ACCT550 CH 7 Summary For Students

CHAPTER 7
Cash and Receivables

LEARNING OBJECTIVES
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*10.
*11.
*12.
Identify items considered cash.

Indicate how to report cash and related items.
Define receivables and identify the different types of receivables.
Explain accounting issues related to recognition of accounts receivable.
Explain accounting issues related to valuation of accounts receivable.
Explain accounting issues related to recognition and valuation of notes receivable.
Explain the fair value option.
Explain accounting issues related to disposition of accounts and notes receivable.
Describe how to report and analyze receivables.
Explain common techniques employed to control cash.
Describe the accounting for a loan impairment.
Compare the accounting procedures for cash and receivables under GAAP and IFRS.
*Note: All asterisked (*) items relate to material contained in the Appendix to the chapter.
1. Chapter 7 presents a detailed discussion of two of the primary liquid assets of
a company, cash and receivables. Cash is the most liquid asset held by a company and
possesses unique problems in its management and control. Receivables are composed of
both accounts and notes receivables. Chapter coverage of accounts receivable places
emphasis on trade receivables. In covering notes receivables, the chapter includes both
short-term and long-term notes.
Nature of Cash
2. (S.O. 1) Cash consists of coin, currency, bank deposits, and negotiable instruments such
as money orders, checks, and bank drafts.
Reporting Cash
3. (S.O. 2) Cash equivalents are short-term, highly liquid investments that are both
(a) readily convertible to known amounts of cash and (b) so near their maturity that they
present insignificant risk of changes in value because of changes in interest rates. If an
asset is not cash and is short-term in nature, it should be reported as as a temporary
investment.
4. It is common practice for a corporation to have an agreement with a bank concerning
credit and borrowing arrangements. When such an agreement exists, the bank usually
requires the company to maintain a minimum cash balance on deposit. This minimum
balance is known as a compensating balance. Compensating balances that result in
legally restricted deposits must be separately classified in the balance sheet. The nature
Copyright 2013 John Wiley & Sons, Inc. K i eso, Intermediate Accounting, 15/e Instructors Manual ( For Instructor Use Only)
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of the borrowing arrangement determines whether the compensating balance is classified

