Chapter 6- Cash, Accounts Receivable, and Internal Controls

Why is cash considered the most important asset?

• Cash is the most liquid asset

• used to pay obligations

• buy inventory

• invest

• operate

• without it, a company cannot function

What are cash equivalents?

Short-term, Highly liquid investments with maturity ≤3 months; easily convertible to cash.

How is foreign currency cash reported?

Converted to Canadian dollars at the reporting date using the current exchange rate.

What is the purpose of a bank reconciliation?

• Ensure cash per books = cash per bank

• adjust for deposits in transit

• outstanding cheques

• bank errors

• NSF cheques

• fees

What are outstanding cheques?

• Payments a business has written, recorded in its books, but not yet cleared or cashed by the bank

• subtracted from the bank statement balance

What are deposits in transit?

• Funds recorded in a company’s books but not yet processed by the bank

• added to the bank statement balance

What are bank service charges?

• Fees charged by banks for account maintenance or transactions

• require a journal entry: Debit Bank Charges Expense, Credit Cash

What are NSF cheques?

• "Non-sufficient funds" cheques returned by the bank

• require a journal entry: Debit Accounts Receivable, Credit Cash.

Journal entry for a $50 bank service fee?

Debit Bank Charges Expense $50, Credit Cash $50.

What does Accounts Receivable represent?

Amounts owed by customers from credit sales; current asset; future cash inflow.

Carrying amount of Accounts Receivable?

Total receivables – Allowance for Expected Credit Losses.

Why do companies sell on credit?

To increase sales, stay competitive, and sometimes earn interest.

What is the Allowance Method?

• Estimates bad debts each period

• matches expense with revenue

• required by GAAP

Journal entry for estimated credit losses of $1,000?

Debit Credit Loss Expense $1,000, Credit Allowance for Expected Credit Losses $1,000.

Write-off uncollectible account of $500?

Debit Allowance for expected credit losses $500, Credit A/R $500.

How to calculate expected credit losses using aging method?

Group receivables by age, multiply each by estimated % uncollectible, sum totals.

Expected credit loss example: $2,000 (1%), $500 (10%)?

$2,000 × 1% + $500 × 10% = $20 + $50 = $70.

What is Factoring Receivables?

• Selling A/R to another company to get cash immediately

• with recourse = seller liable

• without recourse = factor bears risk

How do sales discounts (2/10, n/30) affect A/R?

• Encourages early payment

• speeds up cash inflow

• reduces A/R balance

• shortens collection period

A/R Turnover Formula?

Credit Sales ÷ Average Accounts Receivable

Average Collection Period Formula?

365 ÷ A/R Turnover.

• indicates days to collect receivables.

Current Ratio Formula & Purpose?

Current Assets ÷ Current Liabilities

• measures overall short-term liquidity

• no interest

Acid-Test/Quick Ratio Formula & Purpose?

(Cash + Short-term Investments + Net Current Receivables) ÷ Total Current Liabilities

• focuses on immediate liquidity

• excludes inventory & prepaids

Relationship between A/R Turnover and Average Collection Period?

Inverse relationship; higher turnover → shorter collection period; lower period = better liquidity.

What are internal controls?

Policies & procedures to safeguard assets, ensure accurate reporting, and promote operational efficiency.

Key principles of internal control?

• Physical controls

• assignment of responsibilities

• separation of duties

• independent verification

• proper documentation

If credit sales = $100,000 and estimated bad debt % = 2% what is the expected credit loss expense?

Credit Loss Expense = $100,000 × 2% = $2,000.

Difference between Indirect & Direct Method?

• Indirect: starts with net income → adjusts non-cash & working capital changes

• Direct: lists actual cash inflows/outflows from operations

What is included in cash management?

• Physical cash

• bank deposits

• cash equivalents

• ensure liquidity

• proper valuation

How do you handle company book errors in reconciliation?

Correct via journal entry in the accounting books.

What is an EFT collection?

Electronic Funds Transfer received from a customer; increases cash and reduces A/R.

Example journal entry for EFT received?

Debit Cash, Credit Accounts Receivable for payment received electronically.

What is the purpose of liquidity ratios?

Assess short-term ability to meet obligations using current assets.

Why is the allowance method preferred over direct write-off?

