Chapter 7 Intermediate Accounting

Three features of Allowance Method

1. Companies estimate uncollectible accounts receivable and compare the new estimate to the current balance in the allowance account 2. Companies debit estimated increases in uncollectibles to Bad Debt Expense and credit them to Allowance for Doubtful Accounts ( a contra asset account) through an adjusting entry at the end of each period 3. When companies write off a specific account, they debit actual uncollectibles to Allowance for Doubtful Accounts and credit that amount to Accounts Receivable

Cash Over and Short

A company uses a Cash Over and Short account when the petty cash fund fails to prove out -that is an error occurs such as incorrect change, overpayment of expense, or lost receipt If cash proves out short (i.e. th sum of the receipts and cash in the fund is less than the imprest amount0, the company debits the shortage to the Cash Over and Short account If cash proves out over, it credits the overage to Cash Over and Short The company closes Cash Over and Short only at the end of the year -it generally shows Cash Over and Short on the income statement as an "other expense or revenue" There are usually expense items in the fund except immediately after a reimbursemetn -therefore, to maintain accurate financial statements, a company must reimburse the funds at the end of each accoutning period and also when nearly depleted Under the imprest system, the petty cash custodian is responsible at all times for the amount of the fund on hand either as cahs or in the form of signed receipts -these receipts provide the evidence required by the disbursing officer to issue a reimbursement check further, a company follows two additional procedures to obtain more complete control over the petty cash fund 1. a superior of the petty cash custodian makes surpise counts of the fund from time to time to determine that a satisfactory accounting of the fund has occured 2. The company cancels or multilates petty cash receipts after they have been submitted for reimbursement, so that they cannot be used to secure a second reimbursemetn

Notes Receivable

A note receivable is supported by a formal promissory note, a written promise to pay a certain sum of money at a specific future date -such a note is a negoitable instrumment that a maker signs in favor of a designated payee who may legally and readily sell or otehrwise transfer the note to others although all notes contain an interest element because of the time value of money, companies classify them as interest-bearing or non-interest-bearing interest-bearing notes have a stated rated of interest zero-interest-bearing notes (non-interest bearing) include interest as part of their face amount Notes receivable are considered farily liquid, even if long-term, because companies may easily convert them to cash (although they might pay a fee to do so) Companies frequently accept notes receivable from customers who need to extend the paymetn period of an outstanding receivable -or they reequire notes from high-risk or new customers in addition, companies often use notes in loans to employees and subsidaries, and in the sales of PPE in some industries, notes support all credit sales the majority of notes, however, originate from lendign trasnactions the basic issues in accounting for notes receivable are the same as those for accounts receivable: recognition, valuation, and disposition

Recognition of Accounts Receivable

Accounts receivable generally arise as part of a revenue arrangement the concept of change of control is the deciding factor in determining when a performance obligation is satisfied and an account receivable recognized

Presentation of Allowance for Doubtful Accounts

Allowance for Doubtful Accounts shows the estimated amount of claims on customes that the company expects it will not collect in the future Companies use a contra account instead of a direct credit to Accounts Receivable because they do not know which customres will pay -the credit balance in the allowance account will absorb the specific write-offs when they occur Companies do not close Allowance for Doubtful Accounts at the end of the fiscal year

The Imprest Petty Cash System

Almost every company finds it necessary to pay small amounts for miscelanneous expenses such as taxi fares, minor office suplliers, and employees' lunches Disbursements by check for such items is often impractical, yet some control over them is important A simple method of obtaining reasonable control, while adhering to the rule of disbursement by ehck, is the impreset system for petty cash disbursement 1. The company designates a petty cash custodian, and gives the custodian a small amount of currency from which to make payments. 2. The petty cash custodian obtains signed receipts from each indvidiual to whom he or she pays cash, attachign evidence of the disbursement to the petty cash receipt. Petty cash transactions are not recorded until the fund is reimbursed; someone other tha nthe petty cash custoian records those entries 3. When the supply of cash runs low, the custodian presents to the controller or accounts payable cashier a a requrest for reimbursement supported by the petty cash receipts and other disbursement evidence. The custodian receives a company eheck to replenish the fund. At this point, the company records transactions absed on petty cash receipts. 4. If the company decides that the amount of cash in the petty cash fund is excessive, it lowers the fund balance as follows Subsequent to establishment, a company makes entries to the Petty Cash account only to increase or decrease the size of the fund

