CHAPTER 7 Cash and Receivables Overview We begin our study of assets by looking at cash and receivables the two assets typically listed first in a balance sheet Internal control and classification on the balance sheet are key issues we address in consideration of cash For receivables the key issues are valuation and the related income statement effects of transactions involving accounts receivable and notes receivable Learning Objectives 1 Define what is meant by internal control and describe some key elements of an internal control system for cash receipts and disbursements 2 Explain the possible restrictions on cash and their implications for classification on the balance sheet 3 Distinguish between the gross and net methods of accounting for cash discounts 4 Describe the accounting treatment for merchandise returns 5 Describe the accounting treatment of anticipated uncollectible accounts receivable 6 Describe the two approaches to estimating bad debts 7 Describe the accounting treatment of short term notes receivable 8 Differentiate between the use of receivables in financing arrangements accounted for as a secured borrowing and those accounted for as a sale 9 Describe the variables that influence a company s investment in receivables and calculate the key ratios used by analysts to monitor that investment 10 Discuss the primary differences between U S GAAP and IFRS with respect to cash and receivables Measuring and Reporting Accounts Receivable Recognition Depends on the earnings process for most credit sales revenue and the related receivables are recognized at the point of delivery Initial valuation Initially recorded at the exchange price agreed upon by the buyer and seller Subsequent valuation Initial valuation reduced to net realizable value by 1 Allowance for sales returns 2 Allowance for uncollectible accounts The income statement approach The balance sheet approach Classification Almost always classified as a current asset SALES RETURNS If material sales returns should be anticipated by subtracting an allowance for estimated returns from accounts receivable During 2013 its first year of operations the Hawthorne Manufacturing Company sold merchandise on account for 2 000 000 This merchandise cost 1 200 000 60 of the selling price Industry experience indicates that 10 of all sales will be returned Customers returned 130 000 in sales during 2013 prior to making payment The entries to record sales and merchandise returned during the year assuming that a perpetual inventory system is used are as follows Sales Accounts receivable Sales revenue Cost of goods sold 60 x 2 000 000 Inventory Returns Sales returns actual return Accounts receivable Inventory Cost of goods sold 60 x 130 000 2 000 000 2 000 000 1 200 000 1 200 000 130 000 130 000 78 000 78 000 At the end of 2013 the company would anticipate the remaining estimated returns using the following adjusting entries Adjusting entries Sales returns 10 x 2 000 000 130 000 Allowance for sales returns Inventory estimated returns Cost of goods sold 60 x 70 000 70 000 70 000 42 000 42 000 Assuming that the estimates of future returns are correct the following summary journal entry would be recorded in 2014 Allowance for sales returns Accounts receivable 70 000 70 000 FINANCING WITH RECEIVABLES A SUMMARY Financing with Receivables Is the arrangement a transfer of specific receivables or simply a pledging of receivables in general as collateral for a loan Transfer Pledging Does the transfer meet the three conditions for treatment as a sale Yes Record as a Sale 1 Remove receivables 2 Record proceeds 3 Recognize gain or loss No Record as a secured borrowing 1 Record liability 2 Recognize interest expense Disclose arrangement in debt note DECISION MAKERS PERSPECTIVE A company s investment in receivables is influenced by several variables including the level of sales the nature of the product or service sold and credit and collection policies Management must evaluate the costs and benefits of any change in credit and collection policies The ability to use receivables as a method of financing also offers management alternatives Earnings management may result Investors creditors and financial analysts can gain important insights by monitoring a company s investment in receivables The two ratios designed to monitor receivables are the receivables turnover ratio and the average collection period Receivables turnover ratio Average collection period Net sales Average accounts receivable net 365 Receivables turnover ratio