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currency and coins, balances in checking accounts, and items acceptable for deposit in these accounts, such as checks and money orders received from customers.
money market funds, treasury bills, and commercial paper.
§ Must have a maturity date no longer than 3 months from the date of purchase.
§ Policy on cash equivalents should be disclosed in the financial statements.
- A company’s plan to:
- o Encourage adherence to company policies and procedures.
- o Promote operational efficiency.
- o Minimize errors and theft.
- o Enhance the reliability and accuracy of accounting data.
o The focus of controls in financial accounting is to improve the accuracy and reliability of accounting information and to safeguard assets.
o Committee of Sponsoring Organizations (COSO)-
- dedicated to improving the quality of
- financial reporting through, among other things, effective internal controls.
- § COSO defines internal control as a process, undertaken by an entity’s board of directors, management, and other personnel, designed to provide reasonable assurance regarding the achievement of objectives in the following categories:
- · Effectiveness and efficiency of operations.
- · Reliability of financial reporting.
- · Compliance with applicable laws and regulations.
o Internal Control Procedures –
§ Cash is the most liquid asset so a well-designed and functioning system of internal control must surround all cash transactions.
§ Separation of duties is critical. Those who handle cash should not have access to accounting records or be involved in the reconciliation of cash book or bank balances.
o Internal Control Procedures –
- Cash Disbursements
- § Proper controls for cash disbursements should be designed to prevent any unauthorized payments and ensure that disbursements are recorded in the proper general ledger and subsidiary accounts.
- § Important elements of a cash disbursement system include:
- · All disbursements, other than very small disbursements from petty cash, should be made by check. This provides a permanent record of all disbursements.
- · All expenditures should be authorized before a check is prepared. This process should include verification of the proper general ledger accounts to be debited.
- · Only authorized individuals should sign checks.
Restricted Cash and Compensating Balances
- o Informal restrictions can be set by management to use a certain amount of cash for a specific purpose.
- o Restrictions can be contractually imposed. Debt instruments require the borrower to set aside funds for the future payment of a debt.
- o Compensating balances- a specified balance (usually some percentage of the committed amount) a borrower of a loan is asked to maintain in a low-interest or noninterest-bearing account at the bank.
- § If the restriction is legally binding, the cash is classified as either current or noncurrent depending on the classification of the related debt.
- § If the arrangement is informal with no contractual agreement that restricts the use of cash, the compensating balance can be reported as part of cash and cash equivalents, with note disclosure of the arrangement.
represents a company’s claims to the future collection of cash, other assets, or services.
receivables resulting from the sale of goods or services on account. Often referred to as trade receivables.
a percentage reduction from the list price. A way to change prices without publishing a new catalog or to disguise prices from competitors. Can be used for quantity discounts to large customers.
§ Cash discounts-
- a discount in the amount paid by a credit customer if paid within a specified period of time.
- · Ex: 2/10 n/30 is a 2% discount if paid within 10 days, or full payment within 30 days.
- · Gross method- view a discount not taken by the customer as part of sales revenue.
- o Sales discounts is a contra account to sales revenue.
considers sales revenue to be the net amount, after discount, and any discounts not taken by the customer as interest revenue.
§ The gross method
recognizes discounts not taken as revenue when the sale is made and the net method recognizes them as revenue after the discount period has passed and the cash is collected.
§ Sales return
- when merchandise is returned for are fund or for credit for other purchases.
- · Sales revenue and accounts receivable should be reduced by the amount of returns in the period of sale if the amount of returns is anticipated to be material.
- · Returns must be accounted for including those that occur in the period of sale and those that are estimated to occur in future periods.
- · Reduce sales revenue and accounts receivable by estimated returns by debiting a sales returns account (contra account to sales revenue) and crediting an allowance for sales returns (contra account to accounts receivable.
- · Companies rely on past history to estimate returns.
§ Uncollectable Accounts Receivable
- · The balance sheet should report only the net
- realizable value of the asset, that is, the amount of cash the company actually expects to collect from customers.
- · Companies account for bad debts by debiting bad debt expense and crediting allowance for uncollectable accounts. This is called the allowance method.
