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Chapter 6:Chapter 6:

Cash and Accounts ReceivableCash and Accounts Receivable

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Chapter 6: Chapter 6: Cash and Accounts ReceivableCash and Accounts Receivable

Current asset: if intended to be converted into cash, or used up, within one year or within an operating cycle, whichever is longer.

Industries like aerospace and manufacturers of farm equipment may have operating cycles longer than a year.

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The Operating Cycle, Figure 6-1The Operating Cycle, Figure 6-1

CashCash

Sales to customers

Receive payment

Manufacture or purchase inventory

InventoryInventoryAccounts Accounts ReceivableReceivable

Note that the operating cycle is effectively completewhen the cash is “collectible,” or at the A/R stage.

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Current Asset ClassificationCurrent Asset Classification

The distinction is useful because it provides easy-to-determine, low-cost measures of a company’s short term liquidity.

Working capital = current assets - current liabilities

Current ratio = current assets/current liabilities

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Current Ratio=Current Ratio=Current assets/Current liabilitiesCurrent assets/Current liabilities

Current assets are often compared to current liabilities as an indicator of a company’s solvency.

Average current ratios also vary across industries.

Caution regarding this ratio, as it can actually increase in years before bankruptcy.

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CashCash

The cash account is the first asset listed in the current asset section of the balance sheet.

It consists of coin, checks, and bank drafts received by the company.

The only reporting issues for cash is whether there are restrictions on its use.

Some companies now report “cash and cash equivalents.” (More in Chapter 14)

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Proper Management and Proper Management and Control of CashControl of Cash

Proper cash management requires that enough cash be available to meet the needs of the company’s operations.

Too much cash is undesirable as it loses purchasing power in periods of inflation, and can generate additional cash if it is invested properly.

Control of cash– Control of records

Bank reconciliation– Physical control

Separation of duties

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Accounts ReceivableAccounts ReceivableAccounts receivable arise from selling goods

or services to customers on account.Recorded at face amount to be collected.However, we must also reflect the fact that a

portion of A/R may not be collected.Reasons for lack of collection:

1. sales discounts (cash discounts)2. sales returns3. sales allowances4. uncollectible A/R (bad debts)

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1. Cash Discounts1. Cash Discounts Cash discounts are offered by a company to

encourage its customers to pay early. The terms are usually expressed as “1/10, n/30”, which would mean a 1% discount if the customer pays within 10 days, or the net (full) amount is due within 30 days.

“Cash Discount” or “Sales Discount” is presented as a contra to Sales Revenue on the income statement.

Calculation of net sales on the I/S:Sales revenue

- Sales discounts (SD) - sales returns (see slide 11) (SR)

- sales allowances (see slide 11) (SA) = Net sales

Formula: S - SD - SR - SA = S(net)

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Journal Entries for Cash Discounts Journal Entries for Cash Discounts (gross method)(gross method)

Original sale: $100, terms 2/10, n/30.At time of sale:

A/R 100Sales Revenue 100

If received within 10 days:Cash 98Sales Discount 2

A/R 100If received after 10 days:

Cash 100A/R 100

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2. Sales Returns and Allowances 2. Sales Returns and Allowances If sales returns are small in amount, adjust A/R and

create a contra to Sales called Sales Returns when the merchandise is returned. Sales allowances are negotiated reductions in sales price after the sale.

Sales Allowance xxSales Returns xx

A/R xx If sales returns are significant (e.g., bookstore),

company must estimate the amount of sales returns expected, and adjust A/R (with a contra account similar to Allowance for Bad Debts) at the end of the period.

Estimated Sales Returns xxAllowance for Returns xx

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3.Allowance for Doubtful Accounts 3.Allowance for Doubtful Accounts Created as a contra account to A/R to indicate the

portion of A/R that will not be collected due to defaults on payments by customers.

