Chapter 7: Cash and Receivables - Comprehensive Notes

Chapter 7: Cash and Receivables – Comprehensive Study Notes

Cash and Cash Equivalents

Cash consists of amounts readily available to pay off debt or to use in operations. Examples include currency, coins, checking account balances, and deposits such as checks and money orders received from customers. Cash equivalents are investments with original maturities of three months or less from the date of purchase, such as money market funds, treasury bills, and commercial paper. A company’s policy often states that cash equivalents have a maturity date of three months or less. Walgreens Boots Alliance’s disclosure illustrates the flexibility in designating cash equivalents, and major policy summaries state that cash and cash equivalents include cash on hand and highly liquid investments with short maturities; credit and debit card receivables are generally settled within one to seven business days and may be included in cash and cash equivalents (e.g., $127 million in 2022 and $146 million in 2021). extCash=extcashonhand+extcheckingbalances+extdepositsreceivedext{Cash}= ext{cash on hand} + ext{checking balances} + ext{deposits received} extCashEquivalents=extmaturity≤3extmonthsexamples=extmoneymarketfunds,exttreasurybills,extcommercialpaperext{Cash Equivalents}= ext{maturity} \le 3 ext{ months} \text{examples}= ext{money market funds}, ext{treasury bills}, ext{commercial paper}

IFRS vs US GAAP on overdrafts and cash presentation is also discussed. Under IFRS, overdrafts can be offset against other cash accounts and presented net, while under US GAAP overdrafts are typically reported as current liabilities unless there is a specific offset arrangement. An example contrasts LaDonia Company’s presentation: under US GAAP, cash would be $300,000 and overdraft $15,000; under IFRS, cash could be $285,000 when overdrafts are netted. ext{Overdrafts (IFRS vs US GAAP)}:
ext{US GAAP: Cash} = 300{,}000, ext{ Overdraft} = 15{,}000;
ext{IFRS: Cash} = 285{,}000.

Internal Control

Internal control objectives include adhering to company policies and procedures, promoting operational efficiency, minimizing errors and theft, and enhancing the reliability and accuracy of accounting data. The Sarbanes-Oxley Act (Section 404) requires that a company document its internal controls and assess their adequacy, and that auditors express an opinion on management’s assessment. The Committee of Sponsoring Organizations (COSO) defines internal control as a process designed to provide reasonable assurance about achieving objectives in three categories: (1) effectiveness and efficiency of operations, (2) reliability of financial reporting, and (3) compliance with laws and regulations. LO7-1.

Internal control procedures for cash receipts emphasize separation of duties. Step 1: Employee A opens mail daily and prepares a multicopy listing of all checks with amounts and payor names. Step 2: Employee B takes checks and listing to the person responsible for deposit. Step 3: A second listing copy goes to the accounting department where Employee C records receipts. This separation helps prevent errors and theft and supports accurate accounting. LO7-1

Internal control procedures for cash disbursements stress that all disbursements should be made by check, expenditures authorized, and checks signed only by authorized individuals. The objective is to prevent unauthorized payments and ensure proper recording. LO7-1

Restricted Cash and Compensating Balances

Restricted cash is cash that is restricted in some way and not available for current use. Examples include funds set aside for future plant expansion or funds required by debt covenants. When debt covenants impose a restricted cash balance, it may be noncurrent if debt is noncurrent or current if debt is current. Compensating balances are balances maintained at a bank as compensation for lending and effectively raise the interest rate on the borrowing. The cited example shows that if a borrower obtains a $10,000,000 loan at 12% but must maintain a $2,000,000 compensating balance, the effective interest rate becomes extEffectiverate=10,000,000imes0.1210,000,000−2,000,000=0.15=15ext%.ext{Effective rate}=\frac{10{,}000{,}000 imes 0.12}{10{,}000{,}000-2{,}000{,}000}=0.15=15 ext{\%}. LO7-2.

