intermediate financial accounting i cash and receivables

Intermediate Financial Accounting I

Cash and Receivables

Cash and Receivables 2

Objectives of this Chapter

I. 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 Methods

A. 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.



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.


Cash

Compensating 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 Readily convertible to known amount of

cash, and So near their maturity that they present

insignificant risk of change in value.


Cash Equivalents (CEs) 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. Hard lesson learned: reporting the auction-

rate notes as CEs by Kohl’s and ADC Telecommunications resulting in sizeable write-downs of these CE during the credit crunch due to no market exist for these investments.


Cash Equivalents (CEs) Although these auction-rate notes often

have long maturity dates (i.e., 30-year), they were traded on daily basis prior to the credit crunch in 2008.

This is how the holders of these notes argued to present them as CEs.

When the market for these notes froze (i.e., no buyers of these notes), the value of these assets dropped significantly to warrant a sizeable write down.


Cash Equivalents (CEs) FASB is considering to separate

reporting of cash from CEs. In July 2010, FASB staff proposed to

report cash equivalents (i.e., money market fund) as short-term investments.

This project was reassessed as a low priority project and no action was taken recently.


Cash

Using 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 receivable and notes receivable).

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

Balance Sheet Presentation of Receivables (Illustration 7-3, KWW, 14th e)



Trade Receivables

Accounts Receivable (A/R): 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).


Trade Receivables (contd.)

Notes Receivable (N/R): 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.


Trade 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

Journal Entry of Transaction

Valuation of A/R or N/R

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 units

Sale => 200 units

J.E.:Cash 1,900

Sales 1,900OR A/R 1,900

Sales

1,900


2. Cash Discounts (Sales Discounts)

When to Recognize the Adjustments: both Methods are acceptable.

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

B. Recognized at time of occurrence (Gross price 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 discounts were not taken:b. 1/31/x2 Cash 100

A/R 98Cash Discounts Not Taken 2

Finance charge or Cash Dis. Forfeited (interest revenue)

Note: If the discount period expired 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/R 100

Sales 100

a. 1/2/x2 Cash 98Sales Discounts 2

AR 100If discounts were not taken:b. 1/31/x2 Cash 100

A/R 100


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 10,000Sales 10,000

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

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


4. Uncollectible Accounts The Allowance Method for Uncollectible Accounts:

Estimate the bad debt (B/D) expense 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 Accounts

2,000

When B/D actually occurred: (i.e.,$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.

Presentation of Allowance for Doubtful Accounts



Three Methods in the Estimation of B/D Expense

1. Percentage-of-sales (income statement approach).

2. Percentage-of-accounts receivable (balance sheet approach).

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


1. Percentage-of-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 accounts200


3. Aging of A/R Method

The balance of the allowance prior to adj.= $100

B/D Expense= $2,300 - $100 = $2,200Adj. Entry: B/D expense 2,200 Allowance for Doubtful Account. 2,200

Age Amount B/D% Allowance Amount

0-30 10,000 4 400

31-60 7,000 10 700

61-90 4,000 17 680

Over 90 2,000 26 520

Total 2,300


Earnings Management

Discretionary accruals require a large degree of managers’ judgment

Managers can use the discretionary accruals to manage earnings.

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

Earnings Management Using Accruals: The Case of Nortel

Background: A Canadian communication company filed bankruptcy in 2009. It was hit very hard by the technology stock price decline in the early 2000s.

Accounting Scandals: Nortel overstated its bad debt expense of 2002 in order to reduce its bad debt expense of 2003 (thus, increase its earnings) even though the outstanding accounts receivables were similar for both years.


Earnings Management Using Accruals: The Case of Nortel (contd.)


Earnings Management Using Accruals – Sun Trust Banks Similar to Nortel, some banks also

overstated the loan loss reserve (an expense) for outstanding loans in a good earnings year and reduce the reserve in the following year to manage earnings.


Earnings Management Using Accruals – Sun Trust Banks (contd.) The SEC brought action against Sun

Trust in 1999, alleging Sun Trust manipulated its earnings by overstating loss reserve when it was not experiencing significant loan losses.

The SEC required Sun Trust to reverse the $100 million of loan loss reserve.

source: KWW,14th e, p377 and “The Mythical FDIC Fund by William M. Isaac*, AM BKR Final, 8/27/08).


Presentation of Receivables (see Illustration 7-23 of KWW 14th e)

General Rules : Segregate the different types of receivables. Appropriately offset the valuation accounts

against the proper receivables. Disclose any loss contingencies. Disclose any receivables pledged as collateral. Disclose the nature of credit risk, especially the

concentration of credit risk of receivables (i.e., receivable with common characteristics.).



