Chapter 4

Cash and Receivables

1
 Chapter 4’s Learning Objectives

1. Account for cash

2. Prepare and use a bank reconciliation
3. Account for accounts receivables
4. Estimate and account for uncollectible accounts
receivable
5. Account for notes receivable
6. Explain how to improve cash flows from sales and
receivables
7. Evaluate a company’s liquidity

• .

2
Learning Objective One

Account for cash

3
 Accounting for Cash

• Companies usually combine all cash amounts into a single total on

the balance sheet called “Cash & Cash Equivalents”.
 Cash is the most liquid asset because it is the medium of
exchange used to pay bills and employees’ salaries, repay
loans, buy equipment, etc.
 Cash equivalents include liquid assets such as treasury bills,
commercial papers, and money market funds, which are
interest bearing accounts with less than 3 months maturity.

• Usually companies receive and pay funds by way of electronic

funds transfer (EFT) or cheques.

4
Learning Objective Two

Prepare and use a bank reconciliation

5
 The Need to Control Cash
• Cash is the most liquid asset but it is easy to conceal and relatively
easy to steal.
• Thus, most businesses create specific controls for cash:
1. Keep cash in a bank account.
2. Separation of duties (i.e., the person handling cash should not
be responsible for recording cash transactions).
3. Proper authorization for purchases.
3. Proper authorization for cash payments.
4. Authorize a limited number of people to sign cheques.
5. Require daily deposits of cash receipts.

6
 Banks Controls for Safeguarding Cash

• Keeping cash in a bank account helps control cash because banks

have established practices for safeguarding customers’ money.
• The documents used to control a bank account include:
1. Signature card
2. Deposit slip
3. Cheque
4. Bank statement

7
 Bank Account Documents

• Signature card
 Protects against forgery by requiring each authorized signing
person to provide a signature card.
• Deposit slip
 Proof of transaction (i.e., deposit receipt).
• Cheque
 Maker – signs the cheque
 Payee – to whom the cheque is paid
 Bank – where funds are drawn

8
 Bank Account Documents (cont’d)

• Bank statement
 Reports the activity in a
bank account
 Shows the account’s
beginning and ending
balances, cash receipts,
payments, and
electronic fuds transfers
(EFTs)

9
 Bank Reconciliation
• There are two records of the cash businesses hold:
1. The Cash account in the company’s general ledger, and
– The cash record is known as “chequebook” or the “books.
2. The bank statement.

• The books and bank statement usually have different cash

balances due to timing differences in recording transactions or due
to errors.
• Bank reconciliation explains the differences between the balance
on the bank statement and the balance on the books.
• As an internal control over cash, the person who prepares the
bank reconciliation should have no other cash duties. Otherwise,
he or she can steal cash and manipulate the reconciliation to
conceal the theft.
10
 Bank Reconciliation Sides

 Bank reconciliation reconciles differences between the balance

on the bank statement and the balance on the cash general
ledger.
 The bank statement balance and cash balance on the books
MUST be reconciled each period.
 Bank reconciliation has two sides:
(1) Bank side, and
(2) Book side
→ Each side must be reconciled to the correct balance. After
the reconciliation, the adjusted bank balance equals the.
adjusted book balance

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 Preparing the Bank Reconciliation – Bank Side
Items to be recorded on the Bank side (i.e., recorded by the
company but not yet by the bank):
1. Deposits in transit (outstanding deposits)
These deposits have been recorded by the company but not yet
by the bank Add deposits in transit.

2. Outstanding cheques
These cheques have been issued by the company but not yet paid
by the bank  Subtract outstanding cheques.

3. Bank errors.
Correct all bank errors on the Bank side of the reconciliation.
• Ex: the bank may erroneously subtract from your account a
cheque written by someone else or it may transpose numbers
in recording a deposit to your account.
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 Preparing the Bank Reconciliation – Book Side

Items to be recorded on the Book side (i.e., recorded by the bank

but not yet by the company)

1. Bank collections
The bank has recorded cash receipts for the company but the
company hasn’t recorded these Add it on the book
reconciliation.
2. Electronic funds transfers (EFT)
The bank has received or paid cash on behalf of the company but
the company hasn’t recorded it  Add EFT receipts and subtract
EFT payments on the book reconciliation.
3. Service charges
Bank’s fee for processing your transactions  Subtract service
charges on the book reconciliation.

