CHAPTER 7

Cash and Receivables

CHAPTER REVIEW

        *Note: All asterisked (*) items relate to material contained in the Appendix to the chapter.

   1.   (S.O. 1) Chapter 7 presents a detailed discussion of two of the primary liquid assets of
a company, cash and receivables. Cash is the most liquid asset held by a company and possesses unique problems in its management and control. Receivables are composed of both accounts and notes receivables. Chapter coverage of accounts receivable places emphasis on trade receivables. In covering notes receivables, the chapter includes both short-term and long-term notes.

Nature of Cash
2.   Cash consists of coin, currency, bank deposits, and negotiable instruments such as money orders, checks, and bank drafts. Cash that has been designated for some specific use, other than for payment of currently maturing obligations, is segregated from the general cash account. This amount may be classified as a current asset if it will be disbursed within one year or the operating cycle, whichever is longer. Otherwise, the amount should be shown as a noncurrent asset.

Reporting Cash
3.   (S.O. 2) Cash equivalents are short-term, highly liquid investments that are both
(a) readily convertible to known amounts of cash and (b) so near their maturity that they present insignificant risk of changes in value because of changes in interest rates. If an asset is not cash and is short-term in nature, it should be reported as as a temporary investment.

   4.   It is common practice for a corporation to have an agreement with a bank concerning credit and borrowing arrangements. When such an agreement exists, the bank usually requires the company to maintain a minimum cash balance on deposit. This minimum balance is known as a compensating balance. Compensating balances that result in legally restricted deposits must be separately classified in the balance sheet. The nature of the borrowing arrangement determines whether the compensating balance is classified as a current asset or a noncurrent asset.

   5.   Bank overdrafts occur when a company writes a check for more than the amount in the cash account. Bank overdrafts should be accounted for as accounts payable or, if material, separately disclosed on the balance sheet or in the related notes.

Accounts Receivable
6.   (S.O. 3) Receivables are claims held against customers and others for money, goods, or services. Receivables may generally be classified as trade or nontrade. Trade receivables (accounts receivable and notes receivable) are the most significant receivables an enterprise possesses. Accounts receivable are oral promises of the purchaser to pay for goods and services sold. Notes receivable are written promises to pay a certain sum of money on a specified future date. Nontrade receivables arise from a variety of transactions and can be written promises either to pay or to deliver. Nontrade receivables are generally classified and reported as separate items in the balance sheet.

   7.   (S.O. 4) In most receivable transactions, the amount to be recognized is the exchange price (amount due from the debtor) between the two parties. Two factors that may complicate the measurement of the exchange are (a) the availability of discounts (trade and cash) and (b) the length of time between the sale and the payment due date (the interest element).

   8.   Two types of discounts that must be considered in determining the value of receivables are trade discounts and cash discounts. Trade discounts represent reductions from the list or catalog prices of merchandise. They are often used to avoid frequent changes in catalogs or to quote different prices for different quantities purchased. Cash discounts (also called sales discounts) are offered as an inducement for prompt payment and are communicated in terms that read, for example, 2/10, n/30 (2% discount if paid within
10 days of the purchase or invoice date, otherwise the gross amount is due in 30 days).

   9.   (S.O. 5) It is highly unlikely that a company that extends credit to its customers will be successful in collecting all of its receivables. Thus, some method must be adopted to account for receivables that ultimately prove to be uncollectible. The two methods currently used are the direct write-off method and the allowance method. Under the direct write-off method, the receivable account is reduced and an expense is recorded when a specific account is determined to be uncollectible. The direct-write off method is theoretically deficient because it usually does not match costs and revenues of the period, nor does it result in receivables being stated at estimated realizable value on the balance sheet. The direct write-off method is not appropriate if the amount deemed uncollectible is material.

10.   Use of the allowance method requires a year-end estimate of expected uncollectible accounts based upon credit sales or outstanding receivables. This ensures that companies state receivables on the balance sheet at their net realizable value. Net realizable value is the net amount the company expects to receive in cash. The estimate of uncollectible accounts is recorded by debiting an expense and crediting the allowance account in the period in which the sale is recorded. Then, in a subsequent period, when an account is deemed to be uncollectible, an entry is made debiting the allowance account and crediting accounts receivable.

11.   Advocates of the allowance method contend that its use provides for a proper matching of revenues and expenses as well as reflecting a proper carrying value for accounts receivable at the end of the period. When the allowance method is used, the estimated amount of uncollectible accounts is normally based upon a percentage of sales or outstanding receivables. The percentage-of-sales method attempts to match costs with revenues, and is frequently referred to as the income statement approach. The percentage-of-receivables approach provides a reasonably accurate estimate of the net realizable value of receivables shown on the balance sheet. This approach is commonly referred to as the balance sheet approach.

12.   The method used to determine the amount of bad debt expense each year affects the amount of expense recorded. Under the percentage-of-sales method, the amount recorded as bad debt expense is the amount determined by multiplying the estimated percentage times the credit sales. However, under the percentage-of-receivables approach, the unadjusted ending balance in the allowance account must be considered in arriving at bad debts expense for the year.

Notes Receivable
13.   (S.O. 6) The major differences between trade accounts receivables and trade notes receivables are (a) notes represent a formal promise to pay and (b) notes bear an interest element because of the time value of money. Notes are classified as notes bearing interest equal to the effective rate and those bearing interest different than the effective rate. Interest-bearing notes have a stated rate of interest, whereas zero-interest-bearing notes (noninterest-bearing) include the interest as part of their face amount instead of stating it explicitly.

