978-1259722660 Chapter 7 Lecture Note Part 1

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CHAPTER 7

CASH AND RECEIVABLES

Overview

We begin our study of assets by looking at cash and receivables—the two assets typically listed

first in a balance sheet. Internal control and classification in the balance sheet are key issues we

address in consideration of cash. For receivables, the key issues are valuation and the related income

statement effects of transactions involving accounts receivable and notes receivable.

Learning Objectives

LO7–1 Define what is meant by internal control and describe some key elements of an internal

control system for cash receipts and disbursements.

LO7–2 Explain the possible restrictions on cash and their implications for classification in the

balance sheet.

LO7–3 Distinguish between the gross and net methods of accounting for cash discounts.

LO7–4 Describe the accounting treatment for merchandise returns.

LO7–5 Describe the accounting treatment of anticipated uncollectible accounts receivable.

LO7–6 Describe how to estimate the allowance for uncollectible accounts.

LO7–7 Describe the accounting treatment of notes receivable.

LO7–8 Differentiate between the use of receivables in financing arrangements accounted for as a

secured borrowing and those accounted for as a sale.

LO7–9 Describe the variables that influence a company’s investment in receivables and calculate

the key ratios used by analysts to monitor that investment.

LO7–10 Discuss the primary differences between U.S. GAAP and IFRS with respect to cash and

receivables.

Lecture Outline

Part A: Cash and Cash Equivalents

I. What Is Included?

A. Cash includes currency and coins, balances in checking accounts, and items acceptable for

deposit in these accounts, such as checks and money orders received from customers.

B. Cash equivalents include such items as money market funds, treasury bills, and

commercial paper.

C. Companies typically classify investments with maturity dates of three months or less when

purchased as cash equivalents. The company’s policy must be described in a disclosure

note.

II. Internal Control

A. Internal control refers to a company’s plan to (a) encourage adherence to company policies

and procedures, (b) promote operational efficiency, (c) minimize errors and theft, and (d)

enhance the reliability and accuracy of accounting data.

B. Section 404 of the Sarbanes-Oxley Act requires a company to document and assess its

internal controls. The company’s auditors must provide an opinion on management’s

assessment. The Public Company Accounting Oversight Board AS 2201 further requires

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the auditor to express its own opinion on whether the company has maintained effective

internal control over financial reporting.

C. A critical aspect of an internal control system is the separation of duties.

D. In the cash receipt process, the employee who opens the mail should not also deposit the

checks nor be involved in recordkeeping.

E. In the cash disbursement process, responsibilities for check signing, check writing, check

mailing, cash disbursement documentation, and recordkeeping should be separated

whenever possible.

III. Restricted Cash and Compensating Balances

A. Only cash available for current operations or to pay current liabilities should be classified

as a current asset.

B. Restrictions on cash can be informal, arising from management intent, or they might be

contractually imposed.

1. Cash that is restricted and not available for current use usually is reported as

investments and funds or other assets.

2. An example of a contractual restriction on cash is a lender-imposed compensating

balance requirement.

C. IFRS: U.S. GAAP and IFRS are similar with respect to accounting for cash and cash

equivalents. One difference relates to bank overdrafts. U.S. GAAP requires that overdrafts

typically be treated as liabilities. IFRS allows bank overdrafts to be offset against other

cash accounts.

Part B: Current Receivables

I. Accounts Receivable

A. Receivables resulting from the sale of goods or services on account are called accounts

receivable.

B. Accounts receivable are current assets because, by definition, they will be converted to

cash within the normal operating cycle.

C. The typical account receivable is valued at the amount expected to be received, called the

net realizable value.

D. A trade discount reduces the actual price to a customer and is recognized indirectly by

recording the sale at the net of discount price. Trade discounts are not variable

consideration for purposes of revenue recognition.

E. Cash discounts (sometimes called sales discounts) reduce the amount to be paid if

remittance is made within a specified period of time.

1. Using the gross method, we record the receivable and sales revenue at the gross,

before discount price. Discounts taken are recorded as sales discounts (reductions to

gross sales revenue).

2. Using the net method, we record the receivable and sales revenue at the net of discount

price. Discounts not taken are recorded as sales discounts forfeited (increasing net

sales).

3. The effect on the financial statements of the difference between the two methods

usually is not material.

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4. From the perspective of accounting for revenue recognition under ASU 2014-09, cash

discounts are a form of variable consideration and should be estimated at the time of

sale. That approach is very similar to the net method.