13
Preparing the Bank Reconciliation – Book Side (cont’d)

4. Interest income
Company earns interest on certain types of accounts  Add interest
income on the book reconciliation.
5. Nonsufficient funds (NSF) cheques
NSF cheques are cash receipts from customers for which there are
not enough funds in the bank to cover the amount  Subtract NSF
cheques on the book reconciliation.
6. Cost of printed cheques
This cash payment is handled like a service charge. Subtract this
cost.
7. Book errors
Correct all book errors on the Book side of the reconciliation.
• Ex: You may have recorded a $150 cheque as $510.

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 Summary of Reconciling Items

BANK BALANCE BOOK BALANCE

Add Add
• deposits in transit • bank collections
• EFT receipts
• interest revenue
Subtract Subtract
• outstanding cheques • EFT payments
• services charges
• NSF cheques
Add or subtract Add or subtract
• correction of bank errors • correction of book errors
Adjusted bank balance equals Adjusted book balance

15
 Bank Reconciliation - Example
• In Exhibit 4-2 (page 180), the bank statement of Nixon Partners Inc.
shows an ending cash balance of $5,931.51.

• However, in Exhibit 4-3 (page 181) the company’s cash records

shows an ending cash balance of $3,294.21.

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 Bank Reconciliation – Example (cont’d)
Reconciliation Items
Panel A of Exhibit 4-4 on page 183

17
 Bank Reconciliation – Example (cont’d)

Bank Side:
1. Nixon Partners deposited $1,591.63 late on January 31, but the
bank will not learn of this until they open its overnight deposit box
on February 1.
2. The bank should not have recorded a withdrawal.
3. Nixon Partners have written cheques totalling $1,350.14, but the
bank is not aware of this yet.

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 Bank Reconciliation – Example (cont’d)
Book Side:
4. An automatic payment of $904.03 has been deposited into Nixon’s
account that they have not recorded yet.
5. A note receivable has matured and the cash has been deposited into
Nixon’s account. That is the $1,900.00 principle and $214.00 interest.
6. The bank has paid you $28.01 interest on the cash in Nixon’s account.
7. Nixon recorded a $510 decrease in their cash account when they wrote a
cheque for $150.00. That was $360 too much.
8. The bank charged Nixon $14.25 for the services it provided.
9. Nixon recorded an increase of $52.00 when it thought it had received
payment from a customer. The customer did not have sufficient funds to
cover the cheque that was submitted, so Nixon did not receive any cash.
10. The insurance company withdrew $361.00 from Nixon’s account that was
owed to them.

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 Bank Reconciliation – Example (cont’d)
Bank Reconciliation - Panel B of Exhibit 4-4 on page 183

Increase on Credit Side, and Decrease on Debit Side. 20

 Journalizing Bank Reconciliation Items
• All items on the book side of the bank reconciliation require
journal entries:

 If the item is added to book side

– Debit Cash
 If the item is subtracted from the book side
– Credit Cash
 NEVER record adjusting entries for any items listed on the bank
side of the reconciliation.

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 Bank Reconciliation – Example (cont’d)

JOURNAL
Date Accounts and explanation Debit Credit
4 Cash 904.03
Interest Revenue 904.03
To record interest earned on the bank statement
5 Cash 2,114.00
Note Receivable 1,900.00
Interest revenue 214.00
Note receivable collected by bank
6 Cash 28.01
Interest revenue 28.01
Interest earned on bank balance
7 Cash 360.00
Accounts payable 360.00
Correction of cheque no. 333

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 Bank Reconciliation – Example (cont’d)

JOURNAL
Date Accounts and explanation Debit Credit
8 Bank charge expense 14.25
Cash 14.25
Bank service charge
9 Accounts receivable – L. Ross 52.00
Cash 52.00
NSF customer cheque returned by bank
10 Insurance expense 361.00
Cash 361.00
Payment of monthly insurance

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 Mid-Chapter Summary Problem

• Carefully study the Mid-chapter summary problem on page 495.

• Then, try to solve it on your own without looking at the solution.

