Chapter 6: Cash and Accounts Receivable

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Chapter 6Cash and Accounts Receivable
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Chapter 6 Cash and Accounts Receivable

• Current asset if intended to be converted into
  cash, or used up, within one year or within an
  operating cycle, whichever is longer.
• Industries like aerospace and manufacturers of
  farm equipment may have operating cycles longer
  than a year.

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The Operating Cycle, Figure 6-1
Cash
Receive payment
Manufacture or purchase inventory
Accounts Receivable
Inventory
Sales to customers
Note that the operating cycle is effectively
complete when the cash is collectible, or at
the A/R stage.
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Current Asset Classification

• The distinction is useful because it provides
  easy-to-determine, low-cost measures of a
  companys short term liquidity.
• Working capital current assets - current
  liabilities
• Current ratio current assets/current
  liabilities

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Current RatioCurrent assets/Current liabilities

• Current assets are often compared to current
  liabilities as an indicator of a companys
  solvency.
• Average current ratios also vary across
  industries.
• Caution regarding this ratio, as it can actually
  increase in years before bankruptcy.

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Cash

• The cash account is the first asset listed in the
  current asset section of the balance sheet.
• It consists of coin, checks, and bank drafts
  received by the company.
• The only reporting issues for cash is whether
  there are restrictions on its use.
• Some companies now report cash and cash
  equivalents. (More in Chapter 14)

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Proper Management and Control of Cash

• Proper cash management requires that enough cash
  be available to meet the needs of the companys
  operations.
• Too much cash is undesirable as it loses
  purchasing power in periods of inflation, and can
  generate additional cash if it is invested
  properly.
• Control of cash
• Control of records
• Bank reconciliation
• Physical control
• Separation of duties

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Accounts Receivable

• Accounts receivable arise from selling goods or
  services to customers on account.
• Recorded at face amount to be collected.
• However, we must also reflect the fact that a
  portion of A/R may not be collected.
• Reasons for lack of collection
• 1. sales discounts (cash discounts)
• 2. sales returns
• 3. sales allowances
• 4. uncollectible A/R (bad debts)

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1. Cash Discounts

• Cash discounts are offered by a company to
  encourage its customers to pay early. The terms
  are usually expressed as 1/10, n/30, which
  would mean a 1 discount if the customer pays
  within 10 days, or the net (full) amount is due
  within 30 days.
• Cash Discount or Sales Discount is presented
  as a contra to Sales Revenue on the income
  statement.
• Calculation of net sales on the I/S
• Sales revenue
• - Sales discounts (SD)
• - sales returns (see slide 11) (SR)
• - sales allowances (see slide 11) (SA)
• Net sales
• Formula S - SD - SR - SA S(net)

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Journal Entries for Cash Discounts (gross method)

• Original sale 100, terms 2/10, n/30.
• At time of sale
• A/R 100
• Sales Revenue 100
• If received within 10 days
• Cash 98
• Sales Discount 2
• A/R 100
• If received after 10 days
• Cash 100
• A/R 100

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2. Sales Returns and Allowances

• If sales returns are small in amount, adjust A/R
  and create a contra to Sales called Sales Returns
  when the merchandise is returned. Sales
  allowances are negotiated reductions in sales
  price after the sale.
• Sales Allowance xx
• Sales Returns xx
• A/R xx
• If sales returns are significant (e.g.,
  bookstore), company must estimate the amount of
  sales returns expected, and adjust A/R (with a
  contra account similar to Allowance for Bad
  Debts) at the end of the period.
• Estimated Sales Returns xx
• Allowance for Returns xx

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3.Allowance for Doubtful Accounts

• Created as a contra account to A/R to indicate
  the portion of A/R that will not be collected due
  to defaults on payments by customers.
• Reason for Allowance account Assume 1,000 sale
  in 2004 and default on collection in 2005.
• Record sale in 2004
• A/R 1,000
• Sales Revenue 1,000
• Record default in 2005
• Bad Debt Expense 1,000
• A/R 1,000
• Note this is called the direct method, and is
  not GAAP, for the reasons listed on the next page.

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Problems with Direct Method

• Problem the direct method, on the previous
  slide, does not achieve matching (revenues
  recognized in 2004, but a related expense was
  recognized in 2005).
• Problem the direct method does not correctly
  value the asset, A/R. The assets are overvalued
  until 2005, when the receivable is written off.

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Solution the Allowance Method

• Solution create a contra to A/R, and estimate
  the A/R that will not be collected.
• The AJE to record an estimate for uncollectibles
  in 2004 (for all uncollectibles)
• Bad Debt Expense 4,000
• Allowance 4,000
• The GJE during 2005, when a specific A/R is
  deemed uncollectible (this is called the
  write-off of a specific A/R)
• Allowance 1,000
• A/R 1,000
• When are the income statement and balance sheet
  affected?

