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CHAPTER 7
CASH and RECEIVABLES

Part 1: Read pages 335 - 348 and 363-368. Answer questions 1 - 6 below. Work Brief
Exercises 3, 5 and 6 and Exercises 1, 2, 20 and 23 from the book.
Part 2: Read pages 349-363. Work Brief Exercises 7, 8, 10 and 11 from the book.
Other recommended exercises: BE 15, 16 and 17; EX 4, 6, and 7; PR 2, 12, and 15.

1. “Cash, the most liquid of assets, is the standard medium of exchange and the basis
for measuring and accounting for all other items. It is generally classified as a
current asset.” (pg 336) What characteristics are required of cash amounts that
are reported in the first account on the balance sheet?

2. Sometimes compensating balance arrangements are reported in the notes to the

financial statements while at other times, the compensating balance is reported in
a separate cash account. When is each presentation appropriate?

3. How are bank overdrafts reported on the balance sheet?

4. What are cash equivalents? Give the definition and several examples.

Work Exercises 1 and 2 on page 371.

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INTERNAL CONTROLS:
Since cash is the most liquid of all assets and the most susceptible to theft, it is very
important that we establish good internal controls over cash.

INTERNAL CONTROLS are procedures designed to

1. safeguard assets (physically)
2. ensure reliable financial reporting
3. ensure that management’s objectives are carried out.

We are most interested in the first two objectives as accountants.

5. Read Appendix 7A. List some internal control procedures related to cash.

6. When the bank statement is received each month, the balance reported rarely, if
ever, agrees with the company’s cash balance. The differences are called
reconciling items. List at least five examples of reconciling items.

Work Exercises 20 on page 375 and Exercise 23 on page 376.

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RECEIVABLES

1. CURRENT RECEIVABLES vs. NONCURRENT RECEIVABLES – Current receivables are

those that are expected to be collected within a year or one operating cycle, whichever is longer.
All other receivables are noncurrent.

2. TRADE RECEIVABLES vs. NONTRADE RECEIVABLES -- Trade receivables are amounts

owed by customers for goods sold and services rendered as part of normal business operations.
Nontrade receivables arise from a variety of transactions – see page 341 for list.

3. ACCOUNTS vs. NOTES RECEIVABLE -- Accounts receivable are oral promises to pay for
goods or services sold, are normally due in 30-60 days and represent open accounts. Notes
receivable are written promises to pay a certain sum of money on a specified future date.

4. TRADE DISCOUNTS vs. CASH DISCOUNTS -- Trade discount is an amount subtracted from
list price to determine the selling price of the item. They are used to avoid frequent revisions of
catalogs, to give quantity discounts, and to hide the true selling price from competitors. Trade
discounts are not recorded in accounting records. Cash discounts are reductions in selling price
offered as an inducement for prompt payment.

5. NET METHOD vs. GROSS METHOD of recording cash discounts -- The net method records the
invoice net of the cash discount offered. The cash discount only appears in the accounting records
if it is not taken. The gross method records the invoice at the gross amount. The cash discount
appears in the accounting records only if it is taken. The net method is rarely used for sales
transactions. Work Brief Exercise 3 on page 369.

6. NONRECOGNITION OF THE INTEREST ELEMENT -- Ideally, receivables should be

measured in terms of their present value and any revenue after the sale is interest revenue. The
accounting profession (APB Opinion 21) specifically excludes from present value considerations
“receivables arising from transactions with customers in the normal course of business which are
due in customary trade terms not exceeding approximately one year.”

7. NET REALIZABLE VALUE (NRV) -- Short-term receivables are valued and reported at the NRV,
which is the net amount expected to be received in cash. NRV is the gross receivable balance
minus any amounts not expected to be collected such as bad debts and sales returns, allowances,
and cash discounts expected to be taken.

8. DIRECT WRITE-OFF vs. ALLOWANCE METHOD of recording uncollectibles -- Direct write-

off method makes no entry for bad debts until a specific account has been identified as
uncollectible. This method violates the matching principle because it does not match the expense
to the revenue. The allowance method estimates the amount of bad debts for the period and
records this in an adjusting entry. When a customer’s account is identified as uncollectible, it is
written-off against the allowance account.

