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CHAPTER 4
PAYMENT FOR GOODS AND SERVICES: CASH AND
ACCOUNTS RECEIVABLE
CHAPTER OVERVIEW
The chapter begins with a discussion of cash collections that focuses on control over cash,
emphasizing the bank reconciliation as a critical control function. A complete bank reconciliation
example is presented.
Next, there is a presentation of selling on credit and the concept of accounts receivable. This is
followed by a section on uncollectible accounts and the methods of accounting for uncollectible
accounts (direct write-off method, sales (allowance) method, and accounts receivable
(allowance) method). Accounting for notes receivable is presented. Also, there is a brief
discussion of credit card sales and how these are accounted for by the seller.
The chapter has a summary problem that continues the Team Shirts example from previous
chapters and presents the student with transactions for the sixth month of business. The student is
shown how to make adjusting entries at the end of June and to prepare the four financial
statements for the business.
The accounts receivable turnover ratio is presented. Finally, the chapter wraps up with a
discussion of ways to help a firm safeguard its assets and enhance the accuracy and reliability of
its financial records.
LEARNING OBJECTIVES
After completing Chapter 4, your students should be able to answer these questions:
1. Explain how a firm controls cash and prepares a bank reconciliation.
2. Describe how cash is reported on the financial statements.
3. Calculate bad debts expense and explain how a firm evaluates and reports accounts
receivable.
4. Explain the difference between credit sales and credit card sales.
5. Account for and report notes receivable.
6. Prepare financial statements that include bad debts.
7. Analyze a firm’s accounts receivable with ratio analysis.
8. Identify the risks and controls associated with cash and receivables.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 4-1
CHAPTER OUTLINE
Controlling Cash (LO 1)
I. Assignment of responsibilities for cash
a. A company will analyze the risks associated with cash collections and put controls in
place to minimize those risks.
b. A key control is segregation of duties.
i. The person who has actual physical access to cash at any time and who can
write checks and make deposits cannot be the same person who does the
actual record keeping for cash.
ii. If this was the same person, then it would be easy to keep some of the cash
and alter the records to hide the theft.
Teaching Tip
Suppose it is your company’s policy to require two signatures on all checks written. The
treasurer is going on vacation and has left a number of pre-signed checks so that payments may
be made by the bookkeeper while he is gone. Ask students if they see any internal control
problem with this system. They should point out that cash disbursements should be made only
after all documents have been reviewed. By pre-signing checks, the treasurer has provided the
bookkeeper with the opportunity to make unauthorized, unapproved payments.
II. Bank reconciliation
a. A bank statement is a summary of the activity in a bank account and is sent each
month to the account holder.
b. A bank reconciliation is a comparison between the cash balance in the firm’s
accounting records and the cash balance on the bank statement to identify the reason
for any differences.
i. A bank reconciliation isn’t just a part of record keeping for cash. It is a crucial
part of controlling cash.
c. There are two major steps to completing a bank reconciliation:
i. Start with the balance on the monthly bank statement (called the balance per
bank) and make adjustments for all transactions that have been recorded in the
firm’s books because the bank did not get the transactions recorded as of the
date of the bank statement.
1. Outstanding checks are checks the company has written but have not
cleared the bank. These are subtracted.
2. Deposit in transit is a bank deposit the firm has made but is not
included on the month’s bank statement because the deposit did not
reach the bank’s record-keeping department in time to be included on
the current bank statement. These are added.
3. Errors made by the bank are added or subtracted depending on
circumstances.
ii. Start with the firm’s cash balance (called the balance per books) and make
adjustments for all the transactions that the bank has recorded but have not
been recorded on the firm’s books.
1. Collections made by the bank are added.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 4-2
2. Service charges are subtracted.
3. NSF checks (bounced checks) are subtracted.
4. Interest earned is added
5. Errors made by the firm may be added or subtracted depending on
circumstances.
Teaching Tip
Students are often confused about NSF checks. An NSF check is a customer check that has
been received by the business and returned by the bank because the customer’s account balance
was not sufficient. (NSF does not refer to checks that the company itself has written.)
iii. Afterwards, each section of the bank reconciliation should show the same
reconciled cash balance (true cash balance).
iv. Adjustments are required for the items on the book’s side of the reconciliation.
v. No adjustments are needed for the bank’s side as the bank will record these as
transactions are received.