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.



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 1,000

Sales 1,0005/1/x1 Cash 510

A/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%



Example B Installment Sales (with Interest):

Sales Price = $1,200

CGS = $900

Sales 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 322.83A/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),

product financing is mandatory to be competitive. Companies in these industries often created wholly-owned subsidiaries specializing in receivables financing.


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

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

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 without recourse.


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/R

Example Borrow $100,000 by pledging all receivables

for the borrowing:

Journal Entry:

Cash 100,000Notes Payable

100,000

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


Pledge of A/R

Example (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/R

Example (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 means 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 7-16 of KWW , 14th e 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 493,000 Interest Exp. 7,000 Notes Payable 500,000 A/R Assigned 700,000 A/R 700,000

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

Collection in March of $440,000 of assigned A/R less cash discounts of $6,000. Sales returns of $14,000 were received. Cash 434,000 Cash Discounts 6,000 Sales Returns 14,000 A/R Assigned 454,000

No Entry



Howat Mills Inc Citizens BankRemitted 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



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


An Alternative: Accounts Receivable Are Not Transferred to A/R Assigned

Howat Mills Inc Citizens Bank Issuance of note and assignment of A/R on 3/1: Cash 493,000 Interest Exp. 7,000 Notes Payable 500,000

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

Collection in March of $440,000 of assigned A/R less cash discounts of $6,000. Sales returns of $14,000 were received. Cash 434,000 Cash Discounts 6,000 Sales Returns 14,000 A/R 454,000

No Entry


Accounts Receivable are Not Transferred to A/R Assigned (cont)

Howat Mills Inc Citizens Bank Remitted March collections plus accrued interest ($500,000 x 0.12 x 1/12 = 5,000) to the bank on 4/1: Interest Exp. 5,000 Notes Payable 434,000 Cash 439,000

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

Collection in April of $144,000 of assigned A/R and $2,000 write-off as uncollectible: Cash 144,000 Allow. for Doub. Acct. 2,000 A/R 146,000

No Entry


Accounts Receivable are Not Transferred to A/R Assigned (cont.)

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

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

To transfer the remaining A/R assigned to A/R when the loan is paid off: No Entry

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 (commission is 0.75% to 1.5%) 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 (commission is 4 to 5%).


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 (A Sale of Receivables) 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(Source: Illustrations 7-18 Kieso, etc. 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 Textiles

5/1Cash 460,000Due from Factor 25,000Loss on Sale of Rec. 15,000

A/R 500,000

ABC Bank

A/R 500,000Due to Crest Texti. 25,000Interest Rev. 15,000Cash 460,000

Recognition of Bad Debt Exp.:Bad Debt Exp. 4,100

Allow. 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. 12,100

A/R 495,900Allow. for Doub. Acct. 4,100

A/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 12,900

Cash 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 (Interest revenue – bad debt expense).


Factor with Recourse (source: Kieso, etc. textbook)

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


Factor with Recourse

Three Conditions1. The transferred assets have been isolated

from the transferor (beyond the reach of the seller and its creditors);

2. Each buyer (transferee) 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 agreement.


Factor with Recourse (Contd.)

A recourse is an example of “continuing involvement” in a transfer of receivables

In the case of factor with recourse and meeting all three criteria, the transaction will be recorded as a sale with the recognition of assets obtained and liabilities expected.

The buyer (transferee) 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 (Source: illustrations 7-18, 7-19 and 7-20 of Kieso, etc. textbook) 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.


Factor with Recourse : Example (Contd.)– All Three Conditions Are Met and Treated As a Sale

Crest TextileCash 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

ABC Bank

A/R 500,000Due to 25,000

Crest Interest Rev. 15,000

Cash 460,000


Example of Factor with Recourse(contd.)

Crest Textiles


Due from Factor 12,100

Recourse Liability 6,000 Due from Factor 6,000

ABC Bank

Cash 481,900*Due to Crest 12,100

A/R 494,000Due to Crest 6,000

A/R 6,000*500,000-12,100-6,000

Transactions in May and June: bad debts occurred, $6,000; sales R&A occurred,$9,500; sales discounts taken, $2,600. The A/R collected, $481,900 (i.e., $500,000-12,100-6000).


Example of Factor with Recourse(contd.)

Crest Textile(Treated as a Sale)

Cash 6,900a


ABC Bank

Due to Crest 6,900 Cash 6,900

Settlement between Crest and ABC

a. $6,900 is $6,000 less than $12,900 in the case of factor without recourse. This is due to the bad debt amount $6,000 is absorbed by Crest Textile in the case of factor with recourse.


