cash and receivables

Intermediate Financial Accounting I

Cash and Receivables

Cash and Receivables 2

Objectives of this ChapterI. Discuss the asset valuation methods.II. Identify items to be included in the

cash account and discuss how cash and related items are reported.

III. Explain accounting issues related to valuation of accounts receivables -- trade discount, sales discount, sales returns and allowance, and uncollectible accounts.


Objectives of this Chapter (contd.)

IV.Discuss the means to use accounts receivable as a financial instrument -- pledge, assign and factor.

V. Discuss the valuation of notes receivable and the disposition of notes receivable.


I. Assets Valuation MethodsA. Acquisition Cost (Historical Cost):

Used in the initial recording for all assets except for:1. Investment in debt securities-held-to-

maturity.2. Long-term monetary assets (i.e., Long-term

N/R).

B. Current Entry Value (Replacement Cost): Applied in the inventory valuation (LCM).


Assets Valuation Methods (contd.)

C. Current Exit Value (net selling price or market value): Applied in the valuation of trading securities and securities-available-for-sale.

D. Net Present Value: Applied in the valuation of investment in debt securities-held-to-maturity and long-term monetary assets.Note: SFAS 159 allows the fair value option for financial assets and liablitlieis.


Cash and Receivables Liquidity: The amount of time expected

to elapse until an asset is converted into cash.

Liquid assets: Assets are available for conversion into cash quickly (i.e., cash, receivables, trading securities, etc..).

Liquidity is an indication of a company’s ability to meet its obligation.


II. Cash

What are included in the cash account?

A.Cash on hand:

B.Cash in bank:


Cash (contd.) What are excluded from the cash

account (source: FRR No. 1): Foreign currency with severe

restrictions - separate cash account. Certificates of deposits (CDs) -

Temporary Investments. Bank overdrafts - current liabilities (i.e.,

A/P) unless available cash is present in another account in the same bank (offsetting is required in this case).


Cash (contd.) What are excluded from the cash account

(source: FRR No. 1): Postdated checks- Receivables. IOUs - Receivables. Travel Advances - Prepaids. Employees’ Advances - Receivables. Postage stamps -Office supplies. Special purpose funds - Investments. Compensating balances - Restricted cash. Short-term papera (i.e., commercial paper) - S-

T investments.a. Investments with maturity of 3 to 12 months.


Restricted Cash

Compensating balances are examples of restricted cash which may require separate reporting.

Other restricted cash: petty cash, cash for payroll, cash for dividends. If the amount is material, separate reporting is required.


CashCompensating Balances (CB)

CB: The portion of any deposit maintained by a corporation to support an existing borrowing arrangements (ASR No. 148).

CB will increase the effective interest rate.

CB may also be payment for bank services rendered to the company.


CashCompensating Balances (contd.) If the CB is significant and is to support

short-term borrowing, the CB should be stated separately among the “cash and cash equivalent item” in current assets..

If the CB is significant and is to support long-term borrowing, the CB should be classified as noncurrent assets in either “Investments” or “ Cash on Other Assets” using a caption such as “Deposit Maintained as Compensating Balance”.


CashCompensating Balances (contd.)

The following two situations only require a footnote disclosure of the CB, not a separate reporting: 1) CB arrangement exists without agreements

that restrict the use of cash amount shown on the balance sheet statement;

2) CB arrangement is to assure future credit availability.


Other Cash Related Topics Electronic Fund Transfer (EFT): Cash Equivalents: short-term, highly liquid

investments that are both 1) readily convertible to known amount of cash, and 2) so near their maturity that they present insignificant risk of change in value. In general, only investments with original maturity

of three months or less qualify under these definitions.

Examples: Treasury bills, Commercial paper, and Money Market Funds.


CashUsing Bank Account

General checking accounts Imprest bank accounts Lockbox accounts


Cash Management and Control Cash Management:

1)to maintain sufficient balance of cash on hand for day-to-day operation;

2)to prevent large amount of idle cash on hand. Cash Control: to prevent losses of cash by theft

of fraud 1. Immediate deposit of cash.2.Cash payment by checks except for small

amounts.3.Separation of duties.4.Bank account reconciliation.


III.Receivables Receivables: claims held against

customers and others for money, goods or services.

Current Receivables: expected to be collected within one year or one operating cycle, whichever is longer.


Receivables (contd.) Trade Receivables: amount owed by

customers for goods sold and services rendered as part of normal business operations (i.e., accounts receivables and notes receivables).

