ch07

CHAPTER 7

Cash and Receivables

ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC)

Topics QuestionsBrief

Exercises Exercises ProblemsConcepts

for Analysis

1. Accounting for cash. 1, 2, 3, 4, 22

1 1, 2 1

2. Accounting for accounts receivable, bad debts, other allowances.

5, 6, 7, 8, 9, 10, 11, 12, 13, 14, 16, 20

2, 3, 4, 5 3, 4, 5, 6, 7, 8, 9, 10, 11, 12, 14

2, 3, 4, 5, 6

1, 2, 3, 4, 9, 10

3. Accounting for notes receivable.

14, 15 6, 7 18, 19 8, 9, 10 6, 7, 8

4. Assignment and factoring of accounts receivable.

17, 18, 19 8, 9, 10, 11, 12

12, 13, 14, 15, 16, 17, 21

7, 11 4, 5, 6, 7, 8

5. Analysis of receivables.

21 13 20, 21 1 9

*6. Petty cash and bank reconciliations.

23 14, 15, 16 22, 23, 24, 25

12, 13, 14

*7. Loan impairments. 24, 25 17 26, 27 15

*This material is covered in an Appendix to the chapter.

Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 7-1

ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE)

Learning Objectives Brief Exercises Exercises Problems

1. Identify items considered cash. 1 1, 2

2. Indicate how to report cash and related items.

1

3. Define receivables and identify the different types of receivables.

3, 4 6

4. Explain accounting issues related to recognition of accounts receivable.

2, 3 3, 4, 5, 6, 12 6

5. Explain accounting issues related to valuation of accounts receivable.

4, 5 7, 8, 9, 10, 11, 12, 14

2, 3, 4, 5, 6

6. Explain accounting issues related to recognition and valuation of notes receivable.

6, 7 18, 19 8, 9, 10

7. Explain the fair value option. 19

8. Explain accounting issues related to disposition of accounts and notes receivable.

8, 9, 10,11, 12

12, 13, 14, 15, 16, 17, 21

7, 11

9. Describe how to report and analyze receivables.

13 20 11

*10. Explain common techniques employed to control cash.

14, 15, 16 22, 23, 24, 25 12, 13, 14

*11. Describe the accounting for a loan impairment.

17 26, 27 15

7-2 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only)

ASSIGNMENT CHARACTERISTICS TABLE

Item DescriptionLevel of Difficulty

Time (minutes)

E7-1 Determining cash balance. Moderate 10–15 E7-2 Determining cash balance. Moderate 10–15 E7-3 Financial statement presentation of receivables. Simple 10–15 E7-4 Determining ending accounts receivable. Simple 10–15 E7-5 Record sales gross and net. Simple 15–20 E7-6 Recording sales transactions. Moderate 5–10 E7-7 Recording bad debts. Moderate 10–15 E7-8 Recording bad debts. Simple 5–10 E7-9 Computing bad debts and preparing journal entries. Simple 8–10 E7-10 Bad-debt reporting. Simple 10–12 E7-11 Bad debts—aging. Simple 8–10 E7-12 Journalizing various receivable transactions. Simple 15–20 E7-13 Assigning accounts receivable. Simple 10–15 E7-14 Journalizing various receivable transactions. Simple 15–18 E7-15 Transfer of receivables with recourse. Simple 10–15 E7-16 Transfer of receivables with recourse. Moderate 15–20 E7-17 Transfer of receivables without recourse. Simple 10–15 E7-18 Notes transactions at unrealistic interest rates. Simple 10–15 E7-19 Note receivable with unrealistic interest rate. Moderate 20–25 E7-20 Analysis of receivables. Moderate 10–15 E7-21 Transfer of receivables. Moderate 10–15*E7-22 Petty cash. Simple 5–10*E7-23 Petty cash. Simple 10–15*E7-24 Bank reconciliation and adjusting entries. Moderate 15–20*E7-25 Bank reconciliation and adjusting entries. Simple 15–20*E7-26 Impairments. Moderate 15–25*E7-27 Impairments. Moderate 15–25

P7-1 Determine proper cash balance. Simple 20–25 P7-2 Bad-debt reporting. Moderate 20–25 P7-3 Bad-debt reporting—aging. Moderate 20–30 P7-4 Bad-debt reporting. Moderate 25–35 P7-5 Bad-debt reporting. Moderate 20–30 P7-6 Journalize various accounts receivable transactions. Moderate 25–35 P7-7 Assigned accounts receivable—journal entries. Moderate 25–30 P7-8 Notes receivable with realistic interest rate. Moderate 30–35 P7-9 Notes receivable journal entries. Moderate 30–35 P7-10 Comprehensive receivables problem. Complex 40–50 P7-11 Income effects of receivables transactions. Moderate 20–25*P7-12 Petty cash, bank reconciliation. Moderate 20–25*P7-13 Bank reconciliation and adjusting entries. Moderate 20–30*P7-14 Bank reconciliation and adjusting entries. Moderate 20–30*P7-15 Loan impairment entries. Moderate 30–40