What if only $5,000 bad debts occurred in stead of the expected $6,000 in factor with recourse example on p78?

Crest Textiles



Recourse Liability 6,000 Due from Factor 5,000 Loss on Sale of Rec. 1,000

ABC Bank

Cash 482,900*Due to Crest 12,100

A/R 495,000Due to Crest 5,000

A/R 5,000

Transactions in May and June: bad debts occurred, $5,000; sales R&A occurred,$9,500; sales discounts taken, $2,600. A/R collected, $482,900 (*500,000-12,100-5,000).


What if only $5,000 bad debts occurred (contd.) :

Crest Textile(Treated as a Sale)

Cash 7,900a


ABC Bank

Due to Crest 7,900 Cash 7,900

Settlement between Crest and ABC

a. $7,900 is $5,000 less than in the case of factor without recourse. This is due to the bad debt amount $5,000 is absorbed by the seller (Crest Textile) in the case of factor with recourse.


The Profits of the Buyer (Transferee)under Factor With Recourse

Unlike factor without recourse, the profits for the buyer in the factor with recourse always equal the interest revenue (i.e., $15,000 in the above examples) due to bad debts being covered by the seller . Using previous examples:

When bad debts=$6,000, the profits of ABC = $489,100-$460,000-$6,900 =$15,000.

When bad debts =$5,000, the profits of ABC=$482,900-460,000-7,900=$15,000.


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 Receivable

Case 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 10,000

Sales 10,000

12/31/x1 No adjusting entry for accrued interest because the note is a non-interest bearing note.1/31 Cash 10,000

N/R 10,000

If the note is dishonored on 1/31 => A/R 10,000

N/R 10,000


Notes Receivable

Case 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 10,000

12/31/x1 Interest Receivable 200Interest Revenue 200

1/1/x2 Reversing Entry: Interest Revenue 200

Interest Receivable 2001/31/x2 Cash10,300

N/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/x1

1/31/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



Proceeds received by the firm from discounting the note (the bank will deduct the interest charge from the proceeds):

$10,300 - 309 = $9,991



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 =100

Footnote (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 10,000

N/R 10,000

If 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 10,310

N/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/R

Example 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/R

Example 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/R

Example A (contd.)12/31/x1 (recording receiving of $10,000

interest)Cash 10,000 Discount on N/R 1,594.4

Interest Revenue 11,594.4

P.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/R

Example 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.


Example B: 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 $ 93,169 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 93,169

Dis. on N/R 23,169Land 30,000Gain 40,000

When the market interest rate is unknown, the imputed interest rate is calculated as:

$70,000 = $93,169 x ? ? = 70,000/93,169 = 0.7513 0.7513 is the present value factor of 10%, 3 periods and

therefore, the imputed interest rate is 10%.

.


Notes Received for Property, Goods and Services (contd.) The discount on N/R will be amortized in the

next three years as follows:

.

Year 1 Year 2 Year 3

Discount on N/R 7,000 7,700 8,469

Interest Revenue 7,000 7,700 8.469


Notes Received for Property, Goods and Services (contd.) If the effective rate of the note is known, the present

value of the note will be calculated using the effective interest .

The gain 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 (i.e., $93,169) and the P.V. of the note.

.


Long-Term N/R

Example B (skip p114-121) 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/R

Example 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/R

Example 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/R

Example 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/R

Example 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/R

Example 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.


Fair Value Option (SFAS 159 or ASC825-10-25) Companies may choose the fair value option

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

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

If the company does not elect the fair value option for the financial instrument at the initial recognition, it may not use this option for the instrument in subsequent periods.


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

receivable with a fair value of $70,000 and a carrying amount of $58,000 (e.g. with $60,000 face amount and $2,000 discount on N/R) on 12/31/2011. The company chose the fair value option for these receivables on the first valuation of these recently acquired receivables.

Adjusting Entry:Fair Value Adjustment-N/R 12,000 Unrealized holding gain or loss* 12,000 * Reported in the income statement


Fair Value Option – An Example

For all subsequent periods, the change in fair value of the note will be reported as an unrealized holding gain or loss.

For example, assuming the fair value of the note at December 31, 2012 is $65,000, Loftus will record the following adjusting entry on 12/31/2012:

Unrealized holding gain or loss 5,000 Fair Value Adj. – N/R 5,000

128

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 flows using the historical expected interest rate.

