Chapter 7 Cash and Receivables Skyline College Lecture Notes

Pivotal Issues When Managing Cash and Receivables

1. 2. 3. 4. 5. Cash needs Credit policies Level of accounts receivable Financing receivables Ethical estimates on credit sale losses

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Cash Considerations
 Most liquid of all assets  Central to operating cycle Consists of:  Currency and coins on hand  Checks and money orders from customers  Deposits in checking and savings accounts
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Cash may include a compensating balancea minimum amount required by a bank for a creditgranting agreement.
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Cash Requirements
Seasonal Cycles and Cash Requirements for a Manufacturer of Athletic Sportswear

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Credit Policies
To increase the likelihood of selling to customers who will pay on time, companies develop control procedures and maintain a credit department

The credit department:  Examines the financial resources and debts of the credit applicant  Asks for personal references  Gets credit rating from credit bureaus  Determines the extent to which the company can grant credit, if any
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Evaluating the Level of Accounts Receivable

How many times, on average, does a company turn its receivables into cash during an accounting period? How long, on average, does it take a company to collect its accounts receivables?

Receivable Turnover

Days Sales Uncollected

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Receivable Turnover
Reflects the relative size of a companys accounts receivable and the success of its credit and collection policies Net Sales Receivable Turnover = Average Net Accounts Receivable
(Amounts in Millions)

Nikes Receivable Turnover for 2004

= =

$12,253.1 ($2,120.2 + $2,083.9) 2 5.8 times

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Days Sales Uncollected

To interpret a companys ratios, take into consideration the industry in which it operates
Days Sales Uncollected = 365 days Receivable Turnover

Nikes Days Sales Uncollected

365 days = = 5.8 62.9 days

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Receivable Turnover for Selected Industries

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Financing Receivables
Money tied up in receivables is something that many companies seek to avoid Companies may use one or more of these methods so that they can receive cash faster: Set up a separate finance company
Ford Ford Motor Credit Company GM General Motors Acceptance Corp. Sears Sears Roebuck Acceptance Corp.

Borrow money and pledge A/R

In case of default on loan, A/R (collateral) can be taken and converted to cash to satisfy the loan

Factor A/R
Sale or transfer of A/R; the buyer may bear risk of collection (factoring without recourse) or the seller may bear risk of collection (factoring with recourse)
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How Factoring Works

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Factoring Details
What fees are charged? Typically 2% of total A/R for sales with recourse; Higher fee for sales without recourse

What does the seller of receivables with recourse report in financials?

Reports a contingent liability (a potential debt that can develop if customers dont pay receivables)

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Securitization
A company may sell a group of receivables in a batch at a discount to another company or to investors
When receivables are paid, buyer gets full amount, thus their profit depends on the amount of discount they negotiated

Circuit City Sells its receivables without recourse, so it has no further liability even if customers do not pay
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Discounting
The sale of promissory notes held as notes receivable
Company A Holds $10,000 note payable to Company B; Note will pay $600 in interest  Company A should disclose the contingent liability (in the amount of note plus interest) in notes to its financial statements
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Bank Buys the note for $9,600  If Company B pays, bank will receive $10,600 and realize a $1,000 profit  If Company B defaults, Company A is liable for the note
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Estimating Uncollectibles
 Match these expenses  There will always be of selling on credit to customers who do not the revenues they help pay their accounts, generate called uncollectible accounts, or bad debts
Estimate the uncollectible expense in the fiscal year in which the sales are made

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Estimating Uncollectibles and Ethics

Because estimations are involved, earnings may be easily manipulated
If the amount of losses from uncollectible accounts earnings are overstated. are understated,

If the amount of losses from uncollectible accounts are overstated,

earnings are understated.

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Discussion: Ethics in the World

WorldCom increased revenues and hid losses by continuing to bill customers for service for years after the customers had stopped paying. Q. What impact do you think WorldComs actions had on Accounts Receivable and Sales?

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Cash Equivalents
Investments like time deposits or certificates of deposit (CDs) that have a term of 90 days or less

Nikes Annual Report, 2005

Cash and equivalents represent cash and short-term, highly liquid investments with original maturities of three months or less at the time of purchase. The carrying amounts reflected in the consolidated balance sheet for cash and equivalents approximate fair value due to their short maturities.

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718

Cash Control: Electronic Funds Transfer (EFT)

Method of conducting business transactions in which funds are transferred electronically from one bank to another bank
Wal-Mart makes 75% of its payments to suppliers using EFT Electronic Banking ATM transactions Debit and credit card purchases Online bill-pay

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Direct Charge-Off Method

 Recognize a loss at the time it is determined that an account is uncollectible
Date

 Tax law requires use of this method when computing taxable income
XXX XXX

Uncollectible Accounts Expense Accounts Receivable

Most companies do not use this method for financial reporting purposes because it does not conform to GAAP.
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720

The Allowance Method

Losses from bad debts are matched against the sales they help generate

At the time of sale, management cannot identify which customers will not pay To observe the matching rule, losses from uncollectible accounts must be estimated The estimate becomes an expense in the fiscal year in which the sales are made
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Alternate Account Names

Allowance for Uncollectible Accounts  Allowance for Doubtful Accounts  Allowance for Bad Debts Uncollectible Accounts Expense  Bad Debts Expense

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Estimating Uncollectible Accounts

Estimated loss should be:
Realistic Based on objective information Based on past experience Based on current economic conditions

