Chapter 4: Cash & Receivables

Account for Cash & A/R, Bank Reconciliation, Uncollectible A/R, Note Receivables, Improve Cash Flows, Evaluate Company Liquidity

Account for Cash

What are Cash Equivalents?

Cash equivalents include liquid assets such as treasury bills, commercial paper, money market funds, which are interest-bearing accounts that are very close to maturity (3 months or less at the time of purchase). Slightly less liquid than cash, but similar enough to be reported along with cash.

What are Electronic Funds Transfers (EFT)?

EFTs moves cash by electronic communication through debit & credit card transactions, & if the customer pays through online banking. Many people pay bills & employers pay salary by EFT.

Prepare & Use a Bank Reconciliation

There are multiple documents used to control bank accounts which hold cash for people & companies, which are detailed below.

What is a Signature Card?

Banks require each person authorized to sign on an account to provide a signature card. This protects against forgery.

What is a Deposit Slip?

Banks supply standard account forms such as deposit slips. The customer fills in the amount of each deposit. As proof of the transaction, the customer keeps a deposit receipt.

What are Cheques?

To pay cash, the depositor can write a cheque, which tells the bank to pay the designated party a specified amount.

The 3 Parties to a Cheque

  • Maker: Entity signing the cheque.
  • Payee: The entity to whom the cheque is paid.
  • Bank: On which the cheque is drawn.

What is the Remittance Advice?

It’s an optional attachment to a cheque which tells the payee the reason for the payment & is used as a source document for posting the proper accounts.

What is a Bank Statement?

Reports the activity in a bank account. The statement shows the accounts beginning & ending balances, cash receipts, payments & EFTs.

Bank Reconciliation

What is Bank Reconciliation?

There are 2 records of a business’ cash:

  • The Cash account in the company’s general ledger.
  • The bank statement, which shows the cash receipts & payments transacted through the bank.

The books & the bank statement usually show different cash balances. Differences arise because of a time lag in recording transactions. Here are 2 examples:

  • When you write a cheque, you immediately record it in your chequebook as a deduction. But the bank doesn’t subtract the cheque from your account until the payee cashes it later. Likewise, you record the cash receipts for all your deposits as additions but it may take a day or 2 for the bank to add deposits to your balance.
  • Your EFT payments & cash receipts are recorded by the bank before you learn of them.

To make accurate cash records, they must be updated (either online or after receiving bank statements). The result is preparing a bank reconciliation, which explains all differences. We all the cash records the books or chequebooks.

The person preparing a bank reconciliation should have no other cash duties & be independent of cash activities. Otherwise, they can steal cash & manipulate the reconciliation to conceal the theft.

Preparing the Bank Reconciliation

Bank Side of the Reconciliation

Items to show on the Bank side of the bank reconciliation include the following:

  • Deposits in Transit: Outstanding deposits. You have recorded these deposits, but the bank has not. Add deposits in transit on the bank reconciliation.
  • Outstanding Cheques: You have recorded these cheques, but the payees have not yet cashed them. Subtract outstanding cheques.
  • Bank Errors: Correct all bank errors on the Bank side of reconciliation. For example, the bank may erroneously subtract from your account a cheque written by someone else.

These items are recorded in the company’s books but not by the bank.

Book Side of the Reconciliation

Items to show on the Book side of the bank reconciliation include the following:

  • Bank Collections: Bank collections are cash receipts that the bank has recorded for your account. But you haven’t recorded the cash receipt yet. Many businesses have their customers pay directly to their bank. This is called a lockbox system & reduces theft. An example is a bank collecting an account receivable for you. Add bank collections on the bank reconciliation.
  • EFTs: The bank may receive or pay cash on your behalf. An EFT may be a cash receipt or a cash payment. Add EFT receipts & subtract EFT payments.
  • Service Charge: This cash payment is the bank’s fee for processing your transactions. Subtract service charges.
  • Interest Income: On some bank accounts, you earn interest if you keep enough cash. Add interest income.
  • Nonsufficient Funds (NSF) Cheques: NSF cheques are cash receipts from customer who don’t have sufficient funds in their bank account to cover the amount. These bad cheques are treated as cash payments on your bank reconciliation. Subtract NSF cheques.
  • Cost of Printed Cheques: This cash payment is handled like a service charge. Subtract this cost.
  • Book Errors: Correct all book errors on the Book side of the reconciliation.

These items are recorded by the bank but not company, therefore journal entries must be prepared.

Bank Reconciliation Illustrated

Summary of the Various Reconciling Items

Recording Transactions from the Bank Reconciliation

The bank reconciliation is a tool separate from the journals & ledgers. It doesn’t account for transactions in the journal. To get transactions into the accounts, we must record journals entries & post them to the ledger. All items on the Book side of the bank reconciliation require journal entries.

Online Banking

Online banking allows you to pay bills & view your account electronically without having to wait until the end of the month to get a bank statement. This allows you to reconcile transactions any time & keep your account current whenever you wish.

Account for Receivables

Receivables are the third most-liquid asset after cash and short-term investments.

Types of Receivables

What are Receivables?

Monetary claims against others. They are acquired mainly by selling products on account (accounts receivable) or by lending money (notes receivable).

There are 2 major types of receivables:

  • Accounts Receivable: The amounts collectible from customers from the sale of products. They are current assets, and are sometimes known as trade receivables or receivables. They’re control accounts that summarize total amount receivable from customers. Subsidiary ledgers know separate accounts for each customer, however.
  • Notes Receivable: More formal contracts than accounts receivable. The borrowers sign a written promise to pay the creditor a definite sum at the maturity date. Also known as promissory notes. The note may require the borrower to pledge security for the loan, which gives the lender permission to claim certain assets called collateral.
  • Other Receivables: A miscellaneous category that includes loans to employees & subsidiary companies. Some companies report other receivables under the heading Other Assets on the balance sheet.