9. INCOME STATEMENT vs. BALANCE SHEET APPROACH for estimating bad debts expense.
The income statement approach estimates bad debt expense as a % of credit sales. This amount is
debited to Bad Debt Expense and credited to Allowance for Bad Debts. This method focuses
totally on the income statement and does a better job of matching revenues and expenses. Work
Brief Exercise 5 on page 370.
The balance sheet approach estimates the amount of the accounts receivable outstanding at the
balance sheet date that are expected to be uncollectible (using either a % of total AR or an aging of
AR). The Allowance for Bad Debts account balance is adjusted to this amount (i.e., the adjusted
balance will be the amount determined as uncollectible). The necessary addition to the allowance
account is debited to Bad Debt Expense and credited to Allowance for Bad Debts. This method
focuses totally on the balance sheet and does a better job of reporting accounts receivable at the
net realizable value. Work Brief Exercise 6 on page 370.

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PART II starts here.

10. INTEREST-BEARING vs ZERO-INTEREST-BEARING NOTES RECEIVABLE

Interest-bearing notes have a stated rate of interest that is to be paid in addition to the face amount
of the note. Zero-interest-bearing notes include interest as a part of the face amount instead of
stating it explicitly. (Short-term notes are usually recorded at face value and long-term notes at
present value.) Work Brief Exercises 7 and 8 on page 370.

11. SECURED BORROWING vs. SALE OF RECEIVABLES (methods of transferring receivables)

Secured borrowing occurs when accounts receivable are pledged as collateral in a borrowing
transaction. If the loan is not paid when due, the creditor has the right to collect the receivables.
The creditor will normally charge a finance fee based on the accounts receivable pledged in
addition to the interest charged. This is recorded as an OTHER EXPENSE – FINANCE
CHARGE. The accounts receivable remain on the books until collected but the arrangement
must be disclosed in the notes to the financial statements.

Sale of receivables may occur through factoring or securitization (see page 357 for descriptions).

12. SALE OF RECEIVABLES WITH RECOURSE vs. WITHOUT RECOURSE

Without recourse means the purchaser of the receivables assumes the risk of collectibility of the
receivables and absorbs any credit losses. The sale is recorded as follows:
CASH (amount received) XX
LOSS ON SALE OF RECEIVABLES (purchaser’s fee) XX
DUE FROM FACTOR (amount retained by purchaser
to cover returns, allowances and discounts) XX
ACCOUNTS RECEIVABLE (face amount) XX

With recourse means the seller guarantees payment to the purchaser in the event the debtor fails to
pay. Sale is recorded as follows:
CASH (amount received) XX
LOSS ON SALE OF RECEIVABLES (purchaser’s fee + recourse liability) XX
DUE FROM FACTOR (amount retained by purchaser to cover returns,
allowances and discounts) XX
ACCOUNTS RECEIVABLE (face amount) XX
RECOURSE LIABILITY (amount of bad debts expected) XX

Work Brief Exercises 10 & 11 page 370

13. SALE vs. SECURED BORROWING (see page 359 for rules used to distinguish sales from
secured borrowings)

RATIO ANALYSIS:
Accounts Receivable Turnover Ratio = Net (credit) Sales / Average A/R (net)

Days to collect A/R = 365 days / A/R Turnover

These ratios are used to evaluate the liquidity of the company’s accounts receivable. The A/R Turnover
ratio measures the number of times (on average) the A/R are collected during the year. A higher turnover is
better, in general.

Days to Collect A/R (or days A/R outstanding) is easier to interpret. This tells how long it takes to collect
the A/R. If a company offers terms of 30 days and the ratio is 45 days, this may signal a problem with the
collection of A/R.

