07 Cash and Receivables

Intermediate Financial Accounting I
Cash and Receivables
Objectives of this Chapter

I. Discuss the asset valuation methods. II. Identify items to be included in the cash account and discuss how cash and related items are reported. III. Explain accounting issues related to valuation of accounts receivables -trade discount, sales discount, sales returns and allowance, and uncollectible accounts.
Cash and Receivables 2
Objectives of this Chapter (contd.)

IV.Discuss the means to use accounts receivable as a financial instrument -pledge, assign and factor. V. Discuss the valuation of notes receivable and the disposition of notes receivable.
I. Assets Valuation Methods

A. Acquisition Cost (Historical Cost):
Used in the initial recording for all assets except for:
1. Investment in debt securities-held-tomaturity. 2. Long-term monetary assets (i.e., Longterm N/R).
B. Current Entry Value (Replacement Cost): Applied in the inventory valuation

(LCM).
Assets Valuation Methods (contd.)

C. Current Exit Value (net selling price or market value): Applied in the valuation of trading securities and securitiesavailable-for-sale. D. Net Present Value: Applied in the valuation of investment in debt securities-held-to-maturity and long-term monetary assets. Note: SFAS 159 allows the fair value option for financial assets and liablitlieis.

Liquidity: The amount of time expected to elapse until an asset is converted into cash. Liquid assets: Assets are available for conversion into cash quickly (i.e., cash, receivables, trading securities, etc..). Liquidity is an indication of a companys ability to meet its obligation.
II. Cash

What are included in the cash account? A. Cash on hand: B. Cash in bank:
Cash (contd.)

What are excluded from the cash account (source: FRR No. 1):
Foreign currency with severe restrictions - separate cash account. Certificates of deposits (CDs) Temporary Investments. Bank overdrafts - current liabilities (i.e., A/P) unless available cash is present in another account in the same bank (offsetting is required in this case).

Cash (contd.)

What are excluded from the cash account (source: FRR No. 1): Postdated checks- Receivables. IOUs - Receivables. Travel Advances - Prepaids. Employees Advances - Receivables. Postage stamps -Office supplies. Special purpose funds - Investments. Compensating balances - Restricted cash. Short-term papera (i.e., commercial paper) - S-T investments.
a. Investments with maturity of 3 to 12 months.
Restricted Cash

Compensating balances are examples of restricted cash which may require separate reporting. Other restricted cash: petty cash, cash for payroll, cash for dividends. If the amount is material, separate reporting is required.
Cash
Compensating Balances (CB)

CB: The portion of any deposit maintained by a corporation to support an existing borrowing arrangements (ASR No. 148). CB will increase the effective interest rate. CB may also be payment for bank services rendered to the company.
Cash
Compensating Balances (contd.)

If the CB is significant and is to support short-term borrowing, the CB should be stated separately among the cash and cash equivalent item in current assets.. If the CB is significant and is to support long-term borrowing, the CB should be classified as noncurrent assets in either Investments or Cash on Other Assets using a caption such as Deposit Maintained as Compensating Balance.
Cash
Compensating Balances (contd.)

The following two situations only require a footnote disclosure of the CB, not a separate reporting:
1) CB arrangement exists without agreements that restrict the use of cash amount shown on the balance sheet statement; 2) CB arrangement is to assure future credit availability.
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Other Cash Related Topics

Electronic Fund Transfer (EFT): Cash Equivalents: short-term, highly liquid investments that are both 1) readily convertible to known amount of cash, and 2) so near their maturity that they present insignificant risk of change in value. In general, only investments with original maturity of three months or less qualify under these definitions. Examples: Treasury bills, Commercial paper, and Money Market Funds.
Cash
Using Bank Account

General Imprest
checking accounts bank accounts accounts
Lockbox
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Cash Management and Control

Cash Management: 1)to maintain sufficient balance of cash on hand for day-to-day operation; 2)to prevent large amount of idle cash on hand. Cash Control: to prevent losses of cash by theft of fraud 1. Immediate deposit of cash. 2. Cash payment by checks except for small amounts. 3. Separation of duties. 4. Bank account reconciliation.
III.Receivables

Receivables: claims held against customers and others for money, goods or services. Current Receivables: expected to be collected within one year or one operating cycle, whichever is longer.
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Receivables (contd.)

Trade Receivables: amount owed by customers for goods sold and services rendered as part of normal business operations (i.e., accounts receivables and notes receivables). Nontrade Receivables: all others (i.e., interest receivable, advances to employees, deposits to cover potential damages, etc.)