Reason for Allowance account: Assume $1,000 sale in 2004 and default on collection in 2005.Record sale in 2004:

A/R 1,000Sales Revenue 1,000

Record default in 2005:Bad Debt Expense 1,000

A/R 1,000Note: this is called the direct method, and is not

GAAP, for the reasons listed on the next page.

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Problems with Direct Method Problems with Direct Method Problem: the direct method, on the previous

slide, does not achieve matching (revenues recognized in 2004, but a related expense was recognized in 2005).

Problem: the direct method does not correctly value the asset, A/R. The assets are overvalued until 2005, when the receivable is written off.

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Solution: the Allowance MethodSolution: the Allowance MethodSolution: create a contra to A/R, and estimate the

A/R that will not be collected. The AJE to record an estimate for uncollectibles in

2004 (for all uncollectibles):Bad Debt Expense 4,000

Allowance 4,000The GJE during 2005, when a specific A/R is

deemed uncollectible (this is called the write-off of a specific A/R):

Allowance 1,000A/R 1,000

When are the income statement and balance sheet affected?

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Estimation of UncollectiblesEstimation of UncollectiblesNote that we do not know in 2004 which

A/Rs will not be collected in 2005. Therefore, we must estimate uncollectibles. There are two methods:1. Percentage of sales2. Percentage of accounts receivable

Both methods are used to estimate uncollectibles for the AJE. The percentage of sales method is simpler, but the percentage of A/R method is more accurate.

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1. Percentage of Sales Method1. Percentage of Sales MethodUsually based on credit sales, but may use

total sales or net sales as basis.Calculation: Sales x % = Bad Debt Expense (focus on the debit side of the AJE)Called the Income Statement approach,

because: revenues x % = expense.

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2. Percentage of A/R Method 2. Percentage of A/R Method (using Aging Schedule) (using Aging Schedule)

Based on ending A/R and ending Allowance account.

Calculation: Ending A/R x % = Ending Allowance

(focus on the credit side of the AJE)Called Balance Sheet approach, because:

ending asset x % = ending contra asset.Requires the analysis of the Allowance account

before preparing the AJE.An aging schedule of A/R is the most accurate

way to estimate uncollectibles (see Figure 6-11).

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T-Account Approach for T-Account Approach for Percentage of A/R MethodPercentage of A/R Method

Based on the analysis of the Allowance account.

Calculate the “desired ending balance” based on an aging of A/R.

Now, given the Beginning, Ending and Write-off amounts, calculate the amount of the current estimate that must be added to the Allowance account to achieve the “desired ending balance.”

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Allowance for Doubtful Accts. Allowance for Doubtful Accts. (T-account)(T-account)

Allowance for Doubtful Accts.

1. Beginning Balance

1. The allowance established in the prior period carries forward for current period write-offs.

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Allowance for Doubtful Accts. Allowance for Doubtful Accts. (T-account)(T-account)

Allowance for Doubtful Accts.

Beginning Balance

Accounts Receivable

2. Write-off of specific accountsreceivable

2. Write-off of specific accountsreceivable

2. As specific accounts are determined uncollectible during the year, they are written-off to the allowance account as shown. These write-offs may cause the allowance account to have a debit balance before the AJE if the prior year’s expense was underestimated.

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Allowance for Doubtful Accts.Allowance for Doubtful Accts.(T-account)(T-account)

Allowance for Doubtful Accts.

Beginning Balance

Accounts Receivable

Write-off ofaccountsreceivable

3. Ending Balance

Write-off ofaccountsreceivable

3. The “desired ending balance” in the allowance account is estimated using the percentage calculation or the aging schedule.

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Allowance for Doubtful Accts. Allowance for Doubtful Accts. (T-account)(T-account)

Allowance for Doubtful Accts.

Beginning Balance

4. Recovery of write-offs

4. Recovery of write-offs

Accounts Receivable

Write-off ofaccountsreceivable

Ending Balance

Write-off ofaccountsreceivable

4. The recovery of an account receivable that has been written off must first be reversed back into A/R and the Allowance account. Then the collection is like the collection of any other A/R.

