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LECTURE NOTE MARCO FERNANDO NG


Cash and cash equivalent


The definition of cash includes both cash (cash on hand and demand deposits) and cash equivalents (short-
term, highly liquid investments).

1. Cash equivalents have to be readily convertible into cash and so near maturity that they carry little risk of
changing in value due to interest rate changes. Generally this will include only those investments with original
maturities of three months or less from the date of purchase by the enterprise. Any investment or term
deposit with an initial maturity of more than three months does not become a Cash equivalent when the
remaining maturity period reduces to less than three months.
a. Common examples of cash equivalents include Treasury bills, commercial paper, and money market
funds. Unrestricted cash and cash equivalents available for general use are presented as the first current
asset.
2. Cash set aside for special uses is usually disclosed separately. The entry to set up a special fund is
Special cash fund xx
Cash xx
3. Cash restricted as to use (e.g., not transferable out of a foreign country) should be disclosed separately, but
not as a current asset if it cannot be used in the next year (this is true of special funds also).

4. Imprest (petty) cash funds are generally included in the total cash figure, but unreimbursed expense
vouchers are excluded.

B. Bank Reconciliations

1. Bank reconciliations are prepared by bank depositors when they receive their monthly bank statements. The
reconciliation is made to determine any required adjustments to the cash balance. Two types of reconciling
items are possible.
a. Reconciling items not requiring adjustment on the books (type A)
(1) There are three type A reconciling items. They do not require adjusting journal entries.
statements to general users should outweigh the cost of doing it. Benefits should be in excess of the
cost in disclosing certain information to the users.
(a) Outstanding checks
(b) Deposits in transit
(c) Bank errors
b. Reconciling items requiring adjustment on the books (type B)
(1) All other reconciling items (type B) require adjusting journal entries. Examples of type B
reconciling items include
(a) Unrecorded returned nonsufficient funds (NSF) checks
(b) Unrecorded bank charges
(c) Errors in the cash account
(d) Unrecorded bank collections of notes receivable

2. Two types of formats are used in bank reconciliations.
Format 1 Format 2
Balance per bank Balance per bank
+() A adjustments +() A adjustments
Correct cash balance +() B adjustments
Balance per books
Balance per books +() B adjustments
+() B adjustments Correct cash balance
Correct cash balance

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LECTURE NOTE MARCO FERNANDO NG

a. Type A and B adjustments can be either added or subtracted depending upon the type of format and
the nature of the item.
b. Reconciling items must be analyzed to determine whether they are included in (1) the balance per
bank, and/or (2) the balance per books.

Receivables

Accounts receivable should be disclosed in the balance sheet at net realizable value (gross amount less
estimated uncollectibles) by source (e.g., trade, officer, etc.). Officer, employee, and affiliate company
receivables should be separately disclosed. Unearned interest and finance charges should be deducted from
gross receivables.

1. Anticipation of Sales Discounts


a. Cash discounts are generally recognized as expense when cash payment is received within the
discount period. As long as cash discounts to be taken on year-end receivables remain constant from
year to year, there is no problem. If, however, discounts on year-end receivables fluctuate, a year-end
allowance can be set up or sales can be recorded net of the discounts.
(1) The entries to record sales at net are shown below in comparison to the sales recorded at gross .
Sales at net Sales at gross
a. Sale AR (net) AR (gross)
Sales (net) Sales (gross)
b. Cash receipt within discount
period
Cash (net) Sales disc. (disc.)
AR (net) Cash (net)
AR (gross)
c. Cash receipt after discount
period Cash (gross) Cash (gross)
AR (net) AR (gross)
Disc. not taken (disc.)
(a) The rationale for the net method is that sales are recorded at the cash equivalent amount and
receivables nearer realizable value.

(b) If a sales discount allowance method is used, the entry below is made with the gross method
entries. The entry should be reversed.
Sales discounts (expected disc. on year-end AR)
Allowance for sales disc. (expected disc. on year-end AR)

(c) Similarly, when using the net method, an entry should be made to pick up discounts not
expected to be taken on year-end receivables. Generally, however, these latter adjustments are
not made, because they are assumed to be about the same each period.

