CHAPTER 7

CASH AND RECEIVABLES

What are “Cash”?

Cash includes currency and coins, balances in checking accounts, and items acceptable in
these accounts, such as checks and money orders received from customers.

Cash equivalents are highly liquid investments with maturity dates of three months or
less from the date of purchase. Cash equivalents include money market funds, treasury
bills, and commercial paper.

Internal control refers to a company's plan to (a) encourage adherence to company

policies and procedures, (b) promote operational efficiency, (c) minimize errors and theft,
and (d) enhance the reliability and accuracy of accounting data.

Control for cash receipts:

 Separate responsibility for

1. Handling cash
2. Recording cash transactions
3. Reconciling cash balances

 Agreed cash amounts deposited with cash amounts received.

1
  Close supervision of cash-handling and cash-recording activities.

Control for cash disbursements:

 Separate responsibilities for

 cash disbursement documents,
 check writing,
 check signing,
 check mailing, and
 record keeping.
 All disbursements, except petty cash, made by check.

Restricted cash: cash that is held separate for a particular use such as (1) for a particular
project, (2) to cover certain debt payments (sinking fund), and (3) minimum balances
required by a bank for loans taken (compensating balances).

Compensating balance: Minimum balance that must be maintained in a company’s

account as support for funds borrowed from the bank.

Interest effects of any restriction on cash: change effective interest rate.

Ex: My Bank lends $1,500,000 to Me Company, with a provision requiring a 10%

compensating balance. The line of credit carries an 8% interest rate, and Me Company’s
savings account has a 5% interest rate. What is the effective interest rate on this loan?

1. Effective principle: $1.5M – 10% = 1.35M

2. Effective interest expense: (1.5M x 8%) - (1.5M x 10% x 5%) = 112.5K
3. Effective interest rate: 112.5K/1.35M = 8.33%

Restricted cash not available for current use is usually reported as investments and funds
or other assets.

2
Receivables: Company’s claims to future collection of cash, other assets or services.
 Trade Receivable/Accounts Receivable: oral promises of the purchaser to pay for
good and services sold.
 Notes Receivable: written promises to pay a certain sum of money on a specified
future date.

1. Initial Valuation of Accounts Receivable

While in general receivables should be recorded at the present value of expected cash
receipts, the collection period of accounts receivable are fairly short and are thus usually
recorded at the exchange price initially agreed on.

Trade and Cash Discount:

Trade Discounts are a certain percentage of the original price. The bottom line price is
used in all journal entries.

Cash Discounts provide customers some incentives for early payments. Terms are
usually of the form: 3/10, n/30 indicating that the purchaser will get a 3% discount if
he/she paid within the first 10 days and the total (net) amount is due within thirty days.
The discount lost due to late payment should be interpreted as interest.

A/R can be recorded using Gross Method or net Method:

GROSS method NET method

Record revenue at gross Record revenue at gross

amount of sales. amount of sales less
cash discount.
When customer takes the When customer forfeits
discount, record cash discount, record
discounts. discounts not taken.
Report discounts
Cash discounts reduce forfeited as other
gross sales revenue. revenue.

3
Example:

12/15/2015 Company sells a TV for $500 under the terms 5/10, n/30.

GROSS METHOD NET METHOD

12/15/2015 12/15/2015
Dr. A/R 500 Dr. A/R 475
Cr. Sales Revenue 500 Cr. Sales Revenue 475

Case 1: Suppose payments are made on 12/23/2015:

GROSS METHOD NET METHOD

12/23/2015 12/23/2015
Dr. Cash 475 Dr. Cash 475
Dr. Sales Discount (+XR) 25 Cr. A/R 475
Cr. A/R 500

Case 2: Suppose payments are made on 12/29/2015:

GROSS METHOD NET METHOD

12/29/2015 12/29/2015
Dr. Cash 500 Dr. Cash 500
Cr. A/R 500 Cr. A/R 475
Cr. Interest Revenue 25

Case 3: Suppose payments are made on 1/5/2016:

GROSS METHOD NET METHOD

12/31/2015 12/31/2015
NO ENTRY Dr. Interest Receivable 25
Cr. Interest Revenue 25

1/5/2016 1/5/2016
Dr. Cash 500 Dr. Cash 500
Cr. A/R 500 Cr. A/R 475
Cr. Interest Receivable 25

4
2. Subsequent Valuation of Accounts Receivable

Issue 1: Sales Returns - merchandise returned by a customer to a supplier for a refund or

for a credit for future purchases.

If returns and allowances are infrequent, they can be recorded when returns or allowances
come in.

Example: On June 1, 2015, a customer of LarCo returns $750 of merchandise. The

merchandise had been purchased on account and the customer had not yet paid. The cost
of the merchandise is $600.

