Study Notes on Cash and Receivables
Cash and Receivables - Chapter 7 Study Notes
Cash and Cash Equivalents
LO7.1
Cash:
Definition: Amounts readily available to pay off debt or to use in operations.
Examples:
Currency and coins
Balances in checking accounts
Deposits such as checks and money orders received from customers
Cash Equivalents:
Definition: Investments that have a maturity date no longer than three months from the date of purchase.
Examples:
Money market funds
Treasury bills
Commercial paper
Disclosure of Cash Equivalents: Walgreens Boots Alliance, Inc.
LO7.1
Companies have flexibility in designating cash equivalents.
Note 1: Summary of Major Accounting Policies (excerpt):
Statement: "Cash and cash equivalents include cash on hand and highly liquid investments with an original maturity of three months or less. Credit and debit card receivables, which generally settle within one to seven business days, of $127 million and $146 million were included in cash and cash equivalents at August 31, 2022 and 2021, respectively."
Internal Control
LO7.1
Definition:
Internal Control: Systematic processes designed to ensure adherence to company policies and operational effectiveness, minimize errors and theft, and enhance reliability and accuracy of accounting data.
Sarbanes-Oxley Act (Section 404)
Requirements:
Companies must document internal controls and assess their adequacy
Auditors must express an opinion on management’s assessment
Committee of Sponsoring Organizations (COSO)
Defines internal control as a process designed to provide reasonable assurance regarding the achievement of objectives in three categories:
Effectiveness and efficiency of operations
Reliability of financial reporting
Compliance with applicable laws and regulations
Internal Control Procedures for Cash Receipts
LO7.1
Separation of duties in the cash receipts process:
Employee A opens the mail and prepares a multicopy listing of checks including the amount and payor’s name.
Employee B takes the checks, along with one copy of the listing, to the individual responsible for depositing the checks.
A second copy of the check listing is sent to the accounting department where Employee C records the receipts into the accounting records.
Internal Control Procedures for Cash Disbursements
LO7.1
Objective: Prevent unauthorized payments and ensure proper recording of disbursements.
Important elements:
All disbursements should be made by check
All expenditures should be authorized
Checks should be signed only by authorized individuals
Concept Check: Internal Control Systems
LO7.1
Question: Which of the following is not an element of a good internal control system for cash receipts and disbursements?
a. Maintaining a separation of duties
b. Ensuring all checks are signed by authorized individuals
c. Having the most senior employee handle cash disbursements and bank reconciliations
d. Making disbursements with checks rather than cashCorrect Answer: c. Individuals with physical responsibility for cash or assets should not have access to accounting records.
Restricted Cash
LO7.2
Definition: Cash that is restricted in some way and not available for current use.
Specific Purpose Example: Cash reserved for future plant expansion.
Contractually Imposed Example: Debt instruments requiring the borrower to set aside funds.
Classification:
If Debt → Noncurrent; then Restricted cash → Noncurrent.
If Debt → Current; then Restricted cash → Current.
Compensating Balances
LO7.2
Definition: An amount that compensates the bank for granting the loan or extending the line of credit.
The borrower is asked to maintain a specified balance in a low or noninterest-bearing account.
Required balance equals a percentage of the committed loan amount.
Borrowers pay an effective interest rate that is higher than the stated rate on the debt.
Concept Check: Effective Interest Rates
LO7.2
Problem: Jenks borrowed $13,000,000 at a 10% interest rate, requiring a $3,000,000 compensating balance. What is the effective interest rate?
a. 7.7%
b. 10%
c. 13%
d. 23%
Correct Answer: c. Calculation:
Annual interest paid =
Effective interest rate =
IFRS—Cash and Cash Equivalents
LO7.10
US. GAAP vs IFRS:
Overdrafts treated as liabilities under US. GAAP
IFRS allows overdrafts to be offset against other cash accounts
IFRS requires assets and liabilities to be stated separately on balance sheet
Example: LaDonia Company
Two cash accounts as of December 31, 2027:
National Bank: $300,000
Central Bank: ($15,000)
US GAAP Reporting:
Cash Asset: $300,000
Current Liability: $15,000
IFRS Reporting:
Cash Asset: $285,000
Current Receivables
LO7.2
Definition: Receivables represent a claim to the future collection of cash, other assets, or services.
Accounts Receivable:
Result from the sale of goods/services on account (credit sales).
Nontrade Receivables:
Include tax refund claims, interest receivable, and advances to employees.
Note Receivable:
Refers to trade or nontrade receivables accompanied by a formal promissory note.
Accounts Receivable
LO7.2
Generated when sellers recognize revenue from credit sales.
Performance obligation is satisfied at delivery.
Revenue and receivable are recognized at that time.
Properties:
Most businesses extend credit to customers through informal arrangements supported by an invoice, usually due in 30-60 days.
Classified as current assets due to their collection period being part of operating cycle.
Initial Valuation of Accounts Receivable
LO7.2
Sellers recognize revenue equal to the amount they are entitled to receive when satisfying a performance obligation.
Allocate transaction price to various performance obligations in a contract. - Complexities:
Time value of money
Variable consideration
Trade Discounts and Sales Discounts
LO7.3
Trade Discounts:
A percentage reduction from the list price, often given to large purchases.
Sales Discounts:
Reductions in payment amount provided to incentivize quick payments.
Example term: 2/10, n/30—2% discount if paid within 10 days, otherwise full payment due in 30 days.
Gross Method versus Net Method
LO7.3
Gross Method:
Record accounts receivable at the total sales price.
Net Method:
Record accounts receivable at the amount expected to be collected, considering discounts.
