Chapter 7: Cash and Receivables – Study Notes

Cash and Receivables – Study Notes (Chapter 7)

  • Chapter focus: Cash, cash equivalents, internal controls, receivables (accounts and notes), methods of valuation, discounts and returns, uncollectible accounts, and transfers of receivables.

Cash and Cash Equivalents

  • Cash definitions: cash on hand; funds readily available to pay debts or fund operations.

  • Cash examples: currency and coins; checking accounts; deposits such as checks and money orders received from customers.

  • Cash Equivalents: investments with original maturity ≤ 3 months from purchase.

  • Cash equivalents examples: money market funds, Treasury bills, commercial paper.

  • LO7-1

Disclosure of Cash Equivalents (Illustrative Note: Walgreens Boots Alliance)

  • Companies have flexibility to designate cash equivalents.

  • Major policy note: Cash and cash equivalents include cash and highly liquid investments with original maturity ≤ 3 months.

  • Example data from Walgreens Boots Alliance (as of Aug 31, 2022 and 2021) include card receivables settling within 1–7 business days and included in cash and cash equivalents: amounts of $127M and $146M, respectively.

  • LO7-1

Internal Control

  • Purpose of internal control:

    • Encourage adherence to policies and procedures.

    • Promote operational efficiency.

    • Minimize errors and theft.

    • Enhance reliability and accuracy of accounting data.

  • SOX (Section 404): requires documentation of internal controls and an assessment of their adequacy; auditors express an opinion on management’s assessment.

  • COSO: defines internal control as a process designed to provide reasonable assurance regarding achievement of objectives in: (i) effectiveness and efficiency of operations; (ii) reliability of financial reporting; (iii) compliance with laws and regulations.

  • LO7-1

Internal Control Procedures—Cash Receipts

  • Segregation of duties in cash receipts process (key steps):

    • Step 1: Employee A opens mail daily and prepares a multicopy listing of all checks with amount and payor's name.

    • Step 2: Employee B takes checks and listing to depositary person for bank deposit.

    • Step 3: A copy of the listing goes to accounting (Employee C) to enter receipts into records.

  • LO7-1

Internal Control Procedures—Cash Disbursements

  • Key controls: all disbursements should be made by check; expenditures must be authorized; checks signed only by authorized personnel.

  • Objective: prevent unauthorized payments and ensure proper recording of disbursements.

  • LO7-1

Concept Check: Internal Control Systems

  • Question: Which is not an element of a good internal control system for cash receipts and disbursements?

  • Answer: c) Having the most senior employee handle cash disbursements and bank reconciliations.

  • Explanation: Individuals with physical responsibility for assets should not have access to accounting records or reconciliation duties.

  • LO7-1

Restricted Cash

  • Definition: cash restricted in some way and not available for current use.

  • LO7-2

  • Examples: funds set aside for future plant expansion; debt instruments that require set-aside funds.

  • Classification: restricted cash can be current or noncurrent depending on debt classification (e.g., debt instrument governs current vs noncurrent status).

  • 07-09

Compensating Balances

  • Definition: balance customer must maintain in a low-interest or non-interest-bearing account as compensation to the lender for a loan or line of credit.

  • Effect: increases effective interest rate above stated rate because the borrower ties up cash.

  • Formula: extEffectiverate=racextInterestpaidextNetproceedsborrowed=racextNominalrateimesextFacevalueextFacevalue−extCompensatingbalanceext{Effective rate} = rac{ ext{Interest paid}}{ ext{Net proceeds borrowed}} = rac{ ext{Nominal rate} imes ext{Face value}}{ ext{Face value} - ext{Compensating balance}}

  • Example: Borrow $10,000,000 at 12% with a $2,000,000 compensating balance. Effective rate = $(12 ext{%} imes 10,000,000) / (10,000,000 - 2,000,000) = 15 ext{%}$. LO7-2; 07-11

  • Concept Check: Jenks example (effective rate) illustrates the same principle.

  • LO7-2

IFRS vs U.S. GAAP – Cash and Cash Equivalents

  • IFRS vs US GAAP differences in handling overdrafts and presentation:

    • IFRS: sometimes allows offsetting overdrafts against other cash accounts; US GAAP generally does not.

    • CER: CECL model applies to expected credit losses in both standards for receivables.