IFRS vs US GAAP – Cash and Overdrafts (IFRS/GAAP) – Appendix

IFRS permits offsetting overdrafts against other cash accounts under certain conditions and requires separation of assets and liabilities on the balance sheet, whereas US GAAP typically presents overdrafts as current liabilities. This affects reported cash and net cash position under the two frameworks. LO7-10

Current Receivables and Accounts Receivable

Current receivables are claims to future cash, other assets, or services. Accounts receivable arise from credit sales; nontrade receivables are other receivables such as tax refund claims, interest receivable, and advances to employees. A note receivable is a receivable supported by a formal promissory note. LO7-2.

Accounts receivable (AR) are created when sellers recognize revenue on credit sales; delivery satisfies performance obligations, and revenue and AR are recognized at that time. ARs are typically informal credit arrangements supported by invoices and usually due in 30 to 60 days, and they are classified as current assets because collection is part of the operating cycle. LO7-2, LO7-3.

Initial Valuation of Accounts Receivable and Revenue Considerations

Revenue recognition involves recognizing revenue in an amount the seller is entitled to receive in exchange for satisfying a performance obligation. The transaction price is allocated to performance obligations and recognized as revenue when obligations are satisfied. Potential complexities include the time value of money and variable consideration. LO7-2.

Trade Discounts, Sales Discounts, and the Gross vs Net Method

Trade discounts reduce the list price; sales discounts (such as 2/10, n/30) are offered to encourage quick payment. The notation 2/10, n/30 means a 2% discount if paid within 10 days; otherwise the net amount is due within 30 days. LO7-3.

Gross Method vs Net Method

Under the Hawthorne Manufacturing example, a credit sale of $20,000 with terms 2/10, n/30 can be recorded using either method:

  • Gross method: AR $20,000; Sales revenue $20,000. If paid within the discount period, the discount is recorded when cash is received.
  • Net method: AR $19,600 (i.e., $20,000 × 98%), Sales revenue $19,600, reflecting the expected net amount.
    The gross method recognizes revenue at the gross amount, while the net method reflects the expectation of discount take-up. For payment within the discount period, the gross method would result in recognizing a separate Sales Discounts account when cash is received. The net method typically provides a more accurate depiction of expected receipts. LO7-3, LO7-4.

For 2/10, n/30, the incentive return from taking the discount can be analyzed: paying $98 to save $2 over 20 days yields a return of approximately ext{Return}= rac{2}{98} imes 100\% ext{ for 20 days} \approx 2.04 ext{ ext{%}}. Annualizing this return gives 2.04 ext{ ext{%}} imes rac{365}{20} \approx 37.23 ext{ ext{%}}. LO7-3.

Sales Returns and Allowances

Sales returns occur when merchandise is returned for a refund or credit. An allowance may be provided as a price reduction to encourage customers to keep merchandise. Returns and allowances should be estimated and accrued at the time of sale to avoid overstating income in the period of sale.
LO7-4.

Accounting for Sales Returns and Allowances (Returns) – Examples

If a company expects returns, it estimates and records a liability (for refunds or credits) and an associated reduction in revenue and inventory as appropriate. For example, in Hawthorne’s 2027 operations with $2,000,000 sales and 10% expected returns ($200,000), actual returns occurred at $130,000. Entries include recognizing Sales Returns of $130,000, adjusting Cash/Inventory and Cost of Goods Sold accordingly, and recording the related liability for estimated returns ($70,000) with an inventory reserve and related COGS adjustments. detailed schedules show entries such as:

  • Sales returns $130,000; Inventory $78,000; Cost of goods sold $78,000; Cash $2,000,000; Sales revenue $2,000,000; Cost of goods sold $1,200,000. LO7-4.

At year-end, additional expected returns (e.g., $70,000) require a liability (Refund liability) and an adjustment to Inventory–Estimated Returns of $42,000 with associated COGS adjustments. In subsequent periods (e.g., 2028), actual returns may differ, prompting adjustments to the Allowance for Uncollectible Returns and related accounts. LO7-4.

If actual returns differ from estimates, the accounting for changes in estimates is applied in the period of change (e.g., in 2028, actual returns were $60,000 instead of $70,000, leading to Journal Entries to adjust the Refund liability and Sales returns and Inventory–Estimated Returns). LO7-4.

