Agenda

Administrative
– Go over Midterm
– DQ Multiple Deliverables due Monday Feb
21st (will be posted today)

In Class today and Wed

- Cash and Receivables (Ch. 7, Appendix 7A,
Ch. 18 pp 930-937)
 Chapter 7 & 18 (pp930-937)
Cash, Cash Equivalents, Basic Revenue
Recognition & Receivables

Cash & Cash Equivalents

• Cash: Currency and coins held, checks & money
orders received, bank account balances
• Cash Equivalents are short-term, highly liquid
investments that are:
1. Readily convertible into known amounts of cash
2. So near maturity that there is no risk of change in
valuation from fluctuating interest rates (original
maturities of no longer than 3 months)
– Ex: T-bills, commercial paper, money market funds
 Reporting Issues with Cash

• Cash Equivalents
– Grouped together with cash
– reported as the most liquid current asset on the balance sheet

• Restricted Cash
– Disclosed separately
– If relates terms of LT liability classify as LT

• Bank Overdrafts
– US GAAP: Disclosed as a current liability unless there are other
positive-balance cash accounts at the same bank that it can be
netted against
– IFRS: Included in cash and cash equivalents if repayable on
demand and form a part of an entity’s cash management
 Controls and Cash
Questions
• Why are internal controls over cash so important?
• What is the purpose of controls over cash?

Three Key Controls

1) Management oversight and authorization
• Especially useful in small organizations where the owner
can monitor activities (and where there are limited
resources to have separation of duties)
2) Separation of duties:
• Physical control, authorization and record keeping
• E.g., one employee prepare the deposit slip and make the
entry, and another employee will actually make the deposit
3) The bank reconciliation
 Controls and Cash: Bank
Reconciliation
Example: Hawthorne Co.’s May bank statement is as follows:
Balance May 1, 2011 $33,240
Deposits 82,140
Checks processed (78,433)
Service Chg ( 80)
NSF checks ( 2,187)
Balance May 31, 2011 $34,680
Hawthorne’s GL cash account has a balance of $35,396 at 5/31/11.
A review of the co’s records and the bank statement reveals:
• Cash receipts not yet deposited totaled $2965
• A deposit of $1020 made on 5/31 was not credited to the company’s account until
June.
• All checks written in April have been processed by the bank, but $5536 of checks
from May have not.
 Controls and Cash: Bank
Reconciliation
Bank Balance to Corrected Balance:
Balance per bank statement $34,680
Add: Outstanding deposits 3,985
Less: Outstanding checks (5,536)
Corrected cash balance $33,129

Balance per books $35,396

Less: Service charge ( 80)
Less: NSF checks ( 2,187)
Corrected cash balance $33,129

Why is this an effective control?

 Basic Revenue Recognition

Recall: Revenue is recognized at the earliest moment

that both of the following conditions are met:
1.Earned: The critical event in the process of earning
revenue has taken place. (seller)

2. Realized: The amount of revenue that will be

collected is reasonably assured and measurable with a
reasonable degree of reliability. (buyer)
 Basic Revenue Recognition

Example : On 1/1/07 a magazine publisher receives

$300,000 for 1,000 3-year subscriptions. Magazine delivery
begins in January.

Can the revenue be recognized on 1/1/07?

• Is the revenue earned?
• Is the revenue realized?

When can the revenue be recognized?

 Expense Recognition (Matching)

Hierarchy of matching

• Direct – match expense to the revenue it helps generate

• Systematic and rational – match expense to periods in which

it helps to generate revenue (indirect cause and effect
relation between expense and revenue in periods expected to
be benefited)

• Immediate – expense in period the cost is incurred (i.e. no

discernable or measurable future benefit.)
 Timing of Revenue Recognition

1. Revenue Recognition at point of sale (delivery)

2. Revenue Recognition before delivery
3. Revenue Recognition after delivery
4. Revenue Recognition for specific sales
transactions – franchises & consignment
Revenue Recognition at Point of Sale

Revenues from manufacturing and selling are

commonly recognized at point of sale.