as a current asset or a noncurrent asset.
5. Cash that has been designated for some specific use, other than for payment of currently
maturing obligations, is segregated from the general cash account. This amount may be
classified as a current asset if it will be disbursed within one year or the operating cycle,
whichever is longer. Otherwise, the amount should be shown as a noncurrent asset.
6. Bank overdrafts occur when a company writes a check for more than the amount in the
cash account. Bank overdrafts should be accounted for as accounts payable or, if material,
separately disclosed on the balance sheet or in the related notes.
Accounts Receivable
7. (S.O. 3) Receivables are claims held against customers and others for money, goods, or
services. Receivables may generally be classified as trade or nontrade. Trade
receivables (accounts receivable and notes receivable) are the most significant receivables
an enterprise possesses. Accounts receivable are oral promises of the purchaser to pay
for goods and services sold. Notes receivable are written promises to pay a certain sum of
money on a specified future date. Nontrade receivables arise from a variety of transactions
and can be written promises either to pay or to deliver. Nontrade receivables are generally
classified and reported as separate items in the balance sheet.
8. (S.O. 4) In most receivable transactions, the amount to be recognized is the exchange price
(amount due from the debtor) between the two parties. Two factors that may complicate the
measurement of the exchange are (a) the availability of discounts (trade and cash) and (b)
the length of time between the sale and the payment due date (the interest element).
9. Two types of discounts that must be considered in determining the value of receivables
are trade discounts and cash discounts. Trade discounts represent reductions from the
list or catalog prices of merchandise. They are often used to avoid frequent changes in
catalogs or to quote different prices for different quantities purchased. Cash discounts
(also called sales discounts) are offered as an inducement for prompt payment and are
communicated in terms that read, for example, 2/10, n/30 (2% discount if paid within
10 days of the purchase or invoice date, otherwise the gross amount is due in 30 days).
10. (S.O. 5) It is highly unlikely that a company that extends credit to its customers will be
successful in collecting all of its receivables. Thus, some method must be adopted to
account for receivables that ultimately prove to be uncollectible. The two methods currently
used are the direct write-off method and the allowance method.
11. Under the direct write-off method, the receivable account is reduced and an expense is
recorded when a specific account is determined to be uncollectible. The direct-write off
method is theoretically deficient because it usually does not match costs and revenues of
the period, nor does it result in receivables being stated at estimated realizable value on
the balance sheet. The direct write-off method is not appropriate if the amount deemed
uncollectible is material.
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12. Use of the allowance method requires a year-end estimate of expected uncollectible
accounts based upon credit sales or outstanding receivables. This ensures that
companies state receivables on the balance sheet at their net realizable value. Net
realizable value is the net amount the company expects to receive in cash. The estimate of
uncollectible accounts is recorded by debiting an expense and crediting the allowance
account in the period in which the sale is recorded. Then, in a subsequent period, when
an account is deemed to be uncollectible, an entry is made debiting the allowance
account and crediting accounts receivable.
13. Advocates of the allowance method contend that its use provides for a proper matching of
revenues and expenses as well as reflecting a proper carrying value for accounts receivable
at the end of the period. When the allowance method is used, the estimated amount of
uncollectible accounts is normally based upon a percentage of sales or outstanding receivables.
The percentage-of-sales method attempts to match costs with revenues, and is frequently
referred to as the income statement approach. The percentage-of-receivables approach
provides a reasonably accurate estimate of the net realizable value of receivables shown
on the balance sheet. This approach is commonly referred to as the balance sheet approach.
14. The method used to determine the amount of bad debt expense each year affects the
amount of expense recorded. Under the percentage-of-sales method, the amount recorded
as bad debt expense is the amount determined by multiplying the estimated percentage times
the credit sales. However, under the percentage-of-receivables approach, the unadjusted
ending balance in the allowance account must be considered in arriving at bad debts
expense for the year.
Notes Receivable
15. (S.O. 6) The major differences between trade accounts receivables and trade notes
receivables are (a) notes represent a formal promise to pay and (b) notes bear an
interest element because of the time value of money. Notes are classified as notes
bearing interest equal to the effective rate and those bearing interest different than the
effective rate. Interest-bearing notes have a stated rate of interest, whereas zerointerest-bearing notes (noninterest-bearing) include the interest as part of their face
amount instead of stating it explicitly.
16. Short-term notes are generally recorded at face value (less allowances) because the
interest implicit in the maturity value is immaterial. A general rule is that notes treated as
cash equivalents (maturities of 3 months or less) are not subject to premium or discount
amortization. Long-term notes receivable, however, are recorded at the present value of
the future cash inflows. Determination of the present value can be complicated, particularly
when a zero-interest-bearing note or a note bearing an unreasonable interest rate is
involved.
17. Long-term notes receivable should be recorded and reported at the present value of the
cash expected to be collected. When the interest stated on an interest-bearing note is
equal to the effective (market) rate of interest, the note sells at face value. When the
stated rate is different from the market rate, the cash exchanged (present value) is
different from the face value of the note. The difference between the face value and the
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cash exchanged, either a discount or a premium, is then recorded and amortized over