ASSIGNMENT CHARACTERISTICS TABLE (Continued)

Item DescriptionLevel of Difficulty

Time (minutes)

CA7-1 Bad debt accounting. Simple 10–15CA7-2 Various receivable accounting issues. Simple 15–20CA7-3 Bad-debt reporting issues. Moderate 25–30CA7-4 Basic note and accounts receivable transactions. Moderate 25–30CA7-5 Sale of notes receivable. Moderate 20–25CA7-6 Zero-interest-bearing note receivable. Moderate 20–30CA7-7 Reporting of notes receivable, interest, and sale

of receivables.Moderate 25–30

CA7-8 Accounting for zero-interest-bearing note. Moderate 25–30CA7-9 Receivables management. Moderate 25–30CA7-10 Bad-debt reporting, ethics. Moderate 25–30


LEARNING OBJECTIVES

1. Identify items considered cash.2. Indicate how to report cash and related items.3. Define receivables and identify the different types of receivables.4. Explain accounting issues related to recognition of accounts receivable.5. Explain accounting issues related to valuation of accounts receivable.6. Explain accounting issues related to recognition and valuation of notes receivable.7. Explain the fair value option.8. Explain accounting issues related to disposition of accounts and notes receivable.9. Describe how to report and analyze receivables.

*10. Explain common techniques employed to control cash.*11. Describe the accounting for a loan impairment.*12. Compare the accounting procedures for cash and receivables under GAAP and IFRS.

*This material is covered in an Appendix to the chapter.


CHAPTER REVIEW

*Note: All asterisked (*) items relate to material contained in the Appendix to the chapter.

1. Chapter 7 presents a detailed discussion of two of the primary liquid assets of a company, cash and receivables. Cash is the most liquid asset held by a company and possesses unique problems in its management and control. Receivables are composed of both accounts and notes receivables. Chapter coverage of accounts receivable places emphasis on trade receivables. In covering notes receivables, the chapter includes both short-term and long-term notes.

Nature of Cash

2. (S.O. 1) Cash consists of coin, currency, bank deposits, and negotiable instruments such as money orders, checks, and bank drafts.

Reporting Cash

3. (S.O. 2) Cash equivalents are 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 insignificant risk of changes in value because of changes in interest rates. If an asset is not cash and is short-term in nature, it should be reported as as a temporary investment.

4. It is common practice for a corporation to have an agreement with a bank concerning credit and borrowing arrangements. When such an agreement exists, the bank usually requires the company to maintain a minimum cash balance on deposit. This minimum balance is known as a compensating balance. Compensating balances that result in legally restricted deposits must be separately classified in the balance sheet. The nature of the borrowing arrangement determines whether the compensating balance is classified as a current asset or a noncurrent asset.

5. Cash that has been designated for some specific use, other than for payment of currently maturing obligations, is segregated from the general cash account. This amount may be classified as a current asset if it will be disbursed within one year or the operating cycle, whichever is longer. Otherwise, the amount should be shown as a noncurrent asset.

6. Bank overdrafts occur when a company writes a check for more than the amount in the cash account. Bank overdrafts should be accounted for as accounts payable or, if material, separately disclosed on the balance sheet or in the related notes.

Accounts Receivable

7. (S.O. 3) Receivables are claims held against customers and others for money, goods, or services. Receivables may generally be classified as trade or nontrade. Trade receivables (accounts receivable and notes receivable) are the most significant receivables an enterprise possesses. Accounts receivable are oral promises of the purchaser to pay for goods and services sold. Notes receivable are written promises to pay a certain sum of money on a specified future date. Nontrade receivables arise from a variety of transactions


and can be written promises either to pay or to deliver. Nontrade receivables are generally classified and reported as separate items in the balance sheet.

8. (S.O. 4) In most receivable transactions, the amount to be recognized is the exchange price (amount due from the debtor) between the two parties. Two factors that may complicate the measurement of the exchange are (a) the availability of discounts (trade and cash) and (b) the length of time between the sale and the payment due date (the interest element).

9. Two types of discounts that must be considered in determining the value of receivables are trade discounts and cash discounts. Trade discounts represent reductions from the list or catalog prices of merchandise. They are often used to avoid frequent changes in catalogs or to quote different prices for different quantities purchased. Cash discounts (also called sales discounts) are offered as an inducement for prompt payment and are communicated in terms that read, for example, 2/10, n /30 (2% discount if paid within 10 days of the purchase or invoice date, otherwise the gross amount is due in 30 days).

