Cash and Receivables

Cash and Receivables BUS320 Fall 2010

Cash What is cash?

Terms associated with cash Restricted cash balances Cash equivalents Overdraft Compensating balances Foreign currency

Restricted Cash If the restricted cash balance is material, must be segregated from Cash as follows: Classified ascurrent assets if they relate toshort-termloans Classified asnon-current assets if set aside for investment or financing purposes (e.g. plant expansion) Note disclosure of restricted cash is required • Compensating balances: minimum cash balances maintained by a corporation in support ofexisting borrowings; these funds are notavailable for use by the corporation, but the bank can use the restricted cash • Petty cash, special payroll, and dividend accounts are examples of cash set aside for a special purpose (usually not material)

Cash Equivalents Defined as “short-term, highly liquid investments that are readily convertible to known amounts of cash…subject to an insignificant risk of change in value.” Original maturity is generally three months or less Excludes equity securities Examples: treasury bills, money-market funds, commercial paper Cash equivalents are reported at fair value Under IFRS some equity instruments can be classified as cash equivalents, e.g. preferred shares acquired within a short time of their maturity and with a specified redemption date

Bank Overdrafts Overdrafts represent cheques written in excess of the cash account balance Overdrafts are reported as current liabilities (often reported as accounts payable) In general, bank overdrafts should not be offset against the Cash account However, bank overdrafts may be offset against available cash in another account if both accounts are at the same bank

Foreign Currencies Amount held in foreign currencies is reported in Canadian dollars at the balance sheet date The exchange rate on the balance sheet date is used to translate foreign currencies into Canadian dollars If restrictions exist on the foreign funds, those funds are reported as restricted

E7-2

E7-2 1. 2. 3.

E7-2 (contd.) 4. 5.

Internal control of cash Risk of theft directly related to individual’s access to the accounting system basic rule – division of duties separate cash handling and record keeping use financial institutions to hold cash – bank daily

Bank Reconciliation Ensure that company records for cash agree with the bank’s Start with cash balance on books Add/subtract info the bank knows that you didn’t e.g. service charges, returned cheques, authorized payments Arrive at “correct” cash balance Start with bank balance Add/subtract info the you know that the bank doesn’t e.g. most recent deposit, cheques that haven’t cleared the bank yet, etc. Arrive at “correct” cash balance The two “correct” balances should be the same

E7-25 (a) From the April bank reconciliation: Balance per bank $ 7,120 Add: Deposits in transit 1,540 Deduct: Outstanding cheques (2,000) Balance per books $ 6,660 per Bank per Books For the month of May: Cash balance on May 31 $ 8,760 $9,370 May deposits 5,000 5,810 May cheques 4,000 3,100 May note collected (not included in May deposits) 1,000 - May bank service charges 25 - May NSF cheque from a customer, returned by the bank (recorded by the bank as a charge) 335 - Do you know how to determine the amount of “Deposits in transit” at May 31? Do you know how to determine the amount of “Outstanding cheques” at May 31?

E7-25 (b) Bank Reconciliation, May 31, 2010 Balance per books 9,370 Add: Deduct: Correct cash balance Balance per bank 8,760 Add: Deduct: Correct cash balance

E7-25 (c) Journal entries for the company

Receivables Trade receivables

Recognition and measurement Recognize when amounts are probable, measureable and collectible Cash discount (2/10, net 30) encourage early payment of account how to record? Assuming discount will be taken? OR Ignoring discount and recording gross?

Gross methodNet method Sales of $10,000, terms 2/10, net 30 Accounts rec. 10,000 Accounts rec. 9,800 Sales 10,000 Sales 9,800 Payment of $4,000 received within discount period: Cash 3,920 Cash 3,920 Sales discount 80 Accounts rec. 3,920 Accounts rec. 4,000 Payment of $6,000 after the discount period: Cash 6,000 Accounts rec. 120 Accounts rec. 6,000 Sales discount forfeited 120 Cash 6,000 Accounts rec. 6,000 an adjunct revenue account

Sales returns and allowances Sales returns– return of goods after a sale Sales allowance – discount off sale price if goods are damaged or has some defect – no goods returned If returns are material and not measureable, need to delay the recognition of revenue Common to estimate returns: At year end: Sales returns and allowances 4,000 Allowance for sales returns and allow. 4,000 During the next year when returns occur: Allowance for sales returns and allow. 300 Accounts receivable 300 a contra revenue income statement account a contra asset balance sheet account

