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Chapter 7

Cash: What is it? Coins, currency, funds on deposit (checking and savings), money orders, cashiers’

checks, personal checks, bank drafts, petty cash Cash Equivalents: Very short term investments, highly liquid, maturities of 3 months or less Reporting Cash: 3 Issues 1. Restricted Cash

• If restricted to support short-term borrowing (this could be a compensating balance), then that amount must be reported separately among the “cash and cash equivalents” item in current assets

• If compensating balance supports long-term borrowing, then it’s separately classified as non-current asset in either investments or other assets

• Other types of restrictions – if restricted for a long time (outside of current period), then it’s classified as non-current

• Subject to materiality constraint

2. Bank Overdrafts – when a check is written for more than the amount in cash account -reported as a current liability – usually added to accounts payable -usually not offset against cash unless there is another account in the same

bank 3. Cash Equivalents – highly liquid (1) readily convertible to cash (2) so close to maturity that they have insignificant risk of change in

interest rates – i.e. 3 month maturity or less – T Bills, commercial paper, money market

Receivables – claims against customers for money, goods or services Trade Receivables

• A/R – oral promises • N/R – written, often with interest

Non-Trade • loans to officers, deposits, advances to subsidiary • dividends receivable and interest receivable • generally classified and reported as separate items on Balance Sheet

Because they’re short term, we do not record at their present value (i.e., discount the receivable to its present value) or recognize interest on them

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Recognition Issues A) Trade Discounts or Quantity Discounts – These are deductions from Gross

Billing amount Ex. HP sells a server for $12,000 Offers Trade Discount of 10% -1,200 $10,800 HP would record receivable of $10,800, not $12,000 B) Cash Discounts – used to encourage prompt payment. Most common method

of recording is Gross method, but a company may also use Net method. 9/1/2009 Sales $1,000 2/10, n/30

Gross A/R 1,000 Sales 1,000

Net A/R 980 Sales 980

9/10/2009 Paid Cash 980 Sales Disc. 20 A/R 1,000

Cash 980 A/R 980

10/1/2009 Paid Outside Discount Period

Cash 1,000 A/R 1,000

Cash 1,000 A/R 980 Sales Disc. Not Taken 20

Valuation of A/R -reported at NRV -Uncollectible A/R: 2 methods (1) Direct Write-Off – simple, doesn’t match, not allowable under GAAP (2) Allowance Method (1) % Sales (Income Stmt) approach -focuses on Bad Debt Expense Ex. Estimates 2% of credit sales is uncollectible Credit Sales = 100,000 100,000 (.02) = 2,000 Bad Debt Exp 2,000 Allowance for Bad Debt 2,000 (2) % Receivables (Balance Sheet) approach -uses either % of receivables or aging -focuses on the balance in the allowance account Writing off account: Determine Jones can’t pay $500 account Allowance for Bad Debt 500 A/R 500

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If Jones subsequently pays, 1) Reestablish Receivable A/R 500 Allowance for Bad Debt 500 2) Show it paid Cash 500 A/R 500 If a company generally has material sales returns, it may be necessary to have allowance

accounts for SR&A Assume that ABC Corp generally has sales returns of 8% of sales during a period Sales = $100,000 Sales Returns & Allowances 8,000

Allowances for SR&A 8,000 On Income Stmt

Sales $100,000 Less: SR&A (8,000) Net Sales 92,000

On Balance Sheet

A/R 100,000 Less: Allow. for SR&A (8,000) Net Receivables 92,000

Recognition of N/R

• May be interest bearing or non-interest bearing

• Short-term notes are recorded at face value • Long-term notes are recorded at present value of cash to be collected

Notes issued at Face – these typically have interest rates which are equivalent to market rates

• These are recorded at Face Value

Notes Receivable XX Cash XX

Notes not issued at Face – these can either have no stated interest rate – called Zero-Interest Bearing - or the interest rate is different from market rates Notes with No Interest or Interest Different than Market

• No Interest – Interest is computed Assume the company has a $1,000 A/R that the customer wants to turn into a note and take 3 years to pay. So, the company agrees to accept $1,200 in payment for the receivable 3 years from now

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PV FV | | | | 1,000 1,200 1000 = 1200 (PVss, n=3, i=?) (1000/1200) = .833 or approximately 6.2% They would record this note N/R 1200 (recorded at FV) A/R 1000 Disc. on N/R 200 (represents the interest to be earned) (reported on BS as a contra-asset to N/R) Thus: N/R 1200 Less: Disc (200) Net N/R 1000 The discount is amortized using the Effective Interest Method YR 1: Disc. on N/R 62 Int. Rev. 62