10. (S.O. 5) It is highly unlikely that a company that extends credit to its customers will be successful in collecting all of its receivables. Thus, some method must be adopted to account for receivables that ultimately prove to be uncollectible. The two methods currently used are the direct write-off method and the allowance method.

11. Under the direct write-off method, the receivable account is reduced and an expense is recorded when a specific account is determined to be uncollectible. The direct-write off method is theoretically deficient because it usually does not match costs and revenues of the period, nor does it result in receivables being stated at estimated realizable value on the balance sheet. The direct write-off method is not appropriate if the amount deemed uncollectible is material.

12. Use of the allowance method requires a year-end estimate of expected uncollectible accounts based upon credit sales or outstanding receivables. This ensures that companies state receivables on the balance sheet at their net realizable value. Net realizable value is the net amount the company expects to receive in cash. The estimate of uncollectible accounts is recorded by debiting an expense and crediting the allowance account in the period in which the sale is recorded. Then, in a subsequent period, when an account is deemed to be uncollectible, an entry is made debiting the allowance account and crediting accounts receivable.

13. Advocates of the allowance method contend that its use provides for a proper matching of revenues and expenses as well as reflecting a proper carrying value for accounts receivable at the end of the period. When the allowance method is used, the estimated amount of uncollectible accounts is normally based upon a percentage of sales or outstanding receivables. The percentage-of-sales method attempts to match costs with revenues, and is frequently referred to as the income statement approach. The percentage-of-receivables approach provides a reasonably accurate estimate of the net realizable value of receivables shown on the balance sheet. This approach is commonly referred to as the balance sheet approach.

14. The method used to determine the amount of bad debt expense each year affects the amount of expense recorded. Under the percentage-of-sales method, the amount recorded


as bad debt expense is the amount determined by multiplying the estimated percentage times the credit sales. However, under the percentage-of-receivables approach, the unadjusted ending balance in the allowance account must be considered in arriving at bad debts expense for the year.

Notes Receivable

15. (S.O. 6) The major differences between trade accounts receivables and trade notes receivables are (a) notes represent a formal promise to pay and (b) notes bear an interest element because of the time value of money. Notes are classified as notes bearing interest equal to the effective rate and those bearing interest different than the effective rate. Interest-bearing notes have a stated rate of interest, whereas zero-interest-bearing notes (noninterest-bearing) include the interest as part of their face amount instead of stating it explicitly.

16. Short-term notes are generally recorded at face value (less allowances) because the interest implicit in the maturity value is immaterial. A general rule is that notes treated as cash equivalents (maturities of 3 months or less) are not subject to premium or discount amortization. Long-term notes receivable, however, are recorded at the present value of the future cash inflows. Determination of the present value can be complicated, particularly when a zero-interest-bearing note or a note bearing an unreasonable interest rate is involved.

17. Long-term notes receivable should be recorded and reported at the present value of the cash expected to be collected. When the interest stated on an interest-bearing note is equal to the effective (market) rate of interest, the note sells at face value. When the stated rate is different from the market rate, the cash exchanged (present value) is different from the face value of the note. The difference between the face value and the cash exchanged, either a discount or a premium, is then recorded and amortized over the life of the note to approximate the effective interest rate. The discount or premium is shown on the balance sheet as a direct deduction from or addition to the face of the note.

18. Whenever the face amount of a note does not reasonably represent the present value of the consideration given or received in the exchange, the accountant must evaluate the entire arrangement to properly record the exchange and the subsequent interest. Notes receivable are sometimes issued with no (zero) interest rate stated or at a stated rate that is unreasonable. In such instances the present value of the note is measured by the cash proceeds to the borrower or fair value of the property, goods, or services rendered. The difference between the face amount of the note and the cash proceeds or fair value of the property represents the total amount of interest during the life of the note. If the fair value of the property, goods, or services rendered is not determinable, estimation of the present value requires use of an imputed interest rate. The choice of a rate may be affected specifically by the credit standing of the issuer, restrictive covenants, collateral, payment schedule, and the existing prime interest rate. Determination of the imputed interest rate is made when the note is received; any subsequent changes in prevailing interest rates are ignored.


19. The FASB requires that companies disclose the fair value of receivables in the notes to the financial statements. Recently the Board has given companies the option to use fair value as the basis of measurement in the financial statements. 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 income. 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 revenue.

Secured Borrowing

20. (S.O. 8) Receivables are often used as collateral in a borrowing transaction. A creditor often requires that the debtor designate (assign) or pledge receivables as security for the loan. If the loan is not paid when due, the creditor has the right to convert the collateral to cash, that is, to collect the receivables.