Two commonly used methods for estimating loss

1. Percentage of net sales method 2. Accounts receivable aging method

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Percentage of Net Sales Method

How much of this years net sales will not be collected? The answer determines the amount of uncollectible accounts expense for the year

The percentage amount is ususally based on the companys historic losses It ignores the difference between last years estimated losses and the actual losses incurred during the year

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Percentage of Net Sales Method

Dec. 31, 20x9: Account balances: Sales, $645,000; Sales Returns and Allowances, $40,000; Sales Discounts, $5,000; Allowance for Uncollectible Accounts, $3,600. Management estimates that uncollectible accounts will average about 2 percent of net sales. ncollectible accounts expense ! .02 x ($645,000 $40,000 $5,000) ! $12,000
Dec. 31 Uncollectible Accounts Expense Allowance for Uncollectible Accounts To record the uncollectible accounts expense at 2 percent of $600,000 net sales 12,000 12,000

After the above entry is posted, Allowance for Uncollectible Accounts will have a credit balance of $15,600

Allowance for Uncollectible Accounts

Dec. 31 Dec. 31 adj. Dec 31 bal.

3,600 12,000 15,600

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Accounts Receivable Aging Method

The ending balance of Allowance for Uncollectible Accounts is determined directly through an analysis of accounts receivable

How much of the ending balance of accounts receivable will not be collected?

The difference between the amount determined to be uncollectible and the actual balance of Allowance for Uncollectible Accounts is the expense for the period.

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GM1

Analysis of Accounts Receivable by Age

 The total past due for each category is multiplied by the estimated percentage uncollectible  The sum of the totals for each category is the estimated balance of Allowance for Uncollectible Accounts
Notice that the estimated percentage uncollectible increases as accounts become further past due.
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Slide 27 GM1 Insert Exhibit 1, chapter 7, Financial Accounting,8e, Needles,titled "Analysis of Accounts REceivable by Age" Without the exhibit, it is difficult for me to tell where the two boxes should be placed on the slide. Please palce boxes where appropriate Order of appearance: 1. Exhibit 2. Box - Bullets, no background or outline 3. Box - Ornage and outlined
Gail Mestas, 10/23/2002

Accounts Receivable Aging Method (Case 1)

Dec. 31, 20x6: Management has estimated that $2,459 of Accounts Receivable are uncollectible. Allowance for Uncollectible Accounts has a credit balance of $800.
Allowance for Uncollectible Accounts
Dec. 31 Dec. 31 adj. Dec. 31 bal.

800 1,659 2,459

The target balance for the account is $2,459

Dec. 31

A credit adjustment of $1,659 will bring the account to its target balance
1,659 1,659

ncollectible Accounts pense Allowance for ncollectible Accounts To bring the allowance for uncollectible accounts to the level of estimated losses

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Accounts Receivable Aging Method (Case 2)

Dec. 31, 20x6: Management has estimated that $2,459 of Accounts Receivable are uncollectible. Allowance for Uncollectible Accounts has a debit balance of $800.
Allowance for Uncollectible Accounts
Dec. 31.

800
Dec. 31 adj. Dec. 31 bal.

3,259 2,459

The target balance for the account is $2,459

Dec. 31

A credit adjustment of $3,259 will bring the account to its target balance
3,259 3,259

ncollectible Accounts pense Allowance for ncollectible Accounts To bring the allowance for uncollectible accounts to the level of estimated losses

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Comparison of Two Methods

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Estimates Differ from Write-Offs?

Accounts receivable written off during a period will rarely equal the estimated uncollectible amount
Allowance for Uncollectible Accounts Shows a debit balance when the total of accounts written off is greater than the estimated uncollectible amount Shows a credit balance when the total of accounts written off is less than the estimated uncollectible amount

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731

Writing Off an Uncollectible Account

 When it becomes clear an account will not be collected, the amount should be written off to:
Allowance for Uncollectible Accounts Accounts Receivable

 The uncollectible amount was already accounted for as an expense when the allowance was established
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Writing Off an Uncollectible

Jan. 15, 20x7: R. Deering, who owes the company $250, is declared bankrupt by federal court.
Jan. 15 Allowance for ncollectible Accounts Accounts eceivable To write off receivable from . Deering as uncollectible because of his bankruptcy 250 250

Allowance for Uncollectible Accounts

Dec. 31 Jan. 15

Accounts Receivable
Dec. 31

2,459 2,209

44,400
Jan. 15

250
Bal. Bal.

250

44,150

The write-off does not affect the estimated net realizable value of accounts receivable

Net realizable value of A/R Before write-off $44,400 $2,459 = $41,941 After write-off $44,150 $2,209 = $41,941
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Making and Paying Notes

A promissory note is an unconditional promise to pay a definite sum of money on demand at a future date
Maker Person or company that signs the note and promises to pay the amount
All promissory notes that the maker holds that are due in less than one year are categorized as notes payable in the current liability section of the balance sheet
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Payee Entity to whom payment is to be made

All promissory notes that the payee holds that are due in less than one year are categorized as notes receivable in the current assets section of the balance sheet

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A Promissory Note

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735

Key Components of Promissory Notes

Maturity Date Duration Date on which the note must be paid Length of time in days between the notes issue date and its maturity date Cost of borrowing money or the return for lending money, usually stated on an annual basis Total proceeds of a note at maturity date (face value plus interest)
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Interest and Interest Rate Maturity Value

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