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Chapter 7 18 pp930 937 Cash Cash Equivalents Basic Revenue Recognition Receivables Cash Cash Equivalents • Cash Currency and coins held checks money orders rec by afm90393

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									        Chapter 7 & 18 (pp930-937)
  Cash, Cash Equivalents, Basic Revenue
        Recognition & Receivables

Cash & Cash Equivalents
• Cash: Currency and coins held, checks & money
  orders received, bank account balances
• Cash Equivalents are short-term, highly liquid
  investments that are:
  1. Readily convertible into known amounts of cash
  2. So near maturity that there is no risk of change in
     valuation from fluctuating interest rates (original
     maturities of no longer than 3 months)
  – Ex: T-bills, commercial paper, money market funds
      Reporting Issues with Cash

• Cash Equivalents
   – Grouped together with cash
   – reported as the most liquid current asset on the balance sheet

• Restricted Cash
   – Disclosed separately
   – If relates terms of LT liability classify as LT

• Bank Overdrafts
   – US GAAP: Disclosed as a current liability unless there are other
     positive-balance cash accounts at the same bank that it can be
     netted against
   – IFRS: Included in cash and cash equivalents if repayable on
     demand and form a part of an entity’s cash management
                Controls and Cash
Questions
•    Why are internal controls over cash so important?
•    What is the purpose of controls over cash?

Three Key Controls
    1)  Management oversight and authorization
       • Especially useful in small organizations where the owner
          can monitor activities (and where there are limited
          resources to have separation of duties)
    2) Separation of duties:
       • Physical control, authorization and record keeping
       • E.g., one employee prepare the deposit slip and make the
          entry, and another employee will actually make the deposit
    3) The bank reconciliation
          Controls and Cash: Bank
              Reconciliation
How does it work?
   Balance per bank                $xxx,xxx
   Add: Deposits in Transit           x,xxx
   Less: Outstanding Checks          (x,xxx)
   Adjusted Bank Balance           $xxx,xxx*

   * Should equal current Balance per books


Why is this an effective control?
         Basic Revenue Recognition

Recall: Revenue is recognized at the earliest moment
that both of the following conditions are met:
     1.Earned: The critical event in the process of earning
     revenue has taken place. (seller)

     2. Realized: The amount of revenue that will be
     collected is reasonably assured and measurable with a
     reasonable degree of reliability. (buyer)
          Basic Revenue Recognition

Example : On 1/1/07 a magazine publisher receives
$300,000 for 1,000 3-year subscriptions. Magazine delivery
begins in January.

Can the revenue be recognized on 1/1/07?
•   Is the revenue earned?
•   Is the revenue realized?


When can the revenue be recognized?
      Expense Recognition (Matching)

Hierarchy of matching

•   Direct – match expense to the revenue it helps generate

•   Systematic and rational – match expense to periods in which
    it helps to generate revenue (indirect cause and effect
    relation between expense and revenue in periods expected to
    be benefited)

•   Immediate – expense in period the cost is incurred (i.e. no
    discernable or measurable future benefit.)
     Timing of Revenue Recognition


1.   Revenue Recognition at point of sale (delivery)
2.   Revenue Recognition before delivery
3.   Revenue Recognition after delivery
4.   Revenue Recognition for specific sales
     transactions – franchises & consignment
Revenue Recognition at Point of Sale

Revenues from manufacturing and selling are
commonly recognized at point of sale.

Exceptions:
1. Sales with buyback agreements – No Sale
2. Trade loading and channel stuffing – No Sale
3. Sales when right of return exists (high rates that are not
   reliably estimable) –Specific criteria to be met
   Revenue Recognition at Point of Sale

When right of return exists all of the following 6 criteria must
be met to qualify as sale:
  1.   Price fixed or determinable at sale date
  2.   Buyer has paid seller, or is obligated to pay seller, and obligation is
       not contingent on resale of product
  3.   Buyer’s obligation to seller would not be changed in event of theft or
       damage to product
  4.   Buyer has economic substance apart from the seller
  5.   Seller does not have significant obligations for future performance to
       directly bring about resale of product by buyer
  6.   Seller can reasonably estimate amount of future returns
        Recognition of Accounts
              Receivable
•   Trade Discounts – reduction in list price
    for differential volume
•   Cash discounts – reduction in amount
    owed if paid within a specified period.
    Possible accounting methods :
    –   Gross method records discounts when taken
        by customers (most commonly used)
    –   Net method records discounts not taken by
        customers.
          Cash Discounts - Net & Gross Methods
Sale of $1,000 of inventory, 2/10, n/30 on 1/1/06, for two scenarios:
a) Payment is made on 1/10/06 b) Payment is made on 1/15/06:
Net Method:                                       Gross method:

January 1, 2006:                             January 1, 2006:
Dr. A/R       (1,000 x .98)          980     Dr. A/R                            1,000
Cr.    Sales Revenue                     980 Cr.    Sales Revenue                       1,000

If paid within discount period January 10,        If paid inside discount period on January 10,
2006:                                             2006:
Dr. Cash                             980          Dr. Cash                       980
Cr.     A/R                                       Dr. Sales Discounts             20
980                                               Cr.     A/R                           1,000

If paid outside discount period on 1/15/06:       If paid outside discount period on 1/15/06:
January 15, 2006:                                 January 15, 2006:
Dr. Cash                       1,000              Dr. Cash                       1,000
Cr.     A/R                                 980   Cr.     A/R                           1,000
Cr.     Sales Discounts Forfeited            20
 Valuation of Accounts Receivable

• Short term receivables are reported at their
  net realizable value (NRV)
• What is NRV?
  – less estimated non-collectible accounts
  – less allowance for returns.
           Accounts Receivable:
            IFRS vs. US GAAP
Classification of Accounts Receivable
• US GAAP:
   – Must separately disclose material related party
     receivables (i.e., trade receivables separate from non-
     trade)
• IFRS:
   – Classified on balance sheet as a financial asset
   – May separately disclose material related party
     receivables
        Estimating Uncollectible
              Receivables
                   Methods
Direct Write-Off                       Allowance
Not based on the matching       Based on the matching
principle                       principle

Accounts are written off        Estimated; bad debts are
when determined non-collectible matched against revenue

Appropriate only if             Must be followed if
amounts are not material        amounts are material
                               Accounts Receivable
Direct write-off (used only if low & infrequent bad debts)
Bad debt expense (I/S)                                 XXX
        AR (B/S - Asset)                                     XXX

Indirect (allowance method)
In year of the sale:
Bad debt expense (I/S)                               XXX
            Allowance for bad debts (B/S – Asset)            XXX

When found to be uncollectible:
Allowance for bad debts (B/S – Asset)                XXX
         AR (B/S – Asset)                                    XXX

If payment received after account written off:
AR (B/S – Asset)                                     XXX
          Allowance for bad debts (B/S – Asset)              XXX
Cash (B/S – Asset)                                   XXX
          AR (B/S – Asset)                                   XXX
   AR Allowance Methods: Determining
      the Amount of the Adjustment
Percent of Receivables Allowance method
     • Balance-sheet oriented
     • Uses one B/S account (AR) to estimate another B/S account
       (Allowance)
     • Estimates the ENDING balance in the allowance account
     • Bad debt expense is the “plug”


Percent of Sales Allowance method
     • Income-statement oriented
     • Uses one I/S account (revenue) to estimate another I/S account (bad
       debt expense)
     • Estimates the TOTAL bad debt expense
     • The allowance is the “running total”
                 Allowance Example
1. “Percent of Receivables” method (B/S-oriented)
Husky Co. has $60,000 in sales in 2005. AR at 12/31/05 is
$24,000. Allowance for doubtful accounts at 12/31/05 is
$200. What adjusting entry should be made at year end?
The company estimates allowance based on 1% of AR < 31 days, 2%
31-60 days, 5% 61-90 days and 20% > 90 days:
       Amount                0-30 31-60 61-90 91+
       $24,000               10,000 8,000 4,000 2,000
       Uncollectible %       1%     2%     5%    20%
       Allow. Est. $860 = 100       160    200   400
             Allowance Example (cntd.)
2.     “Percent of Sales” method (I/S-oriented)
Assume instead that Husky estimates bad debt expense based on
1.5% of sales.
       Sales                  $60,000
       Uncollectible %        1.5%
       Bad debt expense        $900
             Allowance Examples (cntd.)

3. % of Sales Method is based on credit sales during the year

Example: Crawford Inc.
Total sales, 2006: $20,000,000
Credit sales, 2006: $15,000,000
A/R Balance, Dec 31, 2006: $1,900,000
Allow. for bad debt balance (before adjustment) 12/31/06: $62,000
Prior history: 1% of credit sales are uncollectible

What is the journal entry to record bad debt expense for 2006
            Allowance Examples (cntd.)
4. Percent of Receivables Now assume Crawford estimates
 their Allowance using an A/R aging. Prior collections history is
 used to estimate the percentage of each category that is
 uncollectible.
 Age Balance       % bad
 0-30 days      1,200,000    x   0.75%       = 9,000
 31-60 days       500,000    x    8.00%      = 40,000
 61+ days         200,000    x   20.00%      = 40,000
                                              89,000
 What is the adjusting journal entry at year end?
            Allowance Examples (cntd.)