2. Bad Debts Expense

There are two approaches to bad debts.

Direct write-off method

Allowance method

a. Under the direct write-off method , bad debts are considered expenses in the period in which they are
written off.
(1) The direct write-off method is the method required for tax purposes.

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LECTURE NOTE MARCO FERNANDO NG

Bad debts expense (uncollectible AR)

AR (uncollectible AR)

b. The allowance method seeks to estimate the amount of uncollectible receivables, and establishes a
contra valuation account (allowance for bad debts) for the amount estimated to be uncollectible.
(1) The adjusting entry to set up the allowance is

Bad debts expense (estimated)

Allowance for bad debts (estimated)

(2) The entry to write off bad debts is


Allowance for bad debts (uncollectible AR)

AR (uncollectible AR)

(a) There are two methods to determine the annual charge to bad debts expense.

1] Annual sales

a] Charging bad debts expense for 1% of annual sales is based on the theory that bad
debts area function of sales; this method emphasizes the income statement.

b] When bad debts expense is estimated as a function of sales, any balance in the
allowance account is ignored in making the adjusting entry. Bad debts expense under
this method is simply the total amount computed (i.e., Sales * Percentage).

2] Year-end AR

a] Charging bad debts on year-end AR is based on the theory that bad debts are a
function of AR collections during the period; this method emphasizes the balance sheet.

b] A bad debts percentage can be applied to total AR or subsets of AR. Often an aging
schedule is prepared for this purpose. An AR aging schedule classifies AR by their age
(e.g., 30, 60, 90, 120, etc., days overdue).

c] When bad debts expense is estimated using outstanding receivables, the expense is
the amount needed to adjust the allowance account to the amount computed (i.e., AR
*Percentage[s]). Thus, bad debts expense under this method is the amount computed
less any credit balance currently in the allowance account (or plus any debit balance).

(3) Net accounts receivable is the balance in accounts receivable less the allowance for bad debts.

(4) The policy for charging off uncollectible trade accounts receivable must be disclosed for
receivables that have a contractual maturity of one year or less and arise from the sale of goods or
services.

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LECTURE NOTE MARCO FERNANDO NG

3. Transfers and servicing of financial assets. Transfers of financial assets include the transfer of an entire
financial asset, a group of financial assets, or a participating interest in an entire financial asset. Specifically, this
topic includes servicing arrangements, recourse arrangements, guarantees, agreements to purchase or redeem
transferred financial assets, options written or held, derivative financial instruments that are entered into with
contemplation of a transfer, arrangements to provide financial support, pledges of collateral, and transferors
beneficial interests in the transferred financial asset.

a. The major types of transfers include


(1) Securitizations Purchasing and selling securities that are collateralized by a pool of assets, such
as a group of receivables.
(2) Factoring Selling receivables at a discount to obtain immediate cash.
(3) Transfers of receivables with recourse Selling receivables at a discount to obtain immediate
cash but retaining the risk of loss if the customer does not pay the amount owed.
(4) Repurchase agreements An agreement to sell an asset to a lender and later repurchase the
asset.
These agreements are in effect using the asset as collateral for a loan.
(5) Loan participations A situation where a group of financial institutions (called participating
interest holders) purchases a share of a financial instruments (e.g., a loan).
(6) Bankers acceptances An order from a customer of a bank for the payment of a specified sum of
money (like a post-dated check) that may be bought and sold.
b. The important determination in accounting for transfers of assets is whether the transaction is
accounted for as a sale of the asset or a secured loan with the asset as collateral.
(1) A transfer may be accounted for as a sale only when the transferor surrenders control of the
financial asset(s) and all of the following conditions are met:
(a) The transferred financial asset(s) are isolated and beyond the reach of the transferor and its
creditors, even in bankruptcy or receivership.
(b) The transferee can pledge or exchange the asset(s) without unreasonable constraints or
conditions.
(c) The transferor does not maintain effective control over the transferred financial asset(s) or a
third-party beneficial interest in the asset(s).

