Cash and Receivables

 All non-cash assets exist because of the accrual accounting system

o Cash reported whether accounting is on cash basis or accrual basis
Cash and Cash Equivalents
Basic premise:
 funds can be readily accessed to settled debts
 amount must have little risk of changes in value

Cash equivalents are short-term highly liquid investments that are readily convertible to
known amounts of cash and subject to insignificant risks of changes in value
o Savings account, terms deposit (maturity of three months), investment in money
market fund, investment in three-month treasury bills
Bank Reconciliations
 Ties together the amount of cash according to company’s records and amount of cash
according to the bank that holds its funds
Two-Step Reconciliation
1. Begin with bank balance and adjust for reconciling items to derive corrected cash balance
a. Items are transactions that bank has not yet recorded (do not required adjusting
entries on books of reporting enterprise)
2. Begin with company’s balances and adjust for reconciling items to derivate the corrected
cash balance
a. Reconciling items in this step are transactions that affect cash but that have not
yet been recorded by the reporting entity
Cash Management, Internal Controls, and Fraud Prevention

 Segregation of Duties
 If sale is on credit, employee could potentially modify the accounts receivable
records to delete the initial sale and take the funds personally
 Risk Minimization
 Restrict ability of sales staff to modify or delete accounts receivable
o Credits or refunds (e.g. defective items) need to be recorded on a credit
score
 On payables side, important to limit who has access to the accounts payable
master file that contains information on supplier’s names, addresses, and so on
 Bank reconciliation should be done periodically, usually at the end of each month
  Monitoring by staff and customers
 Not practical to segregate duties in some situations
o E.g. retail operations => too time consuming or costly to have one employee
ringing up sale and a different employee receiving cash
 Transactions involving cash payment (not cheque or credit card), an unrecorded sale
allows the employee to pocket the proceeds of the sale
 Fraud prevention relies partially on monitoring by other staff and by customers
o Receipts to record purchases
Implications for internal controls of other areas
 Internal controls and fraud prevention not limited to cash
Overview of Accounting for Non-Cash Assets
 All of the non-cash assets are due to accrual accounting which allows the recording of
events and transactions separately from cash flows
Common to all non-cash assets (questions)
 Does a transaction give rise to asset or expense
 For a particular class of assets, what is the appropriate value to be reported at the balance
sheet date
 When should we remove an asset from the balance sheet
Initial Recognition and measurement: Asset or expense
 Expenditure: outflow of cash or other resources; distinguish from expense
 Capitalize: recording an expenditure as an asset on the balance sheet
o Must satisfy the definition of an asset and meet the criteria for recognition and
measurement
 Have future economic benefits
 Be under the entity’s control
 Results from past transactions
 Asset’s future economic benefits must be reasonably measurable

Trade Receivables: Initial Classification, Recognition, and Measurement

 Gross method- records the gross/face value of receivables and records any discounts
taken as a reduction in revenue
o Assumes that the customer will forfeit the discount
 Net method- record the accounts receivable at sale price less the cash discount
o Assume that customers will take the cash discount
Subsequent Measurement of Trade Receivables: Accounting for Bad Debts
 Companies must adjust the value of receivables at the balance sheet date to the amounts
they ultimately expect to collect (net realizable value)
o Adjustments reflects not only information on amounts known to be uncollectible
(e.g. customers who have filed for bankruptcy), but also information about the
portion of receivables that are anticipated to be uncollectible
o Direct write-off method => adjusting only for accounts known to be uncollectible
Reason for adjusting accounts receivable:
 Moral hazard: companies provide credit to customers not because they are altruistic but
because doing so facilitates and encourage sales
o Dealing in cash is cumbersome
o Credit policy is an integral element of the sales package that a company offers to
its customers
o Necessary for management to estimate land, record cost of its credit policy
 Management would be motivated to have tax credit policies so as to
increase sales, because consequences in terms of bad debt would not be
recorded not be recorded until a future date
 Timeliness
o Cost of providing credit in terms of bad debt losses should be recorded in the
same period as when the company records the revenue
 Neutrality and Financial
o Accounts receivable paid on the balance sheet should not overstate (not
understate) the amount that will eventually be collected from customers
 Allowance for doubtful accounts (ADA) is a contra account

Percentage of sales method (income statement approach)

 Some fraction of sales will be uncollectible so to best match expenses with revenues, bad
debts expense should be some percentage of credit sales
o Known as the income statement approach