Reporting Cash

Although the reporting of cash is relatively straightforward, a number of issues merit special attention 1. Cash equivalents 2. Restricted cash 3. Bank overdrafts

Accounts Receceivable Turnover

Analysts frequently compute financial ratios to evaluate the liquidity of a company's accounts receivables To assess the liquidity of the receivables, the use the accounts receivable turnover -this ratio measures the number of time, on average, a company collects receivables during the period The ratio is computed by dividing net sales by average (net) accounts receivable outstanding during the year -theoretically, the numerator should include only net credit sales, but this info is frequently unavailable -however, if the relative amounts of creidt and cash sales remain fairly constant, the trend indicated by the ratio will still be valid Barring signficiant seasonal factors, average receivables outstanding can be computed from the beginning and ending balances of net trade receivables -this information shows how successful the company is in collecting its outstanding receivables If possible, an aging schedule should also be prepared to help determine how long recievables have been outstanding -a satisfactory accounts receivable turnover may have resulted because certain receivables were collected quickly though others have been outstanding for a relatively long period. An aging schedule would reveal such aptterns

Reconciliation of Bank Balances

At the end of each calendar month, the bank supplies each customer with a bank statement ( a copt of the bank's account with the customer) together with the customer's checks that the bank paid during the month If neither the bank nor the customer made any errors, if all deposits made and all checks drawn by the customer reached the bank within the same month, and if no unsuual transactions occured that affected either the company's or the bank's record of cash, the balance of cash is reported by the bank to the customer equals that shown in the customer's own records -this condition seldom occurs due to one or more of the reconciling items presented below a company expects differences between its record of cash and the bank's record -therfore, it must reconcile the two to determine the nature of the differences between the two amounts a bank reconciliaiton is a schedule explaining any differences between the bank's and the company's records of cash -if the difference results only from transactions not yet recorded by the bank, the company's record of cash is considered correct -but, if some part of the difference arises from other items, eitehr the bank or the company must adjusts its record a company may prepare two forms of a bank rec -one form reconciles from the bank statement balance to the book balance or vice versa -the other form reconciles both the bank balance and the book balance to a correct cash balance

Summary of Cash-Related Items

Cash and cash equivalents include the medium of exchange and most negotiable insturments if the item cannot be quickly converted to coin or currency, a company sepearately classifies it as an investment, receivable, or prepaid expense Companies segregate and classify cash that is unavailable for payment of currently maturing liabilities in the long-term assets section

Cash Controls

Cash is the asset most susceptible to improper diversion and use Management faces two problems in accounting for cash transations (1) to establish proper controls to prevent any unauthorized transactions by officers or emplyoees (2) to provide information necessary to properly manage cash on hand and cash transactions Even with sophisticated control devices, erors can and do happen To safeguard cash and to ensure the accuracy of the accounting records for cash, companies need effective internal control over cash Provisions of the Sarbanes-Oxley Act call for enhanced efforts to increase the quality of internal control (for cash and other assets) -such efforts are expected to result in improved financial reporting

Compensating balances

Cash separately classified as a deposit maintained as compensating balance Classify as current or noncurrent in the balance sheet. Disclose separately in notes details of the arrangement

Bank Charges

Charges recorded by the bank against the depositer's balane for such items as bank services, printing checks, not-sufficent-funds (NSF) checks, and safe-deposit box rentals The depositer may not be aware of these charges until the receipt of the bank statement

Postage on hand (as stamps or in postage meters)

Classification: prepaid expenses May also be classified as office supplies inventory

Bank Credits

Collections or deposits by the bank for the benefit of the depositer that may be unknown to the depositer until receipt of the bank statement Examples are note collection for the despositor and interest earned on interest-bearing checking accounts

Collectibility Assessment Based On Expected Cash Flows

Companies continually evalute their recievables to determine their ultimate collectibility many companies start with historical loss rates and modify these rates for changes in economic conditions that could affect a borrower's ability to repay the loan The discussion in the chapter assumed use o this approach to determine the amount of baddebts to be recorded for a period Companies commonly evaluate loans (long-term notes receivable) for collectibility absed on analysis of the expected contractual cash flows -they then apply discounted expected cash flow methods to measure the allowance and to report the loan at the net amount expected ot be collected