Dr. Sales Return $750

Cr. A/R $750

Dr. Inventory $600

Cr. COGS $600

If sales returns are material, they should be estimated and recorded in the same period as
the related sale.

Example: Light Factory sold merchandise for $240,000 during 2015. Industry experience
indicates that 10% of all sales will be returned. The merchandise costs 70% of selling
price.

Dr. A/R $240K

Cr. Sales Revenue $240K

Dr. COGS $168K

Cr. Inventory – estimated return $168K

To estimate returns:
Dr. Sales Revenue $24K
Cr. Allowance for Sales Return (+XA) $24K

Dr. Inventory $16.8K

Cr. COGS $16.8K

What entry to do when actual return happens?

Dr. Allowance for Sales Return $24K
Cr. A/R $24K

Dr. Inventory $16.8K

Cr. Inventory – estimated return $16.8K

5
What if actual returns are only 5% of the sales?
Dr. Allowance for Sales Return $12K
Cr. A/R $12K

Dr. Inventory $8.4K

Cr. Inventory – estimated return $8.4K

Issue 2: Uncollectible Accounts Receivable

Bad debts result from credit customers who are unable to pay the amount they owe,
regardless of continuing collection efforts.

 Matching principle requires that bad debt expense should be recorded in the same
accounting period in which the sales related to the uncollectible account were
recorded.

 In uncollectible amounts are not known, an estimate of the bad debt expense
should be recorded by an adjusting entry at the end of the accounting period.

Accounting for uncollectible accounts:

6
1) Direct Write-off Method

Example: Suppose on 1/15/2015 a customer defaults on a payment of $1000. (Collection

efforts over an extended period ended without a payment). Under the Direct Write-off
Method the following journal entry would be recorded:

1/15/2015 Bad debt expense 1,000

Accounts Receivable 1,000

Problem is that the sale could have been made in 2014, so the matching principle is
violated.

2) Allowance Method:

To adjust for estimated bad debt:

Dr. Bad debt expense xx
Cr. Allowance for uncollectible accounts xx

To write off A/R eventually proven uncollectible:

Dr. Allowance for uncollectible accounts xx
Cr. Accounts receivable xx

7
Estimating bad debt expense:

A. Income Statement Approach (Percentage of Sales method): bad debt expense is

estimated based on a percentage of credit sales.

Example: Suppose Barton Co recorded $500,000 in credit sales in 2015 and estimated 3%
of such sales to be uncollectible, then the following journal entry is recorded at the end of
the year 2015:

12/31/2015
Dr. Bad debt expense $15K
Cr. Allowance for doubtful accounts $15K

B. Balance Sheet Approach (Accounts Receivable Aging Schedule): different

percentages of uncollectibles are applied to different age categories of receivables. The
analysis yields the desired ending balance in the allowance account. So the bad debt
expense of current period is

Bad Debt Expense = estimated uncollectible amount – Allowance before adjustment

Example1: Suppose Barton Co had $180,000 in accounts receivable at the end of year
2015 and estimated 5% of year-end accounts receivable to uncollectible. The balance in
the Allowance for Uncollectible Accounts before this adjustment is 5,000 (credit).
5% x 180K = 9K
What is the bad debt expense for this year?

Dr. Bad debt expense $4K

Cr. Allowance for doubtful accounts $4K

Allowance for doubtful accounts

$5K B/B
XX BDE

$9K E/B

8
Example 2: Barton’s aging schedule for accounts receivable in year 2015 is as follows:

Amount Days outstanding % uncollectible Doubtful accounts

$100,000 30 days or less 4% $4K
50,000 31-60 10% $5K
20,000 61-90 15% $3K
10,000 Over 90 days 25% $2.5K
$14.5K

The beginning balance of the Allowance for Uncollectible Accounts before adjustment is
5,500 (credit). During 2015 $500 bad debts was written off.

What is the ending balance for Allowance for Doubtful Accounts?

Allowance for doubtful accounts

$500 Write off $5.5K B/B
XX BDE

$14.5K E/B

Writing off specific accounts when they are deemed uncollectible:

With the allowance method, when an account is determined to be uncollectible, the debit
goes to Allowance for Uncollectible Accounts. This can be done for both the percentage
of sales method and the aging Method.

Example: Barton’s customer Martin who had not paid had left the country without a
forwarding address. Suppose his unpaid bill was for $500. In this case the following
journal entry would be made:

Dr. Allowance for Uncollectible Accounts $500

Cr. A/R $500

Recovery of Bad Debts:

Subsequent collections on accounts written-off require that the original write-off entry be
reversed before the cash collection is recorded.