  • LaDonia Company example: under US GAAP cash is reported gross, with an overdraft as current liability; under IFRS, overdraft may be offset and reported net cash position.

  • LO7-10

Current Receivables

  • Definition: receivables are claims to future cash, other assets, or services.

  • Accounts receivable: arise from credit sales; typically current assets due in 30–60 days.

  • Nontrade receivables: tax refunds, interest receivable, advances to employees.

  • Note receivable: receivable with a formal promissory note; can be trade or nontrade.

  • LO7-2; 07-14

Accounts Receivable

  • Creation: arises when sellers recognize revenue for credit sales; performance obligation satisfied at delivery; revenue and receivable recognized then.

  • In normal business, credit is extended to customers; AR supported by invoices; due in 30–60 days; usually current asset due in the operating cycle.

  • LO7-2; 07-15

Initial Valuation of Accounts Receivable

  • Revenue recognition: recognize revenue equal to amount seller is entitled to receive; allocate price to performance obligations; recognize revenue as performance obligations are satisfied.

  • Potential complexities: time value of money; variable consideration (e.g., discounts, returns).

  • LO7-2; 07-16

Trade Discounts and Sales Discounts

  • Trade discounts: percentage reductions from list price.

  • Sales discounts (cash discounts): reductions for early payment (e.g., 2/10, n/30).

  • LO7-3; 07-17

Gross Method vs Net Method (Sales Discounts)

  • Hawthorne example (2/10, n/30): If sold at $20,000 with 2% discount for payment within 10 days:

    • Gross Method:

    • Record AR $20,000; Sales revenue $20,000.

    • If paid within discount period, cash received is $13,720 and discounts of $280 are recorded; AR originally $14,000.

    • Net Method:

    • Record AR at net of discount: $19,600; Sales revenue $19,600.

    • If discount not taken, sales discounts forfeited (e.g., $120 in some cases) may be recognized later.

  • LO7-3; 07-18 to 07-21

Concept Check: Sales Discounts

  • Question: Which statement about recording sales discounts is not true?

  • Answer: Net sales revenue is the same under the gross method and the net method.

  • Explanation: Gross method yields $19,720 revenue; net method yields $19,720 revenue when including forfeited discounts, but the timing and recognition differ.

  • LO7-3; 07-22

Gross Method vs Net Method – Which is Correct?

  • Generally, revenue and AR should reflect the amount the seller expects to collect; net method often better reflects expected cash receipts because the discount is a savings customers may not forgo.

  • Effective return on cash forgone to save discount can be significant when early payment is used.

  • LO7-3; 07-23

Sales Returns and Allowances

  • Definition: returns and allowances reduce revenue; an allowance may be given to keep merchandise instead of returning it.

  • Important: accrue sales returns and allowances at the time of sale to avoid overstating income in the sale period.

  • LO7-4; 07-24

Recognizing Returns in the Period Return Occurs (Illustrative Example)

  • If merchandise sold for $10,000 with cost $6,000 in December and 2027 is the first year, recognizing returns affects gross profit in 2027 and 2028 depending on when returns occur.

  • LO7-4; 07-25

Accounting for Sales Returns – Hawthorne Example (2027–2028)

  • 2027 facts: $2,000,000 sales; COGS = $1,200,000 (60% of selling price).

  • Estimated returns expected: 10% of sales ($200,000).

  • 2027 actual returns: $130,000; journal entries for returns and their effect on inventory and COGS are shown.

  • 2027 ending: remaining estimated returns $70,000; inventory–estimated returns $42,000; refund liability $70,000; COGS $42,000.

  • 2028 actual returns: $70,000; entries include refund liability, cash, inventory, and COGS.

  • If actual returns differ from estimate, adjust in subsequent periods (change in estimate).

  • LO7-4; 07-26 to 07-30

Concept Check: Sales Returns – Five Dollar Stores (FDS)

  • Example and solution: Accrue remaining returns using estimated returns; calculation leads to a $2,000 accrual for the period (end of 2027).

  • LO7-31

Concept Check: Sales Returns – Estimates (FDS) – Related Inventory Adjustment

  • Determine cost of estimated returns: $1,200 (from $2,000 accrual at 60% cost of returns).