Fair Value Option

Companies have the option to use fair value as the basis of measurement in the financial statements The FASB believes that fair value measurement for financial instruments provides more relevant and understandable info than historical cost it considres fai r value to be more relevant because it reflects the current cash equivalent value of financial instruments -as a result, companies now have the option to record fair value in their accounts for most financia linstruments, including receivables if companies choose the fair value option, the receivables are recorded at fair value, with unrealized holding gains or losses reported as part of net icnome an unrealized holding gain or loss is the net change in the fair value of the receivable from one period to another, exclusive of interest reenue -as a result, the company reports the receivable at fair value each reporting date, it reprots the chane in value as part of net income companie may elet to use the fair value option at the time the financial instrument is originally recognized or when some event triggers a new basis of accounting (such as when a business acquisiton occurs) if a company elects the fair value option for a financial instrument, it must continue to use fair value measurement for that instrument until the company no logner owns this instrument if the company does not elect the fair value option for a given financial instrument at the date of recognition, it may not use this option on that specific instrument in subequent periods

Cash Discounts (Sales Discounts)

Companies offer cash discounts (sales discounts) to induce prompt payment cash discounts are generally presented in terms such as 2/10, n/30 (2 percent if paid within 10 days, gross amount due in 30 days) Companies usually take sales discounts unless their cash is severely limited -a custoomer at least avoids that rate of interest cost Companies should record accounts receivable and related reveue at the amount of consideration expected to be received from a customer -this approach is often referred to as the net method as it attempts to value the receivable at its realizable value theoretically, the net method is correct because the receivable is stated at realizable value (assuming estimates are correct) and the net sales measures the revenue recognized from the sale -however, many companies continue to use what is referred to as the gross method in recording the receivable and related sales under the gross method, a company recognizes sales discounts when it receives payment within the discount period and the income statment shows sales discounts as a deduction from sales to arrive at net sales

Valuation of Accounts Receivable

Companies record credit losses as debits to Bad Debt Expense (or Uncollectible Accounts Expense) -such losses are a normal and necessary risk of doing business on a credit basis Two methods are used in accounting for uncollectible accounts (1): the direct write off method and (2) the allowance method

Deposits in TransitBank

End-of-month deposits of cash recorded on the depositer's books in one month are received and recorded by the bank in the following month

Bank or Depositor Errors

Erros on either the part of the bank or the part of the depositor causes the bank balance to disagree with the depositor's book balance

Sale with Recourse

For receivables old without recourse (nonrecourse), the seller of the receivables assumes no responsibility for any credit losses associated with the transferred receivables the transfer of accounts receivable in a nonresource transaction is therefore an outright sale of the receivables both in form (transfer of title) and susbtance (transfer of control) in nonresource transactions (as in any sale of assets), the seller 1. Debits cash for the proceeds and credits accounts receivable for the face value of the receivables 2. Recognizes the difference, reduced by an provision for probable adjustments (discounts, returns, allowances, etc.) as Losso n sales of receivables 3. Uses a Due from Factor account (reported as a receivable) to account for the proceed rtained by the factor to cover probable sales discoutns, sales returns, and sales allowances

Secured Borrowing

If the loan is not paid when due, the creditor can convert the collateral to cash- that is, collect the receivables

Classification of Cash

If unrestricted, report as cash If restricted, identify and classify as current and noncurrent assets

Estimating the Allowance

In "real life," companies must estimate that amount when they use the allowance method expected uncollectible accounts are estimated based on infomration about past events (loss experience,) adjusted for current conditions and reasonable forecasts of factors that would affect uncollectible accounts while much judgment is involved, the goal is to develop the best estimate of expected uncollectible receivables

Choice of INterest Rate

In note transactions, other factors involved in the exchange, such as the fair value of the property, goods, or services, determine the effective or real interest rate But, if a company cannot determine that fair value and if the note has no ready market, determining the present value of the note is more difficult to estimate the presentv alue of a note under such circusmtances, the company must approximate an applicable interest rate that may differ from the stated interest rate -this process of itnerest-rate approximation is called imputation -the resulting interest reate is called an imputed interest rate the prevailing rates for ismilar instruments, from issuers with similar credit ratings, affect the choice of a rate restrictive covenants, collateral, payment schedule, ad the existing prime interest rate also impact teh coice a company determines the imputed interest rate when it receives the note -it ignroes any subsequent changes in prevailing interest rates

