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TRANSCRIPT
Chapter 7
Cash and Receivables
Skyline College
Lecture Notes
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Pivotal Issues When Managing Cash and Receivables
1. Cash needs
2. Credit policies
3. Level of accounts receivable
4. Financing receivables
5. Ethical estimates on credit sale losses
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Cash Considerations
Consists of: Currency and coins on
hand
Most liquid of all assets Central to operating cycle
Checks and money orders from customers
Deposits in checking and savings accounts
Cash may include a compensating balance—a minimum amount required
by a bank for a credit-granting agreement.
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Cash Requirements
Seasonal Cycles and Cash Requirements for a Manufacturer of Athletic Sportswear
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Credit Policies
The credit department: Examines the financial resources and debts of the
credit applicant Asks for personal references Gets credit rating from credit bureaus Determines the extent to which the company can
grant credit, if any
To increase the likelihood of selling to customers who will pay on time, companies develop control procedures and
maintain a credit department
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Evaluating the Level of Accounts Receivable
How many times, on average, does a company turn its receivables into
cash during an accounting period?
How long, on average, does it take a company to collect its accounts receivables?
Receivable Turnover Days’ Sales Uncollected
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Receivable Turnover
Reflects the relative size of a company’s accounts receivable and the success of its credit and
collection policies
Receivable Turnover = Net Sales
Average Net Accounts Receivable
$12,253.1
($2,120.2 + $2,083.9) ÷ 2
Nike’s ReceivableTurnover for 2004
(Amounts in Millions)
=
= 5.8 times
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Nike’s Days’ Sales Uncollected =
Days’ Sales Uncollected
Days’ Sales Uncollected =
365 days
Receivable Turnover
365 days
5.8
= 62.9 days
To interpret a company’s ratios, take into consideration the industry in which it operates
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Receivable Turnover for Selected Industries
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Financing Receivables
Money tied up in receivables is something that many companies seek to avoid
Companies may use one or more of these methods so that they can receive cash faster:
Set up a separate finance company
Borrow money and pledge A/R
In case of default on loan, A/R (collateral) can be taken and converted to cash to satisfy the loan
FactorA/R
Sale or transfer of A/R; the buyer may bear risk of collection (factoring without recourse) or the seller may bear risk of collection (factoring with recourse)
Ford Ford Motor Credit CompanyGM General Motors Acceptance Corp. Sears Sears Roebuck Acceptance Corp.
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How Factoring Works
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Factoring Details
Reports a contingent liability (a potential debt that can develop if customers don’t pay receivables)
What does the seller of receivables with recourse report in financials?
Typically 2% of total A/R for sales with recourse; Higher fee for sales without recourse
What fees are charged?
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Securitization
A company may sell a group of receivables in a batch at a discount to another company or to investors
When receivables are paid, buyer gets full amount, thus their profit depends on the amount of discount they negotiated
Circuit CitySells its receivables without recourse, so it has no further liability even if customers
do not pay
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Discounting
The sale of promissory notes held as notes receivable
Company AHolds $10,000 note
payable to Company B; Note will pay $600 in
interest If Company B pays, bank will receive $10,600 and realize a $1,000 profit
If Company B defaults, Company A is liable for the note
Company A should disclose the contingent liability (in the amount of note plus interest) in notes to its financial statements
BankBuys the note for
$9,600
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Estimating Uncollectibles
There will always be customers who do not pay their accounts, called uncollectible accounts, or bad debts
Match these expenses of selling on credit to the revenues they help generate
Estimate the uncollectible expense in the fiscal year
in which the sales are made
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Estimating Uncollectibles and Ethics
Because estimations are involved, earnings may be easily manipulated…
earnings are understated.
If the amount of losses from uncollectible accounts
are overstated,
earnings are overstated. If the amount of losses
from uncollectible accounts are understated,
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Discussion: Ethics in the World
WorldCom increased revenues and hid losses by continuing to bill customers for service for years after the customers had stopped paying.
Q. What impact do you think WorldCom’s actions had on Accounts Receivable and Sales?
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Cash Equivalents
Investments like time deposits or certificates of deposit (CDs) that have a term of 90 days or less
Nike’s Annual Report, 2005Cash and equivalents represent cash and short-term, highly liquid investments with original maturities of three months or less at the time of purchase. The carrying amounts reflected in the consolidated balance sheet for cash and equivalents approximate fair value due to their short maturities.
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Cash Control: Electronic Funds Transfer (EFT)
Method of conducting business transactions in which funds are transferred electronically
from one bank to another bank
Wal-Mart makes 75% of its
payments to suppliers using
EFT
Electronic Banking
ATM transactionsDebit and credit card purchases
Online bill-pay
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Direct Charge-Off Method
Recognize a loss at the time it is determined that an account is uncollectible
Date Uncollectible Accounts Expense XXX
Accounts Receivable XXX
Tax law requires use of this method when computing taxable income
Most companies do not use this method for financial reporting purposes because it does not conform to GAAP.