1. Estimate the percentage factor to apply to the amount of net credit sales => this total
determines what bad debt expense (BDE) should be for the period; call this amount x
a. If no BDE has been recorded previously, x is the amount to be used in the journal
entry to record bad debts expense
2. If some BDE had been previously recorded for the period, amount recorded would be
additional amount necessary to bring the total for the period up to the amount computed
in (1)
 3. Other side of the entry (usually a credit) adds to the balance in the allowance for doubtful
accounts (ADA)
a. ADA is the residual amount
b. ADA should always have a credit balance (or zero)
c. If debit balance ADA, enterprise expects to collect more than what is billed to
customers

Aging of Accounts method (balance sheet approach)

 Focuses on the value of net accounts receivable on the balance sheet
 More concerned about the appropriate value shown as an asset for receivables

1. Categorize individual receivables based on how long each invoice has been
outstanding
2. For each age category, apply a percentage factor to estimate the amount uncollectible
a. Factor should increase with age of receivables
3. Determine existing balance in ADA
4. Other side of the entry affects BDE
a. Expense is the residual figure
 In practice, companies often use a combination of the two methods to estimate BDE and
the ADA
o Percentage of sales method is relatively easy to apply (interim reporting)
o more detailed analysis of accounts using the aging method is then applied at year-
end
o changes in estimates are prospective e.g. new information suggest 3% of credit
sales is an appropriate estimate for bad debts expense
Derecognition of Receivables: Collection, write-offs, and disposals
Receivables are removed from the accounts in one of three ways: as part of normal collections,
through write-offs when they are determined to be uncollectible, and by selling the receivables
1. Collection
For most business, the vast majority of receivables will be collected without too much
trouble
Dr. Cash
Cr. Accounts Receivable

2. Write-Offs
Dr. Allowance for Doubtful Accounts
Cr. Accounts Receivable
  Journal entry does not involve expense – both allowance and the receivable accounts are
balance sheet accounts
 Accounts that was previously written off as uncollectible can become collectible again
Dr. Accounts Receivable
Cr. Allowance for Doubtful Accounts

Dr. Cash
Cr. Accounts Receivable

Transfer of Receivables (factoring)

 To improve cash flow and liquidity, a company may decide not to wait and collect on its
receivables
 Company can transfer receivables to a factor, a financing company that specializes in
buying receivables and then collecting the cash owed
 Company with the receivables needs to pay for the benefits of earlier cash receipt and
reduced processing/collection cost
o Still risk that the receivables will not be collectible, so the factor will compensate
for this risk by lowering the price it is willing to pay for the receivables
o Amount of cash received from the factor will be significantly less than the face
value of receivables
 Accounting treatment => transfer of risks and rewards of ownership

Transfer without recourse

 Factor takes on the risk of uncollectible accounts and does not have recourse to go back
to the company that transferred the receivable to seek funding for bad debts
o Sale of receivables => remove assets off the books
Dr Cash
Dr. Interest Expense
Cr. Accounts Receivable

Transfer with recourse

 Factor can demand money back from the transferor if the customers do not pay
 Since transferor retains risk of bad debts, transfer does not constitute a sale
 Borrowing transaction => transferor received cash from the factor in exchange for a loan
o Factor will demand a payment up front to cove rpossible non-collectibles
 Dr. Cash
Dr. Due from factor (for holdback amount)
Cr. Short-term Debt- asset-backed financing

Journal entries for factoring receivables with recourse after completion of collection
Dr. Cash
Dr. Allowance for doubtful accounts
Cr. Due from factor

Dr. Short-term debt- asset-backed financing

Dr. Interest Expense
Cr. Accounts Receivable
 When transferor is willing to bear risk of bad debts, it is a credible signal that the credit
quality of the receivables is high
 When the seller offloads the risk of bad debts with a sale without recourse, factor has to
be wary that is buying a set of accounts with poor credit quality
 Adverse selection in a transfer or receivables => reduce adverse selection by sending a
credible signal with recourse
o With recourse => Less favorable because transaction creates a liability (short-
term debt) in exchange for cash (worsening measures of liquidity)
o Without recourse => derecognition of the accounts receivable in exchange for
cash
 Factoring transactions with recourse => considered as borrowing transactions
Transfer of receivables (securitization)
 Process of transforming a financial asset (such as accounts receivable) into a security
o E.g. banks securitize packages of mortgage receivables and sell resulting
securities to investors
 Do so through special purpose entities (SPEs)
o Created for limited purposes which are specified in the legal documents that
established the entity
o To securitize receivables, company creates an SPE so that the company can
transfer the receivables to the SPE => SPE sells securities to investors with the
commitment to pay investors the cash flows collected from the receivables
o Different from factoring => relationship between reporting entity and the SPE =>
reporting entity is usually the one that established the SPE in the first place