Example: Hawthorne Manufacturing Company
Sales on October 5:
Amount: $20,000
Gross Method Journal Entry:
Debit Accounts Receivable: $20,000
Credit Sales Revenue: $20,000
Net Method Journal Entry:
Debit Accounts Receivable:
Credit Sales Revenue: $19,600
Concept Check: Sales Discounts
LO7.3
Question: Which of the following is not true about recording sales discounts?
a. The gross method records discounts taken when payment occurs during the discount period.
b. The net method records discounts not taken as sales discounts forfeited.
c. Net sales revenue is higher under the gross method than under the net method.
d. Net sales revenue is the same under both methods.Correct Answer: c. Net revenue is actually the same under both methods.
Sales Returns
LO7.4
Merchandise returned by customers can be refunded or credited.
An allowance may encourage purchases instead of returns.
Sales returns and allowances must be accrued at the time of sale to avoid income distortion.
Example: Impact of Recognizing Returns
LO7.4
Scenario: Merchandise sold for $10,000, costing $6,000, with returns all occurring in the next period.
2027 Gross Profit: $4,000 (overstated)
2028 Gross Profit: Understated due to return impact
Effects:
Assets overstated by $4,000 in 2027.
Accounting for Sales Returns
LO7.4
Example: Hawthorne Manufacturing’s sales of $2,000,000 result in $200,000 of expected returns due to a 10% estimate. During the year, $130,000 was actually returned.
Sales Revenue Entry:
Debit Cash $2,000,000
Credit Sales Revenue $2,000,000
Cost of Goods Sold:
Debit Cost of Goods Sold: $1,200,000
Credit Inventory: $1,200,000
Returning Process in Accounting
LO7.4
During 2027 - Sales Returns:
Debit Sales Returns $130,000
Credit Cash $130,000
Debit Inventory $78,000 (60% of $130,000 COGS)
Credit Cost of Goods Sold $78,000
Estimating Returns
LO7.4
At year-end, Hawthorne estimates $70,000 in returns for the following year. Adjusting for $42,000 estimated cost of returns (60% of $70,000):
Debit Sales Returns $70,000
Credit Refund Liability $70,000
Debit Inventory—Estimated Returns $42,000
Credit Cost of Goods Sold $42,000
Changes in Estimated Returns
LO7.4
Adjustments for any changes in estimated returns must be made in the following period to reflect accurate accounts.
Subsequent Valuation of Accounts Receivable
LO7.5
Entitlement to payment does not guarantee collection.
Methods:
Direct Write-Off Method: Not allowed under GAAP, postpones recognition of bad debts and likely overstates accounts receivable.
Allowance Method: Required under GAAP, utilizes a contra-asset account to represent expected uncollectible accounts.
Allowance Method
LO7.5
Bad Debt Expense: Recognized earlier than actual write-offs.
Hawthorne Manufacturing Example:
Sales: $1,200,000
Collections: $895,000
Accounts Receivable: $305,000
Analysis of receivables expected to collect: $280,000, thus establishing an allowance of $25,000.
Journal Entry:
Debit Bad Debt Expense $25,000
Credit Allowance for Uncollectible Accounts $25,000
When Accounts Are Deemed Uncollectible
LO7.5
Example of writing off accounts receivable for uncollectible amounts using the allowance account.
Concept Check: Uncollectible Accounts
LO7.5
Green Valley Steel: Sales of $1,000,000 and analysis of anticipations for uncollectible amounts lead to setting up an allowance; entries to confirm should be made.
Journal Entries to recognize allowance for uncollectible accounts must follow the net statement approach.
Estimating the Allowance for Uncollectible Accounts
LO7.6
Balance Sheet Approach:
Base bad debt expense on expected carrying values of accounts.
CECL Model: Estimates used must consider all relevant information.
Age-Based Approach
LO7.6
Utilize an aging schedule to assess asset collection and set allowances effectively.
International Financial Reporting Standards—Accounts and Notes Receivable
LO7.10
Differences between US GAAP and IFRS related to reevaluating receivables
Emphasis on the control and risk-reward transfer.
Financing with Receivables
LO7.8
Secured Borrowing:
Accounts receivable pledged as collateral while retaining the responsibility for collections.
Sale of Receivables:
Assets sold at a gain or loss just like any other assets.
Factoring Receivables:
Definition: Selling accounts receivable to a financial institution (the factor) that handles collection and payment liabilities.
Sale Without Recourse
LO7.8
Buyer assumes the risk of bad debts on sales of receivables.
Example of Accounts Receivable Factoring Without Recourse
LO7.8
Santa Teresa Glass Co: Sold $600,000 in AR and collected 90% immediately, making adjustments and recognizing received amounts in journal entries.
Sale With Recourse
LO7.8
Retain risk of bad debts and adjust accordingly when recognizing losses.
Concept Check: Factoring Receivables
LO7.8
Assuring proper transactions and recordings focus on which conditions apply to receivables management.
Bank Reconciliation
Appendix 7A
It is critical for cash control, comparing bank balances with company records, addressing discrepancies via recognized transactions, errors, or timing delays.
Steps for Bank Reconciliation
Adjust the bank balance to the corrected cash.
Adjust the book balance to match corrected cash.
Petty Cash System
Appendix 7A
Functionality: A small amount of cash maintained for minor transactions.
Establishing Petty Cash: Pay a set amount to the custodian for operational convenience.
Example: Initial petty cash setup of $200 with transactions recorded periodically.
Example of Petty Cash Transactions
Appendix 7A
Illustrating cash replenishment and disbursement journal entries reflecting operations for petty cash management.