Disposition of Accounts and Notes Receivable

In the normal course of events, companies collect accounts and notes receivable when due and then remove them from the books However, the growing size and signficiance of creidt sales and receivables has led to changes in this "normal course of events." In order to accelerate the receipt of cash from receivables, teh owner may transfer accounts or notes receivable to another company for cash -various reasons for this early transfer. first for competitive reasons, providing sales financing for customers is virtually mandatory in many indsutries in the sale of durable goods, such as automobiles, trucks, industrial and farm equipment, computers, and appliances, most sales are on an installment contractb asis many major companies in these industries have created wholly owned subsidaries specialziing in receivables finacning second, the holder may sell receivables because money is tight and access to normal credit is unavailable or too expensive -also, a firm may sell its receivables, isntead of borrwoing, to avoid violating existing lending agreements finally, billing and colletion of receivables are often time-consuming and costly -credit card companies and others take over the collection process and provide merchants with immediate cash the transfer of receivables to a third party for cash happens in one of two ways 1. sales of receivables 2. secured borrowing

Lockbox accounts

Large multilocation companies frequently use lockbox acounts to collect in cities with heavy customer billing the company rents a local post office box and authorizes a local bank to pick up the remittances mailed to that box number the bank empties the box at least once a day and immediately creidts the company's account for collections -the greatest advantage of a lockbox is that it acceleartes the availabilitiy of collected cash Generally, in a lockbox arrangmenet the bank microfilms the checks for record purposes and provides the company with a deposit slip, a list of collections, and any customer correspondence A lockbox system improves the control over cash and accelerates collecton of cash If the income generated from accelerating the receipt of funds exceeds the cost of the lockbox system, then it is a worthwhile undertaking

Valuation of Notes Receivable

Like accounts receivable, companies record and report short-term notes receivable at their net amount expected to be collected- that is, at their face amount less all necessary allowances the primary notes receiable allowance account is Allowance for Doubtful Accounts -the computations and estimations involved in valuing short-term notes receivable and in recording bad debt expense and the related allowance exactly paralell that for trade accounts receivable companies estimate the amount of uncollectibles by an analysis of the receivables Long-term notes receivable invovle additional estimation problems -with the passage of time, historical numbers become less and less relevant FASB requires that for financial instruments such as receivables, companies disclose not only their cost but also their fair value in the notes to the financial statements

Physical Protection of Cash Balances

Not only must a company safeguard cash receipts and cash disbursements through internal control measures, but it must also protect the cash on hand and in banks Because receipts become cash on hand and disbursements are made from cash in banks, adequate control of receipts and disbursements is part of the protection of cash balances, along with certain other proceudres Physical protection of cash is so elementary a necessity that it requires little discussion -a company should make every effort to minimze the cash on hand in the office -it should onl have on hand a petty cash fund, the current day's receipts, and perhaps funds for making change Insofar as possible, it should keep these funds in a valut, safe, or locked cash drawwer -the company should transmit intact each day's receipts to the bank as soon as practiacble Accurately stating the amount of available cash both in internal management reports and in external financial statements is also extremely important Every compnay has a record of cash received, disbursed, and the balance -because of the many cash transactions, however, errors or omissions may occur in keeping this refcord a company must periodically prove the balance shown in the general ledger -it can count cash actually present in the office- petty cash, change funds, and undeposited receipts- for comparsion wiht the company records For cash on deposit, a company prepares a bank reconciliation- a reconciliation of the company's record and the bank's record of the compay's cash

Recovery of an Uncollectible Account

Occasionally, a company collects from a customer after it has written off the account as uncollectible The company makes two entries to record the recovery of a bad debt (1) it reverses the entry made in writing off the account, this reinstates the customer's account (2) it journalzies the collection in the usual manner the recovery of a bad debt affects only balance sheet accounts

Average Days to Collect Receivables

Often the accounts receivable turnover is transformed to days to collect accounts receivbale or days outstanding- an average collection period Companies frequently use the average collection period to assess teh effectiveness of a company's credit and collection policies -the general rule is that the average collection period should not greatly exceed the credit term period -that is, if customers are given a 60-day period for payment, then the average collection period should not be too much in excess of 60 days