(2) Transfers of financial assets are disaggregated into separate components of assets and liabilities.
Each entity involved in the transaction

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(a) Recognizes only the assets it controls and liabilities it incurs after the transaction has
occurred, and
(b) Derecognizes assets for which control has been given up or lost, and liabilities for which
extinguishment has occurred.

(3) The proceeds received from the sale of financial assets is the cash or other assets obtained,
including separately recognized servicing assets, less any liabilities incurred.
(a) Any asset obtained that is not an interest in the transferred asset is a part of the proceeds of
the sale.
(b) Any liability incurred, even if it is related to the transferred assets, is treated as a reduction
of the proceeds from the sale.

c. Accounting for transfers of participating interests. In order to be eligible for sale accounting, the entire
financial asset cannot be divided into components before the transfer, unless all the components meet
the definition of a participating interest.
(1) A participating interest must have the following four characteristics: (1) the interest is a
proportionate ownership interest in an entire financial asset; (2) all cash flows received from the
asset are divided proportionately among the participating interest holders based upon their share of
ownership; (3) the rights of each participating interest holder have the same priority (i.e., in transfers,
bankruptcy, or receivership); and (4) no party has the right to pledge or exchange the financial asset
unless all participating interest holders agree.

(2) When a transfer of a participating interest(s) qualifies as a sale, the transferor should
(a) Allocate the carrying amount of the entire financial asset(s) between the participating
interest(s)sold and the participating interest that continues to be held by the transferor. Relative fair
values at the date of transfer are used to allocate the carrying amount.
(b) Derecognize the participating interest(s) sold.
(c) Recognize and measure at fair value servicing assets, servicing liabilities, and any other assets
obtained or liabilities incurred in the sale.
(d) Recognize any gain or loss on the sale in earnings.
(e) Report any participating interest that continues to be held as the difference between the
previous carrying amount and the amount derecognized.

(3) If the transfer of a financial asset does not meet the criteria for a sale, the transferor and
transferee account for the transfer as a secured borrowing with the financial asset(s) pledged as
collateral.
d. Factoring of receivables. This category of financing is the most significant in terms of accounting
implications. Factoring traditionally involves the outright sale of receivables to a financing institution
known as a factor. These arrangements usually involve (1) notification to the customer to forward future
payments to the factor and (2) transfer of receivables without recourse, which means that the factor
assumes the risk of loss from noncollection. Thus, once a factoring arrangement is completed, the entity
has no further involvement with the receivables, unless the customer decides to return the
merchandise. In its simplistic form, the receivables are sold and the difference between the cash
received and the carrying value of the receivables is recognized as a gain or loss.
(1) Factoring without recourse provides two financial benefits to the business: it permits the entity to
obtain cash earlier, and the risk of bad debts is transferred to the factor.
(a) The factor is compensated for each of the aspects of the transaction.
(b) Interest is charged based on the anticipated length of time between the date the factoring is
consummated and the expected collection date of the receivables sold, and a fee is charged based
upon the anticipated bad debt losses.

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(c) Merchandise returns will normally be the responsibility of the transferor, who must then
make the appropriate settlement with the factor.
1] To protect against the possibility of merchandise returns which diminish the total amount of
the receivables to be collected, a factor will often holdback a portion of the amount of the
receivables factored in addition to taking the interest and fee.
2] The transferor will charge any merchandise returns to a factors holdback receivable
account that is created when the receivables are factored. At the end of the return privilege
period, any remaining holdback will become due and payable to the borrower.

(d) Factoring transfers title to the receivables. Thus, if there is a without recourse provision, the
removal of these receivables from the borrowers balance sheet is clearly warranted.

