cash and ar

Cash and Receivables

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WHAT IS CASH?

• The most liquid of all assets• The standard medium of exchange • The basis for measuring and accounting for all

other items• Defined as ‘cash on hand and on deposit’ (IAS

7, AASB 107)• Consists of coin and currency on hand and

available funds on demand deposit in a bank

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MANAGEMENT AND CONTROL OF CASH

• Cash is the asset most susceptible to improper diversion and use

• Two problems of accounting for cash transactions– Proper controls must be established to prevent

unauthorised use of cash– Management must have necessary information

for proper use of cash

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REPORTING CASH

• Issues related to reporting cash include– Restricted cash– Bank overdrafts– Cash equivalents

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Restricted cash

• Cash set aside for a particular purpose e.g. petty cash, payroll,

dividend funds

• If material, restricted cash is segregated from regular cash for reporting purposes

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Restricted cash continued

• Compensating balances are the minimum balances often required by banks and other lending institutions in support of debt arrangements

• Identified as current assets separate from cash, if they relate to short- term loans.

• Identified as non-current assets separate from cash, if they relate to long-term loans

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Bank overdrafts

• Occur represent cheques written in excess of amount in cash account

• Overdrafts may be offset against available cash in another account in the same bank

• Otherwise, overdrafts are not usually offset against cash account

• Reported under as a current liability under ‘borrowings’ (IAS 1; AASB 101)

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Cash equivalents

• ‘Short-term, highly liquid investments that are readily convertible to known amounts of cash’ (IAS 7; AASB 107)

• Generally, only refers to investments with maturities less than or equal to three months

• Includes Treasury bills, bills of exchange, promissory notes

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RECEIVABLES

• Receivables refers to amounts due from individuals and other entities fro goods or services that are expected to be collected in cash

• Current receivables are expected to be collected with one year

• All other receivables are classified as non-current

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RECEIVABLES continued

• Receivables are classified as either trade or non-trade (IAS 39; AASB 139)

Trade Receivables• Amounts owed by customers for goods

sold and services rendered as part of normal business operations

• Also known as accounts receivable• Normally collectable within 30 to 60

days

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Non-trade Receivables• Arise from a variety of transactions• Notes receivable are written promises to pay a

certain sum of money on a specified future date

• They may arise from sales, financing or other transactions

• May be current or non-current

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Examples of Non-trade Receivables

- Advances to offices and employees- Advances to subsidiaries- Deposits to cover potential damages or losses- Deposits as a guarantee of performance/payment- Dividends and interest receivable- Claims against insurance, defendants under suit, government for tax refunds, carriers for damaged goods, creditors for returned or damaged goods, customers for returnable items

RECOGNITION OF ACCOUNTS RECEIVABLE

• Exchange price is amount due from the debtor (customer or borrower)

• Generally evidence by business document such as invoice

• Two complicating factors are– Availability of discounts (trade and cash discounts)– Length of time between sale and due date of

payment (interest element)

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Trade discounts

• Trade discounts are used to quote different prices for different quantities purchased

• Trade discounts are taken into account in measurement of revenue

• Example– Item listed at $4.65 sold at trade discount of 16% (i.e.

$3.90)– Sale revenue and accounts receivable is recorded as

$3.90 not $4.65

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Cash discounts

• Cash discounts (sales discounts) are inducements to customers for prompt payment of accounts (e.g. 2/10, n/30)

• Cash discounts are recorded in books as reductions of sales revenue

• There are two methods of accounting for cash discounts– Gross method– Net method

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Cash discounts continued

• Record revenue at gross amount of sales

• When customer takes the discount, record cash discounts

• Cash discounts reduce gross sales revenue

• Record revenue at gross amount of sales less cash discount

• When customer forfeits discount, record discounts not taken.