• Matches bad debt expense to revenue

• GAAP compliant

• better reflects expected losses

What are limitations of internal controls?

• Human error

• collusion

• management override

• cost vs benefit

• changing circumstances

How do you correct a cheque error where $320 was recorded instead of $230?

Debit Cash $90, Credit Advertising Expense $90.

What is a Notes Receivable (N/R)?

• A written promise to pay a specific sum plus interest at a future maturity date

• formal, longer-term than A/R

Journal entry when issuing a note receivable?

Debit Notes Receivable, Credit Cash (or A/R if converting).

Journal entry to accrue interest on a note receivable?

Debit Interest Receivable, Credit Interest Revenue.

Journal entry when collecting a note receivable at maturity?

• Debit Cash

• Credit Notes Receivable, Credit Interest Revenue

How do you calculate interest on a note?

Interest = Principal × Rate × Time (fraction of year). Example: $1,000 × 9% × 4/12 = $30.

How can a company speed up cash conversion?

• Accept credit cards → speeds up inflow

• Offer early payment discounts (2/10, n/30) → reduces collection days

• Factor receivables → converts A/R to cash immediately.

How is bank interest income recorded?

Debit Cash or Interest Receivable, Credit Interest Revenue.

How is the cost of printed cheques recorded?

Debit Office Expense (or Bank Charges), Credit Cash.

How does recording bad debt affect financial statements?

• Decreases net income (via expense)

• reduces A/R carrying amount

• indirectly impacts cash flow

Formula for Average Daily Sales?

Average Daily Sales = Net Sales ÷ 365

Formula for Days’ Sales in Receivables?

Days’ Sales = Average A/R ÷ Average Daily Sales

Interpretation of Days’ Sales in Receivables?

• Compare to credit terms

• fewer days → faster collections → better liquidity

How do you adjust the allowance for expected credit losses?

• Adjustment = Desired allowance – Existing allowance

• Journal example: Debit Credit Loss Expense, Credit Allowance

How are adjustments applied in bank reconciliation?

Add to bank statement:

• deposits in transit

• bank errors that understate (record lower than actual amount)

Subtract from bank statement:

• outstanding cheques

• bank errors that overstate (record higher than actual amount)

What is the Aging Method?

• Based on age of Accounts Receivable

• More precise

• Balance sheet focus

• Estimates ending Allowance for Doubtful Accounts balance

What is the % of Sales Method?

• Based on sales (usually credit sales)

• Income statement focus

• Estimates bad debt expense for the period

Direct Write-Off Method

• Records expense only when account is known uncollectible

• No estimation

• Not GAAP unless immaterial

• Can distort income between periods

Does the allowance for expected credit losses affect actual cash collected?

• No

• It’s an estimate for accounting purposes

Who should prepare the bank reconciliation?

A person not involved in day-to-day banking activities to maintain separation of duties.

Do write-offs under the allowance method reduce net income?

• No

• write-offs only reduce A/R and the Allowance

How does recovery of a previously written-off receivable affect net income?

• No effect on net income

• adjust Allowance and Accounts Receivable

• then record cash collection

Which items require adjusting entries in company books?

• Bank service charges

• NSF cheques

• EFT receipts

• book errors

• interest income

• printed cheque costs

Do outstanding deposits require an adjusting entry in the company books?

• No

• they are already recorded in the books

• adjustment is only on the bank side

Do outstanding cheques require an adjusting entry in the company books?

• No

• they are subtracted from the bank balance

How do write-offs, recoveries, and credit losses affect net income?

• Write-offs (allowance method) → no effect

• Recoveries → no effect

• Estimated credit losses → reduce net income

What does a higher accounts receivable turnover indicate?

• Faster collection of receivables

• better liquidity

• shorter average collection period

What can a high current ratio indicate?

May indicate:

• inefficient asset management

• excessive cash

• overly high inventory

Which items are NOT reconciling items for the bank?

Interest collected on a note by the bank if already recorded in company books does not need adjustment.

When is the direct write-off method acceptable?

• When expected credit losses are immaterial

• otherwise GAAP requires the allowance method

Where are individual customer account details tracked?

• Subledger

• the control account shows the total A/R balance on the general ledger

Recording recovery of previously written-off A/R

• Debit A/R, Credit Allowance

• then record cash collection:

• Debit Cash, Credit A/R