period has passed Gross method along with added requirement to estimate and record discounts that are expected to be taken after date of SFP, results in same effect on SFP and income statement Sales Returns & Allowances Probable sales returns and price reductions are estimated and deducted as contra accounts against sales on income statement and A/R on the SFP o Results in net sales and net estimated amount of A/R being properly reported on financial statement Sales returns/price allowances reported in same period as sales relate to Nonrecognition of Interest Element Ideally, receivables should be measured initially at fair value, represented by fair value (amount of cash required at date of sale to satisfy outstanding claim) This is equivalent to discounted value of cash that will be received in future Company has to wait for cash receipts, receivable s face amount is not a precise measure of its fair value Both ASPE & IFRS support measuring financial assets as present value of cash expected to receive, and allow NRV to approximate present value for short term trade receivable b/c effect of time value of money is immaterial Measurement of Accounts Receivable after Acquisition A/R measured in subsequent accounting period of amortized cost Where no interest element recognized, nothing to amortize, so then amortized cost & cost are equal
For notes & loans receivable that have interest, asset s carrying amount is amortized Impairment of Accounts Receivable Goal in valuing A/R: report them at no more than the benefits they will ultimately provide to entity Impaired receivables, called bad debts or uncollectible accounts Estimating Uncollectible Trade Account Receivable Companies are exposed to varying levels of credit risk Credit risk: likelihood of loss because of failure of other party to fully pay amount owed Accounting issue ensuring reasonable estimate is made of A/R that is unlikely to be collected Age of accounts is most important indicator used to identify impaired A/R Aging method/percentage of receivables approach : uses past experience to estimate the percentage of its outstanding receivables that will become uncollectible without identifying specific accounts o Objective: report receivables at SFP at NRV (net amount expected to be received in cash) o % used may be a combined rate that reflects an overall estimate of uncollectible receivables o Aging schedules are better approaches as they are more sensitive to actual status of A/R Determines age of each account and applies a different percentage to each of the various age categories based on past experience Shows which accounts need special attention by highlighting how long various A/R have been outstanding Allowance Method Used to account for this estimate of impairment Contra account is used because A/R is supported by subsidiary ledger of each customer s balance owing and management does not know yet which specific accounts will result in non collection and bad debt losses Reports receivables at estimated realizable value, recognizes bad debt losses as expense in same accounting period as when sales on account are made 2 accounting procedures, result in same ending AFDA and Bad Debt Expense accounts o Allowance procedure only Management carries out analysis of A/R balances and makes assessment of estimated uncollectible accounts Bad debt expense account is debited/credited as necessary at end of fiscal year o Mix of procedures Management estimates company s bad debt expense based on percentage of sales (called percentage of sales approach) Fast and simple way to estimate the expense each period For both procedures, at end of year, management must assess year end receivables to ensure AFDA is still appropriate Adjustment may be needed to bring it to necessary balance w/ offsetting debit/credit to bad debt expense
Effects on Accounts Direct Writeoff Method Used where effect of not applying allowance method is highly immaterial No estimates made in advance, no allowance account is used Directly debit BDE and credit A/R; for recovery credit uncollectible amounts recovered Recognition and Measurement of Short Term Notes and Loans Receivable Note receivable is supported by promissory note Promissory note: written promise to pay specific sum of money at a specific future date *makes note receivable a negotiable instrument Notes contain interest element Signed by maker in favour of a designated payee who can then legally and readily sell or transfer the note to others Notes sometimes required by high risk or new companies Often used in loans to employees and subsidiaries and in sales of PPE In some industries, all credit sales supported by notes Basic issues same as A/R: recognition, impairment, measurement, impairment Recognition and Measurement of Long Term Notes and Loans Receivable Recognition & measurement of loans receivable same as A/R o Recognize when entity becomes party to contractual provisions of financial instrument o When initially recognized, measure loans receivable at amortized cost o Recognize bad debt losses on loans receivable when deemed to be impaired Fair value of note/loan receivable: measured at PV of cash amounts that are expected to be collected in future, with amounts discounted at market rate of interest that is appropriate for a loan w/ similar credit risk and other characteristics When stated rate does not equal market rate, FV/PV is different from face value Difference between price for note now and maturity value resulting in either a discount or a premium is amortized over note s life, affecting amount of interest income that is reported IFRS effective interest method of amortization required ASPE amortization method not specified Transaction costs incurred when acquiring loan/note receivable can be treated in 2 ways: o Recognized as expense when occurred o Can be added to fair value of instrument, which then increases original amount that is recognized as its cost at acquisition ASPE loans & receivables accounted for at amortized cost Amortized cost: amount recognized when instrument Is acquired, reduced by any principle payments received, adjusted for amortization of any discount premium if appropriate, write downs for impairments IFRS same accounting applied if loan/note managed on contractual yield basis or loan has basic loan features