24
Learning Objective Three

Account for receivables

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 Receivables
• Receivables are the third most liquid assets after cash and short-
term investments on the balance sheet.
• Receivables are monetary claims against others.
• They are acquired mainly by:
1. selling goods and services (accounts receivable)
 Sometimes referred to as “trade receivables” or
“receivables”.
2. lending money (notes receivable)

 Notes receivable - A written promise to repay (conditions –

amount, time, interest’
3. other receivables - Advances to employees, Interest and
dividend receivable, Taxes receivable (e.g., Income tax, HST)

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 Notes Receivable (N/R)

• Notes receivable are more formal than accounts receivable

 The borrower signs a written promise to pay the lender a
definite sum at the maturity date, plus interest.
 Also called promissory notes.

• The note may require the borrower to pledge security for the loan.
 This means that the borrower gives the lender permission to
claim certain assets, called collateral, if the borrower fails to pay
the amount due.

27
 Accounts Receivable (A/R)

• Accounts receivable (A/R) are the amounts collectible from

customers from the sale of goods and services on account.

• The A/R account in the general ledger serves as a control account

that summarizes the total amount receivable from all customers.
 Subsidiary ledger: companies also keep a subsidiary record
of accounts receivable with a separate account for each
customer.

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Accounts Receivable and Subsidiary Ledger

Accounts Receivable
General Ledger
Subsidiary Ledger
Accounts Receivable Customer A
Balance 9,000 Balance 5,000

Customer B
Total Balance 1,000
$9,000

Customer C
Balance 3,000

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 Risks of Accounts Receivable

• By selling on credit, companies run the risk of not collecting some

receivables.

• The prospect of failing to collect from a customer provides the

biggest challenge in accounting for receivables.

• We will cover accounting for uncollectible accounts receivable (A/R)

in the next Learning Objective.

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Learning Objective Four

Estimate and account for uncollectible

accounts receivable

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 Uncollectible Accounts Receivable

• Accounts receivable arises when a company sells its product or

service on credit (on account) to its customers.
• Often, companies cannot collect all of their accounts receivables.
• Companies must account for their uncollectible accounts
receivable.

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 Benefits and Costs of Selling on Credit
Benefit of selling on credit
• Customers that do not have
cash available can buy on
credit.
• Thus, sales and profits
increase.
Cost of selling on credit
• Company cannot collect from
some customers.
• This cost is called
– bad debt expense,
– uncollectible-account
expense, or
– doubtful-account expense
• These expenses are reported on
the income statement.

So, extending credit should be based on the trade-off between

profit on additional sales vs. cost of additional bad debt.
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 Bad Debts and Bad Debts Expense

• Bad debts (a.k.a. uncollectible accounts or doubtful accounts) are

receivables that are uncollectible because some credit customers
will not pay the business the amounts they owe, regardless of
collection efforts.
• Bad debt expense is an expense associated with the failure to
collect receivables.

34
 Accounting for Bad Debts

There are two accounting methods to estimate bad debts:

1. Direct write-off method

 A specific customer's uncollectible account (in the
subsidiary ledger) is first identified and then Bad Debt
Expense is recognized.
 Does not meet the matching principle. Why?
 Dr to A/R Cr to Sales Revenue----after close the acn,
revenue is closed, realized the A/R uncollectable, but can
not match with the revenue any more.

2. The allowance method----just estimate, not the actual

amount( based on the past, not a fixed number)
 At the end of each period, estimate the amount of
uncollectible receivables (bad debts) and recognize Bad 35
 Allowance Method and Conceptual Framework
• Under the Allowance Method, a company records bad debt expense in
the same accounting period as its related credit sales revenue (the
matching principle).

• Company does not know which specific customers’ A/R will become
bad debt until future accounting periods.
• Since the actual amount of bad debts are not known with certainty at
period end, businesses record an estimate of the Bad Debt Expense
(E) and set up an Allowance for Doubtful Accounts (XA).

36
Allowance for Doubtful Accounts (XA) – Contra account
to A/R (A)

• Allowance for Doubtful Accounts (XA) is a contra-account to A/R

(A), which means it is deducted from A/R (A).
 It shows the amount of receivables the business does NOT
expect to collect.
 A/R(A) is an asset account  it is a debit balance account, thus
 Allowance for Doubtful Accounts (XA) is a credit balance
account.
• Other titles for this account are:
 Allowance for Bad Debts, and
 Allowance for Uncollectible Accounts.

