Chapter 2

Cash and Receivables

Outline

1. Cash and Cash Equivalents

2. Short-term Investments

3. Accounts Receivable

4. Notes Receivable

5. Inventories

1. Cash and Cash Equivalents

1.1 Definition

1.2 Petty cash

1.3 Bank Reconciliation

1.4 Restricted cash and compensating balances

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1.1 Definition

Cash

- Cash on hand: Currency and Coins

- Cash in bank: Balances in checking accounts, and

items acceptable for deposit in these accounts (e.g.

checks, money orders received from customers)

These forms of cash represent amounts readily available

to pay off debt or to use in operations without any

legal or contractual restriction.

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1.1 Definition (cont)

Cash equivalents

- Treasury bills

- Commercial paper

These investments must have a maturity date no

longer than three months from the date of

purchase.

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1.2 Petty cash

Small amount on cash on hand to pay for low-

cost items such as postage, office supplies,

delivery charges, and entertainment expenses.

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Illustration

On May 1, 2003, the Hawthorne Manufacturing

Company established a $200 petty cash fund.

John Ringo is designated as the petty cash fund

custodian. The fund will be replenished at the

end of each month. On May 1, 2003, a check is

written for $200 made out to John Ringo, petty

cash custodian. During the month of May, John

paid bills totaling $160 summarized as follows:

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Postage $40

Office supplies 35

Delivery charges 55

Entertainment 30

Total $160

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Journal entries

May 1, 2003

A petty cash fund is established by writing a

check to the custodian.

May 31, 2003

The appropriate expense accounts are debited

when the petty cash fund is reimbursed.

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1.3 Bank Reconciliation

Differences between the cash book and bank

balance occur due to differences in the timing

of recognition of certain transactions and errors.

Step 1: Adjust the bank balance to the corrected

cash balance

Step 2: Adjust the book balance to the corrected

cash balance

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Step 1: Adjustments to Bank Balance

Bank balance Book balance

+ Deposits outstanding + Collections by bank

- Check outstanding - Service charges

- NSF checks

+/- Errors +/- Errors

----------------------- -----------------------

Corrected balance Corrected balance

The two corrected balances must equal.

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1.4 Restricted cash and

compensating balances

Restricted cash

Cash that is restricted in some way and not available for

current use usually is reported as investments and

funds or other assets.

Compensating balances

The borrower us asked to maintain a specified balance in

a low-interest or noninterest-bearing account at the

bank to compensate the bank for granting the loan or

extending the line of credit.

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2. Accounts Receivable

2.1 Classification

2.2 Initial valuation of accounts receivable

2.3 Subsequent valuation of accounts receivable

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2.1 Classification

Accounts receivable are current assets because,

by definition, they will be converted to cash

within the normal operating cycle.

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2.2 Initial valuation of accounts

receivable

The typical accounts receivable is valued at the

amount expected to be received, not the present

value of that amount.

Trade Discount

Cash Discount (sales discount)

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Trade Discount

Usually a percentage reduction from the list

price to change prices or to give quantity

discount to large customers

The discount is recognized indirectly by

recording the sale at the net of discount price,

not at the list price.

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Cash Discount (sales discount)

Reduce the amount to be paid if remittance is

made within a specified short period of time.

Represent reduction not in the selling price of

good or service but in the amount to be paid

within a specified period of time to provide

incentive for quick payment

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Cash discount: journal entries

The Hawthorne Manufacturing Company offers credit

customers a 2% cash discount if the sales price is paid

within 10 days. Any amounts not paid within 10 days

are due in 30 days. These repayment terms are stated

as 2/10, n/30. On October 5, 2003, Hawthorne sold

merchandise at a price of $20,000. The customer paid

$13,720 ($14,000 less the 2% cash discount) on

October 14 and the remaining balance of $6,000 on

November 4.

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Cash discount: journal entries

By either method, net sales is reduced by

discount taken

Discounts not taken are included in sales

revenue using the gross method and interest

revenue using the net method

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2.3 Subsequent Valuation

Two situations possibly could cause the cash

collected to be less than the initial valuation of

the receivable:

1. Sales returns: The customer could return the

product.

2. Uncollectible Accounts Receivable: The

customer could default and not pay the agreed

on sales price.

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Sales returns

Recognizing sales returns when they occur

could result in an overstatement of income in

the period of the related sale.

To avoid misstating the financial statements,

when amounts are material, when amount are

material, returns should be anticipated by

subtracting an allowance for estimated returns.

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Illustration

During 2003, 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 2003,

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:

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If sales returns are material, they should be

estimated and recorded in the same period in

the same as the related sales

The allowance for sales returns is a contra

account to accounts receivable. When returns

actually occur in the following reporting period,

the allowance for sales returns is debited. In this

way, income is not reduced in the return period

but in the period of the sales revenue.

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Uncollectible Accounts Receivable

Income statement approach

Estimate bad debt expense as a percentage of each

period’s net sales. The balance sheet amount is an

indirect outcome of estimating bad dent expense.

Balance sheet approach

Determine bad debt expense by estimating the net

realizable value of accounts receivable to be reported

in the balance sheet.

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Illustration

The Hawthorne Manufacturing Company sells its

products offering 30 days’ credit to its customers.

During 2003, its first year of operations, the following

events occurred:

Sales on credit $1,2000,000

Cash collections from credit customers (895,000)

Accounts receivable, end of year $305,000

There were no specific accounts determined to be

uncollectible in 2003. The company anticipates that

2% of all credit sales will ultimately become

uncollectible. 25