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The Allowance Method
Losses from bad debts are matched against the sales they help generate
At the time of sale, management cannot identify which customers will not pay
To observe the matching rule, losses from uncollectible accounts must be estimated
The estimate becomes an expense in the fiscal year in which the sales are made
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Alternate Account Names
Allowance for Uncollectible Accounts
Uncollectible Accounts Expense
Allowance for Doubtful Accounts
Allowance for Bad Debts
Bad Debts Expense
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Estimating Uncollectible Accounts
• Estimated loss should be: Realistic Based on objective information Based on past experience Based on current economic conditions
Two commonly used methods for
estimating loss
1. Percentage of net sales method
2. Accounts receivable aging method
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Percentage of Net Sales Method
How much of this year’s net sales will not be collected?
The answer determines the amount of uncollectible accounts expense for the year
The percentage amount is ususally based on the company’s historic losses
It ignores the difference between last year’s estimated losses and the actual losses incurred during the year
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Dec. 31, 20x9: Account balances: Sales, $645,000; Sales Returns and Allowances, $40,000; Sales Discounts, $5,000; Allowance for Uncollectible Accounts, $3,600. Management estimates that uncollectible accounts will average about 2 percent of net sales.
$12,000 $5,000)– $40,000– ($645,000 x .02 expense accounts bleUncollecti ==
Allowance for Uncollectible Accounts
Dec. 31 3,600Dec. 31 adj. 12,000
Dec 31 bal. 15,600
Percentage of Net Sales Method
After the above entry is posted, Allowance for
Uncollectible Accounts will have a credit balance of
$15,600
Dec. 31 Uncollectible Accounts Expense 12,000 Allowance for Uncollectible Accounts 12,000 To record the uncollectible accounts
expense at 2 percent of $600,000 net sales
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Accounts Receivable Aging Method
How much of the ending balance of accounts receivable will not be collected?
The ending balance of Allowance for Uncollectible Accounts is determined directly through an analysis of accounts receivable
The difference between the amount determined to be uncollectible and the actual balance of Allowance for Uncollectible Accounts is the expense for the period.
7–27
Notice that the estimated percentage uncollectible increases as accounts become further past due.
Analysis of Accounts Receivable by Age
The total past due for each category is multiplied by the estimated percentage uncollectible
The sum of the totals for each category is the estimated balance of Allowance for Uncollectible Accounts
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Accounts Receivable Aging Method (Case 1)
Dec. 31, 20x6: Management has estimated that $2,459 of Accounts Receivable are uncollectible. Allowance for Uncollectible Accounts has a credit balance of $800.
Allowance for Uncollectible Accounts
A credit adjustment of $1,659 will bring the account to its target balance
Dec. 31 800Dec. 31 adj. 1,659
Dec. 31 bal. 2,459
The target balance for the account is $2,459
Dec. 31 Uncollectible Accounts Expense 1,659 Allowance for Uncollectible Accounts 1,659 To bring the allowance for uncollectible
accounts to the level of estimated losses
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Accounts Receivable Aging Method (Case 2)
Dec. 31, 20x6: Management has estimated that $2,459 of Accounts Receivable are uncollectible. Allowance for Uncollectible Accounts has a debit balance of $800.
Allowance for Uncollectible Accounts
A credit adjustment of $3,259 will bring the account to its target balance
Dec. 31. 800Dec. 31 adj. 3,259
Dec. 31 bal. 2,459
The target balance for the account is $2,459
Dec. 31 Uncollectible Accounts Expense 3,259 Allowance for Uncollectible Accounts 3,259 To bring the allowance for uncollectible
accounts to the level of estimated losses
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Comparison of Two Methods
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Estimates Differ from Write-Offs?
Accounts receivable written off during a period will rarely equal the estimated uncollectible amount
Shows a credit balance when the total of
accounts written off is less than the estimated uncollectible amount
Shows a debit balance when the total of
accounts written off is greater than the
estimated uncollectible amount
Allowance for Uncollectible Accounts
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Writing Off an Uncollectible Account
When it becomes clear an account will not be collected, the amount should be written off to:
• Allowance for Uncollectible Accounts
• Accounts Receivable
The uncollectible amount was already accounted for as an expense when the allowance was established
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Bal. 2,209
Dec. 31 2,459
Writing Off an Uncollectible
Jan. 15, 20x7: R. Deering, who owes the company $250, is declared bankrupt by federal court.
Allowance for Uncollectible Accounts
Net realizable value of A/RBefore write-off $44,400 – $2,459 = $41,941
Jan. 15 250
The write-off does not affect the estimated net realizable value of accounts receivable
Accounts Receivable
Dec. 31 44,400Jan. 15 250
Bal. 44,150
After write-off $44,150 – $2,209 = $41,941
Jan. 15 Allowance for Uncollectible Accounts 250 Accounts Receivable 250 To write off receivable from R. Deering as
uncollectible because of his bankruptcy
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Making and Paying Notes
A promissory note is an unconditional promise to pay a definite sum of money on demand at a future
dateMaker
Person or company that signs the note and
promises to pay the amount
PayeeEntity to whom
payment is to be made
All promissory notes that the payee holds that are due in less than one year are categorized as notes receivable in the current
assets section of the balance sheet
All promissory notes that the maker holds that are due in less than one year are categorized as
notes payable in the current liability section of the balance
sheet
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A Promissory Note
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Key Components of Promissory Notes
Total proceeds of a note at maturity date (face value plus interest)
Maturity Value
Cost of borrowing money or the return for lending money, usually stated on an annual basis
Interest and Interest Rate
Length of time in days between the note’s issue date and its maturity date
Duration
Date on which the note must be paidMaturity Date