Accounts Receivable: oral promises of the purchasers to pay for goods sold and services rendered. They are usually collected in 30-60 days. Thus, A/R is always reported as a current asset with the net realizable value (i.e., A/R minus the allowance for uncollectible accounts).
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Notes Receivable: written promises to pay a certain sum of money on a specific future date. N/R can be longterm or short-term and can be interesting-bearing or noninterest bearing.
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Short-term N/R is reported at net realizable value (face amount allowances for uncollectibles accounts). Long-term N/R is reported at present value or the fair value (i.e., the quoted market prices of identical assets in active markets).
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Valuation of A/R & N/R

Valuation 1. Cash xx Sales xx 2. A/R xx Sales xx No Net Realizable Value (NRV) Adjustment(s) Volume Dis. Sales R&A Cash Discount, Sales R&A, Volume Dis., Uncollectible Acc. Sales R&A Uncollectible accounts (for short-term)
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3. N/R xx Short-Term- NRV Sales xx Long-TermPresent Value or Fair value

Adjustments Related to Sales

1. Volume Dis. (Trade Discounts) 2. Cash Discounts (Sales Discounts) 3. Sales Returns and Allowances 4. Uncollectible Accounts
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1. Volume Discount

When to Recognize the Adjustments: Not reflected on the J.E.

Unit price = $10
Volume Dis. => 5% if purchase 100 or more units
Sale => 200 units J.E.: Cash 1,900 OR A/R 1,900 Sales 1,900 Sales 1,900
2. Cash Discount

When to Recognize the Adjustments: All Methods are acceptable. A. Recognized at time of sale (Net Price Method) B. Recognized at time of occurrence (Gross price Method) C. Recognized at time of sale (Allowance method)
2A. Recognized at Time of Sale

(Net Price Method)

Sales = $100, terms 2/10, n/30 12/26/x1 A/R Sales a. 1/2/x2 Cash A/R 98
98 98
98
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2A. Recognized at Time of Sale (Net Price Method) (contd.)

If Dis. not taken: b. 1/31/x2 Cash 100 A/R 98 Cash Dis. not taken 2
q q
Finance charge or Cash Dis. Forteited (interest revenue) Note: If the discount period post on 12/31, adjustment is required to bring the A/R to the gross amount.
2B. Recognized at time of occurrence

(Gross price Method)

Sales = $100, terms 2/10, n/30 12/26/x1 A/R 100 Sales 100
a. 1/2/x2 Cash Cash Dis. AR If Dis. not taken: b. 1/31/x2 Cash A/R
98 2 100 100 100
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2C. Recognized at Time of Sale

(Allowance method)

Sales = $100, terms 2/10, n/30 12/26/x1 A/R Sales
Allowance for Cash Dis.
100
2 98
100
a. 1/2/x2
Cash Allowance AR If Dis. not taken: b. 1/31/x2 Cash A/R Allowance Cash Dis. not taken
98 2 100
100 2 2
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3. Sales Returns & Allowances

(FASB 48)
A. The amount of sales R&A is not significant. B. The amount of sales R&A is significant and six conditions are not met. C. The amount of sales R&A is significant and six conditions are met.
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3A. The amount of Sales R&A Is Not Significant

If the amount of sales R&A is not significant, sales R&A are recognized at time of occurrence: Sales Returns & Allowances A/R (or cash) xxx xxx
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3B. The Amount of Sales R&A Is Significant and Six Conditions Are Not Met

If the amount of sales R&A is significant, and the following six conditions are not met, postpone the revenue recognition until all six conditions are met or the return period expired.
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Six Conditions (SFAS No. 48)

1. Sales price is determinable or fixed; 2. Buyers have paid or have the obligation to pay the sales price; 3. The buyers obligation would not be changed due to theft or damage of the product after purchase; 4. Sellers are not responsible for the performance of the product;
Six Conditions (SFAS No. 48)

5. Buyers and sellers are two separate economic entities; 6. The amount of returns can be estimated.
If the amount of returns is significant and these conditions are not met, revenue cannot be recognized.
3C. The Amount of Sales R&A Is Significant and Six Conditions Are Met
Sales can be recognized in the period in which the sales are made. Also, at the end of the same period, the amount of sales returns would be estimated and recognized.

Sales 10,000 12/31/x1 Sales R&A 1,000 Allow. for sale R& A 1,000 (estimate 10% returns) 1/10/x2 Allowance for sales R&A 900 A/R 900
10/5/x1 A/R
10,000
4. Uncollectible Accounts

Current practice: Estimate the B/D exp. at the end of the period and recognize the expense (SFAS No. 5). Adjusting entry for B/D expense: Estimated B/D expense = $2,000
12/31 B/D Expense Allowance for Doubtful accounts 2,000 2,000
When B/D actually occurred: ($200 B/D) Allowance for doubtful Accounts 200 A/R
200
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4. Uncollectible Accounts (contd.)

If $100 of the B/D recovered:
A/R Allow. for Doubtful Acct. Cash A/R

100 100 100 100
The current practice is complied with the matching principle. The direct write-off method (recognize the B/D expense when it occurs) is not recommended.
Estimation of B/D Expense

1. Percentage of net credit sales (I/S approach). 2. Percentage of accounts receivable (B/S approach). 3. Aging of accounts receivable (B/S approach using individual account information).
1. Percentage of Net Credit Sales (I/S

