Chapter 7Cash And Receivables

Cash

What is cash? Reporting cash. Summary of cash-related items.

What is Cash? Most liquid asset. Standard medium of exchange. Basis for measuring and accounting for all items. Current asset. Examples: coin, currency, available funds on deposit

at the bank, money orders, certified checks, cashier’s checks, personal checks, bank drafts and savings accounts.

Reporting Cash: Three issues are related to cash require special

attention:1. Cash equivalents.2. Restricted cash.3. Bank overdraft.

Cash Equivalents: Short-term, highly liquid investments that are both

1. Readily convertible to cash, and2. So near their maturity that they present insignificant

risk of changes in interest rates. Examples: Treasury bills, Commercial paper, and

Money market funds.

Restricted Cash: Companies segregate restricted cash from “regular”

cash for reporting purposes.

1

Examples, restricted for:1. Plant expansion,2. Retirement of long-term debt, and 3. Compensating balances: the minimum cash balance

in checking or saving accounts that the bank requires the customers to maintain.

Bank Overdrafts: Occurs when a company writes a check for more than

the amount in its cash account. Generally reported as a current liability. Offset against cash account only when available cash is

present in another account in the same bank on which the overdraft occurred.

Summary of Cash-Related Items:

2

Petty Cash Fund: Used to pay small amounts. The operation of the fund, often called an imprest

system, involves:1. Establishing the petty cash fund.2. Making payments from the petty cash fund, and3. Replenishing the petty cash fund.

Accounting entries are required when: 1. the fund is established, 2. the fund is replenished, and 3. the amount of the fund is changed.

Example: Lincolnville Company uses an imprest petty cash system. The fund was established on March 1 with a balance of $100. During March the following petty cash receipts were found in the petty cash box.

The fund was replenished on March 15 when the fund contained $3 in cash. On March 20, the amount in the fund was increased to $150.

Instructions: Journalize the entries in March that pertain to the operation of the petty cash fund.

3

Solution:

Date Account Title and Explanation Dr. Cr.Mar. 1 Petty Cash

CashTo establish the petty cash fund.

100100

Mar. 15 Postage ExpenseFreight-Out Miscellaneous ExpenseTravel Expense Cash Over and Short Cash To replenish the petty cash fund.

392111242

97

20 Petty Cash CashTo increase the petty cash fund.

5050

Notice: Total expenses + remaining cash in the fund should equal the original amount of the fund.1. Cash shortage occurs when total expenses +

remaining cash in the fund is less than the original amount of the fund. Cash shortage is debited to the Cash Over and Short account when replenishing the fund.

2. Cash overage occurs when total expenses + remaining cash in the fund is more than the original amount of the fund. Cash overage is credited to the Cash Over and Short account when replenishing the fund.

4

Use of a Bank: The use of a bank minimizes the amount of currency

that must be kept on hand and therefore contributes significantly to good internal control over cash.

A check is a written order signed by the depositor directing the bank to pay a specified sum of money to a designated recipient. The three parties to a check are as follows:

a. The maker (or drawer) who issues the check.b. The bank (or payer) on which the check is drawn.c. The payee to whom the check is payable.

A bank statement shows: a. checks paid and other debits charged against the account,

b. deposits and other credits made to the account, and c. the account balance after each day’s transactions.

A bank debit memoranda is usually included with the bank statement to indicate charges against the depositor’s account such as a bank service charge, cost of printing checks, and when a previously deposited customer’s check “bounces” because of insufficient funds (NSF check).

A bank credit memoranda shows such items as the collection of a note receivable for the depositor by the bank, or interest earned on deposits in the bank.

Reconciling the Bank Account:

5

A reconciliation of a bank account is necessary because the balance per bank and balance per books are seldom in agreement. The lack of agreement may be the result of time lags and errors.

In reconciling the bank statement, it is customary to reconcile the balance per books (the cash balance in the ledger) and the balance per bank (the cash balance according to the bank statement) to their adjusted (corrected) cash balances. The reconciliation schedule consists of two sections.

The steps in preparing a bank reconciliation are:a. Determine deposits in transit.b. Determine outstanding checks.c. Note any errors discovered.d. Trace bank memoranda to the records.

Each reconciling item used in determining the adjusted cash balance per books should be recorded by the depositor (requires a journal entry to correct the cash balance in the ledger).

Reconciliation Procedures:

+ Deposit in Transit + Notes collected by bank - Outstanding Checks - Service charges +- Bank Errors +- Book Errors _____________________ ____________________ CORRECT BALANCE CORRECT BALANCE Example:

6

The following information pertains to Family Video Company.

