Chapter 8--Learning Objectives 4 1.Understand the composition and control of cash.

Chapter 8--Learning Objectives

1. Understand the composition and control of cash

What is cash ?

What is cash ?

For accounting purposes, cash includes: Currency and coins (including petty cash) Demand deposits (checking accounts) Checks, drafts and money orders Readily usable foreign currency Savings accounts (technically investments)

What is NOT cash ?

Postage stamps Post-dated checks Certificates of deposit IOUs and notes receivable

Cash equivalents

Must be readily convertible to cash Must be close to maturity Cash equivalents frequently include:

Treasury bills Commercial paper

Certificates of deposit (within 90 days of maturity)

Internal control

Procedures used to safeguard assets Probably cannot prevent theft altogether But can make the potential crook’s job

more difficult Separate duties Create paper trails

Cash Control

Record and deposit receipts promptly Separation of duties No unauthorized or undocumented disbursements Job rotation Imprest funds Internal and external audits Bank reconciliations

Petty cash fund

Known as imprest (advanced) fund Establish fund with set amount Debit “Petty Cash” when fund set up Subsequent entries debit various expenses

and credit “Cash” Shortages debited to “Cash Over and

Short,” treated as misc. expense

Bank reconciliation

Prepared when statements received Start with “balance per bank” and “balance

per books” Bring both numbers to “corrected cash” or

“true cash” Adjust books for items on “books” side of

reconciliation

Typical items on“bank” side of reconciliation Balance per bank XXX Deposits in transit + XXX Outstanding checks - XXX Errors by bank + or - XXX Corrected cash balance XXX

Typical items on“books” side of reconciliation Balance per books XXX Interest earned on account + XXX Items collected by bank + XXX Bank service charges - XXX NSF checks - XXX Errors on books + or - XXX Corrected cash balance XXX

Typical bank reconciliationadjusting entryAcct. Receivable--Ima Deadbeat XXX

Service Charge Expense XXX

Interest Income XXX

Cash XXX

Note handling of NSF check from Ima Deadbeat, one of our customers.


2. Record and value accounts receivable

Trade Receivables Result from sales of goods or services on account Balance Sheet Measurement:

Net Realizable Value

Discounts

Trade Discounts

Cash Discounts

Net Realizable Value

Amount expected to be realized (collected) Gross Accounts Receivable, net of

Expected returns & Allowances

Cash discounts expected to be taken

Expected uncollectible amounts

Trade Discounts Used to determine prices for different types

of customers e.g., builder’s discount

Cash Discounts Offered to encourage early payment Examples

2, 10, net 30 2, 10, eom

Accounting approaches Gross Method Net Method

Terms and discounts

2 / 10 , n / 30means that a

2 percent discount is available

if paid within 10 days

and that the balance is due in 30 days

Recording sales discountsThe gross methodAssume a $100 sale, terms 2/10, n/30

The sale is recorded:

Accounts Receivable 100

Sales 100

Recording sales discountsThe gross methodIf paid within 10 days:

Cash 98

Sales Discounts 2


“Sales Discounts” is a contra-account to “Sales Revenue”

Recording sales discountsThe gross methodIf paid after 10 days:

Cash 100


Recording sales discountsThe net method Assume a $100 sale, terms 2/10, n/30

The sale is recorded:


Sales 98

Recording sales discountsThe net methodIf paid within 10 days:

Cash 98


Recording sales discountsThe gross methodIf paid after 10 days:

Cash 100


Sales Discounts Forfeited 2

“Sales Discounts Forfeited” is a miscellaneous revenue account

BAD DEBTSIf you do business on credit,

the question is not “whether”

but “how much”

Some people cannot or will not pay their bills

You know that they are out there

You just don’t know who they are

Accounts receivable entries

Making a credit sale

Accounts Receivable XXX

Sales XXX


Collecting from a credit customer

Cash XXX Accounts Receivable XXX


Writing off an uncollectible account

Allowance for Bad Debts XXX Accounts Receivable XXX


Reinstating an account previously written off


Allowance for Bad Debts XXX

Cash XXX



The provision for bad debts(an adjusting entry)