Uncollectible accounts receivable When sell on credit, need to estimate potential uncollectibility - referred to as the “impairment” of accounts receivable Direct write-off method - used when amounts are not considered to be material - easier but could record expense in period after sale When account considered to be uncollectible: Bad debt expense 60 Accounts receivable 60 If you should later collect an account that was previously written off: Cash 60 Uncollectible account recovered 60

Allowance method Recognizes an expense equal to the potential uncollectibility of the accounts receivable – establishes an allowance account against which accounts determined to be uncollectible are written off Percentage-of-credit sales method income statement approach based on net credit sales at the end of year, calculate from formula and increase allowance Bad debt expense xx,xxx Allowance for doubtful accounts xx,xxx

Aging of accounts receivable method Sort accounts receivable according to how long they have been outstanding Wilson Architect Group Accounts Receivable Aging Schedule December 31, 2008 1 to 30 31 to 60 61 to 90 Over days days days 90 days Customer Total Current past due past due past due past due Ace Supply 900 900 Bravo Decoration 350 350 Charton Books 1,100 600 500 Days Heating 750 750 Electric Sound 2,100 1,500 600

Establish a percentage for uncollectibility for each category of age of accounts receivable Multiply total in the age category by percentage, add amounts together to determine amount NEEDED in the allowance account Examine the allowance account to determine its current balance Increase the allowance account so end balance is the amount NEEDED Write off accounts against the allowance If an account is subsequently collected that had been written off: Re-establish through allowance Accounts receivable xx,xxx Allowance for doubtful accounts xx,xxx Then show its collection

E7-8

E7-8 • Morganfield Ltd. accounts receivable write-off: • McKinley Ltd. reinstatement of partial accounts receivable for amounts previously written off and now determined to be collectible: (b)

Cash flow from accounts receivable Credit card transactions Establish own credit card or allow the use of other cards Fee charged to company for each transaction Collection is assured, more convenient for customers, less cash on premises, often leads to increased sales e.g. assume credit card sales of $3,000 with fee of 3% Cash 2,910 Credit card expense 90 Sales 3,000

Debit card sales Similar to credit cards Fee charged by financial institution Money transferred through direct deposit No accounts receivable needed Loans secured by accounts receivable Borrow money with accounts receivable as collateral Record the loan and interest when owed; may also be a financing charge which is expensed When accounts receivable collected, repay the loan Disclose pledged assets in the notes

Transfer of accounts receivable Sale of accounts receivable to another institution (factoring) Early collection of the cash for a fee Usually sale to one company for a fee

Transfer of Receivables - can be named differently e.g. Loans Secured by Accounts Receivable Transfer of Accounts Receivable Let’s call all these Sale of Accounts Receivable “transfer of receivables” Assignment of Accounts Receivable can be with recourse or without recourse Factoring of Accounts Receivable

Securitization the transformation of financial assets such as accounts receivable into securities called asset-backed securities take pools of assets such as credit card receivables, mortgage receivables, etc. sell shares in the pools of interest and principal payments to independent trusts; some trusts may be special purpose entities (SPE) receivables are high quality; seller usually continues to service the receivables

The Dominion Bond Rating Service (DBRS) Canadian Securitization Market Overview – June 2010

Accounting for Transfer of Receivables • Transfer treated as a sale if • The transferred asset has been isolated from the transferor (put beyond reach of the transferor and its creditors even in bankruptcy or receivership) • The transferee has obtained the right to pledge or to exchange either the transferred assets or beneficial interests in the transferred assets • The transferor does not maintain effective control over the transferred assets through an agreement to repurchase or redeem them before their maturity • Cash XX,XXX • Financing expense XX,XXX • Accounts receivable XX,XXX Without recourse substantially all risks transferred With recourse transferor still responsible if not all accounts collected

Transfer treated as a borrowing if • Conditions for treatment as a sale not met • e.g., • - transferee retains substantially all of the risks and rewards of ownership • - transferee retains control over the assets • Cash xx,xxx • Discount on note payable xx,xxx • Note payable xx,xxx

Accounting for Transfers of Receivables Secured Borrowing Sale Continuing involvement by seller No continuing involvement by seller Transfers Record liability, Record interest expense Use financial components approach: 1. Reduce receivables, 2. Recognize component assets and liabilities, 3. Record gain/loss 1. Reduce receivables, 2. Record gain/loss

E7-19(b) Chessman Corporation factors $600,000 of accounts receivable with Liquidity Financing, Inc. on a with recourse basis. Liquidity Financing will collect the receivables. The receivable records are transferred to Liquidity Financing on August 15, 2010. Liquidity Financing assesses a finance charge of 2.5% of the amount of accounts receivable and also reserves an amount equal to 5.25% of accounts receivable to cover probable adjustments. Assume the conditions for a transfer of receivables to be accounted for as a sale are met, prepare the journal entries on August 15, 2010 for Chessman to record the sale of receivables. You have determined that the recourse obligation has a fair value of $6,000. Note: Loss on sale of receivables can also be calculated as the financing charge assessed plus the fair value of the recourse obligation (in this case, $600,000 X 2.5% + $6,000 = $21,000).