Restricted Cash

Petty cash, payroll, and dividend funds are examples of cash set aside for a particular purpose -in most situations, these fund balances are not material, therefore companies do not segregate them from cash in the financial statements When material in amount, companies segregate restricted cash from "regular" cash for reporting purposes Companies classify restricted cash either in the current assets or in the long-term assets section, depending on the date of availability or disbursement Classification in the current section is appropriate if using the cash for payment of existing or maturing obligations (within a year or the operating cycle, whichever is longer) on the other hand, companies show the restricted cash in the long-term section of the balance sheet if holdign the cash for a longer period of time -among other potential restritions, companies need to determine whether any of the cash in accounts outside the US is restricted by regulations against exportation of currency Cash classified in the long-term section is frequently set aside for plant expansion, retirement of long-term debt, or for entry fee depoists Banks and other lending institutions often require customers to maintain minimum cash balances in checking or savings accounts -the SEC defines these minimum balances, called compensating balances, as "that portion of any demand deposit (or any time deposit or certificate of deposit) maintained by a corporation which constitutes support for existing borrowing arrangements of the corproation with a lending institution -such arrangements would include both outstanding borrowings and the assurance of future credit availability To avoid misleading investors about the amount of cash available to meet recurring obligations, the SEC reccomends that companies state separately legally restricted deposits held as compesnating balances against short-term borrrwing arrangements among the "cash and cash equivalent items" in current assets Companies should classify separately restricted depoits held as compensating balances against long-term borrwing arrangments as noncurrent assets in either the investments or other assets section, using a caption such as "cash on deposit maintained as compensating balance" IN cases where compensating balance arrangements exist without agreeements that restrict the use of cash amounts shown on the balance sheet, companies should describe the arrangements and the amounts involved in the notes

Sales of Receivables

Sales of Receiavbles have increased substantially in recent years A common type is a sale to a factor Factors are finance companies or banks that buy receivables from businesses for a fee and then collect the remittances directly from the customers Factoring receivables is traditionally associated with the textile, apparel, footwear, furniture, and home furnishing industries in a factoring or a securtization transaction, a company sells receivables on wither a without recourse or a with recourse basis

Receivables Balance Sheet Presentations

The basic issues in accounting for accounts and notes receivable are the same: recogntion, valuation, and disposition

Presentation of Receivables

The general rules in classifying receivables are: 1. Segregate the different types of receivables that a company possesses, if material 2. Appropriately offest the valuation against hte proper receivable accounts 3. Determine htat receivables classified in the current assets section will be converted into cash within the year or the operating cycle, whichever is longer 4. Disclose any loss contingencies that exist on the recievables 5. Disclose any receivables designated or pledged as collateral 6. Disclose the nature of credit risk inherent in the receivables, how that risk is analyzed and assesed in arriving at the allowance for credit losses, and the changes and reasons for those changes in the allowance for credit losses With respect to additional disclosures, companies are required to disaggregate based on type of receivable -in response to demands for additional information about creidt risk, the FASB recently isseud rules for companie to provide the following disclosures about its receivables on a disaggregated basis (1) a roll-forward schedule fo the allowance for doubtful accoutns from the beginning of the reporting period to the end of the reporting period (2) the nonacural status of recievables by class of receivables (3) imparied receivables by type of receivable Companies should disclose credit quality indicators and the aging of past due recievables Companies must disclose concentratons of credit risk for all financial instruments (includign receivables) -concentrations of credit risk exist when receivables have common characteristics that may affect their collection. These common characteristics ight be companies in the same industry or same region of that country Financial statement users want to know if a substanital amount of receivables from such sales are to customers facing uncertain economic conditions No numerical guidelines are provided as to what is meant by "concentration of credit risk"

Using Bank Accounts

To obtain desired control objectives, a company can vary the number and location of banks and the types of bank accounts For large companies operating in multiple locations, the location of bank accounts can be important Establishing collection accounts in strategic locatiosn can accelrate the flow of cash into the company by shortenring the time between a customer' mailing o fa payment and the company's use of the cash Multiple collection centers generally reduce the size of a company's collection float -the difference between the amount on deposit according to the company's records and teh amount of collected cash according to the bank record

Direct Write-Off Method for Uncollectible Accounts

Under the direct-write off method, when a company determines a particular acount to be uncolletible, it charges the loss to Bad Debt Expense Under this method, Bad Debt Expense will show only actual losses from uncollectibles -the company will report accounts receivable at its grross amount Supporters of the direct-write off method (which is often used for tax purposes) contend that it records facts, not estimates it assumes that a good account receivable resulted from each sale, and that later events revealed certain accounts to be uncollectible and worthless From a practical standpoint, this method is simple and convinent to apply the direct write-off method is theoretically deficient -usually fails to record expenses in the same period as associating revenues -nor does it result in receivables being stated at the net amount expected to be collected on the balance sheet using the direct write-off method is not considered appropriate, except when the amount uncollectible is immaterial