1. Cash balance per bank, July 31, $7,263.2. Cash balance per books, July 31, $7,284.3. July bank service charge not recorded by the depositor

$28.4. Deposits in transit, July 31, $1,500.5. Bank collected $900 note for Family in July, plus

interest $36, less fee $20.The collection has not been recorded by Family, and no interest has been accrued.

6. Outstanding checks, July 31, $591.

Instructionsa) Prepare a bank reconciliation at July 31.b) Journalize the adjusting entries at July 31 on the books

of Family Video Company.

Solution:a)

Family VideoBank Reconciliation Statement

For July, 2010

Cash balance per bank statement $7,288Add: Deposit in transit 1,500Less: Outstanding checks (591)Adjusted cash balance per bank $8,172

Cash balance per books $7,284Add: Collection of notes receivable 900 Collection of interest 36Less: Bank service charge (28) Note collection fee (20)Adjusted cash balance per books $8,172

b) Note: Adjusting journal entry includes only the adjustments to the cash balance per books.

7

Date Account Title and Explanation Dr. Cr.July 31 Cash

Notes Receivable Interest RevenueTo record collection of note receivable plus interest by the bank.

936900 36

July 31 Bank Service ExpenseMiscellaneous Expense CashTo record bank Charges.

2820

48

When the above entries are posted to the cash account in the ledger:

Ledger

CashBalance 7,284July 31 936

July 31 48

Balance 8,172

Note: the cash balance in the ledger now agrees with the adjusted cash balance per books in the bank reconciliation statement.

Receivables:

8

Receivables are defined as claims held against customers and others for money, goods, or services.

Receivables may generally be classified as either trade or non-trade.

Trade receivables : are amounts owed by customers for goods sold or services rendered to them as part of normal business operations.

Trade receivable are classified into:1. Accounts Receivable:Oral promises of the purchaser

to pay for goods and services sold.2. Notes Receivable: Written promises to pay a sum of

money on a specified future date.

Non-Trade Receivable: arise from a variety of transactions such as:1. Interest and dividends receivable, 2. Advances to employees.

Recognition of Accounts Receivables: In most receivable transactions, the amount to be

recognized is the exchange price (amount due from the debtor).

Two elements that must be considered in measuring receivables are: (a) the availability of discounts (trade and cash discounts), and (b) the length of time between the sale and the payment due date (the interest factor).

Trade Discounts Reductions from the list price. Not recognized in the accounting records. Customers are billed net of discounts.

Cash Discounts

9

Companies offer cash discounts (sales discounts) to induce prompt payment (for example, “2/10, n/30”.

There are two methods for recognizing (recording accounts receivable:1. The gross method, and2. The net method.

Example (1):Transaction: 1. Sales of $10,000, terms “2/10, n/30”.2. Collection of amount due within discount period.

Gross Method:

Date Account Title and Explanation Dr. Cr.(1) Accounts Receivable

SalesTo record sales on account terms 2/10, n/30.

10,00010,000

(2) CashSales Discount Accounts ReceivableTo record collection of credit sales within the discount period.

9,800200

10,000

Net Method:

Date Account Title and Explanation Dr. Cr.(1) Accounts Receivable

SalesTo record sales on account terms 2/10, n/30 at net.

9,8009,800

(2) Cash Accounts ReceivableTo record collection of credit sales within the discount period.

9,8009,800

Example (2):

10

If the amount due is collected after the discount period, the collection of cash is recorded as follows under the two methods:

Gross Method:

Date Account Title and Explanation Dr. Cr.Cash Accounts receivableTo record collection of credit sales after the discount period.

10,00010,000

Net Method:

Date Account Title and Explanation Dr. Cr.Cash Accounts Receivable Sales Discount ForfeitedTo record collection of credit sales after the discount period.

10,0009,800200

The sales discount forfeited is reported on the income statement with other revenues (if the net method is used).

Non-recognition of Interest Element ideally, a company should measure receivables in terms

of their present value. That is, the discounted value of the cash to be received in the future.

The profession specifically excludes from present value considerations “receivables arising from transactions with customers in the normal course of business which are due in customary trade terms not exceeding approximately one year.”

Recognition of Notes Receivable:

11

Generally originate from: Customers who need to extend payment period

of an outstanding receivable High-risk or new customers. Loans to employees. Sales of property, plant, and equipment. Lending transactions (the majority of notes)

In terms of interest, notes receivable are classified to:1. Interest-bearing notes: which have a stated rate of

interest.2. Non-interest-bearing notes (or zero-interest bearing

notes): include the interest as part of their face amount instead of stating it explicitly.