• Report discounts not taken as other revenue

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Gross Method Net Method

Cash discounts continued

Sales of $10 000, terms 2/10, n/30Accounts Receivable 10 000 Accounts Receivable 9 800 Sales 10 000 Sales 9 800

Payment of $4000 received within discount periodCash 3 920 Cash 3 920Sales Discounts 80 Accounts Receivable 3 920 Accounts Receivable 4 000

Payment of $6000 received after discount periodCash 6 000 Accounts Receivable 120 Accounts Receivable 6 000 Sales Discounts Forfeited 120

Cash 6 000 Accounts Receivable 6 000

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Gross Method Net Method

Non-recognition of interest element

• Ideally, receivables should be measured in present value terms

• When cash receipts require waiting period, receivable face amount is not worth amount received

• However, interest revenue related to accounts receivable is ignored because discount amount is not normally material

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VALUATION OF ACCOUNTS RECEIVABLE

• Current receivables are valued and reported at net realisable value

• Net realisable value is the net amount expected to be received in cash

• Requires estimation of– Uncollectable receivables– Returns or allowances granted

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Uncollectable accounts receivable

• Not based on matching principle

• Accounts written off when determined uncollectable

• Appropriate only if amounts are not material

• Based on matching principle

• Estimated bad debts matched against revenue

• Must be followed if amounts are material

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Direct Write-Off Method Allowance Method

Two procedures are used to record uncollectable accounts:

Uncollectable accounts receivable continued

• The estimate of uncollectable accounts is normally based on one of two approaches– Percentage-of-credit sales (or income statement)

approach– Percentage-of-receivables (or balance sheet)

approach

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1. Percentage-of-sales approach• Appropriate if there is a fairly stable

relationship between credit sales and bad debts

• Matches costs with revenues because it relates expense to period in which sale is recorded

• Allowance for Doubtful Debts is a contra account which is subtracted from accounts receivable on the balance sheet

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• Example– From past experience it is estimated that 2% of credit

sales will be uncollectable. – Credit sales in 2007 is $400 000– Journal entry:

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Bad Debt Expense 8 000Allowance for Doubtful Debts 8 000


2. Percentage-of-receivables approach• Allows a firm to estimate percentage of

uncollectable outstanding receivables without identifying specific accounts

• Objective is to report receivables in balance sheet at net realisable values

• Often use an ageing schedule which applies a different percentage based on past experience of age categories

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Matching

Sales Bad DebtsExpense

Income statement approach

Net realisable value

Accounts Allowance forReceivable doubtful debts

Balance sheet approach

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Percentage-of-sales Percentage-of-receivables

Comparison of methods of estimating uncollectables:


Collection of accounts receivable written off• When a particular account receivable is

determined uncollectable:

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Allowance for Doubtful Debts XXXAccounts Receivable – A. Customer XXX


• When collection is received that was previously written off, two journal entries are required as the account must be first reinstated

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Accounts Receivable –A. Customer XXXAllowance for Doubtful Debts XXX

Cash XXXAccounts Receivable – A. Customer XXX

RECOGNITION OF NOTES RECEIVABLE

• A note receivable is supported by a formal promissory note promising to pay a certain sum of money at a specific future date

• A negotiable instrument signed by maker in favour of designated payee

• May be sold or otherwise transferred• May be interest-bearing or non-interest-

bearing

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RECOGNITION OF NOTES RECEIVABLE continued

• Zero-interest notes (non-interest-bearing notes) include interest as part of their face amount instead of stating it explicitly

• Considered fairly liquid because they can be readily converted into cash

• Short-term notes generally recorded at face value (less allowances)

• Notes with maturities of 3 months, not subject to premium or amortisation

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RECOGNITION OF NOTES RECEIVABLE continued

• Longer term notes should be recorded and reported at present value of cash expected to be collected

• Stated interest rate (face rate, coupon rate) is rate contracted as part of note

• Effective interest rate (market rate, effective yield) is rate used to determine value of note i.e. discount rate used to determine present value

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Notes issued at face value

Example• M Ltd lends A Ltd $10 000 in exchange for a

$10 000 3 year note bearing interest at 10% p.a.

• Market rate of interest for note of similar risk is also 10%.

• PV of exchange price and PV of interest payments must be calculated.

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Notes issued at face value continued

• Calculation of exchange price

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Face value of note $10 000PV of principal $10 000(PVF3,10%) = $10 000(0.75132) $7 513PV of interest $1000(PVA3,10%) = $1000(2.48685) 2 487 PV of note 10 000Difference $ –

Notes issued at face value continued

• Journal entry to record receipt of note

• Journal entry to recognise interest earned each year

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Notes Receivable 10 000Cash 10 000

Cash 1 000Interest Revenue 1 000

Note not issued at face value

Zero-interest bearing notes• If a zero-interest-bearing note is received

solely for cash, its present value is the cash paid to the issuer

• Because both future (face) amount and present value are known, interest can be calculated (implied)

• Implicit interest rate equates cash paid with amounts receivable

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Note not issued at face value continued