Income Statement Approach
estimate bad debt expense as a percentage of each period’s net credit sales.
· Balance Sheet Approach-
- determines bad debt expense by estimating the net realizable value of accounts receivable to be reported in the balance sheet.
- o Can be done analyzing each customer account, by applying a percentage to the entire outstanding receivable balance, or by applying different percentages to accounts receivable balances depending on the length of time outstanding (Accounts receivable aging schedule).
· When accounts are deemed uncollectible
- o The write-off is recorded as a debit to allowance for uncollectable accounts and a credit to accounts receivable.
- o The write-off reduces both receivables and the allowance, thus having no effect on income or financial position.
· When previously written-off accounts are collected
o The entry to write off the account is reversed.
- o The collection is then recorded the usual way as a debit to cash and a credit to
- accounts receivable.
· Direct write-off of uncollectable accounts
- o If uncollectable accounts are not anticipated or are immaterial, or if it’s not possible to reliably estimate uncollectable accounts, an allowance for uncollectible accounts is not appropriate.
- o Adjusting entries are not recorded and bad debts are simply written off as bad debt expense.
- o Debit to bad debt expense and credit to accounts receivable.
- o If the sale was in a previous reporting period the matching principle is violated.
- o Not permitted by GAAP except in limited circumstances.
- o Required method for most companies for tax purposes.
formal credit arrangements between a creditor and a debtor.
o Interest-Bearing Notes
§ Requires payment of a specified face amount, also called principle, at a specified maturity date or dates. In addition, interest is paid at a stated percentage of the face amount.
§ Face amount X Annual rate X Fraction of the annual period
- § Interest is deducted (discounted) from the face
- amount to determine the cash proceeds made available to the borrower at the outset.
- § The discount on note receivable is a contra account to the note receivable account. It represents future interest revenue that will be recognized as it is earned over time.
- § When interest is discounted from the face amount of a note, the effective interest rate is higher than the stated discount rate.
- § When a noninterest-bearing note is received
- solely in exchange for cash, the amount of cash exchanged is the basis for valuing the note.
Subsequent Valuation of Notes Receivable
- § If a company anticipates bad debts on short-term
- notes receivable it uses an allowance account to reduce the receivable to net realizable value.
- § Estimation of long-term notes (loans) is more difficult.
- § GAAP requires that companies disclose the fair value of their notes receivable in the disclosure notes.
- § GAAP recently changed to allow companies to choose to carry receivables at fair value in their balance sheets, with changes in fair value recognized as gains or losses in the income statements.
- § When it becomes probably that a creditor will be unable to collect all amounts due according to the contractual terms of a note, the receivable is considered impaired.
Financing with Receivables
- o Companies can use their receivables to obtain immediate cash.
- o Shorten operating cycle since they don’t have to wait for cash until credit customers pay.
- o Secured Borrowing
- when trade receivables in general rather than specific receivables are pledged as collateral.
- · No special accounting treatment is needed for pledging and the arrangement is simply described in a disclosure note.
- the transferor (borrower) simply acts like it borrowed money from the transferee (lender), with the receivables remaining in the transferor’s balance sheet and serving as collateral for the loan. The transferee recognizes a note receivable.
- § Companies use receivables as collateral. This is similar to a mortgage.
- §Typically, the lender lends an amount of money that is less than the amount of receivables assigned to the borrower. The difference allows protection for uncollectable accounts.
- § The lender usually charges an up-front finance charge.
The seller (transferor):
- · Removes from the accounts the receivables (and
- any allowance for bad debts associated with them).
- · Recognizes at fair value any assets acquired or liabilities assumed by the seller in the transaction.
- · Record the difference as a gain or loss.
- financial institution that buys receivables for cash, handles the billing and collection of the receivables, and charges a fee for this service.
- · Credit cards are forms of factoring arrangements.
- the company creates a “special purpose entity” (SPE) usually a trust or subsidiary.
- · The SPE buys a pool of trade receivables, credit card receivables, or loans from the company, and then sells related securities, typically debt such as bonds or commercial paper, that are backed by the receivables.
Sale without recourse
· The buyer can’t ask the seller for more money if customers don’t pay the receivables. The buyer assumes the risks of bad debt.
