Cash and Receivables

CURRENT RECEIVABLES
Receivables are the amount owed to the organization by its customers and/or others. Current
receivables will be collected within one year or the current operating cycle which ever is longer.
Noncurrent receivables will be collected at some later date beyond the operating cycle. Trade
receivables are those owed by customers in the ordinary course of business. Accounts receivable
are promises to pay that are not supported by any written documents. Notes receivable are
evidenced by a written note and normally carry an interest rate.

ACCOUNTS RECEIVABLE
Trade accounts receivable are evidenced by invoices that reflect the exchange price of the goods
or services. This exchange price is affected by trade discounts and cash discounts.

a. Trade discounts
Trade discounts are typically quoted as a percentage of the list price of the item. This allows
the seller to give the buyer a discount without having to adjust the list price. The account
receivable is recorded on the sellers books at the amount net of the trade discount.

b. Cash discounts (sales discounts)

Cash or sales discounts are incentives offered to the buyer to pay the invoice early. They are
typically quoted as a percentage discount on the invoice price is paid within a limited period
of time. For example, if the terms are 2/10, net/30. The buyer can take a 2% discount on the
invoice price if the invoice is paid within the first 10 days. If the invoice is not paid within
10 days then the total amount is due on the 30th day.

Most business organizations use the gross method for recording cash discounts. Under this
method the total invoice is booked as an account receivable. At the time the payment is
received the discount is recorded.

Example: assume that Spencer Company sold $10,000 worth of merchandise to Sophie
Company under terms of 2/10, net/30. Within the first 10 days Sophie Company pays the
invoice less the 2% discount. The following reflects the journal entries to record the sale and the
collection on Spencer Companys books.

ACCOUNT DEBIT CREDIT

Accounts receivable 10,000
Sales 10,000
To record the sale of merchandise to Sophie Company

Cash 9,800
Sales discounts 200
Accounts receivable 10,000
To record the collection of the receivable from
Sophie Company net of the 2% discount

Valuation of Accounts Receivable

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Short-term receivables are valued and reported on the balance sheet at net realizable value. The
net amount reported in the balance sheet is the amount that management expects to actually
collect in the future. This requires estimation by management based on the best information
available at the time.

Sales Returns and Allowances

In certain industries sales returns and allowances can be material. If there is a history of returns
and allowances then the company might be required to establish an allowance to accounts
receivable (a contra asset account) estimating the amount included in the accountants receivable
that are currently reported in the balance sheet.

Uncollectible Accounts Receivable

There are two methods of recording uncollectible accounts.
Direct write-off method
Under the direct write-off method the accounts are not written off until it has been
determined that they are uncollectible. The journal entry is a debit to bad debt expense and a
credit to the account receivable. This method is not GAAP and so therefore will not be used
in any future examples.

Allowance method
Under the allowance method we use estimates to establish an allowance account allowance
for doubtful accounts which is a contra-asset account offsetting accounts receivable. The
net of the two accounts is the net realizable receivables reported in the balance sheet. There
are two methods of estimating the amount that should be reported in the allowance account.

a) Balance Sheet Approach

Using the balance sheet approach we are interested in reporting net realizable receivables
correctly in the balance sheet. This is accomplished by examining the aged accounts
receivable and establishing the amount that should be allocated to the allowance account
based on managements estimate of the accounts that may become uncollectible in the
future. The whole point of this approach is to get the correct balance in the allowance
account so that net realizable receivables are fairly stated in the balance sheet. The
resulting charge to bad debt expense in the current period is a residual as a result of this
analysis.

Example: Spencer Company has the following aged accounts receivable at year end December
31, 2000.

Customer Balance Current 30 Days 60 Days 90 Days Over 90 Days

Able Supply Company 500 500
Barney Custom Supply 1,200 100 600 400 100
Casey Grooming 600 600
Dogs Unlimited 1,400 200 500 500 200
Totals 3,700 800 1,100 1,000 600 200

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Based on past experience the credit manager has determined the following amounts should be
allocated to the allowance for doubtful accounts to properly reflect the net realizable receivables
as of December 31, 2000.

Age Amount % Required

Current 800 2% 16
30 Days 1,100 3% 33
60 Days 1,000 4% 40
90 Days 600 5% 30
Over 90 Days 200 20% 40
3,700 159

This means that the balance in the allowance for doubtful accounts should have a balance of
$159 after all of the year-end adjusting journal entries have been posted. The following is the T-
Account of the allowance for doubtful accounts before any year-end adjustment.

Description Debit Credit Balance

Beginning balance (200)
Accounts written off during 2000 225 25
Accounts reinstated during 2000 15 10

As we can see, prior to posting any adjusting journal entry the allowance for doubtful accounts
account has a debit balance of $10. If we need a credit balance of $159 in order to bring the
accounting records current then the adjusting journal entry will be as follows:

ACCOUNT DEBIT CREDIT

Bad debt expense 169
Allowance for doubtful accounts 169
To record bad debt expense by adjusting the allowance
for doubtful accounts

After the above adjusting journal entry has been posted to the accounting records the allowance
for doubtful accounts account will reflect the correct balance of $159.

