Cash and Receivables Notes
Chapter 7: Cash and Receivables
Cash and Cash Equivalents (LO7.1)
Cash:
Refers to amounts readily available to pay off debts or to use in operations.
Examples: Currency and coins, balances in checking accounts, and deposits such as checks and money orders received from customers.
Cash Equivalents:
Defined as short-term investments that are readily convertible to cash and have a maturity date of no longer than three months from the date of purchase.
Examples: Money market funds, treasury bills, and commercial paper.
Disclosure of Cash Equivalents—Case Study: Walgreens Boots Alliance, Inc. (LO7.1)
A company has flexibility in designating its cash equivalents. One such example from Walgreens Boots Alliance, as per Note 1 in the summary of major accounting policies, states:
"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, were included in cash and cash equivalents at August 31, 2022, amounting to $127 million and $146 million for the years 2022 and 2021, respectively."
Internal Controls (LO7.1)
Internal Control:
A framework designed to encourage adherence to company policies and procedures.
Aims to promote operational efficiency, minimize errors and theft, and enhance the reliability and accuracy of accounting data.
Sarbanes-Oxley Act (Section 404) Requirements
Requires companies to document their internal controls and assess their adequacy.
Auditors are required to express an opinion on management’s assessment regarding the internal controls.
Committee of Sponsoring Organizations (COSO) Framework
Defines internal control as a process that provides reasonable assurance regarding the achievement of objectives in:
Effectiveness and efficiency of operations.
Reliability of financial reporting.
Compliance with applicable laws and regulations.
Internal Control Procedures—Cash Receipts (LO7.1)
Separation of Duties:
Step 1: Employee A opens the mail daily and prepares a multicopy listing of all checks received, including amounts and payor’s names.
Step 2: Employee B takes the checks, along with a copy of the listing, to the designated person for depositing in the bank.
Step 3: The second copy of the listing is sent to the accounting department, where Employee C enters the receipts into the accounting records.
Internal Control Procedures—Cash Disbursements (LO7.1)
Objective: To prevent unauthorized payments and ensure proper recording of disbursements.
Key Elements:
All disbursements should be made by check.
All expenditures need to be authorized.
Checks are to be signed only by authorized personnel.
Restricted Cash (LO7.2)
Definition: Cash that is restricted in some manner and not immediately available for use.
Types of Restrictions:
Specific Purpose Restrictions: Funds set aside for future plant expansion, for example.
Contractually Imposed Restrictions: Certain debt instruments require the borrower to set aside funds, classified based on the debt type:
Noncurrent: If the debt is long-term.
Current: If the debt is short-term.
Compensating Balances (LO7.2)
Defined as an amount that compensates a bank for granting a loan or extending a line of credit.
Under this arrangement:
Borrowers are required to maintain a specified balance in a low-interest or non-interest bearing account at the bank (the creditor).
The required balance equals some percentage of the loan committed.
Borrowers end up paying an effective interest rate higher than the stated rate on the debt.
IFRS versus U.S. GAAP on Cash and Cash Equivalents (LO7.10)
Overdraft Treatment: Under U.S. GAAP, overdrafts are treated as a liability whereas under IFRS, overdrafts may be offset against other cash accounts.
Balance Sheet Reporting: U.S. GAAP states that assets and liabilities should be presented separately, whereas IFRS allows for net reporting of liabilities against cash accounts.
Example from LaDonia Company:
As of December 31, 2027, LaDonia has two cash accounts:
National Bank: $300,000
Central Bank: ($15,000) (overdraft)
Under U.S. GAAP, LaDonia’s balance sheet on 12/31/27 would show a cash asset of $300,000 with a current liability of $15,000. Under IFRS, it would report a net cash asset of $285,000.
Current Receivables (LO7.2)
Definition: Receivables represent claims to cash, other assets, or services in the future.
Types of Receivables:
Accounts Receivable: Result from sales of goods or services on credit (also known as credit sales).
Nontrade Receivables: Includes receivables other than those related to trade, such as tax refund claims, interest receivable, and advances to employees.
Notes Receivable: Refers to trade or nontrade receivables that are accompanied by a formal promissory note.
Accounts Receivable (LO7.2)
Created when sellers recognize revenue from a credit sale: the performance obligation is satisfied at point of delivery.
Accounts receivable are informal credit arrangements supported by invoices, typically due within 30 to 60 days after the sale and classified as current assets.
Initial Valuation of Accounts Receivable (LO7.2)
Sellers recognize revenue equal to the amount they are entitled to receive for their performance obligations.
The transaction price is allocated across performance obligations and recognized once satisfied.
Potential Complexities: Include time value of money and variable consideration.
Trade Discounts and Sales Discounts (LO7.3)
Trade Discounts: These refer to percentage reductions from the list price and may be quantity discounts to large customers.
Sales Discounts: Reduce the amount a credit customer must pay if payment is made within a specified period, incentivizing prompt payments.
