Financial Accounting: Chapter 4 – Cash and Receivables (Study Notes)

Cash and Receivables

Introduction

This chapter covers the accounting treatment, reporting, and management of cash and receivables, which are essential components of a company's current assets. Understanding these topics is crucial for accurate financial reporting and effective cash flow management.

Reporting Cash on the Balance Sheet

Cash and Cash Equivalents

Cash is reported as a single total on the balance sheet, often combined with cash equivalents. Cash equivalents are short-term, highly liquid investments that are readily convertible to known amounts of cash and are subject to insignificant risk of changes in value.

• Examples of cash equivalents:

  • Treasury bills

  • Commercial paper

  • Money-market funds

Key Point: Cash and cash equivalents are the most liquid assets and are critical for meeting short-term obligations.

Bank Reconciliation

Purpose and Process

Bank reconciliation is the process of matching the cash balance on a company's books to the corresponding amount on its bank statement. Differences often arise due to timing lags and errors, and reconciliation ensures accuracy in financial records.

• Two records of cash:

  • The Cash account in the general ledger

  • The bank statement

• Common reasons for differences:

  • Time lags in recording transactions

  • Errors in either the bank or book records

Bank Account as a Control Device

Various documents help control and verify cash transactions:

• Signature card: Protects against forgery

• Deposit slip: Proof of transaction

• Cheque:

  • Maker – signs the cheque

  • Payee – to whom the cheque is paid

  • Bank – where funds are drawn

• Bank statement: Reports activity in a bank account

• Bank reconciliation: Matches book and bank records

Bank Statement and Electronic Funds Transfer (EFT)

The bank statement summarizes all transactions, including deposits, withdrawals, and charges. Electronic Funds Transfer (EFT) allows payments and receipts to be made electronically, improving efficiency and control.

Reconciling Items

Reconciling items are classified as either bank-side or book-side adjustments:

• Bank Side:

  • Deposits in transit (add)

  • Outstanding cheques (subtract)

  • Bank errors (add or subtract)

• Book Side:

  • Bank collections (add)

  • Electronic funds transfers (EFT) (add or subtract)

  • Service charges (subtract)

  • Interest income (add)

  • NSF (insufficient funds) cheques (subtract)

  • Cost of printed cheques (subtract)

  • Book errors (add or subtract)

Bank Reconciliation Example

Suppose the bank statement shows $5,931.51 and the company's books show $3,294.21. Reconciling items such as deposits in transit, outstanding cheques, and errors explain the difference.

Bank Side	Book Side
Deposit in transit: $1,591.63 Bank error: +$100.00 Outstanding cheques: -$1,350.14	Rent revenue (EFT): +$904.03 Note receivable collected: +$2,114.00 Interest revenue: +$28.01 Book error correction: +$360.00 Service charge: -$14.25 NSF cheque: -$52.00 Insurance expense (EFT): -$361.00

Journalizing Bank Reconciliation Items

Adjustments on the book side require journal entries:

• Items added to book side: Debit Cash

• Items subtracted from book side: Credit Cash

Example Journal Entry:

• Debit Cash, Credit Interest Revenue (for interest earned)

• Debit Cash, Credit Note Receivable and Interest Revenue (for note collected by bank)

• Debit Accounts Receivable, Credit Cash (for NSF cheque)

Accounts Receivable

Definition and Classification

Accounts receivable are monetary claims against customers arising from selling goods or services on credit. They are the third most liquid asset after cash and short-term investments.

• Control account in the general ledger summarizes total due from customers

• Subsidiary ledger contains separate accounts for each customer

Notes Receivable

Notes receivable are formal written promises to pay a specified amount at a future date, usually with interest. They are also called promissory notes and can be current or long-term assets.

• Lender: Party to whom money is owed

• Maker: Party that borrows and owes money

• Principal: Amount borrowed

• Interest: Cost of borrowing, stated as annual rate

• Maturity date: Date when payment is due

Risks and Management of Credit Sales

Credit Policies

Granting credit increases sales but introduces the risk of non-collection. Companies should:

• Grant credit only to creditworthy customers (run credit checks)

• Monitor customer payment habits

• Minimize collection period to optimize cash flow

Accounting for Uncollectible Receivables

Allowance Method

The allowance method estimates and records losses from uncollectible accounts based on past experience. It uses a contra-account, Allowance for Uncollectible Accounts, to show the expected amount not to be collected.