Approach)
Example: Net credit sales = $20,000 Estimated B/D exp. = 2% of net credit sales Adjusting Entry 12/31 B/D Expense Allow. for Doubtful accounts
400 400
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2. Percentage of A/R
(B/S Approach)
A/R Balance = $50,000 Estimated B/D = 1% of A/R Balance of the allow for doubtful accounts prior to the adjustment = $300 The new balance of the allow. for doubtful accounts = $50,000 x 1% = $500 Bad Debt Expense = $500 - 300 = 200 Adjusting Entry B/D expense Allowance for Doubtful accounts
200 200
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3. Aging-of-A/R
The balance of the allow. acct. = $100
Age Amount B/D (%) Allowance Amount 0-30 $10,000 1 $100 31-60 $7,000 2 $140 61-90 $4,000 3 $120 over 90 $2,000 4 $80 Total $440
B/D expense = $440 - 100 = 340 12/31 adjusting entry:
B/D Exp. 340 Allowance for Doubtful Accounts 340

Earnings Management

Managers can use the discretionary accruals to manipulate the income number. Examples of discriminatory accruals: bad debt expense, warranty expense, sales returns (when expecting sig. returns), etc.
Interest on Receivables

Most of the A/R does not bear interest if the customers pay the amount within the term period. However, if payment is not made within the term period, the customer may have to pay interest on the unpaid balance.
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Example A

Credit sale of $1,000 was made on 3/1/x1, terms 2/10 and n/30. Financial charge is 1% per month on the unpaid balance. The customer paid the first half of the A/R on 5/1/x1 and the second half on 6/1/x1.
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Example A (contd.)
Journal Entries:
3/1/x1 A/R 1,000 1,000 510 505 500 10 a 500 5b Sales 5/1/x1 Cash A/R Interest Revenue 6/1/x1 Cash A/R Interest Revenue
a. 1% x 1000 b. (1,000-500) x 1%
Example B

Installment Sales (with Interest): Sales Price = $1,200 CGS = $900 Sales were made on 5/1/x1, four equal payments of $322.83 were made on 8/1/x1, 11/1/x1, 2/1/x2 and 5/1/x2 with 3% of quarterly interest rate. $1,200 = X v 3.7171 X = $322.83
Example B (contd.)

Accrual Method:
Journal Entries 5/1/x1 A/R 1,200 Sales Revenue 1,200 8/1/x1 Cash 322.83 A/R 286.83 Interest Revenue 36 1 11/1/x1Cash 322.83 A/R 295.43 Interest Revenue 27.40 2
1. 3% v 1,200 2. (1,200 - 286.83) v 3%
Example B (contd.)
2/1/x2 Cash 322.83 A/R 304.30 Interest Revenue 18.53 1 5/1/x2 Cash 322.83 A/R 313.43 Interest Revenue 9.40 2
1. (1,200 - 286.83 - 295.43) v 3% 2. (1,200 - 286.83 - 295.43 - 304.30) v 3%
A/R 1,200 286.43 - 5/1/x1 295.43 - 8/1/x1 304.30 - 2/1/x2 313.43 - 5/1/x2
IV. Financing with Accounts Receivable to accelerate the receipt of cash from receivables
Two ways: 1. Secured borrowing Pledge (General Assignment) Assign (Specific Assignment) 2. Sale of receivables (Factoring) With recourse Without recourse

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IV. Financing with Accounts Receivable (contd.)

Advantages: 1) Immediate use of cash (i.e., pledge, assign and factor); 2) Avoid the cost of billing and collection (i.e., factor). Disadvantages: 1) Service charge (i.e., assign and factor); 2) Interest charge (i.e., pledge and assign)
IV. Financing with Accounts Receivable - Reasons

Pledge and Assign: Cash shortage and other ways of borrowing are not available or too expensive. Factor: In some industries (i.e., durable goods such as automobiles, equipments), product financing is virtually mandatory to be competitive. Companies in these industries often created wholly-owned subsidiaries specializing in receivables financing (i.e., to buyand Receivables receivables from the Cash 51 parent company).
IV. Financing with Accounts Receivable Reasons (Contd.)

Factor (cont.):

To avoid billing and collection costs. To avoid violation of existing lending agreements. From a purchasers point of view, buying receivables may be an alternative of making profits when reaching its legal lending limit.
Note: Credit card sale is a form of factor without recourse.

Pledge of A/R
(General assignment of A/R)

Pledge of A/R: Use A/R as a security (collateral) to borrow money from financial institutions. No journal entries are required for the pledge. Information related to the pledge is disclosed in the footnote.
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Pledge of A/R
Example

Borrow $100,000 by pledging all receivables for the borrowing: Journal Entry: Cash Notes Payable 100,000 100,000
Notes: The companys trade accounts are pledged as collateral for the $100,000 notes payable
Pledge of A/R
Example (contd.)

When the note is due and paid, the following entry will be recorded: Notes Payable 100,000 Interest Expense 3,000 Cash 103,000

Assume a 12% interest and a 3-month duration.

Pledge of A/R
Example (contd.)

If the note is not paid on the maturity date, the lending institution can seize and collect the pledged A/R. The borrower (the company) continues to have the control of the A/R. Cash used to pay off the note can be from any sources including proceeds received from the pledged A/R.
Assignment of Accounts Receivable (specific)

Use A/R as a mean to borrow money from banks or financial institutions. Specific A/R are assigned as collateral for the borrowing. Companies (the borrowers) continue to have the control of the A/R assigned and continue to collect assigned A/R from the customers.
Assignment of Accounts Receivable (contd.)