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CLASS EXAMPLE 1
CASH CLASSIFICATION EXERCISE
Listed below are items that may or may not be reported as cash. For each item that is
reported as cash, put a C in the space provided. If the item would qualify as cash
equivalents, put CE in the space. For all other items, indicate the proper
classification. Assume a balance sheet date of December 31, 2002.

a. Currency and coins on hand at close of business, 12/31/02

b. Money market fund with checking privileges

c. Postage stamps on hand

d. Customer checks received on 12/31/02 but not deposited until 1/01/03

e. Petty cash fund

f. Checking account balance at First National Bank

g. Savings account balance at Second National Bank

h. Certificates of deposit maturing June 15, 2003

i. Money orders received in mail on 12/31/02 but not yet deposited

j. Travel advances to employees (to be deducted from salaries)

k. Travel advances to employees who will not reimburse the company

l. Treasury bills purchased on November 15, 2002 and maturing on 1/15/03

m. Treasury bills purchased on October 12, 2002 and maturing 3/12/03

n. Commercial paper purchased on December 14, 2002 and maturing 2/14/03

o. Money market savings certificate maturing July 2, 2003

p. Legally restricted compensating balances related to short-term borrowing

arrangements

q. Legally restricted compensating balances related to long-term borrowing

arrangements

r. Bank overdrafts with no offsetting accounts

CLASS EXAMPLE 2

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TRADE AND CASH DISCOUNTS

The Roberts Company sold merchandise to Bowden Company on account on October

25, 2002. The catalog price for the merchandise was $10,000. Roberts gave a 20%
trade discount and offered credit terms of 2/10,n/30. In addition, a 1% penalty will be
imposed for every month the account is past due. How much must Bowden pay if the
invoice is paid on
a. November 3, 2002?

b. November 24, 2002?

c. April 25, 2003?

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CLASS EXAMPLE 3 – BAD DEBTS

The Bates Company had credit sales in 2001 of $800,000. Included in these credit sales
were sales to John Doe, $3,000 in December. The company’s year-end is December 31.
In July 2002 the company determined that John Doe would most likely not pay his
account.

1. When should the bad debt expense related to the sales to John Doe be recognized?
In 2001 when the sales were made or in 2002 when the company determines the
account to be uncollectible? Why?

2. If the company uses the direct write off method, when will the expense be
recorded for J. Doe’s account? Give the date and the entry.

3. Assume instead that the company uses the allowance method and estimates that
3% of credit sales will not be collected. Give the adjusting entry on December
31, 2001.

4. What amount will be reported as Bad Debt Expense on the 2001 income
statement?

5. Give the entry to write off John Doe’s account in July 2002.

6. How does the write-off of John Doe’s account affect net realizable accounts
receivable?

7. If John Doe pays his account on August 3, 2002, record the receipt of the cash.

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8. Assume the Houston Company uses the allowance method and based on an aging
of December 31, 2001 accounts receivable, determines that $20,000 of the
outstanding balances will not be collected. Give the adjusting entry on December
31, 2001 if the allowance account has a $2,000 credit balance before adjustment.

9. What amount will be reported as Bad Debt Expense on the 2001 income
statement for Houston Company?

10. What balance will be reported in the Allowance for Bad Debts account on the
December 31, 2001, balance sheet for Houston Company?

11. Give the adjusting entry for the Houston Company on December 31, 2001 if the
allowance account has a $2,000 debit balance before adjustment.

12. What amount will be reported as Bad Debt Expense on the 2001 income
statement for Houston Company?

13. What balance will be reported in the Allowance for Bad Debts account on the
December 31, 2001, balance sheet for Houston Company?

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CLASS EXAMPLE 4 – NOTES RECEIVABLE

The Williams Company received the following note from M. Brown in exchange for
merchandise.
For value received, I promise to pay on January 1, 2004, the sum of $10,000 plus interest at 10% per
annum payable January 1, 2003 and January 1, 2004.
Signed _____________________ Date January 1, 2002

a. Is the above note an interest-bearing or a zero-interest-bearing note?

b. If the market rate of interest on similar notes is 10%, what is the present value of the note?

c. If the market rate of interest on similar notes is 12%, what is the present value of the note?

d. If the market rate of interest on similar notes is 8%, what is the present value of the note?

For (e) – (h), assume the market rate of interest is 10% (see (b) above),
e. Record the receipt of the note on January 1, 2002.

f. Record the interest revenue on the note for 2002.

g. Record the receipt of the interest revenue on January 1, 2003.

h. Record the interest revenue on the note for 2003.

i. Record the receipt of cash in payment of the note on January 1, 2004.