14.   Short-term notes are generally recorded at face value (less allowances) because the interest implicit in the maturity value is immaterial. A general rule is that notes treated as cash equivalents (maturities of 3 months or less) are not subject to premium or discount amortization. Long-term notes receivable, however, are recorded at the present value of the future cash inflows. Determination of the present value can be complicated, particularly when a zero-interest-bearing note or a note bearing an unreasonable interest rate is involved.

15.   Long-term notes receivable should be recorded and reported at the present value of the cash expected to be collected. When the interest stated on an interest-bearing note is equal to the effective (market) rate of interest, the note sells at face value. When the stated rate is different from the market rate, the cash exchanged (present value) is different from the face value of the note. The difference between the face value and the cash exchanged, either a discount or a premium, is then recorded and amortized over the life of the note to approximate the effective interest rate. The discount or premium is shown on the balance sheet as a direct deduction from or addition to the face of the note.

16.   Whenever the face amount of a note does not reasonably represent the present value of the consideration given or received in the exchange, the accountant must evaluate the entire arrangement to record properly the exchange and the subsequent interest. Notes receivable are sometimes issued with zero interest rate stated or at a stated rate that is unreasonable. In such instances the present value of the note is measured by the cash proceeds to the borrower or fair value of the property, goods, or services rendered. The difference between the face amount of the note and the cash proceeds or fair value of the property represents the total amount of interest during the life of the note. If the fair value of the property, goods, or services rendered is not determinable, estimation of the present value requires use of an imputed interest rate. The choice of a rate may be affected specifically by the credit standing of the issuer, restrictive covenants, collateral, payment schedule, and the existing prime interest rate. Determination of the imputed interest rate is made when the note is received; any subsequent changes in prevailing interest rates are ignored.

17.   The FASB requires that companies disclose the fair value of receivables in the notes to the financial statements. Recently the Board has given companies the option to use fair value as the basis of measurement in the financial statements. If companies choose the fair value option, the receivables are recorded at fair value, with unrealized holding gains or losses reported as part of net income. An unrealized holding gain or loss is the net change in the fair value of the receivable from one period to another, exclusive of interest revenue.

Secured Borrowing
18.  (S.O. 8) Receivables are often used as collateral in a borrowing transaction. A creditor often requires that the debtor designate (assign) or pledge receivables as security for the loan. If the loan is not paid when due, the creditor has the right to convert the collateral to cash, that is, to collect the receivables.

Sales of Receivables
19.  When accounts and notes receivable are factored (sold), the factoring arrangement can be with recourse or without recourse. If receivables are factored on a with recourse basis, the seller guarantees payment to the factor in the event the debtor does not make payment. When a factor buys receivables without recourse, the factor assumes the risk of collectibility and absorbs any credit losses. Receivables that are factored with recourse should be accounted for as a sale, recognizing any gain or loss, if all three of the following conditions are met: (a) the transferred asset has been isolated from the transferor, (b) the transferees have obtained the right to pledge or exchange either the transferred assets or beneficial interests in the transferred assets, and (c) the transferor does not maintain effective control over the transferred assets through an agreement to repurchase or redeem them before their maturity.

Presentation and Analysis
20.  (S.O. 9) The presentation of receivables in the balance sheet includes the following considerations: (a) segregate the different types of receivables that a company possesses, if material; (b) appropriately offset the valuation accounts against the proper receivable accounts: (c) determine that receivables classified in the current assets section will be converted into cash within the year or the operating cycle, whichever is longer; (d) disclose any loss contingencies that exist on the receivables; (e) disclose any receivables designated or pledged as collateral; and (f) disclose the nature of credit risk inherent in the receivables, how that risk is analyzed and assessed in arriving at the allowance for credit losses, and the changes and reasons for those changes in the allowance for credit losses.

  21.  The ratio used to assess the liquidity of receivables is the receivables turnover ratio, which measures the number of times, on average, receivables are collected during the period.

Accounts Receivable Turnover		=		Net Sales                   Average Trade Receivables (net)
Days to Collect Accounts Receivable		=		365                       Accounts Receivable Turnover

*Bank Reconciliation
*24.  A basic cash control is preparation of a monthly bank reconciliation. The bank reconciliation, when properly prepared, proves that the cash balance per bank and the cash balance per book are in agreement. The items that cause the bank and book balances to differ, and thus require preparation of a bank reconciliation, are the following:

         a.   Deposits in Transit. Deposits recorded in the cash account in one period but not received by the bank until the next period.

         b.   Outstanding Checks. Checks written by the depositor that have yet to be presented at the bank for collection.

         c.   Bank Charges. Charges by the bank for services that are deducted from the account by the bank and which the company learns of when it receives the bank statement.

         d.   Bank Credits. Collections or deposits in the company’s account that the company is not aware of until receipt of the bank statement.

         e.   Bank or Depositor Errors. Errors made by the company or the bank that must be corrected for the reconciliation to balance.

*25.  Two forms of bank reconciliation may be prepared. One form reconciles from the bank statement balance to the book balance or vice versa. The other form is described as the reconciliation of bank and book balances to corrected cash balance. This form is composed of two separate sections that begin with the bank balance and book balance, respectively. Reconciling items that apply to the bank balance are added and subtracted to arrive at the corrected cash balance. Likewise, reconciling items that apply to the book balance are added and subtracted to arrive at the same corrected cash balance. The corrected cash balance is the amount that should be shown on the balance sheet at the reconciliation date.