Teaching Tip
Preparing the bank reconciliation itself does not change the Cash balance on the books; it just
shows what the ending balance should be. An entry is needed for each reconciling item on the
“Book” side of the reconciliation to adjust the Cash balance to the correct amount. Never record
adjusting entries for any of the items listed on the “Bank” side of the reconciliation.
d. Adjust the cash balance for all transactions that show up on the bank statement but
have not been recorded on the company’s books.
e. The cash reconciliation enables the company to:
i. Locate any errors, whether made by the bank or the company.
ii. Make adjustments to the cash account for information in the bank statement.
Teaching Tip
Use the example on page 156 to illustrate a bank reconciliation. Page 157 shows the items used
on the bank side of a bank reconciliation while page 158 shows those on the book side.
Reporting Cash (LO 2)
I. Cash is shown on the balance sheet and on the statement of cash flows.
II. Cash equivalents are highly liquid investments with a maturity of three months or less
that a firm can easily convert into a known amount of cash.
III. Cash equivalents are combined with cash on the financial statements.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 4-3
Accounts Receivable and Bad Debts Expense (LO 3)
I. Accounts receivable are current assets that arise from sales to customers on credit.
II. Accounts receivable is reported at what the firm expects to collect.
a. Companies rarely expect to collect 100% of their receivables.
b. Net realizable value is the amount expected to be collected.
c. This is equal to the balance of accounts receivable minus what the firm believes is
uncollectible.
d. Allowance method is a method of accounting for bad debts in which the amounts of
the uncollectible accounts are estimated at the end of each accounting period.
III. Recording uncollectible accounts
a. Bad debts expense is the expense to record uncollectible accounts.
b. The allowance for uncollectible accounts is a contra-asset account. Its balance
represents the total amount the firm believes it will not collect from its total accounts
receivable.
c. Allowance for uncollectible accounts is deducted from accounts receivable on the
balance sheet.
IV. Methods of estimating bad debts expense.
a. Allowance method – percentage of sales method
a. Focuses on the income statement.
b. Calculates bad debt expense (uncollectible accounts expense) as a percentage
of current period credit sales
c. Adjusting entry is made at the end of the year to recognize bad debt expense
and allowance for uncollectible accounts (a contra-asset).
b. Allowance method – accounts receivable method
a. Focuses on the balance sheet
b. An aging schedule is an analysis of the amounts owed to a firm by the length
of time they have been outstanding.
c. Based on the aging schedule, management estimates the amount of
uncollectible accounts.
d. Adjusting entry is made to adjust the balance of the allowance for
uncollectible accounts and to recognize bad debt expense.
Teaching Tip
Students can see an example of an aging schedule in Exhibit 4.7.
V. Writing off a specific account
a. When a specific account becomes uncollectible, accounts receivable is
reduced and allowance for uncollectible accounts is reduced.
1. No additional bad debt expense is recognized.
2. Bad debt expense was recognized in a prior period.
3. You are simply reclassifying an unnamed bad debt to a named bad
debt.
Teaching Tip
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 4-4
Write offs, along with the end-of-year adjustment for bad debts, are shown in Exhibit 4.9.
VI. The direct write-off method
a. The direct write-off method is a method of accounting for bad debts in which they
are recorded as an expense in the period in which they are identified as uncollectible.
b. Reduce accounts receivable and recognize bad debt expense when written off
c. Only allowed by GAAP when the amount of uncollectible accounts is very small (not
material)
Teaching Tip
Exhibit 4.10 provides a summary of the allowance methods for uncollectible accounts.
Credit Card Sales (LO 4)
I. One way to avoid the risk of extending credit to customers is to accept payment by credit
card.
II. The credit card companies take the responsibility (and risk) of evaluating a person’s
credit-worthiness.
III. There are costs and benefits to the company of accepting credit cards.
a. Costs equal the credit card expense that the bank or credit card company charges for
accepting the credit cards.
b. Benefits include reducing risk of nonpayment and reducing record keeping.
IV. How credit card transactions work
a. The company makes sales to customers then submits the receipts to the credit card
company.
b. The credit card company pays the company immediately, but deducts a fee for
handling the transaction.
Teaching Tip
Point out that most credit card transactions are handled electronically. When the customer’s
credit card is “swiped,” the amount of the sale (less the credit card company’s fee) is deposited
directly into the company’s bank account.
Notes Receivable (LO 5)
I. A promissory note is a written promise to pay a specified amount of money at a
specified time.