Example: Martin came back from abroad and paid his bill $500. The following entries
would be made:
Dr. A/R $500
Cr. Allowance for Doubtful Acc. $500

Dr. Cash $500

Cr. A/R $500

9
 Accounts Receivable Allowance for uncollectible accounts
Beginning Bal. Beginning Bal.
$400,000 $4,500
Credit Sale Collection Bad debt expense
$330,000 $310,000 $1650
Write-off Write-off Recovery of bad debts
$1,200 $1200
Ending Bal. $418,800 Ending Bal. $4950

Example 1: Hawthorne estimates bad debt expense at ½% of credit sales. The company
reported accounts receivable and allowance for uncollectible accounts of $400,000 and
$4,500 respectively, at December 31, 2014. During 2015, Hawthorne’s credit sales and
collections were $330,000 and $310,000, respectively, and $1, 200 in accounts receivable
were written off. Calculate Hawthorne’s net accounts receivable at December 31, 2015.

Bad debt expense = 0.5% x $330,000 = 1650

Net A/R = A/R – Allowance for uncollectible accounts = 418,800 – 4,950 = 413,850

Example 2: Stridewell estimates bad debt expense at 1% of credit sales. During 2015 the
company reported credit sales and collections as $200,000 and $230,000, respectively.
Stridewell recorded the following balances:

Accounts Receivable Allowance for uncollectible accounts

Beginning Bal. Beginning Bal.
$132,200 $3,000
Credit Sale Collection Bad debt expense
$200,000 $230,000 $2,000
Write-off Write-off Recovery of bad debts
$2,200 2,200 0
Ending Bal. 100K Ending Bal. $2,800

Accounts receivable, 12/31/2015 100,000

Allowance for uncollectible accounts, 1/1/2015 3,000
Allowance for uncollectible accounts, 12/31/2015 2,800

Stridewell had no recovered bad debts during 2015. Calculate Stridewell’s accounts
receivable balance at January 1, 2015.

10
3. Note Receivables: formal credit arrangements between a creditor (lender) and a debtor
(borrower).

Initial Valuation of Notes Receivable:

1) Interest bearing note have a stated rate of interest which require periodic interest
payments.

Face value = principal = amount to be received at the end of the contract.

Interest payment = Face value  Annual rate  Fraction of the annual period

Example: Suppose a company lends $10,000 to one of its customers on 1/1/2015 and
receives a note that pays interest at 12%. Full interest is paid at the maturity (11/1/2015)
along with the principal.

Months to maturity: 10 months

Journal entry:
1/1/2015
Dr. N/R 10,000
Cr. Cash 10,000

11/1/2015
Dr. Cash 11,000
Cr. N/R 10,000
Cr. Interest Revenue 1,000

11
2) Non-interest bearing notes have interest implicitly included in the face value.

Example: Suppose a company lends $9,500 to one of its employees on 1/1/2015 and
receives a $10,000 non-interest bearing note on 1/1/2015. The principle is paid at
maturity (11/1/2015).

1/1/2015:
Dr. N/R 10,000
Cr. Cash 9,500
Cr. Discount on N/R 9,500

Balance Sheet on 1/1:

N/R (Gross) 10,000
Less: Discount on N/R 500
N/R (Net) 9,500

11/1/2015
Dr. Cash 10,000
Cr. N/R 10,000
Dr. Discount on N/R 500
Cr. Interest Revenue 500

Loan loss provisions:

If companies routinely face some defaults, provisions for such losses have to be made.
These “loan loss provisions” are accounted for the same way as bad debt expenses (and
allowance for uncollectible accounts).

For Bank:

Dr. Loan Loss XXX

Cr. Loan Loss Provision XXX

Balance Sheet:
Loan Receivables YYY
Less: Loan Loss Provision (XXX)
Loan Receivables, net ZZZ

4. Financing with Receivables

Financial institutions have developed a wide variety of methods that allow companies to
use their receivables to obtain immediate cash.
 A secured borrowing
 A sale of receivables

12
If the transferor surrenders control over the assets transferred, the arrangement is
accounted for as a sale; otherwise, it is accounted for as a borrowing. In order to
determine whether a sale of receivables has occurred, the FASB requires the following
three conditions to be met:

Are
Arethe
thethree
threeconditions
conditionsmet?met?
receivables
receivablesare
areisolated
isolatedfrom
fromtransferor.
transferor.
transferee
transferee has right to pledge orexchange
has right to pledge or exchangereceivables.
receivables.
transferor
transferordoes
doesnotnothave
havecontrol
controlover
overthe
thereceivables.
receivables.

NO YES

Secured
Borrowing
Without Recourse With Recourse

Record liability
and interest
Reduce receivable Reduce receivable
expense
Record loss and Record loss, due
due from Factor from Factor
Record recourse
liability

Secured borrowing:

Assigning: the use of specific receivables for collateral, and the promise that any failure
to repay debt will result in proceeds from specific accounts receivable collections being
used to repay the debt. The receivables should be reclassified as accounts receivable
assigned in the balance sheet.