An example of sales discount could be expressed as "2/10, n/30" meaning a 2% discount if paid within 10 days; otherwise, full payment is due within 30 days.
Gross Method versus Net Method (LO7.3)
Example: The Hawthorne Manufacturing Company offers a 2% sales discount for payment within 10 days. On October 5, it sold merchandise for $20,000.
Gross Method Journal Entry:
Debit: Accounts Receivable $20,000
Credit: Sales Revenue $20,000
Net Method Journal Entry:
Debit: Accounts Receivable $19,600 (calculated as $20,000 × 98%)
Credit: Sales Revenue $19,600
Payment with Discount (Example) (LO7.3)
On October 14, the customer paid $13,720 (which is $14,000 - 2%).
Gross Method Journal Entry:
Debit: Cash $13,720
Debit: Sales Discounts $280
Credit: Accounts Receivable $14,000
Net Method Journal Entry:
Debit: Cash $13,720
Credit: Accounts Receivable $13,720
Payment Not Within Discount Period (Example) (LO7.3)
Remaining balance of $6,000 was paid on November 4.
Gross Method Journal Entry:
Debit: Cash $6,000
Credit: Accounts Receivable $6,000
Net Method Journal Entry:
Debit: Cash $6,000
Credit: Accounts Receivable $5,880
Credit: Sales Discounts Forfeited $120
Gross Method versus Net Method Summary (LO7.3)
Sales Revenue Overview:
Under the gross method, total sales revenue is higher due to recording potential discounts.
Net method typically better reflects the actual amount expected to be received by considering that customers often take discounts when available, which can result in higher cash flow from operations.
Sales Returns (LO7.4)
Defined as merchandise returned by customers either for a refund or credit. Often, allowances are provided to encourage customers to keep the merchandise instead of returning it.
The accrual of sales returns and allowances should occur at the time of the sale to avoid overstated income in the period of sale, which would otherwise be corrected in the return period.
Recognizing Returns (Example) (LO7.4)
If merchandise sold for $10,000 has a cost of $6,000 and is returned, then:
In 2027 (when sold), $4,000 gross profit is recognized.
In 2028, when returns occur, gross profit would decrease by $4,000.
This also impacts asset valuation, causing assets to be overstated in 2027 and understated in 2028.
Accounting for Sales Returns (LO7.4)
For instance, Hawthorne Manufacturing Company recorded $2,000,000 in sales, with an estimated 10% return:
Total Expected Sales Returns: $200,000.
Actual Returns: $130,000 occurred in the reporting year.
Total Revenues: $2,000,000 with cost of goods sold at $1,200,000 recorded accordingly.
Sales Returns Journal Entry:
Debit: Sales Returns $130,000
Credit: Cash/Accounts Receivable $130,000
Debit: Inventory $78,000 (cost on returns, calculated as $130,000 × 60%)
Credit: Cost of Goods Sold $78,000
Estimation of Future Sales Returns (LO7.4)
If expected future returns at the year-end are $70,000, the anticipated cost of that inventory return is $42,000:
Journal Entries:
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)
If in future periods, the estimate changes (for example, from $70,000 to $60,000), entries must factor in the new net estimates to balance the projections and liabilities.
The necessary adjustments entail:
Adjust the Refund Liability accordingly.
Adjust the Inventory-Estimated Returns likewise to reflect accurate valuations.
Accounting for Bad Debts (LO7.5)
As accounts receivable may not be collectible, companies must recognize this credit loss: Bad debts are an inherent cost of extending credit.
Methods of Accounting:
Direct Write-Off Method (Non-GAAP): Waiting until specific accounts become uncollectible to write them off, which can overstate accounts receivable prior to the write-off.
Allowance Method (GAAP): Utilizing a contra-asset account allowing for the estimation and representation of receivables to the value expected to be collected.
The estimated uncollectibles become the basis for recognizing bad debt expenses early in the accounting process rather than adjusting after write-offs.
Allowance Method Overview (LO7.5)
Allows the creation of an Allowance for Uncollectible Accounts, which reduces the carrying value of accounts receivable to the expected collectable amount on the balance sheet.
Companies present both the gross amount of accounts receivable and the allowance on the balance sheet:
Example Accounting Presentation:
2022: Accounts Receivable Trade, net of Allowances - $203 million (2021: $230 million).
Recognizing Allowance for Uncollectible Accounts (LO7.5)
A real-world application details Hawthorne's receivables where total sales are $1,200,000. After estimating collections likely to be $280,000. A journal entry to establish the allowance would show:
Debit: Bad Debt Expense $25,000
Credit: Allowance for Uncollectible Accounts $25,000
Specific Write-Offs (LO7.5)
If in April 2028 Hawthorne determines that $15,000 is uncollectible, a journal entry would reflect this:
Debit: Allowance for Uncollectible Accounts $15,000
Credit: Accounts Receivable $15,000.