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Estimation of Uncollectibles

• Note that we do not know in 2004 which A/Rs will
  not be collected in 2005. Therefore, we must
  estimate uncollectibles. There are two methods
• 1. Percentage of sales
• 2. Percentage of accounts receivable
• Both methods are used to estimate uncollectibles
  for the AJE. The percentage of sales method is
  simpler, but the percentage of A/R method is more
  accurate.

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1. Percentage of Sales Method

• Usually based on credit sales, but may use total
  sales or net sales as basis.
• Calculation
• Sales x Bad Debt Expense
• (focus on the debit side of the AJE)
• Called the Income Statement approach, because
  revenues x expense.

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2. Percentage of A/R Method (using Aging
Schedule)

• Based on ending A/R and ending Allowance account.
• Calculation
• Ending A/R x Ending Allowance
• (focus on the credit side of the AJE)
• Called Balance Sheet approach, because ending
  asset x ending contra asset.
• Requires the analysis of the Allowance account
  before preparing the AJE.
• An aging schedule of A/R is the most accurate way
  to estimate uncollectibles (see Figure 6-11).

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T-Account Approach for Percentage of A/R Method

• Based on the analysis of the Allowance account.
• Calculate the desired ending balance based on
  an aging of A/R.
• Now, given the Beginning, Ending and Write-off
  amounts, calculate the amount of the current
  estimate that must be added to the Allowance
  account to achieve the desired ending balance.

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Allowance for Doubtful Accts. (T-account)
Allowance for Doubtful Accts.
1. Beginning Balance
1. The allowance established in the prior period
carries forward for current period write-offs.
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Allowance for Doubtful Accts. (T-account)
Allowance for Doubtful Accts.
Beginning Balance
2. Write-off of specific accounts receivable
2. As specific accounts are determined
uncollectible during the year, they are
written-off to the allowance account as shown.
These write-offs may cause the allowance account
to have a debit balance before the AJE if the
prior years expense was underestimated.
Accounts Receivable
2. Write-off of specific accounts receivable
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Allowance for Doubtful Accts.(T-account)
Allowance for Doubtful Accts.
Beginning Balance
Write-off of accounts receivable
3. Ending Balance
3. The desired ending balance in the allowance
account is estimated using the percentage
calculation or the aging schedule.
Accounts Receivable
Write-off of accounts receivable
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Allowance for Doubtful Accts. (T-account)
Allowance for Doubtful Accts.
Beginning Balance
Write-off of accounts receivable
4. Recovery of write-offs
4. The recovery of an account receivable that has
been written off must first be reversed back into
A/R and the Allowance account. Then the
collection is like the collection of any other
A/R.
Ending Balance
Accounts Receivable
4. Recovery of write-offs
Write-off of accounts receivable
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Allowance for Doubtful Accts. (T-account)
Allowance for Doubtful Accts.
Bad Debts Expense
Beginning Balance
5. Recognition of bad debt expense
Write-off recovery
Write-off of accounts receivable
5. Recognition of bad debt expense
Ending Balance
5. The AJE to record the estimate of
uncollectibles is calculated based on the amount
necessary to achieve the desired ending balance
in the allowance account. The focus is on the
Allowance account.
Accounts Receivable
Write-off of accounts receivable
Write off recovery
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Class Problem

• Given the following information
• At December 31, 2004, Company Z prepared an
  aging schedule to determine that the
  uncollectible accounts receivable at that date
  were 18,000. The balance in the Allowance for
  Doubtful Accounts at 1/1/04 was a 3,000 credit.
  During 2004, the company wrote off 5,000 of
  specific accounts receivable that were deemed to
  be uncollectible.
• Required prepare the AJE to record the
  estimated uncollectibles at 12/31/04.

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Solution to Class Problems
(1) Post the beginning balance and write-off.
(2) Post the desired ending balance.
(3) Post the adjusting journal entry.
Allowance for Doubtful Accounts

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Exercise 6-3

• (a) Sale on Dec. 12
• AJE on Dec. 31?
• Payment on Jan. 5 (all 40,000)

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Exercise 6-3

• (b) Sale on Dec. 12
• Payment on Dec. 20
• Less cash received less sales (net)
  recognized because of the sales discount.

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Problem 6-4, Part (a) 2005

• Percentage of Sales method
• (a) 2005
• Net sales Sales - SD - SR - SA
• B.D. Expense 3 of net sales
• AJE at 12/31

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Problem 6-4, Part (b) 2005

Note that, for the percentage of sales method,
the AJE is posted before calculating the ending
balance.
Allowance for Doubtful Accounts


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Problem 6-4, Part (c) 2006

• (c) 2006
• Net sales Sales - SD - SR - SA
• B.D. Expense 3 of net sales
• AJE at 12/31

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Problem 6-4, Part (d) 2006

Note that, for the percentage of sales method,
the AJE is posted before calculating the ending
balance.
Allowance for Doubtful Accounts

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Brief Exercise 6-2, Parts (a) and (b)

• Given in your text 2003 2002
• Beginning 5,500 4,792
• Increases 4,400 3,788
• Decreases (4,492) (3,722)
• Recoveries 848 642
• Ending 6,256 5,500
• (a) Bad debt expense?
• (b) Write-offs?