Exceptions:
1. Sales with buyback agreements – No Sale
2. Trade loading and channel stuffing – No Sale
3. Sales when right of return exists (high rates that are not
reliably estimable) –Specific criteria to be met
 Revenue Recognition at Point of Sale

When right of return exists all of the following 6 criteria must

be met to qualify as sale:
1. Price fixed or determinable at sale date
2. Buyer has paid seller, or is obligated to pay seller, and obligation is
not contingent on resale of product
3. Buyer’s obligation to seller would not be changed in event of theft or
damage to product
4. Buyer has economic substance apart from the seller
5. Seller does not have significant obligations for future performance to
directly bring about resale of product by buyer
6. Seller can reasonably estimate amount of future returns
 Recognition of Accounts
Receivable
• Trade Discounts – reduction in list price
for differential volume
• Cash discounts – reduction in amount
owed if paid within a specified period.
Possible accounting methods :
– Gross method records discounts when taken
by customers (most commonly used)
– Net method records discounts not taken by
customers.
 Cash Discounts - Net & Gross Methods
Sale of $1,000 of inventory, 2/10, n/30 on 1/1/06, for two scenarios:
a) Payment is made on 1/10/06 b) Payment is made on 1/15/06:
Net Method: Gross method:

January 1, 2006: January 1, 2006:

Dr. A/R (1,000 x .98) 980 Dr. A/R 1,000
Cr. Sales Revenue 980 Cr. Sales Revenue 1,000

If paid within discount period January 10, If paid inside discount period on January 10,
2006: 2006:
Dr. Cash 980 Dr. Cash 980
Cr. A/R Dr. Sales Discounts 20
980 Cr. A/R 1,000

If paid outside discount period on 1/15/06: If paid outside discount period on 1/15/06:
January 15, 2006: January 15, 2006:
Dr. Cash 1,000 Dr. Cash 1,000
Cr. A/R 980 Cr. A/R 1,000
Cr. Sales Discounts Forfeited 20
 Valuation of Accounts Receivable

• Short term receivables are reported at their

net realizable value (NRV)
• What is NRV?
– less estimated non-collectible accounts
– less allowance for returns.
 Accounts Receivable:
IFRS vs. US GAAP
Classification of Accounts Receivable
• US GAAP:
– Must separately disclose material related party
receivables (i.e., trade receivables separate from non-
trade)
• IFRS:
– Classified on balance sheet as a financial asset
– May separately disclose material related party
receivables
 Estimating Uncollectible
Receivables
Methods
Direct Write-Off Allowance
Not based on the matching Based on the matching
principle principle

Accounts are written off Estimated; bad debts are

when determined non-collectible matched against revenue

Appropriate only if Must be followed if

amounts are not material amounts are material
 Accounts Receivable
Direct write-off (used only if low & infrequent bad debts)
Bad debt expense (I/S) XXX
AR (B/S - Asset) XXX

Indirect (allowance method)

In year of the sale:
Bad debt expense (I/S) XXX
Allowance for bad debts (B/S – Asset) XXX

When found to be uncollectible:

Allowance for bad debts (B/S – Asset) XXX
AR (B/S – Asset) XXX

If payment received after account written off:

AR (B/S – Asset) XXX
Allowance for bad debts (B/S – Asset) XXX
Cash (B/S – Asset) XXX
AR (B/S – Asset) XXX
 AR Allowance Methods: Determining
the Amount of the Adjustment
Percent of Receivables Allowance method
• Balance-sheet oriented
• Uses one B/S account (AR) to estimate another B/S account
(Allowance)
• Estimates the ENDING balance in the allowance account
• Bad debt expense is the “plug”