The amount collected from the assigned A/R must be remitted to the lending institution periodically. The proceeds collected from the assigned A/R cannot be used for any other purposes until all loans are paid off. The lender usually charges: 1) a service charge (i.e., 5% of the loan amount), 2) interest on the loan.
Example of (Specific) Assignment

(Illustration 7-15 of KWW textbook with little modification for April collections.)

On March 1, 2010, Howat Mills Inc. (HM), assigns $700,000 of its accounts receivable to Citizens Bank as collateral for a $500,000 borrowing. HM continues to collect the A/R; the account debtors are not notified of the assignment (a non-notification assignment). Citizens Bank charges a finance charge of 1% of the A/R assigned. The annual interest on the note is 12%. Settlement by HM to the bank is made monthly for all cash collection on the assigned receivable.
Example of Assignment (contd.)

Howat Mills Inc Citizens Bank Issuance of note and assignment of A/R on 3/1: Cash 493,000 Finance Charge 7,000 Notes Payable 500,000 N/R 500,000 A/R Assigned 700,000 Cash 493,000 A/R 700,000 Finance Revenue 7,000 Collection in March of $440,000 of assigned A/R less cash discounts of $6,000. Sales returns of $14,000 were received. Cash 434,000 Cash Discounts 6,000 No Entry Sales Returns 14,000 A/R Assigned 454,000

Howat Mills Inc Citizens Bank
Remitted March collections plus accrued interest ($500,000 x 0.12 x 1/12 = 5,000) to the bank on 4/1: Interest Exp. 5,000 Cash 439,000 Notes Payable 434,000 Interest Rev. 5,000 Cash 439,000 N/R 434,000 Collection in April of $144,000 of assigned A/R and $2,000 write-off as uncollectible: Cash 144,000 Allow. for No Entry Doub. Acct. 2,000 A/R Assigned 146,000

Howat Mills Inc Citizens Bank
Remitted the balance due of 66,000 ($500,000-434,000) plus interest on May 1 ($66,000 x 0.12 x 1/12) Notes Payable 66,000 Cash 66,660 Interest Exp. 660 N/R 66,000 Cash 66,660 Interest Rev. 660 To transfer the remaining A/R assigned to A/R when the loan is paid off: A/R 100,000 A/R Assigned 100,000 No Entry

The balance sheet statement of HM on 4/1 after the remittance of $434,000 cash collected from A/R Assigned in March, the balance of the A/R assigned account is $246,000 ($700,000 - $454,000) and the balance of the Notes Payable account is $66,000 ($500,000$434,000). These two accounts will be presented on the balance sheet statement as : Current Assets: Accounts Receivable Assigned $246,000 Notes Payable (66,000) Equity in A/R Assigned $180,000
Sale (Factor) of Accounts Receivable

A common type of sale of A/R is a sale to a factor. Factors are finance companies or banks that buy receivables from businesses for a fee and then collect the receivables directly from the customers.
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Sale (Factor) of Accounts Receivable

In the case of factor, A/R would be transferred to the purchaser. The buyer would collect the accounts, not the seller. The seller relinquishes all rights pertaining to the future collection of A/R.
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Sale (Factor) of A/R (contd.)

Sale of A/R is a common practice in some industries such as textile, apparel, footwear, furniture, etc. For some industries, sales financing is necessary in order to be competitive. Credit card transaction is also a type of factoring arrangement.
Sale (Factor) of A/R (contd.)

Credit Card Sale (Contd.) The buyer (the card issuer) of the receivable charges the seller (the merchant) a commission for the receivables purchased. The buyer collects directly from customers (card holder).
Accounting for Factor

Factor without recourse Factor with recourse

Recourse is a right of a buyer of receivables to receive payments from the seller when debtors fail to pay.
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Factor without Recourse

In the case of factor without recourse, the buyer assumes the risk of uncollectibility and absorbs any credit losses (i.e., bad debts). Thus, factor without recourse is a sale of receivables both in form and in substance.
Example of Factor without Recourse

(Source: Illustrations 7-15 and 7-17 of Kieso, etc. textbook with some modifications.)

Crest Textiles factors $500,000 of A/R with ABC Bank on a without recourse basis. The receivables are transferred to ABC bank on 5/1. ABC bank charges 3% of financial charge for factor without recourse and retain an amount equals to 5% of the A/R to cover sales returns and discounts. Credit losses (bad debts) are absorbed by ABC bank due to factor without recourse. The ABC bank expects $4,100 of uncollectible accounts from the receivables purchased.