  • LO7-32

Subsequents Valuation of Accounts Receivable

  • Being entitled to payment does not guarantee collection; bad debts are a cost of extending credit.

  • Methods: Direct Write-Off (not GAAP) vs Allowance Method (GAAP).

  • CECL model: Current Expected Credit Losses: consider historical experience, current conditions, and forecasts.

  • LO7-5; 07-33

Direct Write-Off Method (Not GAAP)

  • Method: wait until account is uncollectible and write it off.

  • Not permitted under GAAP for most (except tax purposes); potential problems: AR overstated before write-off; income distorted.

  • Journal entry example: Bad debt expense debit; Accounts receivable credit.

  • LO7-5; 07-34

Allowance Method (GAAP)

  • Required when bad debts are material; use a contra-asset account: Allowance for uncollectible accounts to reduce AR to cash expected to be collected.

  • Balance sheet presentation shows AR net of allowance; the allowance account is shown on the balance sheet.

  • LO7-5; 07-35

Allowance Method (continued)

  • Bad debt expense is not recognized at the time of write-off; it is recognized earlier when the allowance is established; later, when a specific account is deemed uncollectible, the actual write-off reduces both the allowance and the AR.

  • Hawthorne example: 1/1/2027 beginning balance 0; 1,200,000 sales; 895,000 collections; 12/31/2027 AR 305,000; expected to collect 280,000; required allowance = 25,000; journal entry: Bad debt expense 25,000; Allowance for uncollectible accounts 25,000.

  • LO7-5; 07-37 to 07-38

Concept Check: Uncollectible Accounts

  • Example: Green Valley Steel – select the correct entries to set up allowance given ending balance needs and pre/post adjustments.

  • Correct answer demonstrates computation of ending allowance and corresponding bad debt expense.

  • LO7-6; 07-39 to 07-40

Measuring and Reporting Accounts Receivable

  • Recognition: revenue and AR generally recognized at delivery; initial valuation is the amount expected to be collected; includes cash discounts and variable consideration.

  • Subsequent valuation: AR reduced by allowance; AR shown at cash expected to be collected; Classification: typically current asset.

  • LO7-6; 07-49

Notes Receivable (LO7-7+) – Classification and Types

  • Classification: current vs noncurrent depending on expected collection date.

  • Creditor (lender) vs debtor (borrower) concepts; formal note terms.

  • Short-Term Interest-Bearing Notes: interest is computed on face amount; formula: extInterest=extFaceAmountimesextAnnualRateimesracextTimeinmonths12ext{Interest}= ext{Face Amount} imes ext{Annual Rate} imes rac{ ext{Time in months}}{12}

  • LO7-7; 07-50 to 07-51

Short-Term Interest-Bearing Notes (Example)

  • The Stridewell Wholesale Shoe Company note: $700,000, 6-month, 12% note; interest receivable at maturity; journal entries show revenue recognition and collection.

  • Year-end adjusting entries accrue interest as necessary.

  • LO7-7; 07-52 to 07-53

Interest-Bearing Notes (Continued) – Adjustments

  • End-of-period adjustments: accrue interest receivable; record interest revenue; later, when cash is received, remove receivable and recognize cash and interest.

  • 12/31/27 adjusting entry example: Interest receivable and Interest revenue entries; 2/1/28 cash and interest recorded; notes receivable removed at maturity.

  • LO7-7; 07-53

Short-Term Noninterest-Bearing Notes

  • Noninterest-bearing notes have implicit interest discounted from the face amount; the discount is a contra account to note receivable; cash proceeds at inception are less than face value.

  • LO7-7; 07-54

Noninterest-Bearing Notes (continued) – Example and Calculation

  • Example: six-month, $700,000 noninterest-bearing note; cash proceeds ≈ $658,000; discount = $42,000; interest revenue recognized over term; journal entries show discount on notes receivable and interest revenue;

  • Effective interest rate for the note is computed by comparing discount to cash proceeds and annualizing.

  • LO7-7; 07-55 to 07-56

Noninterest-Bearing Notes (Conclusion) – Year-end and Cash Collections

  • Presenting the cash proceeds and interest revenue; adjusting entries show recognition of interest and financing costs over the life of the note.