37
 Net Realizable Value
• A/R is reported at net realizable value (NRV) on the balance sheet:
NRV = Accounts Receivable - Allowance for Doubtful Accounts
 NRV is the amount the company expects to collect from its
customers.
• The allowance for doubtful accounts can be disclosed in the notes to the
financial statements directly on the balance sheet as follows:

or
Partial Balance Sheet
Current assets:
Accounts receivable, less allowance of $5,000 $95,000
38
 The Allowance Method
Two ways to estimate the allowance for doubtful accounts:
1. Aging-of-receivables method.
- Also called the balance sheet approach because bad debt is
determined based on the A/R balance at period-end.

2. Percentage of credit sales method.

- Also called the income statement approach because bad
debt is determined based on the credit sales during the
period.

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 Estimating Bad Debts - Percentage of Credit Sales

Using this method, at each period end, bad debt expense is based
on an estimate of % of credit sales that will not be collected.
Example:
Company reports credit sales for the year of $300,000 and
estimates bad debts at 1.5% of net credit sales.
Est. uncollectible accounts (bad debts) expense:
$300,000 x 1.5% = $4,500
To record bad debts expense:
Bad debts expense (+E) 4,500
Allowance for Doubtful accounts (+XA) 4,500

40
Estimating Bad Debts – Aging-of-Receivables

Under this method, at each period end:

• The company analyzes customers’ A/R based on how long
they have been outstanding (i.e., aging schedule) to estimate
the doubtful accounts.
• Allowance for Doubtful Accounts (XA) is adjusted to the
estimated doubtful accounts amount from the aging schedule.

41
 Aging-of-Receivables Steps
1. Classify A/R by age of the receivables (i.e., number of days the
A/R has been outstanding).
2. For each age category, estimate the percentage of accounts that
will be uncollectible and apply this percentage to determine the
allowance amount.
3. Sum up the allowance amounts for each age category to obtain
the desired balance in the Allowance for Doubtful Accounts at
period end.
4. The difference between the desired balance obtained in Step
3 and the current balance in the Allowance for Doubtful
Accounts is recorded as a Bad Debt Expense via an AJE:

AJE Bad Debt Expense (+E) XXX

Allowance for doubtful accounts (+XA) XXX
42
 Aging-of-Receivables Steps (cont’d)
Days Past Due
Total A/R
Customer Not Yet Due 1-30 31-60 61-90 Over 90
Balance
Aaron, R. $ 235 $ 235
Step
Baxter, T. $ 1,200 300 1,500
1
Clark, J. $ 50 $ 200 $ 500 750
… … … … … …
Zak, R. 325 325
Total $ 3,500 $ 2,550 $ 1,830 $ 1,540 $ 1,240 $ 10,660
% Uncollectible 1% 4% 10% 25% 40% Step
Estimated
$ 35 $ 102 $ 183 $ 385 $ 496 $ 1,201
2
Uncoll. Amount

Desired balance in the Allowance for Doubtful Accounts

Step 3
at period end (Dec. 31, 2017)

Step 4: Record the Dec. 31, 2017 adjusting entry assuming that the
Allowance for Doubtful Accounts currently has a $100 credit
balance -> See next slide.

43
 Aging-of-Receivables Steps (cont’d)

Desired Ending Balance in Allowance for Doubtful

$1,201
Accounts at Period End
Current Credit Balance in Allowance for Doubtful
- $100
Accounts
Bad Debt Expense to be recognized at Period End $1,101

AJE to Record Bad Debt Expense Estimate at period end:

Dec.31, 2017 Bad Debt Expense (+E) $1,101

Allowance for doubtful accounts (+XA) $1,101

44
 Aging-of-Receivables Method – Example
• Suppose a company has 2 credit customers: Customer A , and
Customer B.
• Customers’ account balances are grouped by days outstanding.
• A percent uncollectible is estimated for each category—the older the
account, the less likely that the payment will be received.

Age of Account
Customer 1-30 days 31-60 days 61-90 days Over 90 days Total Balance
Customer A $1,500 $1,000 $0 $ 2,500 $5,000
Customer B 66,070 57,000 10,300 0 133,370
Totals $67,570 $ 58,000 $ 10,300 $ 2,500 $138,370
Est. % uncollectible × 2% × 5% × 10% × 35%
Allowance balance should be: $1,351 $2,900 $1,030 $875 $6,156

45
 Aging-of-Receivables Method – Example (cont’d)
• Assume A/R and Allowance for Doubtful Accounts had the following
balances before the period-end adjustment (i.e., before calculating
the aging method in previous slide):
Allowance for
Accounts Receivable (A) Uncollectible Accounts (XA)
Bal. 138,370 346

• From the aging-of-receivables method computed at period end

(previous slide), the company knows that the Allowance for
Doubtful Accounts should have the ending credit balance of
$6,156. It already has the a credit balance of $346.
 Adjustment needed to bring the credit balance from $346 to
$6,150 is $5,810.