Sales of Receivables

21. When accounts and notes receivable are factored (sold), the factoring arrangement can be with recourse or without recourse. If receivables are factored on a with recourse basis, the seller guarantees payment to the factor in the event the debtor does not make payment. When a factor buys receivables without recourse, the factor assumes the risk of collectibility and absorbs any credit losses. Receivables that are factored with recourse should be accounted for as a sale, recognizing any gain or loss, if all three of the following conditions are met: (a) the transferred asset has been isolated from the transferor, (b) the transferees have obtained the right to pledge or exchange either the transferred assets or beneficial interests in the transferred assets, and (c) the transferor does not maintain effective control over the transferred assets through an agreement to repurchase or redeem them before their maturity.

Presentation and Analysis

22. (S.O. 9) The presentation of receivables in the balance sheet includes the following considerations: (a) segregate the different types of receivables that a company possesses, if material; (b) appropriately offset the valuation accounts against the proper receivable accounts: (c) determine that receivables classified in the current assets section will be converted into cash within the year or the operating cycle, whichever is longer; (d) disclose any loss contingencies that exist on the receivables; (e) disclose any receivables designated or pledged as collateral; and (f) disclose the nature of credit risk inherent in the receivables, how that risk is analyzed and assessed in arriving at the allowance for credit losses, and the changes and reasons for those changes in the allowance for credit losses.

23. The ratio used to assess the liquidity of receivables is the receivables turnover ratio, which measures the number of times, on average, receivables are collected during the period.

Accounts ReceivableTurnover

= Net Sales Average Trade Receivables (net)

Days to CollectAccounts Receivable

= 365 Accounts Receivable Turnover


*Cash Controls

*24. (S.O. 10) Control over the handling of cash and cash transactions is an important con-sideration for any company. Among the control procedures that are used for cash transactions are the use of a petty cash system, or the use of bank accounts such as a general checking account, imprest bank accounts, and lockbox accounts.

*Petty Cash

*25. In an imprest petty cash system, a petty cash custodian is given a small amount of currency from which to make small payments (minor office supplies, tolls, postage, etc.). Each time a disbursement is made, the petty cashier obtains a signed receipt and makes a payment. When cash in the fund runs low, the petty cashier submits the signed receipts to the general cashier and a check is prepared to replenish the petty cash fund. This process is designed to promote control over small cash disbursements that would be awkward or impossible to pay by check.

*Physical Protection of Cash Balances

*26. Adequate control of receipts and disbursements is part of the protection of cash balances, along with certain other procedures. A company should minimize the cash on hand in the office which is often in the form of a petty cash fund, the current day’s receipts, and perhaps funds for making change. It should keep these funds in a vault, safe, or locked cash drawer. The company should transmit intact each day’s receipts to the bank as soon as practicable. A company must periodically prove the balance shown in the general ledger by counting the cash actually present in the office—petty cash, change funds, and undeposited receipts—for comparison with the company records.

*Bank Reconciliation

*27. A basic cash control is preparation of a monthly bank reconciliation. The bank reconciliation, when properly prepared, proves that the cash balance per bank and the cash balance per book are in agreement. The items that cause the bank and book balances to differ, and thus require preparation of a bank reconciliation, are the following:

a. Deposits in Transit. Deposits recorded in the cash account in one period, but not received by the bank until the next period.

b. Outstanding Checks. Checks written by the depositor that have yet to be presented at the bank for collection.

c. Bank Charges. Charges by the bank for services that are deducted from the account by the bank for which the company may not be aware until it receives the bank statement.

d. Bank Credits. Collections or deposits in the company’s account for which the company may not be aware until it receives the bank statement.

e. Bank or Depositor Errors. Errors made by the company or the bank that must be corrected for the reconciliation to balance.


*28. Two forms of bank reconciliation may be prepared. One form reconciles from the bank statement balance to the book balance or vice versa. The other form is described as the reconciliation of bank and book balances to corrected cash balance. This form is composed of two separate sections that begin with the bank balance and book balance, respectively. Reconciling items that apply to the bank balance are added and subtracted to arrive at the corrected cash balance. Likewise, reconciling items that apply to the book balance are added and subtracted to arrive at the same corrected cash balance. The corrected cash balance is the amount that should be shown on the balance sheet at the reconciliation date.

*Impairments of Receivables

*29. (S.O. 11) A loan receivable is considered impaired when it is probable, based on current information and events, that the company will be unable to collect all amounts due (both principal and interest). If a loan is determined to be individually impaired, the loss due to the impairment is calculated as the difference between the investment in the loan (generally the principal plus accrued interest) and the expected future cash flows discounted at the loan’s historical effective interest rate.


LECTURE OUTLINE

Chapter 7, the first of six asset chapters, covers cash, accounts receivable, and notes receivable.