Entries under Gross and Net Methods of Recording Cash (Sales) Discounts

We present the gross method because companies may not use the net method for practicability reasons the net method requires additional analysis and bookepign to record sales discounts forfeited on accounts receivable that have passed the discount period if collection periods are relatively hort, usign either the gross or the net method results in the same amounts for revenues and receivables equal to the transaction price -any differences that arise are likely to be immaterial

Notes Received for Property, Goods, or SErvices

When a note is received in exchange for property, goods, or services in a bargained transaction entered into at arm's mength, the stated interest rate is presumed to be fair unless: 1. No interest rate is stated, or 2. The stated itnerest rate is unreasonable, or 3. The face amount of the note is materially different from the crurent cash sales price for the same or similar itmes or from the current fair value of the debt instrument In these circumstances, the fompany measures the present value of the note by the fair value of the proprety, goods, or servies or by an amount that reaponsably approximates the fair value of the note

Recording the Write-Off of an Uncollectible Account

When companies have exhausted all means of collecting a past-due account and collection appears impossible, the company should write off the account Bad Debt Expense does not increase when the write-off occurs Under the allowance method, companies debit every bad debt write-off to the allowance account rather than to Bad Debt Expense -a bad debt expense would be incorrect because the company has already recognized the expense when it made the adjusting entry for estiamted bad debts instead the entry to record the write off of an uncollectible accuont reduces both Accounts Receivable and Allowance for Doubtful Accounts

percentage-of-receivables approach

a company can estimate the percentage of its outstanding receivables that will become uncollectible, without identifying specific accounts this procedure provides a reasonably accurate estimate of the receivables' realizabl value companies may apply this method using one composite rate that reflects an estimate of the uncollectible receivables -or companies may set up an aging schdule of accounts receivable, which applies a different percentage based on past experience to the variou age categories -an aging schedule also identifies which accounts reqquire special attnetion by indicating the extent to which certain accounts are past due companies do not prepare an aging schedule only to determine bad debt expense -they often prepare it as a control device to dtermine the composition of receivables and to identify deliquent accounts -other appraoches are acceptable as long as the estiamtion techniques are applied consistnetly over time with the objective of faithfully estimating expected uncollectible accounts -or a company may utilize a probability-weighted discounted cash flow model to estimate expected credit losses (generally appropriate when analyzing an individual loan or receivable) the primary objective for financial statement purposes is to report receivables in the balance sheet at the net amount expected to be collected -the allowance for doubtful accounts as a percentage of receivables will vary, depedning on the ndustry and the economic climate regardless of the estimation appraoch used, determining the expense associated with uncollectible accounts reuqires a large degree of judgment -recent concern exists that some banks use this judgment to manage earnings by overestiamting the amounts of uncollectible loans in a good earnings year, the bank can "save for a rainy dat" in a future period in future, (less profitable) periods, banks can reduce the overly conservative allowance for loan loss account to increase earnings

Receivables

also financial assets often referred to as loans and receivables claims held against customers and others for money, goods, or services For financial statement puposes, companies classify receivables as either current (short-term) or noncurrent (long-term) Companies expect to collect current receivables within a year or during the current operating cycle, whichever is longer -classify all other receivables as noncurrent receviables are futher classifeid in the balance sheet as either trade or nontrade receivables

Sales Returns and Allowances

another form of variable consideration relates to sales returns and allowances Sales Returns and Allowances is a contra revenue account to Sales Revenue and offsets sales revenue on the income statement Allowance for Sales Returns and Allowances is a contra asset account to Accounts Receivable and offsets accounts receivable on the balance sheet 0this allowance account shows the estimated amount of claims expected to pay in the future the allowance account will absorb any additional write-offs that occur in the future The use of both Sales Returns and Allowances, and Allowance for Sales Return and Allowances accounts is helpful to management because they help identify potential problems associated with inferior merchandise, infefficiencies in filling orders, or delivery or shipment mistakes

Nontrade receivables

arise from a variety of transactions ex: -advances to officers and employees -advances to subsidaries -deposite paid to cover potential damanges or losses -deposits paid as a guarantee of performance or payment - dividends and interest receivable claims against -insurance companies for casualties sustained -defendants under suit -governmental bodies for tax refunds -common carriers for damaged or lost goods -creditors for returned, damaged, or lost goods - customers for returnable itms because of the peculiar nature of nontrade receivables, companies generally report them as separate items in the balance sheet

Outstanding Checks

checks written by the depositer are recorded when written but may not be recorded by (may not "clear" the bank until the next moth