Estimates of Uncollectible Accounts (CECL) and Valuation Methods

Uncollectible accounts are an inherent cost of granting credit. Two primary accounting approaches exist for estimating uncollectible accounts: (1) Direct Write-Off Method (not GAAP) and (2) Allowance Method (GAAP). The allowance method uses a contra-asset account, Allowance for Uncollectible Accounts, to reduce AR to the amount expected to be collected. Bad debt expense is recognized through the allowance approach before specific accounts are written off. LO7-5.

Direct Write-Off Method (Not GAAP)

This method delays recognizing bad debt expense until an account is deemed uncollectible and is written off. It tends to overstate AR before write-offs and distorts net income by postponing bad debt expense. GAAP requires the allowance method for material amounts. LO7-5.

Allowance Method (GAAP)

This method uses a contra-asset account (Allowance for Uncollectible Accounts) to reduce AR to the cash expected to be collected. The allowance is established through a bad debt expense entry, and specific write-offs later reduce both AR and the allowance. Hawthorne example illustrates: beginning AR $305,000; expected to collect $280,000, thus allowance needed $25,000. Journal entry: Bad debt expense 25,000; Allowance for uncollectible accounts 25,000. LO7-5.

End-of-Year Estimation under the Balance Sheet Approach (CECL)

The CECL model requires estimating the expected credit losses for all receivables using relevant information (historical data, current conditions, and reasonable forecasts). Estimation techniques include analyzing each account, applying percentages to the aging of AR, or applying different percentages by aging category. The Balance Sheet Approach bases the bad debt expense on the required ending balance of the allowance. The CECL model emphasizes timely recognition of expected credit losses. LO7-6.

Aging of Accounts Receivable (Balance Sheet Approach)

An aging schedule estimates expected losses by the aging category. For example, if AR balance is $400,000 and expected collectibility is $360,000, the allowance should be $40,000. A journal entry debits Bad Debt Expense $28,800 and credits Allowance for Uncollectible Accounts $28,800 to bring the pre-adjustment balance of $11,200 to the required $40,000. LO7-6, LO7-5, LO7-6.

Income Statement Approach

Bad debt expense is estimated directly as a percentage of net credit sales. Example: if 2027 net credit sales were $1,200,000 and the historical bad debt rate is 2%, Bad debt expense would be 2ext%imes1,200,000=24,000.2 ext{\%} imes 1{,}200{,}000 = 24{,}000. Journal entry: Bad debt expense 24,000; Allowance for uncollectible accounts 24,000. LO7-6.

Combined Approaches

A company may use a quarterly income statement approach and refine estimates with the balance sheet approach at year-end. This results in adjustments to the allowance and bad debt expense. LO7-6.

Measuring and Reporting Accounts Receivable

Recognition of AR generally occurs at the point of revenue recognition; initial valuation records AR at the amount of consideration the seller is entitled to receive, adjusted for cash discounts and variable consideration. Subsequent valuation reduces AR by the allowance for uncollectible accounts, presenting AR net of the allowance. AR is almost always classified as a current asset. Notes receivable are classified as current or noncurrent depending on when collection is expected. LO7-6, LO7-7, LO7-42.

Notes Receivable – Classification and Types

Notes receivable are formal credit arrangements that can be short-term or long-term. They may bear interest or be noninterest-bearing. Short-term notes bearing interest are measured at face amount and interest revenue as it accrues. Noninterest-bearing notes are discounted at issuance, with the difference recognized as interest revenue over time, and the note carried at its face value for accounting purposes with a discount account representing the unrecognized interest. LO7-7, LO7-8.

Short-Term Interest-Bearing Notes

Interest on notes is calculated as extInterest=extPrincipalimesextAnnualRateimest12ext{Interest} = ext{Principal} imes ext{Annual Rate} imes \frac{t}{12} where t is the fraction of the year in months. Example: a $700{,}000 note at 12% for 6 months yields 700,000imes0.12imes612=42,000.700{,}000 imes 0.12 imes \frac{6}{12} = 42{,}000. Entries include recording notes receivable and revenue at the time of sale, and at maturity recognizing cash and interest revenue. LO7-7.