This chapter can be covered in two class sessions. With the exception of transfers of receivables with and without recourse, students should have had previous exposure to the chapter concepts in a financial accounting course.

The following lecture outline is appropriate for this chapter.

A. (L.O. 1) Cash represents the most liquid of assets. Liquidity is an indication of an enterprise’s ability to meet its obligations as they come due.

1. Includes coin, currency, bank deposits including checking and savings accounts, and negotiable instruments such as money orders, cashiers’ checks, personal checks, and bank drafts.

2. Postdated checks and I.O.U.s should be reported as receivables. Travel advances to employees should be reported as receivables or as prepaid expenses. Postage stamps on hand should be reported as office supplies inventory or as a prepaid expense. Petty cash funds and change funds should be included in cash.

B. (L.O. 2) Reporting cash and related items.

1. Cash equivalents.

a. This category includes short-term, highly liquid investments that are both (1) readily convertible to known amounts of cash, and (2) so near their maturity that they present insignificant risk of changes in value because of changes in interest rates (generally 3 months or less).

b. Examples of cash equivalents include Treasury bills, commercial paper, money market funds, money market savings certificates, certificates of deposit, and similar types of deposits are nearly “equivalent to cash” in terms of liquidity. However, if these securities contain restrictions or penalties on their conversion to cash, they should be reported as temporary investments.

c. It now appears likely that the FASB will eliminate the cash-equivalent classification from financial statement presentations altogether.

2. Restricted cash.

a. Cash restricted for some special purpose (such as the retirement of bonds) is reported separately in either the current assets section or the long-term assets section of the balance sheet, depending on the date of availability or disbursement.

b. The SEC recommends that legally restricted deposits held as compensating balances against borrowing arrangements be reported separately in either the current assets section or the noncurrent assets section, depending on whether the borrowing arrangement is short-term or long-term.


3. Bank overdrafts should be reported as current liabilities. They are not offset against the cash account unless there is available cash in another account at the same bank.

C. (L.O. 3) Receivables: Claims held against customers and others for money, goods, or services. They are classified as either trade or nontrade, and can be current or non-current.

1. Accounts receivable are oral promises of the purchaser to pay for goods and services sold.

2. Notes receivable are written promises to pay a certain sum of money on a specified future date.

3. Nontrade receivables include advances to officers, employees, or subsidiaries, and for dividends and interest receivable.

D. (L.O. 4) Accounts Receivable—Recognition Issues. These involve the concepts of timing and measurement. The exchange price is the amount due from the debtor. Measurement is complicated by:

1. Trade Discounts. These reductions from the list price are not recognized in the accounting records; customers are billed an amount that is net of trade discounts.

2. Cash Discounts (Sales Discounts). These are inducements for prompt payment and may be recorded using the gross or net method.

TEACHING TIP

Exercise 7-5 can be used to demonstrate accounting for receivables under both the net and gross methods.

a. Gross Method (more practical than the net method). Sales and receivables are recorded at the gross amount. Sales discounts taken by customers are debited to the Sales Discounts account which is reported in the income statement as a reduction of sales.

b. Net Method. Sales and receivables are recorded at the net amount. Sales discounts not taken by customers are credited to the Sales Discounts Forfeited account, which is reported in the other revenue section of the income statement.

3. Interest Element. Theoretically, receivables should be measured at their present value, but the accounting profession has chosen to ignore the implicit interest element in receivables which are due within one year.

E. (L.O. 5) Accounts Receivable—Valuation Issues. Companies value and report receivables at net realizable value (the net amount they expect to receive in cash).

1. Methods of accounting for uncollectible accounts:


a. Direct write-off method—When a specific account is determined to be uncollectible (which may not occur in the period of sale), Bad Debt Expense is debited and Accounts Receivable is credited. This method is theoretically deficient because it:

(1) fails to match costs with revenues of the period.

(2) does not result in receivables being stated at net realizable value in the balance sheet.

b. Allowance method— At the end of each accounting period an estimate is made of expected losses from uncollectible accounts. This estimate is debited to Bad Debt Expense and credited to the Allowance for Doubtful Accounts. This method is justified because a company has experienced a loss the moment customers receive goods or services for which they will never pay. This is true even if the specific identity of such customers will not be known for some time.

(1) Methods of estimating bad debt expense under the allowance method.

TEACHING TIP

Illustration 7-1 emphasizes the computational difference in estimating Bad Debt Expense between the Percentage-of-Sales and Percentage-of-Receivables methods.

(a) Percentage-of-Sales (Income Statement Approach). Bad debt expense is estimated directly by multiplying a percentage times credit sales.