• Difference between future amount and present value is recorded at a discount and amortised to interest revenue over the life of the noteExample– K Ltd receives a 3-year, $10 000 zero-

interest-bearing note the PV of which is $7721.80

– Implicit rate is 9% because it equates FV of $10 000 with PV of $7721.80

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– Journal entry to record transaction

– Journal entry to recognise interest at end of first year

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Notes Receivable 10 000Discount on Notes Receivable

($10 000 – $7721.80) 2 278.20Cash 7 721.80

Discount on Notes Receivable 694.96Interest Revenue

($7721.80 x 9%) 694.96


Interest-bearing notes• Often the stated rate and the effective rate

are differentExample– M Ltd made loan to N Ltd and received 3-year $10

000 note bearing interest at 10% p.a.– Market rate for note of similar risk is 12%

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• Calculation of PV of two cash flows

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Face value of note $10 000PV of principal $10 000(PVF3,12%) = $10 000(0.71178) $7 118PV of interest $1000(PVA3,12%) = $1000(2.40183) 2 402 PV of note 9 520Difference $ 480


– Journal entry to record receipt of note at a discount

– Journal entry to recognise receipt of interest and amortisation of discount for the first year

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Notes Receivable 10 000Discount on Notes Receivable 480Cash 9 520

Cash 1 000Discount on Note Receivable ($9520 x 12%) 142

Interest Revenue 1 142


Notes received for property, goods or services• When this transaction occurs at arm’s length,

the stated interest rate is assumed to be at fair value

• Present value is the amount that reasonably approximates market value of the note

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Choice of interest rates

• In most transactions, effective or real interest rate is either evident or determinable

• However, it is difficult to determine PV of note if either– fair value of goods not determinable– note has no ready market

• Interest rate is approximated to by using an imputed interest rate

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VALUATION OF NOTES RECEIVABLE

• Short-term notes receivable are recorded and reported at their net realisable value

• Longer term notes receivable pose additional estimation problems

• They are considered impaired when it is probable that creditor will be unable to collect all amounts due (both principal and interest)

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DISPOSITION OF ACCOUNTS AND NOTES RECEIVABLE

• Owner may transfer accounts or notes receivable to accelerate cash receipts by secured borrowing or sales of receivables

• Reasons for early transfer– Providing sales financing for customers imperative in

many industries, e.g. sale of vehicles– Money may be tight and access to normal credit not

available or too expensive

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Secured borrowing

• Receivables often used as collateral in a borrowing transaction

• If loan is not paid, creditor has right to convert collateral to cash

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Sale of receivables• Factors are finance companies or banks

that buy receivables from firms for a fee and then collect money owed directly from customers

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CUSTOMERRetailer ofwholesaler

COMPANYManufacturer of

distributor

FACTOR

(3) Approves credit (4) Advances cash

(5) Ships goods

(6) Makes payment

(1) Places order

(2) Requests credit review

Sale of receivables continued

• Securitisation takes a pool of assets such as credit card receivables and sells shares in these pools of interest and principal payments

• In a factoring or securitisation transaction, receivables are sold on either a ‘without recourse’ or a ‘with recourse’ basis

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Sale of receivables continued

• Purchaser assumes risk of collectability and absorbs any credit losses

• Transfer is an outright sale of receivables both in form (title) and substance (control)

• Seller guarantees payment to purchaser in event debtor fails to pay

• Seller has continuing interest

• Each party recognises assets and liabilities it controls

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Sales without Recourse Sales with Recourse

Secured borrowing versus sale

Sale occurs if all the following occur:1. Significant risks and rewards of ownership

transferred to buyer2. Transferor retains neither managerial interest nor

control3. Revenue amount can be reliably measured4. Probable economic benefits will flow to transferor5. Costs incurred can be reliably measured

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PRESENTATION AND ANALYSIS

General rules in classifying receivables1. Segregate different types if material2. Ensure valuation accounts are offset against proper

receivables accounts3. Determine receivables classified as current assets

will be converted to cash within the operating cycle4. Disclose any loss contingencies that exist on

receivables

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Analysis of receivables• Receivables turnover ratio is used to

assess liquidity of receivables

• Provides indication of – Quality of receivables– Success of firm in collecting outstanding

receivables• Ageing schedule should be prepared to

determine how long receivables have been outstanding

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Average accountsreceivable (net)

Netsales

Accounts receivableturnover = ÷

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