Nontrade Receivables: all others (i.e., interest receivable, advances to employees, deposits to cover potential damages, etc.)


Receivables (contd.) Accounts Receivable: oral promises of

the purchasers to pay for goods sold and services rendered. They are usually collected in 30-60 days. Thus, A/R is always reported as a current asset with the net realizable value (i.e., A/R minus the allowance for uncollectible accounts).


Receivables (contd.) Notes Receivable: written promises to

pay a certain sum of money on a specific future date. N/R can be long-term or short-term and can be interesting-bearing or noninterest bearing.


Receivables (contd.) Short-term N/R is reported at net

realizable value (face amount – allowances for uncollectibles accounts).

Long-term N/R is reported at present value or the fair value (i.e., the quoted market prices of identical assets in active markets).


Valuation of A/R & N/R Valuation Adjustment(s) 1. Cash xx Sales xx

No Volume Dis. Sales R&A

2. A/R xx Sales xx

Net Realizable Value (NRV)

Cash Discount, Sales R&A, Volume Dis.,

Uncollectible Acc. 3. N/R xx Sales xx

Short-Term- NRV Long-Term-

Present Value or Fair value

Sales R&A

Uncollectible accounts (for short-term)


Adjustments Related to Sales

1. Volume Dis. (Trade Discounts)

2. Cash Discounts (Sales Discounts)

3. Sales Returns and Allowances

4. Uncollectible Accounts


1. Volume Discount When to Recognize the Adjustments: Not

reflected on the J.E.Unit price = $10Volume Dis. => 5% if purchase 100 or more unitsSale => 200 units

J.E.:Cash 1,900

Sales 1,900OR A/R 1,900

Sales

1,900


2. Cash Discount When to Recognize the Adjustments: All

Methods are acceptable.

A. Recognized at time of sale (Net Price Method)

B. Recognized at time of occurrence (Gross price Method)

C. Recognized at time of sale (Allowance method)


2A. Recognized at Time of Sale(Net Price Method)

Sales = $100, terms 2/10, n/3012/26/x1 A/R 98

Sales 98

a. 1/2/x2 Cash 98A/R 98


2A. Recognized at Time of Sale(Net Price Method) (contd.)

If Dis. not taken:b. 1/31/x2 Cash 100

A/R 98Cash Dis. not taken 2

Finance charge or Cash Dis. Forteited (interest revenue)

Note: If the discount period post on 12/31, adjustment is required to bring the A/R to the gross amount.


2B. Recognized at time of occurrence (Gross price Method)

Sales = $100, terms 2/10, n/3012/26/x1 A/R100

Sales 100

a. 1/2/x2 Cash 98Cash Dis. 2AR 100


A/R 100


2C. Recognized at Time of Sale(Allowance method)

Sales = $100, terms 2/10, n/3012/26/x1 A/R 100

Allowance for Cash Dis. 2Sales 98

a. 1/2/x2 Cash 98Allowance 2AR 100


A/R 100Allowance 2Cash Dis. not taken 2


3. Sales Returns & Allowances (FASB 48)

A. The amount of sales R&A is not significant.

B. The amount of sales R&A is significant and six conditions are not met.

C.The amount of sales R&A is significant and six conditions are met.


3A. The amount of Sales R&A Is Not Significant

If the amount of sales R&A is not significant, sales R&A are recognized at time of occurrence:

Sales Returns & Allowances xxx

A/R (or cash)xxx


3B. The Amount of Sales R&A Is Significant and Six Conditions Are Not Met

If the amount of sales R&A is significant, and the following six conditions are not met, postpone the revenue recognition until all six conditions are met or the return period expired.


Six Conditions (SFAS No. 48)1. Sales price is determinable or fixed;

2. Buyers have paid or have the obligation to pay the sales price;

3. The buyer’s obligation would not be changed due to theft or damage of the product after purchase;

4. Sellers are not responsible for the performance of the product;


Six Conditions (SFAS No. 48)

5. Buyers and sellers are two separate economic entities;

6. The amount of returns can be estimated.

If the amount of returns is significant and these conditions are not met, revenue cannot be recognized.


3C. The Amount of Sales R&A Is Significant and Six Conditions Are Met

Sales can be recognized in the period in which the sales are made.

Also, at the end of the same period, the amount of sales returns would be estimated and recognized.