Notes receivable are considered fairly liquid, even if long-term, because they may be easily converted to cash.

Short-term notes are generally recorded at face value (less allowances) because the interest implicit in the maturity value is immaterial.

Notes maturing in 3 months or less are considered cash equivalents and are not subject to premium or discount amortization.

Long-term notes receivable should be recorded and reported at the present value of the cash expected to be collected.

When the interest stated on an interest-bearing note is equal to the effective (market) rate of interest, the note sells at face value.

12

When the interest stated on an interest-bearing note is less than the market rate of interest, the note sells at a discount.

When the interest stated on an interest-bearing note is grater than the market rate of interest, the note sells at a premium.

The discount, or premium is recorded, and then amortized over the life of the note to approximate the effective interest rate.

Note Issued at Face Value:Example:

Bigelow Corp. lends Scandinavian Imports $10,000 in exchange for a $10,000, three-year note bearing interest at 10% annually. The market rate of interest for a note of similar risk is also 10%. How does Bigelow record the receipt of the note?

Solution:PV of Interest (Present value of ordinary annuity):

PV-OAn,i = A (PVF-OAn,i)

Where:PV-OAn,i = Present value of an ordinary annuity of $1

invested for n periods at I interest rate.

A: the annuity (the annual interest).

PVF-OAn,i = Present value factor of an ordinary annuity of $1 invested for n periods at I interest rate (this factor is extracted from the present value of an ordinary annuity table).

13

PV-OA 3, 10% = $1,000 x 2.48685 = $2,487 Interest Factor Present Received Value

PV of Principal (Present Value of the Face Value of Note)

PV = FV (PVFn,i)

Where:PV: Present value.FV: Future value.PVF: Present value factor of a single amount of $1

invested for n periods at I interest rate.

PV3, 10% = $10,000 x .75132 = $7,513 Principal Factor Present value

Summary Present value of interest $ 2,487Present value of principal 7,513Note current market value (Present value) $10,000

The receipt of the note receivable is recorded by Bigelow as follows:

Date Account Title and Explanation Dr. Cr.Jan. Yr 1 Notes Receivable

CashTo record the receipt of a note receivable for a loan to Scandinavian Imports.

10,00010,000

Each year, Bigelow would record interest revenue on the note receivable as follows:

14

Date Account Title and Explanation Dr. Cr.Dec. Yr 1 Cash

Interest RevenueTo record interest revenue on the note receivable.

1,0001,000

Note Not Issued at Face Value:Zero-Interest-Bearing Note (Non-interest-Bearing Note):

Notes receivable are sometimes issued with zero interest rate stated or at a stated rate that is unreasonable.

In such instances the present value of the note is measured by the cash proceeds to the borrower or fair value of the property, goods, or services rendered.

The difference between the face amount of the note and the cash proceeds or fair value of the property represents the total amount of interest during the life of the note.

Example:Jeremiah Company receives a three-year, $10,000 zero-

interest-bearing note. The market rate of interest for a note of similar risk is 9%. How does Jeremiah record the receipt of the note?

Solution: PV of Principal (Present value of the Face Value of the Note)

PV3, 9% = $10,000 x .77218 = $7,721.80 Principal Factor Present value

Since the present value of the note receivable $7,721.80 is less than its face value, the note receivable is issued at a discount.

15

The discount on the note = Face value of note – Present value of the note

= $10,000 – 7,721.80 =$2,278.20

The amount of the discount on the note receivable ($2,278.20) represents the interest revenue that Jeremiah Company will receive from the note over the three years.

Jeremiah Company records the receipt of the note receivable as follows:

Date Account Title and Explanation Dr. Cr.Jan. Yr 1

Notes Receivable Cash Discount on Notes ReceivableTo record the receipt of a zero-interest note receivable.

10,0007,721.802,278.20

Jeremiah Company records interest revenue on the note at the end of each of the three years as follows:

16

Date Account Title and Explanation Dr. Cr.Dec. Yr 1 Discount on Notes Receivable

Interest RevenueTo record interest revenue on the note receivable.