129

Impairment Measurement and Reporting (contd.) Example (illustration 7B-3 onP355 of

KWW textbook): Carrying amount of investment

$100,000 The PV of expected future cash flows

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

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

130

Impairment Measurement and Reporting (contd.) Recording of impairment losses: Bad Debt Expense 12,434

Allowance for Doubtful Accounts 12,434

Write-off of impaired receivables:

Allowance for Doubtful Accounts 12,434

Notes Receivables 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).

132

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.

133

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.

134

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

usually created by a third party (referred to as a sponsor) 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.

135

The Special Purpose Entity (contd.) The SPE can be in the form of a trust,

partnership or corporation and is legally distinct from the transferor.

136

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 paper due in 30-60 days) collateralized on receivables transferred.

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

137

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

through”. The sponsor of the SPE charges the

transferor fees for creating and operating the SPE.

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

138

Off Balance Sheet Financing SFAS 140 (2000): If the SPE is a

qualifying 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 or the sponsor.

*The SPE has at least 3% (10% under FIN 46 (R)) of the fair value of its total assets invested by a third party.

139

Off Balance Sheet (B/S) Financing (contd.) With a qualifying SPE, the transferor obtain

an off-balance sheet financing. Problems Associated with off B/S financing:

If the receivables defaulted, the transferor may be forced to take back receivables or the banks eat losses.

A mismatch of long-term assets with short-term borrowing on the capital structure of the SPE.

.

140

Subprime Mortgage Crisis in 2007 Many of the subprime mortgage

receivables defaulted in 2007 due to the reckless lending in the early to mid-2000s.

When investors realized that the underlying assets for the SPEs’ securities were subprime mortgage receivables, SPEs had a hard time to issue new commerce paper to refinance the existing commercial paper.

141

Subprime Mortgage Crisis in 2007 (contd.) As a result, many sponsors (i.e.,

banks) of the SPEs had to pay off the commercial paper issued by the SPEs when it matures due to the agreements with the transferors.

These banks would, therefore, take these subprime mortgage receivables into their balance sheets.

142

Subprime Mortgage Crisis in 2007 (contd.) The banks would subsequently

recognize losses (i.e., impairment loss on the subprime mortgage receivables) on these receivables.

143

SFAS 166 and SFAS 167 The concept of qualifying SPE is

eliminated by SFAS No.166 issued in June 2009, and became effective as of the beginning of the first annual reporting period beginning after Nov. 2009 (i.e., January 2010).

SFAS 167 redefine variable interest entity and the assessment method in determining the primary beneficiary.

144

Consolidation of SPEs (source: KWW textbook , appendix 17B and FIN 46 ( R)).

Based on FIN 46 (R) (2003), a SPE is a variable interest entity (VIE ) when 1) wirth insufficient equity (i.e., thinly

capitalized), or

2) with equity holders cannot make decisions, or

3) with equity holders have in-proportionate controlling interest (i.e., holding 60% of voting rights but receiving 20% of benefits).

145

Consolidation (contd.) (source: KWW textbook , appendix 17B and FIN 46 ( R)).

Once an entity is identified as a VIE, a risk-and-reward model, not the voting-interest-model, is used in determining the consolidation party.

The voting-interest-model: the party with more than 50% of voting rights of an entity should consolidate the entity (ARB 51).

146

Consolidation (contd.) (source: KWW textbook , appendix 17B and FIN 46 ( R)).

The risk-and-reward model of FIN 46 (R ): the party who assumes majority of the risks and receive majority of benefits associated with the entity is the primary beneficiary party and should consolidate the entity.

147

Avoiding Consolidation under FIN 46 ( R )

A SPE with at least 10% of the fair value of the total assets invested by a third independent party is considered not thinly capitalized and is a qualifying SPE, not a VIE, under FIN46 (R).

A qualifying SPE is not subject to consolidation by the sponsor or transferor under FIN 46 ( R).

IFRS Insights (Source: KWW 14th e, p428-429)

The accounting on reporting related to cash and cash equivalent is essentially the same under both IFRS and GAAP except for the reporting of bank overdrafts, reported as cash under IFRS.

The allowance for doubtful accounts sometimes refers as provisions for doubtful accounts.

The fair value option is similar under GAAP and IFRS but not identical.


IFRS Insights (contd.)

IFRS and GAAP differ in the criteria used to account for transfers of receivables.

IFRS focused on risks and rewards and loss of control while GAAP uses loss of control as the primary criterion.

Also, IFRS allows partial transfer, GAAP does not.


intermediate financial accounting i cash and receivables

Documents

available cash

cash contd

petty cash

cash account source

examples of restricted

ious receivables

postdated checks receivables

assets valuation methodsa