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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 on 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
1. Define what is meant by internal control and describe some key elements of an internal control
system for cash receipts and disbursements.
2. Explain the possible restrictions on cash and their implications for classification on the balance
sheet.
3. Distinguish between the gross and net methods of accounting for cash discounts.
4. Describe the accounting treatment for merchandise returns.
5. Describe the accounting treatment of anticipated uncollectible accounts receivable.
6. Describe the two approaches to estimating bad debts.
7. Describe the accounting treatment of notes receivable.
8. Differentiate between the use of receivables in financing arrangements accounted for as a
secured borrowing and those accounted for as a sale.
9. Describe the variables that influence a company’s investment in receivables and calculate the
key ratios used by analysts to monitor that investment.
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? (T7-1)
A. Cash includes currency and coins, balances in checking accounts, and items acceptable 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
II. Internal Control of Cash (T7-2)
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.
7-2 Intermediate Accounting, 8/e
further requires the auditor to express its own opinion on whether the company has
maintained effective internal control over financial reporting.
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 might be
contractually imposed.
1. Cash that is restricted and not available for current use usually is reported as
Part B: Current Receivables
I. Initial Valuation of 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.
E. Cash discounts reduce the amount to be paid if remittance is made within a specified short
period of time. (T7-4)
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).
3. The effect on the financial statements of the difference between the two methods
usually is not material.
4. From the perspective of accounting for revenue recognition under ASU 2014-09, cash
II. Subsequent Valuation of Accounts Receivable
A. Possible returns and customer nonpayment could cause subsequent accounts receivable to
be less than initial valuation.
B. If sales returns are material, they should be estimated and recorded in the same period as
the related sale. Estimating returns require 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. (T7-5)
2. If the customer’s account receivable is outstanding, the seller credits a contra–
receivable account, Allowance for sales returns.
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
convenience, rather than adjusting transaction prices of each sale as it occurs.
C. If bad debts are material, the allowance method should be used. The method estimates
future bad debts and matches that expense with the related sales revenue.
1. There are two approaches to estimating bad debts, the income statement approach and
the balance sheet approach. (T7-6)
a. With the income statement approach, bad debt expense is a percentage of the
2. With either approach, accounts receivable is reduced to net realizable value indirectly
by an adjusting entry in which bad debt expense is debited and an allowance account is
D. Direct write-off method
1. This is a method not generally permitted by GAAP.
2. Bad debt expense is simply the actual bad debt write-offs during the period.
III. Measuring and Reporting Accounts Receivable—A Summary
A. Summary of U. S. GAAP (T7-8)
B. International Financial Reporting Standards (T7-9)
IV. Notes Receivable
7-4 Intermediate Accounting, 8/e
1. Noninterest-bearing notes actually do bear interest, but the interest is deducted at the
onset (or discounted) from the face amount to determine the cash proceeds made
available to the borrower. (T7-11)
V. 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:
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. (T7-13)
2. The pledging of accounts receivable involves the assigning of accounts receivable in
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
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, its accounted for as a borrowing. (T7-15)
F. The transfer of a note receivable to a financial institution is called discounting. (T7-16)
G Choosing sales versus secured borrowing:
1. In general, transferors want sale treatment (T7-17)
3. Partial transfers only can be treated as a sale if qualify as a participating interest.
H. Financing with Receivables – A Summary (T7-19)
I. IFRS: Similar treatment of sales and secured borrowings, but a different decision process
for determining which approach to use. (T7-20)
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.
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. (T7-21)
E. Bad debt expense is one of a variety of discretionary accruals that provide management
with the opportunity to manipulate income.
Appendix 7-A: 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. (T7-22)
C. Step one in a bank reconciliation adjusts the bank balance to the corrected cash balance.
In addition to bank errors, adjustments include:
2. Deposits outstanding.
D. Step two adjusts the book balance to the corrected cash balance.
2. Each of these adjustments requires a journal entry to correct the book balance. (T7-23)
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.
Appendix 7–B: 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.
7-6 Intermediate Accounting, 8/e
1. When the receivable is continued, but with modified terms, the difference between the
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. (T7-26)
PowerPoint Slides
A PowerPoint presentation of the chapter is available in the Connect library.