Percent of Sales Allowance method

• Income-statement oriented
• Uses one I/S account (revenue) to estimate another I/S account (bad
debt expense)
• Estimates the TOTAL bad debt expense
• The allowance is the “running total”
 Allowance Example
1. “Percent of Receivables” method (B/S-oriented)
Husky Co. has $60,000 in sales in 2005. AR at 12/31/05 is
$24,000. Allowance for doubtful accounts at 12/31/05 is
$200. What adjusting entry should be made at year end?
The company estimates allowance based on 1% of AR < 31 days, 2%
31-60 days, 5% 61-90 days and 20% > 90 days:
Amount 0-30 31-60 61-90 91+
$24,000 10,000 8,000 4,000 2,000
Uncollectible % 1% 2% 5% 20%
Allow. Est. $860 = 100 160 200 400
 Allowance Example (cntd.)
2. “Percent of Sales” method (I/S-oriented)
Assume instead that Husky estimates bad debt expense based on
1.5% of sales.
Sales $60,000
Uncollectible % 1.5%
Bad debt expense $900
 Allowance Examples (cntd.)

3. % of Sales Method is based on credit sales during the year

Example: Crawford Inc.

Total sales, 2006: $20,000,000
Credit sales, 2006: $15,000,000
A/R Balance, Dec 31, 2006: $1,900,000
Allow. for bad debt balance (before adjustment) 12/31/06: $62,000
Prior history: 1% of credit sales are uncollectible

What is the journal entry to record bad debt expense for 2006
 Allowance Examples (cntd.)
4. Percent of Receivables Now assume Crawford estimates
their Allowance using an A/R aging. Prior collections history is
used to estimate the percentage of each category that is
uncollectible.
Age Balance % bad
0-30 days 1,200,000 x 0.75% = 9,000
31-60 days 500,000 x 8.00% = 40,000
61+ days 200,000 x 20.00% = 40,000
89,000
What is the adjusting journal entry at year end?
 Allowance Examples (cntd.)

5. Percent of Receivables – Write off’s and recovery. At the beginning

of 2004, the balance in the Allowance account was $11,000 (CR).
During the year, $8,000 of delinquent accounts were written off. Then,
$2,000 of these delinquent accounts was ultimately determined to be
collectible, and these accounts were collected. Additionally, the 2004
ending balance in A/R was $150,000. If XYZ estimates that 5% of A/R
is uncollectible, what adjusting entry would be made to account for the
bad debts?

What would be the ending balance in the Allowance for Doubtful

Accounts account?
 Balance Sheet Representation

Short-term accounts receivable are shown at their net

realizable value as follows:
Accounts Receivable (gross): $ XXX
less: Allowance: ($ XX)
Net Realizable Value: $ XX

Or present in line item as:

“AR net of $xxx allowance for doubtful accounts”
 Disposition of Accounts and
Notes Receivable
• The holder of accounts or notes receivable may
transfer them for cash.
• The transfer may be either:
1. A secured borrowing (i.e., the “seller” is really
borrowing from the transferee)
– Holder retains ownership of receivables in a
secured borrowing transaction.
2. A sale of receivables
– Holder transfers ownership of receivables in a
sale (transfers risks of collection).
 Accounting for Transfers of
Receivables
Transfers

Secured Borrowing Sale

With Recourse Without Recourse

-Seller guarantees payment if debtor does not pay -Seller has no future obligation
-Factored receivables are written off, but a -Write-off factored receivables
recourse liability is recognized based on estimate (and recognize any gain / loss)
of future payment firm will have to make
 Secured Borrowing – the Basics