(b) Percentage-of-Receivables (Balance Sheet Approach):

(i) First the required ending balance in the Allowance for Doubtful Accounts account is estimated by multiplying a percentage (a single composite rate or an aging schedule) times the ending outstanding receivables.

(ii) Then bad debt expense is equal to the difference between the required ending balance and the existing balance in the Allowance account.

TEACHING TIP

Illustration 7-2 provides a numerical example of estimating bad debt expense using the percentage-of-sales approach and the percentage-of-receivables approach.

F. (L.O. 6) Notes Receivable—Recognition Issues. The present value of the future cash flows is the proper amount to record for notes.

1. Terminology in accounting for notes:

a. Face value—The principal amount due that is stated on the face of the note. The debit balance of the Notes Receivable account is always equal to the face amount.


b. Stated interest rate—The rate that is stated on the face of the note. This rate is used to determine the amount of periodic interest payments. A note may be zero-interest-bearing (i.e. have a stated rate of zero).

c. Effective (market) rate of interest—This is the rate that is used to look up present value factors in order to account for the note at the date of issuance.

d. Present value—At the date of issuance, a note is valued at the present value of the future principal and interest cash flows, discounted at the market rate of interest. Changes in the market rate of interest are ignored throughout the remainder of the life of the note.

e. Implicit interest rate—The rate that a company computes when it knows the future amount and the present value of a note.

f. Discount on notes receivable—At the date of issuance, this represents the excess

of the face value of the note over the present value. A discount arises because the market rate is greater than the stated interest rate. The Discount on Notes Receivable account is a valuation (contra-asset) account with a credit balance.

g. Premium on notes receivable—At the date of issuance, this represents the excess of the present value of the note over the face value. A premium arises because the market rate is less than the stated rate.

h. Net carrying amount of the note—This is the amount at which notes are reported on the balance sheet. It is equal to the face value of the note less the unamortized discount or plus the unamortized premium.

i. Amortization—The process of writing off the discount or premium over the life of the note. The effective-interest method of amortization should be used.

j. Effective-interest method—Amortization method which determines periodic interest revenue by applying a constant interest rate to the net carrying amount of the note. The dollar amount of interest revenue changes each period as the net carrying amount of the note changes.

2. Notes Bearing Interest Equal to the Effective Rate—The interest element is ignored for short-term notes and therefore they are carried at face value. However, long-term notes are recorded at the present value of the cash expected to be collected.

3. Zero-Interest or Unreasonable Interest-Bearing Notes—An appropriate rate of interest must be determined in order to compute the present value of the note.

a. The present value of the note can be determined by measuring the fair value of the cash or other property, goods, and services exchanged for the note.

b. If the fair value of the note or other property is not determinable, an interest rate may be imputed on the basis of the issuer’s credit standing, collateral, etc.


TEACHING TIP

Illustration 7-3 provides examples of an interest-bearing note and a zero-interest-bearing note, and demonstrates computation of present values and amortization tables. Note that for explanatory purposes, the amortization tables utilize slightly different headings from the ones used in the text.

G. Notes Receivable—Valuation Issues.

1. Notes should be reported at net realizable value although the allowance for doubtful accounts can be difficult to estimate for long-term notes.

2. Companies must disclose the fair value of notes receivables in the notes to the financial statement.

3. A note receivable is considered impaired when it is probable that the creditor will be unable to collect all amounts due (both principal and interest) according to the contractual terms of the receivable. In this case, a loss is recorded for the amount of the impairment.

H. (L.O. 7) Fair Value Option

1. Companies have the option of using fair value as the basis of measurement of notes receivable in the financial statements.

a. If companies choose the fair value option, receivables are recorded at fair value and unrealized holding gains or losses are reported as part of net income.

b. Unrealized holding gains or losses are the net change in the fair value of receiv-ables from one period to another, excluding interest revenue.

I. (L.O. 8) Accounts and Notes Receivable—Disposition Issues. In order to accelerate the receipt of cash from receivables, they may be transferred to a third party for cash.

1. Secured Borrowing (Assigning or Pledging). The owner of the accounts receivable borrows cash by writing a promissory note designating the accounts receivable as collateral.

a. The borrower and lender agree as to the specific receivable accounts that serve as security. The assignor (borrower) typically makes collections on the assigned accounts and remits the collections plus a finance charge (interest cost) to the lender.

b. The borrower also recognizes all discounts, returns and allowances, and bad debts.

2. Sale (Factoring). These transfers of accounts and notes receivable may be without recourse or with recourse.


TEACHING TIP

Illustration 7-4 can be used to highlight the rules pertaining to a secured borrowing and the sale of receivables with or without recourse.

a. Sale Without Recourse—The purchaser assumes the risk of collectibility and absorbs any credit losses. This is an outright sale of receivables both in form and substance. A loss on the sale is recognized for the excess of the face value of the receivables over the cash proceeds.