The Stridewell Case – Short-Term Noninterest-Bearing Notes (Discounted Notes)

Noninterest-bearing notes have an implicit interest that is discounted from the face amount to determine the cash proceeds. For a $700{,}000 note with a cash price of $658{,}000, the discount is 700,000−658,000=42,000.700{,}000 - 658{,}000 = 42{,}000. The initial entry records Notes receivable (face amount) $700,000, Discount on notes receivable $42,000, and Sales revenue $658,000. The discount is recognized over time as interest revenue, and the cash collection at maturity reflects the face amount. The effective interest rate for the holder over the 6-month period can be calculated as ext{Effective six-month rate} = rac{42{,}000}{658{,}000} ext{ (approximately } 6.383 ext{ ext{%})}. Annualizing yields approximately 6.383 ext{ ext{%}} imes 2 \approx 12.766 ext{ ext{%}}. LO7-7, LO7-8.

Long-Term Notes Receivable

Long-term notes are recorded at the present value of their cash flows or at face value with a discount that amortizes over time. The Stridewell example shows a $700{,}000 two-year note with a 12% effective interest rate. The present value (PV) of the note, calculated as extPV=700,000(1+0.12)2=558,036,ext{PV}=\frac{700{,}000}{(1+0.12)^2}=558{,}036, leads to a discount of 700,000−558,036=141,964.700{,}000-558{,}036=141{,}964. Revenue is recognized initially as the difference between the face value and the present value, with the remainder creating the discount on notes receivable. Interest revenue is recognized over time and the note is carried at its face value on settlement. LO7-7.

If a company holds notes solely for cash (not as part of a sale), the transaction is recorded as a simple note receivable and cash equal to the note’s face value is exchanged. LO7-7.

Subsequent valuation of notes receivable follows CECL, using all relevant information and forecasting to estimate credit losses, often using discounted cash flow methods or aging-based approaches similar to AR. LO7-7, LO7-54.

Financing and Transfer of Receivables – Pledges, Assignments, and Sales

Financing receivables can involve pledging accounts receivable as collateral for a loan (secured borrowing) or selling receivables (true sale). In a pledge arrangement, the entire AR balance is pledged, but the company retains collection responsibility and no special accounting treatment is required beyond disclosures. In a sale, the seller removes the receivables from its balance sheet, records a gain or loss, and may have continuing involvement or recourse depending on the terms. LO7-8.

Secured Borrowing – Pledging vs Assigning

Pledging involves using AR as collateral while the company continues to collect and remit; no transfer of ownership is recorded. Assigning receivables is similar to a mortgage on a home; the lender may collect or the borrower may continue to collect depending on terms, with finance charges and interest payments recorded. LO7-8.

Assignment of Accounts Receivable – Santa Teresa Example

Santa Teresa borrows $500,000 and assigns $620,000 AR as collateral. A finance charge of 1.5% of the assigned AR is recorded, equating to $9,300. Interest at 12% on note payable is paid monthly. When cash is collected, entries reflect cash receipt and remittance to the lender, with recognition of the finance charge. The journal entry on December 1 reflects cash received ($490,700), finance charge expense ($9,300), and notes payable ($500,000). LO7-60.

Sale of Receivables – Factoring and Securitization

A sale of receivables transfers ownership of AR to a buyer (factor) who may charge a fee. A sale can be without recourse (buyer bears bad debt risk) or with recourse (seller retains risk and may be liable for losses). The sale is recorded by removing AR, recognizing any gain or loss, and recognizing consideration received from the buyer. LO7-64, LO7-65, LO7-66.

Factoring Arrangements – With and Without Recourse

With recourse, the seller retains the risk of uncollectible accounts and must account for a recourse liability. Without recourse, the buyer bears the risk of nonpayment and the receivable is derecognized without exposing the seller to future losses. Example entries show cash received (90% of AR), a financing fee, and the net effect on AR and the recourse liability if present. LO7-65, LO7-69.

Transfers of Notes Receivable – Discounting

Notes can be discounted at a financial institution for immediate cash, either by pledging the note as collateral or by selling the note. The cash received equals the maturity value minus a financing fee. LO7-70.