10/5/x1 A/R 10,000Sales10,000

12/31/x1 Sales R&A 1,000Allow. for sale R& A1,000(estimate 10% returns)

1/10/x2 Allowance for sales R&A 900A/R 900


4. Uncollectible Accounts Current practice: Estimate the B/D exp. at the end of

the period and recognize the expense (SFAS No. 5).Adjusting entry for B/D expense:

Estimated B/D expense = $2,00012/31 B/D Expense 2,000

Allowance for Doubtful accounts2,000

When B/D actually occurred: ($200 B/D)Allowance for doubtful Accounts 200

A/R200


4. Uncollectible Accounts (contd.)

If $100 of the B/D recovered:A/R 100

Allow. for Doubtful Acct. 100Cash 100

A/R 100 The current practice is complied with the

matching principle. The direct write-off method (recognize the B/D

expense when it occurs) is not recommended.


Estimation of B/D Expense

1. Percentage of net credit sales (I/S approach).

2. Percentage of accounts receivable (B/S approach).

3. Aging of accounts receivable (B/S approach using individual account information).


1. Percentage of Net Credit Sales (I/S Approach)

Example:Net credit sales = $20,000

Estimated B/D exp. = 2% of net credit sales

Adjusting Entry

12/31 B/D Expense 400

Allow. for Doubtful accounts400


2. Percentage of A/R (B/S Approach)

A/R Balance = $50,000Estimated B/D = 1% of A/RBalance of the allow for doubtful accounts prior to

the adjustment = $300The new balance of the allow. for doubtful accounts

= $50,000 x 1% = $500Bad Debt Expense = $500 - 300 = 200

Adjusting EntryB/D expense 200

Allowance for Doubtful accounts 200


Age Amount B/D (%) Allowance Amount0-30 $10,000 1 $10031-60 $7,000 2 $14061-90 $4,000 3 $120

over 90 $2,000 4 $80Total $440

3. Aging-of-A/RThe balance of the allow. acct. = $100

B/D expense = $440 - 100 = 34012/31 adjusting entry:B/D Exp. 340

Allowance for Doubtful Accounts 340


Earnings Management

Managers can use the discretionary accruals to manipulate the income number.

Examples of discriminatory accruals: bad debt expense, warranty expense, sales returns (when expecting sig. returns), etc.


Interest on Receivables

Most of the A/R does not bear interest if the customers pay the amount within the term period. However, if payment is not made within the term period, the customer may have to pay interest on the unpaid balance.


Interest on Receivables Example A Credit sale of $1,000 was made on

3/1/x1, terms 2/10 and n/30. Financial charge is 1% per month on the unpaid balance. The customer paid the first half of the A/R on 5/1/x1 and the second half on 6/1/x1.


Example A (contd.)Journal Entries:

3/1/x1 A/R 1,000Sales 1,000

5/1/x1 Cash 510A/R 500Interest Revenue 10 a

6/1/x1 Cash 505A/R 500Interest Revenue 5 b

a. 1% x 1000 b. (1,000-500) x 1%


Interest on Receivables Example B Installment Sales (with Interest):

Sales Price = $1,200CGS = $900Sales were made on 5/1/x1, four equal payments of $322.83 were made on 8/1/x1, 11/1/x1, 2/1/x2 and 5/1/x2 with 3% of quarterly interest rate.$1,200 = X 3.7171 X = $322.83


Example B (contd.) Accrual Method:

Journal Entries5/1/x1 A/R 1,200

Sales Revenue 1,2008/1/x1 Cash 322.83

A/R 286.83Interest Revenue 36 1

11/1/x1Cash 322.83A/R 295.43Interest Revenue 27.40 2

1. 3% 1,2002. (1,200 - 286.83) 3%


Example B (contd.)2/1/x2 Cash 322.83

A/R 304.30Interest Revenue 18.53 1

5/1/x2 Cash 322.83A/R 313.43Interest Revenue 9.40 2

1. (1,200 - 286.83 - 295.43) 3%2. (1,200 - 286.83 - 295.43 - 304.30) 3% A/R1,200 286.43 - 5/1/x1

295.43 - 8/1/x1304.30 - 2/1/x2313.43 - 5/1/x2


IV. Financing with Accounts Receivable –to accelerate the receipt of cash from receivables Two ways: 1. Secured borrowing

Pledge (General Assignment) Assign (Specific Assignment)

2. Sale of receivables (Factoring) With recourse Without recourse


IV. Financing with Accounts Receivable (contd.)

Advantages: 1) Immediate use of cash (i.e., pledge,

assign and factor); 2) Avoid the cost of billing and collection

(i.e., factor).