5. Percent of Receivables – Write off’s and recovery. At the beginning
   of 2004, the balance in the Allowance account was $11,000 (CR).
   During the year, $8,000 of delinquent accounts were written off. Then,
   $2,000 of these delinquent accounts was ultimately determined to be
   collectible, and these accounts were collected. Additionally, the 2004
   ending balance in A/R was $150,000. If XYZ estimates that 5% of A/R
   is uncollectible, what adjusting entry would be made to account for the
   bad debts?




   What would be the ending balance in the Allowance for Doubtful
   Accounts account?
    Balance Sheet Representation

Short-term accounts receivable are shown at their net
realizable value as follows:
Accounts Receivable (gross):        $ XXX
less: Allowance:                    ($ XX)
Net Realizable Value:               $ XX

Or present in line item as:
“AR net of $xxx allowance for doubtful accounts”
      Disposition of Accounts and
           Notes Receivable
•   The holder of accounts or notes receivable may
    transfer them for cash.
•   The transfer may be either:
    1. A secured borrowing (i.e., the “seller” is really
       borrowing from the transferee)
         – Holder retains ownership of receivables in a
           secured borrowing transaction.
    2. A sale of receivables
         – Holder transfers ownership of receivables in a
           sale (transfers risks of collection).
           Accounting for Transfers of
                  Receivables
                                   Transfers


Secured Borrowing                                               Sale


                         With Recourse                       Without Recourse
 -Seller guarantees payment if debtor does not pay    -Seller has no future obligation
 -Factored receivables are written off, but a         -Write-off factored receivables
 recourse liability is recognized based on estimate   (and recognize any gain / loss)
 of future payment firm will have to make
 Secured Borrowing – the Basics

• Overall - Receivables remain on the books of the
  company borrowing money (i.e. – no sale) (and continue
  to treat A/R as usual (collections, write-off, etc.)
• Also called “pledged” receivables
• Transferor:
   –   Records liability
   –   Records a finance charge.
   –   Collects accounts receivable.
   –   Records sales returns and sales discounts.
   –   Absorbs bad debts expense.
   –   Records interest expense on notes payable.
   –   Pays on the note periodically from collections.
                Secured Borrowing Example
     To help overcome a cash shortage, H Software took out a loan with T Bank. H
     Software used $1000 of A/R as collateral for the loan. T Bank withheld $30 as a
     finance charge, and forwarded $970 to H Software on July 1. H Software
     collected the on the accounts on July 31 ($120 were written off), and repaid T
     Bank on August 2nd with interest of $50.
July 1:
Dr. Cash                                       970
Dr. Finance charge                              30
Cr.       Note Payable                                  1,000

July 31:
Dr. Cash                                               880
Dr. Allowance for doubtful accounts                    120
Cr.      A/R                                           1,000

August 2:
Dr. Interest Expense                             50
Dr. Note Payable                              1,000
Cr.      Cash                                          1,050
 Sale of Receivables – the Basics

• Factor records the (transferred) accounts as assets in its
  books.
• Transferor:
   – Transfers ownership of receivables to factor.
   – Records any amount retained by transferee as “due from factor.”
       • This is an amount held back to protect the transferee in case of non-
         payment by customer
   – Records loss on sale of receivables.
   – Records any component liability IF with recourse
       • i.e., any estimated future liability that the transferor will need to pay
         if customers do not pay (and if the amount held back by the factor is
         insufficient)
  Transfer of Receivables: Sale Without Recourse
To help overcome a cash shortage, H Software factored $1,000 of receivables to W Factor
    on July 1, 2006. W Factor withheld $100 pending collectability, and charged H
    Software $40. The remaining $860 was forwarded to H Software on July 1. W Factor
    collected on the A/R, without recourse. On August 2nd, W Factor informed H
    Software that $75 of the accounts were uncollectible, and W Factor returned to H
    Software the appropriate payment.