Description Debit Credit Balance

Beginning balance (200)
Accounts written off during 2000 225 25
Accounts reinstated during 2000 15 10
Required adjusting journal entry at 12/31/00 169 (159)
The purpose of the balance sheet approach is to fairly state net realizable receivables in the
balance sheet

b) Income Statement Approach

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Using the income statement approach we are interested in matching bad debt expense
with sales revenue for the current period. The estimate is actually an estimate of the bad
debt expense, normally as a percentage of credit sales. The ending balance of the
allowance account is not really of concern to management.

Example: The following information pertains to Spencer Company for the year ended
December 31, 2000.

Cash Sales (net) 10,000

Credit sales 5,000
Sales returns and allowances 1,000
Sales discounts 500
Net credit sales 3,500

Based on prior experience the controller estimates that bad debt expense should be
approximately 5% of net credit sales.

Therefore the adjusting journal entry using the income statement approach will be as follows:

ACCOUNT DEBIT CREDIT

Bad debt expense 175
Allowance for doubtful accounts 175
To record bad debt expense for
2000 based on 5% of net credit
sales

Analysis of bad debt expense:

Net credit sales 3,500
Provision for bad debts 5%
Bad debt expense 175

As we can see from the above example, the object of using the income statement approach is to
get a proper matching of bad debt expense to net credit sales. There is no consideration being
given to the presentation of net realizable receivables.

Accounts Written Off

When an account is deemed uncollectible it must be removed from the balance of accounts
receivable--that is, the account must be written off. In previous periods, an allowance has
been set aside using one of the allowance methods. At this point, the allowance is used to
write off the uncollectible account.

Example: On February 1, 2001, Spencer Company wrote off a $500 as uncollectible. The
following journal entries must be recorded remove the account and reduce the balance of
accounts receivable.

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ACCOUNT DEBIT CREDIT

Allowance for doubtful accounts 500
Accounts receivable 500

To record the removal of an

uncollectible account receivable

Collection of Accounts Written Off

If there is a collection on an account previously written off, using one of the allowance
methods we must first reestablish the account in accounts receivable and then record the
collection.

Example: On April 1, 2001, Spencer Company received payment $500 on the account that had
previously been written off as uncollectible. The following journal entries must be recorded in
order to (1) get the account back on the books and (2) record the collection of the account.

ACCOUNT DEBIT CREDIT

Accounts receivable 500
Allowance for doubtful accounts 500

Cash 500
Accounts receivable 500

To record the reinstatement of an

account receivable and the receipt
of the payment on said account

NOTES RECEIVABLE
Notes receivable are evidenced by a written promissory note normally with terms that require
interest on the outstanding balance. Short-term notes are typically reported at face value,
whereas long-term notes are reported at the present value of the expected future cash collections.

Note Issued at Face Value

If a note is issued at the market rate of interest then the face amount and the net present value are
the same. The note is therefore record at face value in the accounting records. The collection of
interest payments are recorded as interest income as received.

Example: Spencer Company receives a $100,000 note receivable in exchange for cash. The
note is to be repaid in five years with interest payable at 10% per annum. The market rate of
interest at the time the note was issued is 10%. The following journal entries reflect the
issuance of the note and the receipt of interest at the end of the first year.

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ACCOUNT DEBIT CREDIT

Note receivable 100,000
Cash 100,000

Cash 10,000
Interest revenue 10,000

To record the receipt of a note

receivable and the receipt of the first
interest payment at the end of year 1

Zero-Interest-Bearing Notes
A zero-interest-bearing note is one that is issued at an amount less than the face value. Interest is
included in the face value of the note, but is not specifically stated in the contract. The difference
between the cash paid and the amount to be received in the future is interest income. We use the
effective interest method to record the interest income earned in the interim accounting periods
before the final cash collection is made.

Example: Spencer Company received a zero-interest-bearing note of $100,000 in exchange for

cash. The note is to be repaid in five years. The implied rate of interest on the note is 10% per
annum. The following is the present value of the note that will be recorded in Spencer
Companys books when received.

Analysis of Present Value of Note Receivable:

Face amount of note 100,000
PV of $1, n=5, i=10% 0.62092
Present value of note 62,092

ACCOUNT DEBIT CREDIT

Note receivable 100,000
Discount on note receivable 37,908
Cash 62,092

To record the receipt of a zero-interest-bearning note receivable

At the end of each year interest income will be recorded as amortization of the discount. The
following is an amortization table for the entire life of the note.

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Cash Interest Amortization Carrying

Date Received Revenue of Discount Amount
Issue date 62,092
End of year 1 0 6,209 6,209 68,301
End of year 2 0 6,830 6,830 75,131
End of year 3 0 7,513 7,513 82,644
End of year 4 0 8,264 8,264 90,909
End of year 5 100,000 9,091 9,091 (0)

The journal entry at the end of year 1 to reflect the interest earned would be as follows:

ACCOUNT DEBIT CREDIT

Discount on note receivable 6,209
Interest revenue 6,209

At the end of the five years the carrying amount of the note receivable will be $100,000, which is
the amount the Spencer Company will receive when the note is paid off.