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CLASS EXAMPLE 5 – NOTES RECEIVABLE

The Archie Company received the following note from A. Veronica in exchange for
merchandise.
For value received, I promise to pay the sum of $10,000 on January 1, 2004.
Signed _____________________ Date January 1, 2002

a. Is the above note an interest-bearing or zero-interest-bearing note?

b. If the market rate of interest on similar notes is 12%, what is the present value
of the note?

c. If the market rate of interest on similar notes is 10%, what is the present value
of the note?

d. If the normal sales price of the merchandise is $8,420, what is the implicit
interest rate on the note?

e. Assume the facts in (d) above. Record the receipt of the note on the books of
Archie Company.

f. Record the interest revenue on the note for the year 2002. Use the interest rate
you determined in (d) above.

g. Record the interest revenue on the note for the year 2003.

h. Record receipt of cash in payment of the note on January 1, 2004.

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CHAPTER 7 – PRACTICE PROBLEMS

1. Record journal entries for the following transactions. The Beam Company uses a
periodic inventory system. The Accounts Receivable account had a $100,000
balance at the beginning of the year. The Allowance for Bad Debts account had a
$2,000 balance at the beginning of the year.
(a) Total sales for the year were $700,000 of which $300,000 were cash sales and
the remainder credit sales.
(b) Collections on account during the year were $415,000.
(c) Wrote off the accounts of J Doe, $2,500 and B. Smith, $1,000 as uncollectible.
(d) Received payment of $800 from B. Smith in settlement of account written off
earlier. B. Smith indicated that he would not be able to make any further
payments.
(e) An aging of accounts receivable indicated that $3,000 of the outstanding accounts are not
expected to be collected. Prepare the adjusting entry.
Date Account Titles Debit Credit

(f) What amount will be reported as net realizable accounts receivable on the
year-end balance sheet?

(g) What amount will be reported as Bad Debt Expense on the income statement
for the year?

(h) Compute the accounts receivable turnover and the days to collect ratios for the
year.

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2. The Shaw Company accepted two notes during the year. Record the receipt of the
notes and the adjusting entries related to interest on December 31, 2001 for each
note. These are not normal trade terms for Shaw.
(a) Shaw sold inventory with a normal sales price of $500,000 in return for a
non-interest-bearing note. The note was dated May 1, 2001, matures in 3
years and has a face value of $665,500. The implied rate of interest on the
note is 10%.

(b) Shaw sold inventory with a normal sales price of $500,000 in return for an
interest-bearing note. The note was dated July 1, 2001, matures in 3 years,
has a face value of $500,000 and a stated interest rate of 10%. The interest
will be paid annually on July 1.

3. For each item below, indicate where it would appear on a bank reconciliation as
of October 31, 2002. Use the following codes:
a. Added to Balance per Bank
b. Deducted from Balance per Bank
c. Added to Balance per Books
d. Deducted from Balance per Books
e. Would not appear on the October 31, 2002 bank reconciliation

____ 1. The company wrote a check for $121 but posted $112 to the ledger.

____ 2. The bank charged the company’s account for an $800 check written by another
bank customer.

____ 3. Deposits of $7,000 made on October 31 did not appear on the bank statement for
October.

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____ 4. The company made a deposit of $7,457 but posted $4,757 to the ledger.

____ 5. The company wrote a check for $136 but posted $163 to the ledger.

____ 6. Checks for $7,800 were written in October but not processed by the bank.

____ 7. The bank statement included a bank service charge of $23.

____ 8. The bank statement included an NSF check in the amount of $423.

____ 9. The bank statement includes a debit memo for $625 for the company’s rent. The
rent is paid by automatic draft on the 4th of the month. The company has already
recorded the rent payment.

____10. The bank statement shows interest earned on the company’s checking account in
the amount of $32.

Which of the above items should the company make a journal entry for after
preparing the bank reconciliation? Indicate by placing an X by the number of
those items which require a journal entry.

1. ____ 2. _____ 3. _____ 4. _____ 5. _____

6. ____ 7. _____ 8. _____ 9. _____ 10. _____

_

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