Petty cash and change funds

classifcation: cash Report as cash

Short-term paper

classification: cash equivalents investmetns with maturity of less than 3 months, often combined with cash or classifcation: temporary investments investments with maturity of 3 to 12 months

Bank overdrafts

classification: current liability If right of offset exists, reduce cash

Travel advances

classification: receivables Assumed ot be collected from employees or deducted from their salaries

postdated checks and I.O.U.s

classification: receivables assumed to be collectible

Recognition of Notes Receivable

companies record and report long-term notes receivable at the present value of the cash they expect to collect when the interest stated on an interest-bearing not eequals the effective (market) rate of interest, the note sells at ace value whe the stated rate differs from the market rate, the cash exchagned (present value) differes from the face value of the note -companies then record this differnece, either a discount or a premium, and amortize it over the life of a note to approximate the effective (market) interest rate

Imprest Bank Accounts

companies use them to make a specific amount of cash available for a limited purpose the account acts as a clearing account for a large volume of checks or for a specific type of check To clear a specific and intended amount through the imprest account, a company transfers that amount from the general checking account or other source Companies often use imprest bank accounts for disbursing payroll checks, dividends, commissions, bonsues, confidential expenses (e.g. officers' salaries), and travel expenses

Trade receivables

customers often owe a company amounts for goods bought or services rendered usually the most significant item it possesses sub classified into accounts receivable and notes receivable

Time Value of Money

ideally, a company should measure receivables in terms of their present value, that is, the discounted value of the cash to be received in the future When expected cash receipts require a waiting period, the receivable face amount is not worth the amount that the company ultimatley receives Theoretically, any revenue after the period of sale is interest revenue in practice, companies ignore interest revenue related to accounts receivable because the amount of the discount is not usually amterial in relation to the net income for the period -the profession specifically excludes from present value considerations "receivables arising from transactions with customers in the normal corse of busines which are due in customary trade terms not exceeding approximately one year"

Zero-Interst-Bearing Notes

if a company receives a zero-interst-bearing note, its present value is the cash paid to the issuer because the company knows both the future amount adn the present value of the note, it can compute the interst rate -this rate is often referred ot as the implicit interest rate companies record the difference between the future (face) amount and the present value (cash paid) as a discount and amortize it to itnerest revenue over the life of the note Discount on Notes Receivable is a valuation account -companies reprt it on the balance sheet as a contra asset account to notes receivable/ they then amortize the discount and recognize interest revenue annually using the effective-interest method

Variable Consideration

in some cases the price of a good or service is dependent on future events these future events oftne include such items as discounts, returns and allowances, rebates, and performance bonuses here are four items that affect the transaction price and thus the accounts receivable balance (1) trade discounts (2) cash discounts (3) sales returns and allowances (4) time value of money

Recording Fair Value Option

must value receivables at fair value in all subsequent periods in which it holds these receivables -if elects not to use the fair value option, must use its carryin amount for all future period unrealized holding gain- difference between the fair value and the carrying amount in subsequent periods, the company will report any change in fair value as an unrealized holding gain or loss

Bank Overdrafts

occur when a company writes a check for more than the amount in its cash accout Companies should report bank overdrafts in the current liabilities section, adding them to the amount reported as accounts payable if material, companies should disclose these items separately, either on the face of hte balance sheet or in the related notes Bank overdrafts are generally not offset against the cash account -a major exception is when available cash is present in another account in the same bank on which the overdraft occured. Offseeting in this case is required.

Accounts receivable

oral promises of the purchaser to pay for goods and services sold represent "open acconts" resultign from short-term extensiosn of creidt a company normally collects them within 30 to 60 days

Trade Discounts

prices may be subject or quantity discount Companies use such trade discounts to avoid frequent charges in catalogs, to alter prices for different quantities purchased, or to hide the true invoice price from competitiors Trade discounts are commonly quoted in percentages

Cash Equivalents

short-term, highly liquid investments that are both (a) readily convertible to known amounts of cash, and (b) so near their maturity that they present insignficiant risk of changes in value because of changes in interest rates Generally, only investments with original maturities of three months or less qualify under these defintins ex: trasury bills, commercial paper, and money market funds Some companies combine cash with temporary investments on the balance sheet -in these cases, they describe the amount of the temporary investments either parenethically or in the notes Most indivdiuals think of cash equivalents as cash -unfortunately, that is not always the case the FASB has studied whether to eliminate the cash-equivalent classification from financial statment presentations altogether -one idea would have companies report only cash -if an asset is not cash and is short-term in nature, it should be reported as a temporary investment