(1) A Due From Factor account (reported as a receivable) is used by the seller to account for any proceeds retained by the factor to cover probable sales discounts, sales returns, and sales allowances.

(2) The factor maintains a corresponding “Due To” account (reported as a liability).

b. Sale With Recourse—The seller guarantees payment to the purchaser for those receivables which become uncollectible.

(1) A Due From Factor account is maintained as indicated in a sale without recourse.

(2) A Recourse Obligation account (reported as a liability) is used by the seller to recognize the probable payment to the factor for uncollectible accounts.

(3) Loss on sale calculation:

(a) Net proceeds = cash received + due from factor – recourse obligation

(b) Loss = book value of receivables sold – net proceeds

c. The FASB requires that all three of the following conditions must be met before a company can record a sale:

(1) The transferred asset has been isolated from the transferor.

(2) The transferees have obtained the right to pledge or exchange either the transferred assets or beneficial interests in the transferred assets.

(3) The transferor does not maintain effective control over the transferred assets through an agreement to repurchase or redeem them before their maturity.

d. If the transfer with recourse does not meet these three conditions, the transaction is accounted for as a secured borrowing and a liability is recorded.

J. (L.O. 9) Presentation and analysis of receivables.

1. General classification rules:


a. Segregate the different types of receivables, if material.

b. Appropriately offset valuation accounts against the proper receivable accounts.

c. Determine that receivables classified as current assets will be converted into cash within the year or the operating cycle, whichever is longer.

d. Disclose any loss contingencies that exist on the receivables.

e. Disclose any receivables designated or pledged as collateral.

f. Disclose the nature of credit risk inherent in the receivables, how that risk is analyzed and assessed in arriving at the allowance for credit losses, and the changes in the allowance for credit losses.

2. Accounts receivable turnover ratio: measures the number of times, on average, receivables are collected during the period. Companies frequently use the average collection period, also known as days’ outstanding, to assess the effectiveness of a company’s credit and collection policies.

a. A/R Turnover = Net Sales Average Trade Receivables (net)

b. Days’ Outstanding = 365 ___ A/R Turnover

K. (L.O. 10) Appendix 7-A: Cash Controls.

1. Bank Accounts.

a. A company can vary the number and location of banks and the types of bank accounts. Multiple collection centers generally reduce the size of a company’s collection float. This is the difference between the amount on deposit according to the company’s records and the amount of collected cash according to the bank record.

b. Large, multi-location companies frequently use lockbox accounts to collect in cities with heavy customer billing.

c. Companies use imprest bank accounts 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.

2. Imprest Petty Cash System.

a. Accounting procedures for a petty cash system:


TEACHING TIP

Illustration 7-5 provides a numerical example of establishing a petty cash fund and its sub-sequent reimbursement.

(1) The Petty Cash account is debited or credited only when the fund is first established or is changed in size.

(2) Each disbursement from the fund should be evidenced by a signed receipt indicating the recipient and the purpose of the expenditure.

(3) Reimbursements of the petty cash fund are recorded by debiting the expenses, assets, or liabilities involved, and crediting the Cash account.

(4) The Cash Over and Short account is used as a plug (miscellaneous expense or miscellaneous revenue) when the petty cash fund fails to prove out.

3. Physical Protection of Cash Balances.

a. A company should keep funds in a vault, safe, or locked cash drawer. The company should transmit intact each day’s receipts to the bank as soon as practicable

4. Bank Reconciliations.

a. Two forms of bank reconciliations may be prepared:

(1) Reconciliation from the bank statement balance to the book balance or vice versa.

(2) Reconciliation of bank and book balances to the corrected cash balance. This form consists of two separate sections:

(a) “Balance per bank statement” section.

(b) “Balance per books” section.

(3) The latter form is illustrated in the text. It is useful because it facilitates com-putation of the correct cash balance, which is the amount that should be reported on the balance sheet.

b. The preparation of a two-section bank reconciliation.

TEACHING TIP

Illustration 7-6 provides an example format of a two-section bank reconciliation that reconciles the bank and book balances to a corrected cash balance.


(1) “Balance per bank statement” section.

(a) The “balance per bank statement” is the amount shown on the most recent bank statement as of the bank’s closing date for the month.

(b) Add deposits recorded in the company’s books, but not yet credited by the bank (e.g., deposits in transit).

(c) Deduct charges recorded in the company’s books, but not yet recorded by the bank (e.g., outstanding checks).

(2) “Balance per books” section.

(a) The “balance per books” is the amount shown in the company’s Cash or Cash in Checking Account general ledger account as of the desired reconciliation date (i.e., as of the balance sheet date, the month-end date, or whatever date for which it is desired to compute the correct cash balance).