Bad Debt Expense XXX

Allowance for Bad Debts XXX

Valuation of accounts receivableor estimating bad debt expense

Two methods will be examined:

1. The percentage of sales method

(also known as the income

statement method)

2. The percentage of receivables

method (also known as the balance

sheet method)

Percentage of sales method

An income statement approach The more you sell--the more you can expect

to lose Consistent with matching principle Select a percentage based on past

experience or industry averages Multiply the percentage by total credit sales

Percentage of sales method

Assume $1,000,000 sales and 3% estimated bad debts

Bad Debt Expense 30,000

Allow. for Bad Debts 30,000

Percentage of receivables

Based on “aging” the individual accounts receivable

The later they are in paying--the less likely they are to pay up

Percentages likely to default are assigned to each age category

The result is the balance needed in the “Allowance for Bad Debts” account

Assume that an aging schedule yields the following information:

Percent Amount

likely to likely to

Status Amount default default

Current $ 70,000 0 $ -0-

30-60 days overdue 40,000 5 2,000

60-90 days overdue 30,000 10 3,000

90-180 days overdue 30,000 25 7,500

Over 180 days 10,000 30 3,000

Totals $180,000 $15,500

The $15,500 is the total amount needed in the “Allowance” account Assume that the “Allowance for Bad Debts”

account has a $3,000 credit balance prior to adjustment

Allowance for Bad Debts

3,000

The $15,500 is the total amount needed in the “Allowance” account To go from a $3,000 credit to a $15,500

credit will require a $12,500 credit

Allowance for Bad Debts

3,000

15,500

12,500

$12,500 is the amount needed to adjust the “Allowance” account The necessary entry is:

Bad Debt Expense 12,500

Allow. for Bad Debts 12,500

Account write-offs do not reduce total assets ! Assume $10,000 of Accts. Receivable and a

$1,000 Allowance for Bad Debts Net collectible receivables are $9,000

Accounts receivable $10,000

Less: AFBD 1,000

Net receivables $ 9,000

Accts. Rec. AFBD

10,000 1,000

Now assume we write off a $100 account The entry to write off the account is

Allowance for Bad Debts 100 Account Receivable 100

Now assume we write off a $100 account The entry to write off the account is

Allowance for Bad Debts 100 Account Receivable 100 Posting the entry has this result:

Accts. Rec. AFBD

10,000 1,000100100

9,900 900

Note that net collectible receivables are:

Accounts receivable $ 9,900

Less: AFBD 900

Net receivables $ 9,000

BEFORE = $9,000

AFTER = $9,000Accts. Rec. AFBD

10,000 1,000100100

9,900 900

DIRECT

WRITE-OFF

METHOD

DIRECT

WRITE-OFF

METHOD


3. Demonstrate how accounts receivable are used as the basis for financing

Receivables can be used as an immediate source of cash

Assigning accounts receivable means using them as collateral for a loan

Factoring accounts receivable means selling them

Factoring can be with recourse or without recourse

Recourse refers to ultimate responsibility for payment

Factoring with recourse

When accounts are factored with recourse, uncollectible accounts are absorbed by the transferor

Transaction is treated as a sale if all of the following conditions are met:

1. Risks, rewards & benefits are transferred

2. Future cash flows are estimable at time of transfer

3. Transferee cannot require transferor to repurchase receivables except under recourse provisions

Factoring with recourseas a borrowing

If all conditions for treatment as a sale are not meant, factoring with recourse is treated as a borrowing


4. Record and value notes receivable

Notes receivable

Formal, written promises to pay Negotiable Provide legal evidence of debt Usually interest bearing, but may be

noninterest bearing Should be valued at present value of future

cash inflows

Short term note example assumptions

$1,000 note received in exchange for an account receivable

Received on March 1 Matures in six months Interest rate 10 percent

Short term note journal entries

On March 1

Note Receivable 1,000

Accounts Receivable 1,000

On September 1

Cash 1,050


Interest Revenue 50

Noninterest bearing notes

Amount of note is greater than cash or fair value

Difference is recorded in a contra-account to Notes Receivable called “Discount on Note Receivable”