• Overall - Receivables remain on the books of the

company borrowing money (i.e. – no sale) (and continue
to treat A/R as usual (collections, write-off, etc.)
• Also called “pledged” receivables
• Transferor:
– Records liability
– Records a finance charge.
– Collects accounts receivable.
– Records sales returns and sales discounts.
– Absorbs bad debts expense.
– Records interest expense on notes payable.
– Pays on the note periodically from collections.
 Secured Borrowing Example
To help overcome a cash shortage, H Software took out a loan with T Bank. H
Software used $1000 of A/R as collateral for the loan. T Bank withheld $30 as a
finance charge, and forwarded $970 to H Software on July 1. H Software
collected the on the accounts on July 31 ($120 were written off), and repaid T
Bank on August 2nd with interest of $50.
July 1:
Dr. Cash 970
Dr. Finance charge 30
Cr. Note Payable 1,000

July 31:
Dr. Cash 880
Dr. Allowance for doubtful accounts 120
Cr. A/R 1,000

August 2:
Dr. Interest Expense 50
Dr. Note Payable 1,000
Cr. Cash 1,050
 Sale of Receivables – the Basics

• Factor records the (transferred) accounts as assets in its

books.
• Transferor:
– Transfers ownership of receivables to factor.
– Records any amount retained by transferee as “due from factor.”
• This is an amount held back to protect the transferee in case of non-
payment by customer
– Records loss on sale of receivables.
– Records any component liability IF with recourse
• i.e., any estimated future liability that the transferor will need to pay
if customers do not pay (and if the amount held back by the factor is
insufficient)
 Transfer of Receivables: Sale Without Recourse
To help overcome a cash shortage, H Software factored $1,000 of receivables to W Factor
on July 1, 2006. W Factor withheld $100 pending collectability, and charged H
Software $40. The remaining $860 was forwarded to H Software on July 1. W Factor
collected on the A/R, without recourse. On August 2nd, W Factor informed H
Software that $75 of the accounts were uncollectible, and W Factor returned to H
Software the appropriate payment.

Dr. Cash
Dr. Due from Factor
Dr. Loss on sale of A/R
Cr. A/R

Dr. Cash
Dr. Loss
Cr. Due from Factor

What if instead, W Factor informed H Software on Aug 2 that it was able to collect all of
the AR? What would be the journal entry?
Dr. Cash
Cr. Due from Factor
 Transfer of Receivables: Sale With Recourse
To help overcome a cash shortage, H Software factored $1,000 of receivables to W
Factor on July 1, 2006. W Factor withheld $100 pending collectability, and charged
H Software $40. The remaining $860 was forwarded to H Software on July 1. W
Factor collected on the A/R, but had recourse in case of bad debts. H Software
estimated that $150 of the receivables would ultimately be uncollectible. On August
2nd, W Factor informed H Software that $120 of the accounts were uncollectible, and
H Software sent W Factor the appropriate recourse payment.

Dr. Cash
Dr. Due from Factor
Dr. Loss on Sale of A/R (plug)
Cr. A/R
Cr. Recourse Liability

Dr. Recourse Liability

Cr. Cash
Cr. Due from Factor
Cr. Recovery of loss sale

What if W Factor informed H Software that $220 of the accounts were uncollectible?
 Transfer of Receivables: Dawson Example
On January 1, 2006, Dawson Associates is considering outsourcing the collection of its
accounts receivable. The following factoring options are available to Dawson.

Speedy Finance, Inc. Under the terms of the agreement, Speedy Finance would pay
Dawson 98% of the gross amount of the transferred receivables and Dawson would be
responsible to pay Speedy Finance for any uncollectible accounts. Dawson estimates its
recourse liability would be $60,000. Speedy Finance will collect the receivables and will
have the right to pledge or sell the receivables to another party.

Strapped Solutions, Inc. Under the terms of the agreement, Strapped Solutions would
pay Dawson 96.5% of the gross amount of Dawson’s receivables without recourse.
Strapped Solutions will collect the receivables and will have the right to pledge or sell
the receivables to another party.