Disadvantages: 1) Service charge (i.e., assign and factor); 2) Interest charge (i.e., pledge and assign)


IV. Financing with Accounts Receivable - Reasons

Pledge and Assign: Cash shortage and other ways of

borrowing are not available or too expensive.

Factor: In some industries (i.e., durable goods such as

automobiles, equipments), product financing is virtually mandatory to be competitive. Companies in these industries often created wholly-owned subsidiaries specializing in receivables financing (i.e., to buy receivables from the parent company).


IV. Financing with Accounts Receivable – Reasons (Contd.)

Factor (cont.): To avoid billing and collection costs. To avoid violation of existing ending

agreements. From a purchaser’s point of view,

buying receivables may be an alternative of making profits when reaching its legal lending limit.

Note: Credit card sale is a form of factor


Pledge of A/R(General assignment of A/R) Pledge of A/R:

Use A/R as a security (collateral) to borrow money from financial institutions. No journal entries are required for the pledge. Information related to the pledge is disclosed in the footnote.


Pledge of A/RExample Borrow $100,000 by pledging all receivables

for the borrowing:

Journal Entry:Cash 100,000

Notes Payable100,000

Notes: The company’s trade accounts are pledged as collateral for the $100,000 notes payable


Pledge of A/RExample (contd.) When the note is due and paid, the following

entry will be recorded: Notes Payable 100,000Interest Expense 3,000

Cash 103,000 Assume a 12% interest and a 3-month duration.


Pledge of A/RExample (contd.)

If the note is not paid on the maturity date, the lending institution can seize and collect the pledged A/R.

The borrower (the company) continues to have the control of the A/R. Cash used to pay off the note can be from any sources including proceeds received from the pledged A/R.


Assignment of Accounts Receivable(specific)

Use A/R as a mean to borrow money from banks or financial institutions.

Specific A/R are assigned as collateral for the borrowing.

Companies (the borrowers) continue to have the control of the A/R assigned and continue to collect assigned A/R from the customers.


Assignment of Accounts Receivable(contd.) The amount collected from the assigned

A/R must be remitted to the lending institution periodically.

The proceeds collected from the assigned A/R cannot be used for any other purposes until all loans are paid off.

The lender usually charges: 1) a service charge (i.e., 5% of the loan amount), 2) interest on the loan.


Example of (Specific) Assignment(Illustration 7-15 of KWW textbook with little

modification for April collections.) On March 1, 2010, Howat Mills Inc. (HM), assigns

$700,000 of its accounts receivable to Citizens Bank as collateral for a $500,000 borrowing. HM continues to collect the A/R; the account debtors are not notified of the assignment (a non-notification assignment). Citizens Bank charges a finance charge of 1% of the A/R assigned. The annual interest on the note is 12%. Settlement by HM to the bank is made monthly for all cash collection on the assigned receivable.


Example of Assignment (contd.)Howat Mills Inc Citizens Bank

Issuance of note and assignment of A/R on 3/1:Cash 493,000Finance Charge 7,000

Notes Payable 500,000A/R Assigned 700,000

A/R 700,000

N/R 500,000Cash 493,000Finance Revenue 7,000

Collection in March of $440,000 of assigned A/R less cashdiscounts of $6,000. Sales returns of $14,000 were received.Cash 434,000Cash Discounts 6,000Sales Returns 14,000

A/R Assigned 454,000

No Entry


Example of Assignment (contd.)Howat Mills Inc Citizens Bank

Remitted March collections plus accrued interest ($500,000 x0.12 x 1/12 = 5,000) to the bank on 4/1:Interest Exp. 5,000Notes Payable 434,000

Cash 439,000

Cash 439,000Interest Rev. 5,000N/R 434,000

Collection in April of $144,000 of assigned A/R and $2,000write-off as uncollectible:Cash 144,000Allow. for Doub. Acct. 2,000

A/R Assigned 146,000

No Entry


Example of Assignment (contd.)