F. If sales returns are material, they should be estimated and recorded in the same period as

the related sale. Estimating returns requires reducing revenue, typically by debiting a

contra-revenue account called sales returns. The offsetting credit depends on whether the

customer has paid cash or has a receivable outstanding.

1. If the customer has paid cash, the seller credits a refund liability.

2. If the customer’s account receivable is outstanding, the seller still could recognize a

refund liability but also might credit a contra-receivable account, allowance for sales

returns, which offsets the receivable. (That offset makes some sense given that, in the

case of a receivable, no cash has yet been received.)

3. From the perspective of accounting for revenue recognition under ASU 2014-09, sales

returns are a form of variable consideration and should be estimated at the time of sale.

Sellers typically accrue estimated returns at the end of the accounting period for

convenience, rather than adjusting transaction prices of each sale as it occurs.

G. Subsequent Valuation of Accounts Receivable

1. Direct write-off method

a. This is a method not generally permitted by GAAP.

b. Bad debt expense is simply the actual bad debt write-offs during the period.

2. If bad debts are material, the allowance method should be used. The method estimates

future bad debts and writes down accounts receivable to the amount expected to be

collected. It typically results in recognizing bad debt expense in the same period as the

related sales occur.

a. Accounts receivable is reduced to the appropriate carrying value by an adjusting

entry in which bad debt expense is debited and an allowance account is credited.

b. Actual bad debt write-offs reduce both accounts receivable and the allowance

account.

c. When previously written-off accounts are collected, the receivable and the

allowance are reinstated and the cash collection is recorded as usual.

3. There are two approaches to estimating bad debts, the balance sheet approach and the

income statement approach.

a. With the balance sheet approach, the appropriate balance in the allowance account

is determined, often using an aging schedule. Bad debt expense is equal to the

required adjustment to the allowance account.

b. With the income statement approach, bad debt expense is a percentage of the

period’s net credit sales. The amount recorded ignores any prior balance in the

allowance account. The income statement approach only can be used if it produces

an outcome that is immaterially different from writing receivables down using a

balance sheet approach. It often is used in interim periods.

II. Notes Receivable

A. Notes receivable are formal credit arrangements between a creditor (lender) and a debtor

(borrower).

B. The typical note receivable requires the payment of a specified face amount, also called

principal, at a specified maturity date, along with interest at a specified percentage of the

face amount.

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C. Sometimes a receivable assumes the form of a so-called noninterest-bearing note.

1. Noninterest-bearing notes actually do bear interest, but the interest is deducted (or

discounted) at the onset from the face amount to determine the cash proceeds made

available to the borrower.

2. When interest is discounted from the face amount of a note, the effective interest rate

is higher than the stated discount rate.

D. Similar to accounts receivable, if a company anticipates bad debts on short-term notes

receivable, it uses an allowance account to reduce the receivable to a value that reflects the

amount expected to be collected.

E. Long-term notes receivable are accounted for in the same manner as short-term notes

receivable, but the time value of money has a larger effect.

III. Financing with Receivables

A. Financial institutions have developed a wide variety of methods that allow companies to

use their receivables to obtain immediate cash.

B. These methods can be described as either:

1. A secured borrowing.

2. A sale of receivables.

C. Assignment and pledging are examples of arrangements treated as a secured borrowing.

1. An assignment involves the pledging of specific accounts receivable as collateral for

a loan.

2. The pledging of accounts receivable involves the assigning of accounts receivable in

general rather than specific receivables. No specific accounting treatment is needed

other than the disclosure of the pledging arrangement.

D. Two popular arrangements used for the sale of accounts receivable are factoring and

securitization. Recent changes in U.S. GAAP have made it more difficult for

securitizations to achieve sales treatment (QSPEs have been eliminated, and SPEs are

more likely to be required to be consolidated).

E. The sale of accounts receivable can be made without recourse or with recourse.

1. The buyer assumes the risk of uncollectibility when accounts receivable are sold

without recourse, and the transfer is accounted for as a sale. The typical factoring

arrangement is made without recourse.

2. The seller retains the risk of uncollectibility when accounts receivable are sold with

recourse. If certain criteria are met, factoring with recourse is accounted for as a sale;

otherwise, it’s accounted for as a borrowing.

F. The transfer of a note receivable to a financial institution is called discounting.

G. Choosing sales versus secured borrowing:

1. In general, transferors want sale treatment.

2. A full transfer can be treated as a sale when it meets three conditions.

3. Partial transfers only can be treated as a sale if they qualify as a participating interest.

H. IFRS: Similar treatment of sales and secured borrowings, but a different decision process

for determining which approach to use.