Secured Borrowing vs. Sales

the FASB concluded that a sale occurs only if the seller surrenders control of the receivables to the buyer The following three conditionst must be met before a company can record a sale 1. The transferred asset has been isolated from the transferor (put beyond reach of the trasnferor and its creditors) 2. The transferees have obtained the right to pledge or exchange either the transerred asests or beneifical interests in the transferred assets. 3. The transferor does not maintain effective control over the transferred assets through an agreement to repurcahse or redeem them before their maturity If the three conditions are met, a sale occurs. Otherwise, the transferor should record the transfer as a secured borrwing if sale accounting is appropritae, a company must still consider assets obtained and liabilities incurred in the transaction

Measurement of Collectibility

the allowance for doubtful accounts and related bad debt expense on a loan or note receivable can be estimated as teh differnce between the investment in the loan (generally the principal plus accrued interest or amortized cost) and the expected future cash flows discounted at the loan's historical effective interst rate when using the historical effective loan rate, the value of thei nvestement will change only if some of the legally contracted cash flows are reduced -a company recognizes a lossi n this case because the expected future cash flows are now lower -the company ignores interest rate changes caused by current economic events that affect the fair value of the loan as indicated in the chapter, in estimating future cash fows, the creditor shoul use reasonable and supportable assumptions and projections

Allowance Method for Uncollectible Acounts

the allowance method of accounting for bad debts involves estimating uncollectible accounts at the end of each period -this ensures that companies state receivables on the balance sheet at the net amount expected to be collected (carrying vaue of the receivables less estimated uncollectible accounts) at each financial statement date, companies estiamte uncolectible accounts using info about past and current events as well as forecasts of future collectibility -as a result, the balance sheet reflects the current estimate of expected uncollectible account losses at the reporting date, and the income statement reflects the effects of credit deteroritation (or improvement) that has taken place during the period many companies set their credit policies to provide for a certain percentage of uncollectible acocounts (in fact, many feel that failure to reach that percentge means that they are losing sales due to overly restrictive credit policies) FASB requires the allowance method for financial reporting purposes when bad debts are material in amount

Cash

the most liquid of assets standard medium of exchange and the basis for measuring and accounting for all other items Companies generally classify cash as a curent assets Consists of coin, currency, and available funds on deposit at the bank Negotiable instruments such as money orders, certified checks, cashier's checks, personal checks, and bank drafts are also viewed as cash Savings accounts are also considered cash Some negotiable insturments provide small investors with an opportunity to earn interest -these items, more appropriately classified as temporary investments than as cash, include money market funds, money market savings certificates, certificates of deposit (CDs), and similar types of deposits and "short-term paper' -these securities usually contain restrictions or penalities on their conversion to cash Money market funds that provide checking account privelges, however, are ususally classified as cash Certain items present classification problems: companies treat postdated checks and I.O.U.s as receivables -they also treat travel advances as receivables if collected from employees or deducted from their salaries, otherwise companies classify the travel advance as a prepaid expense Postage stamps on hand are classified as part of office supplies inventor as a prepaid expense BEcause petty cash funds and change funds are used to meet current operating expenses and liquidate current liabilities, companies include these funds in current assets as cash

General checking account

the principal bank account in most companies and frequently the only bank account in small businesses a company deposits and disbruses cash from this account A company routes all transactions through it

Measurement of the Transaction price

the transaction price is the amount of consideration that a company expects to receive from a customer in exchange for transferring goods or services companies must consider items such as variable consideration which may affect the accounts receivable balance

Bank Reconciliation Form and Content

this form of reconcilaition consists of two sections: (1) "balance per bank statement" and (2) "balance per depositor's books -both sectin end with the same "Correct cash balance" The correct cash balance is the amount to which the bookst must be adjusted and is the amount reported on the balance sheet Companies prepare adjusting journal entries for all the addition and deduction items appearing in the "Balance per depositor's books" section Companies should immediately call to the bank's attention any errors attributale to it

Other Issues

three additional special issues for accounting and reporting of receivables reltae to the follwing 1. Fair value option 2. Disposition of receivables 3. Presentation and disclosure

Premium

when the present value exceeds the face value, the note is exchanged at a premium companies record the premium on a note receivable as a debit and amortize it using the effective-interest method over the life of the note as annual reduction in teh amount of interest revenue recognized

Notes receivale

written promies to pay a certain sum of money on a specified future date may arise from sales, financing, or other transactions may be short or long term