Dr. Cash
Dr. Due from Factor
Dr. Loss on sale of A/R
Cr.      A/R

Dr. Cash
Dr. Loss
Cr.      Due from Factor

What if instead, W Factor informed H Software on Aug 2 that it was able to collect all of
    the AR? What would be the journal entry?
Dr. Cash
Cr.       Due from Factor
  Transfer of Receivables: Sale With Recourse
To help overcome a cash shortage, H Software factored $1,000 of receivables to W
   Factor on July 1, 2006. W Factor withheld $100 pending collectability, and charged
   H Software $40. The remaining $860 was forwarded to H Software on July 1. W
   Factor collected on the A/R, but had recourse in case of bad debts. H Software
   estimated that $150 of the receivables would ultimately be uncollectible. On August
   2nd, W Factor informed H Software that $120 of the accounts were uncollectible, and
   H Software sent W Factor the appropriate recourse payment.

Dr. Cash
Dr. Due from Factor
Dr. Loss on Sale of A/R (plug)
Cr.      A/R
Cr.      Recourse Liability

Dr. Recourse Liability
Cr.     Cash
Cr.     Due from Factor
Cr.     Recovery of loss sale

What if W Factor informed H Software that $220 of the accounts were uncollectible?
     Transfer of Receivables: Dawson Example
On January 1, 2006, Dawson Associates is considering outsourcing the collection of its
accounts receivable. The following factoring options are available to Dawson.

Speedy Finance, Inc. Under the terms of the agreement, Speedy Finance would pay
Dawson 98% of the gross amount of the transferred receivables and Dawson would be
responsible to pay Speedy Finance for any uncollectible accounts. Dawson estimates its
recourse liability would be $60,000. Speedy Finance will collect the receivables and will
have the right to pledge or sell the receivables to another party.

Strapped Solutions, Inc. Under the terms of the agreement, Strapped Solutions would
pay Dawson 96.5% of the gross amount of Dawson’s receivables without recourse.
Strapped Solutions will collect the receivables and will have the right to pledge or sell
the receivables to another party.

The following information is available from Dawson’s Balance Sheet at Dec. 31, 2005:
         Accounts Receivable                 $5,000,000
         Allowance for doubtful accounts     80,000
Transfer of Receivables: Dawson Example
Prepare the journal entry that Dawson would record on January
1, 2006 if it decides to enter into the agreement with Speedy
Finance.
Transfer of Receivables: Dawson Example

Prepare the journal entry that Dawson would record on January
1, 2006 if it decides to enter into the agreement with Strapped
Solutions.
Transfer of Receivables: Dawson Example

Which alternative should Dawson select if it wants
to maximize reported income in 2006?
   Recognition of Notes Receivable

                   Notes Receivable



  Short term N/R                  Long term N/R


Record at face value          Record at present value
   less allowance              of cash expected to
                                   be collected
  Long-Term Notes Receivable: The
             Basics
• Why does a company issue a notes receivable?
• NR provides a stream of cash to the issuer
   – Principle
   – Interest
• Present value cash inflow = fair value transaction
• Interest rates: Stated vs. market
   –   Stated rate = effective (market rate)  note issued at face value
   –   Stated rate < market rate  note issued at a discount.
   –   Stated rate > market rate  note issued at a premium.
   –   The discount or premium is amortized to interest revenue by the
       effective interest method.
• Record interest revenue each period using the effective
  interest method
           Notes Receivable:
       Stated Rate = Market Rate
On December 31, 2007, Nemo, Inc. finished consultation
services and accepted in exchange a promissory note with a face
value of $600,000, a due date of December 31, 2010, and a stated
rate of 6%, with interest receivable at the end of each year. The
note is considered to have a market rate of interest of 6%.

How much should the Note Receivable be recorded for?

What is the fair value of the transaction?
– PV of cash interest payments
– PV of principle payment
            Notes Receivable:
        Stated Rate = Market Rate

Table 6-2 (PV of single sum)

Periods (n)               3%                6%       9%

        3           0.91514             0.83962   0.77218

Table 6-4 (PV of an ordinary annuity)

Periods (n)               3%                6%       9%

        3           2.82861             2.67301   2.53130
          Notes Receivable:
      Stated Rate = Market Rate
Fair value of transaction:
  Interest:
  Principle:

Journal entries
           Notes Receivable:
       Stated Rate < Market Rate
On December 31, 2007, Nemo, Inc. finished consultation
services and accepted in exchange a promissory note with a face
value of $600,000, a due date of December 31, 2010, and a stated
rate of 3%, with interest receivable at the end of each year. The
note is considered to have a market rate of interest of 6%.

Is this a discount or a premium?