Basic loan features: instrument has contractual terms that result in cash flows that are payments of principal and interest Contractual yield basis: company s business model of holding instruments for principal and interest flows Note Issued At Face Value Always identify the amounts and timing of the interest and principal cash flows Present value of the note = 1/(1 + i)^n Present value of the interest = (1 PV of the note)/i Notes Issued at Other than Face Value Zero interest bearing notes FV and PV are known, so the interest rate can be calculated (implicit interest rate) Effective Interest Method of Amortization o Effective interest or yield rate is calculated when the investment is made o o The rate is used to calculate interest income by applying it to the carrying amount (book value) Net carrying amount is always equal to the PV of the note s remaining cash flows discounted at the market rate at acquisition Interest bearing notes Interest cash flows are dictated by the stated rate, but all cash flows are discounted at the market rate (i) in determining the note s PV If the market/effective interest rate > note s rate, then the face value > PV/fair value This means the note would be exchanged at a discount; if you could get a higher rate somewhere else, the PV should be lower Notes Received for Property, Goods, or Services Two approaches if the market rate is unknown The fair value of the property, goods, or services that are given up can be used as an estimate of the fair value of the note received Appropriate interested rate can be imputed; imputation: process of determining an appropriate interest rate called the imputed interest rate; can be determined by looking at rates for similar instruments of issuers with similar credit ratings Derecognition of Receivables Recently owners often transfer accounts or loans receivable to another company for cash Benefits include competitive reasons (providing sales financing for customers) and because access to normal credit is not available or too expensive Receivables can be used to generate immediate cash = asset backed financing; this occurs through secured borrowings and sales of receivables Secured borrowings > using receivables as collateral under lending agreements; accounts for the assets the same way as before the borrowing, and accounts for the loan obligation as a liability Sale of Receivables Factoring receivables: selling receivables to financial intermediaries, factors that buy receivables for a fee and then collect the amounts owed directly from the customers Larger companies transfer receivables through a process called securitization > process where interests in financial assets are sold to a third party for asset backed securities Factoring usually involves a sale to one company, fees are high, lower quality receivables, and the seller doesn t service the receivables afterwards Securitization involves many investors, tight margins, higher quality receivables, and the seller continues to service the receivables Underlying Principles
Focus under IFRS > entity should derecognize the financial asset from its statements only when it transfers substantially all of the risks and rewards of ownership of that financial asset (same treatment for both IFRS and ASPE) Where the first option isn t applicable, IFRS considers the concept of control. If the transferor has no control, it would derecognize the financial asset. Having no control means the transferee can sell the entire asset to an unrelated party, making that decision on its own without imposing further restrictions Criteria for Treatment as a Sale Most managers prefer the transaction to be treated as a sale (derecognition) rather than a secured borrowing because the additional debt isn t recorded on the financial statements Derecognition when risk and rewards have been transferred (IFRS) or when control over the A/R has been surrendered (ASPE) IFRS: treatment of sale if the entity: o Transfers the contractual rights to receive cash flows from the A/R o Retains contractual rights to receive cash flows from the A/R but has a contractual obligation to pay the cash flows to one or more recipients. In addition The entity has no obligation to pay amounts to the eventual recipient unless it collects equivalent amounts from the original receivable The entity is prohibited by the terms of the transfer contract from selling or pledging the original asset other than as a security The entity has an obligation to remit any cash flow it collects on behalf of the eventual recipients without material delay ASPE: treatment of sale if the entity: o Transferred assets are isolated from transferor o Transferee has the right to pledge or sell the assets o Transferor doesn t maintain control through a repurchase agreement