Cash receivables management

Chapter 7
Cash and
Receivables
Skyline College
Lecture Notes

Pivotal Issues When Managing
Cash and Receivables
1. Cash needs
2. Credit policies
3. Level of accounts receivable
4. Financing receivables
5. Ethical estimates on credit sale
losses
Copyright © Houghton Mifflin Company. All rights reserved. 7–2

Cash Considerations
Most liquid of all assets
Central to operating cycle
Consists of:
Currency and coins on
hand
Checks and money
orders from customers
Deposits in checking
and savings accounts
Cash may include a
compensating balance—a
minimum amount required
by a bank for a credit-granting
agreement.

Cash Requirements
Seasonal
Cycles and
Cash
Requirements
for a
Manufacturer
of Athletic
Sportswear

Credit Policies
To increase the likelihood of selling to customers who will
pay on time, companies develop control procedures and
maintain a credit department
The credit department:
 Examines the financial resources and debts of the
credit applicant
 Asks for personal references
 Gets credit rating from credit bureaus
 Determines the extent to which the company can
grant credit, if any

Evaluating the Level of
Accounts Receivable
How many times, on
average, does a company
turn its receivables into
cash during an accounting
period?
How long, on
average, does it take a
company to collect its
accounts receivables?
Receivable Turnover Days’ Sales
Uncollected

Receivable Turnover
Reflects the relative size of a company’s accounts
receivable and the success of its credit and
collection policies
Receivable Turnover =
Net Sales
Average Net Accounts Receivable
$12,253.1
($2,120.2 + $2,083.9) ÷ 2
(Amounts in Millions)
Nike’s Receivable
Turnover for 2004
=
= 5.8 times

Days’ Sales Uncollected
To interpret a company’s ratios, take into
consideration the industry in which it operates
Days’
Sales Uncollected =
Nike’s Days’
Sales Uncollected =
365 days
Receivable Turnover
365 days
5.8
= 62.9 days

Receivable Turnover for
Selected Industries

Financing Receivables
Money tied up in receivables is something that many
companies seek to avoid
Companies may use one or more of these methods
so that they can receive cash faster:
Set up a separate
finance company
Borrow money
and pledge A/R
In case of default on
loan, A/R (collateral)
can be taken and
converted to cash to
satisfy the loan
Factor
A/R
Sale or transfer of A/R;
the buyer may bear risk
of collection (factoring
without recourse) or the
seller may bear risk of
collection (factoring
with recourse)
Ford Ford Motor Credit
Company
GM General Motors
Acceptance Corp.
Sears Sears Roebuck
Acceptance Corp.

How Factoring Works

Factoring Details
Typically 2% of total A/R for
sales with recourse; Higher fee
for sales without recourse
Reports a contingent liability (a
potential debt that can develop if
customers don’t pay receivables)
What fees are charged?
What does the seller of
receivables with
recourse report in
financials?

Securitization
A company may sell a group of receivables in a batch
at a discount to another company or to investors
When receivables are paid, buyer gets full
amount, thus their profit depends on the amount
of discount they negotiated
Circuit City
Sells its receivables without recourse, so it
has no further liability even if customers
do not pay

Discounting
The sale of promissory notes held
as notes receivable
Company A
Holds $10,000 note
payable to Company B;
Note will pay $600 in
Bank
Buys the note for
$9,600
interest  If Company B pays,
bank will receive
$10,600 and realize a
$1,000 profit
 If Company B defaults,
Company A is liable
for the note
Company A should
disclose the contingent
liability (in the amount
of note plus interest) in
notes to its financial
statements

Estimating Uncollectibles
There will always be
customers who do not
pay their accounts,
called uncollectible
accounts, or bad debts
Match these expenses
of selling on credit to
the revenues they help
generate
Estimate the uncollectible
expense in the fiscal year
in which the sales are
made

Estimating Uncollectibles and Ethics
Because estimations are involved, earnings
may be easily manipulated…
earnings are overstated.
earnings are
understated.
If the amount of losses
from uncollectible accounts
are understated,
If the amount of losses
from uncollectible accounts
are overstated,

Discussion: Ethics in the World
WorldCom increased revenues and hid losses
by continuing to bill customers for service
for years after the customers had stopped
paying.
Q. What impact do you think WorldCom’s
actions had on Accounts Receivable and
Sales?

Cash Equivalents
Investments like time deposits or certificates of
deposit (CDs) that have a term of 90 days or less
Nike’s Annual Report, 2005
Cash and equivalents represent cash and short-term, highly liquid
investments with original maturities of three months or less at the time
of purchase. The carrying amounts reflected in the consolidated
balance sheet for cash and equivalents approximate fair value due to
their short maturities.

Cash Control:
Electronic Funds Transfer (EFT)
Method of conducting business transactions
in which funds are transferred electronically
from one bank to another bank
Wal-Mart makes
75% of its
payments to
suppliers using
EFT
Electronic Banking
ATM transactions
Debit and credit card purchases
Online bill-pay

Direct Charge-Off Method
Recognize a loss
at the time it is
determined that
an account is
uncollectible
Date Uncollectible Accounts Expense XXX
Tax law requires
use of this
method when
computing
taxable income
Accounts Receivable XXX
Most companies do not use this method for financial reporting
purposes because it does not conform to GAAP.