Howat Mills Inc Citizens BankRemitted the balance due of 66,000 ($500,000-434,000) plusinterest on May 1 ($66,000 x 0.12 x 1/12)Notes Payable 66,000Interest Exp. 660

Cash 66,660

Cash 66,660N/R 66,000Interest Rev. 660

To transfer the remaining A/R assigned to A/R when the loanis paid off:A/R 100,000

A/R Assigned 100,000 No Entry


Example of Assignment (contd.) The balance sheet statement of HM on 4/1 after the

remittance of $434,000 cash collected from A/R Assigned in March, the balance of the A/R assigned account is $246,000 ($700,000 - $454,000) and the balance of the Notes Payable account is $66,000 ($500,000-$434,000). These two accounts will be presented on the balance sheet statement as :

Current Assets:Accounts Receivable Assigned $246,000 Notes Payable (66,000)Equity in A/R Assigned $180,000


Sale (Factor) of Accounts Receivable A common type of sale of A/R is a sale

to a factor. Factors are finance companies or banks

that buy receivables from businesses for a fee and then collect the receivables directly from the customers.


Sale (Factor) of Accounts Receivable In the case of factor, A/R would be

transferred to the purchaser. The buyer would collect the accounts,

not the seller. The seller relinquishes all rights

pertaining to the future collection of A/R.


Sale (Factor) of A/R (contd.)

Sale of A/R is a common practice in some industries such as textile, apparel, footwear, furniture, etc.

For some industries, sales financing is necessary in order to be competitive.

Credit card transaction is also a type of factoring arrangement.


Sale (Factor) of A/R (contd.)

Credit Card Sale (Contd.) The buyer (the card issuer) of the

receivable charges the seller (the merchant) a commission for the receivables purchased.

The buyer collects directly from customers (card holder).


Accounting for Factor

Factor without recourse Factor with recourse

Recourse is a right of a buyer of receivables to receive payments from the seller when debtors fail to pay.


Factor without Recourse

In the case of factor without recourse, the buyer assumes the risk of uncollectibility and absorbs any credit losses (i.e., bad debts).

Thus, factor without recourse is a sale of receivables both in form and in substance.


Example of Factor without Recourse(Illustration 7-17 of KWW textbook with some modifications.) Crest Textiles factors $500,000 of A/R with ABC

Bank on a without recourse basis. The receivables are transferred to ABC bank on 5/1. ABC bank charges 3% of financial charge for factor without recourse and retain an amount equals to 5% of the A/R to cover sales returns and discounts. Credit losses (bad debts) are absorbed by ABC bank due to factor without recourse. The ABC bank expects $4,100 of uncollectible accounts from the receivables purchased.


Example of Factor without Recourse(contd.)

Crest Textiles5/1Cash 460,000Due from Factor 25,000Loss on Sale of Rec. 15,000

A/R 500,000

ABC BankA/R 500,000Due to Crest Texti. 25,000Financing Rev. 15,000Cash 460,000Recognition of Bad Debt Exp.:Bad Debt Exp. 4,100Allow. For Doub. Acct. 4,100



Crest Textiles

.Sales R&A 9,500Sales Dis. 2,600

Due from Factor

12,100

ABC Bank

Cash 483,800Due to Crest Texti. 12,100A/R 495,900Allow. for Doub. Acct. 4,100A/R 4,100

Transactions in May and June: collects of $483,800 by ABC bank; sales R&A of $9,500; sales discounts taken of $2,600 and $4,100 bad debts written off by ABC bank.



Crest Textiles

Cash 12,900Due from Factor12,900

ABC Bank

Due to Crest Texi 12,900Cash 12,900

Final settlement between Crest Text and ABC Bank:

Note: The factor’s (ABC Bank) income from this factor is $15,000 - 4,100 (financing revenue - uncollectible receivables).


Factor with Recourse When receivables are sold with

recourse, the seller guarantees payment to the buyer in the event the debtor fails to pay (or the payment of the debtor is less than expected by the purchaser).

Thus, the seller retains the risk of uncollectibility.


Factor with Recourse SFAS No. 140 requires that a sale of

receivables with recourse be recognized as a sale if all three conditions are met, otherwise, the sale with recourse should be treated as a secured borrowing.


Factor with RecourseThree Conditions1. The transferred assets have been isolated

from the seller (transferor);

2. Each buyer has the right to pledge or exchange the assets it received and no constrains attached;

3. The seller does not maintain effective control over the transferred assets through repurchase.


Factor with Recourse (Contd.)

The buyer usually charges a higher fee in the case of factor without recourse than in the case of factor with recourse.


Example of Factor with Recourse Crest Textiles factors $500,000 of A/R with

ABC Bank on a with recourse basis. The receivables are transferred to ABC Bank on 5/1. ABC Bank charges 3% of financial charge for factor with recourse and retains an amount equals to 5% of the A/R to cover sales returns and discounts. Credit losses (bad debts) are absorbed by Crest Textiles, Inc. due to factor with recourse. The Crest Textiles, Inc. expects $6,000 of uncollectible accounts from the receivables factored.