How much should the Note Receivable be recorded for?
          Notes Receivable:
      Stated Rate < Market Rate
Fair value of transaction:
  Interest:
  Principle:

Journal entry at 12/31/07
   N/R: Stated Rate < Market Rate
   Effective Interest Amortization
        Cash      Effective Discount   Carrying
Date   Interest   Int Rev Amortized    Amt N/R
            Notes Receivable:
        Stated Rate < Market Rate
Journal Entries
           Notes Receivable:
       Stated Rate > Market Rate
On December 31, 2007, Nemo, Inc. finished consultation services
and accepted in exchange a promissory note with a face value of
$600,000, a due date of December 31, 2010, and a stated rate of
9%, with interest receivable at the end of each year. The note is
considered to have a market rate of interest of 6%.

Is this a discount or a premium?

How much should the Note Receivable be recorded for?
          Notes Receivable:
      Stated Rate > Market Rate
Fair value of transaction:
  Interest:
  Principle:

Journal entry at 12/31/07
   N/R: Stated Rate > Market Rate
   Effective Interest Amortization
        Cash      Effective Premium   Carrying
Date   Interest   Int Rev Amortized   Amt N/R
            Notes Receivable:
        Stated Rate > Market Rate
Journal Entries
   Non-interest Bearing Notes
This is a special case of a discount.

Steps:
1. Determine issue price on notes receivable
  at implicit rate of interest
2. The discount is amortized to interest
  revenue by the effective interest method
Notes Receivable – Non-Interest Bearing

On 1/1/06 Mickey Co. purchases a machine from Mouse. Co. with
a list price of $10,000. Mickey signs a non-interest bearing note
promising to pay Mouse Co. $10,000 on December 31, 2007. The
fair value of the machine on 1/1/06 is $7,972.

Implicitly, how much interest revenue will Mouse receive over the
2 year period of the note?

What is the implicit interest rate on this note receivable?
   – It is the rate that equates $7972 at t=0 to $10,000 at t=2
   – 7,972F = 10,000; or F=10,000/7,972 = 1.2544
   – In table 6.1, Future Value of 1 (p. 303), the rate is 12% (F=1.2544, n =
     2)-
Notes Receivable – Non-Interest Bearing


                                  Carrying
  Date       Int Rev Disc. Amor. Amt NR
    1/1/2006                         7,972
  12/31/2006       957        957    8,929
  12/31/2007     1,071      1,071 10,000
                            2,028
Notes Receivable – Non-Interest Bearing

January 1, 2006:



December 31, 2006:



December 31, 2007:
    Another Non-Interest Bearing
             Example
General Host’s annual accounting period ends on December
31. On July 1, 2004, General sold land having fair market
value of $700,000 in exchange for a four-year non-interest
bearing promissory note in the face amount of $1,101,460.
The land is carried on General’s books at a cost of $620,000.

Required: Prepare the journal entry to record the sale of land
in exchange for the note.
Another Non-Interest Bearing
         Example
       Impairment of Long-Term
             Receivables

• The “Crisis of Credit”
• When does impairment occur?
• How is the impairment measured?
  – Book value less PV future cash flows
           Impairment of Long-Term
                 Receivables
Example: Brillard Properties owes First Prudent Bank $30million
under a 10% note with two years remaining until maturity. Due to
financial difficulties of the developer, the previous year’s interest of
$3million was not paid. First Prudent agrees to
1. Suspend the interest payment from last year until the following
year
2. Reduce the remaining two interest payments to $2 million each
3. Reduce the principal to $25 million
4. Later decides to forgive the interest payment from last year.

How much impairment loss should be recorded?
              Impairment of Long-Term
                    Receivables
Book value of asset:
  Accrued interest         (10% x $30million)       $ 3,000,000
  Principal                                          30,000,000
        Carrying amount of the receivable                           $33,000,000
New Value:
  PV of future interest ($2million x 1.73554)       $3,471,080
  PV of principal          ($25million x .82645)    20,661,250
        PV of receivable                                            (24,132,330)
Loss                                                                $8,867,670

Journal Entry
Loss on troubled debt restructuring         8,867,670
   Accrued interest receivable                              3,000,000
   Note receivable ($30,000,000-24,132,330)                 5,867,670
          Presentation & Disclosure of
                  Receivables

Rules:
•   Segregate different types of receivables if material
•   Offset valuation accounts against gross balance
•   Ensure all receivables are really current
•   Disclose any loss contingencies on the receivables
•   Disclose amounts pledged as collateral
•   Disclose significant concentrations of credit risk
              Analysis of Receivables

What is purpose of analysis?

Ratios used
  AR Turnover = Net Sales/Average net Trade AR

  Days AR or Average Collection Period = 365 days/AR turnover

								
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