  • LO7-7; 07-57

Long-Term Notes Receivable (LO7-7)

  • Stridewell note example: $700,000 two-year note with 12% effective interest rate; the note is issued at a discount; interest revenue is recognized over time; present value of note at issue and subsequent interest accruals are shown.

  • Journal entries depict recognizing the note receivable, discount on note receivable, and interest revenue over time.

  • LO7-7; 07-58

Concept Check: Recording Sales Revenue (Finkel)

  • Four-year, noninterest-bearing note for $10,000; an equivalent loan with 10% interest rate yields: the correct answer is that sales revenue equals the present value of the note discounted at 10% for four years (i.e., the note’s selling price is the revenue recognized).

  • LO7-7; 07-59

Notes Received Solely for Cash

  • If notes are received as payment for cash loans, the entry records the note receivable at face value and cash exchanged.

  • LO7-7; 07-60

Subvaluation of Notes Receivable (CECL and Measurement)

  • Similar to accounts receivable, companies use an allowance for credit losses to reduce notes receivable to the expected cash realizable value; CECL guidance applies to notes as well.

  • LO7-7; 07-61 to 07-62

International Financial Reporting Standards (IFRS) – Transfers of Receivables (LO7-10)

  • IFRS focuses on whether control of assets has shifted; the transfer may be treated as a sale, secured borrowing, or as a sale if control is achieved.

  • CECL concept analogous to ECL for receivables.

  • LO7-10; 07-63 to 07-64

Financing with Receivables (LO7-8)

  • Pledging receivables as collateral for a loan: entire AR balance serves as collateral; no transfer of ownership; no special accounting treatment beyond disclosure.

  • Secured borrowing when the lender has a claim on receivables as collateral; sometimes the loan is secured by assigning specific receivables.

  • LO7-8; 07-64 to 07-67

Pledging and Assignment – Examples

  • Virco Mfg. Corp. example: revolving line of credit based on a borrowing base (up to 85% of eligible AR); description is disclosed.

  • Assignment of AR: Santa Teresa Glass Company borrows $500,000; assigns AR with a 1.5% finance charge; remits cash monthly; he continues to collect receivables; includes interest and note payable.

  • Journal entries for December collection and finance charge were shown (interest expense and notes payable recognition).

  • LO7-8; 07-68 to 07-71

Sale of Receivables (Factoring and Securitization)

  • Sale of receivables: accounting similar to sale of assets; seller records gain/loss; removes receivables from records; may record assets or liabilities acquired by the buyer depending on terms.

  • Factor (financial institution) purchases receivables; charges a fee.

  • With/without recourse: recourse means seller bears the risk of uncollectible receivables; without recourse, the buyer bears the risk.

  • LO7-8; 07-72 to 07-75

Factoring Receivables – Concept Checks

  • Factoring questions cover whether cash received is less than transferred receivables, recourse obligations, and transfer accounting.

  • Correct answers emphasize that with recourse, the transferor bears the risk and may owe a recourse liability; without recourse, the transferee bears the risk.

  • LO7-8; 07-73 to 07-79

Discounting Notes Receivable (LO7-8)

  • Banks may discount notes to provide immediate cash; cash proceeds equal maturity value minus the discount.

  • Steps commonly include calculating maturity value, discount, and cash proceeds.

  • LO7-8; 07-80 to 07-83

Discounting a Note – Concept Check

  • Problem: Given a note, determine cash proceeds when discounted by a bank with a given discount rate; steps include computing maturity value and discount.

  • Example solution: cash proceeds = maturity value − discount; maturity value is face amount plus interest for the period; discount is applied to the maturity value.

  • LO7-8; 07-83

Discounted Note Treated as a Sale

  • If note is discounted and recorded as a sale, the entries reflect cash received, a loss on sale of note receivable, and derecognition of the note receivable.

  • LO7-8; 07-84

IFRS and U.S. GAAP – Comparison (Transfer Standards)

  • Both standards address transfers of receivables and the decision framework: sale vs secured borrowing vs continuing involvement.

  • IFRS focuses on transfer control; U.S. GAAP focuses on derecognition and transfer accounting.