(b) Add deposits recorded by the bank, but not yet recorded by the company (e.g., collection of notes, interest earned on interest-bearing checking accounts, etc.).

(c) Deduct charges recorded by the bank, but not yet recorded by the company (e.g., service charges, NSF checks, etc.).

(3) Both sections end with the correct cash balance, which is the amount that should be reported on the balance sheet.

(4) Every reconciling item that appears in the “balance per books” section requires an adjusting entry to bring the books to the correct cash balance.

L. (L.O. 11) Appendix 7-B: Impairments.

1. An impaired loan receivable exists when it is probable that the company will be unable to collect all amounts due (principal and interest) according to terms of the loan.

2. Impairment loss is the difference between the investment in the loan and the present value of the future cash flows discounted at the loan’s historical effective interest rate.


M. (L.O. 12) IFRS Insights

The basic accounting and reporting issues related to recognition and measurement of receivables, such as the use of allowance accounts, how to record discounts, use of the allowance method to account for bad debts, and factoring, are similar for both IFRS and U.S. GAAP. IAS 1 (“Presentation of Financial Statements”) is the only standard that discusses issues specifically related to cash. IFRS 7 (“Financial Instruments: Disclosure”) and IAS 39 (“Financial Instruments: Recognition and Measurement”) are the two international standards that address issues related to financial instruments and more specifically receivables.

RELEVANT FACTS

a. The accounting and reporting related to cash is essentially the same under both IFRS and U.S. GAAP. In addition, the definition used for cash equivalents is the same. One difference is that, in general, IFRS classifies bank overdrafts as cash.

b. Like the U.S. GAAP, cash and receivables are generally reported in the current asset section of the balance sheet under IFRS. However, companies may report cash and receivables as the last items in current assets under IFRS.

c. IFRS requires that loans and receivables be accounted for at amortized cost, adjusted for allowances for doubtful accounts. IFRS sometimes refers to these allowances as provisions.

d. Although IFRS implies that receivables with different characteristics should be reported separately, there is no standard that mandates this segregation.

e. IFRS and U.S. GAAP on the fair value option are similar, but not identical. The international standard related to the fair value option is subject to certain qualifying criteria not in the U.S. standard. In addition, there is some difference in the financial instruments covered.

f. IFRS and U.S. GAAP differ in the criteria used to account for transfers of receivables. IFRS is a combination of an approach focused on risks and rewards and loss of control. U.S. GAAP uses loss of control as the primary criterion. In addition, IFRS generally permits partial transfers; U.S. GAAP does not.

g. Impairment evaluation processUnder IFRS, companies assess their receivables for impairment each reporting period and start the impairment assessment by considering whether objective evidence indicates that one or more loss events have occurred. GAAP does not identify a specific approach.

h. Recovery of impairment lossSubsequent to recording an impairment, events or economic conditions may change such that the extent of the impairment loss decreases (e.g., due to an impairment in the debtor’s credit rating). Under IFRS, some or all of the previously recognized impairment loss shall be reversed either directly, with a debit to Accounts Receivable, or by debiting the allowance account and crediting Bad Debt Expense.

ON THE HORIZON

The question of recording fair values for financial instruments will continue to be an important issue to resolve as the Boards work toward convergence. Both the IASB and the FASB have indicated that they believe that financial statements would be more transparent and understandable if companies recorded and reported all financial instruments at fair value. Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 7-21

a. In IFRS 9, which was issued in 2009, the IASB created a split model, where some financial instruments are recorded at fair value, but other financial assets, such as loans and receivables, can be accounted for at amortized cost if certain criteria are met.

b. A proposal by the FASB would require that nearly all financial instruments, including loans and receivables, be accounted for at fair value.

c. It has been suggested that IFRS 9 will likely be changed or replaced as the FASB and IASB continue to deliberate the best treatment for financial instruments. In fact, one member of the IASB said that companies should ignore IFRS 9 and continue to report under the old standard, because in his opinion, it was extremely likely that it would be changed before the mandatory adoption date of this standard arrived in 2013.


ILLUSTRATION 7-1METHODS OF ESTIMATING THE YEAR-END ADJUSTING ENTRY FOR BAD DEBT EXPENSE


ILLUSTRATION 7-2ESTIMATING BAD DEBT EXPENSE


ILLUSTRATION 7-3INTEREST-BEARING AND ZERO-INTEREST-BEARINGNOTES RECEIVABLE


ILLUSTRATION 7-3 (continued)


ILLUSTRATION 7-4ACCOUNTING FOR TRANSFERS OF RECEIVABLES


ILLUSTRATION 7-5PETTY CASH


ILLUSTRATION 7-6BANK RECONCILIATION


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