46
 Aging-of-Receivables Method – Example (cont’d)
Age of Account
1-30 31-60 61-90 Over 90 Total
Customer days days days days Balance
Customer A $1,500 $1,000 $0 $ 2,500 $5,000
Customer B 66,070 57,000 10,300 0 133,370
Totals $67,570 $ 58,000 $ 10,300 $ 2,500 $138,370
Est. % uncollectible × 2% × 5% × 10% × 35%
Allowance balance $1,351 $2,900 $1,030 $875 $6,156
should be:

Allowance for Uncollectible Accounts

Assume beg. credit balance 346
before adjustment
5,810 Adjustment needed ($6,156 - $346)
$6,156 Ending balance should equal $6,156
obtained above

• Let’s look at the journal entry on the next slide.

47
 Aging-of-Receivables Method – Example (cont’d)

• AJE to record Bad Debt Expense at period end:

Bad Debt Expense (+E) ($6,156-$346) 5,810

Allowance for Doubtful Accounts (+XA) 5,810

• Note the balance for A/R and Allowance for Doubtful Accounts after
AJE. There is no change to the gross A/R amount:

Allowance for
Accounts Receivable Uncollectible Accounts
346
Bal 138,370
AJE 5,810
Bal 6,156
48
 Writing Off Uncollectible Accounts

When a specific customer account is deemed uncollectible with

a known amount:
 Specific customer A/R account is reduced (credited) to
remove it from the books, and
 Allowance for Doubtful Accounts is also reduced (debited) for
that specific amount.

JE Allowance for doubtful accounts (-XA) XXX

Accounts Receivable (-A) XXX

49
 Writing Off Uncollectible Accounts – Impact of
Write-Off
Journal Entry to write-off an uncollectible account:

JE Allowance for doubtful accounts (-XA) XXX

Accounts Receivable (-A) XXX

 Notice that writing off uncollectible accounts does not

affect total assets, current assets, and net accounts
receivable.
 It also does not affect net income. Why?
• Because it does not affect an expense account.
• Under the allowance method, expenses are recognized
in the period in which the related sales took place.(debit
bad debt expense account before, not at thie period)

50
 Writing Off Uncollectible Accounts – Example (cont’d)

• Continuing from the example on slides 47-50: Assume the company

has determined that $900 of the accounts receivable is uncollectible.
• The entry write off this uncollectible account is:

JOURNAL
Date Accounts Debit Credit
Allowance for Uncollectible Accounts (-XA) 900
Accounts Receivable (-A) 900

Allowance for Uncollectible

Accounts Receivable Accounts
Bal. $138,370 $900 $900 Bal. $6,156
Bal. $137,470
Bal. $5,256

51
 Impact of Write-Off – Example (cont’d)

• Notice that the net accounts receivable balance does not change
after the write-off.
Partial Balance Sheet – Before Write Off
Current assets:
Accounts receivable $138,370
Less: Allowance for uncollectible accounts (6,156)
Accounts receivable, net $132,214

Partial Balance Sheet – After Write Off

No
Current assets:
change
Accounts receivable $137,470
Less: Allowance for uncollectible accounts (5,256)
Accounts receivable, net $132,214

52
 Recovery of an Uncollectible Account
• Although an account has been written off as uncollectible, the
customer still owes the money and will sometimes pays off the
account in full or in part after the company has deemed it
uncollectible.
• When such a recovery occurs, the company makes 2 JEs:
1. To reverse the earlier write-off
Accounts Receivable (+A) XXX
Allowance for Doubtful Accounts (+XA) XXX

2. To record the cash collection

Cash (+A) XXX
Accounts Receivable (-A) XXX

53
 Summary - Allowance Method AJE and JEs

In sum, the allowance method involve the following journal entries:

Bad Debt Expense (AJE at period end):

Bad Debt Expense (+E, -RE) XXX

Allowance for Doubtful Accounts (+XA) XXX

Write-Off Uncollectible Amounts (JE):

Allowance for Uncollectible Accounts (-XA) XXX

Accounts Receivable (-A) XXX

Recovery of a Bad Debt (JE):