the life of the note to approximate the effective interest rate. The discount or premium is
shown on the balance sheet as a direct deduction from or addition to the face of the note.
18. Whenever the face amount of a note does not reasonably represent the present value of
the consideration given or received in the exchange, the accountant must evaluate the
entire arrangement to properly record the exchange and the subsequent interest. Notes
receivable are sometimes issued with no (zero) interest rate stated or at a stated rate that
is unreasonable. In such instances the present value of the note is measured by the cash
proceeds to the borrower or fair value of the property, goods, or services rendered. The
difference between the face amount of the note and the cash proceeds or fair value of the
property represents the total amount of interest during the life of the note. If the fair value of
the property, goods, or services rendered is not determinable, estimation of the present
value requires use of an imputed interest rate. The choice of a rate may be affected
specifically by the credit standing of the issuer, restrictive covenants, collateral, payment
schedule, and the existing prime interest rate. Determination of the imputed interest rate is
made when the note is received; any subsequent changes in prevailing interest rates are
ignored.
19. The FASB requires that companies disclose the fair value of receivables in the notes to
the financial statements. Recently the Board has given companies the option to use fair
value as the basis of measurement in the financial statements. If companies choose the
fair value option, the receivables are recorded at fair value, with unrealized holding gains
or losses reported as part of net income. An unrealized holding gain or loss is the net
change in the fair value of the receivable from one period to another, exclusive of interest
revenue.
Secured Borrowing
20. (S.O. 8) Receivables are often used as collateral in a borrowing transaction. A creditor
often requires that the debtor designate (assign) or pledge receivables as security for the
loan. If the loan is not paid when due, the creditor has the right to convert the collateral to
cash, that is, to collect the receivables.
Sales of Receivables
21. When accounts and notes receivable are factored (sold), the factoring arrangement can
be with recourse or without recourse. If receivables are factored on a with recourse
basis, the seller guarantees payment to the factor in the event the debtor does not make
payment. When a factor buys receivables without recourse, the factor assumes the risk of
collectibility and absorbs any credit losses. Receivables that are factored with recourse
should be accounted for as a sale, recognizing any gain or loss, if all three of the following
conditions are met: (a) the transferred asset has been isolated from the transferor, (b) the
transferees have obtained the right to pledge or exchange either the transferred assets or
beneficial interests in the transferred assets, and (c) the transferor does not maintain
effective control over the transferred assets through an agreement to repurchase or redeem
them before their maturity.
Presentation and Analysis
7-4
22. (S.O. 9) The presentation of receivables in the balance sheet includes the following
considerations: (a) segregate the different types of receivables that a company possesses,
if material; (b) appropriately offset the valuation accounts against the proper receivable
accounts: (c) determine that receivables classified in the current assets section will be
converted into cash within the year or the operating cycle, whichever is longer; (d) disclose
any loss contingencies that exist on the receivables; (e) disclose any receivables designated
or pledged as collateral; and (f) disclose the nature of credit risk inherent in the
receivables, how that risk is analyzed and assessed in arriving at the allowance for credit
losses, and the changes and reasons for those changes in the allowance for credit
losses.
23. The ratio used to assess the liquidity of receivables is the receivables turnover ratio, which
measures the number of times, on average, receivables are collected during the period.
Accounts Receivable
Turnover
Days to Collect
Accounts Receivable
*Cash Controls
Net Sales
Average Trade Receivables (net)
365
Accounts Receivable Turnover
*24. (S.O. 10) Control over the handling of cash and cash transactions is an important consideration for any company. Among the control procedures that are used for cash
transactions are the use of a petty cash system, or the use of bank accounts such as a
general checking account, imprest bank accounts, and lockbox accounts.
*Petty Cash
*25. In an imprest petty cash system, a petty cash custodian is given a small amount of
currency from which to make small payments (minor office supplies, tolls, postage, etc.).
Each time a disbursement is made, the petty cashier obtains a signed receipt and makes a
payment. When cash in the fund runs low, the petty cashier submits the signed receipts to
the general cashier and a check is prepared to replenish the petty cash fund. This process
is designed to promote control over small cash disbursements that would be awkward or
impossible to pay by check.
*Physical Protection of Cash Balances
*26. Adequate control of receipts and disbursements is part of the protection of cash balances,
along with certain other procedures. A company should minimize the cash on hand in the
office which is often in the form of a petty cash fund, the current days receipts, and
perhaps funds for making change. It should keep these funds in a vault, safe, or locked
cash drawer. The company should transmit intact each days receipts to the bank as soon
as practicable. A company must periodically prove the balance shown in the general
ledger by counting the cash actually present in the officepetty cash, change funds, and
undeposited receiptsfor comparison with the company records.
*Bank Reconciliation
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*27. A basic cash control is preparation of a monthly bank reconciliation. The bank reconciliation,
when properly prepared, proves that the cash balance per bank and the cash balance per
book are in agreement. The items that cause the bank and book balances to differ, and
thus require preparation of a bank reconciliation, are the following:
a. Deposits in Transit.Deposits recorded in the cash account in one period, but not
received by the bank until the next period.
b. Outstanding Checks.Checks written by the depositor that have yet to be presented
at the bank for collection.
c. Bank Charges.Charges by the bank for services that are deducted from the account