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Brief Exercise 6-2, Part (c)

• Given in your text
• 2003 2002
• Beginning 5,500 4,792
• Increases 4,400 3,788
• Decreases (4,492) (3,722)
• Recoveries 848 642
• Ending 6,256 5,500
• (c) Change?

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Manipulation of Sales and Bad Debt Expense

• Financial statement users should be aware of the
  fact that policies may vary from company to
  company in recognition of sales and in estimation
  of bad debt expense.
• Additionally, users should watch for consistency
  in the recognition of these amounts from period
  to period.

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Foreign Currency Receivables and Payables

• U.S. companies may buy and sell inventory with
  foreign companies located in foreign countries.
• If the contract is denominated in a foreign
  currency, U. S. companies must recognize gains
  and losses from the change in the exchange rate
  between the foreign currency and the U.S. dollar.

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Dealing with Exchange Rates

• Foreign currency exchange rates fluctuate daily.
• Daily quotes can be found in the newspaper or
  Wall Street Journal.
• The class examples use direct quotes which
  express one unit of a foreign currency in terms
  of the U.S. dollar. The rates move directly in
  relation to the related foreign currency
  receivable or payable.
• Ex Direct one British pound () 0.70
  (Indirect one U. S. dollar 1.4286 )
• To convert indirect to direct
• 1/indirect direct or 1/direct
  indirect

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Receivables Denominated in a Foreign Currency

• See Motorola example in text (pp. 248 - 249).
• This example is denominated in euros (1.5 million
  euros).
• Date Direct quote
• Dec. 1 1.10 per euro
• Dec. 31 1.00 per euro

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Receivables Denominated in a Foreign Currency

• See journal entries for Motorola. At the date of
  sale, we record a N/R in U.S. dollar equivalent
  based on one euro 1.10
• Calculation 1.5 million euros x 1.10 1.65
  million dollars.
• Journal entry (in millions) at 12/1 to record
  sale
• A/R (foreign currency) 1.65
• Sales revenue 1.65
• Note that a receivable in a foreign currency must
  be converted to dollars before it can be recorded
  in a U.S. companys books. Also, the receivable
  must be revalued as the foreign currency
  fluctuates.

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Receivables Denominated in a Foreign Currency -
continued

• Why a loss for Motorola at Dec. 31?
• The foreign currency went down with respect to
  the dollar (1.10 down to 1.00 decrease of
  0.10). If we received the euros today, we
  would sell it for less dollars, so decrease
  (credit) the foreign currency accounts receivable
  for 0.15 million (1.5 million x 0.10).
• Journal entry (in millions)
• Exchange rate loss 0.15
• A/R (foreign currency) 0.15

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Payables Denominated in a Foreign Currency

• The same concepts hold when a U. S. company buys
  goods from a foreign country, and the contract is
  denominated in the foreign currency, except that
  a decrease in the direct exchange rate means a
  decrease in the liability (as expressed in
  dollars) and an exchange gain (the liability will
  be payable with fewer dollars).
• Increases in the direct exchange rate of the
  dollar with respect to the foreign currency will
  yield reverse effects for gains and losses.

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Hedging of Foreign Currency Receivables and
Payables

• A company may pass off the risk of an
  unfavorable exchange rate change by entering into
  the marketplace and taking a equal and opposite
  position.
• For example, if the company will be receiving 1.5
  million euros, it could contract to sell 1.5
  million euros on the same date. This offsets any
  losses or gains from the exchange rate to the
  date of sale.

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Class Problem P6-11 (1 and 3)

• (a)First, convert the currencies to direct
  exchange rates (dollars per unit of foreign
  currency). For example, convert .5 British pound
  per dollar (indirect) to dollars per British
  pound (direct) 1 per 0.50 1/.5 2.00
  per
• At sale/
• purchase At 12/31
• British pound 2.00 1.66667
• Euros 1.25 1.11111

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Now journal entries for P6-11, parts 1 and 3 (use
direct rates).

• Part 1
• (b) Journal entry at sale
• (c) Journal entry at 12/31

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Now journal entries for P6-11, parts 1 and 3 (use
direct rates).

• Part 3
• (b) Journal entry at purchase
• (c) Journal entry at 12/31

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P6-11, Part (d)

• Exchange gains and losses occur because of the
  differential movement of the two currencies, and
  are dependent on whether the company holds a
  receivable or payable.
• If the company has a receivable denominated in a
  foreign currency, the dollar value of the
  receivable will decrease as the dollar moves down
  with respect to the foreign currency, and will
  result in a loss (see Part 1).
• If the company has a payable denominated in a
  foreign currency, the dollar value of the payable
  will decrease as the dollar moves down with
  respect to the foreign currency, and will result
  in a gain (see Part 3).