Disclosures and IFRS/GAAP Differences in Transfers of Receivables

Disclosures must explain the transfer, continuing involvement, risks, fair value estimates, cash flows, and ongoing accounting for transferred assets. IFRS focuses on whether control has shifted; under the sale approach, control is transferred, while if control remains, the transfer is a secured borrowing. In practice, the accounting treatment (sale vs secured borrowing) depends on whether control has transferred and the transfer terms. LO7-77, LO7-78.

Receivables Management Ratios

Decision-makers monitor receivables using key ratios: the receivables turnover ratio and the average collection period. The formulas are:
extReceivablesturnoverratio=extNetsalesextAverageaccountsreceivable(net)ext{Receivables turnover ratio}=\frac{ ext{Net sales}}{ ext{Average accounts receivable (net)}}
extAveragecollectionperiod=365extReceivablesturnoverext{Average collection period}=\frac{365}{ ext{Receivables turnover}}

Examples include NortonLifeLock, Broadcom, Gen Digital, and Broadcom, where accounts receivable and net sales are used to compute turnover and collection periods. LO7-9.

Bank Reconciliation (Appendix 7A)

A bank reconciliation compares the company’s cash records with the bank statement to identify timing differences, errors, and other discrepancies. The steps include:

  • Step 1: Adjust the bank balance to the corrected cash balance by adding deposits in transit, subtracting outstanding checks, and correcting bank errors.
  • Step 2: Adjust the book balance for items unknown to the bank, such as collections by the bank, bank service charges, NSF checks, and company errors.

The corrected balances from Steps 1 and 2 must agree. An example shows a Hawthorne Manufacturing Co. reconciliation with a May 31, 2027 corrected cash balance of $33,129 after adjusting for deposits in transit, outstanding checks, service charges, and NSF checks. The bank’s records show the same corrected balance. LO7-81 to LO7-87.

Additional Appendix items cover petty cash: establishing a petty cash fund and replenishing it with expenses such as postage, office supplies, delivery charges, and entertainment. LO7-89, LO7-90, LO7-91.

End of Chapter 7 – Key Takeaways

  • Cash and cash equivalents are defined by liquidity and short maturity, with policies allowing certain receivables (e.g., card receivables) to be included. LO7-1.
  • Internal control and SOX/COSO frameworks guide procedures to safeguard cash and ensure reliable accounting data. LO7-1.
  • Cash receipts and disbursements require segregation of duties and authorization controls. LO7-1.
  • Restricted cash and compensating balances affect financing costs and effective interest rates. LO7-2.
  • IFRS vs US GAAP differences in cash overdrafts presentation and offsets lead to different balance sheet presentations. LO7-10.
  • Current receivables include AR, nontrade receivables, and notes receivable; AR is typically a current asset. LO7-2.
  • Discounts and allowances (trade discounts, sales discounts) affect the timing and amount of revenue recognition; gross vs net methods reflect different expectations of cash receipts. LO7-3.
  • Sales returns and allowances require accruals at the time of sale to avoid income distortion; subsequent adjustments reflect actual vs estimated returns. LO7-4.
  • Estimating uncollectible accounts uses CECL, with methods including aging (balance sheet) and income statement approaches; combined approaches are common. LO7-5, LO7-6.
  • Notes receivable include short-term interest-bearing notes, short-term noninterest-bearing notes (discounted), and long-term notes; recognition, discounting, and interest revenue follow standard rules. LO7-7, LO7-8.
  • Transfers of receivables include secured borrowing, sale/assignment, securitization, nor recourse vs with recourse in factoring arrangements, with various journal entries and disclosures. LO7-8, LO7-64 to LO7-69.
  • Receivables management ratios ( turnover and average collection period) are used to monitor liquidity and credit risk. LO7-9.
  • Bank reconciliation is a critical tool for cash control, with a structured process to reconcile bank and book balances. LO7-81 to LO7-88.
  • Petty cash is a small, on-hand cash pool replenished periodically to cover small expenditures. LO7-89 to LO7-91.

This set of notes consolidates the major and minor points from the transcript, including key definitions, policy guidelines, illustrative numerical examples, and the procedural steps relevant to cash and receivables management, all formatted for quick study and review.