(contd.)
Crest Textiles
5/1 Cash 460,000 Due from Factor 25,000 Loss on Sale of Rec. 15,000 A/R 500,000
ABC Bank A/R 500,000 Due to Crest Texti. 25,000 Financing Rev. 15,000 Cash 460,000 Recognition of Bad Debt Exp.: Bad Debt Exp. 4,100 Allow. For Doub. Acct. 4,100

(contd.)
Crest Textiles ABC Bank
Transactions in May and June: collects of $483,800 by ABC bank; sales R&A of $9,500; sales discounts taken of $2,600 and $4,100 bad debts written off by ABC bank.
.
Cash 483,800 Sales R&A 9,500 Due to Sales Dis. 2,600 Crest Texti.12,100 Due from A/R 495,900 Factor 12,100 Allow. for Doub. Acct. 4,100 A/R 4,100

(contd.)
Final settlement between Crest Text and ABC Bank:
Cash 12,900 Due to Crest Texi 12,900 Due from Factor 12,900 Cash 12,900
Note: The factors (ABC Bank) income from this factor is $15,000 - 4,100 (financing revenue uncollectible receivables).
Factor with Recourse (source: Kieso, etc.

textbook)

When receivables are sold with recourse, the seller guarantees payment to the buyer in the event the debtor fails to pay (or the payment of the debtor is less than expected by the purchaser). Thus, the seller retains the risk of uncollectibility.
Factor with Recourse

SFAS No. 140 requires that a sale of receivables with recourse be recognized as a sale if all three conditions are met, otherwise, the sale with recourse should be treated as a secured borrowing.
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Factor with Recourse
Three Conditions
1. The transferred assets have been isolated
from the seller (transferor); 2. Each buyer has the right to pledge or exchange the assets it received and no constrains attached; 3. The seller does not maintain effective control over the transferred assets through repurchase.
Factor with Recourse (Contd.)

The buyer usually charges a higher fee in the case of factor without recourse than in the case of factor with recourse.
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Example of Factor with Recourse

illustrations 7-18, 7-19 and 7-20 of Kieso, etc. textbook) Crest Textiles factors $500,000 of A/R with ABC Bank on a with recourse basis. The receivables are transferred to ABC Bank on 5/1. ABC Bank charges 3% of financial charge for factor with recourse and retains an amount equals to 5% of the A/R to cover sales returns and discounts. Credit losses (bad debts) are absorbed by Crest Textiles, Inc. due to factor with recourse. The Crest Textiles, Inc. expects $6,000 of uncollectible accounts from the receivables factored.
(Source:

(contd.) Treated as a Sale When All
Conditions are met.
Cash 460,000 Due from Factor 25,000 Loss on Sale of Receivable 21,000* A/R 500,000 Recourse Liability 6,000
*$21,000= $500,000x3% +6000 or Net Proceeds = $460,000+25,000 -6000=479,000. $21,000 = $500,000 479,000
Crest Textile
ABC Bank A/R 500,000 Due to 25,000 Crest Financing Rev. 15,000 Cash 460,000

(contd.)
Transactions in May and June: bad debts occurred, $6,000; sales R&A occurred,$9,500; sales discounts taken, $2,600. The A/R collected, $481,900 (i.e., $500,000-12,100-6000). .
Cash 481,900* Sales R&A 9,500 Due to Sales Dis. 2,600 Crest 12,100 Due from A/R 494,000 Factor 12,100 Due to Crest 6,000 Recourse Liability 6,000 A/R 6,000
Due from Factor 6,000 *500,000-12,100-6,000
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(contd.)
(Treated as a Sale) Settlement between Crest and ABC
Crest Textile
ABC Bank
Cash Due from Factor 6,900
6,900a
Due to Crest 6,900 Cash 6,900
a. $6,000 less than in the case of factor without recourse. This is due to the bad debt amount $6,000 is absorbed by the seller (Crest Textile) in the case of factor with recourse.
What if only $5,000 bad debts occurred in stead of the expected $6,000 in factor with recourse example on p78?
Transactions in May and June: bad debts occurred, $5,000; sales R&A occurred,$9,500; sales discounts taken, $2,600. A/R collected, $482,900 (*500,000-12,100-5,000).
.
Cash 482,900* Sales R&A 9,500 Due to Sales Dis. 2,600 Crest 12,100 Due from A/R 495,000 Factor 12,100 Due to Crest 5,000 Recourse Liability 6,000 A/R 5,000
Due from Factor 5,000
Loss on Sale of Rec. 1,000
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What if only $5,000 bad debts occurred (contd.) :

(Treated as a Sale) Settlement between Crest and ABC
Crest Textile
ABC Bank
Cash Due from Factor 7,900
7,900a
Due to Crest 7,900 Cash 7,900
a. $5,000 less than in the case of factor without recourse. This is due to the bad debt amount $5,000 is absorbed by the seller (Crest Textile) in the case of factor with recourse.
The Profits of the Buyer under Factor With Recourse

Unlike factor without recourse, the profits for the buyer in the factor with recourse always equal the financing revenue (i.e., $15,000 in the above examples) due to bad debts being covered by the seller. Using previous examples: When bad debts=$6,000, the profits of ABC = $489,100-$460,000-$6,900 =$15,000. When bad debts =$5,000, the profits of ABC=$482,900-460,000-7,900=$15,000.
V. Notes Receivable
Note receivable: A written promissory note; can be interest bearing or noninterest bearing. Short-term N/R: Recorded at the amount expected to be collected (i.e., NRV). Interest bearing: Accrued interest recognized at the end of a period. Non-interest bearing

Notes Receivable (contd.)