Example of Factor with Recourse(contd.) – Treated as a Sale

Crest Textile(Treated as a Sale)

Cash 460,000Due from Factor 25,000Loss on Sale of Receivable 21,000*A/R 500,000 Recourse Liability 6,000*$21,000= $500,000x3% +6000 orNet Proceeds = $460,000+25,000 -6000=479,000.$21,000 = $500,000 – 479,000


Example of Factor with Recourse(contd.)


Recourse Liability 6,000 Due from Factor 6,000

Recognition of Bad Debts:




Sales R&A 9,500Sales Dis. 2,600

Due from Factor 12,100

Transactions in May and June (same as in without recourse example)




Cash 6,900a

Due from Factor 6,900

(Settlement between Crest and ABC)

a. $6,000 less than in the case of factor without recourse. This is due to the bad debt amount $6,000 is absorbed by the seller (Crest Textile) in the case of factor with recourse.


Factor with Recourse (Contd.) If the bad debt expense equals $4000

instead of as estimated $6,000, the settlement entry will be revised as follows:


Example of Factor with Recourse(contd.)-bad debt exp. < expected


Cash 8,900Due from Factor 8,900

Recourse Liability 2,000 Gain 2,000

(Settlement between Crest and ABC)


V. Notes Receivable Note receivable: A written promissory

note; can be interest bearing or non-interest bearing.

Short-term N/R: Recorded at the amount expected to be collected (i.e., NRV).

Interest bearing: Accrued interest recognized at the end of a period.

Non-interest bearing


Notes Receivable (contd.)

Long-term N/R:

1. Recorded at net present value

2. End of period valuation –NPV or the fair value (SFAS 159)

Note: Reporting a long-term note receivable at the fair value is an option. Once chose, the fair value method will be used for all subsequent periods.


Notes ReceivableCase I: Non-Interesting Bearing Example

Receiving a 3 month non-interest bearing note on 11/1/x1 with a face amount of $10,000.11/1/x1 N/R 10,000Sales 10,00012/31/x1 No adjusting entry for accrued interest because the note is a non-interest bearing note.1/31 Cash 10,000N/R 10,000 If the note is dishonored on 1/31 => A/R 10,000N/R 10,000


Notes ReceivableCase II: Interesting Bearing Example Short-term note with interest bearing;

annual interest rate = 12%. Receiving a 3-month interest bearing

note on 11/1/x1. Face amount is $10,000 and the annual interest rate is 12%


Case II (contd.)

11/1/x1 N/R 10,000Sales 10,00012/31/x1 Interest Receivable 200Interest Revenue 2001/1/x2 Reversing Entry: Interest Revenue 200Interest Receivable 2001/31/x2 Cash 10,300N/R 10,000Interest Revenue 300


Discount of Notes (to a bank or to any finance institution) Example: A 3-month note with a face

amount of $10,000 (received on 11/1/x1) is discounted on 12/1/x1.

Interest rate of the note = 12% (annual)Int. rate charged by the bank = 18% (annual)


11/1/x11/31/x212/1/x1

Bank is lending $10,300 on

12/1/x1

Bank is receiving $10,300 on

1/31/x2

Discount of Notes (contd.)

1. Maturity value of the note= $10,000 + 10,000 12% 3/12 = $10,300

2. Interest charged by the bank (discount)= $10,300 x 18% x 2/12 = $309


Discount of Notes (contd.) Proceeds received by the firm from

discounting the note (the bank will deduct the interest charge from the proceeds):

$10,300 - 309 = $9,991


Discount of Notes (contd.)J.E. on 12/1:

Cash 9,991Loss on Dis. of Note 109

N/R Discounted 10,000Interest Revenuea 100

a.Interest earned by the firm from holding the note for one month (11/1 ~ 12/1) = $10,000 12% 1/12 =100Footnote (FASB): Contingent liability of discounted note of $10,000


Discount of Notes (contd.) On 1/31/x2, the note is paid, the following entry will

be recorded:N/R discounted 10,000N/R 10,000If on 1/31/x2, the note is dishonored, the following entry will be recorded:(Assuming the bank charge $10 fee)N/R Discounted 10,000Loss on Dishonored Note 10,310N/R 10,000Cash 10,310


Long-Term Notes Receivable

Initial Recording: Net present value

End of Period: Net present value or

the fair value.