The following information is available from Dawson’s Balance Sheet at Dec. 31, 2005:
Accounts Receivable $5,000,000
Allowance for doubtful accounts 80,000
Transfer of Receivables: Dawson Example
Prepare the journal entry that Dawson would record on January
1, 2006 if it decides to enter into the agreement with Speedy
Finance.
Transfer of Receivables: Dawson Example

Prepare the journal entry that Dawson would record on January

1, 2006 if it decides to enter into the agreement with Strapped
Solutions.
Transfer of Receivables: Dawson Example

Which alternative should Dawson select if it wants

to maximize reported income in 2006?
 Recognition of Notes Receivable

Notes Receivable

Short term N/R Long term N/R

Record at face value Record at present value

less allowance of cash expected to
be collected
 Long-Term Notes Receivable: The
Basics
• Why does a company issue a notes receivable?
• NR provides a stream of cash to the issuer
– Principle
– interest
• What gets recorded?
– Revenue: Present value cash inflow = fair value transaction
– Note Receivable: Amount of the note
– Maybe a discount or premium: contra account to the note
– Interest revenue: Market rate of interest on the net receivable
– Cash received (interest and principle)
 Long-Term Notes Receivable: The
Basics
What are the true economics of a transaction involving a note?
Consider this example.

Several years ago my husband and I purchased a Ford Explorer.

The sticker price was $30,000. My husband negotiated it down to
$27,000. When we went to pay, we were given two options:
1) Receive a $2000 rebate off the negotiated price, OR
2) Finance for 5 years at 0% interest.

Questions:
1) What is the true value of the transaction (i.e, revenue)?
2) Is the loan really at 0% interest?
 Long-Term Notes Receivable: The
Basics
• To ensure this happens, need to consider interest rates.
• Interest rates: Stated vs. market
– Stated rate = effective (market rate)  note issued at face value
– Stated rate < market rate  note issued at a discount.
– Stated rate > market rate  note issued at a premium.
– The discount or premium is amortized to interest revenue by the effective
interest method.
• Record interest revenue each period using the effective interest
method.
– Yields steady market rate of interest on net investment in note receivable
(i.e., note receivable + premium/discount)
 Notes Receivable:
Stated Rate = Market Rate
On December 31, 2007, Nemo, Inc. finished consultation
services and accepted in exchange a promissory note with a face
value of $600,000, a due date of December 31, 2010, and a stated
rate of 6%, with interest receivable at the end of each year. The
note is considered to have a market rate of interest of 6%.

How much should the Note Receivable be recorded for?

What is the fair value of the transaction?

– PV of cash interest payments
– PV of principle payment
 Notes Receivable:
Stated Rate = Market Rate

Table 6-2 (PV of single sum)

Periods (n) 3% 6% 9%

3 0.91514 0.83962 0.77218

Table 6-4 (PV of an ordinary annuity)

Periods (n) 3% 6% 9%

3 2.82861 2.67301 2.53130

 Notes Receivable:
Stated Rate = Market Rate
Fair value of transaction:
Interest:
Principle:

Journal entries
 Notes Receivable:
Stated Rate < Market Rate
On December 31, 2007, Nemo, Inc. finished consultation
services and accepted in exchange a promissory note with a face
value of $600,000, a due date of December 31, 2010, and a stated
rate of 3%, with interest receivable at the end of each year. The
note is considered to have a market rate of interest of 6%.

Is this a discount or a premium?

How much should the Note Receivable be recorded for?

 Notes Receivable:
Stated Rate < Market Rate
Fair value of transaction:
Interest:
Principle:

Journal entry at 12/31/07

 N/R: Stated Rate < Market Rate
Effective Interest Amortization
Cash Effective Discount Carrying
Date Interest Int Rev Amortized Amt N/R
 Notes Receivable:
Stated Rate < Market Rate
Journal Entries
 Notes Receivable:
Stated Rate > Market Rate
On December 31, 2007, Nemo, Inc. finished consultation services
and accepted in exchange a promissory note with a face value of
$600,000, a due date of December 31, 2010, and a stated rate of
9%, with interest receivable at the end of each year. The note is
considered to have a market rate of interest of 6%.