II. The maker of the note is the person or firm making the promise to pay a promissory
note.
III. The payee of a note is the person or firm receiving the money.
IV. A promissory note is also called a note receivable.
V. Notes receivable are often created when a firm will renegotiate an overdue account by
allowing a customer to sign a promissory note giving the customer more time to pay and
charging interest on the loan.
VI. Interest = Principal x Rate x Time
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 4-5
VII. Notes receivable will be classified as a current asset if the note is less than a year.
Teaching Tip
The formula for calculating interest is: Principal x Rate x Time. Students, though, often
compute the accrued interest incorrectly, because they have counted the length of time
incorrectly. Assume $5,000 is loaned out in the form of an 8%, 60-day note receivable on
December 1, 20X2. The accrued interest on December 31, 20X2, will be $33 ($5,000 x 8% x
1/12). It is very important that the time factor is expressed in annual terms because the interest
rate will always be given in annual terms.
Team Shirts for April (LO 6)
I. The summary problem uses the Team Shirts example developed in previous chapters.
II. Transactions for the month of April are introduced.
III. The students are shown how to make the necessary adjusting entries and prepare financial
statements for the month of April.
Applying Your Knowledge: Ratio Analysis (LO 7)
I. Accounts receivable turnover ratio is a ratio that measures how quickly a firm collects
its receivables.
a. Equal to net sales divided by average net accounts receivable
b. Tells how many times accounts receivable is collected (turned into cash) in a year
c. If accounts receivable turnover is divided into 365 (365 divided by AR turnover), it is
converted into “days receivable” (tells how many days, on average, it takes to collect
receivables from customers).
Business Risk, Control, and Ethics (LO 9)
I. There are three key controls that help a firm safeguard its assets and enhance the
accuracy and reliability of its financial records:
a. Clear assignment of responsibility
b. Specific procedures for documentation
c. Independent verification of data
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 4-6
CHAPTER 4 NAME ___________________________________
TEN-MINUTE QUIZ Section _____________ Date____________
_____________________________________________________________________________
_
_____ 1. Segregation of duties means that the person who has physical custody of an asset
is not the same person who has _______ responsibilities for that asset.
a. purchase
b. sales
c. record-keeping
d. all of the above
_____2. On the bank reconciliation, outstanding checks are:
a. Added to the cash balance per bank
b. Deducted from the cash balance per bank
c. Added to the cash balance per book
d. Deducted from the cash balance per book
_____ 3. On the bank reconciliation, service charges are:
a. Added to the cash balance per bank
b. Deducted from the cash balance per bank
c. Added to the cash balance per book
d. Deducted from the cash balance per book
_____ 4. On the bank reconciliation, collections made by the bank are:
a. Added to the cash balance per bank
b. Deducted from the cash balance per bank
c. Added to the cash balance per book
d. Deducted from the cash balance per book
_____ 5. The cash account must be adjusted for:
a. Transactions recorded on the books, but not on the bank statement
b. Transactions recorded on the bank statement, but not on the books
c. Transactions recorded on both the bank statement and the books
d. All of the above
_____ 6. Methods of accounting for uncollectible accounts include:
a. Direct write-off method
b. Sales (allowance) method
c. Accounts receivable (allowance) method
d. All of the above
_____ 7. Allowance for uncollectible accounts is a(n):
a. Revenue account
b. Expense account
c. Contra-revenue account
d. Contra-asset account
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 4-7
Use the following data for questions 8-9:
Petarama wishes to account for bad debts. Accounts receivable has a balance of $40,000 and
sales for the period are $100,000. The allowance for doubtful accounts has a $2,000 credit
balance.
_____8. Petarama estimates its bad debts at 3.5% and uses the percentage of sales method.
The entry to estimate bad debts will be for what amount?
a. $2,000
b. $1,500
c. $3,500
d. $5,550
_____9. Petarama uses the aging of accounts receivable method. The total amount at the
bottom of its aging schedule is $6,000. The entry to estimate bad debts will be for
what amount?
a. $2,000
b. $4,000
c. $6,000
d. None of the above
_____ 10. Accounts receivable turnover is calculated as:
a. Net sales divided by average inventory
b. Cost of goods sold divided by average inventory
c. Cost of goods sold divided by average accounts receivable
d. Net sales divided by average accounts receivable
ANSWER KEY - CHAPTER 4 – TEN-MINUTE QUIZ
C
B
D
C
B
D
D
C
B
D
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 4-8