by the bank for which the company may not be aware until it receives the bank
statement.
d. Bank Credits.Collections or deposits in the companys account for which the
company may not be aware until it receives the bank statement.
e. Bank or Depositor Errors.Errors made by the company or the bank that must be
corrected for the reconciliation to balance.
*28. Two forms of bank reconciliation may be prepared. One form reconciles from the bank
statement balance to the book balance or vice versa. The other form is described as the
reconciliation of bank and book balances to corrected cash balance. This form is
composed of two separate sections that begin with the bank balance and book balance,
respectively. Reconciling items that apply to the bank balance are added and subtracted
to arrive at the corrected cash balance. Likewise, reconciling items that apply to the book
balance are added and subtracted to arrive at the same corrected cash balance. The
corrected cash balance is the amount that should be shown on the balance sheet at the
reconciliation date.
*Impairments of Receivables
*29. (S.O. 11) A loan receivable is considered impaired when it is probable, based on current
information and events, that the company will be unable to collect all amounts due (both
principal and interest). If a loan is determined to be individually impaired, the loss due to
the impairment is calculated as the difference between the investment in the loan
(generally the principal plus accrued interest) and the expected future cash flows
discounted at the loans historical effective interest rate.
M. (L.O. 12) IFRS Insights
The basic accounting and reporting issues related to recognition and measurement of
receivables, such as the use of allowance accounts, how to record discounts, use of the
allowance method to account for bad debts, and factoring, are similar for both IFRS and U.S.
GAAP. IAS 1 (Presentation of Financial Statements) is the only standard that discusses
issues specifically related to cash. IFRS 7 (Financial Instruments: Disclosure) and IAS 39
(Financial Instruments: Recognition and Measurement) are the two international standards
that address issues related to financial instruments and more specifically receivables.
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RELEVANT FACTS
a. The accounting and reporting related to cash is essentially the same under both IFRS
and U.S. GAAP. In addition, the definition used for cash equivalents is the same. One
difference is that, in general, IFRS classifies bank overdrafts as cash.
b. Like the U.S. GAAP, cash and receivables are generally reported in the current asset
section of the balance sheet under IFRS. However, companies may report cash and
receivables as the last items in current assets under IFRS.
c. IFRS requires that loans and receivables be accounted for at amortized cost, adjusted
for allowances for doubtful accounts. IFRS sometimes refers to these allowances as
provisions.
d. Although IFRS implies that receivables with different characteristics should be reported
separately, there is no standard that mandates this segregation.
e. IFRS and U.S. GAAP on the fair value option are similar, but not identical. The
international standard related to the fair value option is subject to certain qualifying
criteria not in the U.S. standard. In addition, there is some difference in the financial
instruments covered.
f. IFRS and U.S. GAAP differ in the criteria used to account for transfers of receivables.
IFRS is a combination of an approach focused on risks and rewards and loss of control.
U.S. GAAP uses loss of control as the primary criterion. In addition, IFRS generally
permits partial transfers; U.S. GAAP does not.
g. Impairment evaluation process
Under IFRS, companies assess their receivables for impairment each reporting period
and start the impairment assessment by considering whether objective evidence
indicates that one or more loss events have occurred. GAAP does not identify a specific
approach.
h. Recovery of impairment loss
Subsequent to recording an impairment, events or economic conditions may change
such that the extent of the impairment loss decreases (e.g., due to an impairment in the
debtors credit rating). Under IFRS, some or all of the previously recognized impairment
loss shall be reversed either directly, with a debit to Accounts Receivable, or by debiting
the allowance account and crediting Bad Debt Expense.
ON THE HORIZON
The question of recording fair values for financial instruments will continue to be an important
issue to resolve as the Boards work toward convergence. Both the IASB and the FASB have
indicated that they believe that financial statements would be more transparent and
understandable if companies recorded and reported all financial instruments at fair value.
a. In IFRS 9, which was issued in 2009, the IASB created a split model, where some
financial instruments are recorded at fair value, but other financial assets, such as
loans and receivables, can be accounted for at amortized cost if certain criteria are
met.
b. A proposal by the FASB would require that nearly all financial instruments, including
loans and receivables, be accounted for at fair value.
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c. It has been suggested that IFRS 9 will likely be changed or replaced as the FASB
and IASB continue to deliberate the best treatment for financial instruments. In fact,
one member of the IASB said that companies should ignore IFRS 9 and continue to
report under the old standard, because in his opinion, it was extremely likely that it
would be changed before the mandatory adoption date of this standard arrived in
2013.
ILLUSTRATION 7-1
METHODS OF ESTIMATING THE YEAR-END ADJUSTING ENTRY
FOR BAD DEBT EXPENSE
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ILLUSTRATION 7-2
ESTIMATING BAD DEBT EXPENSE
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ILLUSTRATION 7-3
INTEREST-BEARING AND ZERO-INTEREST-BEARING
NOTES RECEIVABLE
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ILLUSTRATION 7-3 (continued)
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ILLUSTRATION 7-4
ACCOUNTING FOR TRANSFERS OF RECEIVABLES
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ILLUSTRATION 7-5
PETTY CASH
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ILLUSTRATION 7-6
BANK RECONCILIATION
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CHAPTER 7

Cash and Receivables

Identify items considered cash.

of the borrowing arrangement determines whether the compensating balance is classified

ILLUSTRATION 7-3 (continued)

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