Long-term N/R: 1. Recorded at net present value 2. End of period valuation NPV or the fair value (SFAS 159)
Note: Reporting a long-term note receivable at the fair value is an option. Once chose, the fair value method will be used for all subsequent periods. and Receivables Cash 86
Notes Receivable
Case I: Non-Interesting Bearing Example

Receiving a 3 month non-interest bearing note on 11/1/x1 with a face amount of $10,000. 11/1/x1 N/R 10,000 Sales 10,000 12/31/x1 No adjusting entry for accrued interest because the note is a non-interest bearing note. 1/31 Cash 10,000 N/R 10,000 If the note is dishonored on 1/31 => A/R 10,000 N/R 10,000
Notes Receivable
Case II: Interesting Bearing Example

Short-term note with interest bearing; annual interest rate = 12%. Receiving a 3-month interest bearing note on 11/1/x1. Face amount is $10,000 and the annual interest rate is 12%
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Case II (contd.)
11/1/x1 N/R 10,000 Sales 10,000 12/31/x1 Interest Receivable 200 Interest Revenue 200 1/1/x2 Reversing Entry: Interest Revenue 200 Interest Receivable 200 1/31/x2 Cash 10,300 N/R 10,000 Interest Revenue 300
Discount of Notes
(to a bank or to any finance institution)

Example: A 3-month note with a face amount of $10,000 (received on 11/1/x1) is discounted on 12/1/x1.
Interest rate of the note = 12% (annual) Int. rate charged by the bank = 18% (annual)
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Discount of Notes (contd.)

1. Maturity value of the note = $10,000 + 10,000 v 12% v 3/12 = $10,300 2. Interest charged by the bank (discount) = $10,300 x 18% x 2/12 = $309
12/1/x1 11/1/x1 Bank is lending $10,300 on 12/1/x1
1/31/x2 Bank is receiving $10,300 on 1/31/x2

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Proceeds received by the firm from discounting the note (the bank will deduct the interest charge from the proceeds): $10,300 - 309 = $9,991
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J.E. on 12/1: Cash Loss on Dis. of Note N/R Discounted Interest Revenuea 9,991 109 10,000 100
a.Interest earned by the firm from holding the note for one month (11/1 ~ 12/1) = $10,000 v 12% v 1/12 =100
Footnote (FASB): Contingent liability of discounted note of $10,000


On 1/31/x2, the note is paid, the following entry will be recorded: N/R discounted 10,000 N/R 10,000 If on 1/31/x2, the note is dishonored, the following entry will be recorded: (Assuming the bank charge $10 fee) N/R Discounted 10,000 Loss on Dishonored Note 10,310 N/R 10,000 Cash 10,310
Long-Term Notes Receivable

Initial Recording: Net present value End of Period: Net present value or the fair value.
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Long-Term N/R
Example A

Receiving a 2-year note on sales of goods on 1/1/x1. The face amount of this note is $100,000 and the annual interest of the note is 10%. The interests are paid annually and the market interest rate is 12%. Present value of the note: $100,000 v 0.79719 + 10,000 v 1.69005 =96,620
Long-Term N/R
Example A (contd.)
1/1/x1 Notes Receivable 100,000 Sales Revenue 96,620 Discounts on N/R 3,380
Effective Interest of 20x1 = PV of note on 1/1/x1 v 12% = ($100,000 - 3,380) v 12% = 11,594.4
Long-Term N/R
Example A (contd.)
12/31/x1 (recording receiving of $10,000 interest) Cash 10,000 Discount on N/R 1,594.4 Interest Revenue 11,594.4
P.V. of the note on 1/1/x2 = 100,000 - (3,380 - 1594.4) = 98,214.4 Effective Interest of 20x2 = PV on 1/1/x2 v 12% = 98,214.4 v 12% = 11,785.7
Long-Term N/R
Example A (contd.)
12/31/x2 (recording int. received on 12/31/x2): Cash 10,000 Discount on N/R 1,785.7 Int. Revenue 11,785.7 12/31/x1 (recording face amount of N/R received on maturity date): Cash 100,000 N/R 100,000
Discount on N/R has been amortized to zero after two years of amortization using the effective interest method.
Long-Term N/R
Example B (Similar to P7-9)

On 12/31/x1 La Tourette Inc. rendered services to Husky Corp. at an agreed price of $73,844.10, accepting $18,000 down and agreeing to accept the balance in four equal installments of $18,000 receivable each 12/31. An assumed interest rate of 11% is imputed. Record the journal entries for La Tourette for the sale and for the receipts and interest on the following dates: 1. 12/31/20x1 2. 12/31/20x2 3. 12/31/20x3 4. 12/31/20x4 5. 12/31/20x5
100
Long-Term N/R
Example B (contd.)