How Do We Manage the Risk of Not Collecting?

Uncollectible Accounts Receivables

What is Bad Debt Expense?

Companies rarely collect all their accounts receivables, so they must account for what they do not collect. When a customer doesn’t pay, the debt has gone bad. This cost is commonly called an uncollectible account expense or a doubtful account expense.

Accounts receivable are reported in the financial statements at cost minus an appropriate allowance for uncollectible accounts. Net realizable value is the amount a company expects to collect. This may be reported in the notes, or on the balance sheet:

Bad debt expense is usually reported as an operating expense on the income statement. To measure bad debt expense, the allowance method is used.

What is the Allowance Method?

Best way to measure bad debts. Records losses from failure to collect receivables. The company estimates Bad Debt Expense and sets up an Allowance for Uncollectible Accounts. Other titles for include Allowance for Doubtful Accounts & Allowance for Bad Debts. This is a contra account to Accounts Receivable.

What is the Aging-of-Receivables Method?

This method is a balance-sheet approach because it focuses on what should be the most relevant and faithful representation of accounts receivable as of the balance sheet date. In the aging method, individual receivables from specific customers are analyzed based on how long they have been outstanding. Time periods (0-30 days, 30-60, 60-90, 90+) have respective percentages that estimate the percent of money that won’t be collected in Account Receivable.

Writing off UncollectIble Accounts

If the write-offs are greater than the balance in the Allowance for Uncollectible Accounts, it will result in a debit balance in the Allowance account. This means that management’s estimate of bad debts was too low and needs to be higher. Write-off has no effect on total assets & net income.

Recovery of an Uncollectible Account

Even though an account is written off, money is still owed & can be paid off, at least in part. To account for this recovery, the company makes 2 journal entries to

  1. Reverse earlier write-off
  2. Record cash collection

Summary of Transactions for Accounts Receivable

Computing Cash Collections from Customers

There’s a time lag between earning revenue & collecting cash. Receivables typically hold only 5 different items:

Suppose you know all these amounts except collections from customers. You can compute collections by solving for X in the T-account. The equation is $200 1 $1,800 2 X 2 $100 5 $400. X 5 $1,500.

Account for Notes Receivable

What are Notes Receivable?

Notes receivable are more formal than accounts receivable. Notes due within 1 year are current assets. Notes due beyond 1 year are long-term receivables & non-current. Some are collected in instalments. The portion due within 1 year is current & remainder is a long-term asset.

The debtor signs the note and thereby creates a contract with the creditor.

Key Terms

  • Creditor: The party to whom money is owed. Also called the lender. The debt is a note receivable from borrower.
  • Debtor: The party that borrowed and owes money on the note. The debtor is also called the maker of the note or the borrower. The debt is a note payable to the lender.
  • Interest: Interest is the cost of borrowing money. The interest is stated as an annual percentage rate.
  • Maturity Date: The date on which the debtor must pay the note.
  • Principal: The amount of money borrowed by the debtor.
  • Term: The length of time the debtor must repay the note.

Accounting for Notes Receivable

Collecting the Note

Things to Note

  • Interest Rates are always for an annual period unless otherwise stated.
  • The time element is the fraction of the year that the note has been in force.
  • Interest is often completed for many days.

Selling on Notes Receivable

Sometimes, when the payment term extends beyond 30-60 days, companies sell on notes receivable. This means entries to record & collect would credit Sales Revenue instead of Cash.

Converting Account Receivable to Note Receivable

A company may also accept a note receivable from a trade customer whose account receivable is past due. The customer signs a note, & the company credits the account receivable & debits a note receivable. We would say the company “received a note receivable from a customer on account”.

Improving Cash Flows from Sales & Receivables

  • Credit Card Sales: The merchant lets the customer pay with a credit card, such as VISA, MasterCard, or a company credit card such as Hudson’s Bay Company. But there’s a cost; the credit card fee is an operating expense.
  • Debit Card Sales: The merchant sells & customer pays by swiping a bank card. This is like cash to the merchant. But there’s a cost; the interac fee.
  • Selling (Factoring) Receivables: Companies can sell its accounts or notes receivable to another business, called a factor. The factor earns revenue by paying a discounted price for the receivables & then collecting the full amount from customers. The discounted price, for the company, is a financing expense.

Reporting Receivables on Statement of Cash Flows

Receivables bring in cash when the business collects from customers. These transactions are reported as operating activities.

Evaluate a Company’s Liquidity

Order of Assets on Balance Sheet based on Liquidity

  1. Cash & Cash Equivalents
  2. Short-Term Investments
  3. Current Receivables
  4. Merchandise Inventory
  5. Prepaid Expenses

What is the Acid-Test (or Quick) Ratio?

A stringent measure of a company’s ability to pay current liabilities. It’s like the current ratio but excludes inventory & prepaid expenses.

The higher the acid-test ratio, the easier it is to pay current liabilities.

What is Days’ Sales in Receivables?

Days’ sales in receivables, also called the collection period, tells how long it takes to collect the average level of receivables. Shorter is better because cash is coming in quickly.

2 Steps to Calculate Days’ Sales in Receivables

  1. Accounts Receivable Turnover =
  2. Days' Sales in Receivable =

Using Liquid Ratios in Decision Making

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