FA2 Module 6' Current financial assets and current liabilities

1
FA2Module 6. Current financial assets and
current liabilities

• Nature of financial instruments
• Cash
• Definitions
• Recognition of accounts receivable
• Valuation (the doubtful accounts issue)
• Disposition of accounts receivable
• Notes receivable
• Notes payable

2
1. Nature of financial instruments

• A financial instrument is any contract that gives
  rise to a financial asset of one party and a
  financial liability or equity instrument of
  another party.

3
A financial asset is an asset that is

• Cash
• A contractual right to receive cash or another
  financial asset from another party
• A contractual right to exchange financial
  instruments with another party under conditions
  that are potentially favourable to the entity or
• An equity instrument of another entity.

4
A financial liability is a liability that is a
contractual obligation

• To deliver cash or another financial asset to
  another party or
• To exchange financial instruments with another
  party under conditions that are potentially
  unfavourable to the entity.

5
Categories of financial assets and liabilities

• Financial assets and financial liabilities held
  for trading
• Held-to-maturity investments
• Available-for-sale financial assets
• Loans and receivables (focus of this module)

6
2. Cash Composition

• Cash is currency, funds on deposit in a bank and
  certain negotiable instruments which are readily
  available for payment of current debts.
• Currency on hand
• Petty cash funds
• Bank deposits (current or savings accounts)
• Cheques (certified, personal, cashiers)
• Bank drafts
• Money orders

7
2. Cash Management and control

• Control of cash is of vital importance in any
  business because
• Cash can be easily concealed and transported
• Everybody wants it (high inherent risk)
• Cash is not a productive asset - it is important
  to maintain sufficient cash to meet current
  obligations, but no more than necessary

8
Reconciliation of bank balances

• The balance in the bank account at any given time
  will often not agree with the balance in the
  companys books. A bank reconciliation is an
  important tool in the control of cash whose
  object is to identify the items that make up the
  difference between the balance on the bank
  statement and the balance of cash according to
  the depositors records (i. e., the items that
  are recorded by the bank or the depositor, but
  not both).

9
Typical bank account discrepancies
10
Procedure Doing a bank reconciliation

• 1. Compare company deposits to deposits recorded
  by the bank to identify deposits in transit.
• 2. Compare cheques written by company to cheques
  cashed by the bank to identify outstanding
  cheques.
• 3. Record all proper bank entries not recorded in
  company books.
• 4. Correct any company errors. Note any bank
  errors.

11
Format of a bank reconciliation
12
3. Accounts receivable

• Receivables
• Assets in the form of claims held against
  customers and others for money, goods, or
  services.
• Trade receivables
• Amounts owed by customers for goods sold and
  services rendered as part of normal business
  operations.

13
3. Accounts receivable

• Nontrade receivables
• Receivables that arise from transaction other
  than sale of products or services that are part
  of normal business operations (e. g., dividends,
  tax refunds, loans to employees).

14
3. Accounts receivable

• Accounts receivable
• Oral promises of customer to pay for goods sold
  or services rendered, usually supported by an
  invoice or bill, and normally payable within 30 -
  60 days.
• Notes receivable
• Written promises to pay, potentially arising from
  many different sorts of transactions can be
  short-term or long-term.

15
4. Recognition of accounts receivable

• Discounts offered to customers
• Vendors often offer terms like 2/10, n/30 (2
  discount if payment is received within 10 days,
  otherwise the full amount is due within 30 days).
• Two methods are used in practice
• Gross method Sales/receivables are recorded at
  list price discounts taken are deducted from
  sales
• Net method Sales/receivables recorded at value
  net of discount discounts missed are treated as
  interest income

16
4. Recognition of accounts receivable

• Discounts example
• Vendor Ltd. sells merchandise (list price 100)
  on credit to a customer, 2/10, n/30.
• Prepare journal entries to record the sale and
  payment under both the gross and net methods,
  assuming
• (a) that the customer pays seven days after the
  merchandise is delivered.
• (b) that the customer pays 30 days after the
  merchandise is delivered.

17
4. Recognition of accounts receivable

• Nonrecognition of interest
• As with most current liabilities, accounts
  receivable are carried at face value (the amount
  the customer promises to pay), rather than the
  present value of the promised payment. This is
  because
• the interest component is probably immaterial
  and
• it is not clear what interest rate should be
  used in present value calculations.

18
5. Valuation of accounts receivable

• Accounts receivable should be valued at net
  realizable value, the amount of cash the entity
  expects to collect.
• Accounting for uncollectible accounts
• Direct write-off method
• Uncollectible accounts are written off, and bad
  debt expense recognized, when it becomes clear
  that a particular account is uncollectible.
  Leads to mismatching of expense and rev, and
  overstates value of AR.