694.96694.96

Dec. Yr 2 Discount on Notes Receivable Interest Revenue

757.51757.51

Dec. Yr 3 Discount on Notes Receivable Interest Revenue

825.73825.73

The discount on notes receivable account over the three years appears as follows:

Discount on Notes ReceivableEnd Yr 1 $694.96 Beg Yr 1 $2,278.20End Yr 2 757.51 Bal end Yr 1 1,583.24End Yr 3 825.73 Bal end Yr 2 825.73

Bal end Yr 3 -0-

The Discount on notes receivable is a contra asset account that is deducted from notes receivable on the balance sheet as shown below:

Beg End End EndYr 1 Yr 1 Yr 2 Yr 3

Notes Receivable 10000 10000 10000 10000Less: Disc on N/R 2278.20 1583.24 825.73 -0- Carrying value 7721.80 8416.76 9174.27 10000

Interest-Bearing Note:Example:

Morgan Corp. makes a loan to Marie Co. and receives in exchange a three-year, $10,000 note bearing interest at 10% annually. The market rate of interest for a note of similar risk is 12%.Required:

1. Compute the present value of the note receivable.

17

2. Compute the discount on notes receivable.3. Prepare a journal entry to record the receipt of the

note receivable.4. Prepare a schedule of note discount amortization

using the effective interest method.5. Prepare journal entries to record the amortization of

the discount on notes receivable.

Solution:PV of Interest (Present value of ordinary annuity):

PV-OA3, 12% = $1,000 x 2.40183 = $2,402 Interest Factor Present value Received

PV of Principal (Present value of the Face Value of the Note)

PV3, 12% = $10,000 x .71178 = $7,118 Principal Factor Present value

Present Value of the Note = Present value of interest + present value of Principal

= $2,402 + $7,118 = $9,520

18

Since the present value of the note receivable $9,520 is less than its face value $10,000, the note receivable is issued at a discount.

The discount on the note = Face value of note – Present value of the note

= $10,000 – $9,520 =$480

The receipt of the note is recorded as shown below:

Date Account Title and Explanation Dr. Cr.Jan. Yr 1

Notes Receivable Cash Discount on Notes ReceivableTo record the receipt of a 3-year, 10% note receivable.

10,0009,520480

The schedule of note discount amortization using the effective interest method is shown below:

19

The amortization of the discount on notes receivable is recorded over the three years as shown below:

Date Account Title and Explanation Dr. Cr.End Yr 1

CashDiscount on Notes receivable Interest revenueTo record interest revenue and amortization of discount on notes receivable.

1,000142

1,142

End Yr 2

CashDiscount on Notes receivable Interest revenueTo record interest revenue and amortization of discount on notes receivable.

1,000159

1,159

End Yr 3

CashDiscount on Notes receivable Interest revenue

1,000179

1,179

20

Discount on Notes ReceivableEnd Yr 1 $142 Beg Yr 1 $480End Yr 2 159 Bal end Yr 1 338End Yr 3 179 Bal end Yr 2 179

Bal end Yr 3 -0-

The Discount on notes receivable is a contra asset account that is deducted from notes receivable on the balance sheet as shown below:

Beg End End EndYr 1 Yr 1 Yr 2 Yr 3

Notes Receivable 10000 10000 10000 10000Less: Disc on N/R 480 338 179 -0- Carrying value 9,520 9,662 9,821 10000

Valuation of Notes Receivable Short-Term reported at Net Realizable Value (same as

accounting for accounts receivable). Long-Term - FASB requires companies disclose not

only their cost but also their fair value in the notes to the financial statements.

Fair Value Option. Companies have the option to use fair value as the basis of measurement in the financial statements.

Example: (recording fair value option): Assume that Escobar Company has notes receivable

that have a fair value of $810,000 and a carrying amount of $620,000. Escobar decides on December 31, 2010, to use the fair value option for these receivables. This is the first valuation of these recently acquired receivables.

At December 31, 2010, Escobar makes an adjusting entry to record the increase in value of Notes Receivable and to record the unrealized holding gain, as follows.

21

Date Account Title and Explanation Dr. Cr.Notes Receivable Unrealized Holding Gain or Loss

190,000190,000

Disposition of Accounts and Notes ReceivableNormally, accounts and notes receivable are collected when due and removed from the books. But in order to accelerate the receipt of cash from receivable owner may transfer accounts or notes receivable to another company for cash.

Transfer accomplished by:1. Secured borrowing.2. Sale of receivables.

Secured Borrowing:The owner of the accounts receivable borrows cash by

writing a promissory note designating the accounts receivable as collateral.

1. The borrower and lender agree as to the specific accounts that serve as security. The borrower typically makes collections on the assigned accounts and remits the collections plus a finance charge (interest) to the lender.