Teaching Transparency Masters
The following can be reproduced on transparency film as they appear here, or you can
CASH AND CASH EQUIVALENTS
Cash includes:
Bank drafts
Cash equivalents include liquid investments that have a
maturity date of three months or less from the date of
purchase, such as:
Money market funds
T7-1
7-8 Intermediate Accounting, 8/e
INTERNAL CONTROL OF CASH
➢ The focus is on controls intended to improve the accuracy and
reliability of accounting information and to safeguard the
company’s assets.
Separation of duties is a key aspect of an internal control
system.
T7-2
International Financial Reporting Standards
Cash and Cash Equivalents. In general, cash and cash equivalents are treated
similarly under IFRS and U.S. GAAP. One difference relates to bank overdrafts,
which occur when withdrawals from a bank account exceed the available balance.
U.S. GAAP requires that overdrafts typically be treated as liabilities. In contrast, IAS
No. 7 allows bank overdrafts to be offset against other cash accounts when overdrafts
are payable on demand and fluctuate between positive and negative amounts as part of
the normal cash management program that a company uses to minimize their cash
balance.
T7-3
7-10 Intermediate Accounting, 8/e
CASH DISCOUNTS
The Hawthorne Manufacturing Company offers credit customers
a 2% cash discount if the sales price is paid within 10 days. Any
amounts not paid within 10 days are due in 30 days. These
repayment terms are stated as 2/10,n/30. On October 5, 2016,
Hawthorne sold merchandise at a price of $20,000. The customer
paid $13,720 ($14,000 less the 2% cash discount) on October 14
and the remaining balance of $6,000 on November 4.
The appropriate journal entries to record the sale and cash
collection, comparing the gross and net methods are as follows:
Gross Method Net Method
October 5, 2016
Accounts receivable 20,000 Accounts receivable 19,600
Sales revenue 20,000 Sales revenue 19,600
Illustration 7-3
SALES RETURNS
If material, sales returns should be anticipated by subtracting an allowance for
estimated returns from accounts receivable. The specific journal entry to record
estimated returns depends on whether cash has been collected from the
customer.
During 2016, its first year of operations, the Hawthorne Manufacturing Company sold
merchandise on account for $2,000,000. This merchandise cost $1,200,000 (60% of the selling
price). Industry experience indicates that 10% of all sales will be returned. Customers returned
$130,000 in sales during 2016, prior to making payment.
Assuming Hawthorne received
cash at the time of sales:
Assuming Hawthorne recorded
accounts receivable at the time of
sales and the receivable has not been
collected:
occurred during 2016.
The cost of returned
inventory is $78,000
Sales of $2,000,000
occurred in 2016, with
Cash 2,000,000
Sales revenue 2,000,000
Accounts receivable 2,000,000
Sales revenue 2,000,000
($130,000 × 60%)
($70,000 × 60%)
At the end of 2016, an
additional $70,000 of
sales returns are
Sales returns 70,000
Refund liability 70,000
Inventory — est. returns 42,000
Sales returns 70,000
Allow. for sales returns 70,000
Inventory — est. returns 42,000
Illustration 7-4
T7-5
7-12 Intermediate Accounting, 8/e
UNCOLLECTIBLE ACCOUNTS RECEIVABLE
The allowance method attempts to estimate future bad debts
and match them with the related sales revenue.
The Hawthorne Manufacturing Company sells its products offering 30 days credit
to its customers. During 2016, its first year of operations, the following events
occurred:
Sales on credit $1,200,000
Illustration 7-7
Income Statement Approach
Bad debt expense (2% x $1,200,000) ………… 24,000
Allowance for uncollectible accounts … 24,000
T7-6
Balance Sheet Approach
Assume an aging of accounts receivable revealed a required allowance of
$25,500, and the allowance account prior to the adjusting entry was a credit
balance of $4,000:
This entry adjusts the allowance account to the required amount.
Accounts receivable $305,000
T7–6 (continued)
7-14 Intermediate Accounting, 8/e
WHEN ACCOUNTS ARE DEEMED UNCOLLECTIBLE
The actual write-off of a receivable using the allowance
method is recorded as a debit to the allowance account and a
credit to accounts receivable.
Assume that actual bad debts in 2017 were $25,000. These bad debts
would be recorded (in a summary journal entry) as follows:
Net realizable value is not directly affected by the write-offs.