Interest-Bearing Notes
If the stated interest rate and the effective interest rate are different the interest-bearing note will
be issued at a premium or discount. The interest collected in each accounting period is adjusted
for the amortization of premium or discount.

Notes Received for Cash and Other Rights

If a note is received in exchange for cash and other rights (such as the right to purchase
merchandise at a bargain price) the value of the right will be treated as a discount against the
note receivable. The debit side of this entry will be to a deferred debit account such as prepaid
purchases. When the merchandise is purchased the value carried in the deferred debit account
will be charged added to the cost of the purchased merchandise.

Notes Received for Property, Goods or Services

A note received in exchange for property, goods or services must be valued based on the fair
value of the property, goods or services exchanged. Gains or losses should be record and the
difference between the fair value and the face value of the note receivable will be treated as a
discount on note receivable.

Example: Spencer Company sold an office building with a book value of $20,000 and a fair
market value of $50,000 in exchange for a 5-year note receivable of $60,000 with no stated
interest rate. The journal entry to record this transaction will establish the carrying value of the
note receivable as the fair value of the property exchanged. The difference is charge to the
discount on notes receivable account.

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ACCOUNT DEBIT CREDIT

Note receivable 60,000
Discount on note receivable 10,000
Building 20,000
Gain on sale of building 30,000

Analysis of discount on note receivable:

Face value of note 60,000
Fair value of building 50,000
Discount on note receivable 10,000

The discount will be amortized using the effective interest method over the five years so that the
face amount of the note receivable when paid off will be $60,000, the amount received.

Imputed Interest
Is a note is received with no stated interest or an unreasonably low rate of interest then the
recipient of the note will need to record the note receivable with an appropriate discount so that
the carrying amount reflects the market rate of interest. This is called the imputed interest rate.
Imputed interest is demonstrated in the above example where Spencer Company received a zero-
interest-bearing note receivable.

Valuation of Notes Receivable

Short-term notes receivable are recorded and reported at net realizable value. Long-term notes
receivable must be recorded and reported at the present value of the expected future cash flows
determined using the market interest rate at the date the note was issued.

FINANCING WITH RECEIVABLES

Secured Borrowing
If a company uses its receivables as collateral for a loan, its customers are not notified of the
transaction. The company continues to collect the receivables and the financial institution is not
involved unless the debtor is unable to repay the loan. In such a situation the financial institution
will step in and collect the receivables in payment of the loan.

Sales of Receivables
If receivables are actually sold (factored) the purchasing company (factor) collects the
receivables from the customers. In this situation, the company actually removes the receivables
from the books and records a loss on the transaction.

Example: Spencer Company sold $500,000 of its accounts receivable to a factor. The factor
will hold back $20,000 for possible sales discounts, sales returns, and sales allowances. The
factor charges a 5% fee for purchasing the accounts receivable. Spencer Company will record the
following journal.

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ACCOUNT DEBIT CREDIT

Cash 455,000
Due from factor 20,000
Loss on sale of receivables 25,000
Accounts receivable 500,000

Analysis of loss:
Face value of receivables 500,000
Discount charged by factor 5%
Loss on sale of receivable 25,000

Discounting a Note
As with accounts receivable, notes receivable may be pledged as collateral for a loan or may be
sold outright. If they are sold the transaction is called discounting a note. The financial
institution is purchasing the future cash flow of the note and will apply a discount rate equal to
the amount of interest required in order to purchase the note. This discount is the financing fee
incurred by the seller of the note.

PRESENTATION AND ANALYSIS

Presentation of Receivables
Receivables should be presented with appropriate disclosure in the notes to the financial
statements according to the following criteria.

(1) Segregated based on the different types of receivables

(2) Valuation accounts are disclosed and offset the appropriate receivables
(3) Current receivables will be converted into cash within on year or the operating cycle
(4) Disclosure of possible loss contingencies on receivables
(5) Disclose receivables that have been pledged as collateral
(6) Disclose significant concentrations of credit risk

Analysis of Receivables
An important ratio that is used to analyze the liquidity of an entities accounts receivable is the
receivables turnover ratio. This is calculated as follows:

Net Sales
Accounts Receivable Turnover =
Average Trade Receivables (net)

Example: Spencer Company has net sales of $2,375,000 for the year ended December 31, 2001.
The accounts receivable on January 1, 2001 were $240,000. At December 31, 2001 the accounts
receivable balance was $260,000. What are the inventory turnover ratio and the average
collection period for accounts receivable?

ACCOUNTS RECEIVABLE TURNOVER RATIO

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Net Sales 2,375,000

=
Average Trade Receivables (net) [(240,000+260,000)/2]

Net Sales 2,375,000

=
Average Trade Receivables (net) 250,000

Net Sales
= 9.5
Average Trade Receivables (net)

AVERAGE COLLECTION PERIOD FOR ACCOUNTS RECEIVABLE

365 Days 365

=
Accounts Receivable Turnover 9.5

365 Days
= 38.42 Days
Accounts Receivable Turnover

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