19
Accounting for uncollectible accounts

• 2. Allowance method
• Amount of uncollectible accounts (bad debt
  expense) is estimated and recorded in the year in
  which credit sales occur.
• Dr. Bad debt expense
• Cr. Allowance for doubtful accounts
• When a particular account is uncollectible,
• Dr. Allowance for doubtful accounts
• Cr. Accounts receivable

20
Estimating bad debt expense

• Balance sheet approach/Aging method
• Year-end accounts receivable are analyzed and an
  estimate made of the amount of uncollectible
  accounts (e. g., percentage of total accounts
  receivable , aging analysis, account-by-account
  analysis).
• Bad debt expense
• required balance in AFDA (per AR analysis)
  unadjusted balance in AFDA
• Example A7-8

21
Estimating bad debt expense

• 2. Income stmt approach/Credit sales method
• An estimate is made of the amount of this years
  sales that will ultimately be uncollectible,
  based on companys experience, economic
  conditions, etc.
• Bad debt expense
• This years (credit) sales
• x
• Estimated bad debt percentage
• Example A7-8

22
6. Disposition of accounts receivable

• To accelerate the conversion of accounts
  receivable into cash and/or to avoid collection
  problems, a company can transfer its receivables
  to another company in exchange for cash. The
  broad categories of transfer transactions
  include
• Secured borrowing
• Sale of receivables

23
1. Secured Borrowing

• Accounts receivable are designated as collateral
  for a loan. If the loan is unpaid, the lender has
  the right to collect the receivables directly
  from the entitys customers.
• General assignment means all receivables are
  collateral. No specific entry is made to record
  the transaction (aside from the Cash/Note Payable
  entry). Information regarding the assignment of
  accounts receivable is disclosed in a footnote to
  the financial statements.

24
2. Sale of receivables

• Receivables are sold to an outside agency(ies)
  (e. g., factoring, securitization) that collects
  directly from the companys customers (the
  debtors).
• Sale or transfer without recourse
• The purchaser of the receivables assumes the risk
  of collectibility.
• Sale or transfer with recourse
• The seller of the receivables guarantees payment
  if the debtor fails to pay.

25
Sale without recourse

• The purchaser assumes all risks of collectibility
  and absorbs any credit losses.
• Cash is received from purchaser of AR
• Dr. Cash
• Cr. Accounts receivable
• Dr. Loss on sale of accounts receivable
• OR Cr. Gain on sale of accounts receivable
• Purchaser collects AR without problem
• NO ENTRY in the books of entity which sold the
  accounts receivable.

26
Sale with recourse

• The seller guarantees payment to the purchaser in
  the event a debtor fails to pay.
• Financial components approach
• The seller (and the purchaser) must estimate and
  record each of the assets and liabilities that it
  controls after the sale. From the sellers point
  of view, the sale gives rise to
• Asset Cash received from purchaser
• Liability Recourse liability (amount seller
  will have to pay in event of debtor default)

27
Accounting for sale with recourse

• Cash received from purchaser
• Dr. Cash
• Cr. Accounts receivable
• Cr. Recourse liability
• Dr. Loss on sale of receivables
• OR Cr. Gain on sale of receivables
• Purchaser experiences collection problems
• Dr. Recourse liability
• Cr. Cash

28
Sale or secured borrowing?

• A sale can be recorded if risks and rewards of
  ownership have been transferred, i. e., if
• Transferred assets are isolated from transferor
  (seller)
• Transferee (purchaser) is free to pledge or
  exchange assets without constraints and
• Transferor has no control over assets (through
  repurchase or redemption clause)
• If any of the three are not met, the transaction
  should be treated as a secured borrowing.
• Example A7-14

29
Accounts receivable disclosure

• Firms must disclose
• Credit risk associated with specific receivables,
  especially individual accounts of unusual size
• Related party receivables
• Non-trade receivables
• Any receivables pledged as security for loans

30
7. Notes receivable

• Notes receivable are similar to accounts
  receivable in that they represent amounts owed by
  external entities. Unlike accounts receivable,
  notes are contracts, typically signed by both
  parties, that generally specify payment dates and
  interest rates. They can be trade or non-trade
  receivables, current or non-current, etc.
• Unlike accounts receivable, the interest rate is
  often specified and is frequently material.

31
Notes receivable vocabulary

• Face value (or principal) This is the amount
  written on the face of the note and represents
  the total amount that will be paid by the debtor
  (plus any explicit interest).
• Interest rate This is the rate that is written
  on the face of the note and is used in the
  calculation of interest payments.
• Amortized cost after acquisition, notes are
  generally measured at amortized cost initial
  value principal repayments /- amortization of
  discount/premium any impairment

32
Types of notes receivable

• Notes bearing normal interest rate
• These notes are initially recorded at face value
  which is equal to present of implied future cash
  flows.
• 2. Notes bearing abnormal (usually, low or zero)
  interest rates
• These notes are valued at their fair market
  values, which is the present value of the implied
  cash flows discounted at a normal interest rate.
  With notes like this, face value is not equal to
  fair value.

33
Recording notes receivable

• 1. Notes bearing normal interest rates
• Dr. Note receivable Face value (Face)
• Cr. Revenue (or whatever) Face
• If the note is bearing a normal interest rate
  (i. e., the rate at which we would discount the
  future cash flows in computing the present
  value), the present value of the implied cash
  flows is equal to the face value of the note.

34
Recording notes receivable

• 2. Notes bearing abnormal (low or zero) interest
  rates
• Net method
• Dr. Note receivable PV of cash flows
• Cr. Revenue (or whatever) PV
• Gross method
• Dr. Note receivable Face value (Face)
• Cr. Discount on note receivable (Face-PV)
• Cr. Revenue (or whatever) PV
• Example A7-18

35
8. Notes payable

• Like accounts payable, notes payable are amounts
  owed to external parties. Unlike accounts
  payable, notes payable are contracts, typically
  signed by both parties, that generally specify
  payment dates and interest rates.
• The interest rate on a note payable is often
  specified and is frequently material.
• Accounting for notes payable is just like
  accounting for notes receivable, but from the
  borrowers point of view.
• Example A7-22