(2) Factoring arrangements may also involve factoring with recourse.
(a) In a with-recourse arrangement, if the customer does not pay the factor, the transferor must
pay the factor the amount due on the account.
(b) The rules for transfer of receivables with recourse vary by jurisdiction; therefore, transfers
with recourse may or may not qualify for sale treatment.
(c) If the factoring with recourse arrangement qualifies as a sale, the recourse liability is treated
as reduction of the proceeds received in the transfer.
1] In computing the gain or loss to be recognized at the date of the transfer of the receivables,
the borrower (transferor) must take into account the anticipated chargebacks from the
transferee for bad debts expected to be incurred. This action requires an estimate by the
transferor, based on past experience.
2] Adjustments should also be made at the time of sale for the estimated effects of any
accelerated payments by customers (where the receivables are interest-bearing or where cash
discounts are available).

e. Servicing of financial assets.
(1) Servicing of financial assets may involve any one or all of the following activities:
(a) Collecting payments
(b) Paying taxes and insurance
(c) Monitoring delinquencies
(d) Foreclosing
(e) Investing
(f) Remitting fees
(g) Accounting
(2) Although inherent in transfers of most financial assets, servicing is a distinct asset or liability only
when separated contractually from the underlying financial asset. The servicing asset usually results
either from separate purchase or assumption of the servicing rights, or from securitization with
retained servicing. The servicers obligations are specified in the contract.
(3) Typically, the servicing contract results in an asset because the benefits are more than adequate
compensation for the cost of servicing. The benefits include fees, late charges, float, and other
income.
(4) If the benefits do not provide fair compensation, the servicing contract is a liability. The fair value
of a servicing contract is based on its value in the market and is not based on the internal cost
structure of the servicer. Thus, the concept of adequate compensation is judged by requirements
that would be imposed by a new or outside servicer. In cases where there is not a reliable market for
the contract, present value methods may be used to value the servicing contract.
(5) In summary, the servicer should record the servicing contract based on the following criteria:
(a) More than adequateresulting in a recorded asset
(b) Adequate compensationresulting in no asset or liability

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(c) Less than adequateresulting in a recorded liability


(6) Servicing assets or servicing liabilities are to be accounted for separately as follows:
(a) Assets are reported separately from liabilities. They are not netted.
(b) Initially measure servicing assets that are retained by the transferor by allocating the carrying
amount based on relative fair values at the date of transfer.
(c) Initially measure at fair value all purchased assets, assumed liabilities, and liabilities
undertaken in a sale or securitization.
(d) Account separately for interest-only strips (future interest income from serviced assets that
exceed servicing fees).
(e) Measure servicing assets and servicing liabilities using one of two methods: amortization
method, or fair value method. An election must be made to use the fair value method for each class
of servicing assets and servicing liabilities. Once the election is made to value using the fair value
method, the election cannot be reversed.
(f) Report servicing assets and servicing liabilities on the balance sheet in one of two ways:
1] Display separate line items for amounts valued at fair value and amounts measured by
amortization method, or
2] Display aggregate amounts for all servicing assets and servicing liabilities, and disclose
parenthetically the amount that is measured at fair value that is included in the aggregate
amount.

(7) The amortization method requires servicing assets and servicing liabilities to be initially recorded
at fair value. Assets are then amortized in proportion to, and over the period of, receipt of estimated
net servicing income or net servicing loss. At the end of each period, the assets are assessed for
impairment or increased obligation based on fair value. Over time, the asset is tested for impairment
which is recognized in a valuation allowance account. Liabilities are amortized in proportion to, and
over the period of, the net servicing loss. In cases where changes have increased the fair value above
the book value, an increased liability and a loss should be recognized.

(8) Under the fair value method, servicing assets and servicing liabilities are initially recorded at fair
value. The fair value is measured at each reporting date. Changes in fair value are reported in
earnings in the period in which the change in fair value occurs.