Accounts Receivable (+A) XXX

Allowance for doubtful accounts (+XA) XXX
Cash (+A) XXX
Accounts Receivable (-A) XXX
54
 Computing Cash Collections from Customers
• For most companies, there is a time lag between earning the income and
collecting the cash. Collections from customers are the single most
important source of cash for any business.
• One can compute a company’s collections from customers by analyzing
its A/R account if you know the opening and ending A/R, the write-offs and
sales on credit.
Beginning A/R Balance + Sales on Credit – Write-off of Uncollectible
Amounts – Collections from Customers = Ending A/R Balance

Accounts Receivable
Beginning balance 200 Write-offs of uncollectibles 100

Sales on credit 1,800 Collections from X?

customers
Ending balance 400

Answer: $200 + $1,800 – $100 – X = $400  X = $1,500

55
Learning Objective Five

Account for notes receivable

56
 Notes Receivable

• Notes receivable are more formal than accounts receivable.

• Notes receivable due within one year or less → current assets.
• Notes due beyond one year → long-term assets.
• Some notes receivable are collected in installments.
 The portion due within one year is a current asset and the
remainder is long-term asset.

57
 Notes Receivable

Key terms:
Creditor Party to whom money is owed; Lender
Debtor Party that borrowed and owes money; Maker, borrower
Interest Cost of borrowing money; stated as annual percentage rate
Maturity date Date when debtor must pay the note
Principal Amount borrowed by debtor
Term Length of time the debtor has to repay the note

• Two parties to a note:

(1) creditor, and
(2) debtor
• The principal amount of the note is the amount borrowed by the
debtor, lent by the creditor.
• Interest is revenue to the creditor and expense to the debtor.
58
 Notes Receivable - Example

This 6-month note receivable is issued July 1, 2017 and matures Dec.
31, 2017, when Lauren Halland (the maker) promises to pay Canadian
Western Bank (the creditor) the principal of $1,000 plus 9% interest.

59
Accounting for Notes Receivable – Example (Cont’d)

• Consider the promissory note on the previous slide: after Lauren Halland
signs the note, Canadian Western Bank gives her $1,000 cash. The
bank’s entry on July 1 would show an increase to Notes Receivable and a
decrease to Cash.
Note Receivable (+A) – L.Holland 1,000
Cash(-A) 1,000

• Assume the bank has an Oct. 31 year-end. The bank earns interest
revenue during July - Oct. At Oct. 31, 2017 the bank accrues interest
revenue of $30 ($1,000 × 9% × 4/12) for 4 months.
[Interest = Principal x interest rate x time factor in annual terms]
Interest Receivable (+A) 30
Interest Revenue (+R, +SE) 30

60
Accounting for Notes Receivable – Example (Cont’d)

• The bank collects the note on Dec. 31, 2017 and debits Cash
account, and credits Notes Receivable for the principal, Interest
Receivable to zero out the amount balance, and Interest Revenue
to record interest revenue accrued in Nov. and Dec.

Cash (+A) 1,045

Note Receivable (-A) – L.Holland 1,000
Interest Receivable (-A) 30
Interest Revenue (+R, +SE) 15

because bank has a year end at Oct 31, so it doesn't has the chance
accrul the interset revenue for Nov and Dec.

61
Learning Objective Six

Explain how to improve cash flows from

sales and receivables

62
 Rapid Cash Flow

• Companies want quick cash receipts because this affects their

ability to pay off current liabilities and make investments (e.g., new
products, new technology, R&D, etc…)
• Thus, companies develop strategies to shorten the credit cycle and
collect cash more quickly such as:
1. Credit card sales
2. Debit card sales
3. Selling (Factoring) Receivables

63
 Credit Card Sales

• Credit card sales may drastically increase sales but the added revenue
comes at a cost:
 Credit card company charges the retailer 2%-3% of the sale
amount
• At the time of the sale, the credit card company automatically credits
the merchant’s account for the sale proceeds, net of their fees.
• Ex: Suppose a company sells products for $5,000, and the customer
pays with a VISA card. Company records sales as follows (JE):

2% of sale
JOURNAL
Date Accounts Debit Credit
Cash (+A) 4,900
Credit Card Fee (+E, -RE) 100
Sales Revenue (+R, +RE) 5,000
64
 Debit Card Sales
• Similar to credit card sales, debit card sales increase sales but the
added revenue comes at a cost:
 The bank charges the retailer, for example $1 per transaction.
• At the time of the sale, the bank transfers money into the merchant’s
account for the sale proceeds, net of the processing fee.
• Suppose a company sells products for $70.30 and the customer
pays with a debit card. The company records sales as follows (JE):