PV of $18,000 annuity @11%, four payments = 18,000 v 3.10245 = 55,844.10 Thus, the revenue from the services = 18,000 + 55,844.10 = 73,844.10 12/31/x1 Cash 18,000 Notes Receivable 72,000 Discount on N/R 16,155.9a Revenue from Services 73,844.10
a. (18,000 v 4) - 55,844.10 = 16,155.9
Long-Term N/R
Example B (contd.)
12/31/x2 (recording install. Payment of $18,000 and the amortization of discount on N/R): Cash 18,000 N/R 18,000 Discount on N/R 6,142.85 Interest Revenue 6,142.85a
a. Interest Revenue of 20x2 = pv of note on 1/1/x2 (or 12/31/x1) v 11% = 55,844.1 v 11% = 6,142.85
Long-Term N/R
Example B (contd.)
12/31/x3 Cash 18,000 N/R 18,000 Discount on N/R 4,838.56 Interest Revenue 4,838.56a
a. Interest Revenue of 20x3 = pv of note on 1/1/x3 v 11% = (55,844.1 - 18,000 + 6,142.85) v 11% = 43,986.95 v 11% = 4,838.56
Long-Term N/R
Example B (contd.)
12/31/x4 (recording install. Payment of 18,000 and the amortization of discount on N/R): Cash 18,000 N/R 18,000 Discount on N/R 3,390.81 Interest Revenue 3,390.81a
Long-Term N/R
Example B (contd.)
12/31/x5 Cash 18,000 N/R 18,000 Discount on N/R 1,783.68 Interest Revenue 1,783.68a
Notes Received for Cash and Other Rights

Avon Co. accepts a 3-year, $100,000, zero-interest-bearing note from Andrew Co. plus the right to purchase 50 machines at a bargain price in exchange for $100,000 in cash. Assume that the current rate is 10% (for a similar note without the right):
106
N/R Received for Cash and Other Rights (contd.)

J.E. for Greene: N/R 100,000 Prepaid Purchase 24,868 Cash 100,000 Discount on N/R 24,868
The $24,868 will be amortized as interest revenue in next 3 years. The prepaid purchase will be amortized (proportionally to 50 machines) to increase the purchase price of machines.
Notes Received for Property, Goods and Services

Example: Lenex sold a lot to Impex as an office site. Lenex accepted a 3-year note with a maturity value of $ 93,169 and with no stated interest rate. The land originally cost Lenex $30,000 and had an appraised fair value of $70,000 on the selling date.
Notes Received for Property, Goods and Services (contd.)

J.E.: N/R Dis. on N/R Land Gaina,b 93,169 23,169 30,000 40,000
a. Use the fair value of the land as the present value of the note when the discount rate of the note is unknown. The discount rate cae be derived as 10%. b. The discount of N/R will be amortized in next three years. If the effective rate of the note is known, the present value of the note can be calculated. The gain amount will be the difference between the P.V. of the note and the cost of the land. The discount amount will be the difference between the maturity value and the P.V. of the note. Cash and Receivables 109
Fair Value Option

Companies can choose the fair value option when the financial instrument is originally recognized or when an event triggers a new basis of accounting (i.e., acquisition). Once chosen, the company has to use the fair value option in subsequent periods.
110
Fair Value Option An Example

Assume that Loftus Company has notes receivable with a fair value of $70,000 and a carrying amount of $58,000 on 12/31/2010. The company chose the fair value option for these receivables on the initial valuation of these recently acquired receivables. Adjusting Entry: Fair Value Adjustment 12,000 Unrealized holding gain or loss* 12,000 * Reported in the income statement
Fair Value Option An Example

For all subsequent periods, the fair value of the note will be compared with the carrying amount of the note. The adjusting entry will be performed to adjust the carrying amount of the notes receivable to the new fair value.
112
Impairment Measurement and Reporting on Investment in Loan Receivables

A loan receivable impaired when it is probable that it will not collect all amounts due (both principle and interest). Measurement: Compare the recorded investment (i..e, the NRV or the carrying amount) with the present value of the expected future cash flows using the historical expected interest rate.
113
Impairment Measurement and Reporting (contd.)

Example (illustration 7B-3 onP355 of KWW textbook): Carrying amount of investment $100,000 The PV of expected future cash flows on the investment at 10% historical effective interest rate is $87,566. The loss on impairment = 100,000 87,566 = 12,434.
114
Impairment Measurement and Reporting (contd.)

Recording of impairment losses:

Bad Debt Expense 12,434 Allowance for Doubtful Accounts 12,434
Write-off of impaired receivables: Allowance for Doubtful Accounts 12,434 Notes Receivables 12,434
115
Securitization

A sale of securities (i.e., bonds or commercial paper) backed (collateralized ) by a pool of assets. These assets can be mortgage receivables (i.e., mortgage-backed securities), consumer loans (i.e., assets-backed securities), and corporate bonds (i.e., collateralized debt obligations).
Securitization (contd.)