E7-19(b)

Long-term Loans Receivable Long-term loans receivable are recognized at fair value – i.e. the present value of the future cash flows When the stated interest rate is the same as the market interest rate, the note or loan is issued at its face value When there is a difference between the stated interest rate and the market interest rate, the note or loan is issued at a premium or a discount (i.e. the present value is greater or less than the face value) IFRS requires the use of the effective interest method of amortization

Note Receivable written promise to pay an amount (or series of amounts) on a specific day usually has an interest component terms: face value (maturity value) interest bearing non-interest bearing stated interest rate market interest rate interest payments only to maturity, then principal and interest OR blended payments of principal and interest

Possible note receivable situations • Principal of note is given; interest rate is considered reasonable • accrue interest as time passes – interest revenue, interest receivable • Interest = principal x rate x time • 2. Principal of note is given but interest is NOT considered reasonable • determine the interest that will be received per period • then calculate the present value of the note • Example: a $1,000, one-year note paying interest at 3% when market rate of interest is 5%, was received to settle an outstanding trade receivable account

PV of the note: N = 1; I = 5; FV = 1,030 (or N = 1; I = 5; PMT=30; FV = 1,000) Solve for the PV PV = 980.95 therefore there is a discount of 19.05 Notes receivable 1,000.00 Discount on note receivable 19.05

If need to calculate accrued interest before note matures: Assume note received on Nov. 1, 2010 and Dec. 31 is year end: On Dec. 31, 2010 Use discounted value of note and market interest rate to calculate interest revenue: 980.95 x .05 x 2/12 = 8.17 Interest receivable = 30 x 2/12 = 5 Interest receivable Interest revenue Discount now equals 19.05 – = Book value of the note receivable is 1,000 – = On Nov. 1, 2011 Interest revenue at maturity = = Interest receivable Interest revenue Cash 1030.00 Interest receivable 30.00 Note receivable 1000.00

Maturity value of the note is higher than the amount owed • but NO interest rate is given. Need to impute an interest rate Example: Customer buys merchandise with a sale price of $1,200 and agrees to pay $1,300 one year from the date of sale Need to find the implied interest rate in the note. N=1, PV = -$1,200, FV = 1,300; solve for interest Note: when using calculator or Excel to find interest rate, one of PV and FV must be stated as a negative amount i = % Note receivable 1,300 Sales 1,200 Discount on note receivable 100

When interest is accrued it is offset against the discount e.g. interest accrued in 6 months 1,200 x x 6/12 = Discount on note receivable Interest revenue

Last situation – blended payments over the life of the note • Payments include principal reduction and interest. By maturity, the • note is zero. e.g. A two-year note receivable for $10,000 at 5% requiring semi- annual payments of $2,658.18. Each interest payment date would have an interest revenue and a principal component. -2658.18 -2658.18 -2658.18 -2658.18 ------|--------------------|--------------------|--------------------|--------------------|---- 0 6 months 12 months 18 months 24 months We can actually confirm the present value of this note: PMT=2658.18; N=4; I=2.5; compute PV PV =

Interest earned in the first six months = 10,000 x .05 x 6/12 = 250 Assume the year end is only four months away 250 x 4/6 = 166.67 Year end journal entry: Interest receivable 166.67 Interest revenue 166.67 Journal entry two months later on the first payment date: Cash 2,658,18 Interest receivable 166.67 Interest revenue 83.33 Note receivable 2,408.18 Interest revenue over the next 6 months: (10,000 – 2,408.18) x .05 x 6/12 = 189.80

Can also prepare an amortization schedule:

E7-14

E7-14 • Interest bearing note (Option 1): • September 30, 2010 • Note Receivable 105,000 • Accounts Receivable 105,000 • December 31, 2010 • Interest Receivable 2,100 • Interest Revenue 2,100 • (105,000 x 8% x 3/12 = 2,100) • September 30, 2011 • Cash 113,400 • Interest Receivable 2,100 • Interest Revenue 6,300 • Note Receivable 105,000 • (105,000 x 8% x 9/12 = 6,300)

Cash and Receivables