  • LO7-10; 07-89 to 07-90

Decision Makers’ Perspective – Receivables Management Ratios (LO7-9)

  • Receivables turnover ratio: extReceivablesTurnover=racextNetsalesextAverageaccountsreceivable(net)ext{Receivables Turnover} = rac{ ext{Net sales}}{ ext{Average accounts receivable (net)}}

  • Average collection period: extAveragecollectionperiod=rac365extReceivablesTurnoverext{Average collection period} = rac{365}{ ext{Receivables Turnover}}

  • LO7-9; 07-91

Receivables Turnover and Average Collection Period – Examples

  • NortonLifeLock, Broadcom, Gen Digital: specific figures given for accounts receivable, net sales, turnover, and collection period.

  • LO7-9; 07-92

Concept Check: Average Collection Period – Cambridge Associates

  • Given beginning AR, ending AR, and net sales, compute AR turnover and then average collection period.

  • Correct answer: 18.25 days.

  • LO7-9; 07-93

Bank Reconciliation (Appendix 7A)

  • Bank reconciliation purpose: reconcile bank balance with company cash records due to timing differences and errors.

  • Key timing differences: deposits in transit; outstanding checks; bank errors; bank charges; NSF checks; other errors.

  • Steps:

    • Step 1: Adjust bank balance to corrected cash balance (timing differences).

    • Step 2: Adjust book balance to corrected cash balance (timing differences and bank items not yet recorded by company).

  • LO7-97; 07-94 to 07-97

Bank Reconciliation – Example (May 2027)

  • Provided data: Bank balance May 1 = $32,120; deposits during May = $82,140; checks processed = $(78,433)$; service charges = $(80)$; NSF checks = $(2,187)$; note collected by bank = $1,120$ (includes $120 interest). Balance May 31 = $34,680.

  • Company ledger cash balance on May 31 = $35,276.

  • Reconciliation highlights adjustments needed to reach corrected cash balance of $33,129.

  • Step 1 and Step 2 break down deposits outstanding, checks outstanding, and book-side adjustments (collections by bank, service charges, NSF checks, errors).

  • Appendices demonstrate how to record the receipt of principal and interest collected by the bank and to record entries for bank-related adjustments (e.g., miscellaneous expenses, NSF checks).

  • LO7-99 to LO7-101

Petty Cash (Appendix 7A)

  • Purpose: small, routine expenses that are impractical to pay by check.

  • Establishment: debit Petty Cash; credit Cash (checking).

  • Replenishment: period-end replenish entries based on expenditures charged to various petty cash accounts (postage, office supplies, delivery, entertainment).

  • LO7-102 to LO7-104

End of Chapter 7

  • End of the content coverage for this chapter.

Notes and formulas to remember:

  • Effective interest with compensating balance: extEffectiverate=racextInterestextBorrowedamountaftercompensatingbalance=racextNominalrateimesextFacevalueextFacevalue−extCompensatingbalanceext{Effective rate}= rac{ ext{Interest}}{ ext{Borrowed amount after compensating balance}}= rac{ ext{Nominal rate} imes ext{Face value}}{ ext{Face value}- ext{Compensating balance}}

  • Trade discounts and sales discounts: gross vs net methods have different effects on AR and Sales Revenue; disclosures show when discounts are taken and whether they are forfeited.

  • Accounts Receivable Aging Schedule: estimate required allowance by aging AR; pre-adjustment balance affects bad debt expense to reach the target allowance.

  • CECL: Current Expected Credit Loss model; incorporate historical experience, current conditions, and forecasts to estimate credit losses over the life of the receivables.

  • Notes receivable: distinguish between short-term vs long-term; interest-bearing vs noninterest-bearing notes; discounting and factoring; sale vs secured borrowing under transfer accounting; fair value option considerations under IFRS/US GAAP.

  • Bank reconciliation: ensure balance per bank and balance per books reconcile to corrected cash balance; identify deposits in transit, outstanding checks, and bank charges; record bank-initiated entries as needed.

If you’d like, I can convert these notes into separate printable flashcards or create a compact one-page summary for quick review. Also tell me if you want emphasis on a particular LO (e.g., LO7-8 vs LO7-10) or a tighter focus on the math-heavy sections (discounting, CECL, and effective interest calculations).

1. Recording Transactions

  • To record a transaction, accurately determine the correct amounts and identify the appropriate accounts from a chart of accounts.