Sale with recourse
· The seller retains all the risk of bad debts. The seller guarantees the buyer will be paid even if some receivables prove to be uncollectible.
Transfer of Notes Receivable
- § Handled in the same manner as transfers of account receivable.
- § A note receivable can be used to obtain
- immediate cash from a financial institution either by pledging the note as collateral for a loan or by selling the note.
- § Discounting- the transfer of a note to a financial institution.
- · The financial institution accepts the note and
- gives the seller cash equal to the maturity value of the note reduced by a discount.
o Deciding Whether to Account for a Transfer as a Sale or a Secured Borrowing
- § Transferors usually prefer to use the sale approach rather than the secured borrowing approach to account for the transfer of a receivable, because the sale approach makes the transferor seem less leveraged, more liquid, and perhaps more profitable than does the secured
- borrowing approach.
- § The transferor is determined to have surrendered
- control over the receivables if and only if all of the following conditions are met.
- · Receivables are isolated from the transferor.
- · Transferee has the right to pledge or exchange the assets it received.
- · Transferor does not have effective control over
- the receivables.
- § If all conditions are met then it is a sale. If not it is a secured borrowing.
- § Transferors must provide qualitative and quantitative information about the transfer at a level that allows financial statement users to fully understand (a) the transfer, (b) any continuing
- involvement with the transferred assets, and (c) any ongoing risks to the transferor.
- § The company has to provide information about the quality of the transferred assets. For example the amount of receivables past due and any credit losses occurring during the period.
- § Also disclosed:
- · How fair values were estimated when recording the transactions.
- · Any cash flows occurring between the transferor and the transferee.
- · How any continuing involvement in the transferred assets will be accounted for on an ongoing basis.
Receivables turnover ratio
- Net sales/Average accounts receivable (net)
- § Shows the number of times during a period that the average accounts receivable balance is collected.
Average collection period
365 days/Receivables turnover ratio
Approximation of the number of days the average accounts receivable balance is outstanding.
- o If the percentage increase in receivables is greater than the percentage increase in sales, the receivables turnover ratio will decline. (average collection period will increase. This could indicate customer dissatisfaction or that the company has extended too generous payment terms.
- o Ratios can also be used to compare relative effectiveness of companies in managing the investment in receivables.
- small amount of cash on hand to pay for low-cost items such as postage, office supplies, delivery charges, and entertainment expenses.
- o Established by transferring a specified amount of cash from the company’s general checking account to an employee designated as the petty cash custodian.
- o Amount of fund should approximate the expenditures made from the fund during a relatively short period of time (say a week or month).
- o The custodian disburses cash from the fund when the appropriate documentation is presented, such as a receipt.
- o Expenditures are recorded when reimbursement is requested at the end of the month. At this time the fund is replenished.
- o Petty cash is only debited when the fund is established or when increasing the size of the fund.
- o Petty cash custodian should not be involved in the process of writing or approving checks, nor in recordkeeping.
Impairment of a Receivable Due to a Troubled Debt Restructuring
- Impairment of a loan receivable occurs if the company believes it is probable that it will not receive all of the cash flows associated with the receivable.
- o The receivable is remeasured based on the discounted present value of currently expected cash flows at the loan’s original effective rate.
- o Debit bad debt expense and credit allowance.
- o Troubled debt restructuring- original terms of a debt agreement are changed as a result of financial difficulties experienced by the debtor (borrower).
- o Arrangement involves some concessions on the part of the creditor.
When the Receivable is Continued, but with Modified Terms
- o In a troubled debt restructuring, it is likely that the bank allows the receivable to continue but with the terms of the debt agreement modified to make it easier for the debtor to comply.
- o The lender might agree to reduce or delay the scheduled interest payments. Or, it may agree to reduce or delay the maturity amount.
When the Receivable is Settled Outright
- o Sometimes a receivable in a troubled debt restructuring is actually settled at the time of the restructuring with the receipt of cash (or a noncash asset), or even shares of the debtor’s stock.
- o In that case, 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.
- o For most active lenders, a troubled debt restructuring unfortunately is not both unusual and infrequent; so the loss is not reported as an extraordinary loss.