Interest is recorded with debits to “Discount on Note Receivable” and credits to “Interest Revenue”

Noninterest bearing note entries

At time of issue

Note Receivable XXX

Discount on Note Rec. XXX

Cash (etc.) XXX

Interest accrual

Discount on Note Rec. XXX

Interest Revenue XXX

Notes receivable with interest rates lower than current market rate Effective interest rate is assigned to note Determine whether fair market value (FMV) of

assets surrendered is known or unknown If FMV is known, use as present value of note If FMV not known, use current rate for borrower

or rate on other similar loans

Note with low interest rate assumptions--FMV known Three-year, noninterest bearing note dated 12-31-

95 Face value $10,000 Exchanged for land which originally cost $5,000

with a fair market value of $7,120 Discount rate for note is 12 percent ($7,120 is the

present value of $10,000 to be received in 3 years at 12 percent)

Discount must be amortized over life of note

Note with low interest rate entries--FMV knownOn 12-31-95


Discount on Note Rec. 2,880

Land 5,000

Gain on Sale of Land 2,120

On 12-31-96 (rounded to nearest dollar)

Discount on Note Rec. 854

Interest Revenue 854

Note with low interest rate entries--FMV knownOn 12-31-97


Interest Revenue 957

On 12-31-98 (maturity)

Discount on Note Rec. 1,069

Interest Revenue 1,069

Cash 10,000


Note with low interest rate assumptions--FMV unknown Three-year note dated 12-31-95 Face value $5,000 Stated interest rate 12 percent paid annually Exchanged for land which cost $2,000 with

unknown fair market value Incremental interest rate for borrower is 15 percent Present value of note at 15 percent is $4,658 (based

on PV of principal and interest)

Note with low interest rate entries--FMV unknownOn 12-31-95


Land 2,000


Gain on Sale of Land 2,658

“Discount” based on difference between PV of note and $5,000 face amount

“Gain” based on difference between PV of note and cost of Land

Formulas for discounting notes receivable

Interest (I) = P x R x T

P = Principal

R = Interest Rate

T = Time

Maturity Value (MV) = P + I

Discount = MV x DR x DP

DR = Discount Rate

DP = Discount Period

Proceeds = MV - Discount

Discounting note receivable assumptions

$1,000, six month note dated 3-1-95 Face interest rate 10 percent Discounted on 7-1-95 Discount rate 12 percent Time to maturity (discount period) is two

months Discounted without recourse

Discount calculations

Interest = $1,000 x .10 x 6/12 = $50 Maturity Value = $1,000 + $50 = $1,050 Discount = $1,050 x .12 x 2/12 = $21

Proceeds = $1,050 - $21 = $1,029

Note value at discount date Interest = $1,000 x .10 x 4/12 = $33

Value = $1,000 + $33 = $1,033

Entry to record discounting of note

July 1, 1995

Cash 1,029

Loss on Sale of Note Rec. 4


Interest Revenue 33

Interest Revenue is interest earned to date

Loss on Sale is difference between Proceeds and value of note at date of sale

Same note discountedwith recourseThe bad news here is that if the original maker of the note defaults when the note is due...

The bank or finance company will hold the party discounting the note responsible for payment


5. Calculate and interpret key liquidity and asset management ratios

Current ratio

Current assets

Current liabilities

Quick ratio

Current assets - Inventory - Prepaid items

Current liabilities

A more stringent indicator of liquidity

than the current ratio

Accounts receivable turnover

Credit Sales

Average net accounts receivable

Average accounts receivable is frequently approximated by adding beginning and ending net

receivables and dividing by two

Average collection periodfor accounts receivable

3 6 5 d a y s

Accounts receivable turnover

Calculation of accounts receivable turnover illustrated on previous slide

Chapter 8--Learning Objectives 4 1.Understand the composition and control of cash.

Documents

control of cash slide

reconciliation slide

cash control

cash equivalents

days slide

credit cash

true cash

expense slide