  • Key transactions covered in Chapter 7 include:

    • Recognition of sales revenue and accounts receivable.

    • Cash receipts from customers.

    • Cash disbursements.

    • Accrual of interest for notes receivable.

    • Establishment and adjustment of the allowance for uncollectible accounts.

    • Write-offs of uncollectible accounts.

    • Recording sales returns and allowances.

    • Bank reconciliation adjustments.

    • Petty cash establishment and replenishment.

2. Account Analysis and Computations (Using "Base")

  • Be proficient in using "base" for computations, often involving T-accounts.

  • Crucial to understand the connections between multiple accounts for computations:

    • Sales and Accounts Receivable: Sales revenue creates accounts receivable.

    • Accounts Receivable and Cash: Collection of accounts receivable increases cash and reduces accounts receivable.

    • Accounts Receivable and Allowance for Uncollectible Accounts: The allowance reduces the net realizable value of accounts receivable; write-offs reduce both AR and the allowance.

    • Notes Receivable and Interest Revenue/Cash: Notes generate interest revenue over time, leading to cash collection at maturity.

3. Account Identification

  • Asset Accounts (Current Assets and Total Assets):

    • Cash and Cash Equivalents: Currency, coins, checking accounts, money orders, money market funds, Treasury bills (original maturity ≤3\le 3 months).

    • Receivables: Accounts Receivable, Notes Receivable, Interest Receivable, Tax Refunds, Advances to Employees.

    • Inventory–Estimated Returns: An asset representing the estimated cost of goods expected to be returned.

    • Restricted Cash: Cash set aside for specific purposes (classified as current or noncurrent based on availability).

  • Liability Accounts:

    • Refund Liability: Estimated amount expected to be refunded to customers for sales returns.

    • Notes Payable: Obligation to a lender for a loan (e.g., from assigning receivables).

    • Bank Overdrafts: When allowed under IFRS, may be offset against cash; under US GAAP, typically a current liability.

    • Recourse Liability: Obligation of the seller when receivables are factored with recourse.

  • Allowance for Uncollectible Accounts: A contra-asset account used to reduce Accounts Receivable to its expected cash realizable value.

    • The CECL Model (Current Expected Credit Losses) is the process used today for this account, requiring consideration of historical experience, current conditions, and future forecasts.

4. The Accounting Equation

  • The fundamental accounting equation is: Assets=Liabilities+EquityAssets = Liabilities + Equity

  • Be able to use this equation to determine missing amounts in various financial scenarios.

5. Gross Method of Accounts Receivable

  • You must know the gross method for recording accounts receivable, especially related to sales discounts (e.g., 2/10, n/30).

  • Journal Entries for the Gross Method (Example):

    1. Initial Sale on Credit:

      • Debit Accounts Receivable (Full amount)

      • Credit Sales Revenue (Full amount)

    2. Collection within Discount Period:

      • Debit Cash (Amount less discount)

      • Debit Sales Discount (Discount amount)

      • Credit Accounts Receivable (Full amount of original sale)

    3. Collection outside Discount Period:

      • Debit Cash (Full amount)

      • Credit Accounts Receivable (Full amount)

6. Journal Entries

  • You will complete five journal entries, two of which will require using a provided chart of accounts.

  • Expect entries related to topics such as:

    • Sales and cash receipts (gross method).

    • Sales returns and allowances accrual.

    • Establishing/adjusting the allowance for uncollectible accounts.

    • Writing off uncollectible accounts.

    • Recording interest for notes receivable.

    • Recording financing activities involving receivables (e.g., assignment).

    • Bank reconciliation adjustments (e.g., service charges, NSF checks, bank collections of notes).

    • Petty cash transactions.

7. Matching Questions

  • There will be 30 matching questions.

  • Preparation Strategy:

    • Review your textbook, focusing on bold, highlighted, or italicized terms.

    • Understand terminology that stands out.

    • Study charts, especially those related to GAAP (Generally Accepted Accounting Principles) and similar concepts (e.g., line or block charts).

    • The goal is to recognize terms and concepts, not to memorize verbatim definitions.

8. General Exam Information

  • Read and answer the question that is asked, not the question you want to answer.

  • The exam will be 75 minutes long.

  • The exam is worth 100 points.

  • Scantrons will be provided; you do not need to bring your own.