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Allowance for Doubtful Accts. Allowance for Doubtful Accts. (T-account)(T-account)

Allowance for Doubtful Accts.

Beginning Balance

5. Recognition of bad debt expense

Bad Debts Expense

5. Recognition of bad debt expense

Accounts Receivable

Write-off ofaccountsreceivable

Ending Balance

Write-off ofaccountsreceivable

5. The AJE to record the estimate of uncollectibles is calculated based on the amount necessary to achieve the “desired ending balance” in the allowance account. The focus is on the Allowance account.

Write-offrecovery

Write off recovery

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Class ProblemClass ProblemGiven the following information: At December 31, 2004, Company Z prepared

an aging schedule to determine that the uncollectible accounts receivable at that date were $18,000. The balance in the Allowance for Doubtful Accounts at 1/1/04 was a $3,000 credit. During 2004, the company wrote off $5,000 of specific accounts receivable that were deemed to be uncollectible.

Required: prepare the AJE to record the estimated uncollectibles at 12/31/04.

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Solution to Class ProblemsSolution to Class Problems

Allowance for Doubtful Accounts

(1) Post the beginning balance and write-off.

(2) Post the desired ending balance.

(3) Post the adjusting journal entry.

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Exercise 6-3Exercise 6-3(a) Sale on Dec. 12:

AJE on Dec. 31?

Payment on Jan. 5 (all $40,000):

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Exercise 6-3Exercise 6-3 (b) Sale on Dec. 12:

Payment on Dec. 20:

Less cash received; less sales (net) recognized because of the sales discount.

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Problem 6-4, Part (a) 2005Problem 6-4, Part (a) 2005Percentage of Sales method (a) 2005

Net sales = Sales - SD - SR - SA

B.D. Expense = 3% of net sales

AJE at 12/31:

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Problem 6-4, Part (b) 2005Problem 6-4, Part (b) 2005

Allowance for Doubtful Accounts

Note that, for the percentage of sales method, the AJE is posted before calculating the ending balance.

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Problem 6-4, Part (c) 2006Problem 6-4, Part (c) 2006(c) 2006

Net sales = Sales - SD - SR - SA

B.D. Expense = 3% of net sales

AJE at 12/31:

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Problem 6-4, Part (d) 2006Problem 6-4, Part (d) 2006

Allowance for Doubtful Accounts

Note that, for the percentage of sales method, the AJE is posted before calculating the ending balance.

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Brief Exercise 6-2, Parts (a) and (b)Brief Exercise 6-2, Parts (a) and (b)Given in your text: 2003 2002Beginning $5,500 $4,792Increases 4,400 3,788Decreases (4,492) (3,722)Recoveries 848 642Ending $6,256 $5,500(a) Bad debt expense?

(b) Write-offs?

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Brief Exercise 6-2, Part (c)Brief Exercise 6-2, Part (c)Given in your text:

2003 2002Beginning $5,500 $4,792Increases 4,400 3,788Decreases (4,492) (3,722)Recoveries 848 642Ending $6,256 $5,500

(c) Change?

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Manipulation of Sales and Bad Debt Manipulation of Sales and Bad Debt ExpenseExpense

Financial statement users should be aware of the fact that policies may vary from company to company in recognition of sales and in estimation of bad debt expense.

Additionally, users should watch for consistency in the recognition of these amounts from period to period.

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Foreign Currency ReceivablesForeign Currency Receivables and Payables and Payables

U.S. companies may buy and sell inventory with foreign companies located in foreign countries.

If the contract is denominated in a foreign currency, U. S. companies must recognize gains and losses from the change in the exchange rate between the foreign currency and the U.S. dollar.

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Dealing with Exchange RatesDealing with Exchange RatesForeign currency exchange rates fluctuate

daily.Daily quotes can be found in the newspaper or

Wall Street Journal.The class examples use direct quotes which

express one unit of a foreign currency in terms of the U.S. dollar. The rates move directly in relation to the related foreign currency receivable or payable.