JOURNAL
Date Accounts Debit Credit
Cash (+A) 69.30
Interac fee (assumed rate) (+E, -RE) 1.00
Sales Revenue (+R, +RE) 70.30

65
 Selling (Factoring) Receivables

• A company may sell its Accounts Receivable to another business,

called a factor.
• Factor pays discounted price.
 Benefit to company  Immediate cash
 Disadvantage to company  Expense and loss of control over
collection process

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 JE for Selling Receivables (Factoring)
• Suppose a company wants to speed up cash flow and therefore
sells $100,000 of accounts receivable, receiving cash of $95,000.
 $5,000 is the financing expense for the company.
• The company record the sale of the receivables as follows:
JOURNAL
Date Accounts Debit Credit
Cash (+A) 95,000
Financing expense (+E, -RE) 5,000
Accounts Receivable (-A) 100,000

revenue already recognized, so credit account receivable.

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Learning Objective Seven

Evaluate a company’s liquidity

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 Liquidity Measures

• We covered current ratio in Ch. 3 as a measure of liquidity.

Current ratio = current assets / current liabilities

• In this chapter we cover two more liquidity measures:

1. Acid test (quick) ratio, and
2. Days’ Sales in Receivables

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 Acid-Test (or Quick) Ratio

• Acid test ratio is a more stringent liquidity measure than the

current ratio.
• It is similar to the current ratio but it excludes inventory and
prepaid expense in the numerator. Why?
• Inventory is not as readily convertible to cash as some of the
other current assets as it takes time to sell inventory.
• Prepaid expense does not represent future cash inflows, but
rather an advance payment of future expenses.
• The higher the acid-test ratio, the better the business is able to
pay its current liabilities.

Cash + Short-term investment + Net receivables

Acid-test ratio =
Total current liabilities

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 Days’ Sales in Receivables

• After a business makes a credit sale, the next step is to collect the
receivable.
• Days’ sales in receivables (or collection period) tells a company
how long it takes to collect its average level of receivables.
• Shorter is better because it indicates that cash is collected more
quickly and therefore, the better the business is able to pay its bills
and expand its operations.

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 Days’ Sales in Receivables
Days’ sales in receivables can be computed in two logical steps:
1. Compute A/R turnover (number of times per year that a business
collects its average A/R)

A/R turnover = Net Sale

Average Net A/R

Where Average Net A/R = (Beginning net A/R + Ending net A/R)/2
*Ideally, net sales represent only credit sales because cash sales
do not give rise to A/R
2. Divide 365 days by the A/R turnover to compute the days’ sales in
receivables (number of days to collect the average A/R)

365 days
Days Sales in Receivables =
A/R turnover
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 Short Exercise 4-16 (page 211)
1. Compute Botany’s acid-test ratio at the end of 2017. How does it
compare with the industry average of 0.95?
2. Compare Botany’s days’ in receivables measure for 2017 with
company’s credit terms of net 30 days?
2017 2016
Current Assets
Cash 9,000 7,000
Short-term Investments 12,000 10,000
Accounts Receivables 60,000 54,000
Less allowance for uncollectibles (5,000) 55,000 (5,000) 49,000
Inventory 170,000 172,000
Prepaid Insurance 1,000 1,000
Total Current Assets 247,000 239,000
Total Current Liabilities 80,000 70,000
Net Sales 803,000 750,000
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 Short Exercise 4-16 (page 211) – Q1 Solution

Q1: Acid-test ratio for 2017?

Cash + Short-term investment + NRV

Acid-test ratio =
= Total Current Liabilities

$9,000 + $12,000 + $55,000 = 0.95

Acid-test ratio =
$80,000

Thus, it is in line with the industry average of 0.95.

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 Short Exercise 4-16 (page 211) – Q2 Solution

Q2: Days’ in sale receivables for 2017?

Net Sales $803,000

A/R turnover = = 15.44
Average Net A/R $52,000
=

365 days 365

Days Sales in Receivables = = = 23.64
A/R turnover 15.44

Thus, the days’-sales-in-receivables ratio of 23.6 is favorable

relative to the 30-day period credit terms.

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