When Accounts Are Reinstated (LO7.5)
If recovery occurs and a previously written-off amount is collected, the initial write-off is reversed through:
Debit: Accounts Receivable $1,200
Credit: Allowance for Uncollectible Accounts $1,200.
Estimating Allowances for Uncollectible Accounts (LO7.6)
Balance Sheet Approach: Companies estimate the ending balance required for the Allowance for Uncollectible Accounts, adjusting through bad debt expenses as necessary to achieve that balance.
CECL Model: Considers historical experiences, current conditions, and forecasts for assessing credit losses. This evaluation could include:
Analyzing each customer account individually.
Applying a general percentage to outstanding receivables based on age.
Accounts Receivable Aging Schedule (Example) (LO7.6)
A sample aging schedule categorizes each receivable based on days outstanding:
Evaluation of estimated uncollectible percentages leads to determining the total allowance required, such as 5% for fresh receivables and 40% for very old accounts. An example computation may yield an overall estimated allowance of $25,000 based on cumulative evaluations.
Notes Receivable (LO7.7)
Classified into current or noncurrent based on expected collection dates:
Less than a year signifies a short-term note, while more than a year represents a long-term note.
Interest-Bearing Notes (LO7.7)
Defined as notes that require interest payments:
Casual calculation where the interest earned = Face Amount × Annual Rate × Fraction of Annual Period.
Example: Stridewell Wholesale Shoe Company sells goods for a $700,000 note at 12% for 6 months. The interest is due at maturity, calculated as $700,000 × 12% × (6/12) = $42,000.
Noninterest-Bearing Notes (LO7.7)
Although labeled noninterest-bearing, these notes have implicit interest:
Interest is discounted from the face amount upfront.
Depicts the contra account for future interest revenue.
Example Promissory note for $700,000 translating to cash sales price of $658,000 indicates the effective interest rate paid by calculating the difference between proceeds and face value.
Long-Term Notes Receivable (LO7.7)
Involves stipulations for loaning amounts plus interest over a designated period.
Accounting for the Financing of Receivables (LO7.8)
Secured Borrowing: Pledging accounts receivable as collateral for a loan; responsibilities for collection stay with the borrower.
Sale of Receivables: Sold at values subject to gains or losses, treated similarly to the sale of asset transactions.
Disclosure of Receivables Used as Collateral (LO7.8)
Necessary for a company to disclose arrangements clearly in financial statements.
Example: A line of credit might detail terms allowing borrowing against designated receivables.
Factoring Without Recourse (LO7.8)
A factoring arrangement where the risk of bad debts is transferred to the factor, not allowing the seller to reclaim funds.
Example Journal Entry: Sale of receivables may include recognition of a cash receipt, factoring fee, and any losses encountered from the sale.
Sale of Receivables—Discounting (LO7.8)
A method of obtaining immediate cash by pledging or selling notes receivable.
Conditions and procedural evaluations dictate whether proceeds are treated as acknowledged sales or secured loans.
Transfers of Notes Receivable—Discounting (LO7.8)
To illustrate, when Stridewell discounts a note at a bank, it accrues interest earned up to the discounting date, then deducts the applicable discount from maturity value to obtain cash proceeds.
Measuring and Reporting Accounts Receivable (LO7.6)
Recognition: Typically upon the sale and receipt of goods/services.
Initial Valuation: Recorded based on the fair consideration entitled to the seller (subject to discounts).
Subsequent Valuation: Adjusted through allowance for uncollectible accounts to reflect the collectable amount.
Classification: Most frequently classified as current assets.
International Financial Reporting Standards vs. U.S. GAAP on Receivable Recognition (LO7.10)
Emphasizes the control shift of asset recognition focusing on overall control from the seller to the buyer. Adequate disclosure on terms is paramount for clarity in financial statements.
Examples of Ratios for Receivables Management: Include receivables turnover ratio and average collection period ratios to evaluate receivables efficiency.
Bank Reconciliation Appendix (Appendix 7A)
A critical tool for cash control; compares the bank's records with internal records to note discrepancies due to timing errors or bank processing delays.
Steps for Bank Reconciliation (Appendix 7A)
Adjust the bank balance:
Add deposits outstanding and deduct checks outstanding to arrive at the corrected balance.
Adjust the book balance:
Add collections made known through bank interactions and deduct service charges or NSF checks.
Ensure both balances match the final corrected figures.
Example—Hawthorne Manufacturing Company (Appendix 7A)
Balance as of May 1, 2027, is $32,120, with additional adjustments detailed involving service charges and check discrepancies.
The reconciliation concludes with verified totals of both sides of accounts balancing.
Petty Cash Handling (Appendix 7A)
Establishment of petty cash accounts for minor expense management promotes efficiency and expedites operational processes.
Documentation for usage must highlight proper entries to represent expenditure tracking.