Long-Term N/RExample A Receiving a 2-year note on sales of

goods on 1/1/x1. The face amount of this note is $100,000 and the annual interest of the note is 10%. The interests are paid annually and the market interest rate is 12%. Present value of the note:

$100,000 0.79719 + 10,000 1.69005=96,620


Long-Term N/RExample A (contd.)1/1/x1Notes Receivable 100,000

Sales Revenue 96,620Discounts on N/R 3,380

Effective Interest of 20x1 = PV of note on 1/1/x1 12% = ($100,000 - 3,380) 12% = 11,594.4


Long-Term N/RExample A (contd.)12/31/x1 (recording receiving of $10,000 interest)Cash 10,000 Discount on N/R 1,594.4

Interest Revenue 11,594.4P.V. of the note on 1/1/x2 = 100,000 - (3,380 - 1594.4) = 98,214.4

Effective Interest of 20x2 = PV on 1/1/x2 12% = 98,214.4 12% = 11,785.7


Long-Term N/RExample A (contd.)12/31/x2 (recording int. received on 12/31/x2):Cash 10,000 Discount on N/R 1,785.7

Int. Revenue 11,785.7

12/31/x1 (recording face amount of N/R received on maturity date):

Cash 100,000 N/R 100,000

Discount on N/R has been amortized to zero after two years of amortization using the effective interest method.


Long-Term N/RExample B On 12/31/x1 La Tourette Inc. rendered services to

Husky Corp. at an agreed price of $73,844.10, accepting $18,000 down and agreeing to accept the balance in four equal installments of $18,000 receivable each 12/31. An assumed interest rate of 11% is imputed. Record the journal entries for La Tourette for the sale and for the receipts and interest on the following dates:1. 12/31/20x1 2. 12/31/20x23. 12/31/20x3 4. 12/31/20x45. 12/31/20x5


Long-Term N/RExample B (contd.) PV of $18,000 annuity @11%, four payments

= 18,000 3.10245 = 55,844.10Thus, the revenue from the services = 18,000 + 55,844.10 = 73,844.10

12/31/x1Cash 18,000Notes Receivable 72,000

Discount on N/R 16,155.9aRevenue from Services 73,844.10

a. (18,000 4) - 55,844.10 = 16,155.9


Long-Term N/RExample B (contd.)12/31/x2 (recording install. Payment of $18,000 and

the amortization of discount on N/R):Cash 18,000

N/R 18,000

Discount on N/R 6,142.85 Interest Revenue 6,142.85a

a. Interest Revenue of 20x2 = pv of note on 1/1/x2 (or 12/31/x1) 11% = 55,844.1 11% = 6,142.85


Long-Term N/RExample B (contd.)12/31/x3Cash 18,000

N/R 18,000 Discount on N/R 4,838.56

Interest Revenue 4,838.56a

a. Interest Revenue of 20x3 = pv of note on 1/1/x3 11% = (55,844.1 - 18,000 + 6,142.85) 11% = 43,986.95 11% = 4,838.56


Long-Term N/RExample B (contd.)12/31/x4 (recording install. Payment of 18,000 and

the amortization of discount on N/R):Cash 18,000



a. Interest Revenue of 20x4= pv of note on 1/1/x4 11% = (43,986.95 - 18,000 + 4,836.56) 11% = 30,825.51 11% = 3,390.81


Long-Term N/RExample B (contd.)12/31/x5Cash 18,000



a. Interest Revenue of 20x5 = pv of note on 1/1/x5 11% = (30,825.51 - 18,000 + 3,390.81) 11% = 16,216.31 11% = 1,783.68


Notes Received for Cash and Other Rights Avon Co. accepts a 3-year, $100,000,

zero-interest-bearing note from Andrew Co. plus the right to purchase 50 machines at a bargain price in exchange for $100,000 in cash. Assume that the current rate is 10% (for a similar note without the right):


N/R Received for Cash and Other Rights (contd.)

J.E. for Greene:N/R 100,000Prepaid Purchase 24,868

Cash 100,000Discount on N/R 24,868

The $24,868 will be amortized as interest revenue in next 3 years. The prepaid purchase will be amortized (proportionally to 50 machines) to increase the purchase price of machines.


Notes Received for Property, Goods and Services Example: Lenex sold a lot to Impex as

an office site. Lenex accepted a 3-year note with a maturity value of $150,200 and with no stated interest rate. The land originally cost Lenex $30,000 and had an appraised fair value of $70,000 on the selling date.