Cash Received Interest Rev Disc. Amortized

Carrying Value

At Issue =CV*Effective Int. Rate

=Int. Rev. – Cash Received

1000

YR 1 0 62 62 1,062 YR 2 0 66 66 1,128 YR 3 0 70 70 1,198 = 1,200

Interest Bearing Notes Different from Market Assume Smith Co. loans $5,000 to Jones Co. The note has an 8% interest rate. Market rates are currently 10%. N=4. To determine how much to loan, Smith takes PV of interest and return of principal. N=5 PV of principal = 5000 (PVss, i=10, n=5) i=10 =5000 (.62092) = 3104.60 PV of interest= 5000(.08) = 400 400 (PVordann, n=5, i=10) 400 (3.79079) = 1516.32 $4620.92

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So, Smith records N/R 5,000 Cash 4,620.92 (only loans this much to make up for underlying interest) Disc. on N/R 379.08 Then amortize Disc. using Effective Interest Method

PMT # Cash Received Int Rev Discount Amortized Carrying Value 0 Mkt i*CV Int Rev – $ Rec’d 4620.92 1 400 462.09 62.09 4683.01 2 400 468.30 68.30 4751.31 3 400 475.13 75.13 4826.44 4 400 482.64 82.64 4909.08 5 400 490.91 90.91 5000

At first interest receipt YR 1 Cash 400 Disc. on N/R 62.09 Int. Rev 462.09

Valuation of N/R • Short-term N/R should be valued at their NRV, just like trade A/R • Note: Companies can elect to report Long-term N/R at their fair value each period

o The FASB has given this option for most financial instruments, including receivables

• LT N/R would first be recorded at fair value (either cash equivalent or fair value of the asset given up)

o Unrealized holding gains or losses would be reported each period as part of income

• If a company elects to use fair value for a fin instrument, then it must continue to use it until it no longer owns the instrument

• If a N/R becomes impaired, then the co. recognizes a loss in the period it recognizes the impairment

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Transferring A/R or N/R Can be accomplished in 2 ways: 1) Secured borrowing -Rec. used as collateral for borrowings Assume ABC borrows 10,000 from XYZ on Sept. 1. ABC pledges 13,000 of Receivables to cover. XYZ charges 1% of receivables plus 10% interest on the loan

ABC

9/1 Cash 9870 Financing Exp 130 N/P 10,000

XYZ

9/1 N/R 10,000 Cash 9870 Financing Rev 130

ABC collected $7000 of receivables less $200 in discounts and 500 in returns

10/1 Cash 6300 Sales Disc 200 SR&A 500 A/R 7000

No entry

Remits to XYZ plus interest

10/3 Interest Exp 83.33 (10000*.1*1/12) N/P 6300 Cash 6383.33

10/3 Cash 6383.33 N/R 6300 Int. Rev. 83.33

Collects Balance

11/1 Cash 6000 A/R 6000

No entry

Remits to XYZ 11/3 N/P 3700 Int. Exp 30.83 (3700*.1*1/12) Cash 3730.83

11/3 Cash 3730.83 Int. Rev 30.83 N/R 3700

Factoring Receivables – Factoring receivables = selling the receivables 1) Factored without recourse – purchaser assumes risk of collectability and absorbs losses -This is an outright sale in both form and substance

Basic form of entry: Loss on Sale of A/R xx (amount of factoring charge, non-collection estimates, discounts, etc.) Cash xx (amount received – less than A/R value) Due from Factor xx (amount withheld by factor to cover extra discounts, returns, etc.) A/R xx

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Assume Bugs Bunny Co. factors $100,000 in receivables to Yogi Bear Bank. Yogi charges 2% of amount factored (A/R) and retains 5% of A/R

Bugs Cash 93,000 Loss on Sale of A/R 2,000 Due from Factor 5,000 A/R 100,000

Yogi A/R 100,000 Cash 93,000 Financing Rev 2,000 Due to Bugs 5,000

2) Factored with recourse -seller guarantees payment and purchases if the A/R proves uncollectible -in this case, the seller has to recognize a liability estimating its obligation under the recourse agreement Suppose same facts except that Bugs determines its obligation under the recourse agreement is $4500. Bugs A/R 100,000 Less: Charge (2,000) Less: Due from Factor (5,000) Resource Obligation (4,500) 88,500 Net proceeds = cash received + due from factor – recourse obligation = 93000 + 5000 – 4500 Cash Received 93,000 Add: Due from factor 5,000 Less: Resource Obligation (4,500) Net proceeds 93,500 Loss = Carrying Value 100,000 Less: (Net Proceeds) (93,500) Loss on sale (6,500) Note: A much easier way to determine the loss on the sale is to calculate it as the $2000 finance charge + recourse obligation of $4500 (2000 + 4500 = 6500) Bugs Cash 93,000 Due from Factor 5,000 Loss on Sale 6,500 A/R 100,000 Recourse liability 4,500

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Yogi A/R 100,000 Cash 93,000 Fin. Rev. 2,000 Due to Bugs 5,000 To be a sale, rather than a secured borrowing, 3 conditions must be met: 1) Transferred asset is isolated from the transferor 2) Buyer has the right to dispose of (transfer or exchange) the assets 3) Transferor doesn’t maintain control through a repurchase agreement If it doesn’t meet the 3 criteria, then it’s a secured borrowing