Is this a discount or a premium?

How much should the Note Receivable be recorded for?

 Notes Receivable:
Stated Rate > Market Rate
Fair value of transaction:
Interest:
Principle:

Journal entry at 12/31/07

 N/R: Stated Rate > Market Rate
Effective Interest Amortization
Cash Effective Premium Carrying
Date Interest Int Rev Amortized Amt N/R
 Notes Receivable:
Stated Rate > Market Rate
Journal Entries
 Non-interest Bearing Notes
This is a special case of a discount.

Steps:
1. Determine issue price on notes receivable
at implicit rate of interest
2. The discount is amortized to interest
revenue by the effective interest method
Notes Receivable – Non-Interest Bearing

On 1/1/06 Mickey Co. purchases a machine from Mouse. Co. with

a list price of $10,000. Mickey signs a non-interest bearing note
promising to pay Mouse Co. $10,000 on December 31, 2007. The
fair value of the machine on 1/1/06 is $7,972.

Implicitly, how much interest revenue will Mouse receive over the
2 year period of the note?

What is the implicit interest rate on this note receivable?

– It is the rate that equates $7972 at t=0 to $10,000 at t=2
– 7,972F = 10,000; or F=10,000/7,972 = 1.2544
– In table 6.1, Future Value of 1 (p. 303), the rate is 12% (F=1.2544, n =
2)-
Notes Receivable – Non-Interest Bearing

Carrying
Date Int Rev Disc. Amor. Amt NR
1/1/2006 7,972
12/31/2006 957 957 8,929
12/31/2007 1,071 1,071 10,000
2,028
Notes Receivable – Non-Interest Bearing

January 1, 2006:

December 31, 2006:

December 31, 2007:

 Another Non-Interest Bearing
Example
General Host’s annual accounting period ends on December
31. On July 1, 2004, General sold land having fair market
value of $700,000 in exchange for a four-year non-interest
bearing promissory note in the face amount of $1,101,460.
The land is carried on General’s books at a cost of $620,000.

Required: Prepare the journal entry to record the sale of

land in exchange for the note.
Another Non-Interest Bearing
Example
 Impairment of Long-Term
Receivables

• The “Crisis of Credit”

• When does impairment occur?
• How is the impairment measured?
– Book value less PV future cash flows
 Impairment of Long-Term
Receivables
Example: Brillard Properties owes First Prudent Bank $30million
under a 10% note with two years remaining until maturity. Due to
financial difficulties of the developer, the previous year’s interest of
$3million was not paid. First Prudent agrees to
1. Forgive the interest payment from last year
2. Reduce the remaining two interest payments to $2 million each
3. Reduce the principal to $25 million

How much impairment loss should be recorded? Assume 10% is

market rate of interest.
 Impairment of Long-Term
Receivables
Book value of asset:
Accrued interest (10% x $30million) $ 3,000,000
Principal 30,000,000
Carrying amount of the receivable $33,000,000
New Value:
PV of future interest ($2million x 1.73554) $3,471,080
PV of principal ($25million x .82645) 20,661,250
PV of receivable (24,132,330)
Loss $8,867,670

Journal Entry
Loss on troubled debt restructuring 8,867,670
Accrued interest receivable 3,000,000
Note receivable ($30,000,000-24,132,330) 5,867,670
 Presentation & Disclosure of
Receivables

Rules:
• Segregate different types of receivables if material
• Offset valuation accounts against gross balance
• Ensure all receivables are really current
• Disclose any loss contingencies on the receivables
• Disclose amounts pledged as collateral
• Disclose significant concentrations of credit risk
 Analysis of Receivables

What is purpose of analysis?

Ratios used
AR Turnover = Net Sales/Average net Trade AR

Days AR or Average Collection Period = 365 days/AR turnover