Example: At the end of November 2015, Banner Mirror Company had an outstanding
accounts receivable of $220,000. On December 1, 2015, the company borrowed
$200,000 from Fidelity Associates and signed a promissory note. Interest at 12% is
payable monthly. The company assigned $220,000 of its specific receivables as collateral
for the loan. Fidelity Associates charges a finance fee equal to 1.5% of the accounts
receivable assigned.

13
12/1/2015:
Dr. Cash 196,700
Dr. Finance Charge Expenses 3,300
Cr. Liability – financing arrangement 200,000

12/31/2015
Dr. Interest Expense $2000
Cr. Cash $2000

Suppose Banner Mirror collected $220,000 from the customer on 1/15/2016.

1/15/2016
Dr. Cash 220,000
Cr. N/R 220,000
Dr. Liability – financing arrangement 200K
Cr. Cash 200K
Dr. Interest Expense 1000
Cr. Cash 1000

Pledging: Receivables in general are pledged as collateral for loans. No specific

accounting treatment is needed other than the disclosure of the pledging arrangement.

Sale of Receivables:

14
Two popular arrangements used for the sale of accounts receivable are factoring and
securitization:

 Factoring: a financial institution that buys receivables for cash, handles the
billing and collection of the receivables and charges a fee for the service.

 Securitization: under this arrangement an intermediary takes ownership of the

receivables and then creates bonds which are secured by the receivables. Money
collected from the bond issue is used to pay the original company (that initially
had the receivables).

The sale of accounts receivable can be made without recourse or with recourse:

Without recourse
 An ordinary sale of receivables to the factor.
 Factor assumes all risk of uncollectibility.
 Control of receivable passes to the factor.
 Receivables are removed from the books, cash is received and a financing
expense or loss is recognized.

Example: Company sells $200,000 in accounts receivable without recourse on 4/1/2015.

The company receives 80% of the receivables in cash on 4/1/2015. The buyer promises to
pay the rest upon collection, less a 5% fee (calculated on the total receivable).
Management estimates the fair value of the 20% receivables to be $35,000.

4/1/2015
Dr. Cash 160,000
Dr. Receivable from factor 25,000
Dr. Loss from sales of receivables 15,000
Cr. A/R 200,000

Suppose the receivables are collected by 9/1/2015 and money paid to the company on
that date:

9/1/2015:

Dr. Cash 25,000

Cr. Receivable from factor 25,000

What if they collect all 20%?  collect $40,000

Dr. Cash 30,000
Cr. Receivable from factor 25,000
Cr. Gains from factor 5,000

15
With recourse
 Transferor (seller) retains risk of uncollectibility.
 Must meet the three conditions of determining surrender of control to be
recognized as a sale.
 If the transaction fails to meet the three conditions necessary to be classified as
a sale, it will be treated as a secured borrowing.

1. The seller would not have access to the receivables.

2. The buyer has the right to exchange or pledge the receivables.
3. There is no repurchase agreement whereby the seller will gain access to the
receivables again in the future.

Example: Company sells $200,000 in accounts receivable with recourse on 4/1/2015.

The company receives 80% of the receivables in cash on 4/1/2015. The buyer promises
to pay the rest upon collection, less a 5% fee (calculated on total receivable).
Management estimates the fair value of the 20% receivables to be $35,000 and fair value
of the recourse liability to be $5,000.

Dr. Cash 160,000

Dr. Receivable from factor 25,000
Dr. Loss on sales of receivable 20,000
Cr. A/R 200,000
Cr. Recourse liabilities 5,000

The transfer of a note receivable to a financial institution is called discounting.

Example: On December 31, Apex accepted a nine-month 10 percent note for $200,000
from a customer. Three months later on March 31, Apex discounted the note at its local
bank. The bank’s discount rate is 12 percent.

3/31/2015: Two steps

Dr. Interest receivable 5,000
Cr. Interest revenue 5,000

Maturity values = Face Value + Interest = 215,000

Discount charged by the bank = 12,900
Cash received: 215K – 12.9K = 202.1K

Dr. Cash 202,100

Dr. Loss on sales of N/R 2,900
Cr. N/R 200K
Cr. Interest Receivable 5K

16
17
 IFRS US GAAP
Bank overdrafts Bank overdrafts are allowed to Bank overdrafts are treated as
be offset against other cash liabilities.
accounts.
Disclosure GAAP requires disaggregation
requirements of IFRS recommends but does not of accounts and notes receivable
receivables require separate disclosure. in the B/S or footnotes.

Deciding if to IFRS requires a more complex U.S. GAAP focuses on whether

account for a decision process. The company control of assets has shifted
transfer as a sale has to have transferred the from the transferor to the
or a secured rights to receive the cash flows transferee.
borrowing from the receivable, and then
considers whether the company
has transferred “substantially all
of the risks and rewards of
ownership,” as well as whether
the company has transferred
control.

18