The Allowance Method
Losses from bad debts are matched against the
sales they help generate
At the time of sale, management cannot
identify which customers will not pay
To observe the matching rule, losses from
uncollectible accounts must be estimated
The estimate becomes an expense in the fiscal
year in which the sales are made

Alternate Account Names
Allowance for
Uncollectible Accounts
Uncollectible
Accounts Expense
Allowance for Doubtful
Accounts
Allowance for Bad
Debts
Bad Debts Expense

Estimating Uncollectible Accounts
• Estimated loss should be:
Realistic
Based on objective information
Based on past experience
Based on current economic conditions
Two commonly used
methods for
estimating loss
1. Percentage of net sales method
2. Accounts receivable aging method

Percentage of Net Sales Method
How much of this year’s
net sales will not be
collected?
The answer determines the
amount of uncollectible
accounts expense for the year
The percentage amount is ususally based on the
company’s historic losses
It ignores the difference between last year’s estimated
losses and the actual losses incurred during the year

Percentage of Net Sales Method
Dec. 31, 20x9: Account balances: Sales, $645,000; Sales Returns and
Allowances, $40,000; Sales Discounts, $5,000; Allowance for
Uncollectible Accounts, $3,600. Management estimates that
uncollectible accounts will average about 2 percent of net sales.
Uncollectible accounts expense = .02 x ($645,000 – $40,000 – $5,000) = $12,000
Dec. 31 Uncollectible Accounts Expense 12,000
Allowance for Uncollectible Accounts 12,000
To record the uncollectible accounts
expense at 2 percent of $600,000 net sales
Allowance for Uncollectible Accounts
Dec. 31 3,600
Dec. 31 adj. 12,000
Dec 31 bal. 15,600
After the above entry is
posted, Allowance for
Uncollectible Accounts will
have a credit balance of
$15,600

Accounts Receivable Aging Method
How much of the ending
balance of accounts
receivable will not be
collected?
The ending balance of
Allowance for
Uncollectible Accounts is
determined directly
through an analysis of
accounts receivable
The difference between the amount determined to be
uncollectible and the actual balance of Allowance for
Uncollectible Accounts is the expense for the period.

7–27
Analysis of Accounts Receivable
by Age
 The total past due for each category is multiplied by the
estimated percentage uncollectible
 The sum of the totals for each category is the estimated
balance of Allowance for Uncollectible Accounts
Notice that the estimated percentage uncollectible increases as
accounts become further past due.

(Case 1)
Dec. 31, 20x6: Management has estimated that $2,459 of Accounts
Receivable are uncollectible. Allowance for Uncollectible Accounts
has a credit balance of $800.
Dec. 31 800
Dec. 31 adj. 1,659
Dec. 31 bal. 2,459
A credit adjustment of $1,659 will bring
the account to its target balance
The target balance for
the account is $2,459
To bring the allowance for uncollectible
accounts to the level of estimated losses

(Case 2)
Dec. 31, 20x6: Management has estimated that $2,459 of Accounts
Receivable are uncollectible. Allowance for Uncollectible Accounts
has a debit balance of $800.
Dec. 31. 800
Dec. 31 adj. 3,259
Dec. 31 bal. 2,459
A credit adjustment of $3,259 will bring
the account to its target balance
The target balance for
the account is $2,459
To bring the allowance for uncollectible
accounts to the level of estimated losses

Comparison of Two Methods

Estimates Differ from Write-Offs?
Accounts receivable written off during a period will
rarely equal the estimated uncollectible amount
Shows a credit balance
when the total of
accounts written off is
less than the estimated
uncollectible amount
Shows a debit balance
when the total of
accounts written off is
greater than the
estimated uncollectible
amount

Writing Off an Uncollectible Account
When it becomes clear an account will not
be collected, the amount should be written
off to:
• Allowance for Uncollectible Accounts
• Accounts Receivable
The uncollectible amount was already
accounted for as an expense when the
allowance was established

Jan. 15, 20x7: R. Deering, who owes the company $250, is
declared bankrupt by federal court.
7–33
Writing Off an Uncollectible
Jan. 15 Allowance for Uncollectible Accounts 250
Accounts Receivable 250
To write off receivable from R. Deering as
uncollectible because of his bankruptcy
D e c . 3 1 2 , 4 5 9
Bal. 2,209
Net realizable value of A/R
Before write-off
$44,400 – $2,459 = $41,941
Jan. 15 250
The write-off does not affect
the estimated net realizable
value of accounts receivable
Accounts Receivable
Dec. 31 44,400
Jan. 15 250
Bal. 44,150
After write-off
$44,150 – $2,209 = $41,941

Making and Paying Notes
A promissory note is an unconditional promise to
pay a definite sum of money on demand at a future
date
Maker
Person or company that
signs the note and
promises to pay the
amount
Payee
Entity to whom
payment is to be made
All promissory notes that the
payee holds that are due in less
than one year are categorized as
notes receivable in the current
assets section of the balance sheet
All promissory notes that the
maker holds that are due in less
than one year are categorized as
notes payable in the current
liability section of the balance
sheet

A Promissory Note

Key Components of Promissory Notes
Maturity Date Date on which the note must be paid
Length of time in days between the
note’s issue date and its maturity date
Cost of borrowing money or the return
for lending money, usually stated on an
annual basis
Total proceeds of a note at maturity
date (face value plus interest)
Duration
Interest and
Interest Rate
Maturity Value

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