When Previously Written-off Accounts Are Collected
Assume a $1,200 account that was previously written off is collected.
The following journal entries record the event:
Accounts receivable ………………………….. 1,200
Allowance for uncollectible accounts 1,200
T7-7
Measuring and Reporting Accounts Receivable
Recognition
Depends on the earnings process; for most credit
sales, revenue and the related receivables are
recognized at the point of delivery.
Subsequent valuation
Initial valuation reduced to net realizable value by:
1. Allowance for sales returns
2. Allowance for uncollectible accounts:
– The income statement approach
– The balance sheet approach
Almost always classified as a current asset.
Illustration 7-8
T7-8
7-16 Intermediate Accounting, 8/e
INTERNATIONAL FINANCIAL REPORTING STANDARDS
• Until recently, IAS No. 39 was the standard that specified appropriate
accounting for accounts and notes receivables, under the category of Loans and
Receivables. However, IFRS No. 9, issued November 12, 2009, will be
required after January 1, 2018, and earlier adoption is allowed, so in the time
period prior to 2018 either standard could be in effect for a particular company
that reports under IFRS.
• IAS No. 39 permits accounting for receivables as “available for sale”
investments if that approach is elected upon initial recognition of the receivable.
IFRS No. 9 does not allow that option for receivables, and U.S. GAAP only
allows “available for sale” accounting for investments in securities (so we
discuss that approach further in chapter 12).
INTEREST-BEARING NOTES RECEIVABLE
The Stridewell Wholesale Shoe Company manufactures athletic shoes that it sells to
retailers. On May 1, 2016, the company sold shoes to Harmon Sporting Goods. Stridewell
agreed to accept a $700,000, 6-month, 12% note in payment for the shoes. Interest is
payable at maturity. Stridewell would account for the note as follows:
To record the sale of goods in exchange for a note receivable.
May 1, 2016
Illustration 7-9
If the sale in the above illustration occurs on August 1, 2016, and the company’s
fiscal year-end is December 31, a year-end adjusting entry accrues interest earned.
December 31, 2016
The February 1 collection is then recorded as follows:
February 1, 2017
T7–10
7-18 Intermediate Accounting, 8/e
NONINTEREST-BEARING NOTES
The preceding note could be packaged as a $700,000 noninterest-bearing note, with
a 12% discount rate.
May 1, 2016
Note receivable (face amount) ……………………………………. 700,000
November 1, 2016
If the sale occurs on August 1, the December 31, 2016, adjusting entry and the entry
to record the cash collection on February 1, 2017, are recorded as follows:
December 31, 2016
Discount on note receivable ……………………………………. 35,000
T7–11
LONG-TERM NONINTEREST-BEARING NOTES
Long-term notes are accounted for similarly, but the time value of money has a
greater effect. For example, assume Stridewell agrees on January 1, 2016, to accept a
two-year noninterest-bearing note with an effective interest rate of 12%.
January 1, 2016
700,000
December 31, 2016
Discount on note receivable …………………………
66,964
Interest revenue ($558,036 × 12%) ……………
December 31, 2017
Cash ……………………………………………………………
700,000
Discount on note receivable …………………………..
75,000
Notes receivable ………………………………………….
Illustration 7-10
T7-12
7-20 Intermediate Accounting, 8/e
ASSIGNMENT OF ACCOUNTS RECEIVABLE
An assignment involves the pledging of specific receivables
as collateral for a debt.
At the end of November 2016, Santa Teresa Glass Company had outstanding
accounts receivable of $750,000. On December 1, 2016, the company borrowed
$500,000 from Finance Affiliates and signed a promissory note. Interest at 12% is
payable monthly. The company assigned $620,000 of its receivables as collateral
for the loan. Finance Affiliates charges a finance fee equal to 1.5% of the accounts
receivable assigned.
Santa Teresa Glass records the borrowing as follows:
Santa Teresa will continue to collect the receivables, record any discounts, sales
returns, and bad debt write-offs, but will remit the cash to Finance Affiliates, usually
on a monthly basis. When $400,000 of the receivables assigned are collected in
December, Santa Teresa Glass records the following entries:
Cash …………………………………………………………… 400,000
Accounts receivable ………………………………… 400,000
Illustration 7-13
T7–13