• Bad debt expense is recognized in the period of the related sales

• Contra-account reduces accounts receivable to its realizable value

Partial Balance Sheet Example:

Current Assets	Amount
Accounts Receivable	$100,000
Less: Allowance for Uncollectible Accounts	($5,000)
Net Accounts Receivable	$95,000

Aging-of-Receivables Method

This method analyzes individual customer balances by age to estimate uncollectibles. Older accounts are more likely to be uncollectible.

• Prepare an aging schedule

• Apply estimated uncollectible percentages to each age category

• Adjust allowance account to match total from aging schedule

Example Aging Schedule:

Age of Account	Balance	Estimated Uncollectible %
Current	$58,000	2%
31-60 days	$10,300	5%
61-90 days	$2,500	10%
Over 90 days	$3,000	35%

Calculation:

• Allowance for Uncollectible Accounts = (58,000 x 2%) + (10,300 x 5%) + (2,500 x 10%) + (3,000 x 35%)

Writing Off Uncollectible Accounts

When an account is deemed uncollectible, it is written off against the allowance account. This does not affect net receivables.

• Journal Entry: Debit Allowance for Uncollectible Accounts, Credit Accounts Receivable

Impact of Write-Off

Net accounts receivable remains unchanged after a write-off, as both gross receivables and the allowance decrease by the same amount.

Computing Cash Collections from Customers

To determine cash collected from customers:

• Start with beginning accounts receivable

• Add credit sales

• Subtract write-offs

• Subtract ending accounts receivable

Formula:

$\text{Collections from customers} = \text{Beginning balance} + \text{Sales on credit} - \text{Write-offs} - \text{Ending balance}$

Speeding Up Cash Flow from Sales

Strategies

Rapid cash flow enables companies to pay liabilities and finance growth. Strategies include:

• Offering sales discounts for early payment

• Charging interest on overdue accounts

• Accepting credit and debit card payments

Credit Card Sales: Increase sales but incur a fee (operating expense) for the retailer.

Accounting for Notes Receivable and Interest Revenue

Notes Receivable

Notes receivable can be current or long-term assets. Key terms:

• Lender: Party to whom money is owed

• Maker: Party that borrows

• Principal: Amount borrowed

• Interest rate: Annual percentage

• Maturity date: Date payment is due

Interest Calculation

Interest is usually stated as an annual rate. For periods less than a year, use a fraction:

$\text{Interest} = \text{Principal} \times \text{Rate} \times \frac{\text{Time}}{12}$ (for months)

$\text{Interest} = \text{Principal} \times \text{Rate} \times \frac{\text{Days}}{365}$ (for days)

Reporting on the Statement of Cash Flows

Cash collected from accounts receivable is reported as an operating activity. Cash collected from notes receivable is reported as an investing activity.

Evaluating Liquidity Using Ratios

Current Ratio

The current ratio measures a company's ability to pay short-term obligations:

$\text{Current Ratio} = \frac{\text{Total Current Assets}}{\text{Total Current Liabilities}}$

Acid-Test (Quick) Ratio

The acid-test ratio (or quick ratio) excludes inventory and prepaid expenses:

$\text{Acid-Test Ratio} = \frac{\text{Cash} + \text{Short-term Investments} + \text{Net Current Receivables}}{\text{Total Current Liabilities}}$

Days' Sales in Receivables

This ratio measures how quickly receivables are collected:

$\text{Average Daily Sales} = \frac{\text{Net Sales}}{365}$

$\text{Days' Sales in Receivables} = \frac{\text{Average Receivables}}{\text{Average Daily Sales}}$

Where average receivables = (Beginning net receivables + Ending net receivables) / 2

Analyzing Receivables Collectability Using Excel Pivot Tables

Pivot Table Application

Managers can use Excel pivot tables to summarize invoices by "Days past due" categories and apply estimated uncollectible percentages to each category, aiding in the estimation of total uncollectible accounts.

Summary Table: Reconciling Items

Bank Balance Adjustments	Book Balance Adjustments
Add deposits in transit Subtract outstanding cheques Add/subtract bank errors	Add bank collections, interest revenue, EFT receipts Subtract service charges, NSF cheques, EFT payments Add/subtract correction of book errors

End of Chapter Four