Notes Received for Property, Goods and Services (contd.)J.E.: N/R 150,200

Dis. on N/R 80,200Land 30,000Gaina,b 40,000

a. Use the fair value of the land as the present value of the note assuming the discount rate of the note is unknown.

b. The discount of N/R will be amortized in next three years. If the effective rate of the note is known, the present value of the note can be calculated. The gain amount will be the difference between the P.V. of the note and the cost of the land. The discount amount will be the difference between the maturity value and the P.V. of the note.


Fair Value Option Companies can choose the fair value

option when the financial instrument is originally recognized or when some event triggers a new basis of accounting (i.e., acquisition).

Once chosen, the company has to use the fair value option in subsequent periods.


Fair Value Option – An Example Assume that Loftus Company has notes

receivable that have a fair value of $70,000 and a carrying amount of $58,000 on 12/31/2010. The company chose the fair value option for these receivables on the first valuation of these recently acquired receivables.

Adjusting Entry:Notes Receivable 12,000 Unrealized holding gain or loss* 12,000 * Reported in the income statement


Fair Value Option – An Example For all subsequent periods, the fair value

of the note will be compared with the carrying amount of the note.

The adjusting entry will be performed to adjust the carrying amount of the notes receivable to the new fair value.

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Impairment Measurement and Reporting on Investment in Loan Receivables A loan receivable impaired when it is

probable that it will not collect all amounts due (both principle and interest).

Measurement: Compare the recorded investment (i..e,

the NRV or the carrying amount) with the present value of the expected future cash flow.

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Impairment Measurement and Reporting (contd.) Example (see P358 of KWW textbook): Carry amount of investment $100,000 The PV of expected future cash flows on the

investment at 10% historical interest rate is $87,566.

The loss on impairment = 100,000 – 87,566 = 12,434.

Recording: Bad Debt Expense 12,434 Allowance for Doubtful Accounts 12,434


Securitization A sale of securities (i.e., bonds or

commercial paper) backed (collateralized ) by a pool of assets.

These assets can be mortgage receivables (i.e., mortgage-backed securities), consumer loans (i.e., assets-backed securities), and corporate bonds (i.e., collateralized debt obligations).

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Securitization (contd.)

Securitizations are popular for two reasons:

1. Investors have a strong appetite in acquiring collateralized securities.

2. Companies and lenders with large amounts of receivables have incentives to engage in securitization.

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Securitization Performed by The Company When a company uses its assets (i.e.,

auto loan receivables) as collaterals to issue bonds (i.e., assets-backed securities), the receivables will remain on its balance sheet.

The company’s liability will be increased from the increase of bonds payable.

As a result, this transaction will have an adverse effect on its return on assets and debt/equity ratios.

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The Special Purpose Entity A special purpose entity (SPE) is usually

created by a third party which is independent of the company with receivables (referred to as the transferor).

The SPE serves the purpose of buying receivables from the transferor and issuing securities collateralized on the receivables transferred from the transferor.

The SPE can be in the form of a trust, partnership or corporation and is legally distinct from the transferor.

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Procedures of Securitization Performed by A SPE1. The transferor will first transfer its

receivables to the SPE.2. The SPE issues securities (i.e.,

commercial papers due in 30 days) using these receivables as collaterals.

3. The cash received by the SPE from issuing securities will go back to the transferor to pay off the receivables transferred.

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Procedures of Securitization Performed by A SPE (contd.) The SPE is served as a “pass

through”. The independent third party (i.e., an

investment bank) charges the transferor fees by creating and operating the SPE.

The transferor can continue to service the loan for a fee.

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Off Balance Sheet Financing If the SPE is a qualified SPE (i.e., with

at least 10% of capital invested by the third party who created the SPE), the transferor does not have to consolidate the balance sheet of the SPE.

As a result, both the receivables and the liabilities from issuing securities will appear only on the balance sheet of the SPE, not the transferor.

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Off Balance Sheet Financing (contd.) The transferor, therefore, has an off-

balance sheet financing. If the receivables goes bad, the transferor

may be forced to take back receivables or the banks eat losses.

Since the receivables on the SPEs are long-term assets while the securities issued by the SPE are short term liabilities, there is a mismatch on the financing of SPEs’ assets.

cash and receivables

Documents

available cash

cash contd

petty cash

cash account source

examples of restricted

ious receivables

postdated checks receivables

assets valuation methodsa