(9) Required disclosures for all servicing assets and servicing liabilities include managements basis for
determining classes, a description of risks, the instruments used to mitigate income statement effect
of changes in fair value, the amount of contractually specified servicing fees, late fees, and ancillary
fees for each period, and quantitative and qualitative information about assumptions used to
estimate fair value.
(a) For servicing assets and liabilities subsequently measured at fair value, disclosures must also
be provided showing the beginning and ending balances, additions, disposals, changes in fair value
inputs or assumptions used, and changes in fair value.
(b) For servicing assets and liabilities that use the amortization method, disclosures must include
the beginning and ending balances, additions, disposals, amortization, application of valuation
allowance to adjust carrying value, and other changes that affect the balance, as well as a description
of the changes. In addition, the fair value at the beginning and end of each period should be disclosed
if it is practicable to estimate the value. The activity in the valuation account, including beginning and
ending balances, recoveries made, and write-downs charged against the allowance for each period
should also be disclosed.


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LECTURE NOTE MARCO FERNANDO NG

f. Securitizations. As described above, securitization is the transformation of financial assets into


securities (asset backed securities). Various assets including mortgages, credit cards, trade receivables,
loans, and leases are grouped and securitized. These groupings of relatively homogeneous assets are
then pooled and divided into securities with cash flows that can be quite different from those of the
original individual assets. With an established market, most of these securities cost less than the
alternative use of the assets as collateral for borrowing. Thus, the benefits of most securitizations
include lower financing costs, increased liquidity, and lower credit risk.

(1) The transferor (also called issuer or sponsor) forms a securitization mechanism to buy the assets
and to issue the securities. Sometimes, another transfer is made to a trust and the trust issues the
securities. These different structures are generally referred to as one-tier or two-tier respectively.
The securitization mechanism then generates beneficial interests in the assets or resulting cash flows
which are sold. The form of the securities chosen depends on such things as the nature of the assets,
income tax considerations, and returns to be received.
(2) Various financial components (assets or liabilities) arise from securitizations. Examples include
servicing contracts, interest-only strips, retained interests, recourse obligations, options, swaps, and
forward contracts. All controlled assets and liabilities must be recognized.
(3) The transferor generally wants to take the assets off the balance sheet. This result can be
accomplished if the transaction results in a sale. The key criterion in this case is to be sure that the
assets are beyond control of the transferor even in bankruptcy.

g. Secured borrowings. In a secured borrowing arrangement, receivables are pledged as collateral for a
loan. The customers whose accounts have been pledged are not aware of this event, and their payments
are still remitted to the borrower. The pledged accounts merely serve as security to the lender, giving
comfort that sufficient assets exist which will generate cash flows adequate in amount and timing to
repay the debt. However the debt is paid by the borrower whether or not the pledged receivables are
collected and whether or not the pattern of such collections matches the payments due on the debt.

(1) The accounts receivable remain on the borrowers books. Both the accounts receivable and the
factor borrowing payable should be cross-referenced in the balance sheet.
(2) In a secured borrowing, the assets of the borrowing entity continue to be shown as assets in its
financial statements but must be identified as having been pledged. This identification can be
accomplished either parenthetically or by footnote disclosures. Similarly, the related debt should be
identified as having been secured by the receivables or other asset.

h. Accounting for collateral. The method of accounting for a collateral agreement depends both on
control of the assets and on the liabilities incurred under the agreement.

(1) Ordinarily, the transferor should carry the collateral as an asset and the transferee should not
record the pledged asset.
(2) If the transferee, however, has control of the asset, the secured party should record the asset at
fair value and also the liability to return it. The transferor should reclassify the asset (probably as a
receivable) and report it separately in the balance sheet.
(3) If the transferor defaults and is not entitled to the return of the collateral, it should be
derecognized. If not already recognized, the transferee should record collateral as an asset at fair
value.

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LECTURE NOTE MARCO FERNANDO NG

4. Disclosures. Additional disclosures required for receivables, off-balance-sheet credit exposure, and foreclosed
and repossessed assets include the following:

a. Accounting policies for loans and trade receivables


b. Assets serving as collateral
c. Nonaccrual and past due financing receivables
d. Accounting policies for off-balance sheet credit exposures
e. Foreclosed and repossessed assets
f. Allowance for credit losses
g. Impaired loans
h. Loss contingencies
i. Risks and uncertainties
j. Fair value disclosures
k. Credit quality information
l. Modifications

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