Securitizations are popular for two reasons: 1. Investors have a strong appetite in acquiring collateralized securities. 2. Companies and lenders with large amounts of receivables have incentives to engage in securitization.
117
Securitization Performed by The Company

When a company uses its assets (i.e., auto loan receivables) as collaterals to issue bonds (i.e., assets-backed securities), the receivables will remain on its balance sheet. The companys liability will be increased from the increase of bonds payable. As a result, this transaction will have an adverse effect on its return on assets and debt/equity ratios.
118
The Special Purpose Entity

A special purpose entity (SPE) is usually created by a third party which is independent of the company with receivables (referred to as the transferor). The SPE serves the purpose of buying receivables from the transferor and issuing securities collateralized on the receivables transferred from the transferor. The SPE can be in the form of a trust, partnership or corporation and is legally distinct from the transferor.
119
Procedures of Securitization Performed by A SPE

1. The transferor will first transfer its receivables to the SPE. 2. The SPE issues securities (i.e., commercial papers due in 30 days) using these receivables as collaterals. 3. The cash received by the SPE from issuing securities will go back to the transferor to pay off the receivables transferred.
120
Procedures of Securitization Performed by A SPE (contd.)

The SPE is served as a pass through. The independent third party (i.e., an investment bank) charges the transferor fees for creating and operating the SPE. The transferor can continue to service the loan for a fee.
121
Off Balance Sheet Financing

If the SPE is a qualifying SPE (i.e., with at least 10% of the fair value of its beneficial interests invested by a party other than the transferor or its affiliates), the transferor does not have to consolidate the balance sheet of the SPE. As a result, both the receivables and the liabilities from issuing securities will appear only on the balance sheet of the SPE, not the transferor.
122
Off Balance Sheet Financing (contd.)

The transferor, therefore, has an offbalance sheet financing. If the receivables went bad, the transferor may be forced to take back receivables or the banks eat losses. Since the receivables on the SPEs are long-term assets while the securities issued by the SPE are short term liabilities, there is a mismatch on the financing of SPEs assets.
123
Consolidation: An Update

The concept of qualifying SPE has been eliminated by SFAS No. 166 passed in May 2009, and became effective as of the beginning of the first annual reporting period beginning after Nov. 2009. The SPE has been replaced by the
variable-interest entity (VIE).
124
Consolidation (contd.) (source: KWW

textbook , appendix 17B).

A VIE is an entity with 1) insufficient equity, or with 2) stockholders lacking control, or with 3) stockholders not sharing profits or losses (source: KWW textbook ,
appendix 17B).
If an entity is a VIE, the risk-and-reward model, instead of the voting-interestmodel, is used in determining the consolidation party.
125
Consolidation (contd.) (source: KWW

textbook , appendix 17B).

Under the risk-and-reward model, the primary beneficiary of a VIE needs to consolidate the VIE. Voting-interest-model: the party with more than 50% of voting rights of an entity should consolidate the entity. The risk-and-reward model: the party who assume majority of the risks and receive majority of benefits associated with the entity is the primary beneficiary party and should consolidate the entity.
126

07 Cash and Receivables

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07 Cash and Receivables

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Intermediate Financial Accounting I

Cash and Receivables

Objectives of this Chapter

Objectives of this Chapter (contd.)

Cash and Receivables

I. Assets Valuation Methods

B. Current Entry Value (Replacement Cost): Applied in the inventory valuation

Assets Valuation Methods (contd.)

Cash and Receivables

Cash and Receivables

Compensating Balances (CB)

Compensating Balances (contd.)

Compensating Balances (contd.)

Cash and Receivables

Other Cash Related Topics

Using Bank Account

checking accounts bank accounts accounts

Cash and Receivables

Cash Management and Control

Cash and Receivables

Cash and Receivables

Cash and Receivables

Cash and Receivables

Valuation of A/R & N/R

3. N/R xx Short-Term- NRV Sales xx Long-TermPresent Value or Fair value

Adjustments Related to Sales

Cash and Receivables

When to Recognize the Adjustments: Not reflected on the J.E.

2A. Recognized at Time of Sale

Cash and Receivables

2A. Recognized at Time of Sale (Net Price Method) (contd.)

2B. Recognized at time of occurrence

98 2 100 100 100

2C. Recognized at Time of Sale

Sales = $100, terms 2/10, n/30 12/26/x1 A/R Sales

Allowance for Cash Dis.

3. Sales Returns & Allowances

Cash and Receivables

3A. The amount of Sales R&A Is Not Significant

Cash and Receivables

Cash and Receivables

Six Conditions (SFAS No. 48)

Six Conditions (SFAS No. 48)

4. Uncollectible Accounts (contd.)

100 100 100 100

Estimation of B/D Expense

1. Percentage of Net Credit Sales (I/S

B/D expense = $440 - 100 = 340 12/31 adjusting entry:

B/D Exp. 340 Allowance for Doubtful Accounts 340

Cash and Receivables

Cash and Receivables

Cash and Receivables

IV. Financing with Accounts Receivable (contd.)

IV. Financing with Accounts Receivable - Reasons

IV. Financing with Accounts Receivable Reasons (Contd.)

Note: Credit card sale is a form of factor without recourse.

Cash and Receivables

Assume a 12% interest and a 3-month duration.

Assignment of Accounts Receivable (specific)

Assignment of Accounts Receivable (contd.)

Example of (Specific) Assignment

Example of Assignment (contd.)

Example of Assignment (contd.)