Decision Makers’ Perspective

A. A company’s investment in receivables is influenced by several variables, including the

level of sales, the nature of the product or service sold, and credit and collection policies.

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B. Management’s choice of credit and collection policies often involves trade-offs.

Management must evaluate the costs and benefits of any change in credit and collection

policies.

C. The ability to use receivables as a method of financing also offers management

alternatives.

D. Investors and creditors can gain insights by monitoring a company’s investment in

receivables.

1. The receivables turnover ratio is calculated by dividing net sales by the average

accounts receivable.

2. The average collection period is calculated by dividing 365 days by the receivables

turnover ratio.

E. Bad debt expense is one of a variety of discretionary accruals that provide management

with the opportunity to manipulate income.

Appendix 7A: Cash Controls

A. One of the most important tools used in the control of cash is the bank reconciliation.

B. Differences between the book and bank balances for cash occur due to (1) differences in

the timing of recognition of certain transactions and (2) errors.

C. Step one in a bank reconciliation adjusts the bank balance to the corrected cash balance. In

addition to bank errors, adjustments include:

1. Checks outstanding.

2. Deposits outstanding.

D. Step two adjusts the book balance to the corrected cash balance.

1. In addition to company errors, these adjustments typically include service charges,

charges for NSF checks, and collections made by the bank on the company’s behalf.

2. Each of these adjustments requires a journal entry to correct the book balance.

E. Companies often keep a small amount of cash on hand to pay for low-cost items such as

postage, office supplies, delivery charges, and entertainment expenses. A petty cash fund

provides an efficient way to handle these payments.

F. The petty cash fund always should have a combination of cash and receipts that together

equal the amount of the fund.

G. The fund is established by writing a check to the custodian, and the appropriate expense

accounts are debited when the petty cash fund is reimbursed.

Appendix 7B: Accounting for Impairment of a Receivable and a Troubled Debt

Restructuring

A. If a creditor’s investment in a receivable becomes impaired, the receivable is remeasured

based on the discounted present value of currently expected cash flows at the loan’s

original effective rate (regardless of the extent to which expected cash receipts have been

reduced).

B. When the terms of a debt agreement are changed as a result of financial difficulties

experienced by the debtor (borrower), the new arrangement is referred to as a troubled

debt restructuring.

1. When the receivable is continued but with modified terms, the difference between the

receivable’s carrying amount and the discounted present value of the cash flows after

the restructuring is reported as a loss.

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2. When the receivable is settled outright at the time of the restructuring, the creditor

simply records a loss for the difference between the carrying amount of the receivable

and the fair value of the asset(s) or equity securities received.

C. IFRS: Accounting for impairments are handled similarly under U.S. GAAP and IFRS, but

differ somewhat in the level of analysis and the specifics of impairment indicators. Both

U.S. GAAP and IFRS allow reversals of impairments under some circumstances.

D. In 2020, companies will be required to use the CECL (Current Expected Credit Loss)

model for recognizing impairments, and they can use that model a year earlier if they

desire (see ASU 2016-13). The CECL model broadens the information used to assess

credit losses and requires impairment recognition regardless of whether the creditor thinks

is it probable that some impairment has occurred.

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PowerPoint Slides

Three PowerPoint presentations of the chapter are available in the Connect Library:

1. With “Concept Checks” useful for classroom presentation, permitting the

instructor to intersperse in the presentation short exercises students can be asked

to solve individually or in small groups before the solution is “revealed” by the

instructor. {These are available only within Instructor Resources.}

2. Without the “Concept Checks” so students don’t have the solutions before being

asked to solve individually or in small groups.

3. Accessible PowerPoint Presentations. Accessibility is becoming even more

important in the education marketplace. Students and instructors with

disabilities use many different assistive technologies, and McGraw-Hill

Education is working to increase compatibility and access that will not only

help those with disabilities achieve better learning outcomes, but also serve the

institutions that are teaching these students. Accessible PowerPoint allows slide

content to be read by a screen reader and provides alternative text descriptions

for any image files used that enrich the learning experience. Accessible

PowerPoint is also designed with high-contrast color palettes and uses texture

when possible, instead of color to denote different aspects of the imagery used

within the slide.

Note: The slides are intended to provide comprehensive coverage of the chapter, but

they can be easily edited to allow instructors to change numbers and content in

illustrations or to delete slides pertaining to topics they choose to omit or

deemphasize. (Using your students’ names for company names in the Concept

Checks or Illustrations can be fun.)

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