Ex: Direct: one British pound (£) = $0.70 (Indirect: one U. S. dollar = 1.4286 £)

To convert indirect to direct: 1/indirect = direct or 1/direct = indirect

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Receivables Denominated in a Receivables Denominated in a Foreign CurrencyForeign Currency

See Motorola example in text (pp. 248 - 249).

This example is denominated in euros (1.5 million euros).

Date Direct quote Dec. 1: $1.10 per euro Dec. 31: $1.00 per euro

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Receivables Denominated in a Receivables Denominated in a Foreign CurrencyForeign Currency

See journal entries for Motorola. At the date of sale, we record a N/R in U.S. dollar equivalent based on one euro = $1.10

Calculation: 1.5 million euros x $1.10 = 1.65 million dollars.

Journal entry (in millions) at 12/1 to record sale:A/R (foreign currency) 1.65

Sales revenue 1.65 Note that a receivable in a foreign currency must be

converted to dollars before it can be recorded in a U.S. company’s books. Also, the receivable must be revalued as the foreign currency fluctuates.

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Receivables Denominated in a Receivables Denominated in a Foreign Currency - continuedForeign Currency - continued

Why a loss for Motorola at Dec. 31? The foreign currency went down with respect to

the dollar ($1.10 down to $1.00 = decrease of $0.10). If we received the euros today, we would sell it for less dollars, so decrease (credit) the foreign currency accounts receivable for $0.15 million (1.5 million x $0.10).

Journal entry (in millions):Exchange rate loss 0.15

A/R (foreign currency) 0.15

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Payables Denominated in a Foreign Payables Denominated in a Foreign CurrencyCurrency

The same concepts hold when a U. S. company buys goods from a foreign country, and the contract is denominated in the foreign currency, except that a decrease in the direct exchange rate means a decrease in the liability (as expressed in dollars) and an exchange gain (the liability will be payable with fewer dollars).

Increases in the direct exchange rate of the dollar with respect to the foreign currency will yield reverse effects for gains and losses.

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Hedging of Foreign Currency Hedging of Foreign Currency Receivables and PayablesReceivables and Payables

A company may “pass off” the risk of an unfavorable exchange rate change by entering into the marketplace and taking a equal and opposite position.

For example, if the company will be receiving 1.5 million euros, it could contract to sell 1.5 million euros on the same date. This offsets any losses or gains from the exchange rate to the date of sale.

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Class Problem P6-11 (1 and 3)Class Problem P6-11 (1 and 3)

(a)First, convert the currencies to direct exchange rates (dollars per unit of foreign currency). For example, convert .5 British pound per dollar (indirect) to dollars per British pound (direct) = $1 per 0.50 £ = 1/.5 = $2.00 per £:

At sale/ purchase At 12/31

British pound $2.00 $1.66667Euros $1.25 $1.11111

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Now journal entries for P6-11, Now journal entries for P6-11, parts 1 and 3 (use direct rates).parts 1 and 3 (use direct rates).

Part 1:(b) Journal entry at sale:

(c) Journal entry at 12/31:

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Now journal entries for P6-11, Now journal entries for P6-11, parts 1 and 3 (use direct rates).parts 1 and 3 (use direct rates).

Part 3:(b) Journal entry at purchase:

(c) Journal entry at 12/31:

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P6-11, Part (d)P6-11, Part (d)Exchange gains and losses occur because of

the differential movement of the two currencies, and are dependent on whether the company holds a receivable or payable.

If the company has a receivable denominated in a foreign currency, the dollar value of the receivable will decrease as the dollar moves down with respect to the foreign currency, and will result in a loss (see Part 1).

If the company has a payable denominated in a foreign currency, the dollar value of the payable will decrease as the dollar moves down with respect to the foreign currency, and will result in a gain (see Part 3).