2. The borrower also recognizes all discounts, returns and allowances, and bad debts.

Example:March 1, 2010, Howat Mills, Inc. provides (assigns)

$700,000 of its accounts receivable to Citizens Bank as collateral for a $500,000 note. Howat Mills continues to collect the accounts receivable; the account debtors are not notified of the arrangement. Citizens Bank assesses a finance charge of 1% of the accounts receivable and interest on the note of 12%. Howat Mills makes monthly

22

payments to the bank for all cash it collects on the receivables.

The following are the transactions related to this event:1. On March 1, the transfer of accounts receivable and

issuance of a note for the loan.2. Collection in March of $440,000 of accounts

receivable less cash discount of $6,000. In addition, sales returns of $14,000 were received.

3. On April 1, Howat Mills remitted March collections plus accrued interest to the bank.

4. Collections in April of the balance of accounts receivable less $2,000 written off as uncollectible.

5. On May 1, Howat Mills remitted the balance due on the note plus interest to the bank.

Instructions: Journalize the above transactions on the records of Howat Mills. Solution:March 1:Finance Charge = $700,000 × 1% = $7,000Cash received = $500,000 loan - $7,000 Finance chare

= $493,000

Date Account Title and Explanation Dr. Cr.Mar. 1 Cash

Finance Charge Notes PayableTo record transfer of accounts receivable and issuance of a note payable to the bank.

493,0007,000

500,000

During March:Cash collected = $440,000 - $6,000 = $434,000Accounts receivable = $440,000 + $14,000 Sales returns = $454,000

Date Account Title and Explanation Dr. Cr.

23

March CashSales DiscountSales Returns Accounts ReceivableTo record collection of accounts receivable less sales discount and sales returns.

434,0006,00014,000

454,000

April 1:Interest expense on the note payable for one month = $500,000 × 12% × 1/12 = $5,000 Cash paid to the bank = $434,000 cash collected from receivable + $5,000 interest on the note payable = $439,000

Date Account Title and Explanation Dr. Cr.April 1 Note Payable

Interest Expense CashTo record remittance of cash collections plus interest on the note payable to the bank.

434,0005,000

439,000

During April:Balance of accounts receivable= $700,000 - $454,000 credits during March $246,000

Cash Collected from receivable = $246,000 - $2,000 Written off = $244,000

Date Account Title and Explanation Dr. Cr.April 1 Cash

Allowance for Doubtful Accounts Accounts ReceivableTo record collections of accounts receivable less accounts written off.

244,0002,000

246,000

May 1:

24

Unpaid balance of the note payable = $500,000 - $434,000 = $66,000

Interest expense on the unpaid balance on the note payable for one month = $66,000 × 12% × 1/12 = $660

Cash paid to the bank = $66,000 unpaid balance of the note payable + $660 interest = $66,660

Date Account Title and Explanation Dr. Cr.April 1 Note Payable

Interest Expense CashTo record Payment of the balance of the note payable plus interest to the bank.

66,000660

66,660

Sales of Receivables:When accounts and notes receivable are factored (sold), the factoring arrangement can be with recourse or without recourse.

If receivables are factored on a with recourse basis, the seller guarantees payment to the factor in the event the debtor does not make payment.

When a factor buys receivables without recourse, the factor assumes the risk of collectibility and absorbs any credit losses.

We will only focus on the case of sale of receivable on a without recourse basis.

Sale of Receivable Without Recourse:

25

Purchaser assumes risk of collection. Transfer is outright sale of receivables.Seller records loss on sale.Seller use Due from Factor (receivable) account to cover discounts, returns, and allowances.

Example:Crest Textiles, Inc. factors $500,000 of accounts

receivable with Commercial Factors, Inc., on a without recourse basis. The receivable records are transferred to Commercial Factors, Inc., which will receive the collections. Commercial Factors assesses a finance charge of 3% of the amount of accounts receivable and retains an amount equal to 5% of the accounts receivable (for probable adjustments).

Instructions: Prepare the journal entry on the records of Crest Textiles, Inc., to record the sale of receivable. Solution:

Loss on sale of receivable (the finance charge) = $500,000 × 3% = $15,000

Due From Factor = $500,000 × 5% = $25,000

Cash collected from sale of receivable = $500,000 – ($15,000 + $25,000) = $460,000

The Journal entry on the records of Crest Textiles, Inc., to record the sale of receivable is shown below:

Date Account Title and Explanation Dr. Cr.CashDue From Factor Loss on Sale of Receivable Accounts Receivable

460,00025,00015,000

500,000

26